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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Fiscal Year ended December 31, 1999
or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ________ to ________
COMMISSION FILE NUMBER: 333-92581
comstar.net, inc.
(Exact name of registrant in its charter)
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Georgia 58-2235514
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
2812 Spring Road, Suite 210, Atlanta, Georgia 30339
(Address of principal executive offices) (Zip Code)
(Registrant's telephone number, including area code): (770) 485-6000
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Securities registered pursuant to Section 12(b) of the Act:
None
(Title of class)
Securities registered pursuant to Section 12(g) of the Act: None
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(Title of each class) (Name of each exchange on which registered)
N/A N/A
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports); and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers in response to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The estimated aggregate market value of the voting stock held by non-affiliates
of the registrant is not determinable because there is no trading market for
the common stock and no shares of common stock have been sold during the past
60 days. As of March 15, 2000, the Registrant had 12,428,514 shares of Common
Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3) under the Securities Act of 1933, included within
the registrant's registration statement on Form S-1 (No. 333-92581), are
incorporated by reference in Part IV of this annual report on Form 10-K.
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INDEX OF FORM 10-K
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Item 1. Business...........................................................................................1
Item 2. Properties........................................................................................15
Item 3. Legal Proceedings.................................................................................15
Item 4. Submission of Matters to a Vote of Security Holders...............................................15
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.............................17
Item 6. Selected Financial Data...........................................................................17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.............19
Item 7A. Quantitative and Qualitative Disclosure About Market Risk.........................................27
Item 8. Consolidated Financial Statements and Supplementary Data..........................................27
Item 9. Changes and Disagreements with Accountants in Accounting and Financial Disclosures................27
Item 10. Directors and Executive Officers of the Registrant................................................28
Item 11. Executive Compensation............................................................................31
Item 12. Security Ownership of Certain Beneficial Owners and Management....................................35
Item 13. Certain Relationships and Related Transactions....................................................36
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................................37
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PART I
ITEM 1. BUSINESS
This Annual Report contains several "forward-looking statements"
concerning comstar.net's operations, performance, prospects, strategies and
financial condition, including its future economic performance, intent, plans
and objectives and the likelihood of success in developing and expanding its
business. These statements are based upon a number of assumptions and estimates
which are subject to significant uncertainties, many of which are beyond the
control of comstar.net. Words such as "may," "would," could," "will," "expect,"
"anticipate," "believe," "intend," "plan," and "estimate" are meant to identify
such forward-looking statements. Actual results may differ materially from
those expressed or implied by such forward-looking statements. Factors that
could cause actual results to differ materially include, but are not limited
to:
- comstar.net's limited operating history and whether it will be able
to achieve or maintain profitability;
- whether comstar.net can attract and retain sales and marketing
personnel or enter new marketing alliances to grow its business;
- whether comstar.net can obtain, continue and manage growth or
execute agreements with new customers;
- increased competition;
- the unknown effects of possible system failures and rapid changes
in technology; and
- other factors discussed in this Annual Report and in comstar.net's
registration statement on Form S-1 (No. 333-92581) as declared
effective by the Securities and Exchange Commission on December 30,
1999, including the "Risk Factors" section contained therein.
OVERVIEW
We are a rapidly growing provider of Internet services to middle
market businesses, educational institutions and governmental organizations
seeking a reliable, timely, and cost-effective Web presence for their business
operations that rely on the Internet. Although we derive more than half of our
revenues from providing high speed Internet access, our growth strategy is
focused on our dedicated application server hosting, or DASH, services and our
co-location services. With our DASH services we provide and maintain a server
for the customer's exclusive use to install any software application the
customer chooses. We also provide co-location services, in which we provide
secure space to house customer-owned Internet equipment, and dedicated
high-speed Internet access through our highly reliable network, which provides
continuous Internet access to our customers by using multiple large ISPs and
routing traffic around congested Internet exchange points.
Our primary target market for our DASH services includes application
service providers, or ASPs, and middle market businesses. We believe our DASH
services offer significant value to:
- ASPs who rely on us to provide the base infrastructure for their
business, reducing the large capital expense for hardware and
facilities that they would otherwise have to incur and allowing
them to focus on delivering applications to their customers.
- Middle-market businesses seeking to develop and deploy competitive
Internet-based strategies. We believe that our affordable DASH
services relieve these businesses of the high capital expenditures
that they would otherwise have to incur for hardware and facilities
and for costly technical experts to develop and maintain their
networks.
We expect our DASH services to grow more rapidly than our other
services, to cost less to offer and to provide us with a suite of products that
differentiate us from our competitors.
In addition, we recently began offering our eCommerce Guarantee, or
eCG, to our Internet access customers. We will reimburse our eCG customers' lost
gross e-commerce profits, up to a specified limit per access line, for certain
interruptions they suffer in their Internet access. The eCG applies if (a) the
interruption occurs outside the point in the
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Internet communications network at which the customer assumes responsibility,
and (b) the customer loses gross e-commerce profits as a result. We expect this
program to be fully operational in April 2000.
We believe our growth and success in serving our target customer base
is the direct result of our competitive strengths, including:
- business Internet solutions that allow our customers to outsource a
significant portion of their Internet technology and staff,
- a network design that permits our customers to bypass congested
Internet exchange points and avoid Internet exchange breakdowns,
which increases the speed and reliability of our customers'
Internet connection,
- our simple, turnkey DASH services, which offer customers high
quality, dedicated Web platforms,
- Internet access that we can tailor to meet each customer's needs,
- over 100 business alliances which provide complementary design,
development and integration services for our customers and
represent a significant source of new customer referrals for us,
- a growing, geographically distributed field sales force,
- knowledgeable and responsive customer support by our network
experts, and
- a senior management team with 60 years of combined experience in
designing, implementing and managing communications networks.
INDUSTRY BACKGROUND AND OPPORTUNITY
The Internet was originally conceived as a communications tool to be
used by a limited number of researchers and academics. Today, it has escalated
into a Web of approximately 196 million interconnected users. The Internet has
evolved from a static, text-based medium to a graphically rich communications
infrastructure. The creation and rapid development of the desktop computer
simplified access to the Internet, encouraging consumers to seek information
through this new medium. As the breadth of the information expanded, the
Internet's applications and users grew as well. Businesses began investigating
the potential of the Internet to reach the growing volume of customers on the
Internet. To capture this emerging customer base, businesses needed a presence
on the Internet and applications to facilitate electronic commerce.
THE INTERNET INFRASTRUCTURE
The Internet has emerged as a significant global business
communications medium, enabling millions of people to communicate, publish and
retrieve information, and conduct business electronically. A multi-tiered
system of local, regional and national ISPs has evolved to provide access to
the Internet, transport data and, more recently, to provide value-added
Internet services such as managed application server hosting, e-commerce and
e-mail. ISPs exchange data in packets generated by their customers through
direct or indirect connections with other ISPs. To meet the needs of ISPs to
exchange data at centralized points, large ISPs have established a series of
central Internet exchanges, which facilitate the transmission of data.
Despite the relatively centralized nature of these exchange points,
data traveling across the Internet often makes multiple connections or "hops"
through a variety of local, regional and national ISPs, as it moves from the
originating site, through a central exchange point, and to its final
destination. While these centralized points have the advantage of having dozens
of ISPs interconnected and exchanging Internet data, they increasingly face
congestion problems that cause significantly longer response times for each end
user. In addition, because data traveling across the Internet must often make
connections through multiple ISPs, the failure of a single ISP's Internet
connection can interrupt a user's data transmission over the Internet. Many
ISPs have sought to improve data transmission reliability and speed by
establishing
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private "peering connections" and network access points. This permits the ISPs
to directly exchange Internet traffic while reducing the number of hops in
their Internet connection and attempting to avoid the often-congested major
Internet exchanges.
THE GROWTH OF THE INTERNET
The Internet has experienced tremendous growth and has become a global
medium for communications and commerce. According to International Data
Corporation, or IDC, the ISP market in the United States reached $10.7 billion
in 1998, representing a 43.0% increase over 1997 revenues. Business-related
Internet access services generated approximately $2.9 billion of the $10.7
billion aggregate 1998 ISP revenue. Moreover, IDC predicts revenues generated
from access services by business-related ISPs will increase by 75.9% to $5.1
billion in 1999 and reach $12.0 billion by 2003, growing at a compound annual
growth rate of 36.2% from 1998 to 2003. In addition, IDC estimates that the
total value of goods and services purchased over the Internet will increase
from $50.5 billion in 1998 to approximately $734.0 billion by the end of 2002.
Trends contributing to the growth of the business-related Internet
market include:
- the competitive need of small and mid-sized businesses to
Web-enable key business processes,
- the availability of Internet-platform packaged software
applications,
- the substantial increase in traditional retailers using the
Internet as an additional marketing, sales and distribution
channel,
- recent enhancements in the Internet's security and reliability,
- an increase in the amount and diversity of business and educational
information available on the Internet and the Web,
- the convenience and speed of conducting business over the Internet,
- the increasing availability of high bandwidth capacity, and
- the proliferation of Internet access and ancillary Internet
services.
The demand generated by these new dynamics, combined with business
customers' high quality service requirements, has fueled the growth in the
number of businesses that outsource their Internet requirements to entities
like comstar.net.
THE TREND TOWARD OUTSOURCING OF INTERNET OPERATIONS
Over the last few years, enterprises that focus solely on distributing
products and services over the Internet have emerged, and more recently,
mainstream businesses have begun to implement Web sites to complement their
traditional business models and applications. Various factors that continue to
attract these businesses to the Internet include the transformation of Web
sites from being primarily text-based and informational to becoming
interactive, multimedia-enabled and transaction oriented.
However, many businesses lack the resources and expertise to
cost-effectively develop, maintain and continually upgrade their network
facilities and systems. Hiring individuals with the expertise to establish and
maintain sophisticated Internet technology is costly, and businesses often find
it difficult to manage new technologies and to integrate them into their
infrastructure. Even when enterprises do possess the necessary resources, those
enterprises are often migrating towards outsourcing their Internet-related
functions to focus on their core businesses, enhance the performance and
reliability of their Web sites and reduce their Internet-related operating
expenses. By outsourcing Internet requirements, customers can maintain
scaleable, cutting-edge Web sites to optimize the value of their operations.
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WEB HOSTING AND CO-LOCATION
To realize the opportunities of the Internet, companies must develop
an attractive Internet presence that is easily accessible to potential
customers. However, rapid Internet and technology growth has outpaced the
ability of many businesses to develop the necessary internal information
technology knowledge and tools. A variety of companies have begun to focus on
providing Internet services such as Web hosting, in which the company provides
and maintains a non-exclusive service to install software applications chosen
by the customer, and co-location services, in which the company provides secure
space to house customer-owned Internet equipment, and other Web-related
services. Typically, companies offering these services build data centers to
serve their customers. According to IDC, corporate Internet access and
value-added services, such as Web hosting and co-location, are the fastest
growing services offered by ISPs. Corporate access revenue and value-added
services revenue were $5.9 billion in 1998 and are expected to grow to
approximately $25.0 billion by 2003.
APPLICATION HOSTING
Historically, companies have used application software to automate and
improve the efficiency of core business functions. However, most applications
were custom designed, requiring large capital expenditures and long periods of
implementation. More recently, software companies have developed packaged
software applications, which allow manufacturers to lower production costs, and
therefore sales prices, by standardizing software applications for multiple
users and disparate operating systems. The application-hosting model further
simplifies and streamlines this process. Rather than access business
applications from an in-house server, a user would remotely access, monitor,
and upgrade the information on its Web site server stored at a hosting
company's stand-alone data center. From the end user's perspective, the two
methods of access are identical. To the ASP's customer, however, the hosted
method offers significant cost savings. There are few limits on the type of
applications that can be hosted, which permits companies to move less expensive
email and office computing software off-site as well as more expensive
back-office applications. In addition, the enterprise customer can often
outsource maintenance requirements, further reducing its overhead costs.
CURRENT BUSINESS STRATEGIES
We intend to become a leader in providing middle market businesses and
ASPs with high quality, cost-effective business solutions that allow them to
take advantage of the Internet without having to develop and maintain their own
Internet technology and hire and retain an extensive Internet staff. To achieve
this objective, we intend to continue to rely on the following core elements of
our business strategy:
- Increasing the Percentage of our Revenues from Data Center
Services.
- Targeting Middle Market Business Customers.
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- Providing Highly Reliable Internet Access.
- Providing Superior Customer Support by Network Experts.
We intend to further develop our business by pursuing the following key
growth strategies:
- Broadening Our Marketing Activities.
- Pursuing Strategic Sales and Distribution Alliances.
- Expanding Our Network Nationally.
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- Engaging in Strategic Acquisitions.
NETWORK DESIGN
To increase Internet access speed for our customers, we designed our
network to avoid congested areas on the Internet. Most Internet traffic moves
through central Internet exchanges. To avoid transporting all of our customers'
traffic through these central exchanges and the related network access points,
we have established transit agreements with very large ISPs, including UUNET,
GTE Internetworking, Sprint and Intermedia Internet. These agreements provide
direct access to the ISP's broad intranet of customers, providing our
customer's data traffic a path to and from its destination and origin that
avoids the central exchanges. Through this network, we can also dynamically
reroute traffic quickly and efficiently. Our network experts monitor traffic
patterns and congestion points throughout the network and reroute our
customers' traffic to a different Internet link when there is excessive
congestion. As a result, we can deliver most of our customers' Internet traffic
while bypassing congested points on the Internet.
Another important characteristic of our network is its high level of
reliability. We maintain multiple links with very large ISPs to protect against
a service outage should one or more links fail. Our equipment automatically
monitors Internet traffic and reroutes it to avoid breakdowns at Internet
exchanges and access points so that our customers' upstream transmissions are
not affected by failures in other systems. In addition, each data center and
POP we operate has multiple fiber or copper telecommunications lines into the
facility so that downstream transmissions operate reliably.
To enhance the functionality of our services, we have entered into a
memorandum of understanding with Akamai Technologies, Inc. to provide our
customers with an advanced content delivery service for their Web sites.
Akamai's network of 1,200 globally distributed servers store or "cache" local
copies of frequently accessed, bandwidth intensive portions of our customers'
Web pages, such as complex graphics, advertisements, logos, software downloads
and pictures. When an Akamai-enhanced Web site is downloaded, these cached
files are downloaded from the server that can deliver the content most
efficiently based on geographic proximity, performance and congestion of all
available servers on Akamai's network. In this way, the Akamai servers
intelligently smooth Internet traffic patterns, thereby leveraging and
enhancing existing bandwidth capacity in our network. We believe our
arrangement with Akamai further enhances our service offerings for our
customers.
SERVICES
We create tailored solutions for our customers based on their business
and technical requirements, modifying these solutions as our customers' needs
evolve. Our highly reliable services are supported by our knowledgeable and
responsive network experts, some of whom are the same professionals that
implemented our network, unlike many of our competitors. Our primary services
include DASH, co-location services and dedicated Internet access. We also offer
Web hosting, email services and domain name services.
Our customer contracts require us to provide our services for a
one-year, two-year or three-year term, and contain, among other things, a
limited service level warranty related to the continuous availability of
service on a 24 hours per day, seven days per week basis, except for scheduled
maintenance periods. This warranty provides a credit for free service for
disruptions in our Internet access services. At the end of the term of a
contract, a customer may elect to extend
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the contract's term on a month-to-month basis. Any change or upgrade in
service, however, typically requires a new contract for a new term.
In addition, we have begun to market our eCommerce Guarantee, or eCG,
to e-commerce customers. Under this program we will reimburse customers for
their lost e-commerce profits, up to a specified limit per access line, due to
disruptions of their Internet connections that occur at any point over which we
assume responsibility for the Internet communications network. Unlike the
service level agreements commonly offered by access providers, we will reimburse
for lost gross e-commerce profits of each customer based on their individual
business patterns, rather than paying a set fee per hour of interruption they
experience. The eCG goes much further than a typical industry service level
agreement toward adequately and appropriately compensating customers for the
lost value to their business of the disruption.
DASH - Dedicated Application Server Hosting. Our managed application
hosting service, which we first introduced in June 1999 and which we refer to
as our dedicated application server hosting, or DASH, service, provides a
server for the customer's exclusive use to install any software application the
customer chooses. In addition, we will provide all required maintenance on the
server hardware. This service, which is similar to the services being offered
by computer service providers, or CSPs, is targeted at businesses with high
volumes of Internet traffic, complex Internet-based applications and Web
services that are extremely important to their daily operations. Unlike typical
Web hosting operations that host multiple customers' Web sites on a single
server, we provide our DASH services with only one customer per server. As a
result, a customer need not be concerned about how its actions or applications
might impact other customers' applications housed on the same server, or how
its server might be affected by other customers' actions or applications.
Our DASH services are compatible with the products of many leading
hardware and software system vendors, including Cobalt Networks, VA Linux
Systems, Hewlett-Packard, Sun Microsystems, Silicon Graphics, Microsoft and
Allaire. This multi-vendor flexibility enables our customers to select their
own technical solutions and to integrate their Internet operations with their
existing information technology. In addition, our customers can augment their
services with hardware or software that we provide or software that they
purchase directly from others.
Co-location. Our co-location services provide secure space to house
customer-owned Internet equipment. Based upon their business and technical
requirements, customers may select from shared cabinet facilities, exclusive
cabinets or custom-built rooms with additional security features. All
co-location facilities include dedicated electrical power circuits to ensure
that we meet each customer's power requirements. Because the Internet
operations of our co-location customers frequently require hardware and
software upgrades, we give customers unlimited but secure access to their
leased co-location space. Additional space, electrical power and Internet
services can be tailored to meet our customers' needs.
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Our Atlanta data center houses the computers that operate the core
functions of our DASH and co-location businesses, including communications
equipment, data storage and retrieval systems, security software and hardware
and related customer support. Our data center provides customers with a secure,
climate-controlled facility that they cannot readily or inexpensively create at
their own place of business. The data center contains:
- a power supply with a back-up generator,
- fire suppression and containment capabilities,
- raised floors,
- fully redundant HVAC, and
- high levels of physical security.
We intend to open new data centers in Washington, D.C. and four other
cities before the end of 2000. We believe our data centers will be an important
factor in attracting customers and marketing our data center services.
Internet Access. Our Internet access services are designed to deliver
the ease of expansion, high availability and performance required by moderate
to high volume Internet operations that are central to a customer's business.
Our Internet access options include:
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SERVICE DESCRIPTION BENEFITS
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T1, Fractional T1 Leased lines are a dedicated Leased lines, which are priced on a per-
and T3 Leased Lines service that delivers access mile basis, provide a customer with a
speeds from 56Kbps to 45Mbps. truly private network where no other
entity's data flows over the same network.
Leased lines are very cost-effective when
reasonably close to one of our POPs or our
data center.
Frame Relay Frame relay is a dedicated Gives customers connecting geographically
service that delivers access dispersed offices an affordable alternative
speeds from 56Kbps to 45Mbps. with pricing that is not based on mileage.
Symmetrical Digital SDSL is a dedicated service Provides inexpensive Internet access for
Subscriber Line, or SDSL using digital technology to customers with high bandwidth
deliver access speeds from requirements.
160Kbps to 1.54Mbps.
Integrated Services ISDN is a dial-up service Provides inexpensive Internet access for
Digital Network, or ISDN utilizing digital signaling customers with low bandwidth
technology to deliver access requirements.
speeds of either 64Kbps or
128Kbps.
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We have begun to market an important enhancement to our Internet access
options - the eCommerce Guarantee, or eCG. We will compensate our eCG customers
for the lost gross e-commerce profits, up to a specified limit per access line,
for certain interruptions they suffer in their Internet access service. The eCG
will apply if the interruption (a) occurs outside the point at which the
customer assumes responsibility for the Internet communications network, and (b)
causes the customer to lose profits. An insurance company has insured our
liability for the eCG, and we will be responsible for a specified interruption
deductible based on the type of line, with an overall deductible limit for any
single event that causes multiple interruptions. The maximum amount any customer
will be able to recover during the term of its contract is based on the type of
line. Although we expect to fully implement our eCG in the near future, we
cannot assure that it will be implemented in a timely manner.
CUSTOMERS
Most of our customers are middle market businesses, but our customer
base also includes other ISPs and several larger companies. The Internet
service needs of our target customers differ significantly from those of
typical individual consumers. Enterprises often view their Internet access and
related services as critical to their business. They demand dedicated, high
speed Internet access and knowledgeable, prompt and often highly technical
customer support. When marketing our services, we focus on creating the best
solutions to meet our customers' needs and not simply promoting our technology.
We work with our customers' management and information technology teams to
analyze their Internet needs and create solutions to specifically address those
needs. Compared to individual consumers, enterprise customers are usually less
price sensitive and more willing to pay a premium for creative solutions
crafted to meet their needs. As a result, we believe that providing Internet
services to enterprise customers generates greater revenues and higher margins
per customer than servicing individual consumers.
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Our customer nBank, a division of The First National Bank of Commerce,
provided 9.1% of our revenues for the year ended December 31, 1998 and 10.0% of
our revenues for the year ended December 31, 1999. No other customer accounted
for more than 10% of our revenues during either period.
SALES AND MARKETING
We sell our services primarily through a direct consultative approach
to end customers. We also develop joint selling relationships with ASPs and
other Internet-focused partners to facilitate indirect sales of our products.
We have developed several "partnership" programs to meet the various
requirements of joint selling arrangements. We have begun a new advertising and
media campaign to build awareness of our name, our DASH services and our
quality of service.
In each market we recruit local sales account executives who are
highly knowledgeable of Internet strategies and capable of assisting customers
in developing their approach to using the Internet as a sales or productivity
tool. These account executives develop our partnership relationships in their
regions as well. The local sales account executives are supported by our
telesales staff in Atlanta, which can handle sales opportunities that require
less complex solutions.
We intend to expand our direct sales force and further develop our
indirect and joint sales channels. We are improving our generation of leads for
prospective customers by using outside telemarketing services in combination
with direct mail and other targeted approaches like print advertising.
DIRECT SALES
The role of our direct sales employees is to follow up and close on
leads generated by our marketing programs, drive personal sales programs
directed at specific industries and to develop partnership relationships. Our
experience indicates that the personal consultative approach afforded by local
sales personnel is critical to the successful promotion of our services. We
will actively monitor our target markets and will add additional sales
professionals to meet customer demand.
INDIRECT SALES
VIP program. Certified reselling, referral and joint marketing
programs have proven to be a successful marketing approach for comstar.net. Our
current program, the Valued Internet Partner, or VIP, program is a referral
relationship whereby the VIP refers qualified opportunities to us and earns a
fee if we secure the business. Typically, the VIP is previously engaged in some
activity with the prospective end customer, such as assisting it on Web-related
issues such as design, software development or customer premise equipment sales
and service.
CAP program. Our new comstar.net Alliance Partner program is a
certified reseller program where the CAP maintains the customer relationship
while selling either branded or private label comstar.net services. The
services are contracted and billed to the CAP on a monthly basis at discounted
fees, and the CAP maintains the billing and collections relationship with the
customer. We perform the installation responsibilities as well as the ongoing
customer support for the comstar.net services.
MAP program. We have also recently begun our Managed Application
Partner program, which seeks to establish joint marketing and sales
relationships with ASPs, independent software developers and software
integrators. This program is designed to establish comstar.net as the preferred
server hosting location for the end user or the ASP.
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Web site referral application. We intend to develop a comstar.net Web
site application to allow our various "partners" to describe their solutions
and competencies to prospective customers. As prospective customers are
encouraged to visit our site via marketing programs, our sales efforts can
introduce incremental opportunities to our partners. In turn, our various
partners have incentives to refer, jointly sell or resell business to us.
TELESALES
Our marketing programs occasionally deliver opportunities that do not
require sophisticated on-site sales resources. These opportunities are handled
by our "telesales" center, located at our headquarters in Atlanta. This center
completes sales of Internet access and less sophisticated dedicated server
opportunities over the phone. Our telesales employees respond to inbound sales
leads resulting from marketing campaigns. They also make outbound calls to
prospects in particular industries we target. During interactions with a
prospective customer, our telesales staff tries to define a customer's needs
and either close a sale or refer the client to our direct sales force,
depending on the complexity and sophistication of the customer's request.
MARKETING AND BRANDING
In 2000, we intend to significantly expand our marketing efforts to
stimulate increased demand for our services and build the comstar.net brand. We
plan to invest in the brand through an integrated marketing process that
frequently and consistently delivers our business model and our competitive
strengths. We intend to focus our combination of print advertising, direct
mail, telemarketing, event marketing and public relations efforts on our
targeted DASH market and differentiating ourselves with the eCG. In addition,
we will use our various "partner" programs to enter new geographic markets as
we expand our network. Therefore, our marketing and branding programs will
attempt to attract partners as well as prospective customers.
We intend to launch an online advertising campaign during the second
half of this year that will build market awareness of comstar.net at key
business junctures on the Internet where we have determined our target
customers regularly travel.
COMPETITION
The market for managed application hosting services, co-location, and
Internet access is very competitive. The tremendous growth and potential size
of the market for Internet services has attracted many new start-ups as well as
existing businesses. In addition to other national, regional and local ISPs,
our current and prospective competitors include long distance and local
exchange telecommunications carriers, cable television operators and their
affiliates, satellite and wireless communications companies and providers of
co-location and other data center services. When compared to us, many of our
competitors have substantially greater financial, technical, marketing and
personnel resources; larger customer bases; a broader range of services; more
extensive networks and facilities; longer operating histories; greater name
recognition and market presence; and more established business relationships in
the industry. Further, intense price competition could significantly reduce our
operating margins and adversely affect our operating results.
The principal competitive factors in our market include:
- Internet system engineering expertise and advanced technical
functions,
- price of services,
- availability and quality of customer service and support,
- timing of introductions of new services,
- network capability,
- network security,
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<PAGE> 14
- reliability of services,
- financial resources,
- variety and quality of services,
- ease of expansion,
- ability to maintain, expand and add new distribution channels,
- broad geographic presence,
- brand name, and
- conformity with industry standards.
Value-Added Service Providers. As we increasingly focus our business
on and increasingly generate revenues from our DASH and co-location services,
competition from other value-added service providers will become more intense.
Value-added service providers are companies that provide a range of
Internet-related services, including co-location, server hosting, maintenance
and security. Our competitors in this market include co-location providers like
Exodus Communications, Frontier GlobalCenter, Digex and USInternetworking. They
also include application service providers such as NaviSite and Digital Nation,
which Verio recently acquired.
ISPs. Our primary competitors for our Internet access services include
other ISPs with a significant national presence that focus on business
customers, such as UUNET, GTE Internetworking, PSINet, Concentric Network,
EarthLink, Verio and Intermedia Internet. We also compete with smaller regional
and local ISPs in our targeted geographic regions such as Net Depot and Lyceum.
Our customer base includes smaller ISPs, which may also compete with us for
customers in their markets.
Telecommunications Carriers. All of the major long distance companies,
including AT&T, MCI Worldcom and Sprint, offer Internet access services and
compete with us. Local exchange carriers, including the regional Bell operating
companies, have also increasingly begun to enter the Internet access market and
compete with us. We believe that many long distance and local
telecommunications carriers will seek to acquire ISPs, enter into joint
ventures with them and purchase Internet access wholesale from ISPs to address
the Internet access requirements of those carriers' current enterprise
customers. Worldcom's acquisition of UUNET, GTE's acquisition of BBN and Cable
& Wireless's acquisition of internetMCI are indicative of this trend.
Accordingly, we expect to experience increased competition from the traditional
large telecommunications carriers.
Cable Operators, Direct Broadcast Satellite and Wireless
Communications Companies. Many of the major cable television operators, such as
MediaOne, have begun to offer or have announced an intention to offer Internet
access through their existing cable infrastructure. Seeking to take advantage
of this installed cable infrastructure and the Internet access opportunities it
affords, many telecommunications providers have acquired cable companies, such
as AT&T's acquisition of TCI and @Home. While many cable companies are faced
with large-scale upgrades of their existing plant equipment and infrastructure
to support connections to the Internet and become competitive, we believe that
some smaller enterprise customers may be attracted by the combined services
already being offered by cable operators. Other alternative service
communications companies have also announced plans to enter the Internet access
market with various wireless and satellite services and technologies.
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<PAGE> 15
GOVERNMENT REGULATION
INTERNET REGULATION
Currently, only a small body of laws and regulations directly apply to
access to or commerce on the Internet. Due to the increasing popularity and use
of the Internet, however, laws and regulations may be adopted at the
international, federal, state and local levels with respect to the Internet,
covering issues such as user privacy, freedom of expression, pricing,
characteristics and quality of products and services, taxation, advertising,
intellectual property rights, information security and the convergence of
traditional telecommunications services with Internet communications. Moreover,
a number of laws and regulations have been proposed and are currently being
considered by federal, state and foreign legislatures with respect to these
issues. We cannot predict the impact on our business of any new laws and
regulations or the manner in which existing and new laws and regulations may be
interpreted and enforced. For example, recently, Congress passed and the
President signed into law:
- The Communications Decency Act, which protects ISPs from defamatory
statements made on or accessible through the provider's service.
- The Digital Millennium Copyright Act, which provides stronger
copyright protection for software, music and other works on the
Internet. Under this law, ISPs and Web site operators must register
with the United States Copyright Office to avoid liability for
infringement by their subscribers.
- The Child Online Protection Act, which makes it illegal to
communicate material that is harmful to minors on the Internet for
commercial purposes in a manner accessible by minors. This law also
requires Web sites to obtain parental consent before collecting
information from children who are age 12 and younger.
- The Child Protection and Sexual Predator Punishment Act, which
imposes criminal penalties for using the Internet to solicit minors
for sexual purposes, and for sending obscene material to persons
under the age of 16.
- The Internet Tax Freedom Act, which imposes a three-year moratorium
on taxes which are multiple or discriminatory, to give state and
federal lawmakers time to develop a more comprehensive approach to
Internet taxation. The moratorium will end in October 2001.
In addition, there is substantial uncertainty as to the applicability
to the Internet of existing laws governing issues such as property ownership,
copyrights and other intellectual property issues, taxation, libel, obscenity
and personal privacy. The vast majority of these laws was adopted before the
advent of the Internet and, as a result, did not contemplate the unique issues
of the Internet. Future developments in the law might decrease the growth of
the Internet, impose taxes or other costly requirements, create uncertainty in
the market or in some other manner have an adverse effect on Internet commerce.
These developments could, in turn, have a material adverse effect on our
business.
While no one has ever filed a claim against us relating to information
carried on, stored on, or disseminated through our network, someone may file a
claim of that type in the future and may be successful in imposing liability on
us. If that happens, we may have to spend significant amounts of money to
defend ourselves against these claims and, if we are not successful in our
defense, the amount of damages that we will have to pay may be significant. Any
costs that we incur as a result of defending these claims or the amount of
liability that we may suffer if our defense is not successful could materially
adversely affect our business. If, as the law in this area develops, we become
liable for information carried on, stored on or disseminated through our
network, we may decide to take actions to reduce our exposure to this type of
liability. This may require us to spend significant amounts for new equipment
and discontinue offering some of our services.
The United Kingdom and the European Union have adopted legislation and
directives that have a direct impact on business conducted over the Internet
and on the use of the Internet. For example, the United Kingdom Defamation Act
of 1996 protects ISPs, under some circumstances, from liability for defamatory
materials stored on its servers. The European Directives on the Protection of
Consumers, Data Protection, and Distance Selling are expected to have direct
effects on the use of the Internet for commercial transactions and will create
additional layers of consumer protection legislation with respect to electronic
commerce. In addition, governmental authorities throughout the world are
contemplating numerous
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<PAGE> 16
other regulatory schemes. As in the United States, there is uncertainty as to
the enactment and impact of foreign regulatory and legal developments. These
developments may have an adverse effect on our business.
Our Internet access service transmits some data over public telephone
lines. Regulations and policies establishing charges, terms and conditions for
communications govern these transmissions. As an ISP, we are not currently
regulated directly by the Federal Communications Commission, or the FCC, or any
other agency, other than regulations applicable to businesses generally. We
could, however, become subject in the future to regulation by the FCC and/or
other regulatory agencies if we become classified as a provider of basic
telecommunications services. As a result, compliance with these FCC regulations
could affect the charges that we pay to connect to the local telephone network
because ISPs, unlike long distance telephone companies, are not currently
required to pay carrier access charges. Access charges are assessed by local
telephone companies on long-distance companies for the use of the local
telephone network when the local telephone companies originate and terminate
long-distance calls, generally on a per-minute basis. The payment of access
charges has been a matter of continuing dispute, with long-distance companies
arguing that the charges are substantially in excess of actual costs and local
telephone companies arguing that access charges are justified to subsidize
lower local rates for end users. In May 1997, the FCC reaffirmed its decision
that ISPs will not be required to pay these access charges. Subsequent
statements issued by the FCC have not altered this conclusion. The FCC also has
concluded that, unlike providers of basic telecommunications services, ISPs are
not currently required to contribute a percentage of their revenues to the
federal universal service fund and are not expected to contribute to similar
funds established at the state level.
Both the access charge issue and the universal service fund treatment
of ISPs are the subjects of further FCC proceedings and may change. Telephone
companies have requested the FCC to reconsider or reverse its decisions in
these areas, and their arguments are gaining support as Internet-based
telecommunications services begin to compete with conventional
telecommunications services. We cannot predict how these matters will be
resolved but it may adversely affect us if, in the future, ISPs are required to
pay access charges or contribute to the universal service fund.
PROPRIETARY RIGHTS
General. Although we believe that our success is more a function of
our technical expertise and customer service than our proprietary rights, our
success and ability to compete depend in part upon our technology. We rely on a
combination of contractual restrictions and copyright, trademark and trade
secret laws to establish and protect our technology. Our policy is to require
employees and consultants and, when possible, suppliers to execute
confidentiality agreements upon the commencement of their relationships with
us. The steps we have taken may not be adequate to prevent misappropriation of
our technology, or our competitors may independently develop technologies that
are substantially equivalent or superior to our technology.
Licenses. We developed some software for nschool Communication
Systems, Inc. and received rights to use the software in exchange for the
development of the software. Specifically, we have the right to use the
separable components of the software for any purpose and to use the combined
software product for limited purposes. We are specifically prohibited from
using the software to provide electronic communications, Internet applications
and services to organized, group-based educational entities.
Trademarks. We own three federal trademark registration applications,
which are currently pending in the United States Patent and Trademark Office.
We filed two applications in May 1999 and one application in August 1999. In
May 1999 we filed applications for the marks ComStar Internet Services, Inc.,
with design, and ComStar Internet & Wireless, Inc., with design, and in August
1999 we filed an application for the mark comstar.net, inc., with logo. The
applications are based on our intent to use these marks in commerce in
connection with Internet access, Web hosting and co-location services for
businesses. We have used marks containing variations of the word "comstar"
since 1996, and no third party has notified us of any objection to our use of
any of these marks.
In addition, our wholly owned subsidiary, Comstar Telecom & Wireless,
Inc., filed an application for the mark Comstar Telecom & Wireless, Inc. in
September 1999. The application is based on our subsidiary's intent to use the
mark in commerce in connection with local exchange carrier and long distance
communication services.
The United States Patent and Trademark Office has now examined our
application to register the mark comstar.net, inc. and the related design.
Registration of the mark has been refused on the ground that the mark, when
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<PAGE> 17
used on or in connection with the identified services, so resembles certain
currently registered marks for COMSTAR or similar terms as to be likely to
cause confusion, to cause mistake or to deceive. We disagree with the findings
of the examining attorney and are taking steps to vigorously contest the
rejection and pursue the registrations.
The United States Patent and Trademark Office has also examined our
application to register the mark Comstar Internet Services, Inc. and the
related design and our application to register the mark Comstar Internet &
Wireless, Inc. and the related design. Registration of both marks has been
refused on the ground that the marks, when used on or in connection with the
identified services, so resemble a currently registered mark for COMSTAR as to
be likely to cause confusion, to cause mistake or to deceive. Registration has
also been provisionally refused in view of a pending application to register a
mark that includes the term COMSTAR owned by a different party. We disagree
with the findings of the examining attorney and are taking steps to vigorously
contest the rejection and pursue the registrations. The Patent and Trademark
Office has not yet responded to our application for our subsidiary's
application for the Comstar Telecom & Wireless, Inc. mark. In addition, we own
the Switch Hotel trademark but have not filed a federal trademark application
for it.
EMPLOYEES
As of December 31, 1999, we employed 42 people, including full-time
and part-time employees. We consider our employee relations to be good. All
employees have entered into non-disclosure, non-compete, and non-solicitation
agreements with us. None of our employees is covered by a collective bargaining
agreement.
FACILITIES
We lease our headquarters facilities in Atlanta, Georgia under a lease
that expires on September 30, 2000. The lease covers approximately 4,200 square
feet and the annual rent is approximately $66,000. The lease relating to the
data center at our Atlanta facility expires on September 30, 2004 and has an
annual rent of approximately $67,000 for the first year. The annual rent will
increase by approximately 4.0% each year for the remainder of the lease. The
data center comprises approximately 4,500 square feet, including external space
for a generator.
We lease approximately 660 square feet of office space in Athens,
Georgia, which contains our POP for that area, as well as several full-time and
part-time employees. We lease this space under an agreement that expires on June
30, 2001. The annual rent for the Athens facility is approximately $7,600. Our
office space in Miami, Florida and Raleigh, North Carolina each comprises less
than 500 square feet and the combined annual rent is approximately $16,000. We
also house servers in additional offices in Miami, Florida; Durham, North
Carolina; Birmingham, Alabama; Columbus, Georgia; and Houston, Texas under
co-location agreements with various customers and telecommunications providers.
ITEM 2. PROPERTIES
See the information provided in Item 1 - Business - Facilities for
information with respect to comstar.net's facilities.
ITEM 3. LEGAL PROCEEDINGS
comstar.net may be involved from time to time in legal proceedings
arising in the normal course of its business and otherwise. comstar.net is not
a party to any pending legal proceedings which it believes are material.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
A special meeting of the shareholders of comstar.net was held on
October 14, 1999 for the following purposes:
1. to approve our amended and restated articles of incorporation
to: effect a 1-for-2 reverse stock split of our outstanding
capital stock; decrease the number of authorized shares of
common stock to 50,000,000; eliminate the authorized shares of
series A common stock and series B common stock and convert
these shares to common stock; require super majority approval by
the directors and shareholders of change in control
transactions; and implement a classified board of directors;
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<PAGE> 18
2. to approve the amended and restated bylaws;
3. to approve our amended and restated 1999 stock option and
incentive plan; and
4. to approve our director stock option plan.
Only shareholders of record at the close of business on September 17,
1999 were entitled to vote at the special meeting. Proxies for the special
meeting were solicited pursuant to the Georgia Business Corporation Code, and
there was no solicitation in opposition to management's solicitations.
Proxies and ballots were received from the holders of 5,264,327 shares
of series A common stock, representing approximately 98% of the total number of
shares of series A common stock outstanding and from the holders of all
5,000,000 shares of series B common stock outstanding.
The results were as follows:
<TABLE>
<CAPTION>
FOR AGAINST ABSTAIN
--- ------- -------
<S> <C> <C> <C> <C>
1. The proposal to amend and restate the
articles of incorporation 55,193,030 27,514 43,783
2. The proposal to amend and restate the
bylaws 55,255,570 8,757 -0-
3. The proposal to amend and restate the 1999
stock option and incentive plan 55,264,327 -0- -0-
4. The proposal to approve the director stock
option plan 55,264,327 -0- -0-
</TABLE>
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<PAGE> 19
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.
MARKET INFORMATION
None of our securities are currently publicly traded. We currently
have approximately 48 shareholders of record.
To date, we have not paid cash dividends on our common stock. We also
do not anticipate paying cash dividends on our common stock in the near future.
RECENT SALES OF UNREGISTERED SECURITIES
(a) Issuances of Capital Stock
Between November 23, 1998 and June 30, 1999, we sold 371,786 shares of
common stock series A at a price per share of $5.71 to 25 investors in a
private financing for a total of $2,122,744 in cash. On January 5, 2000, we
issued a total of 1,276,658 shares of common stock to these investors, pro rata
and without any additional cash payment by those investors.
(b) Certain Grants of Options
As of December 31, 1999, we had issued options to purchase 1,537,250
shares of common stock pursuant to the Amended and Restated 1999 Stock Option
and Incentive Plan and options to purchase 200,000 shares of common stock
pursuant to the Director Stock Option Plan. As of December 31, 1999, 2,000 of
these options had been forfeited.
No placement agents were involved in the foregoing sales of
securities. Each issuance of securities described above was made in reliance on
one or more of the exemptions from registration provided by Sections 3(a)(11),
4(2) and 4(6) of the Securities Act, Regulation D and Rule 701, as promulgated
by the SEC pursuant to the Securities Act. All recipients of securities in
these transactions were either (a) eligible participants in a compensatory plan
or (b) accredited investors who represented their intention to acquire the
securities for investment purposes only and not with a view to or for the sale
in connection with any distribution of those shares. We affixed appropriate
legends to the share certificates we issued in those transactions. All
recipients of these securities had adequate access, through their relationships
with comstar.net, to information about us. All of these securities are deemed
restrictive securities for purposes of the Securities Act.
USE OF PROCEEDS FROM REGISTERED LIMITED PUBLIC OFFERING
On December 30, 1999, our registration statement on Form S-1
(Commission File No. 333-92581) relating to the registered limited public
offering of 100 investment units consisting of an 8% Senior Convertible Note and
a stock purchase warrant sold for an aggregate of $50,000 per unit was declared
effective. This offering closed on January 5, 2000, and net proceeds from the
offering were approximately $4.5 million after deducting placement agent
commissions ($300,000) and expenses related to the offering. In 2000 we repaid
approximately $1.2 million in debt and interest (all of which was either owed to
or guaranteed by one or more of our affiliates, as explained in Item 11 -
Executive Compensation - Compensation Committee Interlocks and Insider
Participation), and we have used or are using the balance of approximately $3.3
million for working capital and to pay for costs associated with our Washington,
D.C. data center, which we plan to open in April 2000.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED FINANCIAL DATA
The following selected financial data of comstar.net for the period
from inception, March 5, 1996, to December 31, 1996, for the years ended
December 31, 1997, 1998 and 1999 and as of December 31, 1996, 1997, 1998 and
1999 are derived from our audited financial statements. You should read the
following data along with Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations and our financial statements and
related notes included elsewhere in this annual report.
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<PAGE> 20
During the year ended December 31, 1999 we incurred compensation
expense of approximately $3.4 million as a result of options we granted to
purchase our common stock. Without giving effect to this compensation expense,
for the year ended December 31, 1999, operating loss would have been
$2,064,673, net loss would have been $3,465,653, net loss per share (basic and
diluted) would have been $.34, and total shareholders' equity would have been
$645,230. For an explanation of the determination of the number of shares used
to compute basic and diluted net loss per share and weighted average shares
outstanding, see note 2 of the notes to our financial statements.
<TABLE>
<CAPTION>
PERIOD FROM INCEPTION
(MARCH 5, 1996) YEAR ENDED
TO DECEMBER 31, DECEMBER 31,
-------------------------------------------------------------------------
1996 1997 1998 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Revenues:
Internet access ............... $ 29,579 $ 399,167 $ 1,334,053 1,972,674
Data center services .......... 33,048 205,171 417,112 643,249
Circuit rebill ................ 276 44,459 255,230 528,312
Other ......................... 2,495 26,772 135,950 91,015
------------ ------------ ------------ ------------
Total ........................... 65,398 675,569 2,142,345 3,235,250
------------ ------------ ------------ ------------
COSTS AND EXPENSES:
Cost of network services ...... 73,963 528,835 1,235,862 2,106,320
Salaries and wages ............ 150,448 370,145 521,570 1,518,843
General and administrative .... 67,259 131,767 379,036 1,071,229
Rent .......................... 21,792 33,152 106,417 124,991
Management fees ............... 8,000 42,000 60,000 30,000
Depreciation and
amortization ................ 11,622 57,255 284,598 448,840
Stock compensation expense .... -- -- -- 3,411,233
------------ ------------ ------------ ------------
OPERATING LOSS .................. (267,686) (487,585) (445,138) (5,475,906)
------------ ------------ ------------ ------------
OTHER (EXPENSE) INCOME:
Costs of canceled initial
public equity offering ....... 0 0 0 (1,082,827)
Interest expense .............. (10,434) (66,201) (150,605) (191,015)
Other income (loss) ........... -- 6,542 (1,987) 14,806
Equity in net loss of
investee .................... -- -- -- (141,944)
============ ============ ============ ============
NET LOSS ........................ $ (278,120) $ (547,244) $ (597,730) $ (6,876,886)
============ ============ ============ ============
PER SHARE DATA:
NET LOSS PER SHARE (BASIC AND
DILUTED) ...................... $ (.03) $ (.05) $ (.06) $ (.67)
============ ============ ============ ============
WEIGHTED AVERAGE SHARES
OUTSTANDING ................... 10,000,000 10,000,000 10,005,731 10,269,640
============ ============ ============ ============
</TABLE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
------------------------------------------------------------------------
1996 1997 1998 1999
------------ ------------ ------------ -------------
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents ...... $ 6,402 $ 54,676 $ 283,621 $ 8,099
Working capital (deficit) ...... (379,483) (883,047) (2,174,370) (3,960,766)
Total assets ................... 123,965 529,519 1,649,847 1,936,055
Total debt, including current
maturities ................... 328,924 1,128,845 2,214,232 2,204,813
Total shareholders' (deficit)
equity ....................... (278,120) (825,364) (1,058,272) (2,766,003)
</TABLE>
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<PAGE> 21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
You should read the following discussion in conjunction with our
financial statements and related notes and other financial information appearing
elsewhere in this annual report. This discussion contains forward-looking
statements relating to our future financial performance, business strategy,
financing plans and other future events that involve risks and uncertainties.
Our actual results could differ materially from the results anticipated in these
forward-looking statements as a result of many known and unknown factors,
including those factors described elsewhere in this annual report.
OVERVIEW
We are a rapidly growing provider of Internet services to middle market
businesses, educational institutions and governmental organizations. Our primary
services include high speed Internet access, co-location services and dedicated
application server hosting, or DASH, services.
We began operations in June 1996. From inception through December 31,
1996, we had total revenues of $65,398. During the year ended December 31, 1997,
we expanded operations from one to three POPs and purchased the business
customer lists and related customer accounts of one Atlanta-based ISP to end the
year with revenues totaling $675,569, an approximate ten-fold growth in
revenues. During the year ended December 31, 1998, we expanded our Atlanta data
center, purchased the business customer lists and related customer accounts of
two Atlanta-based ISPs and purchased Athens' ISP, Inc., based in Athens,
Georgia. For the year ended December 31, 1998, we had revenues totaling
$2,142,345. For the year ended December 31, 1999, we had revenues totaling
$3,235,250, representing 51% growth over 1998. Our customer base grew as follows
during these periods:
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(MARCH 5, 1996)
TO DECEMBER 31, YEAR ENDED DECEMBER 31,
--------------- -------------------------------
1996 1997 1998 1999
---- ---- ---- ----
<S> <C> <C> <C> <C>
Customers at beginning of period............................. 0 26 243 474
New customers................................................ 26 233 297 197
Non-renewing and terminated customers........................ 0 (16) (66) (104)
Customers at end of period................................... 26 243 474 567
</TABLE>
Since 1997, our rate of growth has declined due to the lack of capital
needed to expand our network, market and sell our services and add technical and
support staff. The capital we received from our offering of investment units
that closed on January 5, 2000 will provide us the means to develop our planned
data center network and fund our operations through April 2000. The number of
data centers we ultimately develop will depend upon the amount of capital we
raise in future offerings or financings, the likelihood of which we can give no
assurances.
Although we have experienced significant growth in customers and in
revenues, we have experienced operating losses and negative cash flows from
operations in each quarterly and annual period since our inception. We expect to
continue to incur losses and negative cash flows for the foreseeable future. As
of December 31, 1999, we had an accumulated deficit of approximately $8.3
million.
We derive most of our revenues from Internet access fees and data
center services. Our data center services currently include co-location, Web
hosting and our DASH services. We expect revenues derived from our higher-priced
services, such as DASH, co-location and leased lines, to increase as a
percentage of revenues in the future. For the year ended December 31, 1999,
leased line and co-location revenues increased by 155% and 74%, respectively,
over the year ended December 31, 1998. We also expect Web hosting revenues to
decline as a percentage of revenues in the future.
We offer a variety of services to our customers. Depending on the
complexity of their Internet strategies, our customers subscribe to as few as
one service to over 20 services. As of December 31, 1999, the average customer
subscribed to 2.6 services. Based on revenues during this period, our top three
Internet access services were
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<PAGE> 22
ISDN, T1 and frame relay, and our top two data center services were co-location
and Web hosting. As of December 31, 1999, the number of customers using each of
these services was 388 for ISDN, 47 for leased lines, 25 for frame relay, 29 for
co-location and 90 for Web hosting.
We generally provide our services under one-year, two-year and
three-year contracts. Of the 309 contracts signed during the year ended December
31, 1999, 267 were one-year contracts, 38 were two-year contracts and four were
three-year contracts. We have experienced a low monthly rate of customer
turnover, averaging 1.4% for the year ended December 31, 1997, 1.5% for the year
ended December 31, 1998 and 1.7% for the year ended December 31, 1999.
We charge installation fees for the initial setup of Internet access
and monthly access fees based on a set amount of bandwidth, with additional
incremental fees if the customer orders additional bandwidth. Bandwidth refers
to the amount of data that can be moved in a given period. We charge
installation fees to recover our cost of installing and setting up each customer
for data center services and monthly fees according to the services we provide
under our agreement with the customer. We recognize monthly revenues in the
period in which the services are provided.
Our installation fees are non-refundable and are priced close to our
cost. We do not defer recognition of these fees because we cannot ensure
recovery of these costs through future billings. For example, we may lose the
customer in the future. By recognizing these fees when they are incurred, we
match these revenues with the costs associated with them. We recognize all
installation fees in the period in which the service is installed. Installation
revenues were 8.5% of total revenues for the year ended December 31, 1997, 6.0%
for the year ended December 31, 1998 and 3.9% for the year ended December 31,
1999.
We also receive revenues from circuit rebill charges, which primarily
result from the resale to our customers of distance-sensitive circuits that we
purchase from local circuit providers such as BellSouth and MCI Worldcom.
Circuit rebill charges consist of both one-time fixed fees for circuit
installations that connect the customer to the local provider and variable
recurring circuit charges. Recurring circuit charges are billed on a monthly
basis and vary based upon circuit type, the distance the circuit spans and/or
the circuit usage, as well as the term of the contract. The local circuit
provider charges us for the installation and recurring charges, and we then
rebill those charges to the customer. Our bill to the customer includes an
add-on charge to the recurring circuit charges for which the provider bills us.
Other revenues we receive consist primarily of transaction processing
fees and miscellaneous hardware sales. Transaction processing fees are revenues
generated from our e-commerce software and are recognized based on monthly
usage. Hardware sales consist of the resale of some hardware components to our
customers. Because hardware sales are one-time sales, the revenues we derive
from them may vary significantly from period to period.
Our most significant expense item is our cost of network services,
which consists of data communications costs for upstream access, or our
connections to the Internet, and data communications charges for downstream
access, or our connections to our customers. Upstream access costs consist
primarily of payments to network providers such as UUNET, MCI Worldcom, Sprint,
GTE Internetworking and other providers. Our downstream access costs consist
primarily of payments to BellSouth and MediaOne. The next most significant
expense item is salaries and wages paid to our employees.
Our other costs and expenses include:
- selling, general and administrative expenses, including
advertising costs, employee benefits, professional fees,
insurance, general office expense, recruiting, utilities and
equipment rentals incurred in the normal course of business,
as well as costs associated with various offerings to finance
the Company's growth and working capital needs,
- management fees, consisting of charges from db Telecom
Technologies, Inc., an affiliated company that provided us
with consulting and management services through June 30, 1999,
after which no more management fees will accrue,
- depreciation and amortization, consisting primarily of the
depreciation of our fixed assets, ordinarily over a three to
ten-year period, and the amortization of our customer lists,
on a customer-by-customer basis, over the lesser of three
years or the period the customer uses our services,
20
<PAGE> 23
- stock compensation expense, related to stock options that we
granted to outside directors and directors who are principal
shareholders, as well as stock options granted to employees of
db Telecom Technologies, and
- interest incurred on our debt.
We have significantly increased our sales and marketing activities
through the expansion of our sales force, increased emphasis on developing
reseller and referral channels and increased marketing efforts to build the
comstar.net brand. In June 1999, we hired Steven J. Edwards, our Executive Vice
President of Sales and Marketing, to design and implement comprehensive sales
and marketing plan. Before his hiring, we had not undertaken significant
marketing activities. In the third quarter of 1999, however, we began to
increase our hiring of sales and marketing personnel to support our planned
sales and marketing efforts.
RESULTS OF OPERATIONS
The following table provides a summary statement of operations,
expressed as a percentage of revenues, for the period from inception (March 5,
1996) to December 31, 1996 and for the years ended December 31, 1997, 1998 and
1999. Operating results for any period are not necessarily indicative of results
for any future period.
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(MARCH 5, 1996) YEAR ENDED
TO DECEMBER 31, DECEMBER 31,
---------------- -------------------------------------------------------
1996 1997 1998 1999
---- ---- ---- ----
<S> <C> <C> <C> <C>
REVENUES: $ 65,398 $ 675,569 $ 2,142,345 $ 3,235,250
============ ============ ============ ============
Internet access...................... 45.2% 59.1% 62.3% 61.0%
Data center services................. 50.5 30.4 19.5 19.9
Circuit rebill....................... 0.5 6.5 11.9 16.3
Other................................ 3.8 4.0 6.3 2.8
------------ ------------ ------------ ------------
Total............................. 100.0% 100.0% 100.0% 100.0%
============ ============ ============ ============
COSTS AND EXPENSES:
Cost of network services............. 113.1% 78.3% 57.7% 65.1%
Salaries and wages................... 230.0 54.8 24.3 46.9
General and administrative........... 102.9 19.5 17.7 33.1
Rent................................. 33.3 4.9 5.0 3.9
Management fees...................... 12.2 6.2 2.8 0.9
Stock compensation expense........... 0.0 0.0 0.0 105.4
Depreciation and amortization........ 17.8 8.5 13.3 13.9
------------ ------------ ------------ ------------
OPERATING LOSS (409.3)% (72.2)% (20.8)% (169.2)%
============ ============ ============ ============
OTHER (EXPENSE) INCOME:
Costs of canceled initial public
equity offering...................... 0.0 0.0 0.0 (33.5)
Interest expense..................... (16.0)% (9.8)% (7.0)% (5.9)%
Other income (loss).................. 0.0 1.0 (0.1) 0.5
Equity in net loss of investee....... 0.0 0.0 0.0 (4.4)
------------ ------------ ------------ ------------
NET LOSS............................. (425.3)% (81.0)% (27.9)% (212.6%)
============ ============ ============ ============
</TABLE>
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
REVENUES
Total revenues increased 51.0% to $3,235,250 for the year ended
December 31, 1999 from $2,142,345 for the year ended December 31, 1998 due to
substantial increases in Internet access revenues, data center services revenues
and circuit rebill revenues as described in the following paragraphs. The
increase in total revenues is attributable primarily to a larger number of
customers and a higher amount of sales per customer. We had 567 customers at
December 31, 1999 with an average monthly billing of approximately $526 per
customer for the year ended December 31, 1999 compared with 474
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<PAGE> 24
customers with an average monthly billing of approximately $476 per customer for
the year ended December 31, 1998. The increase in customers at December 31, 1999
was due primarily to successful marketing efforts and additions to our sales
force. The average monthly billing per customer for the year ended December 31,
1999 increased by approximately 10.5% over the average monthly billing per
customer for the year ended December 31, 1998 due to existing customers
upgrading their level of service and new customers purchasing our higher-priced
data center services. We added Symmetrical Digital Subscriber Line, or SDSL,
services in May 1999 and DASH services in June 1999.
Internet access. Internet access revenues were $1,972,674, or 61.0% of
total revenues, for the year ended December 31, 1999 and $1,334,053, or 62.3% of
total revenues, for the year ended December 31, 1998. The increase in aggregate
Internet access revenues was primarily due to overall increases in the customer
base and average billing per customer discussed above, along with new services.
Data center services. Data center services revenues increased to
$643,249, or 19.9% of total revenues, for the year ended December 31, 1999 from
$417,112, or 19.5% of total revenues, for the year ended December 31, 1998,
primarily due to the overall increase in the customer base and average billing
per customer discussed above. We completed our expansion of the Atlanta data
center facilities in April 1998. This expanded facility, which allowed us to
offer our data center services to a broader market, was available to us for the
entire year ended December 31, 1999, compared to only eight months during 1998.
Circuit rebill. Circuit rebill revenues increased to $528,312, or 16.3%
of total revenues, for the year ended December 31, 1999 from $255,230, or 11.9%
of total revenues, for the year ended December 31, 1998. This increase is due to
new and existing customers purchasing or upgrading to higher-end, more expensive
services such as T1 and frame relay.
Other. Other revenues decreased to $91,015, or 2.8% of total revenues,
for the year ended December 31, 1999 from $135,950, or 6.3% of total revenues,
for the year ended December 31, 1998. The decrease is primarily attributable to
a $27,822 decrease in revenues from non-recurring hardware resales.
COST AND EXPENSES
Cost of network services. Cost of network services increased to
$2,106,320, or 65.1% of total revenues, for the year ended December 31, 1999
from $1,235,862, or 57.7% of total revenues, for the year ended December 31,
1998. The increase in cost of network services is due primarily to the increase
in the amount of upstream and downstream access services we purchased to serve
our growing customer base. As a percentage of revenues, the cost of network
services increased due to our purchase of excess upstream capacity to ensure the
availability of bandwidth for network growth.
Salaries and wages. Salaries and wages increased to $1,518,543, or
46.9% of total revenues, for the year ended December 31, 1999 from $521,570, or
24.3% of total revenues, for the year ended December 31, 1998. We had 42
employees, including three new executive officers, as of December 31, 1999
compared to 18 employees at December 31, 1998. We increased the number of our
employees in anticipation of expanding our business with the proceeds of our
initial public offering, which did not close as we expected.
General and administrative. General and administrative expenses
increased to $1,071,229, or 33.1% of total revenues, for the year ended December
31, 1999 from $379,036, or 17.7% of total revenues, for the year ended December
31, 1998. The increase in general and administrative expenses is attributed
primarily to an increase in advertising costs, employee benefits, professional
fees, insurance, general office expenses, recruiting, utilities and bad debt
expense. These costs increased as we added senior management and other personnel
to plan for future growth.
Rent. As a percentage of total revenues, rent decreased to 3.9% for the
year ended December 31, 1999 from 5.0% of total revenues for the year ended
December 31, 1998. Rent increased to $124,991 for the year ended December 31,
1999 from $106,417 for the year ended December 31, 1998. The increase in rent is
primarily attributable to the addition of the offices in Athens, Georgia in July
1998, Raleigh, North Carolina in February 1999 and Miami, Florida in April 1999.
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<PAGE> 25
Management fees. Management fees decreased to $30,000, or 0.9% of total
revenues, for the year ended December 31, 1999 from $60,000, or 2.8% of total
revenues, for the year ended December 31, 1998. As of July 1, 1999, we assumed
the management functions previously provided by db Telecom Technologies, and we
expect to incur no further management fees after that date. We expect no
material effects on our results of operations as a result of the cancellation of
this arrangement.
Stock compensation expense. We incurred stock compensation expense of
$3,411,233 for the year ended December 31, 1999 related to stock options that we
granted to our two outside directors, to two other directors who are principal
shareholders, to employees of db Telecom Technologies employees and to four
employees of the Company who received options with exercise prices below fair
market value. We incurred no corresponding stock compensation expenses during
the year ended December 31, 1998.
Depreciation and amortization. Depreciation and amortization increased
to $448,840, or 13.9% of total revenues, for the year ended December 31, 1999
from $284,598, or 13.3% of total revenues, for the year ended December 31, 1998.
This increase was primarily due to our purchases of network equipment to serve
our growing customer base and office equipment to serve our growing employee
base. Property and equipment totaled $1,500,772 at December 31, 1999, and
$849,828 at December 31, 1998. During 1998, we purchased Athens' ISP and the
business customer lists of two Atlanta-based ISPs, which increased the cost
basis of our customer lists by $462,636. Accordingly, we incurred a full year of
amortization expense on these customer lists during the year ended December 31,
1999, which contributed to the increase in depreciation and amortization
expense.
Costs of canceled initial public equity offering. During the year ended
December 31, 1999, we incurred $1,082,827 of costs associated with our initial
public offering, which we withdrew during the fourth quarter. These costs
represented 33.5% of total revenues for the year ended December 31, 1999. We
incurred no corresponding expenses during the year ended December 31, 1998.
Interest expense. Net interest expense decreased as a percentage of
total revenues to 5.9% for the year ended December 31, 1999 from 7.0% of total
revenues for the year ended December 31, 1998. Interest expense, net of interest
income of $15,965, increased to $191,015 for the year ended December 31, 1999
from $150,605 for the year ended December 31, 1998 due to the additional debt we
incurred to fund our capital purchases and working capital needs. Total debt and
obligations under capital leases at December 31, 1999 was $2,204,813 compared to
$2,214,232 at December 31, 1998.
Other income (loss). Other income increased to $14,806, or 0.5% of
total revenues, for the year ended December 31, 1999 from a loss of $1,987, or
(0.1%) of total revenues, for the year ended December 31, 1998. We recognized a
non-recurring loss of $14,111 on the sale of fixed assets during the year ended
December 31, 1998.
Equity in net loss of investee. We currently own 20.3% of the
outstanding equity interests of nschool Communication Systems, Inc. During 1999,
nschool sustained operating losses exceeding our investment balance. For that
reason, we recorded our percentage of the net loss of nschool, bringing our
investment balance to zero.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
REVENUES
Total revenues increased 217.1% to $2,142,345 for the year ended
December 31, 1998 from $675,569 for the year ended December 31, 1997 due to
substantial increases in Internet access revenues, data center services
revenues, circuit rebill revenues and other revenues as described in the
following paragraphs. The increase in total revenues is attributable primarily
to a larger number of customers, partially offset by a lower amount of sales per
customer. We had 474 customers at December 31, 1998 and an average monthly
billing of approximately $476 per customer for the year ended December 31, 1998,
as compared to 243 customers at December 31, 1997 and an average monthly billing
of approximately $518 per customer for the year ended December 31, 1997. The
increase in customers at December 31, 1998 was due in part to our purchase of
the business customer lists of two ISPs in April 1998 and July 1998 and our
purchase of Athens' ISP in July 1998. The average monthly billing per customer
for the year ended December 31, 1998 decreased by approximately 8.1% over the
average monthly billing for the year ended December 31, 1997 because revenues
from lower-priced Internet access services increased at a higher rate than
revenues from higher-priced data center services.
Internet access. Internet access revenues increased to $1,334,053, or
62.3% of total revenues, for the year ended December 31, 1998 from $399,167, or
59.1% of total revenues, for the year ended December 31, 1997 primarily due to
the overall increase in the customer base, partially offset by a decrease in the
average monthly billing per customer.
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<PAGE> 26
Internet access revenues increased 234.2% for the year ended December
31, 1998 over the year ended December 31, 1997.
Data center services. Data center services revenues increased to
$417,112, or 19.5% of total revenues, for the year ended December 31, 1998 from
$205,171, or 30.4% of total revenues, for the year ended December 31, 1997
primarily due to the overall increase in the customer base, partially offset by
a decrease in the average monthly billing per customer. We completed our
expansion of the Atlanta data center facilities in April 1998. This expanded
facility allowed us to offer our data center services to a broader market. Data
center services revenues increased 103.3% for the year ended December 31, 1998
over the year ended December 31, 1997.
Circuit rebill. Circuit rebill revenues increased to $255,230, or 11.9%
of total revenues, for the year ended December 31, 1998 from $44,459, or 6.5% of
total revenues, for the year ended December 31, 1997. The increase is due to new
and existing customers purchasing or upgrading to higher-end, more expensive
services such as T1 and frame relay.
Other. Other revenues increased to $135,950, or 6.3% of total revenues,
for the year ended December 31, 1998 from $26,772, or 4.0% of total revenues,
for the year ended December 31, 1997. The increase is primarily due to a $42,846
increase in non-recurring hardware resales and $37,533 in transaction processing
fees associated with our e-commerce software. We began offering our e-commerce
software for customer use in July 1998.
COSTS AND EXPENSES
Cost of network services. As a percentage of total revenues, cost of
network services decreased to 57.7% for the year ended December 31, 1998 from
78.3% for the year ended December 31, 1997. Cost of network services increased
to $1,235,862 for the year ended December 31, 1998 from $528,835 for the year
ended December 31, 1997. This increase in cost of network services is due
primarily to the increase in the amount of upstream and downstream access we
purchased to serve our growing customer base. The decrease as a percentage of
revenues is due to increased use of excess upstream capacity resulting from the
increase in our customer base.
Salaries and wages. As a percentage of total revenues, salaries and
wages decreased to 24.3% for the year ended December 31, 1998 from 54.8% for the
year ended December 31, 1997. Salaries and wages increased to $521,570 for the
year ended December 31, 1998 from $370,145 for the year ended December 31, 1997.
The increase in salaries and wages is primarily due to the increased workforce
needed to serve the expanding customer base. We had 18 employees at December 31,
1998 compared to nine employees at December 31, 1997.
General and administrative. As a percentage of total revenues, general
and administrative expenses decreased to 17.7% for the year ended December 31,
1998 from 19.5% for the year ended December 31, 1997. General and administrative
expenses increased to $379,036 for the year ended December 31, 1998 from
$131,767 for the year ended December 31, 1997. The increase in general and
administrative expenses is primarily attributable to increases in advertising
expenditures, additional insurance policies, professional fees, general office
equipment and computer supply costs as well as dues for our membership in
various industry trade organizations.
Rent. Rent increased to $106,417, or 5.0% of total revenues, for the
year ended December 31, 1998 from $33,152, or 4.9% of total revenues, for the
year ended December 31, 1997. This increase in rent is due primarily to
additional rent incurred with the expansion of our data center and our
assumption of a lease in our acquisition of Athens' ISP.
Management fees. As a percentage of total revenues, management fees
decreased to 2.8% for the year ended December 31, 1998 from 6.2% for the year
ended December 31, 1997. Management fees increased to $60,000 for the year ended
December 31, 1998 from $42,000 for the year ended December 31, 1997. The
increase is directly attributable to an increase in monthly management fees from
$2,000 to $5,000 that became effective on July 1, 1997.
Depreciation and amortization expense. Depreciation and amortization
increased to $284,598, or 13.3% of total revenues, for the year ended December
31, 1998 from $57,255, or 8.5% of total revenues, for the year ended December
31, 1997. The increase in depreciation expense is primarily due to an increase
in the capitalized costs of property and equipment acquired during the year. The
cost basis of property and equipment increased to $849,828 at
24
<PAGE> 27
December 31, 1998 from $384,300 at December 31, 1997. The increase in
amortization expense is directly attributed to the amortization of the customer
lists and related customer accounts purchased from two other ISPs in April and
July 1998 and the amortization of the customer list and related customer
accounts acquired with Athens' ISP in 1998. The cost basis of customer lists
increased to $547,974 at December 31, 1998 from $85,338 at December 31, 1997.
Interest expense. As a percentage of total revenues, interest expense
decreased to 7.0% for the year ended December 31, 1998 from 9.8% for the year
ended December 31, 1997. Interest expense increased to $150,605 for the year
ended December 31, 1998 from $66,201 for the year ended December 31, 1997 due to
the additional debt we incurred to fund our capital purchases, customer list
purchases, the Athens' ISP acquisition, and working capital needs. Total debt
and obligations under capital leases at December 31, 1998 was $2,214,232
compared to $1,128,845 at December 31, 1997.
LIQUIDITY AND CAPITAL RESOURCES
Historically, we have funded our operations and capital expenditures
primarily through cash flow from operations; borrowings from banks, shareholders
and db Telecom Technologies; capital leases; and sales of common stock and
investment units. At December 31, 1999, we had outstanding debt and accrued
interest of $2,340,946. On December 30, 1999, our registration statement on Form
S-1 (Commission File No. 333-92581) relating to the registered limited public
offering of 100 investment units consisting of an 8% Senior Convertible Note and
a stock purchase warrant sold for an aggregate of $50,000 per unit was declared
effective. This offering closed on January 5, 2000, and net proceeds from the
offering were approximately $4.5 million after deducting placement agent
commissions ($300,000) and expenses related to the offering. In 2000 we repaid
$1.2 million in debt and interest (all of which was either owed to or guaranteed
by one or more of our affiliates, as explained in Item 11 - Executive
Compensation - Compensation Committee Interlocks and Insider Participation), and
we have used or are using the balance of approximately $3.3 million for working
capital and to pay for costs associated with our Washington, D.C. data center,
which we plan to open in April 2000. In addition, at the closing of that
offering, we issued a total of 543,738 shares of common stock to Dr. Dayton and
Mr. Bruce (one half to each) in exchange for their forgiveness of an additional
$618,549 principal plus accrued interest that we owed them, and we issued
236,337 shares to db Telecom Technologies in exchange for its forgiveness of
$270,188 principal plus accrued interest that we owed it. As a result, we
currently have no long-term debt outstanding, except for $91,991 of capital
leases that we intend to continue to pay in the ordinary course of business and
$5,000,000 in principal amount of our 8% senior promissory notes.
We are currently in the process of offering, through a private
placement, a minimum of $10,000,000 and a maximum of $30,000,000 of Series B
convertible preferred stock to a limited number of investors. In connection with
and concurrent with the closing of the proposed offering, we plan to exchange
our 8% senior promissory notes for 387,600 shares of Series A convertible
preferred stock. The warrants to purchase 1,356,600 shares of our common stock
that were purchased by our current noteholders in January 2000 remain
outstanding as of the date of this report and will not be exchanged for series A
preferred stock.
From November 23, 1998 through June 30, 1999, we sold 371,786 shares of
our common stock in a private placement at a price of $5.71 per share. We used
the $2,122,744 of net proceeds of that private placement for working capital. On
January 5, 2000, we issued 1,276,658 shares of common stock to these investors,
pro rata and without any additional cash payment by those investors.
Net cash used by operating activities was $1,313,882 for the year ended December
31, 1999, $210,355 for the year ended December 31, 1998, $402,451 for the year
ended December 31, 1997 and $202,080 for the period from inception (March 5,
1996) to December 31, 1996. Net cash used in investing activities was $710,144
for the year ended December 31, 1999, $1,010,909 for the year ended December 31,
1998, $349,196 for the year ended December 31, 1997 and $120,442 for the period
from inception (March 5, 1996) to December 31, 1996. Cash used in investing
activities was primarily for the purchase of Athens' ISP in 1998, the purchase
of customer lists and related customer accounts from other ISPs in 1998 and
1997, the investment in nschool in 1998 and 1999 and the purchase of property
and equipment in all three years. Financing activities provided cash in the
amounts of $1,748,504 for the year ended December 31, 1999, $1,450,209 for the
year ended December 31, 1998, $799,921 for the year ended December 31, 1997 and
$328,924 for the period from inception (March 5, 1996) to December 31, 1996. The
primary source of this cash was proceeds from the issuance of long-term debt in
each of those three years and the issuance of common stock in the years ended
December 31, 1998 and 1999.
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<PAGE> 28
We estimate that the net proceeds of the private placement described
above, funds currently on hand and funds to be provided by operations will be
sufficient to fund our expansion plans and our working capital needs through
September 2000 if we raise the minimum $10,000,000 in that offering and through
January 2002 if we raise the maximum $30,000,000. There can be no assurance that
this offering or the related transactions will be completed. Failure to complete
the offering would raise substantial doubt about the Company's ability to
continue as a going concern.
We may seek additional financing in the future to fund ongoing capital
expenditures and liquidity requirements and to further pursue our goal of
purchasing and leasing new data centers. We cannot guarantee that we will obtain
this financing on acceptable terms or at all or that if we do obtain the
financing, it will be adequate to purchase or lease the data centers we need and
to satisfy our cash requirements.
In addition, numerous factors could accelerate our need for additional
funding. For example, we intend to grow, in part, through strategic
acquisitions, some of which may require significant cash expenditures, but we
cannot predict the timing and amount of any acquisitions and expenditures that
may occur.
Our ability to grow will depend not only on acquisitions but also on
our ability to expand and improve our operations, the effectiveness of our
marketing efforts and our customer support capabilities. In addition, we will
need to raise additional capital from equity or debt sources. If we raise
additional funds by issuing equity or convertible debt securities, our
shareholders may experience dilution, and those securities may have rights,
preferences or privileges senior to those of our common stock.
YEAR 2000 COMPLIANCE
OVERVIEW
We rely on computer software programs, internal operating systems and
telephone and other network communications connections to conduct our business.
If any of these programs, systems or network connections are not programmed to
recognize and properly process dates after December 31, 1999, significant system
failures or errors may result. We have experienced no such problems as of the
date of this report, although it is still possible that we could experience
those problems in the future. These matters are commonly referred to as year
2000 issues, and they could have a material adverse effect on both our affected
customers and us. Our potential areas of exposure include:
- information technology, including computers, software and
systems that we have developed internally or purchased or
licensed from others, such as our billing system and accounts
receivable system,
- non-information technology, including telephone systems and
other equipment that we use internally, and
- external systems, particularly the systems that comprise the
Internet and those services that allow us access to the
Internet and our customers to access our network.
We believe that our internal accounting and operating programs and
systems and the network connections we maintain are adequately programmed to
address the year 2000 problem. Our costs for assessment, remediation and testing
related to the year 2000 problem have been minimal to date, and we do not expect
to incur any additional costs that are material.
RISKS
Our failure to correct a material year 2000 problem could result in an
interruption in, or a failure of, normal business activities or operations. We
supply Internet related services to our customers and have not tested any other
products or systems used in our customers' businesses. If our customers have not
successfully addressed year 2000 issues in their operations, and as a result
they experience temporary or permanent interruptions in their businesses, we may
lose revenues from these customers. We cannot estimate the potential expenses
involved or delays that may result from the failure of these customers and third
parties to have resolved their year 2000 issues. If these expenses, failures or
delays do in fact occur, they may have a material adverse effect on our
business, financial condition or results and operations.
In providing Internet access to our customers, we depend upon providers
of telecommunications and data services, government agencies, utility companies
and other service providers over which we have little or no control. If any of
these entities fails to correct its year 2000 issues, our customers may be
unable to use the Internet, and our operations
26
<PAGE> 29
would suffer. See "Risk Factors - Potential year 2000 problems may cause us to
lose customers and subject us to significant liabilities and costs."
CONTINGENCY PLANS
We have no specific contingency plans for any year 2000 failures that
may occur other than the redundancies already built into our system. For
example, we have multiple connections to ISPs, allowing us to route traffic away
from any particular provider that may experience problems. We believe if one or
more of our providers fail, we will be able to obtain additional connections
from either our current providers or new providers. In addition, we have a
back-up generator powered by diesel fuel that will provide power for
approximately 36-48 hours. We have no plans to establish a more specific
contingency plan for year 2000 disruptions, and we have not needed any such
contingency plans to date.
The estimates and conclusions included in this discussion contain
forward-looking statements and are based on our management's best estimates of
future events. Our expectations about risks may turn out to be incorrect, and
any variance from these expectations could cause actual results to differ from
this discussion. Factors that could influence risks, amount of future costs and
the timing of remediation efforts include our success in identifying and
correcting potential year 2000 issues and the ability of others to address their
year 2000 issues.
The statements above related to the ability of our services to operate
properly after January 1, 2000 are "Year 2000 Readiness Disclosures" under the
Year 2000 Information and Readiness Disclosure Act of 1998. Those statements are
not a guaranty, contract or warranty, and our compliance with that act does not
preclude any claims against us based on the federal securities laws.
RECENT ACCOUNTING PRONOUNCEMENTS
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, 1999. 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. In June 1999,
the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities - Deferral of the Effective Date of FASB Statement No. 133." This
statement defers the effective date of SFAS No. 133 to fiscal years beginning
after June 15, 2000. We believe that the adoption of SFAS No. 133 and SFAS No.
137 will not have a material impact on our financial statements.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements," which addresses revenue recognition issues. SAB 101 requires, in
certain cases, nonrefundable up-front fees for services to be deferred and
recognized over the expected period of performance. SAB 101 is required to be
adopted for the quarter ending June 30, 2000. The Company is currently assessing
the types of transactions that may be impacted by this pronouncement. The impact
of SAB 101 on the financial statement of the Company is not yet known.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Our interest income and expense is sensitive to changes in the general
level of United States interest rates. Changes in United States interest rates
affect the interest that we earn on our cash investments as well as the interest
that we incur on our debt. Based on our cash equivalents balance and level of
debt at December 31, 1999, our exposure to interest rate risk is not material.
We believe our exposure to market risks is immaterial. We hold no
market risk sensitive instruments for trading purposes. At present, we do not
employ any derivative financial instruments, other financial instruments or
derivative commodity instruments to hedge any market risks, and we do not
currently plan to employ them in the future.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of comstar.net, including comstar.net's
balance sheets as of December 31, 1999 and 1998 and statements of operations,
statements of cash flows and statements of shareholders' deficit for the three
years ended December 31, 1999, together with the report thereto of Arthur
Andersen LLP dated March 10, 2000, and the schedule containing certain
supporting information, are attached hereto as pages F-1 through F-19.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS IN ACCOUNTING AND FINANCIAL
DISCLOSURES
Not applicable.
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PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
EXECUTIVE OFFICERS, DIRECTORS, AND KEY EMPLOYEES
The executive officers, directors and key employees of comstar.net, and
their ages as of March 15, 2000 are listed in the following table. Our articles
of incorporation divide our board of directors into three classes, as nearly
equal in number as possible. Class I directors' terms expire at the annual
meeting of shareholders in 2000, Class II directors' terms expire at the annual
meeting of shareholders in 2001, and Class III directors' terms expire at the
annual meeting of shareholders in 2002.
<TABLE>
<CAPTION>
NAME AGE CLASS POSITION
- ---- --- ----- --------
<S> <C> <C> <C>
Samuel F. Dayton, Ph.D......................... 64 I Chairman of the Board
J. Cary Howell................................ 40 III Chief Executive Officer and Director
Edward N. Landa................................ 30 I Chief Technology Officer, Secretary and Director
Steven J. Edwards............................. 53 - Executive Vice President of Sales and Marketing
Michael A. Dayton............................ 38 - Vice President of Network Operations
James L. Bruce, Jr........................... 55 II Director
Mark S. Hoffman.............................. 38 * Director
Glenn W. Sturm............................... 46 III Director
Stephen R. Gross............................. 52 II Director
</TABLE>
* Mr. Hoffman was elected to our board by the other directors in January 2000,
and his term will expire at our 2000 annual meeting.
Samuel F. Dayton, Ph.D., a co-founder of comstar.net, has served as
Chairman of the Board since we were incorporated in March 1996, and he served as
President from our incorporation until November 1999. Since 1994, Dr. Dayton has
also served as Chairman and Chief Executive Officer of db Telecom Technologies,
Inc., which helps telecommunications companies develop and install their
transmission sites, test their equipment for quality and strength of signal, and
maintain their equipment after installation. During 1998 and 1999, Dr. Dayton
served as the Chairman of the Board of nschool Communications Systems, Inc., a
developer and licensor of software that links educators, parents and students.
He remains a director of nschool. Dr. Dayton is the father of Michael A. Dayton.
J. Cary Howell, a co-founder of comstar.net, has served as Chief
Executive Officer and as a director since March 1996. From February 1995 to
April 1996, Mr. Howell was Manager of Network Operations for MindSpring
Enterprises, Inc., an ISP. From February 1993 to February 1995, Mr. Howell was a
communications consultant with OmniTech Consulting Group, a consulting group for
telecommunications providers such as BellSouth and served as a consultant for
various other companies. From April 1991 to April 1993, Mr. Howell was a Senior
Engineer for Memotec Corporation, a voice and data service provider. In June
1996, Mr. Howell co-founded the Association of Internet Professionals. He is a
life member, served as its first Chairman from June 1996 to May 1998 and
currently serves as Vice Chairman and a director.
Edward N. Landa, a co-founder of comstar.net, has served as Chief
Technology Officer since January 1999, as Vice President of Engineering from
March 1996 to January 1999, and as Secretary and a director since March 1996.
From February 1996 to May 1996, Mr. Landa was an engineer with MindSpring
Enterprises, Inc. From February 1994 to February 1996, Mr. Landa served as
Network Systems Administrator for Lida Stretch Fabrics, a textile manufacturer.
From March 1990 to February 1994, Mr. Landa worked for the Electric Power
Research Institute, a company that researches technological solutions for the
electricity industry, as an employee of J.A. Jones Applied Research, a research
company. Mr. Landa served in various positions at American Communications
Company and its parent American Systems Corporation, both of which are
communications companies, from 1986 to 1988.
Steven J. Edwards has served as Executive Vice President of Sales and
Marketing since June 1999. From July 1997 to May 1999, Mr. Edwards served as
Director, Global Business Programs, EMEA (Europe, Middle East, Africa) for
28
<PAGE> 31
Bay Networks, a hardware provider of networking equipment that was acquired by
Nortel Networks in September 1998. Mr. Edwards served as Director, Customer
Development, EMEA for Bay Networks from May 1996 to June 1997. From June 1993 to
May 1996, Mr. Edwards held various sales positions at SynOptics Communications,
Inc., a hardware provider of networking equipment which merged with another
company and was renamed Bay Networks in October 1994. Mr. Edwards began his
career in 1970 with International Business Machines Corporation and worked in
many sales and marketing functions until his departure in 1989.
Michael A. Dayton has served as Vice President of Network Operations
since August 1999 and served from June 1999 to August 1999 as Vice President of
Finance and Mergers and Acquisitions. Mr. Dayton coordinated our engineering and
accounting functions from June 1997 to June 1999. From September 1994 to May
1997, Mr. Dayton attended the Whiting School of Engineering at Johns Hopkins
University as a graduate student and was also a research scientist at the Center
for Nondestructive Evaluation at Johns Hopkins University. Mr. Dayton is the son
of Dr. Samuel F. Dayton.
James L. Bruce, Jr., a co-founder of comstar.net, has served as a
director since 1996. He has also served as the President and a director of db
Telecom Technologies since 1994. Since 1970, Mr. Bruce has served as an
executive with a variety of businesses in the textile and manufacturing
industries.
Mark S. Hoffman has served as a director since January 2000. Mr.
Hoffman has been a member of Palisade Capital Management, L.L.C., the investment
manager of Palisade Private Partnership, L.P., since October 1994. Mr. Hoffman
is also a director of Register.com, a company applying for listing on the Nasdaq
National Market as well as several privately held companies including C3i, Inc.,
Berdy Medical Systems, Inc. and Show Digital, Inc.
Glenn W. Sturm has served as a director since July 1999. Mr. Sturm has
been a partner in the law firm of Nelson Mullins Riley & Scarborough, L.L.P.
since 1992, and he presently serves as a member of its Executive Committee. He
is a director of The InterCept Group, Inc. and Towne Services, Inc. Mr. Sturm is
a principal of Capital Appreciation Partners II and a director and the chief
executive officer of Netzee, Inc.
Stephen R. Gross has served as a director since July 1999. In 1979, Mr.
Gross co-founded HLB Gross Collins, P.C., a full-service accounting firm in
Atlanta, Georgia. Mr. Gross also serves as a director of the Concert Investment
Series Funds, ebank.com, Inc., Ikon Ventures, Inc. and SuperCorp, Inc.
The purchasers of the investment units sold in January 2000, acting
through Palisade Private Partnership, L.P., the purchaser of the largest number
of units in this offering, currently have the right:
- to designate two persons as nominees to our board of directors
(one of whom must have relevant industry experience and must
be reasonably satisfactory to the other members of the board),
which together with the four principal shareholders must
constitute a majority of the board unless the holders of 66
2/3% of the outstanding principal amount of the notes consent
otherwise (this right is effective so long as the holders of
the notes in the aggregate own 5% or more of our equity on a
fully diluted basis),
- to designate one additional person as an observer who is
permitted to receive all materials provided to members of the
board and its committees and to attend all meetings of the
board and its committees, and
- upon an event of default under the notes, to designate as
nominees to the board such number of persons as would then be
necessary for all such designees to constitute a majority of
the board.
The noteholders have designated Mr. Hoffman as their nominee to the board, and
he was elected by the directors to fill a newly created vacancy in January 2000.
These rights will terminate upon the exchange of notes for series A preferred
stock, which is expected to occur concurrently with the closing of the offering
of our series B preferred stock, which is ongoing as of the date of this report.
For additional information relating to these designation rights, see
Item 11 - Executive Compensation - Compensation Committee Interlocks and Insider
Participation. We have no information regarding the identity of the other
potential designee to our board.
29
<PAGE> 32
<TABLE>
<CAPTION>
COMMITTEES OF OUR BOARD OF DIRECTORS
COMMITTEES AND MEMBERS FUNCTION OF COMMITTEES
---------------------- ----------------------
<S> <C>
Executive committee - exercises the power of the board of directors
James L. Bruce, Jr. between board meetings, with some limitations
Samuel F. Dayton
Stephen R. Gross
J. Cary Howell
Audit committee - reviews our audit functions, including our
Glenn W. Sturm accounting and financial reporting practices
Stephen R. Gross - reviews the adequacy of our system of internal
accounting controls and the quality and integrity
of our financial statements
- maintains relations with our independent
auditors
Compensation committee - establishes the compensation of our executive
Glenn W. Sturm officers, including salaries, bonuses, commissions, and
Stephen R. Gross benefit plans
- administers our option and incentive plans
</TABLE>
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Not applicable.
30
<PAGE> 33
ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
The following table describes all compensation earned by or paid or
awarded to our chief executive officer for services rendered to us in all
capacities during the year ended December 31, 1998 and to our chief executive
officer and the two other executive officers earning more than $100,000 for the
year ended December 31, 1999. These three officers are the "named executive
officers" of our company. None of our officers received compensation in excess
of $100,000 for the year ended December 31, 1998.
<TABLE>
<CAPTION>
SUMMARY COMPENSATION TABLE
--------------------------
ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION
- --------------------------- ---- ------------ ----- ------------
<S> <C> <C> <C> <C>
J. Cary Howell, Chief Executive Officer..................... 1998 $ 69,030 -0- -0-
............................................................ 1999 103,479 -0- -0-
Edward N. Landa, Chief Technology Officer................... 1999 101,972 -0- -0-
Christopher K. Martin,
former Chief Financial Officer.............................. 1999 103,928 -0- -0-
</TABLE>
OPTION GRANTS DURING 1999
The following table describes the stock options granted to Christopher
K. Martin, the only named executive officer who was granted stock options in
1999. None of the named executive officers exercised options during 1999. The 5%
and 10% assumed rates of compounded stock price appreciation are mandated by SEC
rules. We cannot guarantee that the actual stock price appreciation over the
term will be the assumed 5% and 10% levels or at any other defined level. Unless
the market price of the common stock appreciates over the option term, no value
will be realized from the option grant. At the end of 1999, no options were
in-the-money.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
--------------------------------------------------------------------
POTENTIAL REALIZABLE VALUE
AT ASSUMED ANNUAL RATES
NUMBER OF PERCENT OF OF STOCK PRICE
SECURITIES TOTAL OPTIONS APPRECIATION FOR
UNDERLYING GRANTED TO OPTION TERM
OPTIONS EMPLOYEES IN EXERCISE GRANT EXPIRATION --------------------------
NAME GRANTED FISCAL YEAR PRICE DATE DATE 5% 10%
- ---- --------- ------------ --------- -------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C> <C>
Christopher K. Martin,
former Chief
Financial Officer...... 100,000 6.5% $5.71 03/10/99 03/09/09 $359,099 $910,027
</TABLE>
EMPLOYMENT AGREEMENTS
As a general matter, we do not enter into employment agreements, and we
have not entered into employment agreements with any of our executive officers.
Rather, the employment relationships with each executive officer are "at will."
However, in connection with the initial employment of each executive officer,
comstar.net and the executive executed an offer letter which outlines the
general compensation and benefits provided to the executive, including base
salary, targeted annual bonus, option grants and employee benefits. We granted
Steven J. Edwards, our Executive Vice President of Sales and Marketing, an
option to purchase 100,000 shares of common stock at an exercise price of $5.71
per share concurrently with the commencement of his employment. These options,
which were granted under the comstar.net, inc. Amended and Restated 1999 Stock
Option and Incentive Plan, vest in three equal installments on the first three
anniversaries of the commencement of his employment and have a term of ten years
from the date of grant. In addition, in March 1999 we granted Michael A. Dayton,
our Vice President of Network Operations, an option under the 1999 Option Plan
to purchase 100,000 shares of common stock at an exercise price of $5.71 per
share. As of the date of this memorandum, 66,667 shares subject to the option
are vested and the remaining shares vest in June 2000. Mr. Dayton's options have
a term of ten years from the date of grant.
31
<PAGE> 34
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No member of our compensation committee is or previously has been an
officer or employee of ours. None of our executive officers currently serves as
a member of the compensation committee or as a director of any entity of which
any of our directors serves as an executive officer. Before establishing the
compensation committee in August 1999, our board of directors, acting as a
whole, determined executive compensation. Dr. Samuel F. Dayton, our Chairman of
the Board, and James L. Bruce, Jr., one of our directors, are also directors,
executive officers and the sole shareholders of db Telecom Technologies, and Dr.
Dayton is also a director and shareholder of nschool Communication Systems, Inc.
We have entered into transactions with each of those companies as explained
below.
From the date of our inception in March 1996 and through September
1997, Dr. Dayton and Mr. Bruce loaned us an aggregate of $618,549. These loans
earned simple interest at a rate of 10% per year. Immediately before the closing
of our January 2000 offering, we issued a total of 543,738 shares to Dr. Dayton
and Mr. Bruce (one half to each) in exchange for their forgiveness of this
indebtedness.
From the date of our inception through June 30, 1999, we have paid
monthly management fees to db Telecom Technologies in exchange for various
administrative, accounting, consulting and other management services. For the
year ended December 31, 1998, we paid db Telecom Technologies an aggregate
amount of $60,000 for management fees and $4,305 for other services. For the
year ended December 31, 1999, we paid db Telecom Technologies $30,000 in
management fees and we reimbursed db Telecom Technologies in the amount of
$35,844 for other services. On July 1, 1999, we assumed the management functions
previously provided by db Telecom Technologies, and we will incur no additional
expenses for such management fees after that time.
In December 1996, db Telecom Technologies agreed to provide additional
periodic loans to us on an "as needed" basis. Under this agreement, db Telecom
Technologies loaned us an aggregate of $270,188. All amounts extended under this
loan earned simple interest at a rate of 10% per year. Immediately before the
closing of our January 2000 offering, we issued a total of 236,337 shares to db
Telecom Technologies in exchange for its forgiveness of this indebtedness. The
repayment of this debt was personally guaranteed by each of Dr. Dayton, Mr.
Bruce, J. Cary Howell, our Chief Executive Officer and a director, and Edward N.
Landa, our Chief Technology Officer and a director. Dr. Dayton and Mr. Bruce are
the sole shareholders of db Telecom Technologies.
In May 1998, we established a line of credit with Premier Bank to
borrow up to an aggregate of $700,000 from time to time, at an annual interest
rate of prime plus 1%. Each of Dr. Dayton, Mr. Howell, Mr. Landa and Mr. Bruce
gave personal guarantees to Premier Bank that the amounts due under the credit
line would be repaid. We repaid this loan and the accrued interest with a
portion of the net proceeds from our January 2000 offering.
In July 1998, Dr. Dayton and Mr. Bruce personally borrowed $383,985
from The First National Bank of Commerce on our behalf, and then loaned us the
money to fund our purchase of Athens' ISP. We repaid approximately $100,000 of
this loan in February 1999, when Dr. Dayton and Mr. Bruce obtained an extension
of the loan's maturity date to August 27, 1999. We repaid the principal amount
of $283,985 and accrued interest on loan, which was subsequently extended in
August 1999, with a portion of the net proceeds of our January 2000 offering.
In September 1998, we borrowed $200,100 from Premier Bank under a
promissory note bearing interest at an annual rate of prime plus 1%. Dr. Dayton
personally guaranteed the repayment of this note. We made a principal payment of
$50,000 in each of March 1999 and July 1999. We repaid this loan and the accrued
interest with a portion of the net proceeds from our January 2000 offering.
In December 1998, we entered into an agreement with nschool
Communication Systems, Inc., a developer and licensor of software that links
educators, parents and students. Under the agreement, we developed software
applications for nschool in exchange for 25% of the then outstanding common
stock of nschool. In addition, we promised not to compete with nschool by
utilizing the developed technology, and nschool granted us the right to match
any contract for Internet access presented to nschool by any other ISP. We
granted to nschool a license to use both the combined software product and the
separable components for limited purposes, and nschool granted to us a license
to use the components of the software for any purpose and to use the combined
software product for limited purposes. During 1999, nschool completed a private
placement of its common stock that decreased our ownership interest in nschool
to 20.3% as of December 31, 1999.
32
<PAGE> 35
In September 1999, we granted options to purchase an aggregate of
520,000 shares of our common stock to key employees of db Telecom Technologies
at an exercise price of $5.71 per share in connection with consulting services
these employees performed for us. All of these options were granted pursuant to
our Amended and Restated 1999 Stock Option and Incentive Plan and are currently
exercisable. At December 31, 1999, 2,000 of the options had been forfeited.
In September 1999, the board granted each of Mr. Dayton and Mr. Bruce
an option to purchase 137,500 shares of common stock at an exercise price of
$5.71 per share in consideration for their financial and management support of
us since our inception. These options were granted under our Amended and
Restated 1999 Stock Option and Incentive Plan, are immediately exercisable and
have a term of ten years from the date of grant.
In November 1999, Dr. Dayton agreed to lend us up to $140,000 to cover
short-term expenses. The outstanding principal amount of this loan earned
interest at a rate of 10% per year and was payable on the earlier of January 15,
2000 or the closing of our January 2000 offering. We borrowed the full $140,000
from Dr. Dayton under this arrangement. We repaid this loan and the accrued
interest with a portion of the net proceeds of our January 2000 offering.
Upon the completion of our January 2000 offering, we and our four
principal shareholders - Dr. Dayton, Mr. Bruce, Mr. Landa and Mr. Howell -
entered into a shareholders agreement with Palisade Private Partnership, L.P.,
the purchaser of the largest number of units in that offering, as agent for all
of the holders of the notes sold in that offering. The shareholders agreement
provides that so long as the holders of the notes in the aggregate beneficially
own 5% or more of our equity on a fully diluted basis, the agent, acting on
behalf of the noteholders, will have the right to designate two people as
nominees to serve on our board of directors. These two nominees, together with
the four principal shareholders, must constitute a majority of the board unless
the holders of 66 2/3% of the outstanding principal amount of the notes consent
otherwise. One of these two nominees must have relevant experience in our
industry and must be reasonably satisfactory to the other members of the board.
Additionally, until we complete an initial underwritten public offering of
securities, the agent will have the right to designate one person as an observer
who will be entitled to receive notice of all meetings of the board and its
committees, to receive all materials distributed to members of the board and its
committees, and to attend all meetings of the board and its committees. Upon an
event of default under the notes, the agent will have the right to designate as
nominees to the board such number of persons as would then be necessary for all
of the agent's designees to constitute a majority of the board. Each of the
principal shareholders will agree to vote his shares of our stock and to vote as
a director to achieve the board composition described above. We have no
information regarding the identity of any potential designee under the
shareholders agreement other than Mark S. Hoffman, who was elected to the board
by the directors in January 2000 pursuant to this arrangement. Under the
shareholders agreement, each of the principal shareholders will also agree not
to sell or otherwise dispose of any shares of our capital stock except to
members of his immediate family or related trusts or estates, and these
permitted transferees must agree to hold the shares subject to the terms of the
shareholders agreement. This shareholders agreement terminates when the notes
are satisfied in full. We anticipate that this will occur upon the exchange of
all of the notes for shares of series A preferred stock concurrently with the
closing of the offering of our series B preferred stock, which is ongoing as of
the date of this report.
Since our inception, a portion of our business has resulted from our
relationship with db Telecom Technologies. We expect to continue to benefit from
this relationship in the future, particularly with respect to educational and
governmental contracts we may jointly pursue.
DIRECTOR COMPENSATION
Our bylaws allow our board of directors to determine from time to time
the compensation that directors may receive for their service as directors.
Since inception, however, our directors have served without cash compensation,
except for reimbursement for out-of-pocket expenses for each meeting attended.
We granted to each of Mr. Gross and Mr. Sturm options to purchase
100,000 shares of common stock at an exercise price of $5.71 per share in
September 1999. These options were vested with respect to one-third of the
shares as of the date of grant and will vest with respect to the remaining
shares in two equal installments on each of the next two anniversaries of the
date they commenced service on the board. The options have a term of five years
from the date of grant. For additional information regarding options and awards
directors are eligible to receive under the comstar.net Director Stock Option
Plan, see "- comstar.net, inc. Director Stock Option Plan" below.
33
<PAGE> 36
COMSTAR.NET, INC. AMENDED AND RESTATED 1999 STOCK OPTION AND INCENTIVE PLAN
In March 1999, the board of directors adopted the 1999 Stock Option and
Incentive Plan under which a maximum of 1,700,000 shares of our common stock
were available to be granted to employees, consultants and others rendering
services to us. In September 1999, we increased the number of shares available
for grant under this plan to 2,300,000 shares, and in October 1999 our
shareholders approved the 1999 Option Plan, as amended. The number of shares
that may be granted under the 1999 Option Plan automatically increases on
January 1 of each calendar year to an amount equal to 15% of our common stock
outstanding on December 31 of the previous year, calculated on a fully diluted
basis, if that amount is greater than the maximum amount previously available
for grant under the 1999 Option Plan. Options may be either incentive stock
options within the meaning of Section 422 of the Internal Revenue Code, which
permits the deferral of taxable income related to the exercise of the option, or
nonqualified options not entitled to the tax deferral. Incentive stock options
may only be granted to employees, and the exercise price must be at least equal
to the fair market value of the common stock on the date the options are
granted. In addition, the 1999 Option Plan allows for awards of restricted stock
and stock appreciation rights.
The board of directors and the compensation committee administer the
1999 Option Plan. Under the 1999 Option Plan, the number of shares for which
options may be granted and the number of shares that may be issued under
unexercised options are adjusted to take into account some of the events
affecting the common stock, including stock splits, dividends payable in common
stock and business combinations. Within the limits specified in the 1999 Option
Plan, the board of directors and the compensation committee, in their
discretion, select the recipients of awards and the number of options granted
under the 1999 Option Plan and determine other matters such as:
- vesting and exercisability schedules,
- the exercise price of options, which cannot be less than 100%
of the fair market value of the common stock on the date of
grant for all stock options, and
- the duration of awards.
Our general practice has been to make all options granted under the
1999 Option Plan vest in three equal installments on the first three
anniversaries of the date the optionee commences employment. As of December 31,
1999, we had granted options to purchase 1,537,250 shares of common stock under
the 1999 Option Plan at an exercise price of $5.71 per share. All of these
options have a term of ten years from the date of grant. As of December 31,
1999, 2,000 of the options had been forfeited.
COMSTAR.NET, INC. DIRECTOR STOCK OPTION PLAN
Our board of directors approved the Director Stock Option Plan in
September 1999, and our shareholders approved the Director Stock Option Plan in
October 1999. The Director Option Plan provides for the grant of non-qualified
stock options to our non-employee directors. The Director Option Plan authorizes
the issuance of up to 600,000 shares of common stock under options having an
exercise price equal to the fair market value of the common stock on the date
the options are granted. Under the Director Option Plan, the number of shares
for which options may be granted and the number of shares that may be issued
under unexercised options are adjusted to take into account some of the events
affecting the common stock, including stock splits, dividends payable in common
stock and business combinations. The board of directors administers the Director
Option Plan.
The Director Option Plan provides for grants of options to acquire
shares of common stock to each non-employee director who is initially elected to
the board of directors after the date of approval of the Director Option Plan.
The board of directors will establish the number of shares in each grant, the
exercise terms and vesting schedules of each option on the grant date. Each
option will expire five years after the date of grant, unless cancelled sooner
as a result of termination of service or death, or unless the option is fully
exercised before the end of the option period. As of December 31, 1999, options
to acquire 200,000 shares of common stock were outstanding under the Director
Option Plan at an exercise price of $5.71 per share. All of these options have a
term of five years from the date of grant.
34
<PAGE> 37
DIRECTOR AND OFFICER LIABILITY AND INDEMNIFICATION
Our articles of incorporation provide that no director will be
personally liable to us or any of our shareholders for any breach of the duties
of office, except that the elimination of liability does not apply to:
- appropriations of business opportunities in violation of the
director's duties,
- knowing or intentional misconduct or violation of law,
- liability for assenting to distributions which are illegal or
improper under Georgia law or our articles of incorporation,
and
- liability for any transaction in which the director derived an
improper personal benefit.
In addition, our articles of incorporation state that if Georgia law is
ever amended to allow for greater exculpation of directors than presently
permitted, the directors will be relieved from liabilities to the fullest extent
provided by Georgia law, as so amended. No further action by the board of
directors or our shareholders is required, unless Georgia law provides
otherwise. No modification or repeal of our articles of incorporation will
adversely affect the elimination or reduction in liability provided by them with
respect to any alleged act occurring before the effective date of that
modification or repeal.
We have entered into indemnification agreements with each of our
directors and executive officers that give these individuals similar rights to
indemnification and contribution.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table provides information with respect to the beneficial
ownership of our common stock as of March 15, 2000 by:
o each person known by us to beneficially own more than 5% of the outstanding
shares of common stock, o each of our directors and currently employed executive
officers named in the summary compensation table, and o all of our directors and
executive officers as a group.
Unless otherwise indicated, the address of each of the beneficial
owners identified is c/o comstar.net, inc., 2812 Spring Road, Suite 210,
Atlanta, Georgia 30339. Except as otherwise indicated, the beneficial owners
have sole voting and investment power with respect to all shares of common stock
owned by them. Percentage of ownership is based on 12,428,514 shares of common
stock outstanding as of March 15, 2000. Shares of common stock issuable under
options, common stock purchase warrants, and convertible notes held by the
respective person or group that may be exercised within 60 days after March 15,
2000 are referred to in this memorandum as "presently convertible securities."
Under SEC rules, presently convertible securities are deemed to be outstanding
and to be beneficially owned by the person or group holding those securities for
the purpose of computing the percentage ownership of the person or group, but
are not treated as outstanding for the purpose of computing the percentage
ownership of any other person or group.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY OWNED
BEFORE THE OFFERING
-------------------
NAME OF BENEFICIAL OWNER NUMBER PERCENT
------------------------ ------ -------
<S> <C> <C>
Palisade Private Partnership, L.P. (1) ...................... 2,093,028 14.4%
Samuel F. Dayton(2).......................................... 3,184,538 25.3
J. Cary Howell............................................... 2,482,490 20.0
Edward N. Landa(3)........................................... 2,502,764 20.1
James L. Bruce, Jr.(4)....................................... 3,145,706 25.0
Glenn W. Sturm(5)............................................ 33,333 *
Stephen R. Gross (5)......................................... 33,333 *
Mark S. Hoffman (6) ......................................... 2,093,028 14.4
BB&T Capital Partners, LLC (7)............................... 1,151,165 8.5
All directors and executive officers as a group (9 persons)(8) 13,277,687 89.3
</TABLE>
* Less than 1% of the outstanding common stock.
35
<PAGE> 38
(1) Consists of 1,550,388 shares of common stock that may be issued on the
exercise of a convertible note and 542,640 shares of common stock that
may be acquired on the exercise of a presently exercisable stock
purchase warrant. The address of Palisade Private Partnership, L.P. is
One Bridge Plaza, Fort Lee, New Jersey 07024.
(2) Includes 137,500 shares of common stock that may be issued on the
exercise of presently exercisable stock options. Also includes: 38,832
shares of common stock held by the Mauney Family Limited Partnership;
and 236,337 shares of common stock held by db Telecom Technologies,
Inc., all of which may be deemed to be beneficially owned by Dr.
Dayton. Dr. Dayton disclaims beneficial ownership of the shares held by
the Mauney Family Limited Partnership and db Telecom Technologies,
Inc., except to the extent of his pecuniary interest in the shares.
(3) Includes 10,000 shares of common stock owned by Mr. Landa's wife and
12,264 shares of common stock held by seven trusts of which Mr. Landa
is the sole trustee, all of which may be deemed to be beneficially
owned by Mr. Landa. Mr. Landa disclaims beneficial ownership of all of
these 22,264 shares, except to the extent of his pecuniary interest in
the shares.
(4) Includes 400,000 shares of common stock held by Tartan Family
Properties, L.P., all of which may be deemed to be owned by Mr. Bruce.
Mr. Bruce disclaims beneficial ownership of these 400,000 shares except
to the extent of his pecuniary interest in the shares. Includes 137,500
shares of common stock that may be issued on the exercise of presently
exercisable stock options. Also includes 236,337 shares of common stock
held by db Telecom Technologies, Inc., all of which may be deemed to be
beneficially owned by Mr. Bruce. Mr. Bruce disclaims beneficial
ownership of the shares owned by db Telecom Technologies, Inc., except
to the extent of his pecuniary interest in the shares. Mr. Bruce's
address is c/o Yonah Manufacturing Company, P.O. Box 280, Cornelia,
Georgia 30531.
(5) Consists of 33,333 shares of common stock that may be issued on the
exercise of presently exercisable stock options.
(6) Consists of 1,550,388 shares of common stock that may be issued on the
exercise of a convertible note and 542,640 shares of common stock that
may be acquired on the exercise of a presently exercisable stock
purchase warrant, each of which is owned by Palisade Private
Partnership, L.P. See note (1) above. Mr. Hoffman is a member of
Palisade Capital Management, LLC, the investment manager of Palisade
Private Partnership, L.P. Mr. Hoffman disclaims beneficial ownership of
the securities held by Palisade Private Partnership, L.P., except to
the extent of his pecuniary interest in the securities. Mr. Hoffman's
address is c/o Palisade Private Partnership, L.P., One Bridge Plaza,
Fort Lee, NJ 07024.
(7) Consists of 852,713 shares of common stock that may be issued on the
exercise of a convertible note and 298,452 shares of common stock that
may be acquired on the exercise of a presently exercisable stock
purchase warrant. The address of BB&T Capital Partners, LLC is 200 West
Second Street, Fourth Floor, Winston-Salem, NC 27101.
(8) Includes 341,666 shares of common stock that may be issued on the
exercise of presently exercisable stock options granted to our
directors, 448,832 shares of common stock held by affiliates of certain
members of the group and 12,264 shares of common stock held by trusts
for which members of the group serve as trustee, which may be deemed to
be beneficially owned by those members. Also includes 236,337 shares
held by db Telecom Technologies, Inc., all of the stock of which is
held by Dr. Dayton and Mr. Bruce, and 1,550,388 shares of common stock
that may be issued on the exercise of a convertible note and 542,640
shares of common stock that may be acquired on the exercise of a
presently exercisable stock purchase warrant held by Palisade Private
Partnership, L.P. See notes (1) and (6) above.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We believe that all of the following transactions, as well as all of
the transactions described in Item 11 - Executive Compensation - Compensation
Committee Interlocks and Insider Participation, were made on terms no less
favorable to us than could have been obtained from other unaffiliated parties.
All future transactions, including loans, between us and our officers,
directors, principal shareholders and their affiliates will be approved by a
majority, but not
36
<PAGE> 39
fewer than two, of our disinterested directors, and will continue to be on terms
no less favorable to us than could be obtained from other unaffiliated parties.
In June 1999, we sold 8,757 shares of common stock at $5.71 per share
to Steven J. Edwards, our Executive Vice President of Sales and Marketing, who
was an officer at the time of sale.
Our director Glenn W. Sturm is a partner in the law firm of Nelson
Mullins Riley & Scarborough, L.L.P., where he serves as a member of the
executive committee. Nelson Mullins has advised us regarding securities and
corporate law matters since August 1998.
In addition to the transactions described above, other transactions
involving Dr. Samuel F. Dayton, our Chairman of the Board, James L. Bruce, Jr.,
one of our directors and principal shareholders, their affiliates, J. Cary
Howell, our Chief Executive Officer and a director, and Edward N. Landa, our
Chief Technology Officer and a director, are described in Item 11 - Executive
Compensation - Compensation Committee Interlocks and Insider Participation.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) Financial Statements
The following consolidated financial statements of comstar.net, inc.
and its subsidiaries are filed as part of this Annual Report and are attached
hereto as pages F-1 to F-24:
Report of Independent Public Accountants
Balance Sheets as of December 31, 1998 and 1999
Statements of Operations for the years ended December 31,
1997, 1998 and 1999
Statements of Shareholders' Equity for the years ended
December 31, 1997, 1998 and 1999
Statements of Cash Flows for the years ended December 31,
1997, 1998 and 1999 Notes to Financial Statements
37
<PAGE> 40
(a)(2) Financial Statement Schedules
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Charged to
Beginning Costs and Ending
Description Balance Expenses Deductions Balance
--------- ---------- ---------- --------
<S> <C> <C> <C> <C>
For fiscal year ended:
December 31, 1997: Allowance for doubtful
accounts $ -- $ 19,426 $ -- $ 19,426
December 31, 1998: Allowance for doubtful
accounts $19,426 $ 24,039 $18,018 $ 25,447
December 31, 1999: Allowance for doubtful
accounts $25,447 $120,275 $31,090 $114,632
</TABLE>
38
<PAGE> 41
(a)(3) Exhibits
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
2.1*+ Asset Purchase Agreement dated as of June 30, 1998 between
ISP, Inc. and the registrant.
3.1* Amended and Restated Articles of Incorporation dated November
22, 1998.
3.2* Amended and Restated Bylaws.
4.1 See Exhibits 3.1 and 3.2 for provisions defining the rights of
the comstar.net shareholders.
4.2 Form of 8% Senior Promissory Note (incorporated by reference
to Appendix A to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
4.3 Form of Stock Purchase Warrant (incorporated by reference to
Appendix B to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
4.4* Amended and Restated Shareholder Agreement dated December 1,
1998; Amendment No. 1 to Amended and Restated Shareholder
Agreement dated August 31, 1999.
4.5 Form of Shareholders Agreement (incorporated by reference to
Appendix C to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
4.6 Form of Subscription Agreement (incorporated by reference to
Appendix D to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
10.1*/** Amended and Restated 1999 Stock Option and Incentive Plan,
including form of Stock Option Agreement attached thereto.
10.2*/** Director Stock Option Plan, including form of Director Stock
Option Agreement attached thereto. 10.3* Form of
Indemnification Agreement between comstar.net, inc. and each
of its directors and executive officers.
10.4* Lease of office space from The Emerson Center Company dated
September 30, 1999.
10.5* Lease of office space from The Emerson Center Company dated
October 15, 1999.
10.6* Form of Network Services Agreement between comstar.net and its
customers.
10.7* Form of Internet Access Service Addendum to the Network
Services Agreement.
10.8* Form of Colocation Service Addendum to the Network Services
Agreement.
10.9* Form of Corporate Acceptable Use Policy Addendum to the
Network Services Agreement.
10.10* Form of Special Access Services Agreement between comstar.net
and its customers.
10.11* Form of Non-Solicitation, Confidentiality and Assignment
Agreement between comstar.net, inc. and each of its employees.
21.1* Subsidiaries of the Company.
24.1 Power of Attorney (included on signature pages hereto).
27.1 Financial Data Schedule (for SEC use only).
------------------
* Incorporated by reference to the exhibits to the Company's
Registration Statement on Form S-1 (No. 333-92581) as declared
effective by the Securities and Exchange Commission on
December 30, 1999.
** This agreement is a compensatory plan or arrangement required
to be filed as an exhibit to this Form 10-K pursuant to Item
14(c).
+ We agree to furnish supplementally a copy of any omitted
schedule or exhibit to the SEC upon request, as provided in
Item 601(b)(2) of Regulation S-K.
(b) Reports on Form 8-K
There were no Reports on Form 8-K filed during the fiscal quarter
ending December 31, 1999.
39
<PAGE> 42
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereto duly authorized.
comstar.net, Inc.
March 29, 2000
- ----------------------------------- By: /s/ J. Cary Howell
Date ----------------------------------
J. Cary Howell
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints jointly and severally, J. Cary Howell and
Samuel F. Dayton, and each one of them, his attorneys-in-fact, each with the
power of substitution, for him in any and all capacities, to sign any and all
amendments to this Annual Report (Form 10-K) and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each said
attorneys-in-fact, or his substitute or substitutes, may do or cause to be done
by virtue hereof.
Pursuant to the requirements of the Securities Exchanges Act of 1934,
this Report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signatures Title Date
- ---------- ----- ----
<S> <C> <C>
/s/ J. Cary Howell Chief Executive Officer March 29, 2000
- -------------------------------------------- (principal executive officer)
J. Cary Howell
/s/ Edward N. Landa Chief Technology Officer and March 29, 2000
- -------------------------------------------- Director
Edward N. Landa
/s/ Steven J. Edwards
- -------------------------------------------- Executive Vice President of March 29, 2000
Steven J. Edwards Sales and Marketing
/s/ Steven F. Jerman
- -------------------------------------------- Controller and Acting March 29, 2000
Steven F. Jerman Principal Financial Officer
/s/ Samuel F. Dayton
- -------------------------------------------- Director March 29, 2000
Samuel F. Dayton
/s/ James L. Bruce, Jr.
- -------------------------------------------- Director March 29, 2000
James L. Bruce, Jr.
- -------------------------------------------- Director March __, 2000
Glenn W. Sturm
/s/ Stephen R. Gross
- -------------------------------------------- Director March 29, 2000
Stephen R. Gross
/s/ Mark S. Hoffman
- -------------------------------------------- Director March 29, 2000
Mark S. Hoffman
</TABLE>
40
<PAGE> 43
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To comstar.net, inc.:
We have audited the accompanying balance sheets of COMSTAR.NET, INC. (a Georgia
corporation) as of December 31, 1998 and 1999 and the related statements of
operations, shareholders' deficit, and cash flows for each of the three years
ended December 31, 1999. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits 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 of 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 audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of comstar.net, inc. as of
December 31, 1998 and 1999 and the results of its operations and its cash flows
for each of the three ended December 31, 1999 in conformity with generally
accepted accounting principles.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company has incurred significant net operating losses
in each year since its formation. As of December 31, 1999, the Company had an
accumulated deficit of approximately $8.3 million. The Company has also
sustained negative cash flows from operations since inception. The Company has
yet to obtain funding to finance operations through fiscal year 2000. These
factors raise substantial doubt about the Company's ability to continue as a
going concern. Management's plans in regard to these matters are described in
Note 1 to the financial statements. The accompanying financial statements do not
include any adjustments relating to the recoverability and classification of
asset carrying amounts or the amount and classification of liabilities that
might result should the Company be unable to continue as a going concern.
Arthur Andersen LLP
Atlanta, Georgia
March 10, 2000
F-1
<PAGE> 44
COMSTAR.NET, INC.
BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31
----------------------------
1998 1999
----------- -----------
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents $ 283,621 $ 8,099
Accounts receivable, net of allowance for
doubtful accounts of $25,447 and
$114,632 in 1998 and 1999, respectively 234,390 271,388
Prepaid and other current assets 4,764 86,817
Deferred transaction costs 0 323,320
----------- -----------
Total current assets 522,775 689,624
----------- -----------
PROPERTY AND EQUIPMENT:
Computers and telecommunications equipment 689,350 1,251,108
Furniture and fixtures 11,613 23,527
Property under capital leases (Note 8) 46,886 124,158
Leasehold improvements 101,979 101,979
----------- -----------
849,828 1,500,772
Less accumulated depreciation (195,999) (426,132)
----------- -----------
Property and equipment, net 653,829 1,074,640
----------- -----------
OTHER ASSETS:
Investment in nschool (Note 4) 82,744 0
Acquired customer base, net of accumulated
amortization of $157,475 and $376,182
in 1998 and 1999, respectively (Note 3) 390,499 171,791
----------- -----------
Total other assets 473,243 171,791
----------- -----------
Total assets $ 1,649,847 $ 1,936,055
=========== ===========
LIABILITIES AND SHAREHOLDERS' DEFICIT
CURRENT LIABILITIES:
Current maturities of debt (Note 5) $ 902,469 $ 800,100
Note payable to related party (Note 5) 270,188 270,188
Notes payable to shareholders (Note 5) 1,002,534 1,042,534
Current portion of obligations under capital leases (Note 8) 28,067 40,323
Accounts payable 113,604 1,436,334
Accrued professional fees 28,100 641,974
Accrued liabilities 141,629 184,491
Accrued interest 135,501 136,133
Advance billings 75,053 98,313
----------- -----------
Total current liabilities 2,697,145 4,650,390
=========== ===========
LONG-TERM LIABILITIES:
Obligations under capital leases (Note 8) 10,974 51,668
----------- -----------
Total long-term liabilities 10,974 51,668
----------- -----------
COMMITMENTS AND CONTINGENCIES (NOTE 8)
SHAREHOLDERS' DEFICIT (NOTE 6):
Preferred stock, $0 par value; 5,000,000
shares authorized, 0 shares issued and
outstanding in 1998 and 1999 0 0
Common stock, $0 par value:
50,000,000 shares authorized, 10,063,892 and
10,371,786 shares issued and
outstanding in 1998 and 1999, respectively 364,822 2,122,744
Additional paid-in capital 0 3,510,092
Deferred compensation (Note 6) 0 (98,859)
Accumulated deficit (1,423,094) (8,299,980)
----------- -----------
Total shareholders' deficit (1,058,272) (2,766,003)
----------- -----------
Total liabilities and shareholders' deficit $ 1,649,847 $ 1,936,055
=========== ===========
</TABLE>
The accompanying notes are an integral part of these balance sheets.
F-2
<PAGE> 45
COMSTAR.NET, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
DECEMBER 31
------------------------------------------------
1997 1998 1999
------------ ------------ ------------
<S> <C> <C> <C>
REVENUES:
Internet access $ 399,167 $ 1,334,053 $ 1,972,674
Data center services 205,171 417,112 643,249
Circuit rebills 44,459 255,230 528,312
Other 26,772 135,950 91,015
------------ ------------ ------------
Total revenues 675,569 2,142,345 3,235,250
------------ ------------ ------------
COSTS AND EXPENSES:
Cost of network services 528,835 1,235,862 2,106,320
Salaries and wages 370,145 521,570 1,518,543
General and administrative 131,767 379,036 1,071,229
Rent 33,152 106,417 124,991
Management fees (Note 9) 42,000 60,000 30,000
Depreciation and amortization 57,255 284,598 448,840
Stock compensation expense 0 0 3,411,233
------------ ------------ ------------
Total costs and expenses 1,163,154 2,587,483 8,711,156
------------ ------------ ------------
OPERATING LOSS (487,585) (445,138) (5,475,906)
------------ ------------ ------------
OTHER (EXPENSE) INCOME:
Costs of canceled initial public equity offering
(Note 6) 0 0 (1,082,827)
Interest expense, net (66,201) (150,605) (191,015)
Other income (loss) 6,542 (1,987) 14,806
Equity in net loss of investee 0 0 (141,944)
------------ ------------ ------------
Total other expenses (59,659) (152,592) (1,400,980)
------------ ------------ ------------
LOSS BEFORE INCOME TAXES (547,244) (597,730) (6,876,886)
INCOME TAX BENEFIT 0 0 0
------------ ------------ ------------
NET LOSS $ (547,244) $ (597,730) $ (6,876,886)
============ ============ ============
NET LOSS PER SHARE:
Basic and diluted $ (0.05) $ (0.06) $ (0.67)
============ ============ ============
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 10,000,000 10,005,731 10,269,640
============ ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-3
<PAGE> 46
COMSTAR.NET, INC.
STATEMENTS OF SHAREHOLDERS' DEFICIT
<TABLE>
<CAPTION>
COMMON STOCK
UNDESIGNATED ADDITIONAL
------------------------- PAID IN DEFERRED ACCUMULATED
SHARES AMOUNT CAPITAL COMPENSATION DEFICIT TOTAL
---------- ---------- ---------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1996 1,000 $ 0 $ 0 $ 0 $ (278,120) $ (278,120)
Net loss 0 0 0 0 (547,244) (547,244)
---------- ---------- ---------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1997 1,000 0 0 0 (825,364) (825,364)
Net loss 0 0 0 0 (597,730) (597,730)
Exchange of common stock 9,999,000 0 0 0 0 0
Issuance of common stock 63,892 364,822 0 0 0 364,822
---------- ---------- ---------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1998 10,063,892 364,822 0 0 (1,423,094) (1,058,272)
Net loss 0 0 0 0 (6,876,886) (6,876,886)
Issuance of common stock 307,894 1,757,922 0 0 0 1,757,922
Issuance of stock options 0 0 3,510,092 (3,510,092) 0 0
Amortization of deferred compensation 0 0 0 3,411,233 0 3,411,233
---------- ---------- ---------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1999 10,371,786 $2,122,744 $3,510,092 $ (98,859) $(8,299,980) $(2,766,003)
========== ========== ========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these statements.
F-4
<PAGE> 47
COMSTAR.NET, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
DECEMBER 31
-------------------------------------------
1997 1998 1999
--------- ----------- -----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(547,244) $ (597,730) $(6,876,886)
--------- ----------- -----------
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 57,255 284,598 448,840
Equity in net loss of investee 0 0 141,944
Stock compensation expense 0 0 3,411,233
Changes in operating assets and liabilities:
Accounts receivable, net (65,339) (160,308) (36,998)
Prepaid and other current assets 0 (4,764) (82,053)
Deferred transaction costs 0 0 (323,320)
Accounts payable 111,565 2,039 1,322,730
Accrued professional fees 0 25,600 613,874
Accrued liabilities (28,128) 109,143 42,862
Accrued interest 50,893 74,561 632
Advance billings 18,547 56,506 23,260
--------- ----------- -----------
Total adjustments 144,793 387,375 5,563,004
--------- ----------- -----------
Net cash used in operating activities (402,451) (210,355) (1,313,882)
--------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of businesses and customer base (85,338) (513,836) 0
Purchases of property and equipment, net (263,858) (414,329) (650,944)
Investment in nschool 0 (82,744) (59,200)
--------- ----------- -----------
Net cash used in investing activities (349,196) (1,010,909) (710,144)
--------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of debt 455,355 469,731 0
Proceeds from note payable to related party 55,124 233,080 0
Proceeds from notes payable to shareholders 313,250 409,095 140,000
Principal payments on debt (16,464) (20,434) (102,369)
Repayments of note payable to related party (6,000) (20,016) 0
Repayments of notes payable to shareholders (1,344) (25,110) (100,000)
Obligations under capital leases 0 39,041 52,951
Proceeds from issuance of common stock 0 364,822 1,757,922
Bank overdraft 0 0 0
--------- ----------- -----------
Net cash provided by financing activities 799,921 1,450,209 1,748,504
--------- ----------- -----------
NET INCREASE (DECREASE) IN CASH 48,274 228,945 (275,522)
CASH AT BEGINNING OF PERIOD 6,402 54,676 283,621
--------- ----------- -----------
CASH AT END OF PERIOD $ 54,676 $ 283,621 $ 8,099
========= =========== ===========
CASH PAID FOR INTEREST $ 15,308 $ 76,044 $ 206,349
========= =========== ===========
</TABLE>
The accompanying notes are an integral part of these statements.
F-5
<PAGE> 48
COMSTAR.NET, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998, AND 1999
1. ORGANIZATION AND BUSINESS OPERATIONS
comstar.net, inc. (formerly Comstar Communications, Inc.) (the
"Company") (a Georgia corporation) is a local, regional, and national
provider of Internet access and other enhanced Internet services to
businesses, educational institutions, and governmental organizations.
The Company was incorporated on March 5, 1996 and commenced operations
on June 10, 1996.
The Company has incurred significant net operating losses in each year
since its formation. As of December 31, 1999, the Company had an
accumulated deficit of approximately $8.3 million. The Company has also
sustained negative cash flows from operations since inception. The
Company expects that it will continue to incur net losses and negative
cash flows from operations as it continues to expend substantial
resources on sales and marketing initiatives and network expansion
efforts. There can be no assurance that the Company will achieve or
sustain profitability or positive cash flow from its operations.
In addition, any increase in the Company's growth rate, shortfalls in
anticipated revenues, increases in anticipated expenses, increase in
customer lists acquired, or significant acquisition opportunities could
have a material adverse effects on the Company's liquidity and capital
resources and would require the Company to raise additional capital
from public or private equity or debt sources in order to finance
operating losses, anticipated growth, and contemplated capital
expenditures. If such sources of financing are insufficient or
unavailable, the Company will be required to modify its growth and
operating plans in accordance with the extent of available funding and
attempt to attain profitability in its existing markets. The Company
may need to raise additional funds in order to take advantage of
unanticipated opportunities, such as the acquisition of a complementary
business or the development of new services, or otherwise respond to
unanticipated competitive pressures. There can be no assurance that the
Company will be able to raise any such capital on terms acceptable to
the Company or at all.
On January 5, 2000, the Company completed a registered offering with
the Securities and Exchange Commission raising net proceeds of
approximately $4.5 million through the sale of 100 investment units at
$50,000 each, each unit consisting of an 8% senior promissory note and
a stock purchase warrant (Note 11). The proceeds of the offering are
being used to fund working capital needs and to repay outstanding debt
and accrued interest of approximately $1.2 million. However, the
Company currently anticipates needing substantially more cash to fund
fiscal year 2000 operations. It currently is in the process of
offering, through a private placement, a minimum of $10,000,000 and a
maximum of $30,000,000 of Series B convertible preferred stock to a
limited number of investors. In connection with and concurrent with the
closing of the proposed offering, the Company plans to exchange its 8%
senior promissory notes for Series A convertible preferred stock. There
can be no assurance that this offering or the related transactions will
be completed. Failure to complete the offering would raise substantial
doubt about the Company's ability to continue as a going concern.
F-6
<PAGE> 49
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from those estimates.
SOURCES OF SUPPLIES
The Company relies on third-party networks, local and long distance
telephone companies, and other companies to provide data communications
capacity. Although management believes that alternative
telecommunications facilities could be found in a timely manner, any
disruption of these services could have an adverse effect on operating
results.
LONG-LIVED ASSETS
Statement of Financial Accounting Standards ("SFAS") No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" establishes accounting standards for the
impairment of long-lived assets, certain identifiable intangibles, and
cost in excess of net assets acquired related to those assets to be
held and used and for long-lived assets and certain identifiable
intangible assets to be disposed of.
The Company periodically reviews the values assigned to long-lived
assets, such as property and equipment and acquired customer base to
determine whether any impairment exists. If circumstances suggest that
the asset values may be impaired, an assessment of the assets'
estimated fair values is performed based on the estimated undiscounted
cash flows expected to be generated from such assets over the remaining
lives of the long-lived assets, and an impairment loss is recognized in
the statement of operations equal to the difference between the
estimated fair values and the assets' carrying values. Management
believes that the long-lived assets in the accompanying balance sheets
are appropriately valued.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Expenditures for
improvements are capitalized, and replacements, maintenance, and
repairs that do not improve or extend the lives of the respective
assets are expensed as incurred. Depreciation is provided on a
straight-line basis over the remaining estimated useful lives, as
follows:
<TABLE>
<S> <C>
Computers and telecommunications equipment Five years
Furniture and fixtures Ten years
Leasehold improvements Three years
</TABLE>
PROPERTY UNDER CAPITAL LEASES
The Company leases certain of its data communication and other
equipment under lease agreements accounted for as capital leases. The
assets and liabilities under capital leases are recorded at the lesser
of the present value of aggregate future minimum lease payments,
including estimated bargain purchase options, or the fair value of the
assets under lease. Property under capital leases is depreciated over
the lesser of their estimated useful lives of five years or the terms
of the leases.
F-7
<PAGE> 50
ADVERTISING COSTS
The Company expenses all advertising costs as incurred.
REVENUE RECOGNITION
The Company's revenues consist primarily of (i) Internet access, (ii)
data center services, (iii) circuit rebills, and (iv) other revenues.
Internet access revenues consist primarily of recurring revenues
received for Internet access services. Data center services revenues
consist primarily of recurring revenues received for co-location,
dedicated application server hosting, E-mail, domain name, and Web
hosting services. Circuit rebills consists primarily of the resale of
distance-sensitive circuits from local loop providers to the Company's
customers. Other revenues consist primarily of transaction processing
fees and miscellaneous hardware sales.
Revenues are recognized as services are provided. Installation and
customer set-up fees are recognized upon completion of services and
comprised approximately 4% of total monthly revenues during 1999. Fees
billed to customers related to installation and customer set-up are
charged in order to recover the Company's cost of installing and
setting up each customer. Transaction processing fees are generated
from the use of the Company's e-commerce software and are recognized
based upon monthly usage. Hardware sales are recognized upon the
delivery of the hardware to the customer.
ADVANCE BILLINGS
Advance billings represent the liability for billings made to customers
in advance of services being provided. Such amounts are recognized as
revenue when the related services are performed.
LIMITED SERVICE WARRANTIES
The Company's customer contracts provide a limited service level
warranty related to the continuous availability of service. This
warranty provides a credit for free service for disruption in Internet
access services. The Company accrues for such costs as estimated at the
time of the sale. Credits issued for disruption in service were
approximately $1,400, $5,200, and $500 for the years ended December 31,
1997, 1998, and 1999, respectively.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments include cash, debt, and other
short-term assets and liabilities. Based on the short-term nature or
variable interest rates of these financial instruments, the estimated
fair values of the Company's financial instruments approximate their
carrying values as of December 31, 1998 and 1999.
CREDIT RISK
The Company's accounts receivable potentially subject the Company to
credit risk, as collateral is generally not required. The Company's
risk of loss is limited due to advance billings to customers for
services and the ability to terminate access on delinquent accounts.
The concentration of credit risk is mitigated by the large number of
customers comprising the customer base. The carrying amounts of the
Company's receivables approximate their fair values as of December 31,
1998 and 1999.
F-8
<PAGE> 51
SIGNIFICANT CUSTOMERS
During the year ended December 31, 1997, sales to one of the Company's
customers were approximately $128,000, representing approximately 19%
of the Company's total revenues. There were no amounts due from this
customer as of December 31, 1997. There were no sales to customers
representing 10% or more of the Company's revenues during the year
ended December 31, 1998.
During the year ended December 31, 1999, sales to one of the Company's
customers were approximately $325,000, representing approximately 10%
of the Company's total revenues. There were no amounts due from this
customer as of December 31, 1999.
NET LOSS PER SHARE
Basic and diluted net loss per share were computed in accordance with
SFAS No. 128, "Earnings per Share," using the weighted average number
of common shares outstanding. Basic loss per share is based on the
weighted average number of shares outstanding. Diluted loss per share
is based on the weighted average number of shares outstanding, and the
dilutive effect of common stock equivalent shares issuable upon the
exercise of stock options (using the treasury stock method). Net loss
for basic and diluted earnings per share is the same for basic and
diluted earnings (loss) per share; therefore, no reconciliation of the
numerator is presented.
On February 4, 1998, the Securities and Exchange Commission released
Staff Accounting Bulletin ("SAB") No. 98, "Computation of Earnings Per
Share." SAB No. 98 requires the retroactive inclusion of nominal
issuances of common stock and common stock equivalents on earnings per
share calculations for all periods presented and precludes the use of
the treasury stock method for these issuances. Management believes that
all issuances of common stock and stock options have been made at the
current market value at the time of issuance either in exchange for
cash, services or other consideration and that there have been no
nominal issuances.
RECENT ACCOUNTING PRONOUNCEMENTS
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, 1999. 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 as well
as the type of hedge transaction. In June 1999, the FASB issued SFAS
No. 137, "Accounting for Derivative Instruments and Hedging
Activities-Deferral of the Effective Date of FASB Statement No. 133".
This statement defers the effective date of SFAS No. 133 to fiscal
years beginning after June 15, 2000. The Company believes that the
adoption of SFAS No. 133 and SFAS No. 137 will not have a material
impact on the Company's financial statements.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in
Financial Statements," which addresses revenue recognition issues. SAB
101 requires, in certain cases, nonrefundable up-front fees for
services to be deferred and recognized over the expected period of
performance. SAB 101 is required to be adopted for the quarter ending
June 30, 2000. The Company is currently assessing the types of
transactions that may be impacted by this pronouncement. The impact of
SAB 101 on the financial statement of the Company is not yet known.
3. ACQUISITIONS
ATHENS' ISP, INC.
On July 1, 1998, Comstar acquired certain assets of Athens' ISP, Inc.
under the terms of an asset purchase agreement. The acquisition
consisted primarily of Internet access business subscribers and related
computer and telecommunications equipment. The purchase price was
$326,678, of which $275,478 was allocated to the customer list and
related accounts and $51,200 was allocated to the equipment acquired.
F-9
<PAGE> 52
The customer list and related accounts acquired is being amortized on a
straight-line basis over three years. No goodwill was recorded.
This acquisition was accounted for under the purchase method in
accordance with Accounting Principles Board ("APB") Opinion No. 16,
"Business Combinations." Accordingly, the purchase price has been
allocated to the net assets acquired based on their estimated fair
values.
ACQUIRED CUSTOMER BASE
The Company capitalizes specific costs incurred related to the purchase
of customer lists and related accounts from other Internet service
providers. These costs include the actual fees paid as well as other
expenses specifically related to the transactions. The following less
significant purchases of customer lists and related accounts occurred
during fiscal years 1997 and 1998:
SYSTEMS ATLANTA COMMUNICATIONS SYSTEMS, INC.
On July 25, 1997, the Company acquired the business customer
list and related accounts of Systems Atlanta Communications
Systems, Inc. and certain related generic computer and
telecommunications equipment under the terms of a purchase
agreement. The purchase price was $148,343, of which $85,338
was allocated to the customer list and related accounts and
$63,005 was allocated to the equipment acquired.
HOLLANDER, DOWS AND REINHARDT
On April 3, 1998, the Company acquired the business customer
list and related accounts of Hollander, Dows and Reinhardt
under the terms of a purchase agreement. The purchase price
was $30,808, all of which was allocated to the customer list
and related accounts.
WATCH ME NOW, INC.
On July 31, 1998, the Company acquired the business customer
list and related accounts and certain related computer and
telecommunications equipment from Watch Me Now, Inc. under the
terms of a purchase agreement. The purchase price was
$179,350, of which $156,350 was allocated to the customer list
and related accounts and $23,000 was allocated to the
equipment acquired.
The Company amortizes customer lists and related accounts over the
lesser of three years or their calculated customer churn. Subsequent to
an acquisition that results in the recording of customer lists or other
intangible assets, the Company continually evaluates whether later
events and circumstances have occurred that indicate that the remaining
estimated useful lives of intangible assets may warrant revision or
that the remaining balance of intangible assets may not be recoverable.
When factors indicate that intangible assets should be evaluated for
possible impairment, the Company uses a calculation of customer churn
or an estimate of the related business segment's undiscounted net
income or cash flows, as appropriate, over the remaining life of the
assets in measuring whether such assets are recoverable in accordance
with SFAS No. 121.
4. INVESTMENT IN NSCHOOL COMMUNICATION SYSTEMS, INC.
On December 10, 1998, the Company entered into an agreement with
nschool Communication Systems, Inc. ("nschool"), an internet
communications company servicing educational institutions. The
agreement required the Company to develop specialized software
applications and provide related services to
F-10
<PAGE> 53
nschool in exchange for a 25% ownership interest in nschool. In
accordance with APB Opinion No. 17, "Intangible Assets," the ownership
interest in nschool was valued at the cost incurred to develop the
software provided. Services were provided under this agreement from
August 1998 through June 1999. The Company accounts for the investment
in nschool under the equity method of accounting.
During 1999, nschool sustained operating losses exceeding the Company's
investment balance. The Company therefore, recorded its percentage of
the net loss of nschool bringing its investment balance to zero. The
Company will track those losses in excess separately, and any
subsequent realization of income from nschool will first go to reduce
the excess losses. During 1999, nschool completed a private placement
of its common stock resulting in a decrease of the Company's ownership
interest in nschool to 20.3% as of December 31, 1999.
5. DEBT
Borrowings at December 31, 1998 and 1999 consisted of the following:
<TABLE>
<CAPTION>
1998 1999
----------- -----------
<S> <C> <C>
Note payable to related party, interest at 10%, principal and interest
payable at maturity, April 30, 2000 or upon closing of an initial public
offering, whichever is sooner; secured by certain assets of the Company and
personal guarantees by four of the Company's principal shareholders $ 270,188 $ 270,188
Note payable to shareholders, interest at 8.75%, principal and interest
payments payable at maturity, January 27, 2000 383,985 283,985
Note payable to shareholders, interest at 10%, principal and interest
payable at maturity, April 30, 2000 or upon closing of an initial public
offering, whichever is sooner, secured by certain assets of the Company 618,549 618,549
Note payable to shareholder, interest at 10%, principal and interest
payable at maturity, January 15, 2000, or upon closing of an initial public
offering, whichever is sooner 0 140,000
Note payable to bank, interest at prime plus 1%, principal payable at
maturity, January 15, 2000 and interest payments payable monthly; secured
by certain assets of the Company and personal guarantees by one of the
Company's principal shareholders 200,100 100,100
Revolving credit facility, interest at prime plus 1%, principal and accrued
interest due at maturity, January 15, 2000 secured by certain assets of the
Company and personal guarantees by four of the Company's principal
shareholders 700,000 700,000
Note payable to bank, interest at prime plus 1%, principal and interest
payments payable monthly through February 15, 1999; secured by certain
assets of the Company $ 2,369 $ 0
----------- -----------
2,175,191 2,112,822
Less current maturities of debt (2,175,191) (2,112,822)
----------- -----------
$ 0 $ 0
=========== ===========
</TABLE>
F-11
<PAGE> 54
In April 1997, the Company entered into a one-year revolving credit
facility (the "Revolving Credit Facility") with a local commercial
lending institution to provide up to $500,000 of financing for the
Company's operations. In May 1998, the Company extended the Revolving
Credit Facility an additional year and increased the available credit
to $700,000. During 1999, the Company extended the maturity of the
Revolving Credit Facility to January 15, 2000. At December 31, 1998 and
1999, the Revolving Credit Facility had been fully drawn (Note 11).
In July 1998, two of the Company's principal shareholders entered into
a lending arrangement with a bank on behalf of the Company. In
connection with this lending arrangement, the shareholders then loaned
the funds obtained to the Company with terms that mirrored the terms of
the shareholders' note payable to the bank. The Company has been making
principal and interest payments directly to the bank on behalf of the
shareholders since the inception of the obligation. During 1999, the
bank extended the maturity of the obligation from the shareholders to
January 27, 2000 and the interest rate was lowered from 9% to 8.75%.
The shareholders then extended the maturity of the note to the Company
and lowered the interest rate on the note with terms that mirrored the
terms negotiated with the bank. (Note 11).
In November 1999, one of the Company's principal shareholders agreed to
lend the Company up to $140,000 to cover short-term operating expenses.
The outstanding principal amount of this loan earns interest at a rate
of 10% per year and is payable on January 15, 2000 (Note 11).
On December 10, 1999, the maturities of the notes payable to a related
party and to shareholders totaling $270,188 and $618,549, respectively,
were extended from January 1, 2000 to April 30, 2000 (Note 11).
6. SHAREHOLDERS' DEFICIT
COMMON STOCK
In April 1996, the Company's board of directors authorized the issuance
of 1,000 shares of zero par value common stock. Each of the Company's
four founders received 250 shares of the common stock.
On November 19, 1998, the Company's articles of incorporation were
amended and restated to authorize 105,000,000 shares of stock of all
series. The authorization included 10,000,000 shares of common stock
designated as Series A, 10,000,000 shares of common stock designated as
Series B, 80,000,000 shares of undesignated common stock, and 5,000,000
shares designated as preferred stock. The two classes of common stock
are identical except that shares of common stock Series A are entitled
to one vote per share and shares of common stock Series B are entitled
to ten votes per share. All of the series of stock have zero par
values. Two of the original shareholders exchanged 250 shares each of
the previously issued common stock for 2,500,000 shares each of the
Series A common stock. The two remaining shareholders exchanged their
previously issued shares for 2,500,000 shares each of the newly issued
Series B common stock. All per share and share amounts (except for
shareholders' deficit) have been restated for the exchanges.
F-12
<PAGE> 55
SALE OF COMMON STOCK
In November and December 1998, the Company sold 63,892 shares of Series
A common stock for $5.71 per share to several private investors
resulting in total proceeds of $364,822.
From January 1, 1999 to June 30, 1999, the Company sold 307,894 shares
of Series A common stock to several private investors for total
proceeds of $1,757,922. All shares were sold at $5.71 per share.
REVERSE STOCK SPLIT
On November 22, 1999, the Company, after obtaining board and
shareholder approval, amended and restated the articles of
incorporation and effected a 1-for-2 reverse stock split with respect
to its outstanding capital stock. The amendment to the articles of
incorporation decreased the number of authorized shares of its
undesignated common stock to 50,000,000, eliminated the authorized
shares of Series A and Series B common stock, and converted all
outstanding shares of each series to shares of common stock without
designation as to series. Additionally, the amendment to the articles
of incorporation required supermajority approval by the directors and
shareholders of change of control transactions, such as mergers, a sale
of substantially all assets, etc., and implemented a classified board
of directors. All common share and per share information in these
financial statements have been retroactively adjusted to reflect the
reverse stock split, the decrease in the number of authorized shares of
the Company's undesignated common stock to 50,000,000, and the
elimination of the authorized shares of Series A and Series B common
stock (Note 11).
CANCELED INITIAL PUBLIC EQUITY OFFERING
In November 1999, the Company withdrew a planned initial public equity
offering of its common stock. As a result of the decision not to
complete the offering, the Company wrote off associated expenses of
approximately $1,083,000 which primarily related to SEC filing fees,
accounting and legal fees, and printing costs directly attributable to
the canceled initial public equity offering.
EMPLOYEE STOCK OPTION PLAN
On March 1, 1999, the Company's board of directors approved the 1999
Stock Option and Incentive Plan (the "Plan") to grant incentive stock
options to purchase the Company's common stock. The Plan provided for
the issuance of options to purchase up to 1,700,000 shares of the
Company's common stock. On September 1, 1999, the Company's board of
directors amended the Plan. The Amended and Restated 1999 Stock Option
and Incentive Plan (the "Amended Plan") provides for an additional
600,000 shares of the Company's common stock to be available for grant,
bringing the total amount of shares available from 1,700,000 to
2,300,000.
STOCK OPTION GRANTS
The Company granted 677,250 stock options to employees of the Company
under the Plan at $5.71 per share between March 10, 1999 and July 16,
1999. In the opinion of management, the fair value of the Company's
common stock on the dates of grant was equal to the exercise price;
therefore, no compensation expense was recorded at the dates of grant.
These options vest at the rate of one-third per year from the date of
original hire and expire ten years from the date of grant.
On September 1, 1999, two of the Company's principal shareholders were
granted 137,500 options each under the Amended Plan at $5.71 per share.
These options vest immediately upon the date of grant and expire ten
years from the date of grant. Compensation expense of approximately
$162,000 was recorded in connection with this grant.
F-13
<PAGE> 56
On September 1, 1999, 520,000 option grants were made to certain
employees of dbTelecom Technologies, Inc. ("Teletech") under the
Amended Plan at $5.71 per share. These options vest immediately upon
the date of grant and expire ten years from the date of grant.
Compensation expense of approximately $3,204,000 was recorded in
connection with these grants using the fair value method of accounting
as prescribed by SFAS No 123.
On September 17, 1999, 65,000 options were made to four employees of
the Company under the Amended Plan at $5.71 per share. These options
vest at the rate of one-third per year from the date of original hire
and expire ten years from the date of grant. Compensation expense of
approximately $5,000 was recorded during 1999 in connection with these
grants. A summary of the status of the Company's stock options at
December 31, 1999 and changes during the year then ended is presented
in the following table:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
PRICE PER
SHARES SHARE
---------- ---------
<S> <C> <C>
Outstanding at December 31, 1998 0 $ 0.00
Granted 1,537,250 5.71
Forfeited (2,000) (5.71)
---------- --------
Outstanding at December 31, 1999 1,535,250 $ 5.71
========== ========
Exercisable at December 31, 1999 1,032,418 $ 5.71
========== ========
</TABLE>
The Company accounts for its stock-based compensation plan under APB
Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No.
123, "Accounting for Stock-Based Compensation," defines a fair
value-based method of accounting for an employee stock option plan or
similar equity instrument and allows an entity to continue to measure
compensation cost for those plans using the method of accounting
prescribed by APB Opinion No. 25. Entities electing to remain with the
accounting in APB Opinion No. 25 must make pro forma disclosures of net
income and, if presented, earnings per share, as if the fair
value-based method of accounting defined in the statement had been
applied.
The Company has computed for pro forma disclosure purposes the value of
all options granted during the year ended December 31, 1999 using the
minimum value method as prescribed by SFAS No. 123 using the following
assumptions:
<TABLE>
<S> <C>
Risk free interest rate 5.2% to 6%
Expected dividend yield 0
Expected lives Five to ten years
Expected volatility 84%
</TABLE>
If the Company had accounted for these grants in accordance with SFAS
No. 123, the Company's reported pro forma net loss for the year ended
December 31, 1999 would have increased to the following pro forma
amount:
F-14
<PAGE> 57
<TABLE>
<S> <C>
Net loss:
As reported $ (6,876,886)
Pro forma (10,615,800)
Net loss per share:
Basic and diluted:
As reported $ (0.67)
Pro forma (1.03)
</TABLE>
DIRECTOR STOCK OPTION PLAN
On September 1, 1999, the Company's board of directors approved the
Director Stock Option Plan (the "Director Plan"). The Director Plan
provides for the issuance of options to purchase up to 600,000 shares
of the Company's common stock. On September 1, 1999, the Company
granted 100,000 options each to two of the Company's directors at $5.71
per share. These options vest one-third immediately upon the date of
grant, and then at a rate of one-third per year for the next two years
from the date they commenced services as directors. The options expire
five years from the date of grant. Compensation expense of
approximately $52,000 was recorded in connection with these grants
during 1999. The Company's board of directors will establish the number
of shares and vesting schedules for each future grant made under the
Director Plan.
7. INCOME TAXES
Prior to January 1, 1999, the Company was an S corporation and was
generally not subject to corporate level taxes on its net income
because such income was attributed to the Company's shareholders, and
taxes on such income were directly payable by them.
On January 1, 1999, the Company became a C corporation for income tax
purposes. Accordingly, the Company adopted SFAS No. 109, "Accounting
for Income Taxes," which requires the use of the liability method in
accounting for income taxes. Under SFAS No. 109, deferred tax assets
and liabilities are determined based on the difference between the
financial reporting and tax bases of assets and liabilities using
enacted tax rates in effect for the year in which the differences are
expected to reverse. Deferred income taxes also reflect the value of
net operating losses and offsetting valuation allowances provided
against assets which are not likely to be realized.
Upon conversion to C corporation status, the Company recorded deferred
taxes for which it will be responsible resulting from the termination
of S corporation status. The components of the total deferred tax
assets as of December 31, 1999 are as follows:
<TABLE>
<S> <C>
Deferred tax assets:
Net operating loss carryforward $ 2,512,605
Allowance for doubtful accounts 43,514
Amortization of customer lists 119,559
Accrued interest 44,690
-----------
Total deferred tax assets 2,720,368
-----------
Deferred tax liabilities:
Depreciation of property and equipment 69,777
-----------
Net deferred tax assets before valuation allowance 2,650,591
Less valuation allowance (2,650,591)
-----------
Net deferred tax assets $ 0
===========
</TABLE>
F-15
<PAGE> 58
At December 31, 1999, the Company provided a valuation allowance
against the entire net deferred tax asset balance because it is
uncertain whether the net deferred tax assets resulting from these
deferred tax items will be realized through future taxable income.
The following summarizes the components of the income tax benefit for
the year ended December 31, 1999:
<TABLE>
<S> <C>
Current
Federal $(2,336,693)
State (272,156)
Deferred:
Federal 56,769
State 6,612
Valuation allowance 2,545,468
-----------
$ 0
===========
</TABLE>
A reconciliation from the federal statutory rate to the tax benefit for
the year ended December 31, 1999 is as follows:
<TABLE>
<S> <C>
Statutory federal tax rate (34.0)%
State income taxes, net of federal tax benefits (4.0)
Permanent differences--meals and entertainment 1.0
Valuation allowance 37.0
----
0.0%
====
</TABLE>
8. COMMITMENTS AND CONTINGENCIES
LEASE OBLIGATIONS
The Company leases office space under noncancelable operating leases
expiring on various dates through 2004. The Company recorded rent
expense of approximately $33,152, $106,417, and $124,991 for the years
ended December 31, 1997, 1998, and 1999, respectively, related to these
operating leases.
F-16
<PAGE> 59
Minimum future payments under noncancelable capital and operating
leases as of December 31, 1999 for each of the next five years ended
December 31 are as follows:
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES
--------- --------
<S> <C> <C>
2000 $ 48,963 $133,082
2001 33,084 74,406
2002 21,456 73,304
2003 0 76,119
2004 0 58,730
--------- --------
Total minimum lease payments 103,503 $415,641
========
Less imputed interest (11,512)
---------
Present value of minimum capitalized lease payments 91,991
Less current portion of obligations under capital leases (40,323)
---------
Long-term portion of obligations under capital leases $ 51,668
=========
</TABLE>
LEGAL PROCEEDINGS
The Company is subject to lawsuits arising in the ordinary course of
business. In the opinion of management, the ultimate resolution of any
pending legal proceedings will not have a material adverse effect on
the Company's business or financial condition.
DEPENDENCE ON OTHER INTERNET ACCESS AND TELECOMMUNICATIONS PROVIDERS
The Company depends on other corporations such as UUNET Technologies,
Inc. ("UUNET"), GTE Internetworking ("GTE"), Sprint Communications
Company, L.P. ("Sprint"), Intermedia Communications, Inc., and other
facilities-based and nonfacilities-based carriers for the Company's
subscribers' access to Internet. The Company has entered into supply
agreements with Sprint, GTE, UUNET, and other carriers to provide
access to the Internet. The contracts are generally for a term of one
to three years but are subject to early termination in certain
instances. Some of the contracts also contain minimum purchase
requirements. In addition, the Company depends on local carriers such
as BellSouth and MediaOne for their subscribers' transmission to the
Company's network. The Company's ability to maintain and expand
business depends in part on its ability to enter into favorable
contracts with the aforementioned access providers and carriers. The
Company's success also depends on the cooperation of interexchange and
local exchange carriers originating and terminating service in a timely
manner. The partial or total loss of ability to initiate or terminate
access to the internet would result in a loss of revenues and could
lead to a loss of subscribers.
9. RELATED-PARTY TRANSACTIONS
DB TELECOM TECHNOLOGIES, INC.
Teletech is a communications company that builds, maintains and
installs technology upgrades on cellular and PCS networks. Teletech is
co-owned by two of the shareholders of the Company. In December 1996,
Teletech agreed to pay certain operating expenditures on the Company's
behalf and began to charge the Company a management fee for the use of
certain employees of Teletech. All expenditures paid by Teletech are
included in the Company's note payable to Teletech. During 1997, 1998,
and 1999, Teletech paid $7,124, $153,065, and $35,844, respectively, in
operating expenses on the Company's behalf.
F-17
<PAGE> 60
Additionally, Teletech charged the Company management fees of $42,000,
$60,000, and $30,000 during 1997, 1998, and 1999, respectively. As of
December 31, 1998 and 1999, the Company's note payable balance to
Teletech was $270,188. The Company also reimbursed Teletech directly in
cash for various expenses totaling $35,844 through September 1, 1999.
On July 1, 1999, the Company assumed the management functions
previously provided by Teletech and therefore will no longer pay
management fees in the future.
NSCHOOL
The Company owned 20.3% of the outstanding common stock of nschool as
of December 31, 1999 (Note 4). In addition to the development of the
software, the Company performed services related to the design of
nschool's corporate logo for which it charged a total of $1,462 during
1998. No such services were provided during 1999. One of the Company's
principal shareholders and its Chairman of the board of directors was
also the Chairman of the board of directors of nschool through January
2000. This shareholder was also granted a 5% interest in nschool at
December 10, 1998 which was diluted as a result of nschool's private
offering during 1999.
SALE OF COMMON STOCK TO EXECUTIVES
In connection with the sale of the Company's shares to several private
investors from November 23, 1998 through June 30, 1999 (Note 6), the
Company sold 8,757 shares of common stock at $5.71 per share to each of
two executives of the Company on June 30, 1999.
SHAREHOLDER LOAN
In November 1999, one of the Company's principal shareholders agreed to
lend the Company up to $140,000 to cover short-term operating expenses.
The outstanding principal amount of this loan earns interest at a rate
of 10% per year and is payable on the earlier of January 15, 2000 or
the closing of an initial public offering, whichever is sooner (Note
11).
DIRECTOR APPOINTMENT
On July 29, 1999, a partner in a law firm which is providing services
to the Company with respect to general corporate matters as well as in
connection with the Company's proposed initial public offering was one
of two directors appointed to the board of directors of the Company. As
of December 31, 1999, approximately $480,750 was due to this law firm
for previously provided services. Professional fees totaling $67,576
were paid to this law firm during the year ended December 31, 1999.
10. COMPANY NAME CHANGE
On July 29, 1999, the Company's board of directors unanimously voted to
change the name of the Company to comstar.net, inc. from ComStar
Communications, Inc. The name change became legally effective on August
2, 1999. The accompanying financial statements have been modified to
reflect that change.
F-18
<PAGE> 61
11. SUBSEQUENT EVENTS
REGISTERED OFFERINGS AND RELATED TRANSACTIONS
On January 5, 2000, the Company completed a registered offering with
the Securities and Exchange Commission of 100 investment units at
$50,000 each with each unit consisting of an 8% senior promissory note
and a stock purchase warrant. The Company paid approximately $486,000
in fees and expenses associated with the offering out of the proceeds.
The offering was made to a limited number of investors. In connection
with and concurrent with the closing of the offering, the Company
completed the following three transactions. First, the Company effected
a two-for-one forward stock split. Second, the Company issued a total
of 1,276,658 shares of common stock (after the completion of the
two-for-one stock split) to purchasers in the private placement of
common stock completed in June 1999 (Note 6) without any additional
cash payment by those investors. Third, the Company issued a total of
780,075 shares of common stock (after the completion of the two-for-one
stock split) to shareholders and Teletech to settle the outstanding
principal and accrued interest of the $270,188 note payable to Teletech
and the $618,549 note payable to its shareholders (Note 5).
The Company used some of the proceeds of this offering to pay off
amounts outstanding under its Revolving Credit Facility ($700,000), its
note payable to its bank ($100,100), and its notes payable to its
shareholders ($283,985 and $140,000, respectively) (Note 5).
All common share and per share information in these financial
statements have been adjusted to reflect the forward two-for-one stock
split discussed above and the reverse one-for-two split discussed in
Note 6.
The Company is in the process of offering through a private placement a
minimum of $10,000,000 and a maximum of $30,000,000 of Series B
convertible preferred stock to a limited number of investors. In
connection with and concurrent with the closing of the proposed
offering, the Company plans to exchange its 8% senior promissory notes
for newly issued Series A convertible preferred stock. There can be no
assurance that this offering or the related transactions will be
completed.
F-19
<PAGE> 62
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
2.1*+ Asset Purchase Agreement dated as of June 30, 1998 between
ISP, Inc. and the registrant.
3.1* Amended and Restated Articles of Incorporation dated November
22, 1998.
3.2* Amended and Restated Bylaws.
4.1 See Exhibits 3.1 and 3.2 for provisions defining the rights of
the comstar.net shareholders.
4.2 Form of 8% Senior Promissory Note (incorporated by reference
to Appendix A to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
4.3 Form of Stock Purchase Warrant (incorporated by reference to
Appendix B to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
4.4* Amended and Restated Shareholder Agreement dated December 1,
1998; Amendment No. 1 to Amended and Restated Shareholder
Agreement dated August 31, 1999.
4.5 Form of Shareholders Agreement (incorporated by reference to
Appendix C to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
4.6 Form of Subscription Agreement (incorporated by reference to
Appendix D to the prospectus filed on December 30, 1999
pursuant to Rule 424(b)(3), included in registration statement
no. 333-92581).
10.1*/** Amended and Restated 1999 Stock Option and Incentive Plan,
including form of Stock Option Agreement attached thereto.
10.2*/** Director Stock Option Plan, including form of Director Stock
Option Agreement attached thereto.
10.3* Form of Indemnification Agreement between comstar.net, inc.
and each of its directors and executive officers.
10.4* Lease of office space from The Emerson Center Company dated
September 30, 1999.
10.5* Lease of office space from The Emerson Center Company dated
October 15, 1999.
10.6* Form of Network Services Agreement between comstar.net and its
customers.
10.7* Form of Internet Access Service Addendum to the Network
Services Agreement.
10.8* Form of Colocation Service Addendum to the Network Services
Agreement.
10.9* Form of Corporate Acceptable Use Policy Addendum to the
Network Services Agreement.
10.10* Form of Special Access Services Agreement between comstar.net
and its customers.
10.11* Form of Non-Solicitation, Confidentiality and Assignment
Agreement between comstar.net, inc. and each of its employees.
21.1* Subsidiaries of the Company.
24.1 Power of Attorney (included on signature pages hereto).
27.1 Financial Data Schedule (for SEC use only).
- -------------
* Incorporated by reference to the exhibits to the Company's
Registration Statement on Form S-1 (No. 333-92581) as declared
effective by the Securities and Exchange Commission on
December 30, 1999.
** This agreement is a compensatory plan or arrangement required
to be filed as an exhibit to this Form 10-K pursuant to Item
14(c).
+ We agree to furnish supplementally a copy of any omitted
schedule or exhibit to the SEC upon request, as provided in
Item 601(b)(2) of Regulation S-K.
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> DEC-31-1999
<EXCHANGE-RATE> 1
<CASH> 8,099
<SECURITIES> 0
<RECEIVABLES> 386,020
<ALLOWANCES> 114,632
<INVENTORY> 0
<CURRENT-ASSETS> 689,624
<PP&E> 1,500,772
<DEPRECIATION> 426,132
<TOTAL-ASSETS> 1,936,055
<CURRENT-LIABILITIES> 4,650,390
<BONDS> 0
0
0
<COMMON> 2,122,744
<OTHER-SE> (4,888,747)
<TOTAL-LIABILITY-AND-EQUITY> 1,936,055
<SALES> 0
<TOTAL-REVENUES> 3,235,250
<CGS> 0
<TOTAL-COSTS> 8,711,156
<OTHER-EXPENSES> 1,209,965
<LOSS-PROVISION> 120,275
<INTEREST-EXPENSE> 191,015
<INCOME-PRETAX> (6,876,886)
<INCOME-TAX> 0
<INCOME-CONTINUING> (6,876,886)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (6,876,886)
<EPS-BASIC> (0.67)
<EPS-DILUTED> (0.67)
</TABLE>
