3.     LEGAL MATTERS AND CONTINGENCIES

4.     SHAREHOLDERS' EQUITY

We are based in Irvine, California and, through our wholly-owned subsidiary VitalStream, Inc., we offer our customers a range of content delivery services and software solutions including audio and video streaming, live event streaming, media asset management, integrated managed services, download services, vertical solutions such as digital dailies for the entertainment industry, encoding (via third-party resellers) and consulting. Through our wholly-owned subsidiary VitalStream Broadcasting Corporation, we offer hosting and colocation services to customers we acquired from Epoch Hosting and Epoch Networks. Our mix of products and services enables our customers to concentrate on the creation and marketing of their content, while outsourcing the encoding, data storage, broadcasting, hosting and related functions to VitalStream and its partners. Our business model relies upon leveraging our expertise and resources in audio and video streaming as well as our integrated hosting technology to persuade customers to utilize our Internet broadcasting services, thereby allowing our company to build a base of recurring revenues from monthly or other periodic broadcasting fees.

We believe we are well positioned to take advantage of the growth opportunities within the streaming media marketplace. Since the end of 2003, we have continued to build up our sales force by adding additional sales staff including dedicated channel and OEM sales functions. We established our first regional sales office in New York and have increased funds for select marketing efforts. We have also enhanced our customer support department by hiring additional employees with greater levels of experience including a senior customer support manager. By adopting a more solutions-oriented sales approach, we believe our marketing proposition is value-based, allowing us to sell increasingly customized solutions in addition to our off-the-shelf products. We believe this solutions-oriented approach has increased demand for our products and services and created higher switching costs for customers to move to competitor's services.

While improving the revenue growth rate, we have also focused on efficiency and economies of scale within our cost of service expense structure. As a result of favorably renegotiating certain bandwidth contracts over the past year through higher volume purchasing, we were able to reduce our bandwidth per unit cost of service during 2004. As our gross profits increased in 2004, we reinvested, and intend to continue to reinvest, some of those gains in the further development of our service offering and network infrastructure including development of additional functionality for our rich media streaming services, and increased capacity and security for our content delivery network. By continuing to develop our service platform with additional unique and proprietary features, and strengthening our content delivery network, we expect to be able to further differentiate ourselves from our competitors, enabling us to gain greater market share, and to increase our prospects for customer retention and renewals. We expect that these investments in our product portfolio and network, will be increasingly offset by our operational efficiency and purchasing gains, and coupled with our improving top line growth rate, should result in gross margins that on the average, increase during 2005 as compared to 2004.

Section 404 of the Sarbanes-Oxley Act of 2002 applies to all public companies. Under Section 404, public companies are required to design, establish and maintain an adequate system of internal financial and disclosure controls, assess such controls as of the end of each fiscal year, and engage an independent accounting firm to evaluate and provide an opinion on management's assessment of their controls. To adequately prepare for implementation of Section 404 assessment and auditing requirements beginning with the end of fiscal 2005, we had employed the additional resources and tools of a professional accounting firm to minimize disruption to our regular business processes and personnel, and to effectively meet the design, evaluation, documentation, testing and monitoring requirements of this Act. On March 2, 2005, the Securities and Exchange Commission postponed by one year the date of effectiveness for compliance with the assessment and auditing requirements of Section 404 for non-acceler ated filers such as the Company until the end of fiscal 2006. Given this announcement, we now expect to spread the costs of completing this project more evenly over 2005 and 2006.

While the opportunities for us are increasing, they are not without risk. Our business and our industry face numerous risks (see "Risk Factors" at the end of this Item 2), only some of which can be mitigated to varying degrees in advance, and others of which can only be dealt with reactively. As with any technology company, new technological advances within our industry could cause a paradigm shift in how we develop, market and deliver our products and services. Some of these advances may be unavailable to us and we may not have a comparable or competitive technological offering.     

Because of the highly-fragmented nature of the streaming media services industry, economies of scale enable companies in our industry to be more competitive. We believe that our experience in acquiring new accounts and integrating acquired businesses, combined with our strong operational focus on our business, positions us to gain a greater market share in our industry. Further, the upward trend in our sales growth combined with continuous achievement of operational efficiencies creates an opportunity for us to become profitable in the future.

On April 27, 2005, the Company acquired the business of PlayStream, LLC, a provider of small business streaming media services, headquartered in Seattle, Washington, effective as of April 1, 2005, for $500,000 in cash, 3,750,000 shares of VitalStream Holdings, Inc. common stock and 200,000 warrants to purchase common stock at an exercise price of $1.35. Through PlayStream, we offer fully automated, self service video and audio streaming services to small and medium sized businesses under the PlayStream brand. PlayStream offers both live and on demand streaming services.

Management is basing this discussion and analysis of our financial condition and results of operations on our consolidated financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, valuation of accounts receivable, property, plant and equipment, long-lived assets, intangible assets, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or co nditions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. These judgments and estimates affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting periods. Changes to these judgments and estimates could materially affect the Company's future results of operations and cash flows.

The following table sets forth, for the periods indicated, items included in our consolidated statements of operations, stated as a percentage of revenues:

Revenue Revenue consists primarily of fees for Internet broadcasting, including streaming media services, managed services, web hosting and sales of hardware and software. Revenues increased from $1,991,437 for the quarter ended March 31, 2004, to $3,397,888 for the quarter ended March 31, 2005, an increase of 70.6%. This increase in revenue is primarily attributable to the addition of new customers using VitalStream services and technology to deliver streaming media. We expect continued revenue growth from the addition of new customers and from increased services to existing customers as we continue to strengthen our sales force, build on our existing and add new channel and OEM partnerships, increase our marketing efforts, gain greater market recognition from potential customers and release new products and services. We expect PlayStream to begin contributing revenue on April 1, 2005.

Cost of Revenue Cost of revenue consists primarily of Internet backbone and transport costs, data center rent and power costs, depreciation of network and server equipment, network operations employee costs, hardware costs and software license fees. Cost of revenue increased from $900,710 for the quarter ended March 31, 2004, to $1,653,945 for the quarter ended March 31, 2005. The increased cost in absolute dollars primarily reflects the increase in bandwidth consumption, software license fees and depreciation from increased capital expenditures necessary to increase the capacity, reliability and security of our content delivery network, in addition to increases in other costs necessary to support the increase in revenue between the two quarters. The increase in the cost of revenue as a percentage of revenue between the two quarters, from 45.2% of revenue in the quarter ended March 31, 2004 to 48.7% of revenue for the quarter ended March 31, 2005, is primarily attributable to incre ases in depreciation from additional investment to increase the scalability of our network and increased sales of lower margined product. Overall, management expects the cost of revenue to decrease as a percentage of revenue over the next several quarters, as increases in depreciation from additional investment to increase the scalability of our network are offset by additional per unit cost savings resulting from the purchase of bandwidth and other items with variable costs, and economies of scale in our fixed costs including our Internet data center facility costs.

Research and Development Research and development expense consists primarily of personnel costs to develop new products, and maintain and enhance our current product portfolio. Research and development expense increased $44,267, from $110,505 for the quarter ended March 31, 2004, to $154,772 for the quarter ended March 31, 2005. As a percentage of revenue, research and development decreased from 5.6% for the quarter ended March 31, 2004 to 4.5% for the quarter ended March 31, 2005. This absolute dollar increase reflects higher payroll and other costs to support our expanding product and service mix. We expect research and development expense to increase in absolute dollars and to increase as a percentage of revenue during 2005 as we increase our efforts to develop additional technology related to our core product offering.

Sales and Marketing Sales and marketing expense consists primarily of sales and marketing-related personnel costs, including salary and commissions, in addition to the costs of various marketing programs and events. Sales and marketing expense increased from $611,718 for the quarter ended March 31, 2004 to $1,031,919 for the quarter ended March 31, 2005. As a percentage of revenue, sales and marketing expense was approximately the same at 30.7% and 30.4% for the quarters ended March 31, 2004 and March 31, 2005 respectively. This absolute dollar increase reflects increased payroll and related costs to expand and support the sales force, increased marketing and advertising costs to increase market awareness and generate new customers, and a one-time severance charge of approximately $70,000. We expect sales and marketing expense to increase in absolute terms and remain relatively constant as a percentage of revenue through 2005 as we continue to expand and support our sales force, a nd we invest further in marketing and advertising efforts to drive growth in our customer base.

General and Administrative General and administrative expense consists primarily of personnel expense, professional fees and costs to maintain and support our facilities. General and administrative expense increased from $517,385 for the quarter ended March 31, 2004 to $888,599 for the quarter ended March 31, 2005. The increase in the expense during the quarter ended March 31, 2005 primarily related to increased payroll and related costs to enhance administrative infrastructure to support higher growth, costs for implementation of Section 404 of the Sarbanes-Oxley Act of 2002, and higher overall professional fees. General and administrative expense as a percentage of revenue was approximately the same at 26.0% for the quarter ended March 31, 2004 and 26.2% for the quarter ended March 31, 2005. We expect general and administrative expense to increase in absolute dollar value, and to decrease as a percentage of revenue through the balance of 2005.

Net Interest Expense Net interest expense increased from $51,758 for the quarter ended March 31, 2004 to $60,744 for the quarter ended March 31, 2005. The increase in net interest expense was primarily due to higher interest rates on our equipment line of credit. We expect our net interest expense to increase through the balance of 2005 as we continue to finance equipment through our credit facility.

Other Income (Expense) Other income (expense) was an expense of ($10,128) for the quarter ended March 31, 2004 compared to income of $196,498 for the quarter ended March 31, 2005. The increase in income was primarily due to a one-time gain of approximately $200,000 from the sale of certain smaller non-core business hosting accounts to a third party.

The Company's EBITDA was $286,478 for the quarter ended March 31, 2005 compared with $34,861 for the quarter ended March 31, 2004. The increase in EBITDA for the three month period ended March 31, 2005 compared to the similar period in 2004 was primarily due to a one-time gain of approximately $200,000 from the sale of certain smaller non-core business hosting accounts to a third party, and to the increase in revenue and a decrease in our cost of service excluding depreciation as a percentage of revenue, partially offset by absolute dollar increases in Sales and Marketing, and General and Administrative expenses as described above.

The Company defines EBITDA as net income (loss) before interest, income taxes, and depreciation and amortization. EBITDA is not a measure used in financial statements reported in accordance with generally accepted accounting principles, does not represent funds available for discretionary use and is not intended to represent cash flow from operations as measured under generally accepted accounting principles. EBITDA should not be considered as an alternative to net loss or net cash used in operating activities. The Company's calculation of EBITDA may not be comparable to the computation of similarly titled measures of other companies.

We use EBITDA as a measure of our operating performance. In addition, we believe that EBITDA may be useful to existing and potential creditors, and to analysts and investors that follow our performance, because it is one measure of income generated that is available to service any outstanding bank or lease obligations.

          Reconciliation of the net loss for the three month periods ended March 31, 2005 and 2004 to EBITDA is as follows:

The following table discloses aggregate information about our contractual obligations including operating and capital lease payments, office lease payments and contractual service agreements, and the periods in which payments are due as of March 31, 2005:

Our capital leases represent $1,353,135 plus interest spread over eight capital lease financing arrangements. The hardware and software obtained through these capital lease arrangements are used in our data center operations, for supplying service to our customers, maintaining and increasing the capacity of our internal network and providing the equipment needed for internal staff.

Cash used during the three months ended March 31, 2005 included $1,083,311 used in operations as well as $529,618 used in investing activities. Net cash provided by financing activities during the three month period ended March 31, 2005 was $468,396, primarily from the proceeds of our equipment line of credit and the proceeds from the exercise of stock options, offset by payments on capital leases.

Capital expenditures in the first three months of 2005 and 2004 were $529,653 and $38,090, respectively. Equipment acquired under capitalized leases in the first three months of 2005 and 2004 were zero and $413,108, respectively. Capital expenditures are primarily related to the purchase of network infrastructure equipment.

During the quarter, the Company made a payment to a licensor in the amount of $750,000 representing a prepayment against royalties to be incurred in the future.

The Company had $200,254 of restricted cash at March 31, 2005, securing a facility lease.

On April 27, 2005, the Company acquired the business of PlayStream, LLC, a provider of small business streaming media services, headquartered in Seattle, Washington, effective as of April 1, 2005, for $500,000 in cash, 3,750,000 shares of VitalStream Holdings, Inc. common stock and 200,000 warrants to purchase common stock at an exercise price of $1.35.

We hope to rapidly expand our operations during 2005. We may seek to expand our operations through additional strategic acquisitions. If we were to engage in further acquisitions, we may need to seek additional financing in order to pay for the transaction costs of any large mergers and/or acquisitions (e.g., legal and accounting fees, integration expense and working capital to support the acquired entity). However, we expect that the cash we have on hand, together with recurring operating revenues and funds obtained through our credit facility, will be sufficient to meet our current and future obligations until the time that the Company can consistently sustain itself on its internally-generated cash flow.

On October 13, 2004, the FASB issued an exposure draft of Statement No. 123-R, "Share Based Payment, an amendment of FASB Statements No. 123 and 95." This change in accounting would replace existing requirements. The statement covers a wide range of equity-based compensation arrangements and will require all companies to measure compensation cost for all share-based payment (including employee stock options) at fair value. Under the Board's proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. This proposal has no impact on the fiscal year 2005 financial statements; however it will affect the Company's financial statements beginning in fiscal year 2006 when it is adopted.

We have experienced net losses in each quarter since inception, with cumulative net losses of $8.8 million from inception through March 31, 2005, and we are uncertain when, or if, we will experience net income from operations. Even if we do experience net income in one or more calendar quarters in the future, subsequent developments in our industry, customer base, business or cost structure or expenses associated with significant litigation or a significant transaction may cause us to again experience net losses. We may never become profitable.

The market for Internet broadcasting and streaming services is evolving, and we cannot be certain that a viable market for our services will emerge or be sustainable. Factors that may inhibit the development of a viable market for Internet broadcasting services include:

If the market for Internet broadcasting services does not continue to develop, or develops more slowly than expected, our business, results of operations and financial condition will be seriously harmed.

 We have pledged substantially all of our assets to secure a bank financing arrangement which requires that we afford rights and remedies that are commonly provided a secured creditor. If we default under such arrangements, subject to laws restricting the remedies of creditors, such creditors may immediately seize and dispose of all pledged assets up to the aggregate amount of the debt secured and certain collection expenses of the creditor.

In order to successfully implement our business strategy, we must establish and achieve substantial growth in our customer base through sales, business acquisitions or a combination thereof. If achieved, significant growth would place significant demands on our management and systems of financial and internal controls, and will almost certainly require an increase in the capacity, efficiency and accuracy of our billing and customer support systems. Moreover, significant growth would require an increase in the number of our personnel, particularly within sales and marketing, customer service and technical support. The market for such personnel remains highly competitive, and we may not be able to attract and retain the qualified personnel required by our business strategy. If successful in attracting new customers, we may outgrow our present facilities and/or network capacity, placing additional strains on our human resources in trying to locate, manage and staff multiple locations and to s cale our network.

Through their holdings of common stock, as of March 31, 2005, affiliates of Dolphin Equity Partners presently control 15,257,849 votes in connection with the election of directors and other matters, 25.1% of the voting power of our company, and affiliates of WaldenVC presently control 9,876,324 votes in connection with the election of directors and other matters, representing 16.2% of the voting power of the Company. In addition, if Dolphin and WaldenVC exercised all warrants they hold, Dolphin's and WaldenVC's respective aggregate beneficial ownership would increase to approximately 17,596,021 and 12,839,221 votes in connection with the election of directors and other matters, constituting 27.9% and 20.1%, respectively of the voting power of our company following such exercises. As a result of their stock holdings, Dolphin or WaldenVC may be able to block, or extract concessions or special benefits in connection with, various transactions, including any future merger or asset sale transac tions.

Our current and future competitors in Internet streaming may include other digital content delivery providers, Internet broadcast network specialty providers and alternative access providers such as various cable television companies, direct broadcast satellite, DSL, wireless communications providers and other established media companies. Our current and future competitors in hosting and colocation may include other Internet hosting, colocation and access businesses, including such major providers as Savvis and AT&T, and essentially any other participant in the Internet industry.

Many of these competitors have a longer operating history and greater market presence, brand recognition, engineering and marketing capabilities, and financial, technological and personnel resources than we do. Competitors with an extended operating history, a strong financial position and an established reputation have an inherent marketing advantage because of the reluctance of many potential customers to entrust key operations to a company that may be perceived as unproven or unstable. In addition, our competitors may be able to use their extensive resources:

If we are unable to compete effectively in our various markets, or if competitive pressures place downward pressure on the prices at which we offer our services, our business, financial condition and results of operations may suffer.

Our services are subject to system failure and security risks.

Our operations are dependent upon our ability to protect our network infrastructure against interruptions, damages and other events that may adversely affect our ability to provide services to our customers (on a short-term or long-term basis) and may lead to lawsuits and contingent liabilities. Despite the implementation of precautions, the core of our network infrastructure is vulnerable to various potential problems, including the following:

The occurrence of any natural disaster (including earthquakes), power outage, unauthorized access, computer virus, equipment failure or other disruptive problem could have a material adverse affect on our business, financial condition and results of operations.

The network architecture and data tracking technology underlying our streaming and hosting services is complex and includes software and code used to generate customer invoices. This software and code is either developed internally or licensed from third parties. Any of the system architecture, system administration, software or code may contain errors, or may be implemented or interpreted incorrectly, particularly when they are first introduced or when new versions or enhancements to our services are released. In addition, with respect to certain usage-based billing, the data used to bill the customer for usage is an estimate, based upon complex formulas or algorithms. We or the customer may subsequently believe that such formulas or algorithms overstate or understate actual usage. In any such case, a design or application error could cause overbilling or underbilling of our customers, which may;