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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended December 31, 2002

OR

For the transition period from                 to                

Commission File number 0-30905

StorageNetworks, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, including area code:    (781) 622-6700

Securities registered pursuant to Section 12(b) of the Act:    None.

Securities registered pursuant to Section 12(g) of the Act:    Common Stock, $.01 par value

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  Yes   x  No  ¨

The aggregate market value of voting Common Stock held by non-affiliates of the registrant was approximately $127,705,091 based on the last reported sale price of the Common Stock on the Nasdaq National Market on June 28, 2002.

The number of shares of the registrant’s Common Stock outstanding as of March 7, 2003 was 99,379,787 shares.

DOCUMENTS INCORPORATED BY REFERENCE: None.

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StorageNetworks, Inc.

Annual Report on Form 10-K

For the Fiscal Year Ended December 31, 2002

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PART I

This annual report on Form 10-K contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “anticipate,” “expect,” “intend,” “may,” “should,” “will,” and “would” or similar words. You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or of our financial position or other “forward-looking” information. We believe that it is important to communicate our future expectations to our stockholders. However, there may be events in the future that we are not able to accurately predict or control. The factors listed below under the caption “Factors Affecting Future Operating Results,” as well as any cautionary language elsewhere in this Form 10-K, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations indicated by forward-looking statements.

Item 1.    Business.

OVERVIEW

StorageNetworks, Inc. is a provider of data storage management software and services. StorageNetworks was founded in late 1998 to offer professional and managed services designed to provide customers with efficient and cost-effective data storage. Historically, we have had three business segments: managed services (both primary data storage services and backup storage services), professional services and software products. Through our managed services we manage our customers’ data, and through our professional services we performed a variety of data storage related services for our customers, including the design and implementation of networked storage infrastructures. To more efficiently deliver our managed services, we developed proprietary software that enabled us to reduce the complexity of managing heterogeneous storage environments. In 2001 we began the process of developing our software as a stand-alone product that could be sold directly to customers. In May, 2002, we launched the company’s first standalone software product, STORos StorageManager v5.0, a storage resource management (SRM) application, and we focused our sales activities primarily on our software products. In late 2002, due to the economic climate, weakening demand and anticipated diminishing profit margins, we determined to exit the managed services business and ceased offering professional services. In addition, because our software products have generated only limited user license fees, in early 2003 we reduced our work force by fifty percent by eliminating our direct sales, corporate marketing, professional services and non-partner product development employees. We also announced that we are actively seeking companies to partner with or acquire in order to grow our business and generate revenues, and that we had engaged investment banking firms to assist us in identifying and assessing all available alternatives to maximize shareholder value.

Our revenues for the year ended December 31, 2002 were $94.9 million. Our managed services segment accounted for $91.1 million, or approximately 96%, of our total revenues, our professional services segment accounted for $3.0 million, or approximately 3%, of our total revenues, and our software segment accounted for $799,000, or less than 1%, of our total revenues. We believe that our limited user license fees resulted from the immaturity of the SRM software market, customers’ requirements and demands not being aligned with the functionality of our STORos StorageManager applications, and the overall economic environment. Today we are focused on delivering services to customers with existing contracts, exiting the managed services business, and working with our advisors to identify and assess all opportunities to maximize shareholder value. As a result of these significant changes in our business strategy, the relative contributions of each of our segments to our total revenues in 2002 may not be indicative of future periods. In addition, total revenues in 2002 are likely not to be indicative of total revenues for 2003 because we will not be signing new managed services customer contracts or seeking renewals of our existing contracts, and because we have significantly reduced our sales and marketing organizations.

For more financial information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements included in this annual report on Form 10-K.

Managed Services

Historically, we have sold and delivered a suite of managed services, including both primary storage and backup services. We designed these services to enable customers to achieve higher levels of data availability,

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optimize utilization rates, and improve recovery rates. Our managed services were purchased by customers through service level agreements or other contracts that guaranteed our services would meet or exceed specific performance criteria. We derived the majority of our revenues, including 64% of our revenues in 2000, 92% of our revenues in 2001, and 96% of our revenues in 2002, from these services. One managed services customer, Merrill Lynch, accounted for approximately 18% of our total consolidated revenues for the year ended December 31, 2002. In 2001, as the economy continued to decline, demand for our managed services in third party hosting centers weakened. In addition, we recognized that there was limited demand, at selling prices that made economic sense, for primary data managed services from enterprise customers. As a result, in late 2001 and early 2002, we focused our sales and marketing efforts on selling software and managed backup services to large enterprise organizations. Sufficient demand for our managed services from enterprise customers did not develop and the renewal rate began to decline. As a result, we anticipate that revenues from our managed services operations will decline at a greater rate in 2003 and that gross profit margins will erode. Therefore, in the fourth quarter of 2002, we determined that the best way to maximize the value in the signed managed services contracts was to exit the managed services business, and eliminate the related costs, as soon as possible. We expect, however, as the customer contracts wind down, that a majority of our revenues for the immediate future will still be derived from such services.

Professional Services

We offered a range of professional services, through which we advised our customers on the design, implementation, and migration of their data storage environments. Our professional services helped enterprise organizations design their primary data storage systems and optimize their existing data storage infrastructures. In 2002, we focused our professional services activities on software related services. However, due to weak economic conditions and the overall lack of demand for our professional services, we decided to exit the professional services business in late 2002.

Storage Management Software

We originally developed our software applications to enable us to more efficiently deliver our managed services to our customers. We utilize these applications in delivering our managed services to centralize the management of multi-vendor networked storage and to provide our managed services customers with visibility into the performance of their storage environments. In 2001, we began developing our software as stand-alone products to be sold directly to customers. In May 2002, we launched our first stand-alone SRM solution, STORos StorageManager v5.0, and later in 2002, we announced the availability of STORos StorageManager for Backup. Due to the immaturity of the SRM market, customers’ requirements and demands not being aligned with the functionality of our products, the lack of success we had in selling our SRM products, and the overall economic climate, we have ceased our sales efforts with respect to our current products and our software development group is currently focused on responding to the needs of existing customers.

Sales and Marketing

Historically, we marketed our software and services primarily through our direct sales force. Our direct sales team targeted large enterprises and service providers that wanted to improve the performance and management of their multi-vendor data storage environments. During 2002, we also entered into agreements with several regional software resellers to resell our software products. Our future sales and marketing activities will to a large extent be determined based upon the terms of any partnerships or other strategic transactions we may enter into with other companies.

Software Development

Our software development group is focused on developing products to meet commitments to our current customers. This group also maintains our testing center, which tests interoperability of equipment and serves as a controlled, secure environment for evaluating storage technologies. Company-sponsored research and development expenses totaled $15.3 million in 2002, $22.0 million in 2001 and $11.9 million in 2000.

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Operations

Our operations group consists of our personnel in our Customer Support Center and our personnel in the field responsible for delivery of our managed services. The Customer Support Center remotely monitors events in our managed services customers’ storage environments and manages our responses to such events and customer requests. It also provides maintenance and support services to software customers. Our field personnel are responsible for the delivery and deployment of our managed services to customers, both in the customer’s own data centers and in third-party hosting centers, including the implementation and ongoing management of storage environments.

Competition

The storage services and storage management software markets are highly competitive and fragmented. Companies that compete in the managed services, professional services and storage software markets are storage hardware, storage software and service vendors such as EMC, Computer Associates, VERITAS Software, IBM, Hitachi Data Systems, Sun Microsystems and other announced entrants to the storage management software market.

Intellectual Property

We rely on a combination of trademark, trade secret and copyright laws and contractual restrictions to protect the proprietary aspects of our software, services and other technology. These legal protections afford only limited protection. We have no significant issued patents. We seek to limit disclosure of our intellectual property by requiring employees, consultants and business associates with access to our proprietary information to execute confidentiality agreements with us and by restricting access to our proprietary information. Due to rapid technological change, we believe that factors such as expertise and technological and creative skills are more important to establishing and maintaining proprietary technology than the various available legal protections.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our software and services or to obtain and use information that we regard as proprietary. The laws of many countries do not protect proprietary rights to the same extent as the laws of the United States. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. Any such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar information or technology. Any failure by us to adequately protect our intellectual property could have a material adverse effect on our business, operating results and financial condition.

Employees

As of December 31, 2002, we had a total of 220 full-time employees. In January, 2003, we announced a reduction in our workforce and, as of March 10, 2002, we had a total of 106 full-time employees. We expect to further reduce our workforce as we exit the managed services business. Our employees are not represented by any collective bargaining representative.

Available Information

We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports available on our website, free of charge, as soon as reasonably practicable after we file such material with, or furnish it to, the Securities and Exchange Commission, or the SEC. Our internet address is http://www.storagenetworks.com. The contents of our website are not part of this annual report on Form 10-K, and our internet address is included in this document as an inactive textual reference only.

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Item 2.    Properties.

Our headquarters are located in Waltham, Massachusetts, where we have entered into a lease for approximately 117,000 square feet of office space, of which we are actively using approximately 49% and the balance of which is vacant. The lease for this space terminates on December 31, 2010. As of December 31, 2002, we also leased approximately 138,000 square feet of additional office space. We are not actively utilizing any of this additional office space, and we sublet approximately 57% of this additional office space. We are actively seeking sublessors or early terminations with our lessors for our vacant office space, including the vacant space located at our corporate headquarters. We also lease on a monthly basis S-POP data centers in locations in the United States and the United Kingdom.

Item 3.    Legal Proceedings.

In July, 2001 we initiated an action against Metromedia Fiber Network (“MFN”) in Middlesex (Massachusetts) Superior Court. This action seeks compensatory, punitive and declaratory relief, alleging, among other things, misrepresentation, fraudulent inducement and breach of contract as a result of MFN’s failure to possess or to deliver fiber optic capacity in accordance with representations made by MFN and as specified under our Fiber Optic Network Leased Fiber Agreement with MFN. This action is currently stayed due to MFN’s bankruptcy proceedings. MFN also initiated an action in New York, New York alleging that we have breached such agreement, which action was dismissed in favor of the Massachusetts action. While the outcome of this matter is not currently determinable, we believe that the result will not have a material adverse effect on the results of our operations or our financial position, although we can make no assurances in this regard.

In August, 2001, a purported class action lawsuit was filed in the United States District Court for the Southern District of New York against us and several of our officers as well as against the underwriters of our initial public offering of common stock in June, 2000. The complaint, which seeks unspecified damages, was filed allegedly on behalf of persons who purchased our common stock between June 30, 2000 and December 6, 2000. The complaint alleges violations of the Securities Act of 1933 and the Securities Exchange Act of 1934, each as amended, primarily based on allegations that StorageNetworks, the underwriters and the other named defendants made material false and misleading statements concerning fees paid by purchasers of our common stock to the underwriters in the prospectus that was part of the registration statement on Form S-1 that was filed in connection with our initial public offering. The allegations in the complaint are generally related to the alleged receipt of excessive and undisclosed commissions by the underwriters and alleged prohibited after-market transactions by the underwriters. The complaint alleges that the underwriters obtained excessive commissions and inflated transactions fees from their customers, and allegedly entered into agreements with their customers pursuant to which the customers, in return for being allocated shares in the initial public offering, agreed to purchase additional shares on the open market at specified increased prices. In April 2002, the complaint was amended to add allegations, substantially similar to those described above, concerning the Company’s secondary public offering of stock. In October, 2002, the individual defendants were dismissed without prejudice from this lawsuit pursuant to tolling agreements entered into with the plaintiffs. Although we believe that these claims are without merit and intend to defend ourselves vigorously against such claims, we are not presently able to reasonably estimate potential losses, if any, related to this matter.

In addition, we are subject to various claims and proceedings in the ordinary course of business. Based on information currently available, we believe that none of such current claims or proceedings, individually or in the aggregate, will materially harm our financial condition or results of operations, although we can make no assurances in this regard.

Item 4.    Submission of Matters to a Vote of Security Holders.

No matter was submitted to a vote of our stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of 2002.

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PART II

Item 5. Market For Registrant’s Common Equity and Related Stockholder Matters.

(a)    Market Price of and Dividends of the Company’s Common Stock and Related Stockholder Matters

Our common stock is listed on the Nasdaq National Market under the symbol “STOR.” The following table sets forth, for the periods indicated, the range of the high and low bid information per share of our common stock, as reported on the Nasdaq National Market. On March 19, 2003, we received notice from Nasdaq stating that our common stock had for 30 consecutive trading days closed below the minimum $1.00 per share bid price listing requirement. In accordance with Nasdaq rules, we have until September 15, 2003 to regain compliance with this requirement. If compliance cannot be demonstrated by September 15, 2003, Nasdaq may make a determination to delist our stock.

As of March 11, 2003, there were 349 holders of record of our common stock, as shown in the records of our transfer agent.

We have never declared or paid any cash dividends on our capital stock. We presently intend to retain future earnings, if any, to finance the expansion of our business. Payment of future cash dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion.

(b)    Use of Proceeds from Sales of Registered Securities

In our initial public offering, we sold 10,350,000 shares of our common stock at a price of $27.00 per share, less underwriting discounts and commissions, pursuant to a Registration Statement on Form S-1 (Registration No. 333-31430) that was declared effective by the SEC on June 29, 2000. In addition to expenses incurred in connection with the IPO and previously disclosed in our Forms 10-Q for the quarters ended June 30, 2000 and September 30, 2000, from the effective date of the registration statement through December 31, 2002, we have spent approximately $139.6 million of the $258.6 million of net proceeds from the IPO on capital lease obligations, approximately $22.4 million for operating expenses, which may include salary payments to executive officers and related expenses, and approximately $4.4 million for property and equipment. Except as otherwise indicated, none of the net proceeds of the IPO has been paid to us, directly or indirectly, to any director, officer or general partner of us, or any of their associates, or to any person owning ten percent or more of any class of our equity securities, or any of our affiliates.

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Item 6.    Selected Financial Data.

You should read the selected financial data set forth below along with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. We have derived the consolidated statement of operations data for 1998, 1999, 2000, 2001 and 2002 and the consolidated balance sheet data as of December 31, 1998, 1999, 2000, 2001 and 2002 from our audited consolidated financial statements.

Consolidated Statement of Operations Data:

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Consolidated Balance Sheet Data:

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion and analysis together with our consolidated financial statements and the related notes and the other financial information appearing elsewhere in this annual report on Form 10-K. In addition to the historical information, the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in such forward-looking statements due to various factors, including, but not limited to, our critical accounting policies and those factors set forth below under “Factors Affecting Future Operating Results” and elsewhere in this annual report.

Overview

We are a provider of storage management software and services. Through our managed services, we manage our customers’ data, both onsite and in third-party hosting center facilities. Through our professional services, we performed a variety of data storage related services, such as the design and implementation of networked storage infrastructures for our customers. In May, 2002, our storage management software, STORos StorageManager, became generally available on a standalone basis.

Nearly all of our revenues to date have been derived from our managed services and our professional services. During 2001, due to weakened demand for our managed services, financial challenges faced by our hosting service provider partners and the general economic environment, we experienced decreases in revenues and contract backlog that caused us to reevaluate our business plan. We began marketing and selling our STORos StorageManager software in May, 2002. However, we concluded in the quarter ended December 31, 2002, that as a result of the immaturity of the storage resource management software market, feedback from prospective customers regarding the functionality of our existing products and the overall economic environment, we needed to re-focus our business on enhancing, repackaging and modifying the architecture of our software products to solve the challenges faced by our existing software and managed services customers. In early 2003, we had a reduction in work force of 50%, which included the majority of both the sales and marketing organizations. Due to weakening demand and anticipated diminishing profit margins resulting from decreasing revenues, we also decided in the quarter ended December 31, 2002 to exit our managed services business segment, as well as our professional services business segment, in 2003. Therefore we will not be signing new managed services customer contracts or seeking renewals of our existing contracts. As a result of these activities, we recorded asset impairment and other related charges of $59.7 million in the fourth quarter of 2002. We have announced that we are actively seeking companies to partner with or acquire in order to grow our business and generate revenues, and that we have engaged investment banking firms to assist us in identifying and assessing all available alternatives to maximize shareholder value.

Since our inception, we have incurred significant losses and negative operating cash flows, including a net loss of $76.6 million during the year ended December 31, 2002. As of December 31, 2002, we had an accumulated deficit of $450.9 million. We have not achieved profitability on a quarterly or an annual basis. We believe that we will continue to incur losses in the future. The revenue and income potential of our business in general and of our stand-alone software products in particular, is unproven, and our limited operating history makes an evaluation of our company difficult. In light of our recent decision to exit the managed services business

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as well as the unknown demand for our software products, we believe that you should not rely on the period-to-period comparison of our operating results to predict our future performance. You must consider our prospects in light of the risks, expenses and difficulties encountered by new companies in rapidly evolving industries. We may not be successful in addressing these risks and difficulties.

Application of Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported assets and liabilities, revenues and expenses, and other financial information. Actual results may differ significantly from these estimates under different assumptions and conditions.

We regard an accounting estimate underlying our financial statements as a “critical accounting estimate” if the accounting estimate requires us to make assumptions about matters that are highly uncertain at the time of estimation and if different estimates that we reasonably could have used in the current period, or changes in the estimate that are reasonably likely to occur from period to period, would have a material effect on the presentation of our financial condition, changes in financial condition or results of operations.

Our significant accounting policies are more fully described in Note 2 to our consolidated financial statements. Not all of these significant accounting policies require management to make difficult, complex or subjective judgments or estimates. Our management has discussed our accounting policies with the audit committee of our board of directors, and we believe that our accounting policies relating to revenue recognition, impairment of long-lived assets, restructuring charge estimates, allowance for doubtful accounts, depreciation expense and provision for income taxes described below fit the definition of “critical accounting estimates.”

Revenues

We derive revenues from primarily two sources: user fee software licenses and services. Service revenues include revenues derived from fees from customer use of our managed services and revenues derived from professional services. User fee software license revenue consists of revenues derived from perpetual licenses for our STORos StorageManager product. Service revenues also include revenues derived from software transactions under contracts for software maintenance and technical support, consulting and training.

Revenues for managed services and professional services are recognized in accordance with the guidance of Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements,” when all of the following conditions are met: persuasive evidence of an agreement exists, delivery has occurred or services have been rendered, the sales price is fixed or determinable and collection is reasonably assured.

Revenues from our managed services primarily include monthly service fees charged on a per usage basis and are recognized as the managed services are provided.

Revenues from professional services engagements are recognized as the services are provided. Revenues on fixed-price contracts are recognized using the percentage of completion method of accounting and are adjusted monthly for the cumulative impact of any revision in estimates. We determine the percentage of completion of our contracts by comparing costs incurred to date to total estimated costs. Contract costs include all direct labor and expenses related to the contract performance.

We recognize revenues from software transactions by applying the provisions of Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (as amended by SOP 98-4 and SOP 98-9) and related interpretations.

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We allocate revenue on software arrangements involving multiple elements to each element based on the relative fair values of the elements. The determination of fair value of each element in multiple element arrangements is based on the price charged when the same element is sold separately.

A typical software arrangement includes software licenses, maintenance, consulting and training.

Maintenance includes updates (unspecified product upgrades and enhancements) on a when-and-if available basis, telephone support, and bug fixes or patches. Consulting consists primarily of product installation, which does not involve customization of the software. Consulting fees are based on the level of effort required to perform the installation and the billing rate per hour when these services are sold separately. Training consists of courses taught by our instructors at the customer’s site. Training fees are based on a per course fixed-price basis.

We have analyzed all of the elements included in our multiple-element arrangements and determined that we have vendor-specific, objective evidence of fair value to allocate revenues to the maintenance, consulting and training. Accordingly, assuming all other revenue recognition criteria are met, revenues from perpetual licenses are recognized upon delivery of the software using the residual method in accordance with SOP 98-9. Some of our software revenues are recognized on a subscription basis where monthly fees are charged on a per usage basis. Revenues from maintenance are recognized ratably over the maintenance term. Revenues from consulting and training are recognized as the services are performed.

Impairment of Long-Lived Assets

We continually review the carrying value of long-lived assets according to Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (“SFAS 144”) including property and equipment to determine whether there are any indications of impairment losses. Recoverability of long-lived assets is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

During 2001 and 2002, we conducted impairment reviews of long-lived assets, primarily storage hardware assets used in delivering our managed services. In conducting both impairment reviews, we separated assets in production (assets to be held and used) from idle assets (assets to be disposed of).

In 2001, we calculated the expected net undiscounted cash flows of each S-POP data center to determine which group of assets was impaired. For those assets where impairment was present, a loss was recognized for the difference between the asset carrying values and fair market values. We determined fair market value based on multiple quotes from third party data storage equipment resellers.

In 2002, we calculated the expected net undiscounted cash flows of our operating business to determine if there was an impairment of our long-lived assets. For those assets used in operations where impairment was present, a loss was recognized for the difference between the asset net book value and the asset fair market value. For assets held for sale, a loss was recognized for the difference between the asset net book value and the asset fair value, less cost to sell. We determined fair market value based on multiple quotes from third party resellers.

Restructuring Charges

We assess the need to record restructuring charges in accordance with Emerging Issues Task Force No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). In accordance with this guidance, management must execute an exit plan that will result in the incurrence of costs that have no future economic benefit. Under the terms of EITF 94-3, a liability for the restructuring charge is recognized in the period management approves the restructuring plan. In January, 2003, we adopted Statement of Financial Accounting Standard No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (“SFAS 146”) which will govern the accounting for any future disposal or exit related charges.

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Allowance for Doubtful Accounts

We evaluate the collectibility of our accounts receivable based on specific identification of uncollectible accounts. In circumstances where we are aware of a customer’s inability to meet its financial obligations to us (e.g., bankruptcy filings and substantial downgrading of credit scores), we record a specific reserve for bad debts against amounts due, to reduce the net recognized receivable to the amount we reasonably believe will be collected. If circumstances change (e.g., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations to us), our estimates of the recoverability of amounts due to us could be reduced by a material amount.

Depreciation

We periodically review the depreciable lives of all our assets in production to determine whether there has been a change in their estimated useful lives. Although our managed services assets generally have economic lives between one and four years, we will adjust their depreciable lives subsequent to the initial purchase when, due to a customers’ financial difficulties or a decrease in demand for our services, assets with no future use are taken out of production. When we believe the assets will no longer be in use for the initial term, we will make a change in estimate of their useful lives.

Provision for Income Taxes

We incurred a net taxable loss in 1998, 1999, 2000, 2001 and 2002, and therefore did not record a provision for income taxes in these periods. As of December 31, 2002, we had a federal and state net operating loss and tax credit carryforwards of $308.1 million, which may be used, subject to limitations and expiration, to offset future state and federal taxable income. We have recorded a valuation allowance against the entire net operating loss and tax credit carryforwards because we are uncertain that we will be able to realize the benefit of the carryforwards before they expire.

Results of Operations

Years ended December 31, 2001 and 2002

Revenues

Revenues decreased from $123.6 million in 2001 to $94.9 million in 2002.

Managed services revenues decreased from $113.5 million in 2001 to $91.1 million in 2002. The decrease in managed services revenues resulted from fewer customers and contracts generating revenue in the 2002 period, which was primarily attributed to customers not renewing their contracts and an overall decrease in demand, which resulted in limited new bookings and lack of growth from existing customers. One managed services customer, Merrill Lynch, accounted for approximately 10% and 18% of total consolidated revenues for the years ended December 31, 2001 and 2002, respectively. Approximately 6% of our total consolidated revenues earned in the year ended December 31, 2002 were recognized from fees paid for non-recurring customer contract renegotiations.

As a result of the decline in demand for our managed services, revenues are expected to decline in 2003 at a faster rate than the 2002 decline. In addition, we also expect our decline in revenues to be more rapid than our decline in our cost of delivery. Therefore, in December, 2002, management decided to exit the managed services business. In 2003, we plan to deliver services to customers with existing contracts and we also plan to work with customers to enable them to manage their data storage environment in-house or transition the services to another service provider. However, we will not be signing new managed services customer contracts or seeking renewals on our existing contracts.

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Professional services revenues decreased from $10.1 million in 2001 to $3.0 million in 2002. The decrease resulted primarily from fewer professional services engagements in 2002 due to the weak economy, the lack of demand for our professional services and our reduced focus on non-software related professional services. We do not anticipate further revenues from professional services due to our decision to exit the professional services business.

Revenues from user license fees were $799,000 in 2002. We did not sell as much software as we had anticipated in 2002, which we believe was due to the immaturity of the storage resource management software market, the overall economic climate and customer requirements that were not aligned with the functionality of our products. We do not expect growth in our user license fees revenue as we have significantly reduced our sales and marketing organizations.

Cost of Revenues

Cost of managed services revenues decreased from $120.2 million in 2001 to $59.9 million in 2002.

The decrease resulted primarily from lower depreciation and maintenance expense related to equipment used to deliver our services. Our cost basis for the infrastructure used in the delivery of our services was lower in 2002 as a result of an asset impairment charge recognized in the fourth quarter of 2001, thus lowering our depreciation expense in the 2002 period. Our depreciation expense was $53.1 million in 2001 compared to $26.3 million in 2002. In addition, we incurred lower floor space costs because we had fewer S-POP data centers located inside hosting service providers. Our S-POP floor space costs were $13.9 million in 2001 compared to $4.7 million in 2002. Finally, because of the decrease in S-POP data centers, our need for personnel inside the data centers decreased, and managed services headcount was reduced from 161 at December 31, 2001 to 69 at December 31, 2002.

Although our managed services revenues declined 20% from 2001 to 2002, our cost of sales declined 50% due to the cost reductions noted above. Accordingly, our gross margins from providing managed services improved from (6%) in 2001 to 34% in 2002. Further, as a result of an asset impairment charge recorded in the quarter ended December 31, 2002 (see “Impairment Charge and Other Related Costs” below), we recognized a charge of $31.6 million to write-down certain managed services assets to fair market value. As a result, we expect our depreciation expense to further decline in 2003.

Cost of professional services revenues decreased from $7.0 million in 2001 to $2.5 million in 2002. The decrease was caused by a reduction in the number of professional services personnel from 79 at the beginning of 2001 to 11 at December 31, 2002. We reduced personnel within professional services because we performed fewer professional services engagements in 2002. Our professional services revenues declined by 47% in the second half of 2002 compared to the first half of 2002. However, our costs remained the same in the respective periods because, in the second half of 2002, we shifted the focus of our professional services organization to software engagements and continued to incur the same costs but we did not recognize significant revenue from these services. As a result, we suffered negative margins in the third and fourth quarters of 2002 and our gross margins from professional services decreased from 31% in 2001 to 18% in 2002. We expect our professional services costs to continue to decrease due to our decision to eliminate the professional services organization in 2003.

Sales and Marketing

Sales and marketing expenses decreased from $56.7 million in 2001 to $17.9 million in 2002. The decrease was caused primarily by reductions in the number of sales and marketing personnel, and the related salaries, benefits and commissions paid to those personnel. In addition, lower fees paid to third parties, such as hosting service providers, who resell or market our services to customers, were incurred because we recognized less revenue from services within third party data centers in 2002. Finally, there was less promotional and advertising activity in 2002.

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General and Administrative

General and administrative expenses decreased from $24.7 million in 2001 to $15.4 million in 2002. The decrease was caused primarily by the reduction in the number of general and administrative personnel and the related salaries, benefits and travel expenses incurred by those personnel. We also recovered $1.5 million of bad debt expense in the first quarter of 2002, which represented an estimate of uncollectible accounts receivable recorded during the third quarter of 2001 as a result of the Chapter 11 Bankruptcy filing by Exodus Communications. Thus, bad debt expense decreased $3.0 million in the 2002 period.

Research and Development

Research and development expenses decreased from $22.0 million in 2001 to $15.3 million in 2002. The decrease in 2002 resulted primarily from the reduction in the number of research and development personnel and the related salaries, benefits and travel expenses incurred by those personnel. Also, we spent less on third party consultants and recruiters. Third party consultants were used in 2001 to assist in the software development projects relating to the enhancement of our software. These projects were completed in 2001 reducing the need for outside consultants.

Amortization of Deferred Stock Compensation

Amortization of deferred stock compensation decreased from $3.9 million in 2001 to $1.3 million in 2002. The decrease in 2002 resulted from the termination of certain compensatory stock options as a result of employee terminations before such options vested.

Impairment Charge and Other Related Costs

Fiscal 2001 Restructuring:

Beginning in 2001, the demand for services in third party data centers weakened, and we recognized that there was less demand for our primary data managed services from enterprise customers. As hosting service providers faced financial difficulties and general economic conditions continued to decline, we focused our attention on selling and marketing our back-up managed services and our software to large enterprise customers, we significantly scaled back our operations inside third party data centers and we stopped marketing our primary data managed services offerings.

As a result, on December 31, 2001, we recorded an impairment charge for managed services related assets of $79.0 million and other one-time charges of $35.4 million. The other one-time charges consisted of the following: fiber related assets and obligations ($12.4 million), the permanent impairment of strategic investments in privately-held companies with businesses complementary to our primary data managed services ($12.1 million), future commitments for office space and data center floor space ($6.6 million), future commitments for assets related to primary data managed services ($3.0 million) and employee termination costs and other charges ($1.3 million). We recovered $1.8 million from a 2001 reserve related to a fiber commitment, which was settled in the fourth quarter of 2002.

At December 31, 2002, we had $10.0 million in accrued expenses related to these charges as summarized below:

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Fiscal 2002 Restructuring:

Minimal demand for our back-up managed services from enterprise customers and low renewal rates from existing customers resulted in anticipated diminishing returns from the managed services business segment. Therefore, in the fourth quarter of 2002, we decided to exit the managed services business. Although we intend to deliver to our existing contracts and help enable our customers to manage their data storage environment in-house or transition the services to other service providers, we are no longer going to sell new services or renew existing contracts. In addition, we significantly reduced headcount as we focused our attention on enhancing, repackaging and modifying the architecture of our software.

As a result of these exit activities, we recorded asset impairment charges and other related costs of $59.7 million in the quarter ended December 31, 2002. The charges consisted of fixed asset impairments of $31.6 million, other asset impairments of $1.0 million and a net restructuring charge of $27.1 million.

We calculated the net undiscounted cash flows of our operating business to determine if there was an impairment of our long-lived assets. To do so, we compared our estimated cash inflows, which consisted of revenues expected to be received on our existing managed services contracts, and compared them to our estimated cash outflows resulting from those operating and general corporate assets associated with delivering the managed services. We distinguished between assets used in operations and assets held for sale. Assets held for sale included only those assets that were available for sale at December 31, 2002. For assets used in operations, we recognized a loss for the difference between the asset net book value and the estimated asset fair market value at December 31, 2002, which accounted for an impairment of $30.0 million. For assets held for sale, we recognized a loss for the difference between the asset net book value and estimated asset fair market value, less cost to sell, which resulted in an impairment of $1.6 million.

In addition, as a result of our exit activities within the managed services business and our overall reduction in personnel, we incurred certain other asset impairments and exit cost liabilities at December 31, 2002. We recognized asset impairments of $1.0 million, which included prepaid equipment maintenance contracts relating to our managed services assets in which the maintenance period extended beyond the assets remaining useful life, and prepaid royalties relating to our STORos StorageManager product. We also recognized restructuring charges of $32.7 million comprised of the following: future charges for contractually committed global office space ($21.0 million), other contractual obligations arising from the termination of leases ($10.1 million) and employee termination costs ($1.6 million). These restructuring charges were offset by the recovery of $1.8 million from a 2001 reserve related to a fiber commitment, which was settled in the fourth quarter of 2002 (see Fiscal 2001 Restructuring above) and a $3.8 million recovery of accruals taken in 2002, resulting in a net restructuring charge of $27.1 million. The accruals that were recovered consisted of data center rent, utilities and marketing related to our managed services business.

At December 31, 2002, we had $32.0 million remaining in accrued expenses relating to these charges, as summarized below (in thousands):

Interest Income

Interest income decreased from $15.1 million in 2001 to $5.7 million in 2002. A lower average cash and investment balance, and lower overall money market and commercial paper interest rates caused interest income to decrease in 2002.

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Interest Expense

Interest expense decreased from $14.7 million in 2001 to $9.4 million in 2002. The decrease resulted from the payment of $75.5 million in capital lease obligations, under which interest expense is incurred.

Other Income

In December, 2002, we recognized a gain of $4.1 million from the sale of one of our earlier strategic investments. We made an earlier strategic investment in a company that we subsequently sold when that company was acquired by a publicly traded company.

Years ended December 31, 2000 and 2001

Revenues

Revenues increased from $48.2 million in 2000 to $123.6 million in 2001.

Managed services revenues increased from $30.7 million in 2000 to $113.5 million in 2001. The increase resulted from more capacity under management. Our customer base in 2001 consisted of companies for whom we managed larger volumes of data, primarily with our back-up services. Accordingly, our average annualized revenue per customer increased each quarter in 2001. Approximately 10% of our total consolidated revenues earned in the year ended December 31, 2001 were recognized from fees paid for non-recurring customer contract renegotiations.

In addition, in 2001, our managed services customer base consisted of a higher ratio of large enterprise customers to Internet-related companies than in 2000. The capacity under management in hosting service provider S-POP data centers declined in the second half of 2001 as a result of the weakening economy and related decline in demand for services within the data centers of hosting service providers.

Professional services revenues decreased from $17.5 million in 2000 to $10.1 million in 2001. The decrease resulted primarily from the decrease in the number of professional services engagements in 2001. In 2000, we performed subcontracted professional services engagements for customers of EMC Corporation and Compaq Computer Corp. that accounted for approximately 14% and 12%, respectively, of our total consolidated revenues. In the second half of 2001, we focused our professional services organization on delivering higher scale and increased value-added services, and we performed fewer sub-contracting engagements. As a result, we performed fewer overall professional services engagements and our professional services revenues declined.

Cost of Revenues

Cost of managed services revenues increased from $73.0 million in 2000 to $120.2 million in 2001.

The increase resulted primarily from higher depreciation and equipment maintenance expense related to equipment used in 2001. We had more capacity under management in 2001 than we did in 2000 and needed to procure more data storage capital equipment to satisfy this increase. However, our gross margins from providing managed services increased from (137%) in 2000 to (6%) in 2001. We achieved this improvement through greater efficiencies from the equipment deployed and personnel required to manage the 2001 storage capacity. Our software allowed our delivery of managed services to scale as capacity under management increased.

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Cost of professional services revenues decreased from $18.9 million in 2000 to $7.0 million in 2001. The decrease was caused by a decrease in the number of professional services personnel in 2001. Our professional services organization was scaled down in the second half of 2001 as a result of our performing fewer subcontracting engagements. Subcontracting engagements required us to maintain a large group of consultants due to the unpredictability of the timing and volume of these engagements at any point in time. As a result of a smaller, more focused professional services group, we were able to increase gross margins from professional services from (8%) in 2000 to 31% in 2001.

Sales and Marketing

Sales and marketing expenses increased from $54.0 million in 2000 to $56.7 million in 2001. The increase was caused primarily by an increase in the number of sales and marketing personnel in the first half of 2001. Also, because revenues increased during 2001, we incurred higher direct sales-related compensation expenses, such as commissions and fees paid to resellers.

General and Administrative

General and administrative expenses increased from $17.9 million in 2000 to $24.7 million in 2001. The increase was primarily caused by higher salary and related costs in 2001 as a result of more general and administrative personnel in the first half of 2001. In addition, we incurred higher insurance costs, professional services fees, and legal costs in 2001, our first full year as a public company, than in 2000. Finally, we incurred higher facilities and related costs in 2001 as we established a new corporate headquarters.

Research and Development

Research and development expenses increased from $11.9 million in 2000 to $22.0 million in 2001. The increase was caused primarily by higher salary and related costs in 2001 as a result of more research and development personnel in 2001, specifically within software development. We also incurred higher consulting costs in 2001 as we initiated software development projects relating to the enhancement of our software. Consulting costs were significant in the first half of 2001, and were reduced in the second half as we continued to add full-time software development personnel. Depreciation of fixed assets, equipment and maintenance costs all increased in 2001 as we procured equipment used in our development, interoperability and quality assurance activities.

Amortization of Deferred Stock Compensation

Amortization of deferred stock compensation decreased from $5.1 million in 2000 to $3.9 million in 2001. The decrease in 2001 resulted from the termination of certain compensatory stock options as a result of employee terminations before such options vested.

Interest Income

Interest income remained unchanged at $15.1 million for 2000 and 2001. A larger average cash and investment balance, offset by lower overall money market and commercial paper interest rates in 2001, caused interest income to remain unchanged.

Interest Expense

Interest expense increased from $7.5 million in 2000 to $14.7 million in 2001. The increase resulted from higher capital lease obligations throughout the year under which interest expense was incurred in 2001.

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Liquidity and Capital Resources

At December 31, 2002, we had cash and cash equivalents, including temporarily restricted cash equivalents, of $89.2 million, marketable investments of $126.4 million and working capital of $100.2 million. Not included in working capital, due to their long term classification, are marketable investments of $46.0 million. All of our marketable investments are represented by government bonds or A1/P1 commercial paper. We invest a portion of our cash in debt instruments that have maturities beyond twelve months. Despite the liquid nature of these marketable investments, they are classified as long term because we have the intent and ability to hold the investments until their maturities in order to maximize our returns.

We have entered into a number of operating leases for our facilities, which expire from 2003 through 2010. We also lease certain data center infrastructure and equipment under capital leases. The following table sets forth information with respect to our long-term obligations payable in cash as of December 31, 2002 (in thousands):

Included in our current and long-term accrued expenses on our balance sheet at December 31, 2002 are $24.1 million, or 53%, of our operating lease commitments. In addition, $29.2 million, representing the principal portion of our capital lease obligations, is reflected on our balance sheet at December 31, 2002.

Net cash used in operating activities totaled $90.4 million in 2000, $48.4 million in 2001 and $545,000 in 2002. Our use of cash in 2000, 2001 and 2002 was primarily attributable to our operating loss generated by our business, which in the year ended December 31, 2000 included an increase in personnel from 276 as of December 31, 1999 to 581 as of December 31, 2000 and the related costs associated with the increase in personnel. Although our operating loss in 2001 was greater than our operating loss in 2000, our operating cash used was significantly less because the loss included $114.3 million in asset impairment and other non-cash charges, higher depreciation and amortization as well as an increase in accrued expenses. In 2002, our net loss was $76.6 million, however, our cash used in operations was only $545,000. The difference relates primarily to non-cash charges to operations during 2002 including $26.3 million of depreciation and amortization, $4.1 million from losses on disposal of property and equipment and $32.6 million of asset impairment charges. Approximately $42.0 million of the 2001 and 2002 asset impairment and other charges is included in accrued expenses at December 31, 2002 and is expected to result in a use of cash in future periods.

Net cash used in investing activities totaled $108.1 million in 2000, $8.6 million in 2001 and $44.4 million in 2002. Our cash used in investing activities in 2000 resulted primarily from our purchase of short-term investments partially offset by maturities of such investments, the purchase of restricted cash equivalents in order to secure certain lease facilities and additional procurement of capital equipment related to our managed services. In 2000, we also made strategic investments in the preferred stock of private companies. In 2001, our use of cash was primarily from our purchase of capital equipment, partially offset by net redemptions of investments. In 2002, the majority of our use of cash was the purchase of investments partially offset by redemptions.

Net cash provided by financing activities totaled $503.7 million in 2000. Net cash used in financing activities totaled $62.7 million in 2001 and $73.9 million in 2002. In 2000, we raised $143.0 million from the sale of convertible preferred stock, $259.9 million from our initial public offering and $116.8 million from our follow-on public offering completed in November, 2000. Our use of cash from financing activities in 2001 and 2002 primarily related to the payment of capital lease obligations associated with storage assets. We paid $64.1 million in 2001 and $75.5 million in 2002 to repay certain equipment lease obligations.

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We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital, lease terminations and capital expenditures for at least the next twelve months. However, we may need to raise additional funds through debt or equity offerings to finance the expansion of our business with regard to new products or services or the acquisition of complementary businesses or technologies. In the event that additional financing is required, we may not be able to raise it on terms acceptable to us, if at all.

Recent Accounting Pronouncements

In August, 2001, the FASB issued Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (“SFAS 144”). SFAS 144, which is effective for all quarters in fiscal years beginning after December 15, 2001, establishes accounting and reporting standards for recognizing and measuring the impairment of long-lived assets. The adoption of this standard did not have a significant impact on our consolidated financial statements.

In June, 2002, the FASB issued Statement of Financial Accounting Standard No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (“SFAS 146”) which addresses the accounting for disposal and exit activities, and supercedes EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 is required to be adopted for disposal activities initiated after December 31, 2002. Under SFAS 146, certain types of restructuring charges will be recorded as they are incurred over time, rather than being accrued at the time of management’s commitment to an exit plan as specified by EITF 94-3. The adoption of this standard is not expected to have a significant impact on our consolidated financial statements.

In December, 2002, the FASB issued Statement of Financial Accounting Standard No. 148, “Accounting for Stock Based Compensation—Transition and Disclosure” (“SFAS 148”). SFAS 148 provides two additional transition methods for entities that adopt the fair value method of accounting for stock based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when, or how an entity adopts the fair value based method of accounting. These disclosures are now required for interim periods in addition to the traditional annual disclosure. SFAS 148 is effective for fiscal periods ending after December 15, 2002. We have provided the new disclosures in “Stock-Based Compensation” in Note 2 of our consolidated financial statements.

Factors Affecting Future Operating Results

As part of our business strategy, we are exiting our primary business segments, which may not be done successfully and may have a negative impact on the viability of our business

In January 2003, we announced that we are exiting the business segments that have historically generated virtually all of our revenue. We announced that we had reduced our workforce by fifty percent and that we are in the process of exiting the managed services business. We also eliminated our professional services business. In 2002, our managed services business and professional services business accounted for $91.1 million and $3.0 million, respectively, or approximately 96% and 3%, respectively, of our total revenues of $94.9 million.

Our workforce reduction included substantial reductions in our sales, marketing and software development organizations, and we have no current plan to rebuild our sales and marketing organizations. Our remaining software development employees are focusing on enhancing, repackaging and modifying the architecture of our software products. However, in 2002, software revenue accounted for only $799,000, or less than 1%, of our total revenues. Our product strategy will require the development or acquisition of new products or technology. These products may not be available on schedule, or at all, and may not be accepted by our customers and potential customers. If we are unable to successfully execute on this plan to exit and downscale our existing business segments, our business, operating results and financial condition will be seriously harmed. Our prospects based on this new business model are uncertain.

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In addition, in March, 2003 we announced that we had engaged investment banks to identify and assess all available alternatives to maximize shareholder value. We cannot assure you that these engagements will result in the consummation of a transaction involving us.

If we are not successful in implementing our business strategy, including the acquisition of or partnering with other companies, our business will be negatively impacted

In early 2003, we announced our intention to acquire or partner with companies that have revenues, established channels and leading technology and that we had engaged investment bankers to identify and assess all alternatives for maximizing shareholder value. However, we may not be successful in identifying appropriate companies, in completing acquisitions or partnerships or engaging in other transactions. Acquisitions, partnerships and related transactions involve a number of risks, including:

Our prospects are uncertain, in part, because acquiring or partnering with other businesses as a means of achieving growth is inherently risky. If we are unable to successfully execute on this strategic plan or to successfully pursue other alternatives, our future revenues will be uncertain and our business, operating results and financial condition may be materially and adversely affected.

Our business is difficult to evaluate because we have a limited operating history

Due to the changing nature of our business strategy, our limited operating history and the emerging nature of our markets, products and services, it is difficult to evaluate our business and prospects. We commenced operations in October, 1998. We began offering our managed services in May, 1999 and derived 12% of our revenues in 1999, 64% of our revenues in 2000, 92% of our revenues in 2001, and 96% of our revenues in 2002 from these services. Although we shifted our focus from services to software beginning in 2001, none of our revenues in 2001 and less than 1% of our revenues in 2002 were derived from the direct licensing of software products. The storage management software market is relatively new, highly competitive, and may not continue to grow or be sustainable. Our existing or potential customers may choose to purchase storage management software from a competitor, may choose not to purchase or may choose to develop the software themselves. It is possible that our software may never achieve significant market acceptance. If the storage management software market does not mature, or develops more slowly than we expect, our business, results of operations and financial condition will be seriously harmed.

We have never achieved profitability

We have incurred losses in each quarter since our inception. We experienced net losses of $23.9 million in 1999, $124.9 million in 2000, $225.0 million in 2001 and $76.6 million in 2002. As of December 31, 2002, we had an accumulated deficit of $450.9 million. We are unable to project that our revenues will grow or that we will generate sufficient revenues to achieve profitability. We believe that we will incur losses in the future. We will need to generate higher revenues in order to achieve and maintain profitability. If our revenues do not grow, grow slowly or continue to decrease, or if our operating or capital expenses increase more than we expect or cannot be further reduced in the event of lower revenues, our business will be materially and adversely affected.

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Our stock price has been depressed and could result in substantial losses for investors and litigation against us

The market for technology stocks, and the price of our common stock in the public market, has been depressed. The following factors could cause our stock price to remain depressed and could result in substantial losses for investors and litigation against us:

We may not be able to maintain our listing on the Nasdaq National Market and, if we fail to do so, the price and liquidity of our common stock may decline

The Nasdaq Stock Market has quantitative maintenance criteria for the continued listing of common stock on the Nasdaq National Market. These criteria contain several requirements, including a requirement that we maintain a minimum bid price per share of $1.00. Under the Nasdaq criteria, if our minimum closing bid price is below $1.00 for more than 30 consecutive trading days, our common stock may be subject to delisting from the Nasdaq National Market. On March 19, 2003, we were notified by Nasdaq that our minimum bid price had closed below $1.00 for 30 consecutive trading days and that we have until September 15, 2003 to regain compliance. We are also required to comply with the Nasdaq National Market’s requirements that we maintain a minimum of $10 million in stockholders’ equity, a public float of at least 750,000 shares, and a market capitalization of at least $5 million. Additionally, we must comply with the Nasdaq National Market’s corporate governance requirements, including a requirement that our audit committee be comprised of at least three independent members. We do not currently comply with this requirement as our audit committee consists of only one independent director. There can be no assurance that we will be able to regain compliance with the minimum bid requirement or continue to comply with these other quantitative maintenance criteria, corporate governance criteria, or any other Nasdaq National Market rules in the future. If we fail to maintain continued listing on the Nasdaq National Market and must move to a market with less liquidity, our financial condition could be harmed and our stock price would likely decline. If we are delisted, it could have a material adverse effect on the market price of, and the liquidity of the trading market for, our common stock.

Quarterly and annual operating results and revenue are subject to fluctuations caused by many factors, which may cause our stock price to decline and could cause long-term harm to our business

Quarterly and annual results of operations are affected by a number of factors, which in turn could adversely affect our revenue, profitability or cash flow in the future and could cause serious harm to our business. These factors include:

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If we are unable to collect fees from Cable & Wireless, our revenues could be adversely affected

Although we are exiting the managed services business, a significant portion of our revenues is derived from managed services provided under our joint marketing and services agreement with Cable & Wireless. As we exit the managed services business, if our relationship with Cable & Wireless is terminated, or if we are otherwise unable to collect revenue from Cable & Wireless, its subsidiaries, or from these customers, our business and results of operations would be substantially harmed.

The storage management software market is highly competitive, and our competition includes established storage hardware and software vendors against whom we may not be able to compete successfully

The storage management software market is highly competitive and is marked by rapid and substantial technological change, the emergence of new competitive companies, products, services and evolving technical standards. To be competitive, we must develop or acquire software products that are attractive to our existing and potential customers. We may be unsuccessful in our attempts to enhance our software products in ways that meet the needs of our customers or that are timely. We currently face competition from hardware and software vendors whose products compete with our software products and who also provide consulting and related services that we do not offer. Many of these vendors have longer operating histories, greater name recognition and substantially greater financial, technical and marketing resources than we have. Many of these vendors also have more extensive customer bases, broader customer relationships and broader industry alliances than us. Increased competition from any of these sources could result in a loss of customers and market share. Our current and future competitors could introduce products with superior features and functionality, and could bundle their services and software with other products in order to compete. Additionally, price competition, particularly from competitors with greater resources, could require us to reduce the prices for our software. Any of these results could seriously harm our business and financial condition.

Our future software products, if successfully developed, may become obsolete if we do not respond rapidly to technological and market changes

The storage management software market is and will continue to be characterized by rapid technological change and frequent new product introductions. We may be unable to respond quickly or effectively to these developments. If competitors introduce products or technologies that are better than ours or that gain greater market acceptance, or if new industry standards emerge, our software products may become obsolete, which would materially harm our business and results of operations. In developing our software we have made, and will continue to make, assumptions about the standards that our customers, competitors, and the industry in general,

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may adopt. If the standards adopted are different from those that we may now or in the future promote or support, market acceptance of our software may be significantly reduced or delayed, and our business will be harmed. In addition, the introduction of products incorporating new technologies and the emergence of new industry standards could render our existing products obsolete. The development of enhanced products is a complex and uncertain process that requires the accurate anticipation of technological and market trends. A failure to anticipate and meet changing customer and technological requirements could materially adversely affect our business, results of operations and financial condition.

We might experience significant defects in our products

Software products frequently contain errors or failures, especially when first introduced or when new versions are released. We might experience significant errors or failures in our products, or they might not work with other hardware or software as expected, which could delay the enhancement of our products, or which could adversely affect market acceptance of our products. Any significant product errors or design flaws would slow the adoption of our products and cause damage to our reputation, which would seriously harm our business. If customers were dissatisfied with product functionality or performance, we could lose revenue or be subject to liability for service or warranty costs and claims, and our business, operating results and financial condition could be adversely affected.

Certain software is licensed from third parties

Some of our products contain software licensed from third parties. Some of these licenses may not be available to us in the future or on terms that are acceptable or allow our products to remain competitive. Our inability to use any of this third party software could result in shipment delays, delays in the development of future products or enhancements of existing products, or other disruptions in our business, which could materially and adversely affect our business, financial condition and operating results.

We may rely on enterprise transactions and indirect sales channels in the future

We may market our software products in the future to large enterprise customers. However, we have not been successful in selling to such customers to date and we may be unable to do so in the future. Such failure could seriously harm our business, operating results and financial condition. Many of the large organizations that we may target as customers have lowered their rate of spending on enterprise software and have chosen to consolidate the number of vendors from which they buy products and services. Due to the large size of enterprise transactions, if orders forecasted for a specific transaction for a particular quarter are not realized in that quarter, our operating results for that quarter could be seriously harmed.

We may also rely on distributors, systems integrators, other software makers, and hardware vendors for the marketing and distribution of our products. Agreements with such resellers may not be exclusive and may be terminable by either party without cause. These resellers might also market products that are competitive with ours. The development of business relationships with resellers will require a significant amount of resources. Any failure of these reseller arrangements, or any failure to develop such reseller arrangements, could have a materially adverse effect on our business, financial conditions and operating results.

We disclose pro forma information

We prepare and release quarterly unaudited financial statements prepared in accordance with generally accepted accounting principles (“GAAP”). We also disclose and discuss certain pro forma information in the related earnings release and investor conference call. This pro forma financial information excludes or may exclude certain special charges and other costs. We believe the disclosure of the pro forma financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to

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carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases, and to compare the GAAP financial information with the pro forma financial results disclosed in our quarterly earnings releases and investor calls.

A class action lawsuit has been filed against us, and additional suits may be filed, which may result in litigation that is costly to defend and the outcome of which may harm our business

We and several of our officers were named as defendants in a purported class action complaint that has been filed on behalf of certain persons who purchased our common stock between June 30, 2000 and December 6, 2000. This complaint alleges violations of the Securities Act of 1933 and the Securities Exchange Act of 1934, each as amended. This complaint primarily alleges that there was undisclosed compensation received by our underwriters from purchasers of our common stock in connection with our initial public offering.

We can provide no assurance as to the outcome of this matter. Any conclusion of this matter in a manner adverse to us could have a material adverse affect on our financial position and results of operation. In addition, the costs to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial. We may also be subject to other class action litigation in the future and in the ordinary course of business we may also become involved in litigation, administrative proceedings and governmental proceedings. Such matters can be time-consuming and could substantially divert the attention of our management and our resources in general and could have a materially adverse effect on our business and results of operations.

We may be unable to develop and protect our proprietary technology

We rely on a combination of copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We do not have any significant issued patents. We cannot be certain that any future application, if any, will be granted, that any future patent will not be challenged, invalidated or circumvented, or that rights granted under any patent issued to us will afford us a competitive advantage. Our intellectual property may be subject to even greater risk in foreign jurisdictions. The laws of many countries do not protect proprietary rights to the same extent as the laws of the United States.

Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. Any such litigation could result in substantial costs and diversion of resources. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar information or technology. Our inability to continue to expand our services or to develop and adequately protect our proprietary technology would have a material adverse effect on our business and financial condition and our ability to compete effectively.

We may not be able to obtain additional financing

Our future business activities and future acquisitions, if any, may require additional financing. We cannot be sure that we will be able to secure additional financing on acceptable terms. Additionally, holders of any future debt instruments may have rights senior to those of the holders of our common stock, and any future issuance of common or preferred stock would result in dilution of existing stockholders’ equity interests.

Provisions of our charter documents may have anti-takeover effects that could prevent a change in control even if the change in control would be beneficial to our stockholders

Provisions of our amended and restated certificate of incorporation, by-laws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. For example, our Board of Directors is staggered in three classes, so that only a portion of the directors may be replaced at any annual meeting. Our by-laws limit the persons authorized to call special meetings of stockholders and require advance notice for stockholders to submit proposals for consideration at stockholder meetings. Additionally, our certificate of incorporation permits our Board of Directors to authorize the issuance of preferred stock without stockholder approval that could have the effect not only of delaying or preventing an acquisition, but also of adversely affecting the price of our common stock.

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Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

Nearly all of our revenues to date have been denominated in U.S. dollars and are primarily from customers located in the United States. Although we also operate outside the United States, revenues from international customers to date have not been significant, and we expect those revenues to continue to decrease for the foreseeable future. We incur costs for our overseas operations in the local currency of those offices for staffing, rent, telecommunications and other services. As a result, our operating results could become subject to fluctuations based upon changes in the exchange rates of those currencies in relation to the U.S. dollar. Although currency fluctuations are currently not a material risk to our operating results, we will continue to monitor our exposure to currency fluctuations and, when appropriate, use financial hedging techniques to minimize the effect of these fluctuations in the future. We do not currently utilize any derivative financial instruments or derivative commodity instruments.

Our interest income is sensitive to changes in the general level of U.S. interest rates. We typically do not attempt to reduce or eliminate our market risk on our investments because substantially all of our investments are in fixed-rate securities with an average maturity not exceeding twelve months. The fair value of our investment portfolio or related income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due to the fixed-rate, short-term nature of our investment portfolio.

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Item 8.    Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT AUDITORS

Board of Directors and Stockholders

StorageNetworks, Inc.

We have audited the accompanying consolidated balance sheets of StorageNetworks, Inc. (the Company) as of December 31, 2001 and 2002, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of StorageNetworks, Inc. at December 31, 2001 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion the related financial statement schedule when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

/s/ Ernst & Young LLP

Boston, Massachusetts

January 29, 2003, except for the matters discussed in Note 12 as to which the date is March 24, 2003

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StorageNetworks, Inc.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

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StorageNetworks, Inc.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

See accompanying notes to consolidated financial statements.

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StorageNetworks, Inc.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)