<PAGE> 1
SCHEDULE 14A
(RULE 14a-101)
INFORMATION REQUIRED IN PROXY STATEMENT
SCHEDULE 14A INFORMATION
PROXY STATEMENT PURSUANT TO SECTION 14(a) OF THE SECURITIES
EXCHANGE ACT OF 1934
Filed by the Registrant [ ]
Filed by a Party other than the Registrant [X]
CHECK THE APPROPRIATE BOX:
[ ] Preliminary Proxy Statement
[ ] Confidential, for Use of the Commission Only (as permitted by Rule
14a-6(e)(2))
[X] Definitive Proxy Statement
[ ] Definitive Additional Materials
[ ] Soliciting Material Pursuant to Rule 14a-11(c) or Rule 14a-12
MIDCOM COMMUNICATIONS INC.
- --------------------------------------------------------------------------------
(NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
- --------------------------------------------------------------------------------
(NAME OF PERSON(S) FILING PROXY STATEMENT, IF OTHER THAN REGISTRANT)
Payment of Filing Fee (Check the appropriate box):
[X] $125 per Exchange Act Rules 0-11(c)(1)(ii), 14a-6(i)(1), or 14a-6(i)(2)
or Item 22(a)(2) of Schedule 14A.
[ ] $500 per each party to the controversy pursuant to Exchange Act Rule
14a-6(i)(3).
[ ] Fee computed on table below per Exchange Act Rules 14a-6(i)(4) and
0-11.
(1) Title of each class of securities to which transaction applies.
---------------------------------------------------------------------------
(2) Aggregate number of securities to which transaction applies:
---------------------------------------------------------------------------
(3) Per unit price or other underlying value of transaction computed
pursuant to Exchange Act Rule 0-11 (Set forth the amount on which the filing fee
is calculated and state how it was determined):
--------------------------------------------------------------------------
(4) Proposed maximum aggregate value of transaction:
---------------------------------------------------------------------------
(5) Total fee paid:
---------------------------------------------------------------------------
[ ] Check box if any part of the fee is offset as provided by Exchange Act
Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid
previously. Identify the previous filing by registration statement number, or
the Form or Schedule and the date of its filing.
(1) Amount Previously Paid:________________________________________________
(2) Form, Schedule or Registration Statement No.___________________________
(3) Filing Party:__________________________________________________________
(4) Date Filed:____________________________________________________________
<PAGE> 2
LOGO
October 7, 1996
Dear Fellow Shareholder:
You are cordially invited to attend the Annual Meeting of Shareholders (the
"Annual Meeting") of MIDCOM Communications Inc. ("MIDCOM"), which will be held
on October 29, 1996, at 1:00 p.m., local time, at the Olympic Four Seasons
Hotel, Congress Room, 411 University Street, Seattle, Washington.
At the Annual Meeting, you will be asked to elect eight directors to
MIDCOM's Board of Directors divided into three classes and to approve amendments
to the Stock Option Plan to increase the number of shares authorized for
issuance under the Stock Option Plan by an additional 3,000,000 shares, to
permit and ratify the grant of options to certain incumbent directors and to
create a maximum number of options that may be granted under the Stock Option
Plan to any one employee in any three consecutive fiscal years.
Please read the proxy material carefully. Your vote is important. MIDCOM
appreciates your considering and acting on the proposals presented.
MIDCOM'S BOARD OF DIRECTORS RECOMMENDS THAT YOU VOTE FOR THE ELECTION OF
THE EIGHT NOMINEES FOR DIRECTOR AND FOR THE AMENDMENTS TO THE STOCK OPTION PLAN.
Whether or not you plan to attend the Annual Meeting, please complete, sign
and date the enclosed proxy card and return it promptly in the enclosed
postage-prepaid envelope. If you attend the Annual Meeting, you may vote in
person if you wish, even though you previously have returned your proxy card.
Sincerely,
/s/ William H. Oberlin
WILLIAM H. OBERLIN
President and Chief Executive Officer
PLEASE COMPLETE, SIGN, DATE AND RETURN THE ENCLOSED PROXY CARD.
<PAGE> 3
MIDCOM COMMUNICATIONS INC.
NOTICE OF ANNUAL MEETING OF SHAREHOLDERS
TO BE HELD OCTOBER 29, 1996
TO THE SHAREHOLDERS OF MIDCOM COMMUNICATIONS INC.:
Notice is hereby given that the Annual Meeting of Shareholders (the "Annual
Meeting") of MIDCOM Communications Inc., a Washington corporation ("MIDCOM"),
will be held on October 29, 1996, at 1:00 p.m., local time, at the Olympic Four
Seasons Hotel, Congress Room, 411 University Street, Seattle, Washington, for
the following purposes:
1. To elect eight directors divided into three classes, to hold office
for one, two and three-year terms.
2. To consider and vote upon a proposed amendment to the MIDCOM Stock
Option Plan (the "Stock Option Plan") to increase the number of shares of
Common Stock authorized for issuance under the Stock Option Plan by an
additional 3,000,000 shares.
3. To consider and vote upon a proposed amendment to the Stock Option
Plan to permit and ratify the grant of options to certain incumbent
directors.
4. To consider and vote upon a proposed amendment to the Stock Option
Plan to create a maximum number of options that may be granted under the
Stock Option Plan to any one employee in any three consecutive fiscal
years.
5. To transact such other business as may properly come before the
Annual Meeting or any adjournments or postponements thereof.
Only holders of record of Common Stock at the closing of business on August
23, 1996, the record date for the Annual Meeting, are entitled to notice of and
to vote at the Annual Meeting and any adjournments or postponements thereof.
By Order of the Board of Directors
/s/ Paul P. Senio
PAUL P. SENIO
Secretary
Seattle, Washington
October 7, 1996
YOUR VOTE IS IMPORTANT
Whether or not you expect to attend the meeting in person, we urge you to
sign, date and return the accompanying proxy at your earliest convenience. This
will ensure the presence of a quorum at the meeting. PROMPTLY RETURNING A SIGNED
AND DATED PROXY WILL SAVE THE COMPANY THE EXTRA EXPENSE OF ADDITIONAL
SOLICITATIONS. An addressed, postage paid envelope is provided for that purpose.
Sending in your proxy will not prevent you from voting your shares at the
meeting if you desire to do so, as the proxy is revocable at your option in the
manner stated in the accompanying proxy statement.
<PAGE> 4
MIDCOM COMMUNICATIONS INC.
1111 THIRD AVENUE
SEATTLE, WASHINGTON 98101
------------------------
PROXY STATEMENT
------------------------
INFORMATION REGARDING PROXIES
This Proxy Statement and the accompanying form of proxy are furnished in
connection with the solicitation of proxies by the Board of Directors of MIDCOM
Communications Inc. ("MIDCOM" or the "Company") for use at the Annual Meeting of
Shareholders to be held on October 29, 1996, and at any adjournment thereof (the
"Annual Meeting"). Only shareholders of record on the books of the Company at
the close of business on August 23, 1996 (the "Record Date") will be entitled to
notice of and to vote at the Annual Meeting. It is anticipated that these proxy
solicitation materials and a copy of the Company's 1995 Annual Report to
Shareholders will be first sent to shareholders on or about October 7, 1996.
A proxy card is enclosed for your use. YOU ARE REQUESTED ON BEHALF OF THE
BOARD OF DIRECTORS TO SIGN, DATE AND RETURN THE PROXY CARD IN THE ACCOMPANYING
ENVELOPE, which is postage-paid if mailed in the United States or Canada. If the
accompanying form of proxy is properly executed and returned, the shares
represented thereby will be voted in accordance with the instructions specified
thereon. In the absence of instructions to the contrary, such shares will be
voted for all nominees for election to the Board of Directors listed in this
Proxy Statement and for each of the other the proposals described in this Proxy
Statement. Any shareholder executing a proxy has the power to revoke it at any
time prior to the voting thereof on any matter (without, however, affecting any
vote taken prior to such revocation) by delivering written notice to Paul Senio,
Vice President, Secretary and General Counsel of the Company, by executing and
delivering to the Company another proxy dated as of a later date or by voting in
person at the Annual Meeting.
VOTING SECURITIES AND PRINCIPAL HOLDERS
The only outstanding voting securities of the Company are shares of common
stock (the "Common Stock"), each of which is entitled to one vote. As of the
Record Date, there were 15,865,691 shares of Common Stock issued and
outstanding. The presence in person or by proxy of holders of record of a
majority of the outstanding shares of Common Stock is required to constitute a
quorum for the transaction of business at the Annual Meeting.
Under Washington law and the Company's Amended and Restated Articles of
Incorporation (the "Articles") and Bylaws, if a quorum is present, (1) the
nominees for election to the Board of Directors who receive the greatest number
of affirmative votes cast for the election of directors shall be elected
directors and (2) the proposals to amend the Company's Stock Option Plan will be
approved if they receive the affirmative vote of the holders of a majority of
the shares of Common Stock present in person or represented by proxy at the
meeting, and entitled to vote on such proposals. Abstentions and broker
non-votes will be considered represented at the Annual Meeting for the purpose
of calculating a quorum and will have no effect on the election of directors. An
abstention from voting on the option plan proposals will have the practical
effect of a vote "against" such proposal because it is one less vote in favor of
such proposals. Broker non-votes will have no effect on such proposal other than
to reduce the number of "FOR" votes necessary to approve such matters since such
non-votes are not considered "shares entitled to vote" on such proposals.
Proxies and ballots will be received and tabulated by First Interstate Bank, an
independent business entity not affiliated with the Company.
The Common Stock is traded on the Nasdaq National Market. The last sale
price for the Common Stock as reported by Nasdaq on September 23, 1996, was
$15 1/8 per share.
<PAGE> 5
The following table sets forth certain information regarding beneficial
ownership of MIDCOM's Common Stock, as of August 23, 1996, with respect to (i)
each shareholder known by the Company to be the beneficial owner of more than
five percent of the outstanding Common Stock; (ii) each director of MIDCOM;
(iii) the executive officers of the Company named in the Summary Annual
Compensation Table; and (iv) all current directors and executive officers as a
group. Except as otherwise indicated, the Company believes that the beneficial
owners of the Common Stock listed below have sole investment and voting power
with respect to such shares, subject to community property laws where
applicable.
<TABLE>
<CAPTION>
PERCENT OF
AMOUNT AND NATURE OF OUTSTANDING
NAME AND ADDRESS BENEFICIAL OWNERSHIP SHARES(1)
- -------------------------------------------------------------- -------------------- -----------
<S> <C> <C>
Black Creek Limited Partnership(2)............................ 5,691,907 26.84%
(Paul Pfleger)
1201 Third Avenue
Suite 5400
Seattle, WA 98101
Madrona Ridge Limited Partnership(3).......................... 2,167,089 12.0
(John M. Orehek)
1201 Third Avenue
Suite 540l
Seattle, WA 98101
US Online Communications L.L.C.(4)............................ 1,666,667 9.5
1201 Third Avenue
Suite 5400
Seattle, WA 98101
Ashok Rao..................................................... 846,723(5) 5.1
5456 E. Mercer Way
Mercer Island, WA 98040
William H. Oberlin(7)......................................... 188,110 1.2
Jay T. Caldwell............................................... 19,928(6) *
Scott B. Perper(8)............................................ 3,000 *
Karl D. Guelich............................................... 225 *
John M. Zrno(9)............................................... 28,393
Marvin C. Moses(10)........................................... 17,746 *
Daniel M. Dennis.............................................. 0 *
All Executive Officers and Directors as a Group (15
persons).................................................... 6,469,831(11) 29.0
</TABLE>
- ---------------
* Less than 1%
(1) This table is based upon information supplied by directors, officers and
principal shareholders. Percentage of ownership is based on 15,865,691
shares of Common Stock outstanding as of August 23, 1996. Beneficial
ownership is determined in accordance with the Rules of the Securities and
Exchange Commission (the "Commission"), and includes voting and investment
power with respect to the shares. Shares of Common Stock subject to
options, warrants or other securities which are currently exercisable or
exercisable within 60 days of August 23, 1996 are deemed outstanding when
computing the percentage of the person holding such options, but are not
deemed outstanding when computing the percentage of any other person.
(2) Mr. Paul Pfleger, the Chairman of the Board of the Company, has sole voting
and investment power with respect to 3,993,297 shares by virtue of being
the President and sole director of the corporate general partner of this
limited partnership. Includes 31,943 shares of Common Stock issuable upon
conversion of $450,000 aggregate principal of convertible notes held by Mr.
Pfleger which are currently convertible. See "Certain Transactions." Also
includes 1,666,667 shares of Common Stock held by US Online Communications
L.L.C. (formerly Communications Access L.L.C.) with respect to Mr. Pfleger
shares voting and investment power. See footnote (4) below. Also does not
include options which are subject to approval by shareholders at the Annual
Meeting. See "Proposal 3 -- Approval of an
2
<PAGE> 6
Amendment to the Stock Option Plan to Permit and Ratify the Grant of
Options to Certain Incumbent Directors."
(3) Mr. Orehek has sole voting and investment power with respect to 482,676
shares owned by Madrona Ridge Limited Partnership by virtue of being the
President and sole director of the corporate general partner of this
limited partnership. Includes 1,666,667 shares held by US Online
Communications L.L.C. with respect to which Mr. Orehek shares voting and
investment power. See footnote (4) below. Also includes 17,746 shares of
Common Stock issuable upon conversion of $250,000 aggregate principal of
convertible notes held by Mr. Orehek which are currently convertible. See
"Certain Transactions." Also does not include options which are subject to
approval by shareholders at the Annual Meeting. See "Proposal 3 -- Approval
of an Amendment to the Stock Option Plan to Permit and Ratify the Grant of
Options to Certain Incumbent Directors."
(4) Mr. Pfleger and Mr. Orehek are managers of US Online Communications L.L.C.
and share voting and investment power over the shares held by this entity.
(5) Does not include 38,637 shares of Common Stock held in trusts for the
benefit of the children, two nieces and a nephew of Mr. Rao and one
unrelated party, over which Mr. Rao disclaims beneficial ownership. All
shares owned by Mr. Rao and the trusts will be repurchased by the Company
in connection with Mr. Rao's resignation as President, Chief Executive
Officer and Director of the Company. See "Certain Transactions."
(6) Represents options exercisable within 60 days of August 23, 1996.
(7) Includes 188,110 shares of Common Stock issuable upon conversion of
$2,650,000 aggregate principal of convertible notes held by Mr. Oberlin
which are currently convertible. See "Certain Transactions." Also does not
include options which will be granted subject to approval by shareholders
of an increase in shares available for purchase under the Stock Option Plan
at the Annual Meeting. See "Proposal 2 -- Approval of an Amendment to the
Stock Option Plan to Increase the Number of Shares Subject to Options."
(8) Scott B. Perper is an officer of First Union Corporation. Does not include
640,484 shares of Common Stock held by First Union Corporation, as to which
Mr. Perper disclaims beneficial ownership. Also does not include options
which are subject to approval by shareholders at the Annual Meeting. See
"Proposal 3 -- Approval of an Amendment to the Stock Option Plan to Permit
and Ratify the Grant of Options to Certain Incumbent Directors."
(9) Includes 28,393 shares of Common Stock issuable upon conversion of $400,000
aggregate principal of convertible notes held by Mr. Zrno which are
currently convertible. See "Certain Transactions." Also does not include
options which will be granted subject to approval by shareholders of an
increase in shares available for purchase under the Stock Option Plan at
the Annual Meeting. See "Proposal 2 -- Approval of an Amendment to the
Stock Option Plan to Increase the Number of Shares Subject to Options."
(10) Includes 17,746 shares of Common Stock issuable upon conversion of $250,000
aggregate principal of convertible notes held by Mr. Moses which are
currently convertible. See "Certain Transactions." Also does not include
options which will be granted subject to approval by shareholders of an
increase in shares available for purchase under the Stock Option Plan at
the Annual Meeting. See "Proposal 2 -- Approval of an Amendment to the
Stock Option Plan to Increase the Number of Shares Subject to Options."
(11) Includes (i) 34,708 shares of Common Stock subject to options exercisable
within 60 days of August 23, 1996 and (ii) 283,938 shares of Common Stock
issuable upon conversion of convertible notes which are currently
convertible. Also does not include options which are subject to approval by
shareholders at the Annual Meeting. See "Proposal 3 -- Approval of an
Amendment to the Stock Option Plan to Permit and Ratify the Grant of
Options to Certain Incumbent Directors." Also does not include options
which will be granted subject to approval by shareholders of an increase in
shares available for purchase under the Stock Option Plan at the Annual
Meeting. See "Proposal 2 -- Approval of an Amendment to the Stock Option
Plan to Increase the Number of Shares Subject to Options."
3
<PAGE> 7
PROPOSAL 1 -- ELECTION OF DIRECTORS
The Board of Directors of the Company currently consists of eight (8)
directors. Pursuant to the Company's Articles, commencing with the Annual
Meeting, the first election of directors to occur after the completion of the
Company's initial public offering, the Board of Directors will be classified
into three classes, each of which shall be as nearly equal in number as
possible. At such meeting of shareholders, one class will be elected for a
one-year term, one class will be elected for a two-year term and one class will
be elected for a three-year term. All directors hold office until the annual
meeting of shareholders at which their terms expire and the election and
qualification of their successors.
The Board of Directors has approved the nominees named below, all of whom
are currently members of the Board of Directors. Although the Board of Directors
anticipates that all of the nominees will be available to serve as directors of
the Company, should any one or more of them not accept the nomination, or
otherwise be unwilling or unable to serve, it is intended that proxies will be
voted for election of the substitute nominee or nominees designated by the Board
of Directors.
VOTE REQUIRED FOR ELECTION, RECOMMENDATION OF THE BOARD OF DIRECTORS
The three nominees in each class (two in the case of Class I) receiving the
highest number of votes cast for the election of directors shall be elected to
that class of director. Unless otherwise instructed, it is the intention of the
persons named in the accompanying form of proxy to vote shares represented by
properly executed proxies for all nominees named below.
THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR EACH OF THE FOLLOWING
NOMINEES.
NOMINEES FOR DIRECTORS -- CLASS I (TERM EXPIRES AT ANNUAL MEETING IN 1997)
Karl D. Guelich(1)
Scott B. Perper(2)
NOMINEES FOR DIRECTORS -- CLASS II (TERM EXPIRES AT ANNUAL MEETING IN 1998)
Daniel M. Dennis(2)
Marvin C. Moses(1)
John M. Orehek(1)(2)
NOMINEES FOR DIRECTORS -- CLASS III (TERM EXPIRES AT ANNUAL MEETING IN 1999)
William H. Oberlin
Paul Pfleger
John M. Zrno
- ---------------
(1) Member of the Audit Committee.
(2) Member of the Compensation Committee.
Mr. Karl D. Guelich, 53, has served as a director of the Company since
November 1995 and served as a consultant to the Company from March 1996 to April
1996. Since March 1993, Mr. Guelich has been in private practice as a certified
public accountant. From June 1964 to February 1993, Mr. Guelich was employed by
Ernst & Young LLP, where he served as the Area Managing Partner for the Pacific
Northwest offices headquartered in Seattle from October 1986 to November 1992.
Mr. Scott B. Perper, 40, has served as a director of the Company since June
1994. Mr. Perper has been a Senior Vice President of First Union Corporation, a
bank holding company, and of First Union National Bank of North Carolina since
January 1990, and an executive of First Union Capital Partners, the private
equity and mezzanine investment arm of First Union Corporation, since February
1989.
4
<PAGE> 8
Mr. Daniel M. Dennis, 48, has served as a director of the Company since
July 1996. Mr. Dennis served in numerous executive positions since joining MCI
in 1973, the most recent being president of MCI Large Accounts, a division of
MCI, from February 1996 to August 1996. Although Mr. Dennis continues to serve
as a consultant to MCI, he otherwise resigned from MCI effective August 1996.
Mr. Marvin C. Moses, 51, has served as a director of the Company and a
consultant to the Company since May 1996. From August 1995 to January 1996, Mr.
Moses was Vice President and Chief Financial Officer and from January 1996 to
April 1996 Mr. Moses was Vice Chairman and Chief Financial Officer of Frontier
Corporation. He also was Chief Financial Officer and a director of ALC from
October 1988 and September 1989, respectively, until its merger with Frontier in
August of 1995.
Mr. John M. Orehek, 42, has served as a director of the Company since
December 1992. Mr. Orehek has served as President and Chief Executive Officer of
SP Investments Inc., an investment management company, from 1991 to the present.
In addition, Mr. Orehek has been a director of Interfinancial Real Estate
Management Company ("IREMCO") since 1993. IREMCO is the General Partner of the
following four limited partnerships: Urban Improvement Fund Limited ("UIFL");
UIFL 1973; UIFL 1973-II; and UIFL 1974. From 1987 to 1991, Mr. Orehek was
President of Hallmark Capital Partners, Ltd., a Seattle-based real estate
development corporation.
Mr. William H. Oberlin, 51, has served as President, Chief Executive
Officer and a director of the Company since May 1996. Prior to joining the
Company, Mr. Oberlin was President and Chief Operating Officer of Frontier
Corporation, a long-distance telecommunications provider, from August 1995 to
November 1995 and was Executive Vice President, Chief Operating Officer and a
director of ALC Communications Corporation, a long-distance telecommunications
provider, from October 1988, July 1990 and July 1993, respectively, until its
merger with Frontier in August 1995.
Mr. Paul Pfleger, 60, has been Chairman of the Board of the Company since
its formation in 1989. Mr. Pfleger served as acting President and Chief
Executive Officer of the Company from April 1996 to May 1996. Since 1969, Mr.
Pfleger has been actively involved in the real estate industry. He was a founder
and currently is Chairman of the Board of Directors of SP Investments, Inc. Mr.
Pfleger has been Chairman of the Board of Directors of IREMCO since 1984 and has
been its President since April 1993. Pursuant to a shareholders' agreement (the
"Shareholders' Agreement") among certain shareholders and their assignees and
the Company, Mr. Orehek and entities that he controls have agreed to vote their
shares to elect Mr. Pfleger to the Board of Directors. The agreement expires on
June 7, 1999.
Mr. John M. Zrno, 58, has served as a director of the Company and a
consultant to the Company since May 1996. From August 1995 to October 1995, Mr.
Zrno was vice chairman of Frontier Corporation, a long-distance
telecommunications provider, and was President, Chief Executive Officer and a
director of ALC from August 1988 until its merger with Frontier in August of
1995.
BOARD AND COMMITTEE MEETINGS
During the fiscal year ended December 31, 1995, there were 3 meetings and
29 actions by consent in lieu of a meeting of the Board of Directors. Each of
the incumbent directors attended at least seventy-five percent (75%) of the
meetings of the Board of Directors and committees of the Board of Directors on
which he served during his term of service on the Board during 1995.
The Company has established two standing committees of the Board of
Directors: an Audit Committee and a Compensation Committee. The Audit Committee
reviews the functions of the Company's management and independent auditors
pertaining to the Company's financial statements and performs such other related
duties and functions as are deemed appropriate by the Audit Committee and the
Board of Directors. The Audit Committee did not meet during the fiscal year
ended December 31, 1995. The Audit Committee first met in January 1996 to review
year end results. The Compensation Committee makes recommendations to the Board
of Directors concerning the compensation of the Company's executive officers and
directors of the Company and administers the Company's Stock Option Plan and
Stock Purchase Plans. During the fiscal year ended December 31, 1995, the
Compensation Committee conducted its business by consent in lieu of meeting
5
<PAGE> 9
and did not otherwise meet as a separate standing committee. During 1995, the
members of the Audit Committee were Mr. Orehek, Messrs. Josiah H. Low and George
J. Vasilakos, both former directors of the Company, and Mr. Guelich joined the
Audit Committee in November 1995 when he was elected to the Board of Directors.
The members of the Compensation Committee during 1995 were Messrs. Orehek,
Perper, Vasilakos and Mr. William H. Davidson, a former director of the Company.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The current Compensation Committee of the Board of Directors consists of
John M. Orehek, Scott B. Perper and Daniel M. Dennis. None of these individuals
has served at any time as an officer or employee of the Company.
From time to time, the Company has engaged in certain transactions with
members of the Board of Directors and the Compensation Committee. See "Certain
Transactions."
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), requires the Company's directors, certain officers and persons
who own more than ten percent (10%) of the Company's outstanding Common Stock
("Reporting Persons") to file with the Securities and Exchange Commission
("SEC") initial reports of ownership and reports of changes in ownership of
Common Stock and other equity securities of the Company. Reporting Persons are
required by SEC regulations to furnish the Company with copies of all Section
16(a) reports.
To the Company's knowledge, based solely on its review of copies of all
such reports furnished to the Company and written representations that no other
reports were required, all Section 16(a) filing requirements applicable to its
officers and directors were complied with except that U.S. Online Communications
L.L.C. (formerly Communication Access L.L.C.) filed one Form 3 late and Paul H.
Pfleger, John M. Orehek and the Black Creek Limited Partnership each filed one
Form 4 late. All such late filings were in connection with the initial
capitalization of U.S. Online Communications L.L.C. where Black Creek Limited,
Mr. Pfleger and Mr. Orehek contributed shares of the Company to U.S. Online
Communications L.L.C.
EXECUTIVE COMPENSATION
The following table shows compensation paid by the Company for services
rendered during its last two fiscal years ended December 31, 1994 and 1995 to
the Chief Executive Officer during 1995 and to the only two executive officers
of the Company serving on December 31, 1995, whose salary and bonuses exceeded
$100,000 (collectively, the "Named Executive Officers").
6
<PAGE> 10
SUMMARY ANNUAL COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
AWARDS
--------------
SECURITIES
UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS(#)(1) COMPENSATION($)(2)
- ------------------------------ ---- -------- -------- -------------- ------------------
<S> <C> <C> <C> <C> <C>
Ashok Rao(3).................. 1995 $292,500 0 3,000 $ 7,830
President and Chief 1994 300,000 0 278,775 3,762
Executive Officer
Eric G. Peterson(4)........... 1995 117,000 0 1,000 4,105
Executive Vice President and 1994 118,667 0 1,663 4,521
Treasurer
Jay T. Caldwell............... 1995 97,500 0 15,750 3,207
Senior Vice President of 1994 100,000 0 5,478 17,289
Revenue Management
</TABLE>
- ---------------
(1) The 1994 amounts include immediately exercisable options granted in March
1995 in lieu of cash bonuses for 1994 to Messrs. Rao, Peterson and Caldwell
of 18,375, 1,663 and 1,103 shares of Common Stock, respectively. These
options are exercisable at $2.29 per share and expire on the tenth
anniversary of the date of grant or ninety days after termination of
employment.
(2) Represents payments under the Company's 401(k) plan and payments for term
life insurance premiums.
(3) Mr. Rao resigned as an officer of the Company during April 1996.
(4) Mr. Peterson resigned as an officer of the Company during May 1996.
STOCK OPTION GRANTS
The following table sets forth further information regarding grants of
options to purchase Common Stock made by the Company pursuant to the Company's
Stock Option Plan during the fiscal year ended December 31, 1995 to each of the
Named Executive Officers.
7
<PAGE> 11
OPTION GRANTS IN 1995
<TABLE>
<CAPTION>
PERCENT OF POTENTIAL REALIZABLE VALUE AT
NUMBER OF TOTAL ASSUMED ANNUAL RATES OF
SECURITIES OPTIONS EXERCISE MARKET STOCK PRICE APPRECIATION FOR
UNDERLYING GRANTED TO PRICE PER PRICE ON OPTION TERM(4)
OPTIONS EMPLOYEES SHARE DATE OF EXPIRATION ------------------------------
NAME GRANTED(#)(1) IN 1995 ($/SH)(2) GRANT($)(3) DATE 0%($) 5%($) 10%($)
- ---------------- ------------- ----------- ---------- ----------- ---------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Ashok Rao(5).... 18,375 2.48% $ 2.29 $ 9.14 03/15/05 $125,869 $231,490 $393,534
3,000 0.40 15.75 15.75 07/26/05 -- 29,715 75,304
Eric G.
Peterson(5)... 1,663 0.22 2.29 9.14 03/15/05 11,392 20,951 35,616
1,000 0.13 15.75 15.75 07/26/05 -- 9,905 25,101
Jay T.
Caldwell...... 8,750 1.18 9.14 9.14 02/07/05 -- 50,296 127,460
1,103 0.15 2.29 9.14 03/15/05 7,556 13,896 23,623
6,000 0.81 10.50 11.00 07/06/05 3,000 44,507 108,187
1,000 0.13 15.75 15.75 07/26/05 -- 9,905 25,101
</TABLE>
- ---------------
(1) Generally under the Company's Stock Option Plan, twenty percent of the
options vest for each full year that the optionee renders services to the
Company after the date of grant. All of the grants listed, however, were
fully vested at the time of the grant, with the exception of the grants of
options for 8,750 and 6,000 shares to Mr. Caldwell. The vesting of options
may be accelerated at the discretion of the administrator of the Stock
Option Plan.
(2) The exercise price may be paid by delivery of already owned shares, subject
to certain conditions.
(3) The fair market value of the underlying Common Stock on the date of grant
for all options granted prior to the Company's initial public offering on
July 6, 1995 was determined by the Board of Directors.
(4) Potential realizable value is based on the assumption that the fair market
value of the Common Stock appreciates at the annual rate shown (compounded
annually) from the date of grant until the end of the option term.
Disclosure of these assumed rates of appreciation are mandated by the rules
of the SEC and do not represent the Company's estimate or projection of
future Common Stock prices. The actual value realized may be greater or
less than the potential realizable value set forth in the table.
(5) Messrs. Rao and Peterson resigned during April and May 1996, respectively.
The following table sets forth certain information regarding options to
purchase Common Stock held as of December 31, 1995 by each of the Named
Executive Officers. None of such executive officers exercised any options during
the year ended December 31, 1995.
AGGREGATED 1995 YEAR-END OPTIONS
<TABLE>
<CAPTION>
NUMBER OF SHARES VALUE OF UNEXERCISED
UNDERLYING IN-THE-MONEY OPTIONS
UNEXERCISED OPTIONS AT AT DECEMBER 31,
DECEMBER 31, 1995(#) 1995($)(2)
-------------------------------- --------------------------------
EXERCISABLE UNEXERCISABLE(1) EXERCISABLE UNEXERCISABLE(1)
----------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C>
Ashok Rao(3)......................... 125,535 156,240 $ 1,701,717 $2,101,427
Eric G. Peterson(3).................. 68,288 21,875 1,076,416 349,125
Jay T. Caldwell...................... 16,103 22,625 208,623 221,938
</TABLE>
- ---------------
(1) Future ability to exercise is subject to vesting and the optionee remaining
employed by the Company.
(2) Calculated on the basis of the closing price of the Company's Common Stock
on December 29, 1995 which was $18.25, less the exercise price. There is no
guarantee that if and when these options are exercised they will have this
value.
(3) Messrs. Rao and Peterson resigned during April and May 1996, respectively.
8
<PAGE> 12
DIRECTOR COMPENSATION
At the time of the Company's initial public offering on July 6, 1995, the
Company's Stock Option Plan provided for the automatic grant of a Nonqualified
Option (as defined herein) to purchase 8,750 shares of Common Stock to
non-employee directors of the Company (other than Paul Pfleger, John M. Orehek
and Scott B. Perper) upon their election to the Board of Directors, and an
additional option to purchase 4,375 shares of Common Stock each subsequent year,
both at a price equal to the fair market value of the Company's Common Stock on
the date of grant. Such options vest at a rate of fifty percent (50%) per year
and expire ten (10) years after the date of grant. On November 9, 1995, the
Board of Directors approved an amendment to the Stock Option Plan that would
allow Paul Pfleger, John M. Orehek and Scott B. Perper to receive Nonqualified
Options pursuant to the Stock Option Plan with the same terms and conditions as
other non-employee directors of the Company subject to the approval of such
amendment by the shareholders. See Proposal 3 below. If Proposal 3 is approved
at the Annual Meeting, Messrs. Pfleger, Orehek and Perper will each be deemed to
have been granted an option to purchase 8,750 shares of Common Stock as of
November 9, 1995 at an exercise price of $18.50, of which fifty percent (50%)
will be exercisable as of November 9, 1996 and the balance exercisable as of
November 9, 1997. In addition, pursuant to automatic grants under the plan to
all non-employee directors, Messrs. Pfleger, Orehek and Perper were each also
granted options to purchase 4,375 shares of Common Stock at an exercise price of
$8.63 per share of which fifty percent (50%) vest beginning on March 19, 1997
and the balance vest on March 19, 1998.
On July 25, 1996, the Board approved an additional amendment to the Stock
Option Plan to revise the provisions relating to automatic grants of options to
purchase shares of the Company's Common Stock to all non-employee directors.
Pursuant to the Stock Option Plan as amended, non-employee directors are each
granted a Nonqualified Option to purchase 50,000 shares of Common Stock upon
initial election to the Board of Directors at an exercise price equal to the
fair market value of the Common Stock on the date of the grant. Such options
vest at a rate of twenty percent (20%) per year and expire ten years after the
date of grant. The July 1996 Board action also provided for the grant to each
non-employee director serving on the Board on July 25, 1996 of an option to
purchase shares of Common Stock equal to 50,000 minus the number of shares
subject to options granted to each non-employee director under the Stock Option
Plan prior to its amendment. The vesting schedule of these additional option
grants begins on November 9, 1995 with respect to Messrs. Pfleger, Orehek, and
Perper and on the date of election to the Board for all other non-employee
directors, the date the Stock Option Plan was originally amended, at a rate of
twenty percent (20%) per year. These options were granted subject to approval by
shareholders of an increase in shares available for purchase under the Stock
Option Plan at the Annual Meeting. See Proposal 2 below.
On March 15, 1996, the Company entered into a consulting agreement with
Karl D. Guelich whereby Mr. Guelich would assist the Company with respect to
financial matters. The consulting agreement provided for monthly compensation of
$20,000. The consulting agreement terminated effective April 30, 1996. Mr.
Guelich was paid a total of $35,000 pursuant to this agreement.
The Company has entered into consulting agreements with Marvin C. Moses and
John M. Zrno pursuant to which Messrs. Moses and Zrno (collectively, the
"Consultants") have each agreed to provide consulting services to the Company
with respect to (a) identifying and assisting in the negotiation and closing of
new business acquisitions, (b) establishing investor and other strategic
relations, and (c) advising the Company's Board of Directors on critical
strategic financial matters. Under the consulting agreements, the Consultants
are to make themselves reasonably available to the Company's Board of Directors
and are to devote approximately twenty-five percent (25%) of their time and
efforts to the Company's affairs. Pursuant to the consulting agreements, the
Company is required to pay each of the Consultants a retainer of $8,333 per
month. In addition to the retainers, the Company has granted to each of the
Consultants Nonqualified Options for the purchase of 253,681 shares of the
Company's Common Stock pursuant to and in accordance with the Company's Stock
Option Plan, subject to shareholder approval of an amendment to the Stock Option
Plan increasing the number of shares authorized for issuance thereunder. See
Proposal 2. The options vest rateably over a five-year period beginning in June
1997 and are exercisable for $8.00 per share. The consulting agreements each
terminate after a period of five years beginning on June 1, 1996, unless
terminated earlier in accordance with the terms thereof. The Company has the
right to terminate the consulting agreements at any
9
<PAGE> 13
time for cause, as defined therein. The Company or either of the Consultants may
terminate the consulting agreements, or reduce the time required to be devoted
to the Company thereunder, at any time upon 30 days prior written notice, in
which case the Consultant's retainer and unvested stock options shall be reduced
proportionately.
STOCK OPTION PLAN
Pursuant to the Company's Stock Option Plan, Nonqualified Options are
automatically granted to non-employee directors of the Company, with certain
exceptions, as described in "Director Compensation" above. For a general
description of the Stock Option Plan, see Proposal 2 below.
Assuming shareholder approval of an amendment to the Stock Option Plan
increasing the number of shares authorized for issuance thereunder, there were
an aggregate of 4,211,463 shares of Common Stock reserved for issuance pursuant
to the Stock Option Plan at August 23, 1996, subject to adjustment for stock
splits and similar changes in the Company's capitalization. At August 23, 1996,
options to purchase an aggregate of 3,401,286 shares of Common Stock were
outstanding under the Stock Option Plan (of which 2,217,751 had been granted
subject to shareholder approval of the proposed 3,000,000 share increase) and a
total of 782,249 shares of Common Stock remained available for grant. At August
23, 1996, outstanding options were exercisable at prices ranging from $2.29 to
$18.50 per share. Shares subject to options granted under the Stock Option Plan
that have lapsed or terminated may again be subject to options granted under the
Stock Option Plan.
EMPLOYMENT AGREEMENTS
The Company has entered into an employment agreement with William Oberlin,
the Company's President and Chief Executive Officer. The agreement is effective
as of May 24, 1996 and provides for a monthly base salary of $25,000 per month
as well as certain other compensation, subject to annual review by the Board of
Directors. The agreement requires that the Board of Directors formulate and
adopt a bonus plan for the year ending December 31, 1996 on or before August 30,
1996. For each calendar year effective with the year starting January 1, 1997,
the bonus plan is to be structured to provide one hundred percent of Mr.
Oberlin's base salary if the Company meets targets set forth in its annual
business plan, or a greater or lesser percentage of the base salary in
proportion to the amount by which the Company exceeds or falls short of such
targets. In connection with entering into the agreement, the Company has granted
Mr. Oberlin options to purchase 1,214,724 shares of Common Stock pursuant to the
Stock Option Plan, subject to shareholder approval of an amendment to the Stock
Option Plan increasing the number of shares authorized for issuance thereunder.
See Proposal 2. The options are to vest ratably over a five-year period
beginning in May 1996 (twenty percent (20%) vested in May 1997) and are
exercisable for $8.00 per share. In the event that Mr. Oberlin's employment is
terminated by the Board of Directors "without cause," or if Mr. Oberlin
voluntarily resigns within 180 days of a "change of control" of the Company (as
such terms are defined in the agreement), Mr. Oberlin is entitled to two years
severance. In the event that Mr. Oberlin's employment is terminated by mutual
agreement, or if Mr. Oberlin voluntarily resigns under certain limited
circumstances, Mr. Oberlin is entitled to 12 months severance. Severance equals
the sum of (i) the annualized base salary at the time of termination, and (ii)
either the average annual bonuses for the fiscal years preceding termination or,
if no bonuses have been established or paid for such period, the annualized base
salary at the time of termination. Severance is payable in equal monthly
installments, without interest, commencing on the last day of the month of
termination. In the event the Mr. Oberlin is entitled to severance, he will
continue to receive medical, life, disability and group term life insurance
benefits (or the cash equivalent thereof), and options granted to him under the
Stock Option Plan will continue to vest, during the applicable severance period
as if his employment had not been terminated. In the event of Mr. Oberlin's
death, vesting of options otherwise vesting over the two-year period following
his death will be accelerated. The agreement also contains a non-interference
provision pursuant to which Mr. Oberlin has agreed, for a period of six months
after the termination of his employment, to preserve the confidentiality of the
Company's customer list, to refrain from actively soliciting the Company's
customers existing at the date of termination and to refrain from soliciting or
hiring the Company's executive or management level employees.
10
<PAGE> 14
REPORT OF THE COMPENSATION COMMITTEE ON ANNUAL COMPENSATION
The Compensation Committee is composed entirely of non-employee, outside
directors and it reviews and approves executive officer salaries upon
recommendations made by the President and Chief Executive Officer, and
administers certain of the Company's compensation plans. The Compensation
Committee believes that compensation of its executive officers should be
substantially related to the performance of the Company. Performance is measured
by objective considerations such as revenue growth, earnings before income tax,
depreciation and amortization, earnings per share and stock price of the
Company, as well as other subjective considerations.
The compensation package provided to executive officers consists primarily
of (i) base salary, (ii) bonus and (iii) long-term incentives in the form of
stock options.
Base Salary. In 1995, it was the goal of the Committee that the
combination of base salary and incentive bonus paid to the executive officers of
the Company be within the approximate range of cash remuneration paid to
executives performing similar duties for companies of comparable size. Although
generally available data on the compensation of executive officers in the
Pacific Northwest is considered, the experience of the Chief Executive Officer
and the members of the Committee and their knowledge of the community and
industry practice was the primary basis for this determination.
Base salaries for executive officers other than the President and Chief
Executive Officer are determined annually by the President and Chief Executive
Officer, and reviewed by the Committee. In determining salary adjustments for
executive officers, the President and Chief Executive Officer and the Committee
consider the individual officer's historical performance against his or her job
responsibilities and personal compensation packages provided to executives
performing similar duties for companies of comparable size in the Pacific
Northwest, the rate of inflation, salary adjustments to be awarded to other
executive officers of the Company, and other subjective factors.
Bonus. Prior to 1996, bonuses were determined annually by the President
and Chief Executive Officer, and reviewed by the Committee. No bonuses were paid
in 1995 or 1996 with respect to performance in 1995. On January 10, 1996, the
Board of Directors approved the 1996 Executive Bonus Plan (the "Bonus Plan").
The Bonus Plan establishes four factors to be consider by the Compensation
Committee to determine the amount of bonuses paid to the executive officers of
the Company. These factors are overall revenue, earnings before income tax,
depreciation and amortization, earnings per share and the stock price of the
Company.
Stock Option Plans. In 1995, the Committee shared administration of the
Company's stock option plans with the Board of Directors. Commencing with
completion of the Company's initial public offering in July 1996, the
Compensation Committee became the sole administrator of the Stock Option Plan.
Options to purchase the Company's Common Stock may be granted under the Stock
Option Plan in an effort to align the interest of management with those of
shareholders and provide a reward for long-term performance. Historically,
except for options granted in March 1995 in lieu of cash bonuses, options
granted by the Company have been granted with an exercise price equal to the
market price of the Company's stock on the date of grant. Accordingly, options
generally will have value to the holder only if the Company's stock price
increases. Outstanding options generally become exercisable at a rate of twenty
percent (20%) per year, Options are granted from time to time to executive
officers and other management and supervisory personnel based on recommendations
of the President and Chief Executive Officer, with the size of grants generally
falling within predetermined ranges tied to job grade. At December 31, 1995,
outstanding options as a percent of the outstanding shares of Common Stock was
8.9%.
President and Chief Executive Officer Compensation. As indicated above,
the Company's compensation philosophy in 1995 was to compensate executives at
levels comparable to competitive companies. While the independent data disclosed
that Mr. Rao's base salary in 1995 was lower than comparable base salaries of
other comparable companies' chief executive officers, he declined to recommend a
base salary increase for himself in 1995. In an effort to conserve the Company's
resources in 1995, Mr. Rao and other senior executives had their salaries
reduced by approximately 12% during a two and a half month period from July 16,
1995 to September 30, 1995.
11
<PAGE> 15
Omnibus Budget Reconciliation Act Implications for Executive
Compensation. Under the Omnibus Budget Reconciliation Act of 1993, beginning in
1994, the federal income tax deduction for certain non-performance based
compensation paid to the chief executive officer and four other most highly
compensated officers of publicly held companies is limited $1 million per
officer per fiscal year. One of the proposed amendments to the Stock Option Plan
is intended to cause the compensation associated with options granted under the
Stock Option Plan to be excluded from the $1 million cap. See Proposal 4. The
Committee's present intention is to seek to comply with the requirements to
permit the compensation paid to the Company's officers to be deductible, unless
the Committee feels that required changes would not be in the best interest of
the Company or it shareholders.
COMPENSATION COMMITTEE
John M. Orehek
Scott B. Perper
Daniel M. Dennis
CERTAIN TRANSACTIONS
In June 1994, the Company entered into a Senior Subordinated Note and
Warrant Agreement with, and completed the sale of $14.8 million principal amount
of senior subordinated notes (the "Subordinated Notes") to, First Union
Corporation ("First Union"). Following the sale of the Subordinated Notes, Scott
B. Perper, a Senior Vice President of First Union, was appointed to serve on the
Company's Board of Directors, and he continues to serve in that capacity. The
Company paid First Union a loan initiation fee of $375,000 in connection with
issuance of the Subordinated Notes. During 1995 the Company paid interest on the
Subordinated Notes to First Union in the amount of $782,575. The Company prepaid
the Subordinated Notes in full with the proceeds of its initial public offering.
In connection with the issuance of the Subordinated Notes, the Company also
issued warrants to First Union to acquire up to 640,484 of the Company's Common
Stock, for a nominal purchase price of $.0001 per share. In July 1995, First
Union exercised its Warrants for a total of 640,484 shares of Common Stock.
First Union has certain preemptive rights to purchase additional shares of
Common Stock offered by the Company, subject to a number of exceptions. The
Company has granted certain registration rights with respect to the shares of
Common Stock held by it. In addition, First Union has rights to certain
information concerning the Company until the shares of Common Stock held by it
constitute less than one percent of the outstanding Common Stock.
In August 1994, the Company entered into a revolving credit agreement with
First Union National Bank of North Carolina ("First Union Bank"), a subsidiary
of First Union, providing a line of credit of up to $25.0 million, for which
First Union received a commitment fee of $43,750. In March 1995, this facility
was amended to increase the maximum amount of borrowings by $4.0 million to a
total of $29.0 million, for which First Union Bank was paid an additional
commitment fee of $80,000. This additional amount was due on June 30, 1995. In
June 1995, First Union Bank agreed to extend the due date for borrowings in
excess of $25.0 million to July 20, 1995. Mr. Perper, a director of the Company,
is also a Senior Vice President of First Union Bank. During 1995, the Company
paid interest of $2,021,055, to First Union Bank in connection with this
revolving credit facility. The revolving credit facility was paid in full and
terminated on November 8, 1995.
In June 1994, the Company issued to Paul Pfleger 859,653 shares of Series A
Redeemable Preferred Stock in consideration of (i) the contribution to the
Company by Mr. Pfleger of two notes payable by the Company to Mr. Pfleger, net
of a receivable for the benefit of the Company from Mr. Pfleger in the amount of
$1,233,846, and (ii) the assumption by Mr. Pfleger of a note payable by the
Company by December 31, 2002 to Theodore McCaugherty in the amount of $4,864,795
which included accrued interest at the rate of 12% per annum. The two notes
payable by the Company which were contributed by Mr. Pfleger were for an
aggregate of $6,865,578, including accrued interest. The Company's receivable
from Mr. Pfleger arose from his assignment to the Company earlier in 1994 of his
right to receive payments later in 1994 from a third party, for
12
<PAGE> 16
which the Company paid $1.2 million. Remaining principal and accrued interest
under the Company's notes payable to Mr. Pfleger, aggregating $1.9 million, were
paid in June 1994, and there were no related party notes outstanding as of
December 31, 1994. In July 1995, the Company redeemed all of the shares of
Series A Redeemable Preferred Stock held by Mr. Pfleger for $8.6 million.
Paul Pfleger and Ashok Rao, formerly the Company's Chief Executive Officer,
President and a director, own 88% and 12%, respectively, of QuestWest Inc.
("QuestWest"), one of two general partners of Quest America L.P., ("Quest LP").
John M. Orehek is the sole limited partner of Quest LP. Messrs. Pfleger, Rao and
Orehek are directors and Messrs. Rao and Orehek are officers of QuestWest.
QuestWest holds an 84.995% interest in Quest LP, subject to reduction if Quest
LP meets certain earnings and sales targets. In December 1993, Quest LP entered
into a distribution agreement with the Company pursuant to which Quest LP is
entitled to receive commissions on sales for the Company at a rate equal to the
most favorable rate provided by the Company to any of its distributors. Quest LP
received $66,456 in net commissions on 1994 invoices. Effective March 6, 1995,
Messrs. Pfleger, Rao and Orehek granted the Company an option to purchase their
entire interests in QuestWest and Quest LP for an exercise price equal to the
total amount paid to acquire their respective interests, which then aggregated
$823,170. The parties terminated the option effective October 24, 1995.
In June 1995, Paul Pfleger and Ashok Rao agreed in writing to indemnify and
hold the Company harmless from any costs, expenses or other liabilities incurred
by the Company in connection with a claim asserted in June 1995 by an affiliate
of the co-general partner of Quest LP that he or an affiliated party is entitled
to purchase 3% of the Company's outstanding stock for $1 million. The Company
believes that no such right exists and that this claim is without merit.
In June 1994, the Company entered into an employment agreement with Ashok
Rao, then the President, Chief Executive Officer and a director of the Company.
In April 1996, Mr. Rao resigned from the Company. The Company and Mr. Rao are
currently negotiating a Resignation Agreement and General Release (the
"Resignation Agreement") to define the terms of Mr. Rao's resignation from the
Company. The terms of the Resignation Agreement are not finalized, but it likely
will include payments to Mr. Rao for 24 months, confirmation of noncompetition
and confidentiality agreements signed by Mr. Rao upon joining the Company and
mutual releases of claims. Pursuant to the terms of a Shareholders' Agreement,
the Company has called for the repurchase of all of the shares of Common Stock
owned by Mr. Rao and by certain trusts established by Mr. Rao (the "Rao
Shares"). Because the Company and Mr. Rao have been unable to reach mutual
agreement on the purchase price for the Rao Shares, pursuant to the
Shareholders' Agreement the purchase price shall be the fair market value of the
Rao Shares as of the date of Mr. Rao's resignation as determined by arbitration.
The purchase price shall be payable in 36 equal monthly installments and will
bear interest at a rate of 8% per annum. Under an agreement between Mr. Rao and
Paul Pfleger pursuant to which Mr. Rao purchased the Rao Shares from Mr.
Pfleger, Mr. Pfleger is entitled to receive payments aggregating approximately
$2.2 million out of the proceeds received by Mr. Rao from the redemption of the
Rao Shares.
On April 4, 1996, the Company entered into an agreement with Tie
Communications, Inc., ("Tie"), appointing Tie as an independent distributor for
selling the Company's long distance services. Mr. Pfleger and Mr. Orehek
together own 95.2% of Tie. Through June 30, 1996, no commissions have yet been
paid to Tie pursuant to this agreement.
In 1996, the Company entered into consulting agreements with Karl D.
Guelich, Marvin Moses and John Zrno. See "Director Compensation." Mr. Guelich's
consulting agreement was terminated in April 1996.
On August 22 and September 6, 1996, the Company sold $97,743,000 aggregate
principal amount of 8.25% Convertible Subordinate Notes Due 2003 (the "Notes")
in a private placement (the "Note Placement"). William H. Oberlin, John M. Zrno,
Marvin C. Moses, Paul Pfleger and John M. Orehek purchased Notes from the
Company in the Note Placement and beneficially own $2,650,000, $400,000,
$250,000, $450,000 and $250,000 principal amount of Notes, respectively. Mr.
Oberlin is the Company's President and Chief Executive Officer as well as a
director. Mr. Pfleger is Chairman of the Company's Board of Directors. Messrs.
Zrno, Moses and Orehek are directors. The foregoing individuals purchased and
own the
13
<PAGE> 17
Notes on the same terms, and subject to the same conditions, applicable to all
other holders of the Notes acquired in the Note Placement.
MIDCOM STOCK PERFORMANCE GRAPH
The following graph shows a comparison of cumulative total returns on the
Company's Common Stock against the cumulative total return for The Nasdaq Stock
Market -- U.S. Index and The Nasdaq Telecommunications Index. The graph assumes
an investment of $100 on July 7, 1995, the date of the Company's Common Stock
began trading on The Nasdaq National Market, in the Company's Common Stock, The
Nasdaq Stock Market -- U.S. Index and The Nasdaq Telecommunications Index.
Cumulative total return assumes reinvestment of dividends. The performance shown
is not necessarily indicative of future performance.
COMPARISON OF 6-MONTH CUMULATIVE TOTAL RETURN*
AMONG MIDCOM COMMON STOCK, THE NASDAQ STOCK MARKET -- U.S. INDEX
AND THE NASDAQ TELECOMMUNICATIONS INDEX
<TABLE>
<CAPTION>
MIDCOM NASDAQ
MEASUREMENT PERIOD COMMUNI- NASDAQ STOCK TELECOM-
(FISCAL YEAR COVERED) CATIONS INC. MARKET-- US MUNICATIONS
<S> <C> <C> <C>
7/7/95 100 100 100
12/95 166 109 109
</TABLE>
* $100 INVESTED ON 07/07/95 IN STOCK OR INDEX --
INCLUDING REINVESTMENT OF DIVIDENDS,
FISCAL YEAR ENDING DECEMBER 31.
PROPOSAL 2 -- APPROVAL OF AN AMENDMENT TO THE STOCK OPTION PLAN
TO INCREASE THE NUMBER OF SHARES SUBJECT TO OPTIONS
On July 25, 1996, the Company's Board adopted an amendment to the Stock
Option Plan which, subject to shareholder approval of such amendment, increased
the number of shares of Common Stock available for issuance thereunder by
3,000,000 from 1,739,063 to 4,739,063 shares to enable the Company to grant
options
14
<PAGE> 18
to the new management team. As of August 23, 1996, including the grant of
options contingent on shareholder approval of the 3,000,000 increase in shares
authorized for issuance, options to purchase 3,401,286 shares of Common Stock
were outstanding under the Stock Option Plan, options to purchase 555,528 shares
of Common Stock had been exercised and 782,249 shares of Common Stock remained
available for issuance. The outstanding options are exercisable at prices
ranging from $2.29 to $18.50 per share. Shares subject to options granted under
the plan that have lapsed or terminated may again be subject to options granted
under the Stock Option Plan.
SUMMARY OF STOCK OPTION PLAN
The following summary of the Stock Option Plan is a brief description of
the material provisions of the Stock Option Plan and is qualified in its
entirety by the full text of the Stock Option Plan, copies of which may be
obtained by shareholders of the Company upon written request directed to the
Company's Secretary at the address listed on the first page of this Proxy
Statement.
General. Pursuant to the Stock Option Plan, the Company may grant options
to purchase shares of Common Stock which qualify as "incentive stock options"
within the meaning of Section 422 of the Internal Revenue Code of 1986, as
amended ("Code") ("Incentive Options") or which do not so qualify ("Nonqualified
Options"). The Compensation Committee of the Board of Directors is currently the
Plan Administrator for the Stock Option Plan. Incentive Options may be granted
to any employee, including employees who are directors, and Nonqualified Options
may be granted to such persons as the Plan Administrator shall select, including
employees, consultants and directors of the Company. The Plan Administrator
determines the terms and conditions of options granted under the Stock Option
Plan, including the exercise price, provided that the exercise price for
Incentive Options must be equal to or greater than the fair market value of the
Common Stock on the date of grant.
Unless otherwise provided by the Plan Administrator, options granted under
the Stock Option Plan vest at a rate of twenty percent (20%) after the first
year and thereafter at twenty percent (20%) per year over a four-year period so
that all options are fully vested after five years. Outstanding options vest, at
the discretion of the Plan Administrator, upon the occurrence of the liquidation
or dissolution of the Company. Options are exercisable for a period of ten years
from the date of grant, except that Incentive Options granted to persons who own
more than ten percent of the Common Stock are exercisable only for a period of
five years from the date of grant. Options granted under the Stock Option Plan
are nontransferable other than by will or the laws of descent and distribution.
Notwithstanding a vesting schedule, the Stock Option Plan provides for the
immediate vesting of options that have been outstanding for at least six months
upon the occurrence of certain events. In general, such events include (i) the
purchase by any person of thirty percent (30%) or more of the Common Stock of
the Company pursuant to a tender offer or exchange offer made by any person
other than the Company, and (ii) the approval by the Company's shareholders of
any merger, consolidation, reorganization or other transaction providing for the
conversion or exchange of more than fifty percent (50%) of the outstanding
shares of Common Stock of the Company. Under certain circumstances, accelerated
vesting could have the effect of delaying, deferring or preventing unfriendly
offers or other efforts to obtain control of the Company and could thereby
deprive the shareholders of opportunities to receive a premium on their Common
Stock and could make removal of incumbent management more difficult. On the
other hand, accelerated vesting may induce any person seeking control of the
Company or business combination with the Company to negotiate on terms
acceptable to the Board of Directors. The Stock Option Plan was recently amended
to permit limited transfers of certain options pursuant to newly effective SEC
regulations.
The Stock Option Plan also provides for automatic grants of Nonqualified
Options to non-employee directors of the Company as described under Proposals 1
and 3.
The following table sets forth certain information, as of the Record Date,
concerning options which will be granted under the Stock Option Plan to the
persons and groups specified below if Proposals 2 and 3 are approved by the
shareholders at the Annual Meeting.
15
<PAGE> 19
NEW PLAN BENEFITS
<TABLE>
<CAPTION>
NUMBER OF
SHARES
EXERCISE PRICE UNDERLYING
NAME AND POSITION ($ PER SHARE)(1) OPTIONS
- ----------------------------------------------------------------- ---------------- ----------
<S> <C> <C>
William H. Oberlin............................................... $8.00 1,214,724(2)
President, Chief Executive
Officer and Director
Robert L. Nitschke............................................... -- --
Executive Vice President
and Chief Operating Officer
Robert J. Chamberlain............................................ $8.00 70,000(2)
Senior Vice President of
Finance and Administration and
Chief Financial Officer
Jay T. Caldwell.................................................. -- --
Senior Vice President of
Revenue Management
Executive Group.................................................. $8.00 1,489,724(2)
Non-Executive Director Group..................................... $8.00-$18.50 646,737(3)
Non-Executive Officer Employee Group............................. $3.12-$8.43 552,150(2)
</TABLE>
- ---------------
(1) Future exercise prices of options are unknown as they are based upon fair
market value at the date of grant.
(2) Options to be granted subject to shareholder approval of Proposal 2.
(3) Includes 607,362 options to be granted subject to shareholder approval of
Proposal 2 and 39,375 options to be granted subject to shareholder approval
of Proposal 3.
RECOMMENDATIONS OF THE BOARD OF DIRECTORS
The affirmative vote of at least a majority of shares of Common Stock
present in person or represented by Proxy at the Annual Meeting and entitled to
vote on the proposal is required for approval of the amendment to the Stock
Option Plan. THE BOARD OF DIRECTORS OF MIDCOM HAS APPROVED THE FOREGOING
AMENDMENTS TO THE STOCK OPTION PLAN TO INCREASE THE NUMBER OF SHARES SUBJECT TO
OPTIONS AND RECOMMENDS THAT THE SHAREHOLDERS VOTE FOR APPROVAL OF SUCH
AMENDMENT. Unless otherwise instructed, it is the intention of the persons named
in the accompanying form of proxy to vote shares represented by properly
executed proxies in favor of the Proposal 2.
PROPOSAL 3 -- APPROVAL OF AN AMENDMENT TO THE STOCK OPTION PLAN TO
PERMIT AND RATIFY THE GRANT OF OPTIONS TO CERTAIN INCUMBENT DIRECTORS
At the time of the Company's initial public offering on July 6, 1995, the
Company's Stock Option Plan provided for the automatic grant of a Nonqualified
Option to purchase 8,750 shares of Common Stock to non-employee directors of the
Company (other than Paul Pfleger, John M. Orehek and Scott B. Perper) upon their
election to the Board of Directors, and an additional option to purchase 4,375
shares of Common Stock each subsequent year, both at a price equal to the fair
market value of the Company's Common Stock on the date of grant. Such options
vested at a rate of fifty percent (50%) per year and expire ten (10) years after
the date of grant. On November 9, 1995, the Board of Directors approved an
amendment to the Stock Option Plan that would allow Paul Pfleger, John M. Orehek
and Scott B. Perper to receive Nonqualified Options pursuant to the Stock Option
Plan with the same terms and conditions as other non-employee directors of the
Company, subject to the approval of such amendment by the shareholders. If
Proposal 3 is approved at the Annual Meeting, Messrs. Pfleger, Orehek and Perper
will each be deemed to have been granted options to purchase 8,750 shares of
Common Stock as of November 9, 1995 at an exercise price of $18.50, of which
fifty
16
<PAGE> 20
percent (50%) will be exercisable as of November 9, 1996 and the balance
exercisable as of November 9, 1997 and 4375 shares at an exercise price of $8.63
of which fifty percent (50%) will be exercisable on March 19, 1997 and the
balance vest on March 19, 1998.
RECOMMENDATIONS OF THE BOARD OF DIRECTORS
The affirmative vote of at least a majority of shares of Common Stock
present in person or represented by Proxy at the Annual Meeting and entitled to
vote on the proposal is required for approval of the amendment to the Stock
Option Plan. THE BOARD OF DIRECTORS OF MIDCOM HAS APPROVED THE FOREGOING
AMENDMENT TO THE STOCK OPTION PLAN TO PERMIT AND RATIFY THE GRANT OF OPTIONS TO
CERTAIN INCUMBENT DIRECTORS AND RECOMMENDS THAT THE SHAREHOLDERS VOTE FOR
APPROVAL OF SUCH AMENDMENT. Unless otherwise instructed, it is the intention of
the persons named in the accompanying form of proxy to vote shares represented
by properly executed proxies in favor of Proposal 3.
PROPOSAL 4 -- APPROVAL OF AMENDMENT TO THE STOCK OPTION PLAN TO CREATE
A MAXIMUM NUMBER OF OPTIONS THAT MAY BE GRANTED UNDER THE STOCK
OPTION PLAN TO ANY ONE EMPLOYEE IN ANY THREE CONSECUTIVE FISCAL YEARS
On July 25, 1996, the Company's Board adopted an amendment to the Stock
Option Plan which, subject to shareholder approval of such amendment, provides
that no participant will be granted options to acquire more than 1,500,000
shares of Common Stock in any three-year period. This limitation adjusts
proportionately in connection with any change in the Company's capitalization.
The Board of Directors believes that this amendment is necessary for the Plans
to comply with the Omnibus Budget Reconciliation Act of 1993 ("OBRA"), which
limits to $1,000,000 per person the amount that the Company may deduct for
compensation paid to any of its most highly compensated executive officers in
any taxable year beginning on or after January 1, 1994. Under final regulations,
compensation received through the exercise of an option will not be subject to
the $1,000,000 limit if the option and the plan meet certain requirements. One
such requirement is that shareholders approve a per-employee limit on the number
of shares as to which options may be granted during any specific period. Other
requirements are that the options be granted by a committee consisting solely of
at least two outside directors and that the exercise price of the option be not
less than the fair market value of the Common Stock on the date of grant.
Accordingly, the Company believes that if the proposed amendments are approved
by shareholders, compensation received on exercise of options granted under the
Plans in compliance with all of the above requirements will not be subject to
the $1,000,000 deduction limit.
RECOMMENDATIONS OF THE BOARD OF DIRECTORS
The affirmative vote of at least a majority of shares of Common Stock
present in person or represented by Proxy at the Annual Meeting and entitled to
vote on the proposal is required for approval of the amendment to the Stock
Option Plan. THE BOARD OF DIRECTORS OF MIDCOM HAS APPROVED THE FOREGOING
AMENDMENT TO THE STOCK OPTION PLAN TO CREATE A MAXIMUM NUMBER OF OPTIONS THAT
MAY BE GRANTED UNDER THE STOCK OPTION PLAN TO ANY ONE EMPLOYEE IN ANY THREE
CONSECUTIVE FISCAL YEARS AND RECOMMENDS THAT THE SHAREHOLDERS VOTE FOR APPROVAL
OF SUCH AMENDMENTS. Unless otherwise instructed, it is the intention of the
persons named in the accompanying form of proxy to vote shares represented by
properly executed proxies in favor of Proposal 4.
17
<PAGE> 21
FEDERAL INCOME TAX EFFECTS OF STOCK OPTION PLAN PARTICIPATION
The following summary of federal income tax consequences is based upon
existing statutes, regulations, and interpretations thereof. Because the
applicable rules are complex and because income tax consequences may vary
depending upon the particular circumstances of each optionee, no attempt has
been made to outline the tax consequences to any particular optionee. Each
optionee should consult his or her own tax advisor concerning federal (and any
foreign, state, or local) income tax consequences of participation in the Stock
Option Plan. This proxy does not purport to describe foreign, state, or local
income tax consequences, which may differ from United States federal income tax
consequences.
INCENTIVE STOCK OPTIONS
Award; Exercise. Incentive Options granted under the Stock Option Plan are
intended to constitute "incentive stock options" within the meaning of Section
422 of the Internal Revenue Code of 1986, as amended ("Code"). Incentive Options
may be granted only to employees of the Company. An optionee will not have
taxable income upon either the grant or exercise of an Incentive Option.
However, the excess of the fair market value of the shares purchased upon
exercise over the option exercise price (the "Option Spread") will be includable
in the optionee's "alternative minimum taxable income" ("AMTI") for purposes of
the alternative minimum tax. The Option Spread will generally be measured on the
date of exercise and will be includable in AMTI in the year of exercise; special
rules regarding the amount and timing of AMTI inclusion may apply for shares
subject to a "substantial risk of forfeiture" (including restrictions to comply
with certain requirements for "pooling-of-interests" accounting and, in the case
of Reporting Persons, certain limitations on resale of shares imposed under
Section 16(b) of the Exchange Act).
Sale of Option Shares. If an optionee holds the shares acquired upon
exercise of an Incentive Option ("ISO Stock") for at least two years from the
date the Incentive Option was granted and for at least one year from the date
the Incentive Option was exercised (together the "Holding Period"), any gain
from a sale of the ISO Stock, other than to the Company, should be taxable as
capital gain. If an optionee disposes of ISO Stock before the end of the Holding
Period (a "Disqualifying Disposition"), the amount of the Option Spread at the
date of exercise (or, if less, the amount of gain realized upon the sale) will
be taxable as ordinary income. Such income will be subject to information
reporting requirements. Gain from a Disqualifying Disposition in excess of the
amount required to be recognized as ordinary income will be capital gain.
Special rules may apply regarding the date the Option Spread is measured for ISO
Stock purchased subject to a "substantial risk of forfeiture."
Exercise With Stock. If an optionee pays the Incentive Option exercise
price with shares of the Company acquired under an Incentive Option or a
qualified employee stock purchase plan ("Statutory Option Stock") the tender of
shares will be a Disqualifying Disposition of the Statutory Option Stock if the
Holding Period respecting those shares has not been satisfied. If the Holding
Period with respect to the Statutory Option Stock is satisfied, or if the shares
were not Statutory Option Stock, then any appreciation in the surrendered shares
will not be taxable upon surrender. Shares acquired upon exercise that are equal
in value to the fair market value of the shares surrendered in payment are
treated as if they had been substituted for the surrendered shares, taking as
their basis and holding period the basis and holding period that the optionee
had in the surrendered shares (the basis of these shares would be increased by
the amount, if any, of taxable income generated by a Disqualifying Disposition
of ISO Stock upon exercise). The remaining shares of stock will have a zero
basis, unless the optionee has taxable income or pays cash upon exercise.
NONQUALIFIED STOCK OPTIONS
Award; Exercise. An optionee does not have taxable income due to the grant
of a Nonqualified Option under the Stock Option Plan. Upon exercise of the
Nonqualified Option, the optionee will have taxable ordinary income equal to the
excess of the fair market value of the shares purchased over the Nonqualified
Option exercise price (the "Option Spread"). The optionee's tax basis in the
shares will be equal to the fair market value of such shares on the date of
exercise, and the holding period will also begin on that date. In general,
shares acquired by exercise of Nonqualified Options granted under the Stock
Option Plan will not be
18
<PAGE> 22
subject to a "substantial risk of forfeiture," which includes a right of the
Company to repurchase shares at their purchase price, restriction of sale of the
shares by the Section 16 of the Exchange Act, and restriction of sale of the
shares to comply with certain requirements for "pooling-of-interests"
accounting. If shares are subject to such a restriction and the optionee files
an election under Code Section 83(b) ("Section 83(b) Election") within 30 days
after the date of purchase, the optionee will generally have the tax treatment
described above. If the shares are subject to a substantial risk of forfeiture
and no Section 83(b) Election is filed, the optionee will not be taxable upon
exercise, but instead will have ordinary income, on the date the restrictions
lapse, in an amount equal to the Option Spread as of the date of lapse; in
addition, the optionee's holding period will begin on the date of lapse.
Regardless of whether the shares are subject to a substantial risk of
forfeiture, the amount of ordinary income taxable to an optionee who is an
employee at the time of grant will constitute "supplemental wages" subject to
withholding of income and employment taxes by the Company.
Sale of Option Shares. Upon sale, other than to the Company, of shares
acquired under a Nonqualified Option, an optionee generally will have a capital
gain or loss to the extent of the difference between the sale price and the
optionee's tax basis in the shares. Such gain or loss will be long-term if the
optionee has held the shares for more than one year.
Exercise with Stock. If an optionee tenders Common Stock to pay all or
part of the exercise price of a Nonqualified Option, the optionee will not have
a taxable gain or deductible loss on the surrendered shares. Instead, shares
acquired upon exercise that are equal in value to the fair market value of the
shares surrendered in payment are treated as if they had been substituted for
the surrendered shares, taking as their basis and holding period the basis and
holding period that the optionee had in the surrendered shares. The fair market
value of the additional shares will be treated as taxable compensation for
services and such shares will have a basis equal to their fair market value. The
holding period for the additional shares will begin on the date of exercise.
Special rules apply if the stock received upon exercise is subject to a
substantial risk of forfeiture.
ALTERNATIVE METHODS OF PAYMENT OF TAX WITHHOLDING OBLIGATIONS
The Plan Administrator, in its sole discretion, may permit an optionee to
pay the federal and state withholding and employment taxes due upon option
exercise by any means. If an optionee is permitted to tender shares in
satisfaction of an income tax withholding obligation described above, the
surrendered shares will be treated as redeemed by the Company at their
then-fair-market value. It is possible, although the Company believes it
unlikely, that election by an optionee to have shares of Common Stock withheld
in satisfaction of the optionee's withholding tax obligation upon exercise of a
Nonqualified Option may result in dividend income to the optionee. Optionees
should consult their personal tax advisors before tendering shares in
satisfaction of a withholding obligation.
SALE OF STOCK TO THE COMPANY
If stock is sold to the Company rather than to a third party, the sale may
not produce capital gain or loss. A sale of shares to the Company will
constitute a redemption of such shares, which could be taxable as a dividend
unless the redemption is "not essentially equivalent to a dividend" within the
meaning of the Code.
SPECIAL FEDERAL INCOME TAX CONSIDERATION DUE TO SHORT SWING PROFIT RULE
As noted above, the potential liability of Reporting Persons to repay
"short-swing" profits from the resale of shares acquired upon option exercise
constitutes a "substantial risk of forfeiture" within the meaning of the
above-described rules, which is treated as lapsing at such time as the potential
liability under Section 16 of the Exchange Act lapses or six months after the
date of grant, whichever is earlier. Reporting Persons who would be required by
Section 16 to repay profits from the immediate resale of option stock should
consider filing a Section 83(b) Election at the time they exercise options in
order to avoid deferral of the date that they are deemed to acquire shares for
federal income tax purposes.
19
<PAGE> 23
INDEPENDENT AUDITORS
The Company has selected Ernst & Young LLP to continue as its principal
independent accounting firm for the current year. Representatives of Ernst &
Young LLP are expected to be present at the Annual Meeting and have the
opportunity to make a statement if they so desire and to respond to appropriate
questions.
OTHER BUSINESS
Management knows of no other business which will be presented for action at
the Annual Meeting. If any other business requiring a vote of the shareholders
should come before the meeting the persons designated as your proxies will vote
or refrain from voting in accordance with their best judgment.
PROPOSALS BY SHAREHOLDERS
In order to be eligible for inclusion in the proxy materials of the Company
for the 1996 Annual Meeting of Shareholders, any shareholder proposals to be
presented at such meeting must be received by the Company no later than December
31, 1996. Such proposals must be mailed to the Company's executive offices at
1111 Third Avenue, Seattle, Washington 98101, Attn: Corporate Secretary. Any
such proposal shall be subject to the requirements of the proxy rules under the
Exchange Act.
SOLICITATION OF PROXIES
This solicitation is made on behalf of the Board of Directors of the
Company. Proxies may be solicited by officers, directors and employees of the
Company, none of whom will receive any additional compensation for their
services. In addition, Company may engage an outside proxy solicitation firm to
render proxy solicitation services and, if so, will pay a fee for such services.
Solicitations of proxies may be made personally, or by mail, telephone,
telegraph, telephone facsimile, electronic mail, messenger or by other means.
The Company may pay persons holding shares of Common Stock in their names
or in the names of nominees, but not owning such shares beneficially, such as
brokerage houses, banks and other fiduciaries, for the expense of forwarding
soliciting materials to their principals. All of the costs of solicitation of
proxies will be paid by the Company.
By Order of the Board of Directors
/s/ Paul P. Senio
PAUL P. SENIO
Secretary
20
<PAGE> 24
Annex A
MIDCOM COMMUNICATIONS INC.
REVISED AND RESTATED
1993 STOCK OPTION PLAN
AS AMENDED ON FEBRUARY 21, 1994, MARCH 28, 1994,
JULY 26, 1995, AND JULY 25, 1996
This Stock Option Plan (the "Plan") provides for the grant of
options to acquire shares of Common Stock, $.0001 par value (the "Common
Stock"), of MIDCOM COMMUNICATIONS INC., a Washington corporation (the
"Company"). Stock options granted under this Plan that qualify under Section 422
of the Internal Revenue Code of 1986, as amended (the "Code"), are referred to
in this Plan as "Incentive Stock Options." Both Incentive Stock Options and
stock options that do not qualify under Section 422 of the Code ("Non-Qualified
Stock Options") granted under this Plan are referred to as "Options."
1. PURPOSES.
The purposes of this Plan are to retain the services of valued
key employees and consultants of the Company and such other persons as the Plan
Administrator shall select in accordance with Section 3 below, to encourage such
persons to acquire a greater proprietary interest in the Company, thereby
strengthening their incentive to achieve the objectives of the shareholders of
the Company, and to serve as an aid and inducement in the hiring of new
employees, consultants and other persons selected by the Plan Administrator.
2. ADMINISTRATION.
This Plan shall be administered by the Board of Directors of
the Company (the "Board"). If the Board so desires, the Plan shall be
administered by a committee designated by the Board and composed of one (1) or
more members of the Board, which committee (the "Committee") may be an
executive, compensation or other committee, including a separate committee
especially created for this purpose. In the event the Company is or becomes
subject to the provisions of Section 16 of the Securities Exchange Act of 1934,
as amended (the "Exchange Act"), the Board shall attempt to provide for
administration of the Plan, insofar as it relates to the participation of
officers, directors or shareholders of the Company who are subject to the
reporting and liability provisions of Section 16 of the Exchange Act (the
"Insiders"), in a manner which shall qualify the grant, exercise, expiration or
surrender of Options under this Plan for the treatment afforded by Securities
and Exchange Commission Rule 16b-3, as amended from time to time, or any
successor rule or regulatory requirements (the "Rule"). The Committee shall have
the powers and authority vested in the Board hereunder (including the power and
authority to interpret any provision of this Plan or of any Option). The members
of any such Committee shall serve at the pleasure of the Board. A majority of
the members of the Committee shall constitute a quorum, and all actions of the
Committee shall be taken by a majority of the members present. Any action may be
taken by a written instrument signed by all of the members of the Committee and
any action so taken shall be fully effective
<PAGE> 25
as if it had been taken at a meeting. The Board, or any committee thereof
appointed to administer the Plan, is referred to herein as the "Plan
Administrator."
Subject to the provisions of this Plan, and with a view to
effecting its purpose, the Plan Administrator shall have sole authority, in its
absolute discretion, to (a) construe and interpret this Plan; (b) define the
terms used in this Plan; (c) prescribe, amend and rescind rules and regulations
relating to this Plan; (d) correct any defect, supply any omission or reconcile
any inconsistency in this Plan; (e) determine the individuals to whom Options
shall be granted under this Plan and whether the Option is an Incentive Stock
Option or a Non-Qualified Stock option; (f) determine the time or times at
which options shall be granted under this Plan; (g) determine the number of
shares of Common Stock subject to each Option, the exercise price of each
Option, the duration of each Option and the times at which each Option shall
become exercisable; (h) determine all other terms and conditions of Options; and
(i) make all other determinations necessary or advisable for the administration
of this Plan. In addition, the Plan Administrator may grant to any officer of
the Company the authority to grant options and otherwise administer the Plan
solely with respect to persons who are not Insiders. All decisions,
determinations and interpretations made by the Plan Administrator shall be
binding and conclusive on all participants in this Plan and on their legal
representatives, heirs and beneficiaries.
The Board or the Committee may delegate to one or more
executive officers of the Company the authority to grant Options under this Plan
to employees of the Company who, at the time of grant, are not subject to
Section 16(b) of the Exchange Act with respect to the Common Stock
("Non-Insiders"), and in connection therewith the authority to determine: (a)
whether the Option in an Incentive Stock Option or a Non-qualified Stock Option;
(b) the number of shares of Common Stock subject to such Option; (c) the
duration of the Option; (d) the vesting schedule for determining the times at
which such Option shall become exercisable; and (e) all other terms and
conditions of such Options. The exercise price for any Option granted by action
of an executive officer pursuant to such delegation of authority shall not be
less than the fair market value per share of the Common Stock on the Date of
Grant determined by reference to the closing price for the Common Stock on the
day preceding the Date of Grant. Unless expressly approved in advance by the
Board or the Committee, such delegation of authority shall not include the
authority to accelerate the vesting, extend the period for exercise or otherwise
alter the terms of outstanding Options. The term "Plan Administrator" when used
in any provision of this Plan other than Sections 2, 5(1) and 11 shall be deemed
to refer to the Board, Ashok Rao, or the Committee, as the case may be, who are
hereby authorized to grant Options pursuant hereto, insofar as such provision
may be applied to Non-Insiders and Options granted to Non-Insiders.
3. ELIGIBILITY.
Incentive stock options may be granted to any individual who,
at the time the Option is granted, is an employee of the Company or any Related
Corporation (as defined below), including employees who are Directors of the
Company ("Employees"). Non-Qualified Stock Options may be granted to Employees
and to such other persons who are not Employees as the Plan Administrator shall
select. Options may be granted in substitution for outstanding Options of
another corporation in connection with the merger, consolidation, acquisition of
2
<PAGE> 26
property or stock or other reorganization between such other corporation and the
Company or any subsidiary of the Company. Options also may be granted in
exchange for outstanding Options. Any person to whom an Option is granted under
this Plan is referred to as an "Optionee."
Provided that shares of Common Stock remain available for
issuance pursuant to Options granted pursuant to this Plan, Directors of the
Company who at the time of election to the Board of Directors are not also
employees of the Company or of any Related Corporation shall concurrent with
election to the Board of Directors (the "Election Date"), automatically receive
a Non-Qualified Stock Option to purchase 50,000 shares of Common Stock, subject
to adjustment as set forth in Section 5(m) below, at an exercise price equal to
the fair market value of the Common Stock on the Election Date. Except as noted
below with respect to prior grants, each Option granted pursuant to this
paragraph shall become exercisable at a rate of twenty percent (20%) for each
year of service commencing on the Election Date, and such option shall expire,
unless otherwise terminated pursuant to Section 5(g), ten (10) years from the
Election Date. Each Non-Employee Director serving as a director of the Company
as of July 25, 1996, shall receive an increase to 50,000 in the Option shares
granted to Non-Employee Directors pursuant to this paragraph, an Option (a
"Recognition Option") to purchase a number of shares of Common Stock equal to
50,000 minus the number of shares covered by Options previously granted to such
Non-Employee Director pursuant to this paragraph. The vesting schedule for the
Recognition Options will be twenty percent (20%) per year as stated above. The
vesting schedule applicable to a Recognition Option shall commence with the date
of the earliest prior grant under this section before the amendment of July 25,
1996, but in no event will the vesting schedule change with respect to the
earlier grant or grants made before the enactment of the amendment to this
section on July 25, 1996. For purposes of this paragraph, the term "fair market
value" on the Date of Grant shall be deemed to be the closing price on the day
preceding the Date of Grant. Such increase in Option shares may not be sold by
the option holder for a period of at least six (6) months from the date of
shareholder ratification of the number of shares which may be issued under the
Plan.
As used in this Plan, the term "Related Corporation," when
referring to a subsidiary corporation, shall mean any corporation (other than
the Company) in an unbroken chain of corporations beginning with the Company if,
at the time of the granting of the Option, each of the corporations other than
the last corporation in the unbroken chain owns stock possessing fifty percent
(50%) or more of the total combined voting power of all classes of stock of one
of the other corporations in such chain. When referring to a parent corporation,
the term "Related Corporation" shall mean any corporation (other than the
Company) in an unbroken chain of corporations ending with the Company if, at the
time of granting of the Option, each of the corporations other than the Company
owns stock possessing fifty percent (50%) or more of the total combined voting
power of all classes of stock of one of the other corporations in such chain.
4. STOCK.
The Plan Administrator is authorized to grant Options to
acquire up to a total of Four Million Seven Hundred and Thirty-Nine Thousand and
Sixty-Two (4,739,062) shares of the Company's authorized but unissued Class A
Common Stock. The number of
3
<PAGE> 27
shares with respect to which Options may be granted hereunder is subject to
adjustment as set forth in Section 5(m) hereof. In the event that any
outstanding Option expires or is terminated for any reason, the shares of Common
Stock allocable to the unexercised portion of such Option may again be subject
to an Option to the same Optionee or to a different person eligible under
Section 3 of this Plan.
5. TERMS AND CONDITIONS OF OPTIONS.
Each Option granted under this Plan shall be evidenced by a
written agreement approved by the Plan Administrator (the "Agreement").
Agreements may contain such additional provisions, not inconsistent with this
Plan, as the Plan Administrator in its discretion may deem advisable. All
Options also shall comply with the following requirements:
(a) Number of Shares and Type of Option.
Each Agreement shall state the number of shares of Common
Stock to which it pertains and whether the Option is intended to be an Incentive
Stock Option or a Non-Qualified Stock Option. In the absence of action to the
contrary by the Plan Administrator in connection with the grant of an Option,
all Options shall be Non-Qualified Stock Options. The aggregate fair market
value (determined at the Date of Grant, as defined below) of the stock with
respect to which Incentive Stock Options are exercisable for the first time by
the Optionee during any calendar year (granted under this Plan and all other
Incentive Stock Option plans of the Company, a Related Corporation or a
predecessor corporation) shall not exceed $100,000, or such other limit as may
be prescribed by the Code as it may be amended from time to time. Any Option
which exceeds the annual limit shall not be void but rather shall be a
Non-Qualified Stock option.
(b) Date of Grant.
Each Agreement shall state the date the Plan Administrator has
deemed to be the effective date of the option for purposes of this Plan (the
"Date of Grant").
(c) Option Price.
Each Agreement shall state the price per share of Common Stock
at which it is exercisable. The exercise price shall be fixed by the Plan
Administrator at whatever price the Plan Administrator may determine in the
exercise of its sole discretion in good faith; provided that the per share
exercise price for an Incentive Stock Option shall not be less than the fair
market value per share of the Common Stock at the Date of Grant as determined by
the Plan Administrator in good faith; provided further, that with respect to
Incentive Stock Options granted to greater-than-10 percent (>10%) shareholders
of the Company (as determined with reference to Section 424(d) of the Code), the
exercise price per share shall not be less than 110 percent (110%) of the fair
market value per share of the Common Stock at the Date of Grant; and, provided
further, that Options granted in substitution for outstanding options of another
corporation in connection with the merger, consolidation, acquisition of
property or stock or other reorganization involving such other corporation and
the Company or any subsidiary of the Company may be granted with an exercise
price equal to the exercise price for the substituted
4
<PAGE> 28
option of the other corporation, subject to any adjustment consistent with the
terms of the transaction pursuant to which the substitution is to occur.
(d) Duration of Options.
At the time of the grant of the Option, the Plan Administrator
shall designate, subject to paragraph 5(g) below, the expiration date of the
Option, which date shall not be later than 10 years from the Date of Grant in
the case of Incentive Stock Options; provided, that the expiration date of any
Incentive Stock Option granted to a greater-than-10 percent shareholder of the
Company (as determined with reference to Section 424(d) of the Code) shall not
be later than five years from the Date of Grant. In the absence of action to the
contrary by the Plan Administrator in connection with the grant of a particular
Option, and except in the case of Incentive Stock Options as described above,
all Options granted under this Plan shall expire ten (10) years from the Date of
Grant.
(e) Vesting Schedule.
No Option shall be exercisable until it has vested. The
vesting schedule for each Option shall be specified by the Plan Administrator at
the time of grant of the Option; provided, that if no vesting schedule is
specified at the time of grant, the Option shall vest according to the following
schedule:
<TABLE>
<CAPTION>
Number of Years Percentage of Total
Following Date of Grant Option Vested
----------------------- -------------------
<S> <C>
One 20%
Two 40%
Three 60%
Four 80%
Five 100%
</TABLE>
(f) Acceleration of Vesting.
The vesting of one or more outstanding Options may be
accelerated by the Plan Administrator at such times and in such amounts as it
shall determine in its sole discretion. The vesting of Options also shall be
accelerated under the circumstances described in Section 5(m) below.
(g) Term of Option.
Vested Options shall terminate, to the extent not previously
exercised, upon the occurrence of the first of the following events: (i) the
expiration of the Option, as designated by the Plan Administrator in accordance
with Section 5(d) above; (ii) the expiration of 90 days from the date of an
Optionee's termination of employment or contractual relationship with the
Company or any Related Corporation for any reason whatsoever other than death or
Disability (as defined below) unless, in the case of a Non-Qualified Stock
Option, the exercise period is
5
<PAGE> 29
extended by the Plan Administrator until a date not later than the expiration
date of the Option; or (iii) the expiration of one year from (A) the date of
death of the optionee or (B) cessation of an Optionee's employment or
contractual relationship by reason of Disability (as defined below) unless, in
the case of a Non-Qualified Stock Option, the exercise period is extended by the
Plan Administrator until a date not later than the expiration date of the
Option. If an Optionee's employment or contractual relationship is terminated by
death, any option held by the Optionee shall be exercisable only by the person
or persons to whom such Optionee's rights under such Option shall pass by the
Optionee's will or by the laws of descent and distribution of the state or
county of the Optionee's domicile at the time of death. For purposes of the
Plan, unless otherwise defined in the Agreement, "Disability" shall mean any
physical, mental or other health condition which substantially impairs the
Optionee's ability to perform her or his assigned duties for one hundred twenty
(120) days or more in any two hundred forty (240) day period or that can be
expected to result in death. The Plan Administrator shall determine whether an
Optionee has incurred a Disability on the basis of medical evidence acceptable
to the Plan Administrator. Upon making a determination of Disability, the Plan
Administrator shall, for purposes of the Plan, determine the date of an
Optionee's termination of employment or contractual relationship. Unvested
Options shall terminate immediately upon the termination of employment of the
Optionee by the Company for any reason whatsoever, including death or
disability.
Unless accelerated in accordance with Section 5(f) above,
unvested Options shall terminate immediately upon termination of employment of
the Optionee by the Company for any reason whatsoever, including death or
Disability. If, in the case of an Incentive Stock Option, an Optionee's
relationship with the Company changes (e.g., from an Employee to a non-
Employee, such as a consultant), such change shall not constitute a termination
of an Optionee's employment with the Company but rather the optionee's Incentive
Stock Option shall automatically be converted into a Non-Qualified Stock Option
if the Plan Administrator so determines.
For purposes of this Plan, transfer of employment between or
among the Company and/or any Related Corporation shall not be deemed to
constitute a termination of employment with the Company or any Related
Corporations. For purposes of this subsection with respect to Incentive Stock
Options, employment shall be deemed to continue while the Optionee is on
military leave, sick leave or other bona fide leave of absence (as determined by
the Plan Administrator). The foregoing notwithstanding, employment shall not be
deemed to continue beyond the first ninety (90) days of such leave, unless the
optionee's re-employment rights are guaranteed by statute or by contract.
(h) Exercise of Options.
Options shall be exercisable, either all or in part, at any
time after vesting, until termination; provided, however, that after
registration of any of the Company's securities under Section 12 of the Exchange
Act and regardless of when the Option is exercised, any Optionee who is an
Insider shall be precluded from selling or transferring any Common Stock or
other security underlying an Option during the six (6) months immediately
following the grant of that Option. If less than all of the shares included in
the vested portion of any Option are purchased, the remainder may be purchased
at any subsequent time prior to the expiration of the option term. No portion of
any Option for less than 100 shares (as adjusted pursuant to Section
6
<PAGE> 30
5(m) below) may be exercised; provided, that if the vested portion of any Option
is less than 100 shares, it may be exercised with respect to all shares for
which it is vested. Only whole shares may be issued pursuant to an Option, and
to the extent that an Option covers less than one (1) share, it is
unexercisable. Options or portions thereof may be exercised by giving written
notice to the Company, which notice shall specify the number of shares to be
purchased, and be accompanied by payment in the amount of the aggregate exercise
price for the Common Stock so purchased, which payment shall be in the form
specified in Section 5(i) below. The Company shall not be obligated to issue,
transfer or deliver a certificate of Common Stock to any Optionee, or to his
personal representative, until the aggregate exercise price has been paid for
all shares for which the option shall have been exercised and adequate provision
has been made by the Optionee for satisfaction of any tax withholding
obligations associated with such exercise. During the lifetime of an Optionee,
Options are exercisable only by the Optionee.
(i) Payment upon Exercise of Option.
Upon the exercise of any Option, the aggregate exercise price
shall be paid to the Company in cash or by certified or cashier's check. In
addition, upon approval of the Plan Administrator, an Optionee may pay for all
or any portion of the aggregate exercise price by delivering to the Company
shares of Common Stock previously held by such Optionee, or by complying with
any other payment mechanism approved by the Plan Administrator from time to
time. The shares of Common Stock received or withheld by the Company as payment
for shares of Common Stock purchased upon the exercise of Options shall have a
fair market value at the date of exercise (as determined by the Plan
Administrator) equal to the aggregate exercise price (or portion thereof) to be
paid by the Optionee upon such exercise.
(j) Rights as a Shareholder.
An Optionee shall have no rights as a shareholder with respect
to any shares covered by an Option until such Optionee becomes a record holder
of such shares, irrespective of whether such optionee has given notice of
exercise. Subject to the provisions of Sections 5(m) hereof, no rights shall
accrue to an Optionee and no adjustments shall be made on account of dividends
(ordinary or extraordinary, whether in cash, securities or other property) or
distributions or other rights declared on, or created in, the Common Stock for
which the record date is prior to the date the Optionee becomes a record holder
of the shares of Common Stock covered by the Option, irrespective of whether
such Optionee has given notice of exercise.
(k) Transfer of Option.
Unless otherwise specified in the Agreement or by the Plan
Administrator, Options granted under this Plan and the rights and privileges
conferred by this Plan may not be transferred, assigned, pledged or hypothecated
in any manner (whether by operation of law or otherwise) other than by will or
by applicable laws of descent and distribution, and shall not be subject to
execution, attachment or similar process. Upon any attempt to transfer, assign,
pledge, hypothecate or otherwise dispose of any Option or of any right or
privilege conferred by this Plan contrary to the provisions hereof, or upon the
sale, levy or any attachment or similar process upon the rights and privileges
conferred by this Plan, such Option shall thereupon terminate and become null
and void, provided, however, that, effective August 15,
7
<PAGE> 31
1996, nothing contained in this Section 5(k) shall preclude an Optionee, upon
written notice to the Administrator, from transferring an option held by the
Optionee or to be granted to the Optionee to (i) a trust or series of trusts
which are established solely for the benefit of the immediate family members of
the Optionee, or (ii) a partnership or partnerships of which the only partners
are members of the Optionee's immediate family.
(l) Securities Regulation and Tax Withholding.
(1) Shares shall not be issued with respect to an Option
unless the exercise of such Option and the issuance and delivery of
such shares shall comply with all relevant provisions of law,
including, without limitation, any applicable state securities laws,
the Securities Exchange Act of 1933, as amended, the Exchange Act,
the rules and regulations thereunder and the requirements of any
stock exchange upon which such shares may then be listed, and such
issuance shall be further subject to the approval of counsel for the
Company with respect to such compliance, including the availability
of an exemption from registration for the issuance and sale of such
shares. The inability of the Company to obtain from any regulatory
body the authority deemed by the Company to be necessary for the
lawful issuance and sale of any shares under this Plan, or the
unavailability of an exemption from registration for the issuance
and sale of any shares under this Plan, shall relieve the Company of
any liability with respect to the non-issuance or sale of such
shares.
As a condition to the exercise of an Option, the Plan
Administrator may require the optionee to represent and warrant in
writing at the time of such exercise that the shares are being
purchased only for investment and without any then-present intention
to sell or distribute such shares. At the option of the Plan
Administrator, a stop-transfer order against such shares may be
placed on the stock books and records of the Company, and a legend
indicating that the stock may not be pledged, sold or otherwise
transferred unless an opinion of counsel is provided stating that
such transfer is not in violation of any applicable law or
regulation, may be stamped on the certificates representing such
shares in order to assure an exemption from registration. The Plan
Administrator also may require such other documentation as may from
time to time be necessary to comply with federal and state
securities laws. THE COMPANY HAS NO OBLIGATION TO UNDERTAKE
REGISTRATION OF OPTIONS OR THE SHARES OF STOCK ISSUABLE UPON THE
EXERCISE OF OPTIONS.
(2) As a condition to the exercise of any Option granted
under this Plan, the optionee shall make such arrangements as the
Plan Administrator may require for the satisfaction of any federal,
state or local withholding tax obligations that may arise in
connection with such exercise.
(3) The issuance, transfer or delivery of certificates
of Common Stock pursuant to the exercise of Options may be delayed,
at the discretion of the Plan Administrator, until the Plan
Administrator is satisfied that the applicable
8
<PAGE> 32
requirements of the federal and state securities laws and the
withholding provisions of the Code have been met.
(m) Stock Dividend, Reorganization or Liquidation.
(1) If (i) the Company shall at any time be involved in
a transaction described in Section 424(a) of the Code (or any
successor provision) or any "corporate transaction" described in the
regulations thereunder; (ii) the Company shall declare a dividend
payable in, or shall subdivide or combine, its Common Stock or (iii)
any other event with substantially the same effect shall occur, the
Plan Administrator shall, with respect to each outstanding Option,
proportionately adjust the number of shares of Common Stock and/or
the exercise price per share so as to preserve the rights of the
Optionee substantially proportionate to the rights of the Optionee
prior to such event, and to the extent that such action shall
include an increase or decrease in the number of shares of Common
Stock subject to outstanding Options, the number of shares available
under Section 4 of this Plan shall automatically be increased or
decreased, as the case may be, proportionately, without further
action on the part of the Plan Administrator, the Company or the
Company's shareholders.
(2) If the Company is liquidated or dissolved, the Plan
Administrator shall allow the holders of any outstanding Options to
exercise all or any part of the unvested portion of the Options held
by them; provided, however, that such options must be exercised
prior to the effective date of such liquidation or dissolution. If
the Option holders do not exercise their Options prior to such
effective date, each outstanding Option shall terminate as of the
effective date of the liquidation or dissolution.
(3) The foregoing adjustments in the shares subject to
Options shall be made by the Plan Administrator, or by any successor
administrator of this Plan, or by the applicable terms of any
assumption or substitution document.
(4) The grant of an Option shall not affect in any way
the right or power of the Company to make adjustments,
reclassifications, reorganizations or changes of its capital or
business structure, to merge, consolidate or dissolve, to liquidate
or to sell or transfer all or any part of its business or assets.
(n) Change of Control.
Any and all options granted under this Plan that have been
outstanding hereunder for at least six (6) months at the time of occurrence of
any of the events described in Subparagraphs (1) and (2) below (an "Eligible
Option") shall become immediately vested and fully exercisable upon the
occurence of the following events:
(1) The date that a tender or exchange offer for Common
Stock by any Person (other than the Company, any subsidiary of the
Company, any employee benefit plan of the Company or of any
subsidiary of the Company, or
9
<PAGE> 33
any Person or entity organized, appointed or established by the
Company for or pursuant to the terms of any such employee benefit
plan) is first published or sent or given within the meaning of Rule
14d-2 under the Exchange Act (including any extensions or renewals
of such offer), unless by the terms of such offer the offeror, upon
consummation thereof, would be the Beneficial Owner of less than
thirty percent (30%) of the shares of Common Stock then outstanding;
(2) The day on which the shareholders of the Company
(or, if later, approval by the shareholders of any Person) duly
approve any merger, consolidation, reorganization or other
transaction providing for the conversion or exchange of more than
fifty percent (50%) of the outstanding shares of Common Stock into
securities of any Person, or cash, or property, or a combination of
any of the foregoing; provided, however, that no Option which is to
be converted into an option to purchase shares of Exchange Stock as
stated at item (3) below shall be accelerated pursuant to this
Section 5(n).
Provided however, that with respect to the events specified in
Subparagraphs (1) and (2) above, such accelerated vesting shall not
occur if the event that would otherwise trigger the accelerated
vesting of Eligible Options has received the prior approval of a
majority of all of the directors of the Corporation, excluding for
such purposes the votes of directors who are directors or officers
of, or have a material financial interest in any Person (other than
the Corporation) who is a party to the event specified in
Subparagraph (1) or (2) above which otherwise would trigger
acceleration of vesting; provided, further, that no Option which is
to be converted into an option to purchase shares of Exchange Stock
as stated at item (3) below shall be accelerated pursuant to this
Section 5(n).
(3) If the shareholders of the Company receive shares of
capital stock of another Person ("Exchange Stock") in exchange for
or in place of shares of Common Stock in any transaction involving
any merger, consolidation, reorganization or other transaction
providing for the conversion or exchange of all or substantially all
outstanding shares of Common Stock into Exchange Stock, then at the
closing of such transaction all Options granted hereunder shall be
converted into options to purchase shares of Exchange Stock. The
amount and price of converted Options shall be determined by
adjusting the amount and price of the Options granted hereunder in
the same proportion as used for determining the shares of Exchange
Stock the holders of the Common Stock received in such merger,
consolidation, reorganization or other transaction. Unless altered
by the Plan Administrator, the vesting schedule set forth in the
Option Agreement shall continue to apply to the Options granted for
Exchange Stock.
(4) For the purpose of this policy: (i) "Person" shall
include any individual, firm, corporation, partnership or other
entity; (ii) "Affiliate" and "Associate" shall have the meanings
assigned to them in Rule 12b-2 under the Exchange Act; and (iii)
"Beneficial Owner" shall have the meaning assigned to it in Rule
16a-1 under the Exchange Act.
10
<PAGE> 34
(o) No individual shall be granted options hereunder of an
amount in excess of 1,500,000 shares in any three (3) year period.
6. EFFECTIVE DATE; TERM.
This Plan shall be effective as of December 10, 1993, SUBJECT
TO RECEIPT OF SHAREHOLDER APPROVAL. Incentive Stock options may be granted by
the Plan Administrator from time to time thereafter until December 9, 2003.
Non-Qualified Stock options may be granted until this Plan is terminated by the
Board in its sole discretion. Termination of this Plan shall not terminate any
Option granted prior to such termination. Any Options granted by the Plan
Administrator prior to the approval of this Plan by a majority of the
shareholders of the Company shall be granted subject to ratification of this
Plan by the shareholders of the Company within twelve (12) months after this
Plan is adopted by the Board, and if shareholder ratification is not obtained,
each and every Option granted under this Plan shall be null and void and shall
convey no rights to the holder thereof.
7. NO OBLIGATIONS TO EXERCISE OPTION.
The grant of an Option shall impose no obligation upon the
optionee to exercise such Option.
8. NO RIGHT TO OPTIONS OR TO EMPLOYMENT.
Whether or not any Options are to be granted under this Plan
shall be exclusively within the discretion of the Plan Administrator, and
nothing contained in this Plan shall be construed as giving any person any right
to participate under this Plan. The grant of an Option shall in no way
constitute any form of agreement or understanding binding on the Company or any
Related Company, express or implied, that the Company or any Related Company
will employ or contract with an Optionee for any length of time, nor shall it
interfere in any way with the Company's or, where applicable, a Related
Company's right to terminate Optionee's employment at any time, which right is
hereby reserved.
9. APPLICATION OF FUNDS.
The proceeds received by the Company from the sale of Common
Stock issued upon the exercise of Options shall be used for general corporate
purposes, unless otherwise directed by the Board.
10. INDEMNIFICATION OF PLAN ADMINISTRATOR.
In addition to all other rights of indemnification they may
have as members of the Board, members of the Plan Administrator shall be
indemnified by the Company for all reasonable expenses and liabilities of any
type or nature, including attorneys' fees, incurred in connection with any
action, suit or proceeding to which they or any of them are a party by reason
of, or in connection with, this Plan or any Option granted under this Plan, and
against all amounts paid by them in settlement thereof (provided that such
settlement is approved by independent legal counsel selected by the Company),
except to the extent that such expenses
11
<PAGE> 35
relate to matters for which it is adjudged that such Plan Administrator member
is liable for willful misconduct; provided, that within fifteen (15) days after
the institution of any such action, suit or proceeding, the Plan Administrator
member involved therein shall, in writing, notify the Company of such action,
suit or proceeding, so that the Company may have the opportunity to make
appropriate arrangements to prosecute or defend the same.
11. AMENDMENT OF PLAN.
The Plan Administrator may, at any time, modify, amend or
terminate this Plan and Options granted under this Plan, including, without
limitation, such modifications or amendments as are necessary to maintain
compliance with applicable statutes, rules or regulations; provided however,
that any amendment for which shareholder approval is required by the Rule in
order for the Plan to be eligible or continue to qualify for the benefits of the
Rule shall be subject to approval of the requisite percentage of the
shareholders of the Company in accordance with the Rule. Without limiting the
generality of the foregoing, the Plan Administrator may modify grants to persons
who are eligible to receive Options under this Plan who are foreign nationals or
employed outside the United States to recognize differences in local law, tax
policy or custom.
Dates of Approval (as amended) by Board of Directors of the Company:
December 29, 1993, February 21, 1994, March 28, 1994, July 26,
1995, and July 25, 1996.
______________________________________
Paul P. Senio, Corporate Secretary
Date of Original Approval by Shareholders of Company: December 29,
1993
______________________________________
Paul P. Senio, Corporate Secretary
12
<PAGE> 36
MIDCOM COMMUNICATIONS INC.
REVISED AND RESTATED 1993 STOCK OPTION PLAN
AMENDMENT OF JULY 26, 1995 NOTE, 1995
. . . [T]he Board of Directors desiring to amend the 1993 Stock
Option Plan (the "Plan") to provide for the delegation to the Compensation
Committee ("Committee") and to the Chief Executive Officer of the Company of the
authority to grant options under the Plan to employees of the Company
("Non-Insiders") who, at the time of grant, are not subject to the provisions of
Section 16(b) of the Securities and Exchange Act of 1934, as amended, with
respect to the Company's Common Stock;
RESOLVED BY FORMAL RESOLUTION:
That Section 2 of the Plan be amended by adding the following
paragraph to the end of Section 2 thereof;
"The Board or the Committee may delegate to one or more executive
officers of the Company the authority to grant Options under this Plan to
employees of the Company who, at the time of grant, are not subject to Section
16(b) of the Exchange Act with respect to the Common Stock ("Non-Insiders"), and
in connection therewith the authority to determine: (a) whether the Option in an
Incentive Stock Option or a Non-qualified Stock Option; (b) the number of shares
of Common Stock subject to such Option; (c) the duration of the Option; (d) the
vesting schedule for determining the times at which such Option shall become
exercisable; and (e) all other terms and conditions of such Options. The
exercise price for any Option granted by action of an executive officer pursuant
to such delegation of authority shall not be less than the fair market value per
share of the Common Stock on the Date of Grant determined by reference to the
closing price for the Common Stock on the day preceding the Date of Grant.
Unless expressly approved in advance by the Board or the Committee, such
delegation of authority shall not include the authority to accelerate the
vesting, extend the period for exercise or otherwise alter the terms of
outstanding Options. The term "Plan Administrator" when used in any provision of
this Plan other than Sections 2, 5(1) and 11 shall be deemed to refer to the
Board, Ashok Rao, or the Committee, as the case may be, who are hereby
authorized to grant Options pursuant hereto, insofar as such provision may be
applied to Non-Insiders and Options granted to Non-Insiders."
<PAGE> 37
a n n u a l r e p o r t
1995
MIDCOM(R)
<PAGE> 38
INTRODUCTION
MIDCOM Communications Inc. provides long distance voice and data
telecommunications services. As primarily a nonfacilities-based reseller, Midcom
principally utilizes the network switching and transport facilities of Tier I
long distance carriers, such as AT&T Corp. ("AT&T"), Sprint Corporation
("Sprint") and WorldCom, Inc. ("WorldCom"), to provide a broad array of
integrated long distance telecommunications services on a seamless and highly
reliable basis. Midcom's service offerings include basic "1 plus" and "800" long
distance, frame relay data transmission and wireless communications services, as
well as enhanced telecommunications services such as dedicated private lines
between customer locations, facsimile broadcast services, calling cards and
conference calling.
Midcom focuses on serving small to medium-sized businesses. The Company
estimates that during the second quarter of 1996 it invoiced approximately
125,000 customer locations per month, a significant majority of which were
located in the major metropolitan areas of California, Florida, Illinois, New
York, Ohio and Washington. The Company believes that the larger long distance
carriers, such as AT&T, Sprint, WorldCom and MCI Communications Corporation
("MCI"), tend to focus their sales and customer support efforts on residential
and large commercial customers and do not routinely provide significant pricing
discounts for small to medium-sized businesses. By purchasing large usage
volumes from the facilities-based carriers at wholesale prices, Midcom seeks to
offer its customers more favorable pricing than they could obtain from such
carriers directly. In addition, the Company believes that businesses in this
market segment do not typically have in-house telecommunications expertise and
therefore require more assistance with the assessment and management of their
telecommunications requirements. As a result, the Company believes that it is
able to differentiate its service offerings from the larger carriers in this
market segment on the basis of price, breadth of service offerings, customer
service and support and the ability to provide customized solutions to the
telecommunications requirements of its customers.
Midcom believes that the recently enacted Telecommunications Act of 1996
(the "Telecommunications Act") will substantially expand its market
opportunities. The Telecommunications Act removes substantial legal barriers to
competitive entry into the local telecommunications market and directs incumbent
local exchange carriers to allow competing telecommunications service providers
such as the Company to interconnect their facilities with the local exchange
networks, to lease network components on an unbundled basis and to resell local
telecommunications services. According to Federal Communications Commission
("FCC") and other industry estimates, in 1995, long distance providers reported
revenue of $72.4 billion while local telecommunications providers reported
revenue of $102.9 billion.
Subsequent to its initial public offering in July 1995, Midcom completed
numerous acquisitions of businesses and customer bases. Although these
acquisitions contributed to substantial growth, they have also placed
significant demands on management resources and have disrupted Midcom's normal
business operations. In particular, the Company has been unable to fully
integrate the sales and marketing, customer support, billing and other functions
of certain acquired operations which has increased the Company's overall cost
structure and has resulted in lower profitability and cash flows. During the
same period, the Company was in the process of implementing a new management
information system, including the installation of a new billing system. Problems
encountered in this implementation process contributed to the Company's
operational difficulties. In addition, certain reports generated by the new
management information system that were used to estimate unbilled revenue for
the third quarter of 1995 failed to fully reflect all discounts that were
properly included in the bills subsequently sent to the Company's customers.
Primarily as a result of this failure, reported revenue was overstated for the
third quarter of 1995 and the Company's Quarterly Report on Form 10-Q for that
period had to be amended to restate reported results. In addition, the Company's
profitability has been reduced as a result of the Company's supply contract with
AT&T which provides for higher rates than those provided by competitive
suppliers. The Company and AT&T have entered into a letter of intent
contemplating substantial modifications to this contract which will provide more
favorable rates in the future. These factors contributed to defaults under the
Company's revolving credit facility and caused the Company's auditors to include
a going concern qualification in their report on the Company's consolidated
financial statements for the year ended December 31, 1995. The Company's
auditors also identified certain material weaknesses in the Company's internal
financial controls.
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<PAGE> 39
In response to these developments, during the second and third quarters of
1996 Midcom recruited a new executive management team with extensive experience
and expertise in the telecommunications industry. In May 1996, the Company hired
William H. Oberlin as its President and Chief Executive Officer, appointed Mr.
Oberlin, Marvin C. Moses and John M. Zrno to its Board of Directors and engaged
Mr. Moses and Mr. Zrno as consultants. These individuals formerly held senior
management positions at ALC Communications Corporation ("ALC"), a leading
provider of long distance and other services to small and medium-sized
businesses. During their tenure at ALC, ALC completed a successful turn-around
and experienced profitable growth. From the fiscal year ended December 31, 1991
through the 12 months ended June 30, 1995 (prior to ALC's merger into Frontier
Corporation), ALC's revenue increased from $346.9 million to $677.1 million and
net income increased from $5.3 million to $75.0 million. In addition, in July
1996 the Company appointed Daniel M. Dennis to the Company's Board of Directors.
Mr. Dennis has served in a number of management positions with MCI for over 23
years.
The new executive management team has developed a restructuring, network
and marketing strategy which it plans to implement during 1996 and 1997 and
which is designed to address the Company's recent operational challenges and
increase internally generated sales and profitability. Principal components of
the Company's strategy include the following:
Continue to Build Management Team and Restructure Operations. Midcom
will continue to seek opportunities to augment management with individuals
who have telecommunications industry experience and expertise. Between May
and September 1996, the Company appointed 10 individuals to key operational
management positions. These individuals have extensive experience in the
operation of a telecommunications company, including (i) network design,
implementation and operation, (ii) marketing and sales, (iii) management
information systems and (iv) bill processing and collection. Midcom
believes that the experience and depth of this management team will improve
the Company's ability to address its current operational challenges and to
pursue its transition from primarily a nonfacilities-based reseller of long
distance and other telecommunications services to a switch-based provider
of integrated telecommunications services. In addition, Midcom's management
team intends to focus on consolidating and integrating the Company's
multiple information and billing systems and other redundant functions of
certain acquired operations, enlarging and enhancing its information
system, improving its financial reporting and internal controls and
renegotiating its existing carrier supply agreements to obtain more
favorable terms.
Deploy Switching Facilities. At the end of the second quarter of
1996, Midcom owned and operated limited capacity switches in nine
locations. The Company intends to use a portion of the proceeds of a
recently completed debt offering to acquire and install state-of-the-art
high capacity switches, with local and long distance functionality, in
areas of the country where it has a sufficient volume of long distance
traffic and where the regulatory environment and market conditions will
permit it to provide local service at acceptable margins. The Company
believes that, in the cities where it intends to deploy switches, there
will be significant local circuit capacity at attractive rates available
from incumbent local exchange carriers, competitive local exchange carriers
and 38GHz wireless providers. Using its own switches will enable the
Company to (i) direct customer call traffic over multiple networks which is
expected to minimize costs and improve gross margin, (ii) switch local
traffic, thereby increasing the economic viability of entering the market
for local telecommunications services, (iii) shield proprietary information
regarding its customers from the underlying carriers, thereby increasing
customer control, (iv) facilitate access to call data records and (v)
implement differentiating features and billing enhancements without
involving the underlying carrier.
Reorganize and Expand Sales Efforts. To take full advantage of its
planned network of switching facilities and expanded product offerings,
Midcom is in the process of reorganizing its direct sales force into (i) a
special accounts group consisting of highly experienced sales personnel
focused on larger customers with sophisticated telecommunications
requirements and (ii) a general accounts group focused on smaller
customers. Both groups will be located in major metropolitan areas where
the Company believes it has significant market opportunities and can
compete effectively on the basis of price. The Company intends to implement
training programs and financial incentives designed to increase
2
<PAGE> 40
the cross-selling efforts of its direct sales force and further integrate
the Company's broad array of service offerings. In addition to reorganizing
its sales efforts, the Company intends to increase the number of sales
representatives during 1996 and 1997 from approximately 35 at the end of
July 1996, to approximately 200. The Company will continue to supplement
its direct sales force with its existing network of resellers and
distributors. In addition, the Company intends to develop a new tier of
distributors who will be offered long-term financial incentives and who
will be required to market and sell the Company's service offerings
exclusively within selected territories. The Company believes that these
long-term financial incentives and exclusive marketing arrangements will
result in improved performance and increased loyalty to the Company and its
service offerings.
Expand and Enhance Customer Support Efforts. Midcom intends to
support its expanded sales efforts and reduce customer attrition by
building an enhanced customer service and support operation. The Company
intends to increase its customer service and support staff during 1996 and
1997 from approximately 45 at the end of July 1996 to approximately 60.
This expanded operation will include (i) a staff of trained customer
service representatives available during normal business hours at a number
of integrated customer service centers, (ii) trained account
representatives assigned and dedicated to individual customers with
sophisticated telecommunications requirements and (iii) teams of technical
specialists available to develop customized solutions for a customer's
unique telecommunication needs.
Resell Local Services and Provide a Single-Source
Solution. Regulatory changes resulting from the Telecommunications Act
significantly expand the number and types of services Midcom is permitted
to offer. As a result, Midcom intends to offer its customers local dial
tone and a variety of other local telecommunications services primarily in
locations where it has a significant sales and marketing presence or where
it plans to deploy switching facilities. The Company believes that its
large and geographically concentrated customer base of small to
medium-sized businesses represents a significant potential market for these
additional services. These additional services will afford the Company the
opportunity to provide its customers with a single-source solution for
local, long distance, wireless and enhanced telecommunications services.
The Company believes that bundling these services will provide substantial
advantages to its customers, including lower overall costs and a higher
level of service due to a single source for ordering, installation,
customer service and account management. In addition, Midcom believes that
offering a single source for telecommunications services will permit the
Company to (i) increase sales by increasing its share of the
telecommunications expenditures of its customers and (ii) improve customer
control and retention by strengthening its relationships with its
customers.
Midcom believes that its new management team has the skills and experience
necessary to implement the foregoing strategy. However, management's ability to
implement the Company's strategy and achieve the intended positive results is
subject to an unusual number of risks and uncertainties, and there can be no
assurance that the strategy will be successfully implemented or that the
intended positive results will be achieved.
FORWARD-LOOKING STATEMENTS AND THE
PRIVATE SECURITIES LITIGATION REFORM ACT
Statements in this report concerning expectations for the future constitute
forward-looking statements which are subject to a number of known and unknown
risks, uncertainties and other factors which might cause actual results to
differ materially from stated expectations. Forward-Looking statements in this
report include those concerning anticipated growth in sales,
services-per-customer ratio and profitability, deployment of a network of high
capacity local and long distance switching facilities, introduction of local and
other additional telecommunications services, geographic expansion, increases in
sales, customer service and other personnel, improvements in customer service,
sales through new sales channels, adequacy of available sources of working
capital to implement strategies, negotiation of more favorable carrier supply
contracts; and expectations for growth in the telecommunications industry.
Relevant risks and uncertainties include, but are not limited to, unanticipated
actions by competitors, regulatory or other obstacles which restrict the
Company's ability to implement local or other services, greater than expected
costs to open new offices, acquire switching
3
<PAGE> 41
equipment or execute other aspects of the Company's growth strategy, greater
than expected declines in sales, inability to hire and retain key personnel,
unfavorable determinations of pending lawsuits or other disputes, inability to
obtain more favorable pricing and other terms from suppliers, inability to
secure additional sources of working capital if and when needed, inability to
manage growth or integrate acquired operations and regulatory changes.
Additional risks and uncertainties include those described in the Company's
Interim Report on Form 8-K as filed with the Securities and Exchange Commission
on August 2, 1996, the Company's Annual Report on Form 10-K for the year ended
December 31, 1996 and those described from time to time in the Company's other
filings with the Securities and Exchange Commission, press releases and other
communications. Although the Company believes that all forward-looking
statements are reasonable, there can be no assurance that actual results,
achievements, performance or developments will not differ materially from those
expressed or implied by such forward-looking statements.
4
<PAGE> 42
SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------------------------------
1991 1992 1993 1994 1995
------- ------- ------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENTS OF OPERATIONS DATA:
Revenue................................ $10,895 $27,894 $66,010 $111,699 $203,554
Cost of revenue........................ 1,690 14,817 45,363 79,044 139,546
------- ------- ------- -------- --------
Gross profit........................... 9,205 13,077 20,647 32,655 64,008
Selling, general and administrative
expense.............................. 8,871 11,246 18,125 27,697 62,061
Depreciation and amortization.......... 245 295 1,881 4,134 13,790
Loss on impairment of assets(1)........ -- -- -- -- 11,830
------- ------- ------- -------- --------
Operating income (loss).............. 89 1,536 641 824 (23,673)
Interest expense....................... 685 951 1,368 2,965 5,288
Other expense (income)................. 1,880 (65) (249) 871 390
------- ------- ------- -------- --------
Income (loss) before income taxes and
extraordinary item................ (2,476) 650 (478) (3,012) (29,351)
Provision (benefit) for income taxes... (118) (4) 51 17 --
------- ------- ------- -------- --------
Loss before extraordinary item....... (2,358) 654 (529) (3,029) (29,351)
Extraordinary item(2).................. -- -- -- -- (4,067)
------- ------- ------- -------- --------
Net income (loss).................... $(2,358) $ 654 $ (529) $ (3,029) $(33,418)
======= ======= ======= ======== ========
Per share amounts(3):
Income (loss) before extraordinary
item................................. $ (0.24) $ 0.07 $ (0.05) $ (0.31) $ (2.42)
Extraordinary item..................... -- -- -- -- (0.34)
------- ------- ------- -------- --------
Net income (loss).................... $ (0.24) $ 0.07 $ (0.05) $ (0.31) $ (2.76)
======= ======= ======= ======== ========
Shares used in calculating per share
data................................. 9,930 9,930 9,930 9,930 12,101
SUPPLEMENTAL OPERATING DATA:
EBITDA(4).............................. $ 334 $ 1,831 $ 2,522 $ 4,958 $ 1,947
BALANCE SHEET DATA:
Cash................................. $ 447 $ 1,461 $ 808 $ 960 $ 1,083
Total assets......................... 3,530 11,090 35,414 66,078 133,331
Short-term obligations, including
current portion of long-term
obligations(5).................... 294 279 8,719 2,241 56,297
Long-term obligations, less current
portion(5)........................ 8,119 8,618 16,431 34,195 3,691
Redeemable preferred stock........... -- -- -- 8,597 --
Shareholders' equity (deficit)....... (6,479) (6,196) (6,565) (6,304) 23,799
</TABLE>
- ---------------
(1) Consists of the following: (i) a $6.8 million write-down of the Company's
interest in its joint venture in Russia, (ii) a $2.5 million write-off of
the Company's existing limited capacity switching equipment as a result of
its decision to deploy new, state-of-the-art high capacity switches and
(iii) a $2.5 million partial write-down of the Company's capitalized
software development costs for its management information system.
(2) Includes $3.0 million of original issue discount and $1.1 million of
deferred financing costs written off in the third and fourth quarters of
1995.
(3) Net loss per share is based on the weighted average number of common and
equivalent shares outstanding using the treasury stock method. Common stock
equivalents are excluded from the calculation of net loss per share due to
their antidilutive effect except that, pursuant to requirements of the
Commission, for periods prior to the Company's initial public offering in
July 1995, common and equivalent shares issued during the 12-month period
prior to filing the registration statement with the
5
<PAGE> 43
Commission in connection with the initial public offering have been included
in the calculation as if they were outstanding for all periods presented
using the treasury stock method.
(4) As used herein, "EBITDA" is defined as operating income plus depreciation,
amortization, loss on impairment of assets, restructuring charge and
settlement of contract dispute. EBITDA is commonly used to measure
performance of telecommunications companies because of (i) the importance of
maintaining cash flows in excess of debt-service obligations due to the
capital and acquisition-intensive nature of the telecommunications industry
and (ii) the non-cash effect on earnings of generally high levels of both
amortization and depreciation expenses associated with capital equipment and
acquisitions common in this industry. EBITDA does not purport to represent
cash provided by operating activities as reflected in the Company's
consolidated statements of cash flows, is not a measure of financial
performance under generally accepted accounting principles and should not be
considered in isolation or as a substitute for measures of performance
prepared in accordance with generally accepted accounting principles. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
(5) As a result of defaults existing on December 31, 1995 under the Revolving
Credit Facility, and corresponding cross-defaults under certain of the
Company's capital leases, short-term obligations as of December 31, 1995
includes borrowings under the Company's revolving credit facility of $34.4
million and non-current capital lease obligations of $2.9 million.
Short-term obligations include $12.0 million payable in connection with two
customer base acquisitions which may be paid in cash or by delivery of
shares of Common Stock, as the Company may elect; provided, however, that
the revolving credit facility, as amended in March 1996, prohibits payment
of this obligation in cash without the lenders' prior written consent.
6
<PAGE> 44
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
Midcom was formed in 1989 and initially operated as an aggregator of long
distance telecommunications services. In 1991, Midcom shifted its focus from
aggregation to providing telecommunications services and, accordingly, began to
(i) enter into volume-based supply agreements with multiple underlying
facilities-based carriers, (ii) establish a knowledgeable direct sales force to
target small and medium-sized business customers, (iii) obtain the necessary
federal and state certifications to provide interstate, intrastate and
international service, (iv) build an infrastructure to bill and service a large
volume of customers and (v) develop enhanced and value-added products and
services to supplement its basic long distance service. Midcom does not provide
its telecommunications services through the operation of its own transmission
network. Rather, Midcom purchases large volumes of long distance services
utilizing transmission networks owned and operated by various other
interexchange carriers, and then resells those services to its customers.
Midcom, or one of its billing agents, receives monthly records from its
underlying carriers which detail the calls made by its customers, then rates the
calls and bills its customers.
Subsequent to its initial public offering in July 1995, Midcom completed
numerous acquisitions of businesses and customer bases. Although these
acquisitions contributed to substantial growth, they have placed significant
demands on management resources and have disrupted Midcom's normal business
operations. In particular, the Company has been unable to fully integrate the
sales and marketing, customer support, billing and other functions of certain
acquired operations which has increased the Company's overall cost structure and
has resulted in lower profitability and cash flows. During the same period, the
Company was in the process of implementing a new management information system,
including the installation of a new billing system. Problems encountered in this
implementation process contributed to the Company's operational difficulties. In
addition, certain reports generated by the new management information system
that were used to estimate unbilled revenue for the third quarter of 1995 failed
to fully reflect all discounts that were properly included in the bills
subsequently sent to the Company's customers. Primarily as a result of this
failure, reported revenue was overstated for the third quarter of 1995 and the
Company's Quarterly Report on Form 10-Q for that period had to be amended to
restate reported results. In addition, the Company's profitability has been
reduced as a result of the Company's supply contract with AT&T which provides
for higher rates than those provided by competitive suppliers, although the
Company and AT&T have entered into a letter of intent contemplating substantial
modifications to this contract which will provide for more favorable rates in
the future. These factors contributed to defaults under the Company's revolving
credit facility (the "Revolving Credit Facility") (which defaults were
subsequently waived) and caused the Company's auditors to include a going
concern qualification in their report on the Company's financial statements for
the year ended December 31, 1995. The Company's auditors also identified certain
material weaknesses in the Company's internal financial controls. See
"Restatement of Results for the Third Quarter of 1995" and "Material
Weaknesses."
In response to these developments, during the second and third quarters of
1996 Midcom recruited a new executive management team with extensive experience
and expertise in the telecommunications industry. The new executive management
team has developed a restructuring, network and marketing strategy which it
plans to implement during 1996 and 1997 and which is designed to address the
Company's recent operational challenges and increase internally generated sales
and profitability. As a result of restructuring costs, customer attrition and
other factors, the Company expects that in the near term, revenue is likely to
decrease and selling, general and administrative expenses are likely to increase
substantially. These expected trends will have a material adverse impact on the
Company's near term profitability and levels of cash flows. In August and
September of 1996 the Company completed a private placement (the "Private
Placement") of $97,743,000 in aggregate principal amount of 8 1/4% Convertible
Subordinated Notes (the "Notes") due 2003. The net proceeds to the Company from
the Private Placement were approximately $94.2 million and the Company expects
that the net proceeds of the Private Placement, funds available under the
Revolving Credit Facility and cash flows from operations will be sufficient to
fund its capital requirements during 1996 and
7
<PAGE> 45
1997. However, there can be no assurance that the Revolving Credit Facility will
continue to be available to the Company or that the net proceeds of the Private
Placement together with funds available under the Revolving Credit Facility and
cash flows from operations will be sufficient to fully implement the Company's
new operating strategy or meet its other capital requirements.
If Midcom successfully implements its new operating strategy, it
anticipates that over the long term, (i) revenue will increase as a result of
its reorganized and expanded direct sales efforts, the development of a new tier
of distributors and reduced customer attrition and (ii) operating expenses will
decrease as a result of deploying its network of switching facilities and
obtaining more favorable terms from its suppliers. As a result of these expected
trends, the Company expects that gross margin as a percentage of revenue will,
over the long term, be comparable to other telecommunications providers despite
an anticipated increase in costs associated with its larger sales force and
customer support efforts. Although the Company believes that its new management
team has the relevant skills and experience necessary to implement this
strategy, its ability to do so is subject to an unusual number of risks and
uncertainties, and there can be no assurance that this strategy will be
successfully implemented or that the intended positive results will be achieved.
See "Forward-Looking Statements and the Private Securities Litigation Reform
Act."
RECENT ACQUISITIONS
In 1994, Midcom acquired PacNet, Inc. ("PacNet") and certain assets of
American Telephone Network, Inc. ("ATN"). In 1995, Midcom acquired Adval, Inc.
("Adval"), Cel-Tech International Corp. ("Cel-Tech"), ADNET Telemanagement, Inc.
("Adnet") and certain assets of Communique Telecommunications, Inc.
("Communique"). With the exception of ATN, the consideration for these
acquisitions was paid primarily in the form of Common Stock and the assumption
of certain liabilities. The consideration for ATN was primarily in the form of
cash and the assumption of certain liabilities, financed principally through
working capital and borrowings under an expired revolving credit facility. In
addition to the acquisitions of businesses, the Company has made numerous
acquisitions of customer bases, including acquisitions of two significant
customer bases from Cherry Communications Incorporated ("Cherry Communications")
in September and November 1995.
To date, all business combinations have been accounted for using the
purchase method except for Adval and Adnet which have been accounted for as
pooling of interests transactions. The Company's consolidated financial
statements for the years ended December 31, 1994 and 1993 and the following
Management's Discussion and Analysis of Financial Condition and Results of
Operations for 1994 versus 1993 have been restated to reflect the inclusion of
the accounts and results of operations of Adval and Adnet in both of those
periods. The former shareholders of Adnet have asserted a number of claims
against the Company arising from the acquisition. Should the Company agree or
otherwise be required to pay additional consideration to the sellers, the
Company may be required to account for the acquisition of Adnet using the
purchase method, which would require the Company to restate its financial
statements for all prior periods. Using the purchase method, the purchase price
paid in excess of the fair market value of the assets acquired is recorded as an
intangible asset and amortized generally over three years using the
straight-line method. During the second quarter of 1996, the Company wrote down
certain acquired customer bases and equipment and recorded a loss on impairment
of assets of $18.8 million. See Note 5 of the Notes to Consolidated Financial
Statements.
SUPPLIER RELATIONSHIPS
Midcom has entered into multiple-year contracts with AT&T, Sprint and
WorldCom and short-term contracts with a number of other suppliers for the long
distance telecommunication services provided to its customers. To obtain
favorable forward pricing from certain suppliers, the Company has committed to
purchase minimum volumes of a variety of long distance services during stated
periods whether or not such volumes are used or, in one case, to pay a surcharge
equal to a percentage of the Company's shortfall from a specified quarterly
minimum volume. For 1995, these commitments and maximum surcharge totaled
approximately $74.1 million, and for the final six months of 1996 they total
approximately $53.2 million (including approximately $37.2 million attributable
to AT&T). Under the Company's agreements with other suppliers, if certain volume
levels are not achieved during stated periods, pricing is adjusted going forward
to
8
<PAGE> 46
levels justified by actual volumes. Historically, the Company has directed its
customers' traffic among its suppliers in order to meet its minimum volume
commitments. The allocation of traffic among the Company's various suppliers
could contribute to fluctuations in gross margin between periods. The Company
estimated that as of September 30, 1996, it would have been in shortfall of its
minimum commitments to AT&T by approximately $27.6 million. The Company's
current usage rates with AT&T are continuing to fall below its minimum
commitment levels and such shortfalls are expected to continue to grow under
current contract terms. However, on July 19, 1996, the Company and AT&T executed
a letter of intent to settle this anticipated liability as well as all other
pending disputes between the Company and AT&T, and to negotiate a new contract
pursuant to which the Company's minimum commitment to AT&T will be reduced to
$17.0 million. The letter of intent also provides for the payment by the Company
to AT&T of $8.8 million in two installments and contemplates that Midcom would
obtain more favorable pricing for certain network services provided by AT&T. The
settlement and new rates will not be effective until the Company and AT&T have
negotiated and executed a mutually acceptable definitive agreement, which the
parties are currently pursuing. The Company believes that the renegotiation of
these agreements is an important element to the Company's restructuring strategy
and will increase the Company's flexibility in utilizing those suppliers while
lowering its costs. There can be no assurance, however, that the Company will be
successful in its efforts to renegotiate the terms of these agreements or that
the Company will be able to obtain relief from minimum contractual commitments
in the future. If existing or future shortfalls are not eliminated, the Company
may be required to make substantial payments without associated revenue from
customers or the supplier may terminate service and commence formal action
against the Company. Such payments are not presently contemplated in the
Company's capital budgets and would have a material adverse effect on the
Company's business, financial condition and results of operation. See Note 14 of
the Notes to Consolidated Financial Statements.
ATTRITION
Midcom's revenue is affected by customer attrition, a problem inherent in
the long distance industry. The attrition experienced by the Company is
attributable to a variety of factors, including the Company's termination of
customers for non-payment and the marketing and sales initiatives of the
Company's competitors such as, among other things, national advertising
campaigns, telemarketing programs and the use of cash or other forms of
incentives. In particular, the Company commonly experiences high initial
customer attrition from acquired customer bases as these customers are
transitioned to the Company's services and systems. The Company believes that
this attrition occurs as a result of difficulties encountered in transitioning
acquired customer bases to the Company's services and systems, a process which
often prompts customers to consider competitive alternatives in the
telecommunications marketplace. Also, where the Company has not acquired the
sales channel associated with an acquired customer base, there is often a period
of increased exposure to competitors as the Company's sales force establishes a
relationship with its new customers. Moreover, one of the Company's selling
points in the past has been the ability to accommodate its customers who express
a preference for a particular underlying long distance carrier, such as AT&T. In
connection with the establishment of its own network of switching facilities,
the Company no longer plans to accommodate such customer preferences. The
Company expects that, as a result, certain of its existing customers will
discontinue or reduce their purchases from the Company following implementation
of its network of switching facilities. This is expected to contribute to
anticipated declines in revenue and could also impair the Company's ability to
compete for customers. The Company is aware of the significant impact attrition
has on its business. However, because of numerous acquisitions and lack of
historical data concerning its acquired customer bases, the Company has found it
difficult to measure customer attrition in a consistently meaningful manner. As
a consequence, the Company has not formulated a statistical basis for measuring
or reporting customer attrition.
MATERIAL WEAKNESSES
In connection with the audit of Midcom's 1995 Consolidated Financial
Statements, Midcom's independent auditors identified two conditions which were
characterized as material weaknesses in its internal financial controls. One
material weakness identified by the auditors was the failure of the Company's
9
<PAGE> 47
accounting and finance systems to provide accurate information to monitor the
Company's financial position, results of operations and liquidity. Factors
identified as contributing to this weakness and requiring immediate attention
included insufficient staffing and systems to accommodate significant growth
from acquisitions, transitional difficulties associated with major new
information and billing systems, inadequate communication between senior
management and the finance department and demands associated with the Company's
initial public offering. The second material weakness identified by the auditors
was the Company's process of estimating unbilled receivables. With respect to
this material weakness, the auditors recommended that the Company review and
revise, as necessary, all policies and procedures with regard to its
reconciliation of unbilled receivables with actual billings to ensure that all
unbilled amounts at a reporting date represent properly recorded revenue. In
response to these recommendations, the Company has hired new finance and
accounting personnel, curtailed acquisitions and established a policy of billing
substantially all customer call traffic in a financial reporting period before
revenue for the period is reported.
RESTATEMENT OF RESULTS FOR THE THIRD QUARTER OF 1995
Midcom announced on March 4, 1996 that it would issue restated financial
statements for the third quarter and nine months ended September 30, 1995 that
would lower previously announced results. The restatement was primarily
attributable to an overrecognition of revenue and unbilled accounts receivable
which occurred during the conversion to a new billing system. In the process of
reconciling unbilled accounts as of December 31, 1995 with amounts ultimately
billed, the Company discovered that certain reports generated by its new
information management system that were used for recognizing unbilled revenue
did not fully reflect all discounts that were properly included in the bills
subsequently sent to the Company's customers. Primarily as a result of this
failure, the Company's Quarterly Report on form 10-Q for the third quarter of
1995 was amended to report a $3.3 million reduction in revenue and a $4.5
million reduction in accounts receivable, consisting of a $3.8 million reduction
in unbilled accounts receivable and a $0.7 million increase in the allowance for
doubtful accounts. The amended 10-Q also reflects a reclassification of $1.2
million of customer adjustments to revenue to bad debt expense (included in
selling, general and administrative expenses on the statement of operations).
These adjustments resulted in the net loss for the quarter and nine months ended
September 30, 1995 being increased from $3.8 million and $8.0 million,
respectively, to $8.3 million and $12.5 million, respectively.
SEASONALITY
Due to its predominately commercial customer base, Midcom tends to
experience decreases in customer usage and revenue around national holidays and
traditional vacation periods. The Company anticipates revenue from existing
customers during the last two quarters of the year to be somewhat lower than
during the first two quarters. Historically, however, results have been affected
more significantly by acquisitions of customer bases and growth through
wholesale, direct and other sales channels than by seasonal factors.
10
<PAGE> 48
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentages
that certain items bear, except as noted, to total revenues:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------
1993 1994 1995
----- ----- -----
<S> <C> <C> <C>
Revenues
Telecommunication Services................................ 89.4% 94.6% 99.1%
Aggregation............................................... 10.6 5.4 0.9
----- ----- -----
Total revenues....................................... 100.0 100.0 100.0
Cost of revenues
Telecommunication Services(1)............................. 76.8 74.8 69.2
Aggregation............................................... 0.0 0.0 0.0
----- ----- -----
Total cost of revenues............................... 68.7 70.8 68.5
Gross margin................................................ 31.3 29.2 31.5
Selling, general and administrative expenses................ 27.5 24.8 30.5
Depreciation and amortization............................... 2.8 3.7 6.8
Loss on impairment of assets................................ -- -- 5.8
----- ----- -----
Operating income (loss)................................... 1.0 0.7 (11.6)
Interest expense............................................ (2.1) (2.6) (2.6)
Other income (expense)...................................... 0.3 (0.8) (0.2)
----- ----- -----
Loss before extraordinary item.............................. (0.8) (2.7) (14.4)
----- ----- -----
Extraordinary item.......................................... -- -- (2.0)
----- ----- -----
Net loss.................................................... (0.8)% (2.7)% (16.4)%
===== ===== =====
SUPPLEMENTAL OPERATING DATA:
EBITDA(2)................................................... 3.8% 4.4% 1.0%
</TABLE>
- ---------------
(1) Cost of telecommunications services is stated as a percentage of
telecommunication services revenue.
(2) As used herein, "EBITDA" is defined as operating income plus depreciation,
amortization and loss on impairment of assets.
1995 COMPARED TO 1994
Revenues. Total revenue in 1995 increased 82.2% to $203.6 million from
$111.7 million in 1994. The increase is primarily attributable to incremental
telecommunications services revenues resulting from acquisitions and, to a
lesser extent, new sales through the Company's combined sales channels, offset
by the impact of attrition. Increased revenues also were partially offset by a
70.6% decrease in aggregation fee revenues compared to 1994. The decline in
aggregation fees is due to the attrition of aggregation customers and the
Company's efforts to convert aggregation customers to other Midcom products.
Gross Margin. The Company's cost of revenues consists of the cost of
services provided by local and interexchange carriers. Cost of revenues grew
76.5% in 1995, primarily as a result of the increase in revenues as discussed
above. The gross margin percentage for 1995 increased to 31.5% versus 29.2% in
1994. Telecommunication services gross margin increased to 30.8% in 1995, up
from 25.2% in 1994. The higher gross margin in 1995 is attributable to several
factors, including (1) acquisitions of customer bases whose mix of customers
generally result in higher average revenue per minute and acquisitions of higher
margin businesses, such as PacNet, (2) negotiation of price reductions with some
of the Company's interexchange suppliers as a result of increased traffic
volume, and (3) an increase in traffic over the Company's own switches, all of
which were acquired or placed in service on or after September 30, 1994. These
factors were partially offset by an increase in wholesale revenues as a
percentage of total revenues, which carries a lower
11
<PAGE> 49
gross margin percentage, and a decline in aggregation fee revenue as a
percentage of total revenues, which has no cost of revenues and the write-off of
calls which were not billed during the conversion to the Company's new billing
system.
Selling, General and Administrative Expenses. The Company's selling,
general and administrative expenses consist primarily of payroll and related
expenses for administrative, customer support and marketing personnel,
compensation costs for direct sales personnel, commissions and other costs
related to indirect distribution and bad debt expense. These expenses increased
as a percentage of total revenues from 24.8% in 1994 to 30.5% in 1995. The
increase was due to several factors, including a substantial increase in bad
debt expense and other adjustments given to customers largely attributable to
delays in billing which occurred during the conversion to the new billing
system, higher commission rates associated with a telemarketing program for
lower volume customers, the addition of personnel and other costs incurred in
connection with conversion to the Company's new information processing systems
and costs to open sales offices, some of which were closed in the first quarter
of 1996. Midcom also incurred additional expenses during 1995 in connection with
the maintenance of duplicate billing and information systems, including those of
acquired businesses, and to a lesser extent, additional personnel costs. The
Company employed 457 and 366 persons on a full-time basis as of December 31,
1995 and 1994, respectively. Commencing January 1, 1996, the Company will no
longer capitalize software development expenditures related to its existing
billing system, but rather will expense them in the period in which they are
incurred. In addition, in March 1996 the Company announced actions to reduce
operating expenses including office closures and a reduction in its workforce
accomplished by consolidation of a number of job functions. These March actions
resulted in a restructuring charge of approximately $1.6 million in the first
quarter of 1996.
Depreciation and Amortization. Depreciation and amortization expense
increased as a percentage of revenues during 1995. This increase reflects the
amortization of customer bases and goodwill, the depreciation of telephone
switching equipment resulting from acquisitions in the second half of 1994 and
throughout 1995 and the depreciation/amortization of significant continued
capital investment in computer equipment and software development used to
support internal systems. The Company expects depreciation and amortization
expenses to continue to increase due to the effect of recent acquisitions and
the development and placement into service of management information systems.
Loss on Impairment of Assets. The loss on impairment of assets consists of
the following: (i) a $6.8 million write-down of the Company's interest in the
joint venture in Russia to reflect the estimated current value of this
investment, (ii) a $2.5 million write-off of the Company's current telephone
switching equipment as a result of its decision to migrate to a different
switching platform and (iii) a $2.5 million partial write-down of the Company's
capitalized software for its management information system due to weaknesses
identified in the system.
Interest Expense. Interest expense increased 78.4% to $5.3 million in 1995
from $3.0 million in 1994 primarily due to the increase in average borrowings
outstanding in 1995. At December 31, 1995, the Company had outstanding
interest-bearing obligations of $58.1 million, up from $36.3 million outstanding
as of December 31, 1994. The increase in debt was due to the funding of
acquisitions and the development of management information systems and purchase
of related equipment.
Extraordinary Item. In July 1995, the Company completed an initial public
offering which resulted in net proceeds of $54.2 million to the Company. The
Company used the proceeds to pay down various obligations, including $15.0
million in principal amount of certain subordinated notes. As a result of the
early extinguishment of these notes, the Company expensed as an extraordinary
item in the third quarter of 1995 the unamortized portion of original issue
discount which aggregated approximately $3.0 million. In addition, in the fourth
quarter of 1995, the Company obtained a new credit facility and paid off its
prior revolving credit facility. As a result, the Company was required to
write-off as an extraordinary item during the fourth quarter unamortized
deferred financing costs associated with its prior credit facility totaling
approximately $1.1 million.
12
<PAGE> 50
Other Expense/Equity in Loss of Joint Venture. Other expense consists
mainly of finance charges and other nonoperating expenses. The Company's portion
of the loss generated by its Russian joint venture, Dal Telecom, was $52,000 in
1995, down from $458,000 in 1994, due mainly to improved operating results of
the joint venture.
Income Taxes. The Company has incurred losses for all periods presented.
No tax benefit has been recorded with respect to these losses due to the
Company's net operating loss carryforward which totalled approximately $19.1
million as of December 31, 1995.
1994 COMPARED TO 1993
Revenues. Total revenues in 1994 increased 69.2% to $111.7 million from
$66.0 million in 1993. This increase consisted primarily of an 78.9% increase in
revenue from telecommunications services, to $105.6 million from $59.0 million
in 1993, which was offset by a 12.7% decrease in revenue from aggregation fees.
The increase in telecommunication services revenues in 1994 is attributable to
increased sales from the Company's direct sales and field service
representatives and independent distributors, as well as revenue attributable to
acquired customer bases. In 1993 and early 1994, the Company significantly
increased the size of its sales force. Also, in late 1993 the Company increased
the number of its independent distributors, primarily through acquisitions. To a
lesser extent, 1994 revenues increased as a result of the expansion of the
Company's products and services and increased sales to resellers.
Gross Margin. The Company's gross margin declined in 1994 to 29.2% from
31.3% in 1993. The decline was largely attributable to the decrease in
aggregation fees, which has no cost of sales. Telecommunication services gross
margin increased from 23.2% in 1993 to 25.1% in 1994 in spite of declining
revenue per minute caused by increasingly competitive market conditions. The
revenue per minute decline also reflects the Company's increasing emphasis,
commencing in mid-1993, on term contracts (two or three years) which offered
lower rates in exchange for fixed term commitments. Nevertheless, these factors
were offset by price reductions obtained from some of the Company's
interexchange suppliers as a result of the Company's increased volume of use. In
addition, in the fourth quarter of 1994 the Company commenced use of its own
switches which also benefited gross margins.
Selling, General and Administrative Expenses. From 1993 to 1994, the
Company's selling, general, and administrative expenses declined as a percentage
of revenues from 27.5% to 24.8%. The actual dollar increase was primarily a
result of growth, including growth by means of acquisitions. The 1994 increase
is also attributable to additional personnel and other costs incurred in
connection with the development and initial implementation of the Company's new
information processing systems and to operate and maintain switches. The
percentage decline in 1994 is also attributable to the fact that the Company did
not pay any consulting fees to shareholders, compared to shareholder consulting
fees of $1,025,000 paid with respect to 1993 to Paul Pfleger, the Company's then
sole shareholder. In 1993, Mr. Pfleger, as a director and the sole shareholder
of the Company, actively consulted with management of the Company by
participating in major decisions and regularly giving direction and guidance to
the Company's senior officers. The amount paid for these services was based
primarily on the Company's operating results. Midcom incurred additional
expenses in 1994 due to the cost of maintaining duplicate systems of acquired
businesses pending full integration of these acquisitions. The decline in
selling, general and administrative expenses as a percentage of revenue was
attributable to improved operating leverage. The Company employed 366 and 248
persons on a full-time basis at the end of 1994 and 1993, respectively.
Depreciation and Amortization. From 1993 to 1994, depreciation and
amortization expense increased as a percentage of revenue from 2.7% to 3.7%.
This increase reflects the significant capital investment in internal systems
and the amortization of intangible assets associated with acquisitions.
13
<PAGE> 51
Interest Expense. From 1993 to 1994, interest expense increased from $1.4
million to $3.0 million. This increase was primarily due to increased borrowings
and, to a lesser extent, an increase in overall interest rates. At December 31,
1993, the Company had outstanding interest-bearing obligations of approximately
$23.5 million, while at December 31, 1994, this amount had grown to $36.3
million. The increase in debt is primarily due to funding acquisitions and the
purchase of systems and equipment.
Other Expense. Other expense in 1994 is mainly composed of the Company's
portion of the loss of its Russian joint venture. The Company's pro rata share
of the loss generated by its Russian joint venture in 1994 was $365,000.
Additionally, the Company recorded a $93,000 incremental loss for the difference
between the Company's investment and its 50% allocable share of Dal Telecom's
net assets.
Income Taxes. Through December 31, 1993, the Company was an S corporation
for income tax purposes. Accordingly, the Company's income (losses) were
reported by the shareholders rather than by the Company. Effective with the
change from an S corporation to a C corporation, the Company recorded a tax
provision of $207,000, which was subsequently reversed due to losses incurred
during 1994.
LIQUIDITY AND CAPITAL RESOURCES
Historically, Midcom has experienced rapid growth, which has required
substantial working capital to finance receivables, capital expenditures and
acquisitions and service indebtedness. Given Midcom's billing and collection
cycle with its customers and suppliers, Midcom generally pays its underlying
suppliers approximately 30 to 45 days prior to the time it is paid by its
customers for the related services. The Company has financed its growth with the
proceeds from its July 1995 initial public offering, proceeds from the Private
Placement, bank borrowings, subordinated debt, vendor financing, loans from
shareholders, capital leases, cash flows from operations, and the issuance of
Common Stock and assumption of indebtedness in connection with acquisitions of
businesses and customer bases.
Net cash provided by (used in) operating activities was $2.2 million, ($2.1
million), and ($5.9 million) in 1993, 1994 and 1995, respectively. The increase
in cash used in operating activities in 1995 versus 1994 is primarily due to an
increase in the net loss before non-cash items offset in part by an increase in
other long-term liabilities. The use of cash from operating activities in 1994
is primarily attributable to the increase in accounts receivable which exceeded
the increases in carrier payables and other current liabilities.
Net cash used in investing activities was $12.8 million, $14.7 million and
$20.9 million in 1993, 1994 and 1995, respectively. Net cash used in investing
activities increased during 1995 primarily due to an increase in cash used in
the acquisition of businesses and customer bases, an increase in costs incurred
in connection with the development and acquisition of information systems and
expenditures for telephone switching equipment, including switches acquired in
business acquisitions, offset in part, by a decrease in investments in the
Russian joint venture. The increase in 1994 was primarily attributable to
acquisitions of businesses and customer bases, costs incurred in connection with
the development and acquisition of information systems, other capital
expenditures and investments in the Company's Russian joint venture.
Net cash provided by financing activities was $9.9 million, $17.0 million
and $27.0 million in 1993, 1994 and 1995, respectively. The increase in net cash
provided by financing activities in 1995 over 1994 is primarily attributable to
the Company's initial public offering ($54.2 million of net proceeds) and
increased long-term borrowings, offset by the repayment of a prior credit
facility and notes payable and the redemption of preferred stock. The 1994
increase is attributable to increased long-term borrowings, offset by repayments
of a prior credit facility and other long-term debt, repayment of loans from
shareholders and deferred financing costs.
The Company has experienced significant losses since its inception, with
net losses of approximately $3.0 million, and $33.4 million for 1994, and 1995
respectively. As a result of these losses, the billing and collection cycle with
its customers, acquisition strategy and other factors, the Company has required
substantial external working capital.
In addition to funds required for day to day operations, the Company's
principal working capital requirements include capital expenditures, including
those associated with the proposed installation of new switching facilities,
interest and principal payable under the Notes and the other contingencies and
obligations
14
<PAGE> 52
described below. The Notes will mature on August 15, 2003. Interest on the Notes
is payable semi-annually on February 15 and August 15 of each year, commencing
February 15, 1997, in the aggregate amount of $4,031,899.
In connection with the resignation of Ashok Rao, the Company's former
President and Chief Executive Officer, the Company has elected to repurchase
885,360 shares of common Stock held by Mr. Rao and certain trusts established by
Mr. Rao at a price equal to the fair market value of such Common Stock on the
date of Mr. Rao's resignation, as determined by arbitration, to be paid ratably
over a period of 36 months. The Company's election to repurchase such shares of
Common Stock will adversely affect the Company's liquidity. In addition, the
unpaid balance of a promissory note delivered to Cherry Communications in
connection with the acquisitions of two customer bases is approximately $10.2
million, of which $9.0 million may be paid in cash or by delivery of Common
Stock, as the Company may elect, and the remaining $1.2 million is subject to
certain hold-back arrangements. The acquired customer bases have not generated
required minimum revenue levels and Cherry Communications has failed to remit to
the Company collections received by Cherry Communications from a portion of the
acquired customers. Accordingly, the Company has withheld the final three
installment payments for the second of the two acquisitions, payment of invoices
for carrier services for the acquired bases (up to $9.7 million through June 30,
1996) and accrued customer service charges through June 30, 1996 of $720,000.
Negotiations between Cherry Communications and the Company failed to produce a
settlement of these disputes and Cherry Communications has filed suit against
the Company seeking to recover alleged past due amounts. The Company is also
obligated to pay up to $2.0 million additional cash pursuant to a customer base
purchase agreement upon attainment of specified revenue levels by such customer
base, and a payment of a maximum of $2.0 million to the former shareholder of
Cel-Tech in the event that the Company sells or transfers a majority of
Cel-Tech's voting stock.
As of June 30, 1996, Midcom's minimum volume commitment under its supply
contract with AT&T, its largest supply contract, was $117.0 million. The Company
estimated that as of September 30, 1996, it would have been in shortfall of its
minimum commitments to AT&T by approximately $27.6 million based on current
contract requirements. However, on July 19, 1996, the Company and AT&T executed
a letter of intent to settle this anticipated liability as well as all other
pending disputes between the Company and AT&T, and to negotiate a new contract
pursuant to which the Company's minimum commitment to AT&T will be $17.0
million. In addition, Midcom expects to obtain more favorable pricing for
certain network services provided by AT&T. Pursuant to the same letter of
intent, Midcom and AT&T have negotiated a payment schedule for overdue payments
which will bring the Company's obligations to AT&T current by the middle of
October 1996. The settlement and new rate structure will not be effective until
the Company and AT&T have executed a mutually acceptable definitive agreement,
which the parties are currently pursuing. Moreover, in connection with the
letter of intent, the AT&T tariff was amended to extend the accrued shortfall
penalty payment date to September 30, 1996 pending negotiation and execution of
a mutually acceptable definitive agreement. However, there can be no assurance
that the parties will reach a definitive agreement or that further extensions of
the accrued shortfall penalty payment date can be obtained by the Company. In
consideration for the terms of the settlement and new rate structure, the letter
of intent provides for the payment by the Company to AT&T of $8.8 million in two
installments. The first payment of $5.0 million will be due upon the execution
of a definitive agreement, and the remaining balance of $3.8 million will be due
within 30 days of Midcom announcing quarterly gross revenue in excess of $75.0
million, or upon completion of a change in control.
The Company's available sources of working capital consist of cash flows
from operations; approximately $50.0 million at September 15, 1996 in cash and
short-term, investment grade, interest-bearing securities, which funds represent
the remaining net proceeds from the Private Placement, and expected available
borrowings under its Revolving Credit Facility. Prior to completion of the
Private Placement, the Company had for several months experienced a severe
working capital short-fall which required the Company to seek extended payment
terms from certain of its suppliers, delay payments to many of its suppliers and
other vendors, delay or cancel purchases and take other steps to conserve many
of its suppliers and other vendors, delay or cancel purchases and take other
steps to conserve operating capital. As a result, a number of suppliers placed
the Company on credit hold and/or initiated collection actions. Also, for
several months prior to
15
<PAGE> 53
completion the Private Placement, the Company was in default of certain
financial and other covenants under its Revolving Credit Facility, although the
lenders continued to permit borrowings under that facility. The existence of
defaults under the Revolving Credit Facility also constituted defaults under
certain of the Company's equipment lease facilities having outstanding balances
of approximately $2.8 million at December 31, 1995. As a result of these
defaults, Revolving Loans and capitalized lease obligations under these
equipment lease facilities have been classified as short-term obligations on the
Company's balance sheet at December 31, 1995. In addition, the report of the
Company's independent auditors with respect to the Company's Consolidated
Financial Statements for the year ended December 31, 1995 states that the
Company's recurring operating losses, working capital deficiency and credit
agreement defaults raise substantial doubt about the Company's ability to
continue as a going concern. The nature of this opinion itself constituted a
default under the Revolving Credit Facility. In connection with the completion
of the Private Placement and the application of the net proceeds therefrom to
the repayment in full of all obligations outstanding under the Revolving Credit
Facility, which aggregated approximately $34.0 million, the lenders under the
Revolving Credit Facility waived all existing defaults and amended the financial
covenants under the Revolving Credit Facility to be consistent with Midcom's
revised business plan. The Company's maximum borrowing availability under the
Revolving Credit Facility, as amended, is $43.0 million, subject to a borrowing
base equal to 85% of the Company's eligible accounts receivable less a minimum
excess availability requirement of $20.0 million for the months of August 1996
through February 1997, declining in stages to $8.0 million for the months of
September through November 1997. As of September 15, 1996, after giving effect
to the amendment, the Company had a borrowing base of approximately $21.0
million and a maximum borrowing availability, net of the minimum excess
availability requirement, of approximately $1.0 million. These amounts will
fluctuate from day to day based on the timing of cash collections and payments.
The Company expects that it will require between $40.0 million and $50.0
million during 1996 and 1997 in order to fund (i) operating losses, (ii) working
capital requirements and (iii) capital expenditures, including an estimated
$22.0 million to acquire and install high capacity switches. The Company expects
that the remaining proceeds of the Private Placement, together with funds
available under the Revolving Credit Facility and cash flows from operations,
will be sufficient to fund these requirements during 1996 and 1997. However, the
exact amount and timing of these capital requirements will be determined by
numerous factors, including the level of, and gross margin on, future sales, the
outcome of outstanding contingencies and disputes such as pending lawsuits and
payment terms obtained from the Company's suppliers and the timing of capital
expenditures. Although the Company's current plans assume that the Company will
be able to replace or extend the Revolving Credit Facility after its expiration
in November 1997, there can be no assurance that the Revolving Credit Facility
will continue to be available to the Company. Further, there can be no assurance
that the net proceeds of the Private Placement together with funds available
under the Revolving Credit Facility and cash flows from operations will be
sufficient to fully implement the Company's new operating strategy or meet its
other capital requirements. If (i) the Company experiences greater than
anticipated capital requirements, (ii) it is determined to be liable for, or
otherwise agrees to settle or compromise, any material claim against it, (iii)
it is unable to make future borrowings under the Revolving Credit Facility for
any reason or (iv) the implementation of the Company's new operating strategy
fails to produce the anticipated cash flows from operations, the Company may be
required to refinance all or a portion of its existing debt, sell assets or
obtain additional equity or debt financing. There can be no assurance that any
such refinancing or asset sales would be possible or that the Company will be
able to obtain additional equity or debt financing, if and when needed, on terms
that the Company finds acceptable. Any additional equity or debt financing may
involve substantial dilution to the interests of the Company's shareholders as
well as the holders of the Notes. The failure of the Company to complete one or
more of such alternatives or otherwise obtain sufficient funds to satisfy its
cash requirements could prevent the Company from implementing its operating
strategy and, ultimately, could force the Company to seek protection under the
federal bankruptcy laws. Such events would materially and adversely affect the
value of the Company's debt and equity securities.
16
<PAGE> 54
ADOPTION OF ACCOUNTING STANDARDS
In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, "Accounting for Stock-Based Compensation." This pronouncement
establishes accounting and reporting standards for stock-based employee
compensation plans, including stock purchase plans, stock options and stock
appreciation rights. This standard defines a fair value based method of
accounting for these equity instruments. This method measures compensation cost
based on the value of the award and recognizes that cost over the service
period. Companies may elect to adopt this standard or to continue accounting for
these types of equity instruments under current guidance, APB Opinion No. 25,
"Accounting for Stock Issued to Employees." Companies which elect to continue
using the rules of APB Opinion No. 25 must make pro forma disclosures of net
income and earnings per share as if this new statement had been applied.
Effective January 1, 1996, the Company adopted Statement 123 and elected to
continue following the guidance of APB Opinion No. 25.
Financial Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which was issued
in March 1995, requires impairment losses to be recorded on certain long-lived
assets used in operations or expected to be disposed of. The Company adopted
Statement 121 in the fourth quarter of 1995.
17
<PAGE> 55
MIDCOM COMMUNICATIONS INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1994
-------- -------
(IN THOUSANDS,
EXCEPT SHARE DATA)
<S> <C> <C>
ASSETS
Current assets:
Cash.................................................................. $ 1,083 $ 960
Accounts receivable, less allowance for doubtful accounts of $10,581
and $2,872 in 1995 and 1994........................................ 51,814 28,702
Due from related parties.............................................. 502 640
Notes receivable...................................................... 86 476
Prepaid expenses and other current assets............................. 2,424 1,621
-------- --------
Total current assets.......................................... 55,909 32,399
Investments in and advances to joint venture.......................... 2,000 5,643
Plant and equipment, net.............................................. 13,719 12,983
Intangible assets, less accumulated amortization of $12,812 and $3,514
in 1995 and 1994................................................... 60,781 13,278
Other assets and deferred charges, net................................ 922 1,775
-------- --------
Total assets.................................................. $133,331 $66,078
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable...................................................... $ 7,397 $ 5,145
Carrier accounts payable.............................................. 32,534 19,336
Accrued expenses...................................................... 9,570 2,801
Notes payable......................................................... 14,576 1,627
Current portion of long-term obligations.............................. 41,721 614
Deferred income....................................................... 43 67
-------- --------
Total current liabilities..................................... 105,841 29,590
Long-term debt, less current portion.................................... 827 32,070
Capital lease obligations, less current portion......................... 1,017 1,952
Deferred income......................................................... 130 173
Other long-term liabilities............................................. 1,717 --
Commitments and contingencies
Preferred stock, 10,000,000 shares authorized for all Series, $.0001
par value, 859,653 shares designated as Series A Redeemable
Preferred, all of which are issued and outstanding in 1994......... -- 8,597
Shareholders' equity (deficit):
Common stock, $.0001 par value (stated at amounts paid in); 90,000,000
shares authorized, 15,128,829 and 8,124,675 shares issued and
outstanding in 1995 and 1994....................................... 62,400 (2,691)
Deferred compensation................................................. (13) (34)
Accumulated deficit................................................... (38,588) (3,579)
-------- --------
Total shareholders' equity (deficit).......................... 23,799 (6,304)
-------- --------
Total liabilities and shareholders' equity (deficit).......... $133,331 $66,078
======== ========
</TABLE>
See accompanying notes.
18
<PAGE> 56
MIDCOM COMMUNICATIONS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------
1995 1994 1993
-------- -------- -------
(IN THOUSANDS, EXCEPT PER SHARE
DATA)
<S> <C> <C> <C>
Revenues.................................................... $203,554 $111,699 $66,010
Cost of revenues............................................ 139,546 79,044 45,363
-------- -------- -------
Gross profit................................................ 64,008 32,655 20,647
Operating expenses:
Selling, general and administrative....................... 62,061 27,697 18,125
Depreciation.............................................. 4,481 1,477 644
Amortization.............................................. 9,309 2,657 1,237
Loss on impairment of assets.............................. 11,830 -- --
-------- -------- -------
Total operating expenses.................................... 87,681 31,831 20,006
-------- -------- -------
Operating income (loss)..................................... (23,673) 824 641
Equity in loss of joint venture............................. (52) (458) --
Other income (expense)...................................... (338) (413) 249
Interest expense............................................ (5,288) (2,531) (304)
Interest expense -- shareholders............................ -- (434) (1,064)
-------- -------- -------
Loss before income taxes and extraordinary item............. (29,351) (3,012) (478)
Income tax expense.......................................... -- (17) (51)
-------- -------- -------
Loss before extraordinary item.............................. (29,351) (3,029) (529)
Extraordinary item: loss on early redemption of debt........ (4,067) -- --
-------- -------- -------
Net loss............................................... $(33,418) $ (3,029) $ (529)
======== ======== =======
Per share amounts:
Loss before extraordinary item............................ $(2.42) $(0.31) $(0.05)
Extraordinary item........................................ (0.34) -- --
------ ------ ------
Net loss............................................... $(2.76) $(0.31) $(0.05)
====== ====== ======
Shares used in calculating per share data................... 12,101 9,930 9,930
====== ====== ======
</TABLE>
See accompanying notes.
19
<PAGE> 57
MIDCOM COMMUNICATIONS INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
TOTAL
SHAREHOLDERS'
NUMBER COMMON DEFERRED ACCUMULATED EQUITY
OF SHARES STOCK COMPENSATION DEFICIT (DEFICIT)
--------- ------- ------------ ----------- -------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Balance at January 1, 1993............... 7,786 $ 154 $ -- $ (6,350) $ (6,196)
Issuance of compensatory stock
options............................. -- 146 (146) -- --
Issuance of common stock............... 225 202 -- -- 202
Compensation attributable to stock
options vesting..................... -- -- 42 -- 42
Distributions by acquired company...... -- -- -- (84) (84)
Net loss for the year.................. -- -- -- (529) (529)
------ ------- ----- -------- --------
Balance at December 31, 1993............. 8,011 502 (104) (6,963) (6,565)
Conversion from S corporation to
C corporation....................... -- (7,679) -- 7,679 --
Stock issued in acquisition............ 114 1,040 -- -- 1,040
Compensation attributable to stock
options vesting..................... -- -- 20 -- 20
Stock option forfeitures............... -- (54) 50 -- (4)
Issuance of common stock warrant....... -- 3,500 -- -- 3,500
Distributions by acquired company...... -- -- -- (1,266) (1,266)
Net loss for the year.................. -- -- -- (3,029) (3,029)
------ ------- ----- -------- --------
Balance at December 31, 1994............. 8,125 (2,691) (34) (3,579) (6,304)
Issuance of compensatory stock
options............................. -- 268 -- -- 268
Stock issued in acquisitions .......... 500 4,757 -- -- 4,757
Compensation attributable to stock
options vesting..................... -- -- 21 -- 21
Stock issued in initial public
offering............................ 5,456 54,182 -- -- 54,182
Stock issued in customer base
acquisitions........................ 331 5,120 -- -- 5,120
Stock issued for exercise of stock
options and warrants and employee
stock purchase plan................. 717 442 -- -- 442
Distributions by acquired company...... -- -- -- (1,269) (1,269)
Conversion of acquired company from
S corporation to C corporation...... -- 322 -- (322) --
Net loss for the year.................. -- -- -- (33,418) (33,418)
------ ------- ----- -------- --------
Balance at December 31, 1995............. 15,129 $62,400 $ (13) $ (38,588) $ 23,799
====== ======= ===== ======== ========
</TABLE>
See accompanying notes.
20
<PAGE> 58
MIDCOM COMMUNICATIONS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------
1995 1994 1993
-------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
OPERATING ACTIVITIES
Reconciliation of net loss to net cash provided by (used in) operating
activities:
Net loss................................................................. $(33,418) $(3,029) $ (529)
Depreciation............................................................. 4,481 1,477 644
Amortization of intangibles.............................................. 9,309 2,657 1,237
Amortization of original issue discount financing........................ 620 483 --
Loss on impairment of assets............................................. 11,830 -- --
Equity in loss of joint venture.......................................... 52 458 --
Compensation attributable to stock options............................... 289 16 42
Noncompetition payments.................................................. -- (250) (300)
Extraordinary item -- write-off of original issue discount and deferred
financing costs....................................................... 4,067 -- --
Changes in operating assets and liabilities:
Increase in accounts receivable.......................................... (17,784) (9,811) (10,361)
(Increase) decrease in due from related parties.......................... 138 (606) 336
(Increase) decrease in notes receivable.................................. 390 (348) (128)
(Increase) decrease in prepaid expenses and other current assets......... (719) (1,201) 24
(Increase) decrease in other assets...................................... (142) 11 (64)
Increase (decrease) in accounts payable and accrued expenses............. (3,559) 4,062 2,414
Increase in carrier accounts payable..................................... 16,638 8,236 5,429
Increase (decrease) in deferred income................................... (67) (3,229) 2,912
Increase (decrease) in other long-term liabilities....................... 1,717 (202) 168
Increase (decrease) in accrued interest payable............................ 228 (869) 384
--------- -------- --------
Net cash provided by (used in) operating activities........................ (5,930) (2,145) 2,208
INVESTING ACTIVITIES
Purchases of plant and equipment........................................... (6,884) (4,187) (1,614)
Net assets acquired in business and customer base acquisitions............. (11,407) (5,089) (9,282)
Investment in and advances to joint venture................................ (2,625) (4,190) (1,911)
Loan to related party...................................................... -- (1,234) --
--------- -------- --------
Net cash used in investing activities...................................... (20,916) (14,700) (12,807)
FINANCING ACTIVITIES
Proceeds of loans from related parties..................................... -- -- 5,292
Repayment of loans from related parties.................................... -- (3,617) (798)
Proceeds from notes payable................................................ -- 3,485 6,411
Repayment of notes payable................................................. (21,628) (10,592) --
Proceeds from long-term debt............................................... 69,205 34,350 --
Proceeds from common stock issued for stock purchase plan and stock
options.................................................................. 442 -- --
Issuance of common stock................................................... 54,182 -- --
Preferred stock redemption................................................. (8,597) -- --
Repayment of long-term debt................................................ (64,841) (3,851) (875)
Distributions to shareholders of acquired companies........................ (1,269) (1,266) (84)
Deferred financing costs................................................... (525) (1,512) --
--------- -------- --------
Net cash provided by financing activities.................................. 26,969 16,997 9,946
--------- -------- --------
Net increase (decrease) in cash and cash equivalents....................... 123 152 (653)
Cash at the beginning of period............................................ 960 808 1,461
--------- -------- --------
Cash at the end of period.................................................. $ 1,083 $ 960 $ 808
========= ======== ========
</TABLE>
See accompanying notes.
21
<PAGE> 59
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
1. NATURE OF OPERATIONS AND GOING CONCERN
MIDCOM Communications Inc. and Subsidiaries (Midcom or Company) resells
long distance voice and data communication services, cellular and paging
communication services, and enhanced facsimile services. The Company's customers
are primarily small to medium-sized commercial businesses, wholesalers and
certain significant customers located throughout the United States.
Going Concern and Liquidity
The Company incurred operating losses during each of the three years ended
December 31, 1995 and, as of December 31, 1995, had an accumulated deficit of
$38,588, a working capital deficit of $49,932 and was in default with regard to
certain agreements with its lenders. The consolidated financial statements have
been prepared assuming the Company will continue as a going concern and do not
include any adjustments to reflect the possible future effects on the
recoverability and classification of assets and liabilities that may result from
the outcome of this uncertainty.
As a result of its rapid growth, acquisition strategy, operating losses and
other factors, the Company has required substantial working capital to fund its
operations. To date, the Company has financed its operations principally through
bank borrowings, subordinated debt, a capital lease facility and the net
proceeds from its July 1995 initial public offering of common stock. The
Company's available sources of working capital consist of cash flow from
operations and available borrowings under a revolving credit facility. The
existence of the going concern paragraph in the independent auditors' report, as
well as other covenant violations, constitute default under the Company's
revolving credit facility. Although the lenders were continuing to permit
borrowings under the facility in spite of the existence of certain covenant
violations, there can be no assurance that borrowings will continue to be
permitted under the facility. The events of default under the credit facility
trigger default clauses in certain capital lease obligations. As noted in Note
7, all long-term debt in default has been classified as a current liability in
these financial statements. Based on existing covenants, it is reasonably
possible that further covenant violations could occur. The Company is engaged in
discussions with its lenders concerning waivers and modifications to certain
covenants.
The Company is uncertain how long cash flow from operations and borrowings
under the credit facility will be sufficient to continue operations at current
levels. However, these sources are not sufficient to repay a $15,000 bridge loan
due April 27, 1996, which can be extended to September 24, 1996, (See Note 7)
and fund remaining cash payments aggregating approximately $2,700 to sellers of
customer bases. The Company's ability to continue as a going concern depends on
its ability to reduce operating expenses, increase its gross margins and obtain
additional working capital. The Company has taken steps to reduce expenses,
curtail acquisition activities and reduce capital equipment expenditures. The
Company is also actively pursuing possible sources of additional working capital
through the issuance of subordinated debt or equity securities, and has engaged
investment bankers to assist with this process and to investigate strategic
alternatives to maximize shareholder value, including a possible sale or merger
of the Company. The Company has received proposals from investors which would
provide additional working capital, although each of these proposals is subject
to a number of conditions.
If the Company is not able to secure additional sources of working capital,
it will be forced to further curtail operations, dispose of assets or seek
extended payment terms from its vendors in order to continue as a going concern.
There can be no assurance that the Company's lenders will waive existing or
future covenant violations or continue to make borrowings available under the
Credit Agreement, that additional financing will be available on acceptable
terms or, at all, or that the Company will be able to further reduce expenses,
obtain payment terms from vendors or successfully complete other steps necessary
to continue as a going concern. Any additional financing may involve substantial
dilution to the interests of the Company's shareholders.
22
<PAGE> 60
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Risks and Uncertainties
The Company is also subject to certain other significant risks and
uncertainties that may affect the amounts reported in the financial statements.
These significant risks and uncertainties include limits on acquisitions due to
the current financial condition, impairment of assets and litigation. Additional
information concerning these risks and uncertainties is included in the notes to
the consolidated financial statements.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying consolidated financial statements include the accounts of
MIDCOM Communications Inc. and its whollyowned subsidiaries, PacNet Inc.
(PacNet), Cel-Tech International Corp. (Cel-Tech), AdVal, Inc. (AdVal) and
Advanced Network Design (AND) (collectively referred to as the "Company"). All
significant intercompany accounts and transactions have been eliminated. AdVal
and AdNet Telemanagement, Inc. (AdNet), the parent company of AND, were acquired
on September 29, 1995 and December 29, 1995, respectively, in transactions that
were accounted for as pooling of interests. As a result, the consolidated
financial statements for all periods prior to the acquisitions have been
restated to include the accounts and results of operations of AdVal and AdNet
and its wholly-owned subsidiary.
The Company's investment in Dal Telecom International (Dal Telecom), a
Russian corporate joint venture, is accounted for on the equity method, adjusted
to estimated fair value, in accordance with generally accepted accounting
principles. The Company recorded its pro rata share of Dal Telecom's income or
loss one month in arrears (see Note 4).
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 at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Actual results could differ from those
estimates.
Revenue Recognition
Resale and transmission revenue and related costs are recognized in the
period the customer utilizes the Company's service. Aggregation fees are
recognized by the Company based upon notification of customers' participation in
the AT&T program. At December 31, 1995 and 1994, unbilled resale revenue totaled
$27,985 and $13,373, respectively.
Concentration of Credit Risk
The Company's financial instruments consist of cash, accounts and notes
receivable, accounts and carrier accounts payable, notes payable and long-term
obligations. The fair value of the financial instruments, except long-term
obligations, approximates their recorded value based on the short-term maturity
of the instruments. The fair value of the long-term obligations approximates
their recorded value based on the current rates offered to the Company for
similar debt of the same maturities. The Company does not have financial
instruments with off-balance-sheet risk.
Financial instruments that potentially subject the Company to
concentrations of credit risk are accounts receivable. The Company continually
evaluates the creditworthiness of its customers; however, it generally does not
require collateral. The Company's allowance for doubtful accounts is based on
historical trends, current market conditions and other relevant factors.
23
<PAGE> 61
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Deferred Financing Costs
Financing costs are capitalized and amortized over the term of the related
debt on a straight-line basis which approximates the effective-interest method.
Included in other assets at December 31, 1995 are deferred financing costs of
$510 which is net of accumulated amortization of $15.
Plant and Equipment
Plant and equipment are stated at cost. The direct employee costs and
outside consultant costs related to development of its management information
systems were capitalized (see Note 3). Depreciation and amortization, which
includes amortization of assets recorded under capital leases, are computed
using the straight-line method over the following useful lives:
<TABLE>
<S> <C>
Buildings and towers.................................................. 30 years
Transmission equipment................................................ 12 to 15 years
Data processing systems and equipment................................. 3 to 5 years
Switches.............................................................. 5 to 7 years
Furniture, equipment and leasehold improvements....................... 3 to 7 years
</TABLE>
Intangible Assets
Intangible assets represent the excess of the purchase price over the
estimated fair value of identifiable assets acquired in business and customer
base acquisitions. Amounts are allocated primarily to customer bases which are
amortized over five years using the straight-line method. Amounts are also
allocated to noncompete agreements, goodwill and a reseller agreement, as
applicable, which are amortized using the straight-line method over terms
ranging from 18 months to 25 years.
Income Taxes
Prior to January 1, 1994, Midcom was taxed as an S corporation. As an S
corporation, all earnings or losses of Midcom were taxed directly to the
shareholders. Effective January 1, 1994, Midcom became subject to income taxes
directly as a C corporation.
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes," which
requires that deferred income taxes be provided based on the estimated future
tax effects of differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for income tax
purposes.
Foreign Currency Translation
The Company's Russian joint venture, Dal Telecom, operates in a highly
inflationary country, and therefore, a combination of current and historical
rates is used in translating assets and liabilities. The related exchange
adjustments are included in net loss. Operating results are translated at the
average rates during the period.
Net Loss Per Share
Net loss per share is based on the weighted average number of common and
equivalent shares outstanding using the treasury stock method and the number of
shares issued in the Company's initial public offering whose net proceeds were
used to redeem the Series A Redeemable Preferred Stock. Common stock equivalents
are excluded from the calculation of net loss per share due to their
antidilutive effect, except that pursuant to Securities and Exchange Commission
(SEC) requirements, for periods prior to the Company's
24
<PAGE> 62
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
initial public offering, common and equivalent shares issued during the 12-month
period prior to the initial public offering have been included in the
calculation as if they were outstanding for all periods prior to the completion
of the Company's initial public offering using the treasury stock method.
Accounting for Long-Lived Assets
Financial Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which was issued
in March 1995, requires impairment losses to be recorded on certain long-lived
assets used in operations or expected to be disposed of. The Company adopted
Statement 121 in the fourth quarter of 1995.
Reclassifications
Certain reclassifications have been made to the prior years' financial
statements to conform with the current year presentation.
3. PLANT AND EQUIPMENT
Major classes of plant and equipment, including assets under capital
leases, consisted of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1995 1994
------- -------
<S> <C> <C>
Buildings and towers............................................. $ 787 $ 764
Transmission equipment........................................... 3,747 2,772
Data processing systems and equipment............................ 11,120 6,260
Switches......................................................... -- 1,487
Furniture, equipment and leasehold improvements.................. 4,663 4,552
------- -------
20,317 15,835
Accumulated depreciation and amortization........................ (6,598) (2,852)
------- -------
$13,719 $12,983
======= =======
</TABLE>
The gross amount of plant and equipment recorded under capital leases at
December 31, 1994 and 1995 was $2,685 and $6,073, respectively, primarily data
processing equipment.
Included in plant and equipment at December 31, 1995 are unamortized
development costs related to the Company's proprietary management information
system. This system was placed in service in May 1995 and is being amortized on
a straight-line basis over five years. As a result of billing problems
encountered after the system was placed in service, the Company evaluated the
system during the fourth quarter and determined that the system would require
additional enhancements to meet its initial design objectives and that its value
had been impaired. As a result, the Company reduced the unamortized costs from
$4,471 to $2,000 and recorded a $2,471 loss on impairment of the asset.
Included in plant and equipment are switches, the majority of which were
acquired through acquisitions of other telecommunications service providers.
During the fourth quarter of 1995, the Company determined that it intended to
replace these limited capacity switches with newer switches with increased
functionality and capacity through sharing or reseller arrangements with
operators of switches. As a result of this decision, the Company wrote off its
existing switches and recorded a $2,544 loss on impairment of these assets.
4. INVESTMENT IN AND ADVANCES TO JOINT VENTURE
In December 1993, Midcom advanced $1,911 to Dal Telecom, to be used in
building a long distance telephone network in the Russian Far East. In January
1994, Midcom formed a 50/50 joint venture with the
25
<PAGE> 63
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Russian owner of Dal Telecom to continue this activity and committed to invest a
total of $15,000 to acquire its 50% interest in the joint venture. This amount
was subsequently reduced to $12,700. Midcom converted the advance outstanding at
December 31, 1993 to an investment in the joint venture and during 1994 and
1995, invested an additional $4,190 and $2,625, respectively.
Summarized financial data for Dal Telecom follows:
<TABLE>
<CAPTION>
NOVEMBER 30,
------------------
1995 1994
------- ------
<S> <C> <C>
Current assets.................................................... $ 2,708 $1,569
Noncurrent assets................................................. 9,567 7,029
Current liabilities............................................... 352 1,700
Noncurrent liabilities............................................ 668 --
Equity............................................................ 11,255 6,898
</TABLE>
<TABLE>
<CAPTION>
12 MONTHS 11 MONTHS
ENDED ENDED
NOVEMBER 30, NOVEMBER 30,
1995 1994
------------ ------------
<S> <C> <C>
Revenues................................................... $3,821 $2,314
Gross profit............................................... 1,902 727
Translation loss........................................... (127) (143)
Net income (loss).......................................... 135 (730)
</TABLE>
Substantially all of the assets of Dal Telecom are located in Russia. The
Company has obtained insurance against political and expropriation risks of up
to 90% of the Company's invested capital in the joint venture through a U.S.
Government sponsored agency.
As of December 31, 1995, the Company was required to invest an additional
$3.1 million in order to maintain its 50% interest in Dal Telecom, although
there is currently no fixed schedule for providing these funds. The Russian
joint venture partner disputes the amount remaining to be contributed by Midcom
for a variety of tax, accounting and other reasons. The Company believes that
its contributions to date are sufficient to secure at least a 30% interest in
the joint venture, although that has not been agreed to by the Russian joint
venture partner.
The Company's commitment to the Russian joint venture has required
significant amounts of capital resources and management attention given the
logistics of maintaining a relationship in Russia. Given the Company's current
financial condition, it is unable to fund any additional contributions to the
joint venture. The Company now believes it is in its best interests to focus on
its domestic business and, as a consequence, is actively seeking to sell its
interest in Dal Telecom during 1996. As result of this decision, the Company
wrote down its investment in Dal Telecom to $2,000, which is the Company's
estimate of the net recoverable value of its investment in Dal Telecom, and
recorded a $6,870 loss on impairment of the asset. This estimate is based on
market information currently available to the Company and certain assumptions
about the future operations of Dal Telecom, over which the Company has limited
control. As a result, a material change in these estimates could occur in the
near future.
There can be no assurance that the Company will be successful in its
efforts to sell its interest in Dal Telecom or that, if sold, the Company will
recover its carrying value or that additional losses on its investment in Dal
Telecom will not be incurred in the future.
At December 31, 1995, prior to the write-down of its investment, the
difference between the Company's investment and 50% of the equity in Dal
Telecom's net assets was $2,210. The difference relates to the Company's
investment in the joint venture and was being amortized over 20 years. During
1995 and 1994,
26
<PAGE> 64
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
$120 and $93 was amortized, respectively, and is included in equity in loss of
joint venture in the consolidated statements of operations. As a result of the
write-down described above, this difference has been eliminated.
5. BUSINESS COMBINATIONS
In September 1995, the Company acquired all of the outstanding stock of
AdVal in exchange for 250,000 shares of common stock valued at $3,750. In
December 1995, the Company acquired all of the outstanding stock of AdNet and
its wholly-owned subsidiary, Advanced Network Design, in exchange for 453,250
shares of common stock valued at $8,272. These transactions have been accounted
for as pooling of interests and, accordingly, the consolidated financial
statements for all periods presented have been restated to include the accounts
and results of operations of AdVal and AdNet.
Net revenues, extraordinary items and net income (loss) of the separate
companies were as follows:
<TABLE>
<CAPTION>
MIDCOM ADVAL ADNET COMBINED
-------- ------ ------ --------
<S> <C> <C> <C> <C>
YEARS ENDED DECEMBER 31,
1995:
Net revenues............................ $191,990 $3,102 $8,462 $203,554
Extraordinary loss...................... (4,067) -- -- (4,067)
Net income (loss)....................... (34,274) (69) 925 (33,418)
1994:
Net revenues............................ $ 99,815 $3,282 $8,602 $111,699
Net income (loss)....................... (3,984) (313) 1,268 (3,029)
1993:
Net revenues............................ $ 56,623 $ 733 $8,654 $ 66,010
Net income (loss)....................... (840) 51 260 (529)
</TABLE>
During 1994 and 1995, the Company also completed a series of acquisitions
from other telecommunications companies offering services similar to those
offered by the Company. Certain of these acquisitions included the purchase of
substantially all of the operating assets of the acquiree, including customer
bases, and in other situations only specific customer bases. The asset
acquisitions have been accounted for using the purchase method, with the excess
of the purchase price over the net tangible assets acquired being allocated to
acquired customer bases, non-compete agreements and goodwill. Revenues generated
from the acquired customer bases are included in the accompanying statements of
operations from the dates of the acquisitions.
27
<PAGE> 65
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Summary information concerning the acquisitions is as follows:
<TABLE>
<CAPTION>
TOTAL GROSS
PURCHASE INTANGIBLE
SELLING COMPANY ACQUISITION DATE PRICE ASSETS
------------------------------------------- ------------------- ------- ----------
<S> <C> <C> <C>
Balance at December 31, 1993............... $10,788 $ 8,882
Business acquisitions:
American Telephone Network Inc. (ATN).... September 30, 1994 2,030 509
PacNet, Inc. (PacNet).................... December 30, 1994 4,816 439
Customer base acquisitions................. Various 6,962 6,962
------- -------
Balance at December 31, 1994............... 24,596 16,792
Communique Telecommunications, Inc.
(Communique).......................... January 20, 1995 14,829 11,265
Concord Network, Inc..................... January 31, 1995 1,292 613
(Concord) Cel-Tech International Corp.
(Cel-Tech)............................ September 12, 1995 4,587 4,155
Customer base acquisitions................. Various 43,323 40,768
------- -------
Balance at December 31, 1995............... $88,627 $ 73,593
======= =======
</TABLE>
The above purchases have generally been financed through borrowings under
the Company's lines of credit, issuance of debt and stock (see Notes 6 and 7)
and assumption of liabilities.
Components of intangible assets at December 31, 1995 and their respective
estimated useful lives were as follows:
<TABLE>
<CAPTION>
ESTIMATED
USEFUL
AMOUNT LIFE
------- -------------
<S> <C> <C>
Customer bases....................................... $66,855 5 years
Non-compete agreements............................... 3,195 2 to 4 years
Reseller license..................................... 1,695 10 years
Goodwill............................................. 1,848 25 years
-------
$73,593
=======
</TABLE>
The Company periodically reviews the carrying value of its intangible
assets whenever events or changes in circumstances indicate that the carrying
value may not be recoverable. To the extent the estimated future cash inflows
attributable to the asset, less estimated future cash outflows, is less than the
carrying amount, an impairment loss is recognized. Substantially all of the
Company's intangible assets consist of acquired customer bases which are subject
to attrition. The estimated useful lives of these customer bases are based on
attrition rates considered standard in the industry. If the Company's actual
attrition rates were to exceed these estimates, or other unfavorable changes in
business conditions were to occur, the value of the related customer bases would
be impaired and future operating results would be adversely affected.
The following condensed pro forma information presents the results of
operations of Midcom as if the acquisitions of ATN, PacNet, Communique, Concord
and Cel-Tech had occurred on January 1, 1995 and 1994, respectively.
28
<PAGE> 66
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER
31,
---------------------
1995 1994
-------- --------
<S> <C> <C>
Revenue................................................ $205,494 $169,718
Net loss............................................... (33,364) (1,873)
Pro forma loss per share............................... (2.76) (0.19)
</TABLE>
The pro forma results do not necessarily represent results which would have
occurred if the acquisitions had taken place on the dates indicated nor are they
necessarily indicative of the results of future operations.
In connection with the Communique acquisition, 371,875 shares of common
stock were held in escrow and subsequently sold as part of the Company's initial
public offering in July 1995 (see Note 16). The net proceeds of $3,800 from the
sale of these shares were held in escrow pending the results of an arbitration
hearing. On March 13, 1996, the arbitration decision was received, pursuant to
which the Company received approximately $352.
In connection with several of the other transactions described above, the
Company has an obligation to issue or release from escrow up to a maximum of
276,346 additional shares of its common stock representing an aggregate value of
approximately $4,226 at the transaction dates, upon the satisfaction of certain
contingencies. Such contingencies include, among other things, maintenance of
specified revenue levels, adjustment of liabilities assumed and receivables
purchased, and satisfaction of general representations and warranties. The
contingency periods range from six months to two years. The Company is also
obligated to pay up to a maximum of $2,000 additional cash in connection with a
customer base purchase agreement upon the maintenance of specified revenue
levels. In addition, in the event of the sale or other transfer of the majority
of the voting stock of Cel-Tech, a payment of a maximum of $2,000 would become
payable to the former shareholder.
In accordance with applicable accounting standards, the common stock or
other consideration issuable under the contingency arrangements has not been
included in the determination of purchase price, nor have the shares been
considered outstanding for purposes of earnings per share calculations.
Additional consideration will be recorded when the outcome of a contingency is
determined.
The Company is also obligated in certain cases to issue additional shares
of its common stock in the event that the market price of such stock, when the
shares become registerable, is less than the price at the acquisition dates.
Based on the Company's stock price on March 29, 1996, approximately 513,000
additional shares would be issuable as a result of these obligations.
6. NOTES PAYABLE
At December 31, 1994 and 1995, the Company had $680 in 8% per annum
subordinated convertible demand notes outstanding held by the three sellers of
TelNet, secured by a personal guarantee of the principal shareholder of the
Company. Interest was payable monthly on these notes and they were convertible,
at the option of the holders, into 0.1% per $100 of principal debt of the
Company's common stock. Effective April 1, 1995, the notes and associated
agreements were amended as follows: (i) the convertibility option was
eliminated, (ii) if not paid sooner upon 30-day demand, the maturity date was
set at March 28, 1999, (iii) interest was set at a prime plus 2%, but in no
event lower than 9% or greater than 13% per annum, and (iv) the three note
holders were granted warrants to purchase up to a total of 59,500 shares of
common stock at an exercise price of $7.44 per share, subject to adjustments in
the exercise price related to dilutive or anti-dilutive activities. The warrants
expire on March 28, 1999.
At December 31, 1994, the Company had notes payable of $947 which were
secured by certain assets of the Company and were repaid in full in 1995.
29
<PAGE> 67
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
In connection with the acquisition of Communique in January 1995, and the
extension of a payable to one carrier in March 1995, the Company issued notes
payable to three carriers aggregating $8.5 million with interest ranging from
10% to 12%. The notes were paid in full in July 1995 with the proceeds from the
Company's initial public offering.
In connection with a customer base purchase agreement, the Company has a
noninterest-bearing obligation totaling $12.0 million as of December 31, 1995.
The unsecured obligation required monthly payments of $3.0 million from January
through April 1996, payable in cash or common stock. The Company paid $3.0
million to the seller in January 1996 and is currently in negotiations with the
seller to satisfy the remaining payment obligation, including possibly selling
back a portion of the customer bases originally acquired. There can be no
assurance that the Company will be successful in selling back these customer
bases or that, if sold, it would not incur a material loss on such disposition.
The Company is currently prohibited from paying this obligation in cash without
the prior written consent of its primary lender. Based on the Company's stock
price on March 29, 1996, the Company would be required to issue 1,252,174 shares
of its common stock to satisfy this obligation.
At December 31, 1995, the Company had approximately $2,000 in additional
notes payable to sellers of certain customer bases. These notes bore interest at
rates up to 10% and were payable in varying installments in 1996. In connection
with the issuance of a note payable to one seller of a customer base, the
Company issued a warrant to acquire $2,000 of the Company's common stock. In the
event of non-payment of the note, the exercise price is cancellation of the
note, the principal amount of which is subject to adjustment, and the number of
shares to be issued upon exercise of the warrant equals $2,000 divided by the
then current market price of the Company's common stock. The warrant would
expire on April 30, 1997.
30
<PAGE> 68
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
7. LONG-TERM OBLIGATIONS
Long-term obligations consisted of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------
1995 1994
------- -------
<S> <C> <C>
$25,000 Senior Revolving Credit Facility with First Union National Bank
of North Carolina. Interest was generally payable at the Company's
option at either the Bank's prime rate plus 1% or LIBOR plus 2.57%.
Applicable interest rates on outstanding advances at December 31,
1994 ranged from 7.625% to 8.75%. This facility was secured by
substantially all of the Company's assets and was paid in full
November, 1995....................................................... $ -- $19,350
Senior Revolving Credit Facility with Transamerica Business Credit.
Interest is generally payable at the Company's option at either LIBOR
plus 2.50% or .5% plus the higher of the Prime Rate or the latest
published annualized rate for 90-day dealer commercial paper.
Applicable interest rate on outstanding advances at December 31, 1995
was 9%. The balance is due November 7, 1997. This facility is secured
by substantially all of the Company's assets......................... 37,428 --
10% Senior Subordinated Notes Payable. Interest paid quarterly. The
note was repaid in full in July 1995................................. -- 15,000
Unsecured seller notes payable, interest at 5% to 8%, principal and
interest are payable in quarterly installments through May 31,
1997................................................................. 89 386
Note payable to bank, secured by certain property and equipment,
interest at the bank's prime rate plus 1%. Paid in full in January
1996................................................................. 240 --
Note payable secured by assets acquired, interest payable quarterly at
the prime rate plus 1%. Balance due in full September 30, 1998....... 800 800
Notes payable to equipment vendors, secured by related equipment,
interest at 9.5% to 15%, principal and interest payments due in
monthly installments through November 1, 1996........................ 79 159
------- -------
38,636 35,695
Less original issue discount on 10% Senior Subordinated Notes
Payable.............................................................. -- 3,247
------- -------
38,636 32,448
Less current portion................................................... 37,809 378
------- -------
$ 827 $32,070
======= =======
</TABLE>
The $25,000 Senior Revolving Credit Facility and the Senior Subordinated
Note agreements contained covenants which, among other matters, restricted the
ability of the Company to pay dividends, incur additional indebtedness, and
repurchase stock, and required the Company to maintain certain financial
covenants.
In connection with the issuance of the Senior Subordinated Notes Payable in
the amounts of $14,800 and $200 to First Union Corporation and the
Robinson-Humphrey Company, Inc., respectively, the Company issued detachable
warrants to the note holders to purchase common stock of the Company for $.0001
per share. The number of shares of common stock issuable upon exercise of the
warrants was dependent upon the completion of a public offering or other defined
events ("Liquidity Event(s)"). On July 6, 1995, the Company successfully
completed an initial public offering of its stock and 648,119 shares of common
stock were issued upon exercise of the warrants. The Company repaid the Senior
Subordinated Notes with proceeds from the initial public offering and recorded
as an extraordinary item in the third quarter a $2,992 loss on write-off of
unamortized original issue discount.
31
<PAGE> 69
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
During 1995, the $25,000 Senior Revolving Credit Facility was amended to
increase the maximum borrowing by $4,000 (total of $29,000). Interest was
payable on the additional amount at the prime rate plus 2.5% and this amount was
repaid with proceeds from the Company's initial public offering of its stock.
In November 1995, the Company obtained a new Senior Revolving Credit
Facility, (Facility) which provided for borrowings of up to $50,000 subject to a
limitation of 85% of eligible receivables and other financial covenants. The
Company was not in compliance with some of these covenants as of December 31,
1995. The agreement was further amended in March 1996 to reduce the overall
commitment by the lender from $50,000 to $43,000. As of March 29, 1996, the
Company was again in default of certain covenants under its Senior Revolving
Credit Facility and as a result, all borrowings under this Facility are
classified as current in the accompanying consolidated financial statements. The
default on this Facility also creates a default under the bridge loan described
below.
Concurrent with obtaining the new Senior Revolving Credit Facility, the
Company terminated its prior credit facility and recorded, as an extraordinary
item in the fourth quarter, a $1,075 loss on write-off of deferred financing
costs.
Principal maturities of long-term debt at December 31, 1995 are as follows:
<TABLE>
<S> <C>
1996............................................................... $37,809
1997............................................................... 27
1998............................................................... 800
-------
Total.................................................... $38,636
=======
</TABLE>
On March 28, 1996, the Company obtained a bridge loan of $15,000 from the
principal lender of its Facility. The bridge loan is secured by substantially
all of the Company's assets, bears interest at 12% and is due April 27, 1996.
The Company paid an initial loan fee of $500 and has the right to extend the due
date of the loan for 30-day periods upon payment of an additional fee of $200
for each 30-day extension, with final payment due by September 24, 1996. The
Company also gave the lender a warrant to purchase 815,470 shares of the
Company's common stock for nominal consideration. The number of shares that can
be purchased is subject to adjustment for certain defined dilutive events. The
warrant only becomes exercisable if the bridge loan is not paid in full on or
before September 24, 1996.
8. PREFERRED STOCK
During 1994, the Company's Board of Directors approved the issuance of a
new Series of preferred stock and issued 859,653 shares to retire shareholder
notes payable (see Note 12). The preferred stock was nonvoting, was not entitled
to dividends and had a preference in liquidation of $10 per share. The preferred
stock was redeemed at $10 per share in July 1995 with proceeds from the
Company's initial public offering.
9. COMMON STOCK
Prior to its initial public offering, the Company had authorized Voting and
Nonvoting common stock. Nonvoting common stock was convertible into an equal
number of shares of common stock upon the occurrence of certain events,
including the public sale of securities of the Company or a change in control of
the Company. In all other respects, the two classes have the same rights and
privileges. Concurrent with the closing of the Company's initial public
offering, all authorized Nonvoting common stock converted by its terms to Voting
common stock.
32
<PAGE> 70
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
At December 31, 1995, common stock was reserved for the following:
<TABLE>
<S> <C>
Exercise and future grant of stock options........................ 1,672,730
Employee stock purchase plan...................................... 260,071
Exercise of outstanding warrants.................................. 59,500
-------
1,992,301
=======
</TABLE>
10. STOCK OPTION PLAN
The Company has a stock option plan and as of December 31, 1995, the plan
provides for the granting of nonqualified and incentive stock options to
purchase up to 1,739,063 shares of common stock. Options granted become
exercisable over vesting periods of up to five years at exercise prices
determined by the Board of Directors, generally expire ten years from the date
of grant and are dependent upon continuous employment.
A summary of activity under the stock option plan is as follows:
<TABLE>
<CAPTION>
SHARES EXERCISE PRICE
--------- --------------
<S> <C> <C>
Options outstanding at December 31, 1993................... 484,805 $2.29-$ 5.71
Granted.................................................. 663,139 $2.29-$ 9.14
Canceled................................................. (117,460) $2.29-$ 9.14
---------
Options outstanding at December 31, 1994................... 1,030,484 $2.29-$ 9.14
Granted.................................................. 740,954 $1.00-$18.50
Canceled................................................. (365,619) $2.29-$15.75
Exercises................................................ (66,333) $2.29-$18.50
---------
Options outstanding at December 31, 1995................... 1,339,486 $1.00-$18.50
=========
</TABLE>
Stock options have generally been granted at or in excess of the estimated
fair value as determined by the Board of Directors, at the date of grant.
However, certain options have been granted at less than the estimated fair
value, in which case compensation expense is recognized over the vesting period
based on the excess of the fair value of the stock at the date of grant over the
exercise price.
At December 31, 1995, options to purchase 585,427 shares were fully vested
and exercisable at prices ranging from $2.29 to $15.75 per share. During the
year ended December 31, 1995, compensation expense of $268 was recognized on the
$2.29 options.
11. INCOME TAXES
Until January 1, 1994, Midcom was treated as an S corporation for income
tax purposes. Accordingly, Midcom's income (losses) were taxed directly to the
shareholders rather than to Midcom. When Midcom made the conversion to a C
corporation, a net deferred tax liability of $207 was recorded. However, this
amount was offset by losses during the balance of the year and, accordingly, no
provision for income taxes was required.
33
<PAGE> 71
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Significant components of the Company's deferred tax liabilities and assets
as of December 31, 1995 and 1994 are as follows:
<TABLE>
<CAPTION>
1995 1994
-------- -------
<S> <C> <C>
Deferred tax assets:
Sales reserves and allowances................................. $ 1,326 $ 469
Intangible tax amortization different than financial
accounting amortization.................................... 1,832 200
Provisions not currently deductible........................... 1,343 370
Losses and write-down of foreign joint venture................ 2,953 184
Net operating loss carryforwards.............................. 7,648 1,435
Other......................................................... 69 87
------- ------
Total deferred tax assets............................. 15,171 2,745
Valuation allowance for deferred tax assets..................... (13,017) (316)
------- ------
2,154 2,429
Deferred tax liabilities:
Systems development expensed for tax.......................... (995) (719)
Tax depreciation different than financial accounting
depreciation............................................... (396) (590)
Cash to accrual change........................................ (763) (1,120)
------- ------
Total deferred tax liabilities........................ (2,154) (2,429)
======= ======
Net deferred tax liabilities.......................... $ -- $ --
======= ======
</TABLE>
On January 1, 1994, when the Company became a C corporation, a valuation
allowance on deferred tax assets was not required due to the net deferred tax
liability position. At December 31, 1994, the valuation allowance of $316 was
established for the deferred tax assets in excess of deferred tax liabilities.
At December 31, 1995, the valuation allowance was increased to $13,017 for
deferred tax assets in excess of deferred tax liabilities.
At December 31, 1995, the Company has net operating loss carryforwards for
federal income tax purposes of $19.1 million, which are available to offset
future federal taxable income, if any, through 2010.
The provisions for income taxes differ from "expected" income tax benefit
as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------------
1995 1994
----------------- ----------------
<S> <C> <C> <C> <C>
Computed expected federal tax benefit.......... $(11,362) (34)% $(1,030) (34)%
State taxes, net of federal benefit............ (2,005) (6) (182) (6)
Deferred taxes associated with Midcom S
corporation to C corporation conversion,
January 1, 1994.............................. -- -- 207 7
Deferred tax asset realization related to
acquisitions................................. -- -- 507 17
Change in valuation allowance for net deferred
tax assets................................... 12,701 38 316 10
Nondeductible expenses......................... 142 1 182 6
Other.......................................... 524 1 -- --
-------- --- ------- ---
$ -- --% $ -- --%
======== === ======= ===
</TABLE>
34
<PAGE> 72
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
12. RELATED-PARTY TRANSACTIONS
At December 31, 1993, the Company had notes payable to certain shareholders
and officers totaling $13,448, including accrued interest of $1,277. The notes
accrued interest at rates ranging from 12% to 18% per annum. In 1994, $9,831 of
the notes and accrued interest was repaid by offsetting a shareholder note
receivable of $1,234 and issuing 859,653 shares of redeemable preferred stock.
The remaining notes and related accrued interest were paid in full in June 1994.
During 1993, the Company charged to expense $1,025 for business consulting
services provided by shareholders. Such charges were based, in part, on
available earnings and approved by the Company's Board of Directors. The
consulting arrangement was terminated effective January 1, 1994.
Mid-Com Consultants, Inc. (Consultants) is a long distance
telecommunications distributor owned indirectly by the Company's majority
shareholder. Prior to March 1994, Consultants owned certain AT&T contracts which
the Company utilized in its aggregation business in exchange for the Company
providing various billing, collection and operational support services to
Consultants. No value has been assigned to the exchange of these services in the
financial statements as the amounts are not material. At December 31, 1994, the
Company was owed approximately $137 for cash forwarded to Consultants in advance
of actual collections, which was paid to the Company in 1995.
At December 31, 1994, the Company also had a receivable from ATN of $465
for expenses paid by the Company on behalf of ATN which was collected in 1995.
The President and the largest shareholder of the Company jointly own
QuestWest Inc. QuestWest Inc., in turn, holds approximately an 85% interest in
Quest America Limited Partnership (Quest LP). In December 1993, the Company
entered into a distribution agreement with Quest LP that entitles Quest LP to a
sales commission from the Company at a rate equal to the most favorable rate
available to other comparable Company distributors. In October 1995 the
President and the largest shareholder sold their interest in Quest LP to a third
party and the most favorable rate clause in the distribution agreement was
eliminated. During 1995 and 1994, Quest LP received $295 and $66, respectively,
in net commissions.
In March 1995, the Company was granted an option to purchase 100% of the
stock of QuestWest Inc. through March 2000. The option price will be equal to
the amount the shareholders have currently invested in QuestWest Inc. plus 9.0%
per annum, reduced by the pro rata amount of any distributions made by Quest LP
to QuestWest Inc. This option was cancelled in October 1995.
At December 31, 1995, the Company had loans outstanding to certain
employees of approximately $502.
13. EMPLOYEE BENEFIT PLANS
401(k) Salary Deferral and Profit Sharing Plan
Prior to February 1, 1996, the Company maintained a 401(k) Salary Deferral
and Profit Sharing Plan ("Retirement Plan") with its affiliate SP Investments
Inc. ("SPII"). Effective February 1, 1996, SPII withdrew from the Retirement
Plan and the Company will continue to maintain the Retirement Plan on the same
terms.
The Retirement Plan contains profit sharing and 401(k) components. Under
the 401(k) portion of the Retirement Plan, each eligible employee may elect to
contribute up to 15% of his or her pre-tax gross earnings subject to annual
limits. Under the profit sharing portion of the Retirement Plan, the Company
makes annual matching contributions equal to 50% of the participant's
contributions up to 6% of his or her compensation. In general, a participant is
100% vested in his or her own contributions and vests in the Company matching
and
35
<PAGE> 73
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
discretionary contributions at 20% for each full year of service. The Company
reserves the right to amend the Retirement Plan at any time.
PacNet, a wholly owned subsidiary of the Company, had a 401(k) Profit
Sharing Plan (the "PacNet Plan") with profit sharing and 401(k) components.
Under the 401(k) portion of the PacNet Plan, each eligible employee could elect
to contribute up to 5% of his or her pre-tax gross earnings subject to annual
limits. Under the profit sharing portion of the PacNet Plan, PacNet made annual
mandatory contributions equal to 100% of the participant's contributions and
could make additional discretionary contribution of 5% of the employee's gross
earnings. In general, a participant was 100% vested in his or her own
contributions and in PacNet's matching contributions. In May 1995, the Company's
Board of Directors voted to combine the Retirement Plan and the PacNet Plan
under the terms and conditions of the Retirement Plan, effective July 1, 1995.
Contributions to all salary deferral and profit sharing plans are subject
to statutory limitations regarding maximum contributions. Contribution expense
was $253, $156 and $54 for the years ended December 31, 1995, 1994 and 1993,
respectively.
Employee Stock Purchase Plan
In December 1994, the Company established an Employee Stock Purchase Plan
(the "Purchase Plan") which is meant to qualify under Section 423 of the
Internal Revenue Code. The Purchase Plan became effective upon the successful
completion of the Company's initial public offering of common stock. Under the
Purchase Plan, the Company reserved up to 262,500 shares of common stock for
purchase by employees who meet certain eligibility requirements. Eligible
employees may contribute up to 10% of their compensation to the Purchase Plan to
purchase shares at 95% of the fair market value of the stock on the first or the
last day of each six-month offering period, as defined in the Purchase Plan. The
Purchase Plan establishes a maximum number of shares a participant may purchase
during any period. This maximum number of shares is determined by dividing
$12,500 by the fair market value of a share of common stock on the first day of
the offering period. The offering periods generally begin January 1 and July 1,
and the first offering period was September 1, 1995 to December 31, 1995. During
this initial period, 2,429 shares were purchased at an average price of $14.61
per share.
14. COMMITMENTS AND CONTINGENCIES
Leases
The Company leases its office space and certain equipment under terms of
noncancelable operating leases, which expire on various dates through 1998. The
Company also leases equipment under various capital leases expiring on various
dates through 2001. The leases generally require that the Company pay certain
maintenance, insurance and other operating expenses. Rent expense under
operating leases for the years ended December 31, 1995, 1994 and 1993 was
$2,535, $566 and $1,163, respectively.
36
<PAGE> 74
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
At December 31, 1995, minimum future lease payments under capital leases
and noncancelable operating leases with initial or remaining terms of one year
or more are as follows:
<TABLE>
<CAPTION>
CAPITAL OPERATING
YEARS ENDING DECEMBER 31, LEASES LEASES
----------------------------------------------------------------- ------- ---------
<S> <C> <C>
1996............................................................. $ 1,542 $ 2,099
1997............................................................. 1,644 1,723
1998............................................................. 1,015 1,537
1999............................................................. 789 1,447
Thereafter....................................................... 1,282 5,515
------ -------
Total minimum future lease payments.................... 6,272 $12,321
=======
Less interest.................................................... 1,343
------
Present value of future minimum lease payments................... 4,929
Less current portion............................................. 3,912
------
$ 1,017
======
</TABLE>
The Company is currently in default of certain capital lease covenants and
as a result an additional $2,885 of capital lease obligations has been
classified as a current liability in the accompanying consolidated financial
statements.
Commitments with Providers
Under the terms of carrier contracts executed with AT&T and other carriers,
the Company has made commitments to maintain or achieve certain volume levels in
order to obtain special forward pricing. Under some of these contracts, the
Company guarantees to sell a certain amount of long distance volume within a
certain time period or purchase all or a portion of any unused volume. Under
others, if certain volume levels are not achieved during stated periods, pricing
is adjusted going forward to levels justified by current volumes.
As of December 31, 1995, total future minimum usage commitments are as
follows:
<TABLE>
<CAPTION>
YEARS ENDING DECEMBER 31, AMOUNT
------------------------------------------------------------------ --------
<S> <C>
1996.............................................................. $126,000
1997.............................................................. 111,000
1998.............................................................. 77,000
--------
$314,000
========
</TABLE>
Subsequent to year-end, the Company renegotiated its minimum usage
commitments and reduced the minimum usage commitments as of March 29, 1996 to
$99,000, $75,000 and $44,000 for the years ending December 31, 1996, 1997 and
1998, respectively. At the present time, the Company has achieved all of its
required volume commitments or received waivers from the carriers. There can be
no assurance that the minimum usage commitments will be achieved in the future,
and if such commitments are not achieved future operating results could be
adversely affected.
During the years ended December 31, 1995, 1994 and 1993, the Company relied
on three carriers to carry traffic representing approximately 67%, 97% and 98%
of the Company's revenues, respectively. The Company has the ability to transfer
its customers' traffic from one supplier to another in the event a supplier
declines to continue to carry the Company's traffic. However, such transfers
could result in disruption of service to the customers, with a subsequent loss
of revenue which would adversely affect operating results.
37
<PAGE> 75
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
Acquisitions
In connection with several business or customer base acquisition
agreements, the Company is obligated to issue additional consideration upon the
satisfaction of certain contingencies (see Note 5).
REGULATION
Federal
The Company has all necessary authority to provide domestic interstate and
international telecommunications services under current FCC regulations. Midcom
has filed both domestic and international tariffs with the FCC, and Pac Net has,
and is only required to file, international tariffs. Pursuant to a recent court
decision, detailed rate schedules now must be filed in lieu of the "reasonable
range of rates" tariff previously accepted by the FCC. In reliance on the FCC's
past practice of allowing relaxed range of rates tariffs for non-dominant
carriers, Midcom and most of its competitors did not maintain detailed rate
schedules. Until the two-year statute of limitations expires, Midcom could be
held liable for damages for its failure to maintain detailed rate schedules,
although it believes that such an outcome is highly unlikely and would not have
a material adverse effect on it. Pursuant to authority granted to it in the 1996
Telecommunications Act, the FCC is considering "mandatory detariffing" for
domestic non-dominant carriers. This proposal, if adopted, would relieve the
Company of its obligation to file tariffs applicable to its domestic
interexchange offerings.
State
The intrastate long distance operations of Midcom are also subject to
various state laws. The majority of states require certification or
registration, which the Company has secured in 47 states and Washington, D.C.
Many states require tariff filings as well.
In certain states, approval for transfers of control and acquisitions of
customer bases must be obtained. Midcom has been successful in obtaining all
necessary regulatory approvals to date, although revisions of tariffs,
authorities and approvals are being made on a continuing basis, and many such
requests are pending at any one time.
Some states may assess penalties on long distance service providers for
traffic sold prior to tariff approval or the state's consent to an acquisition.
Such states may require refunds to be made to customers. It is the opinion of
management that such penalties and refunds, if any, would not have a material
adverse effect on the results of operations or financial condition of the
Company.
LITIGATION
In the third quarter of 1993, the Company was named a defendant in a
lawsuit by a distributor of Consultants. The allegations include interference
with the plaintiff's ability to generate business through Consultants. The
Company has filed a counterclaim against the distributor for unfair competition
and trade name and trademark infringement. Although the outcome of any
litigation is uncertain, the Company believes that it has significant defenses
to such claims and intends to vigorously defend itself in this matter, and also
believes that the outcome of this matter will not have a material adverse effect
on the Company's financial condition, results of operations or liquidity.
EMPLOYMENT AGREEMENTS
In June 1994, the Company entered into an employment agreement with the
President and Chief Executive Officer of the Company. The agreement provides for
a base salary of $25 per month through December 31, 1998, unless there is
termination for cause.
38
<PAGE> 76
MIDCOM COMMUNICATIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
15. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
<TABLE>
<CAPTION>
1995 1994 1993
------- ------ ------
<S> <C> <C> <C>
Noncash investing and financing activities:
Application of related-party accounts receivable to
related-party accounts payable..................... $ -- $1,234 $ --
Conversion of amounts due to related parties to
redeemable preferred stock......................... -- 8,597 --
Issuance of notes payable and assumption of
liabilities for acquisitions of customer bases..... 42,591 5,154 3,557
Capital lease obligation for equipment................ 1,892 2,207 239
Issuance of notes payable for equipment............... 310 -- 255
Issuance of common stock warrants in connection with
financing.......................................... -- 3,500 --
Issuance of common stock for acquisitions............. 9,877 1,040 202
Issuance of note payable for settlement of carrier
accounts payable................................... 3,500 -- --
Cash paid for interest.................................. 4,128 1,453 1,215
Cash paid for income taxes.............................. 25 131 21
</TABLE>
16. INITIAL PUBLIC OFFERING
On March 21, 1995, the Company's Board of Directors authorized management
to file a Registration Statement with the Securities and Exchange Commission to
permit the Company to sell shares of its common stock to the public.
On July 6, 1995, the Company completed the initial public offering of
shares of its common stock at $11.00 per share, which resulted in net proceeds
of approximately $54,182 to the Company after deducting the expenses of the
offering. The net proceeds were used to repay indebtedness and redeem all of the
outstanding Series A Redeemable Preferred Stock.
17. NEW ACCOUNTING STANDARD
In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, Accounting for Stock-Based Compensation. This pronouncement establishes
accounting and reporting standards for stock-based employee compensation plans,
including: stock purchase plans, stock options and stock appreciation rights.
This standard defines a fair value-based method of accounting for these equity
instruments. This method measures compensation cost based on the value of the
award and recognizes that cost over the service period. Companies may elect to
adopt this standard or to continue accounting for these types of equity
instruments under current guidance, APB Opinion No. 25, Accounting for Stock
Issued to Employees. Companies which elect to continue using the rules of APB
Opinion No. 25 must make pro forma disclosures of net income and earnings per
share as if this new Statement had been applied. This new standard is required
for fiscal years beginning after December 15, 1995.
The Company is in the process of evaluating this Statement and its impact
on the Company's financial condition and results of operations.
39
<PAGE> 77
REPORT OF INDEPENDENT AUDITORS
The Shareholders and Board of Directors
MIDCOM Communications Inc.
We have audited the accompanying consolidated balance sheets of MIDCOM
Communications Inc. as of December 31, 1994 and 1995, and the related
consolidated statements of operations, shareholders' equity (deficit), and cash
flows for each of the three years in the period ended December 31, 1995. 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
MIDCOM Communications Inc. at December 31, 1994 and 1995, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1995, 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 more fully described in Note 1, the
Company has incurred recurring operating losses and has a working capital
deficiency. In addition, the Company is in default with regard to certain loan
agreements with its lenders. These conditions raise substantial doubt about the
Company's ability to continue as a going concern. Management's plans in regard
to these matters are also described in Note 1. The financial statements do not
include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification of
liabilities that may result from the outcome of this uncertainty.
ERNST & YOUNG LLP
Seattle, Washington
March 29, 1996
40
<PAGE> 78
PRICE RANGE OF COMMON STOCK
Midcom's Common Stock is traded in the over-the-counter market and has been
quoted on the Nasdaq National Market since July 6, 1995 under the symbol "MCCI."
The stock prices below are the high and low closing sales prices on the Nasdaq
National Market for the periods indicated.
<TABLE>
<CAPTION>
HIGH LOW
----- -----
<S> <C> <C>
1995
Third Quarter (from July 6, 1995)........................... $16 3/4 $11 1/4
Fourth Quarter.............................................. 18 7/8 13 3/4
1996
First Quarter............................................... $18 1/4 $ 7
Second Quarter.............................................. 15 1/4 6 1/2
Third Quarter (through September 25, 1996).................. 16 10 1/4
</TABLE>
On September 25, 1996, the closing sale price reported by the Nasdaq
National Market for the Common Stock was $14.41. As of July 31, 1996, there were
approximately 129 holders of record of the Common Stock.
Since its incorporation in 1989, the Company has not declared or paid cash
dividends on its Common Stock, and the Company anticipates that any future
earnings will be retained for investment in its business. In addition, the terms
of the Company's Revolving Credit Facility prohibit the payment of cash
dividends without the consent of the Company's lenders.
41
<PAGE> 79
MIDCOM(R) MIDCOM 1111 THIRD AVENUE
COMMUNICATIONS SUITE 1600
INC. SEATTLE, WA 98101
<PAGE> 80
PROXY MIDCOM COMMUNICATIONS INC. PROXY
ANNUAL MEETING OF SHAREHOLDERS -- OCTOBER 29, 1996
THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS
The undersigned hereby appoints William H. Oberlin and Paul P. Senio, and
each of them, as proxies, each with the power to appoint his substitute, and
hereby authorizes them to represent and to vote as designated below, all the
shares of Common Stock of MIDCOM Communications Inc. that the undersigned would
be entitled to vote if personally present at the annual meeting of shareholders
to be held on October 29, 1996, or at any adjournment thereof.
1. ELECTION OF DIRECTORS
/ / FOR all nominees listed below (except as marked to the contrary below)
/ / WITHHOLD AUTHORITY to vote for all nominees listed below.
INSTRUCTION: To withhold authority to vote for any individual nominee, strike a
line through the nominee's name in the list below.
CLASS I -- KARL D. GUELICH AND SCOTT B. PERPER
CLASS II -- DANIEL M. DENNIS, MARVIN C. MOSES AND JOHN M. OREHEK
CLASS III -- WILLIAM H. OBERLIN, PAUL PFLEGER AND JOHN M. ZRNO
2. To ratify and approve the amendment to the MIDCOM Communications Inc. 1993
Stock Option Plan to increase the number of MIDCOM Common Stock authorized
for issuance thereunder by 3,000,000 shares.
/ / FOR / / AGAINST / / ABSTAIN
3. To ratify and approve the amendment to the Stock Option Plan and the grants
of options to certain incumbent directors as more fully described in the Notice
of Annual Meeting and Proxy Statement dated October 7, 1996.
/ / FOR / / AGAINST / / ABSTAIN
<PAGE> 81
4. To ratify and approve the amendment to the MIDCOM Stock Option Plan to create
a maximum number of options that may be granted under the Stock Option Plan
to any one employee in three consecutive fiscal years as more fully described
in the Notice of Annual Meeting and Proxy Statement dated October 7, 1996.
/ / FOR / / AGAINST / / ABSTAIN
5. In their discretion, the holders of this proxy are authorized to vote upon
such other business as may properly come before the meeting.
Please sign and date below. This Proxy, when properly executed, will be voted
in the manner herein directed by the undersigned shareholder. If no
specification is made, this Proxy will be voted FOR the election of all
nominees for director listed in Proposal 1 and FOR Proposals 2, 3 and 4 and
will be voted in accordance with the discretion of the proxies on all other
matters which may come before the meeting or any adjournment. The undersigned
hereby revokes any proxy or proxies heretofore given for such shares and
ratifies all that the above named proxies or their substitutes may lawfully
do by virtue hereof. Please sign as name appears below. When shares are held
by joint tenants, both should sign. When signing as attorney, executor,
administrator, trustee or guardian, please give full title as such. If a
corporation, please sign in corporate name by authorized officer. If a
partnership, please sign in partnership name by authorized person.
Dated ____________________, 1996
Signature
------------------------
Signature
------------------------
Please mark, sign, date and return the Proxy Card promptly using the enclosed
envelope.
