Back to GetFilings.com
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES
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)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
for the fiscal year ended December 31, 1998
OR
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
for the transition period from to .
----------------
Commission file number 333-49397
Focal Communications Corporation
(Exact name of registrant as specified in its charter)
Delaware 36-4167094
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or
organization)
200 North LaSalle Street,
Suite 1100, Chicago, Illinois 60601
(Address of principal executive (Zip Code)
offices)
Registrant's telephone number, including area code: (312) 895-8400
Securities registered pursuant to Section 12(b) of the Act: None.
Securities registered pursuant to Section 12(g) of the Act: None.
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 registrant's knowledge, in definitive proxy or information
statements incorporated by reference on Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
As of February 28, 1999, there was no established trading market for any
class of the Registrant's common stock.
As of February 28, 1999, there were 75,674 shares of the Registrant's Class
A common stock, 22,000 shares of the Registrant's Class B common stock and no
shares of the Registrant's Class C common stock, each $.01 par value per
share, outstanding.
Documents Incorporated by Reference
None.
Index of Exhibits is located on page 34.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
We have made statements in this Annual Report on Form 10-K that are not
historical facts. These "forward-looking statements" can be identified by the
use of terminology such as "believes," "expects," "may," "will," "should" or
"anticipates" or comparable terminology. These forward-looking statements
include, among others, statements concerning:
. Our business strategy and competitive advantages
. Statements regarding the growth of the telecommunications industry and
our business
. The markets for our services and products
. Forecasts of when we will enter particular markets or begin offering
particular services
. Our anticipated capital expenditures and funding requirements
. Anticipated regulatory developments
These statements are only predictions. You should be aware that these
forward-looking statements are subject to risks and uncertainties, including
financial, regulatory developments, industry growth and trend projections,
that could cause actual events or results to differ materially from those
expressed or implied by the statements. The most important factors that could
affect these statements or prevent us from achieving our stated goals include,
but are not limited to, our failure to:
. Prevail in legal and regulatory proceedings regarding reciprocal
compensation for Internet-related calls or changes to regulations that
govern reciprocal compensation
. Successfully expand our operations into new geographic markets on a
timely and cost-effective basis
. Respond to competitors in our existing and planned markets
. Execute and renew interconnection agreements with incumbent carriers on
terms satisfactory to us
. Maintain our agreements for transport facilities
. Maintain acceptance of our services by new and existing customers
. Attract and retain talented employees
. Obtain and maintain any required governmental authorizations, franchises
and permits, all in a timely manner, at reasonable costs and on
satisfactory terms and conditions
. Respond effectively to regulatory, legislative and judicial developments
. Manage administrative, technical or operational issues presented by our
expansion plans
. Address Year 2000 remediation issues
1
PART I
ITEM 1. BUSINESS
Except as otherwise required by the context, references in this report to
the "Company," "Focal," "we," "us," or "our" refer to the combined business of
Focal Communications Corporation and all of its subsidiaries.
Introduction
Focal is a competitive local exchange carrier, or CLEC, that provides local
telecommunications services to large corporations, value-added resellers
(VARs), and information service providers (including Internet service
providers (ISPs)) in large metropolitan markets. We began operations in 1996,
initiated service first in Chicago in May 1997 and currently offer service in
the following 12 markets:
Chicago New York Philadelphia
San Francisco San Jose Oakland
Orange County, California
Los Angeles Northern Virginia
Washington, D.C. Boston Northern New Jersey
As part of our expansion, we plan to offer services in Dallas, Ft. Worth,
Detroit, and Seattle by the end of 1999. An inability to effectively manage
our planned expansion could adversely affect our operations.
We have chosen to initially do business only in large metropolitan markets
with a high concentration of telecommunications-intensive customers. We select
our target geographical markets using several criteria:
.Sufficient market size
.Favorable state regulatory environment
.The existence of multiple fiber transport providers with extensive
networks
.The existence of or ability to obtain attractive interconnection
agreements with the incumbent local exchange carriers, or ILECs
We believe telecommunications-intensive users in large metropolitan markets
are inadequately supplied with highly reliable, local switched services. We
also believe that these types of users will increasingly demand diversity in
local telecommunications providers as they have already done in long distance
and private-line telecommunications services.
We believe that our primary competitor in each of our target markets is the
ILEC. Most CLECs initially chose to compete in smaller markets, effectively
ceding the large metropolitan markets to a select group of early generation
CLECs (i.e., MFS Communications and Teleport Communications Group). Moreover,
the vast majority of CLECs provide bundled communications services to
primarily small- and medium-sized business customers. Our experience has
supported our belief that, unlike residential and small- to medium-sized
businesses who may prefer "one-stop" telecommunications providers, large
telecommunications-intensive users will purchase different types of
telecommunications services from different providers. As such, we believe that
there are few competitors offering telecommunications-intensive users a stand-
alone alternative to ILEC-switched local services. We believe that we have a
competitive advantage over other local service providers as a result of our
decision to provide diverse, reliable and innovative local switched services
to this significant and underserved market segment.
As of December 31, 1998, we had sold 68,184 access lines, of which 52,011
were installed and in service. This compares to 13,411 lines sold and 7,394
lines installed and in service as of December 31, 1997.
2
We were incorporated in Delaware in June 1997 in connection with a Plan of
Reorganization and Agreement dated June 12, 1997, whereby we became the
holding company of Focal Communications of Illinois and each of its
subsidiaries. Our principal executive offices are located at 200 North LaSalle
Street, Suite 1100, Chicago, Illinois 60601 and our phone number is (312) 895-
8400.
Networks
Focal has initially chosen to design networks using a "smart-build"
approach, which involves purchasing and maintaining our own switches while
leasing fiber transport facilities on an as-needed basis. This smart-build
approach is possible because there are multiple vendors of fiber transport
facilities in each of our large metropolitan markets, both current and
planned. Our switch-based, leased transport network architecture allows us to:
.Reduce the time and money required to launch a new market
.Minimize financial risk associated with under-utilized networks
.Generate revenue and cash flow more quickly
We lease 100% of our transport facilities from multiple vendors in each of
our markets. This provides us with added negotiating leverage in obtaining
favorable terms and allows us to offer our customers both redundancy and
diversity. In addition, we have designed our networks to maximize call
completion and significantly reduce the likelihood of blocked calls, which
helps us satisfy the needs of our high-volume corporate customers.
We have the flexibility to add or subtract leased transport capacity on an
incremental basis with the addition or loss of customers. We believe that the
quantity of existing and planned fiber transport facilities available from
numerous carriers will be sufficient to satisfy our need for leased transport
facilities and permit us to obtain these facilities at competitive prices for
the foreseeable future. The fiber transport providers in our current and
planned markets compete with each other for our business in order to maximize
the return on their fixed-asset networks, which enables us to obtain
competitive pricing. Because the costs of building and maintaining fiber
networks are high and the markets in which we compete are relatively well-
supplied, the fact that many of our fiber providers are our competitors in the
local switched services market does not affect our ability to obtain
competitively-priced transport facility leases. In addition, because each of
our fiber transport capacity providers is a common carrier, they are required
to make their transport services available to us on terms no less favorable
than those provided to similar customers. However, any unexpected material
increase in the cost of leased fiber transport facilities could have a
material adverse effect on our results.
We currently lease a majority of our transport facilities from one carrier.
Although we believe that adequate alternative sources of transport facilities
exist, should this carrier's facilities become unavailable, our business could
be disrupted.
We are a party to a products purchase agreement with Northern Telecom that
expires March 5, 2001. This agreement establishes terms and conditions for our
purchase of Northern Telecom products, including switches and related
software, and services. This contract requires us to place orders for the
delivery and installation of Northern Telecom products, including DMS-500
central office switches, in a minimum amount of $15 million every 12 months,
or an aggregate over the term of the agreement of $45 million, at pre-
established prices. If we fail to meet our minimum requirements on an annual
basis, we are required to pay a penalty of 15% of the difference between our
requirement and the amount actually purchased. If we exceed our minimum annual
requirement, we receive a credit towards our purchase of Northern Telecom
software. We are required to purchase all of our requirements of particular
switching equipment from Northern Telecom during the term of the agreement,
with limited exceptions.
We have also entered into a software license agreement with DPI/TFS, Inc.,
dated as of April 10, 1997, under which we were granted a personal, non-
exclusive and non-transferable license to use select DPI/TFS
3
billing software. We paid an initial license fee and are required to pay
specified incremental use fees based on the number of access lines for which
we use the software. Unless terminated by us or DPI/TFS as permitted by the
agreement, the license is perpetual.
Products and Services
We primarily offer local switched services to our customers. These services
can generally be segmented into inbound and outbound calling services.
Inbound Services. Our basic, inbound service allows for the completion of
calls to a new phone number we supply to our customers. Alternatively, local
number portability ("LNP") allows us to provide inbound services using a
customer's existing phone number. While LNP is occasionally unavailable and
cumbersome to implement, it permits us to serve customers without altering
their existing phone numbers.
We offer a number of inbound calling applications:
.Direct inward dial service allows inbound calls to reach a particular
station on a customer's phone system without operator intervention. We
market direct inward dial service to our corporate customers as both a
primary and backup service. As a primary service, the customer uses Focal
numbers where a new line and number are needed, as when a customer hires
a new employee. As a backup service, we can implement an alternative
numbering plan for the customer in case the customer's primary service
from the ILEC or another CLEC is interrupted.
.Focal Virtual Office is designed to allow a corporate customer's employees
to dial-in to the corporate customer's local area network by a telephone
number in the employee's unmetered local calling area. This allows the
employee to access the local area network without incurring per minute
charges and enables our corporate customer to avoid the higher cost of
maintaining region-wide 800 service for local area network access. We are
planning future enhancements to our inbound services that are expected to
increase the screening capabilities and add another layer of security to
a corporate customer's local area network.
.Focal Multi-Exchange Service(TM), a variant of the Focal Virtual Office
service marketed to ISPs, allows ISP customers to cost-effectively access
the ISP's remote access servers.
Outbound Services. Our basic outbound services allow local and toll calls
to be completed within a metropolitan region and long distance calls to be
completed worldwide. This direct outward dial service is utilized by end users
in several ways. As a primary service, a customer uses Focal as a replacement
for the ILEC in placing calls to destinations within the region. In our least
cost routing application, a customer can utilize our service in conjunction
with its existing ILEC service to route calls using whichever carrier is least
expensive for that particular type of call or time of day.
Our other outbound applications include outbound 800 calling and long
distance overflow service. In order to encourage customers to use our service,
we offer customers an incentive for letting us provide their outbound 800
calls. In the case of long distance overflow service, we act as a backup to
the customer's existing long distance carrier in order to optimize the number
of direct, special access lines installed from the customer's premises to the
long distance carrier's network.
FocalFLOW is an outbound service marketed to VARs that need to be able to
switch outbound traffic among multiple long distance or international
carriers. We partition our central office switch so VARs can utilize the core
switching capability of our equipment at reasonable per minute or per port
cost.
All of the services described above are commonly provisioned over a high-
speed digital communications circuit called a T-1 facility and interface
directly with our customers' private branch exchange or other customer-owned
equipment. This averts our need to provide multiplexing equipment, which
combines a number of communications paths onto one path, at the customer's
location. This is possible due to the high call volume
4
generated by the large telecommunications-intensive customers we target. Our
ability to directly interface existing customer equipment further minimizes
our capital investment and maximizes our overall return on capital.
We also offer our customers the ability to colocate equipment in our
switching and operations centers. Equipment colocation benefits the customer
by allowing it to inexpensively house its equipment without having to maintain
environmentally controlled space. In addition, customers that colocate qualify
for special discounts on our monthly line rates. This service is particularly
well-suited to our ISP customers, who frequently operate remote access servers
and routers in conjunction with our switched services.
Sales and Marketing
Our primary objective is to satisfy the need for highly reliable, local
switched telecommunications services for telecommunications-intensive users in
the large metropolitan markets in which we operate by providing diverse,
reliable and sophisticated services.
Diversity. Focal provides diversity to telecommunications-intensive users
by delivering highly reliable, local switched telecommunications services as
an alternative to the ILEC. This type of diversity already exists in other
areas of telecommunications services, such as long distance.
Telecommunications-intensive customers clearly embrace the benefits of
diversity, particularly because redundancy minimizes the effects of facilities
failures and maximizes competitive pricing. As a result, most of our target
customers typically have multiple long distance providers, multiple equipment
vendors and multiple local private-line providers.
Reliability. We provide reliable service to telecommunications-intensive
users, who are highly sensitive to the potential effects of facilities
failures, by designing our networks around the same theme of diversity that we
advocate for our customers. Although local switched services are perceived as
simple, basic services, the delivery of highly reliable, local switched
services requires sophisticated systems. We have engineered our switching and
transport networks to meet the demanding traffic and reliability requirements
of our target customers. Our network strategy is based on developing and
operating a robust, reliable, high-throughput local network relative to the
ILECs and other CLECs. Because we are a relatively new entrant to the markets
we serve, we must meet or exceed the performance quality of the existing local
networks in order to attract telecommunications-intensive users to our
networks. Unlike smaller users that tend to pre-qualify vendors based on
price, we believe that telecommunications-intensive customers choose vendors
based on the performance of their networks, and specifically, their
reliability. As a result, the design and operation of our network is a key
success factor in our business development process.
In choosing our equipment, we conducted extensive research to identify the
best hardware for the high-volume users that we serve. As a result of this
research, we selected Northern Telecom's DMS-500 SuperNode central office
switches, which we have engineered to reduce significantly the likelihood of
blocked calls and to maximize call completion. As such, our customers are
unlikely to find themselves unable to complete or receive calls due to
limitations inherent in our switches. We also engineer our fiber capacity to
avoid blocking. We typically connect to a large number of switches in the
ILEC's network. This increases call completion even if a portion of the ILEC's
trunking network becomes blocked. We optimize the configuration of our network
by implementing overflow routing between the ILEC's network and ours, where
available. Because the customer base of the ILECs and other CLECs is not
typically as telecommunications-intensive as ours, we specifically engineered
our network to accommodate traffic volumes per customer far in excess of that
which the ILECs or other CLECs typically experience. In addition, we enhance
our reliability by delivering service from our switches to customers over
multiple fiber transport systems.
We have also implemented safeguards in our network design to maximize
reliability. The DMS-500 switch allows us to distribute customer traffic
across multiple bays of equipment, thus minimizing the effects of any customer
outage. In addition, these switches were engineered by Northern Telecom with
fully redundant processors and memory in the event of a temporary failure. Our
disaster prevention strategy includes service
5
from multiple power sources where available, on-site battery backup and diesel
generator power at each switching facility to protect against failures of our
electrical service.
Any expansion or adaptation of our networks will require substantial
additional financial, operational, technical and managerial resources. These
resources could include additional hardware or software to enable our network
and switching facilities to manage increased traffic loads and the addition of
new customers. If we are unable to expand or adapt our networks to respond to
these developments on a timely basis and at commercially reasonable costs, our
business will be materially adversely affected. Our business could also be
adversely affected if we fail to keep pace with the rapid technological
changes to which our industry is prone.
Sophistication. Our target customers are knowledgeable, sophisticated
buyers of telecommunications services that demand a high level of
professionalism throughout a vendor's organization. We believe that the
technical sophistication of our management and operations team has been a
critical factor in our initial success and will continue to differentiate us
from our competitors. Execution of our strategy of penetrating
telecommunications-intensive accounts requires a well-experienced team of
sales professionals. As a result, attracting and retaining experienced sales
professionals is important to our overall success. Our sales professionals'
compensation is structured to retain these valuable employees through the
grant of stock options and cash compensation incentives based on our revenue
and operating cash flow objectives.
Financial Information about Industry Segments
Focal operates in a single industry segment, telecommunication services.
Operations are managed and financial performance is evaluated based on the
delivery of multiple telecommunication services to customers over fiber
networks. See our Consolidated Financial Statements included in Item 8 of this
report for information related to revenues and operating profit or loss.
Significant Relationships
Ameritech Illinois accounted for approximately 81% of our consolidated
revenues in 1997. Ameritech Illinois and Bell Atlantic New York accounted for
approximately 59% and 16% of our consolidated revenues in 1998, respectively.
The revenues from these carriers in 1997 and 1998 are the result of
interconnection agreements we have entered into with them that provide for
reciprocal compensation relating to the transport and termination of
telecommunications traffic. Further discussion regarding reciprocal
compensation is located in Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations," in this report. No other
entities accounted for more than 10% of 1997 or 1998 revenues.
Competition
Our industry is highly competitive. We face a variety of existing and
potential competitors, including:
. The ILECs in our current and target markets
. Other CLECs
. Long distance carriers
. Potential market entrants, including cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and
private networks built by large end-users
Our primary competitor in each of our existing markets is the ILEC.
Examples include BellSouth, Bell Atlantic, Ameritech, U S WEST, SBC and GTE.
These ILECs are generally required to file their prices with the states in
their service areas. Any price changes must be reflected in these filings. The
ILECs have also generally been given the flexibility to respond to competition
with lower pricing. In most cases, proposals for lower pricing must also be
filed with the applicable state utility commissions and the pricing must be
made available to
6
similarly situated customers. As a result, while the ILECs in many states may
have some pricing flexibility for local services, they must usually file any
special pricing plans offered and make these plans available to all of their
similarly-situated customers. We believe this provides a disincentive for the
ILECs to significantly vary or discount prices even in competitive situations.
However, as a CLEC, similar obligations apply to us. See "--Regulation--State
Regulation."
Certain Regional Bell Operating Companies recently requested that the
Federal Communications Commission (the "FCC") relax regulation of their
provision of advanced data networks, which may also be used for voice traffic.
While the FCC has denied those requests, it has initiated rule-making that is
intended to establish the procedures and safeguards necessary before these
ILECs could, through separate subsidiary companies, provide these services on
a largely deregulated basis. If adopted, these rules may provide additional
opportunities for competition from these ILECs.
The ILECs offer a wider variety of services in a broader geographic area
than ours and have much greater resources than we do. This may encourage an
ILEC to subsidize the pricing for services with which we compete with the
profits of other services in which the ILEC remains the dominant provider.
Subsidies of this type could have a material adverse effect on our results. We
believe competition has limited the number of services dominated by ILECs. In
addition, state regulators have exercised their enforcement powers in a way
that makes it unlikely the ILECs would be able to successfully pursue this
type of protective pricing strategy for an extended period.
In addition to competition from ILECs, we also face competition from a
growing number of other CLECs. There are typically several other CLECs
competing in each metropolitan market we serve or plan to enter. Examples of
CLECs in our markets include Allegiance Telecom, Inc., NEXTLINK
Communications, Inc., MFS Communications and Teleport Communications Group. In
some instances, these CLECs have resources greater than ours and offer a wider
range of services. Many of the CLECs in our markets target small- and medium-
sized business customers, which differs from our target customer base of
large, telecommunications-intensive users. Although CLECs overall have only
captured approximately two to three percent of local access lines, we
nevertheless compete to some extent with other CLECs in our customer segments.
In addition to ILECs and other CLECs, we are increasingly competing with
long distance carriers. A number of long distance carriers have introduced
local telecommunications services to compete with us and the ILECs. These
services include toll calling and other local calling services, which are
often packaged with the carrier's long distance service. While we do not
believe the packaging aspect of the service is particularly attractive to the
telecommunications-intensive customers we target, large long distance carriers
enjoy certain competitive advantages due to their vast financial resources and
brand name recognition. In addition, we believe there is a risk the long
distance carriers may subsidize the pricing of their local services with
profits from long distance services. We anticipate that the entry of the
Regional Bell Operating Companies into the long distance market will reduce
the risk of this type of activity by reducing the profitability of the long
distance carrier's long distance minutes. Further, to the extent the long
distance carrier purchases our service on a wholesale basis and rebundles it
at a subsidized rate, we may benefit as the subsidized, wholesale service
could result in higher market penetration than we would otherwise have
achieved. In addition, we have displaced long distance carriers where the
customer was dissatisfied with the quality of the long distance carrier's
local service. We expect our reputation for exceptional service quality and
customer care will continue to result in us displacing the long distance
carrier as the primary alternative to the ILEC in competitive situations. In
addition, we expect that some of our recent and proposed service offerings,
which enable long distance calls to be priced like local calls, will increase
our level of competition with long distance providers. We also expect to face
competition from potential market entrants.
For a description of how we compete, see "--Sales and Marketing."
7
Regulation
The following summary of regulatory developments and legislation is not
complete. It does not describe all present and proposed federal, state and
local regulation and legislation affecting the telecommunications industry.
Existing federal and state regulations are currently subject to judicial
proceedings, legislative hearings and administrative proposals that could
change, in varying degrees, the manner in which our industry operates. We
cannot predict the outcome of these proceedings or their impact on the
telecommunications industry or us.
Overview. Our services are subject to varying degrees of federal, state and
local regulation. The FCC exercises jurisdiction over all the facilities of,
and services offered by, telecommunications common carriers like us to the
extent we use our facilities to provide, originate or terminate interstate or
international communications. State regulatory commissions retain jurisdiction
over most of the same facilities and services to the extent they are used to
provide, originate or terminate intrastate communications. The decisions of
these regulatory bodies are often subject to judicial review, which makes it
difficult for us to predict outcomes in this area.
Federal Regulation. We must comply with the requirements of common carriage
under the Communications Act of 1934. Comprehensive amendments to the
Communications Act of 1934 were made by the Telecommunications Act of 1996,
referred to as the Telecom Act, which substantially altered both federal and
state regulation of the telecommunications industry. The purpose of this
legislation was to deregulate the telecommunications industry to a significant
degree, thereby fostering increased competition among carriers. Because
implementation of the Telecom Act is subject to numerous federal and state
policy rule-making and judicial review, we cannot predict with certainty what
its ultimate effect on us will be. We believe, however, that it will take
years for our industry to feel the full impact of the Telecom Act. Even so, it
is already clear that this legislation creates both opportunities and
challenges for us. One challenge is the lack of effective enforcement
mechanisms designed to speed resolutions of Telecom Act-related disputes
between competitors.
Under the Telecom Act, any entity may enter a telecommunications market,
subject to reasonable state safety, quality and consumer protection
regulations. The Telecom Act makes local markets accessible by requiring the
ILEC to permit interconnection to its network and establishing ILEC
obligations with respect to:
.Colocation of equipment. This allows companies like us to install and
maintain our own network termination equipment in ILEC central offices.
.Reciprocal compensation. This requires the ILECs and CLECs to compensate
each other for telecommunications traffic, which originates on the
network of one carrier and is sent to the network of the other.
. Resale of service offerings. This requires the ILEC to establish
wholesale rates for services it provides to end-users at retail rates to
promote resale by CLECs.
. Interconnection. This requires the ILECs to permit their competitors to
interconnect with ILEC facilities at any technically feasible point in
the ILECs' networks.
. Access to unbundled network elements. This requires the ILECs to unbundle
and provide access to some components of their local service network to
other local service providers. Unbundled network elements are portions of
an ILEC's network, such as cooper lines, that CLECs can lease in order to
build their own facilities networks.
. Number portability. This requires the ILECs and CLECs to allow a customer
to retain an existing phone number within the same local area even if the
customer changes telecommunications services providers. All
telecommunications carriers will be required to contribute to the shared
industry costs of number portability, with the first payments being due
in the fourth quarter of 1999.
. Dialing parity. This requires the ILECs and CLECs to establish dialing
parity so that customers do not perceive a quality difference between
networks when dialing.
. Access to rights-of-way. This requires the ILECs and CLECs to establish
non-discriminatory access to telephone poles, ducts, conduits and rights-
of-way.
8
ILECs are required to negotiate in good faith with other carriers that
request any or all of the arrangements discussed above. If a requesting
carrier is unable to reach agreement with the ILEC within a prescribed time,
either carrier may request arbitration by the applicable state commission. If
an agreement still cannot be reached, carriers are forced to abide by the
obligations established by the FCC and the applicable state commission.
We have entered into a number of interconnection agreements with the ILECs
in our markets and will enter into additional agreements as our build-out
progresses. We have existing interconnection agreements in each of our
existing markets and in several of our planned markets. Seven of the
interconnection agreements covering our existing markets, including the
agreement covering Chicago, expire in 1999. Five of the interconnection
agreements covering our existing markets, including the agreement covering New
York, expire in 2000. The expiration of these agreements will require that we
negotiate new interconnection terms with the ILECs, including new rates for
reciprocal compensation, which are subject to significant uncertainty due to
regulatory changes and other business trends. Pending conclusion of these
negotiations, the existing interconnection agreements will continue to govern
the payment of reciprocal compensation and other interconnection terms.
The FCC is charged with establishing guidelines to implement the Telecom
Act. In August 1996, the FCC released a decision, known as the Interconnection
Decision, that established rules for the interconnection requirements outlined
above and provided guidelines for interconnection agreements by state
commissions. The U.S. Court of Appeals for the Eighth Circuit vacated portions
of the Interconnection Decision, based in part on its finding that the FCC did
not have the authority to adopt some of the rules it adopted. On January 25,
1999, the U.S. Supreme Court reversed the Eighth Circuit and upheld the FCC's
authority to issue regulations governing pricing of unbundled network elements
provided by the ILECs in interconnection agreements, including regulations
governing reciprocal compensation, which are discussed in more detail below.
In addition, the Supreme Court affirmed an FCC rule that allows requesting
carriers to "pick and choose" individual portions of existing interconnection
agreements with other carriers and to "opt-in" to only to those portions of
the interconnection agreement that they find most attractive. The Supreme
Court did not, however, address other challenges raised about the FCC's rules
at the Eighth Circuit because those challenges were not decided by the Eighth
Circuit. These challenges will have to be addressed by the Eighth Circuit in
light of the Supreme Court's decision. In addition, the Supreme Court
disagreed with the standard applied by the FCC for determining whether an ILEC
should be required to provide a competitor with particular unbundled network
elements. This issue will have to be addressed by the FCC in a new rule-making
proceeding that the FCC intends to initiate in the spring of 1999.
The Eighth Circuit decisions and their reversal by the Supreme Court
continue to create uncertainty about the rules governing the pricing terms and
conditions of interconnection agreements. The Supreme Court's actions in
particular may give rise to the renegotiation of existing agreements. The
ILECs may, as a result of the Supreme Court reversal, seek to stop providing
some unbundled elements. Although state commissions continue to implement and
enforce interconnection agreements, the Supreme Court ruling and future FCC
and court rulings may affect these commissions' authority to implement or
enforce interconnection agreements or lead to additional rule-making by the
FCC. The resulting uncertainty makes it difficult to predict whether we will
be able to continue to rely on our existing interconnection agreements or have
the ability to negotiate acceptable interconnection agreements in the future.
In addition to requiring the ILECs to open their networks to competitors
and reducing the level of regulation applicable to CLECs, the Telecom Act also
reduces the level of regulation that applies to the ILECs, thereby increasing
their ability to respond quickly in a competitive market. For example, the FCC
has applied "streamlined" tariff regulation of the ILECs, which accelerates
the time prior to which changes to tariffed service rates may take effect and
removes FCC pre-approval requirements to the ILEC's construction of new
facilities. These developments enable the ILECs to change rates more quickly
in response to competitive pressures. The FCC has also proposed heightened
price flexibility for the ILECs, subject to specified caps. If implemented,
this flexibility may decrease our ability to effectively compete with the
ILECs in our markets. Finally, because the Telecom Act's interconnection
requirements also apply to long distance carriers and CLECs, including us, it
may make competitive entry into other services or geographic markets more
attractive to the ILECs, long distance carriers and other companies, which
would likely increase the level of competition we face.
9
The Telecom Act also gives the FCC authority to determine not to regulate
carriers if it believes regulation would not serve the public interest. The
FCC is charged with reviewing its regulations for continued relevance on a
regular basis. As a result of this mandate, a number of regulations that apply
to CLECs have been and may in the future continue to be eliminated. We cannot,
however, guarantee that any regulations that are now or will in the future be
applicable to us will be eliminated.
Reciprocal Compensation. We expect that reciprocal compensation payments,
which we currently receive from the ILEC in each of our markets, will make up
a significant portion of our initial revenues in each of our markets.
Reciprocal compensation is the compensation paid by one carrier to send
particular calls to another carrier's network. Because ISPs and corporate
customers typically receive more calls than they make, and a large number of
our customers are ISPs and large corporations, we expect to receive more
reciprocal compensation than we pay for calls that originate on our networks.
As a result of several trends in our business and the current regulatory
environment, which are discussed below, we expect our revenues from reciprocal
compensation to decline significantly.
Some ILECs have refused to pay reciprocal compensation charges that they
estimate are the result of inbound ISP traffic because they believe that type
of traffic should be considered interstate in nature. For example, Ameritech
Illinois disputed a portion of the reciprocal compensation charges billed to
it by us, which it believes are related to Internet access charges. In March
of 1998, the Illinois Commerce Commission ruled in favor of Focal and other
CLECs regarding this dispute. In late March, Ameritech Illinois filed suit in
the U.S. District Court for the Northern District of Illinois seeking reversal
of the earlier Commission order. Ameritech Illinois was granted a stay of the
Commission order while the appeal was considered, but in July 1998, the court
affirmed the Commission order. Ameritech Illinois then appealed the decision
to the U.S. Court of Appeals for the Seventh Circuit and was denied a stay
while the appeal is pending. In October 1998, Ameritech complied with the
order and we received payment for past reciprocal compensation charges that
represent substantially all of the disputed amounts. Reciprocal compensation
payments from Ameritech Illinois comprised approximately 81% of our revenues
for the year ended December 31, 1997 and payments from Ameritech and another
ILEC comprised approximately 75% of our revenues for the year ended December
31, 1998. Briefing in the Seventh Circuit has been completed, but we cannot
predict when the court will make a final determination or what the outcome
will be. Any determination by the Seventh Circuit that Internet traffic is
ineligible for reciprocal compensation payments would have a material adverse
effect on our business and results of operations.
While some states in which our current and planned markets are located have
ordered the ILECs to pay reciprocal compensation for Internet-related calls,
other states have not yet considered the issue or the issue is subject to
judicial review, like in Illinois. States that have not yet addressed the
issue may determine that no reciprocal compensation is due for calls made to
ISPs. In addition, on February 26, 1999, the FCC issued a declaratory ruling
and Notice of Proposed Rulemaking concerning inbound ISP traffic. The FCC
concluded in its ruling that ISP traffic is jurisdictionally interstate in
nature. The FCC has requested comment as to what reciprocal compensation rules
should govern this traffic upon expiration of existing interconnection
agreements. The FCC also determined that no federal rule existed that governed
reciprocal compensation for ISP traffic at the time existing interconnection
agreements were negotiated and concluded that it should permit states to
determine whether reciprocal compensation should be paid for calls to ISPs
under existing interconnection agreements.
In light of the FCC's order, state commissions, which previously addressed
this issue and required reciprocal compensation to be paid for ISP traffic may
reconsider and may modify their prior rulings. The FCC order has been appealed
by several parties. No procedural calendar has been established yet. Several
ILECs, including Ameritech, have publicly stated that they will seek to
overturn prior orders that they claim are inconsistent with the FCC's February
26, 1999 order. Relief sought could include repayment of reciprocal
compensation amounts previously paid by the ILECs. In addition, at least one
ILEC has already filed suit seeking a refund from another carrier of
reciprocal compensation the ILEC has paid to that carrier.
Upon expiration of our existing interconnection agreements, we must
negotiate new rates for reciprocal compensation with each carrier. Pending
conclusion of these negotiations, the existing interconnection
10
agreements will continue to govern the payment of reciprocal compensation.
Because of the uncertainty surrounding reciprocal compensation in general and
the FCC's February 26th ruling and our need to renegotiate our existing
interconnection agreements in particular, it is unlikely that current rates of
reciprocal compensation will continue in new interconnection agreements. A
reduction in rates payable for reciprocal compensation could have a material
adverse effect on us, as could any requirement to refund reciprocal
compensation paid to date.
Universal Support Fund. On May 8, 1997, in compliance with the requirements
of the Telecom Act, the FCC released an order establishing a new federal
universal service support fund, which provides subsidies to carriers that
provide service to under-served individuals and customers in high-cost or low-
income areas, and to companies that provide telecommunications services for
schools, libraries and rural health care providers. We are required to
contribute into the universal service fund and are also required to contribute
to state universal service funds. We may also obtain subsidies from the
universal service fund for some services we provide. The new universal service
rules are administered jointly by the FCC, the fund administrator, and state
regulatory authorities, many of which are still in the process of establishing
their administrative rules. Although we have already begun contributing to the
fund, the amount of our required contribution changes each quarter. As a
result, we cannot predict the revenue effect these regulations will have on us
in the future.
Tariff and Filing Requirements. Non-dominant carriers, including Focal,
must file tariffs with the FCC listing the rates, terms and conditions of
interstate and international services provided by the carrier. On October 29,
1996, the FCC adopted an order in which it eliminated the requirement that
non-dominant interstate carriers maintain tariffs on file with the FCC for
domestic interstate services. The FCC's order was issued pursuant to authority
granted in the Telecom Act to forebear from regulating any telecommunications
services provider if specified statutory analyses are satisfied. The FCC's
order, however, has been stayed by a federal court. Accordingly, non-dominant
interstate carriers, including Focal, currently must continue to file
interstate tariffs with the FCC until final determination of the issue.
Challenges to these tariffs by regulators or third parties could cause us to
incur substantial legal and administrative expenses.
In addition, periodic reports concerning carriers' interstate circuits and
deployment of network facilities also are required to be filed with the FCC.
The FCC generally does not exercise direct oversight over cost justification
and the level of charges for services of non-dominant carriers, although it
has the power to do so. The FCC also imposes prior approval requirements on
transfers of control and assignments of operating authorizations. Fines or
other penalties also may be imposed for violations of FCC rules or
regulations. The FCC also requires that certified carriers like Focal notify
the FCC of foreign carrier affiliations and secure a determination that such
affiliations, if in excess of a specified amount, are in the public interest.
State Regulation. Most states regulate entry into the markets for local
exchange and other intrastate services, and states' regulation of CLECs vary
in their regulatory intensity. The majority of states require that companies
seeking to provide local exchange and other intrastate services to apply for
and obtain the requisite authorization from a state regulatory body, such as a
state commission. This authorization process generally requires the carrier to
demonstrate that it has sufficient financial, technical and managerial
capabilities and that granting the authorization will serve the public
interest. As of March 1, 1999, we had obtained local exchange certification or
were otherwise authorized to provide local exchange service in:
California Illinois Michigan Texas
Delaware Indiana New Jersey Virginia
District of Columbia
Maryland New York Washington
Florida Massachusetts Pennsylvania
We also had applications pending for local exchange certification or other
authorization in Georgia and Missouri. To the extent that an area within a
state in which we provide service is served by a small or rural exchange
carrier not currently subject to competition, we may not currently have
authority to provide service in those areas. Our interconnection agreements
with the ILECs are also subject to approval by the applicable state
commission.
11
As a CLEC, we are and will continue to be subject to the regulatory
directives of each state in which we are and will be certified. Most states
require that CLECs charge just and reasonable rates and not discriminate among
similarly situated customers. Some other state requirements include:
. The filing of periodic reports
. The payment of various regulatory fees and surcharges
. Compliance with service standards and consumer protection rules
States also often require prior approvals or notifications for certain
transfers of assets, customers, or ownership of a CLEC and for issuances by
certified carriers of equity securities, notes or indebtedness. States
generally retain the right to sanction a carrier or to revoke certifications
if a carrier violates relevant laws and/or regulations. Delays in receiving
required regulatory approvals could also have a material adverse effect on us.
We cannot assure you that regulators or third parties will not raise material
issues with regard to our compliance or non-compliance with applicable laws or
regulations.
In most states, certificated carriers like us are required to file tariffs
setting forth the terms, conditions, and prices for services which are
classified as intrastate. In some states, the required tariff may list a range
of prices for particular services, and in others, such prices can be set on an
individual customer basis. We may, however, be required to file tariff addenda
of the contract terms.
Under the Telecom Act, implementation of our plans to compete in local
markets is and will continue to be, to a certain extent, controlled by the
individual states. The states in which we operate or intend to operate have
taken regulatory and legislative action to open local communications markets
to various degrees of local exchange competition.
Local Regulation. We are also subject to numerous local regulations, such
as building code requirements. These regulations may vary greatly from state
to state and from city to city.
Employees
As of December 31, 1998, we employed 233 full-time employees, none of whom
were represented by a union. We believe that our future success will depend on
our continued ability to attract and retain highly skilled and qualified
employees. We believe that our relations with our employees are good.
We rely on a relatively small number of senior management and operating
personnel. Losing any one or some members of this senior management team or
key operating personnel could have a material adverse effect on us.
ITEM 2. DESCRIPTION OF PROPERTY
We lease office space in a number of locations, primarily for network
equipment installations and sales and administrative offices. Our material
leased switching and network properties are listed below:
Square
Location Feet Lease Term
-------- ------ ----------
Chicago,
Illinois 57,474 June 2004
Chicago,
Illinois 10,236 April 2007, with two five-year renewal options
New York, New
York 15,196 June 2012, with one five-year renewal option
San Francisco,
California 20,151 July 2008, with two five-year renewal options
Philadelphia,
Pennsylvania 17,608 June 2008, with two five-year renewal options
Washington,
D.C. 19,414 October 2013
Los Angeles,
California 19,199 December 2008
Southfield,
Michigan 22,600 August 2008, with two five-year renewal options
Seattle,
Washington 20,000 January 2009, with one four-year and one six-year renewal option
Cambridge,
Massachusetts 12,863 December 2008, with two five-year renewal options
Dallas, Texas 19,249 June 2009, with two five-year renewal options
Atlanta,
Georgia 21,948 May 2009, with two five-year renewal options
Jersey City,
New Jersey 18,500 February 2009, with two five-year renewal options
12
A number of these locations also house sales and administrative offices.
Our corporate headquarters are located in one of our Chicago, Illinois
facilities. In addition, we have sales offices in New York and San Jose. We
also own approximately 13 acres of real property in Elk Grove Township,
Illinois. This property, which includes a 52,000 square foot building, houses
our second Chicago switching center, national data center and national network
operations center.
ITEM 3. LEGAL PROCEEDINGS
With the exception of the matters discussed below, we are not aware of any
litigation against us. In the ordinary course of our business, we are involved
in a number of regulatory proceedings before various state commissions and the
FCC.
On September 16, 1997, we filed a complaint and request for temporary
injunction against Ameritech Illinois with the Illinois Commerce Commission.
The complaint claimed breach of the terms of the interconnection agreement
between us and Ameritech Illinois because Ameritech Illinois refused to pay
reciprocal compensation for our transport and termination of calls to our end-
users that Ameritech Illinois believed were ISPs. In the interests of
obtaining a more timely judgment, we withdrew our complaint without prejudice
on October 17, 1997 and filed to intervene in a consolidated suit that
included similar complaints against Ameritech Illinois by several other CLECs.
On March 11, 1998, the Illinois Commerce Commission issued an order that
required Ameritech Illinois to pay reciprocal compensation for calls made to
ISPs. On March 15, 1998, Ameritech Illinois filed a motion with the Illinois
Commerce Commission to stay the order pending an appeal, which was denied on
March 23, 1998. On March 27, 1998, Ameritech Illinois filed suit in the United
States District Court for the Northern District of Illinois seeking reversal
of the Illinois Commerce Commission order. Ameritech Illinois also sought a
stay of the ICC order from the District Court, which was granted while the
case was decided. On July 21, 1998, the District Court upheld the Illinois
Commerce Commission's order, finding that calls to ISPs are local calls and
therefore subject to the reciprocal compensation rules contained in the
Telecom Act. The District Court stayed the decision to permit any party to
appeal. Ameritech Illinois then appealed the decision to the U.S. Court of
Appeals for the Seventh Circuit on August 25, 1998 and was denied a stay while
the appeal is pending. In October 1998, Ameritech Illinois complied with the
order and we received payment for past reciprocal compensation charges that
represent substantially all of the disputed amounts. Reciprocal compensation
payments from Ameritech Illinois comprised approximately 81% of our revenues
for the year ended December 31, 1997 and payments from Ameritech Illinois and
another ILEC comprised approximately 75% of our revenues for the year ended
December 31, 1998. Briefing in the Seventh Circuit has been completed, but we
cannot predict when the court will make a final determination or the outcome
of the Court's decision. Any determination by the Seventh Circuit that
Internet traffic is ineligible for reciprocal compensation payments would have
a material adverse effect on our business and our results of operations.
While some states in which our current and planned markets are located have
ordered the ILECs to pay reciprocal compensation for Internet-related calls,
other states have not yet considered the issue or the issue is subject to
judicial review, as in Illinois. To date, state commissions in the following
states have ruled that reciprocal compensation arrangements apply to ISP
traffic:
Alabama Hawaii New York Utah
Arizona Illinois North Carolina Virginia
Arkansas Indiana Ohio Washington
California Maryland Oklahoma West Virginia
Colorado Massachusetts Oregon Wisconsin
Connecticut Michigan Pennsylvania
Florida Minnesota Tennessee
Georgia Missouri Texas
13
These decisions are presently on appeal to federal courts in a number of these
states. These states and states that have not yet addressed the issue may
determine that no reciprocal compensation is due for calls made to ISPs. A
finding that reciprocal compensation is not payable for ISP traffic in
Illinois, New York or Pennsylvania would have a material adverse effect on us.
See Item I, "Business--Regulation" for a description of federal rule-making
and other developments affecting reciprocal compensation.
In addition, on February 26, 1999, the FCC issued a declaratory ruling and
Notice of Proposed Rulemaking concerning inbound ISP traffic. The FCC
concluded in its ruling that ISP traffic is jurisdictionally interstate in
nature. The FCC has requested comment as to what reciprocal compensation rules
should govern this traffic upon expiration of existing interconnection
agreements. The FCC also determined that no federal rule existed that governed
reciprocal compensation for ISP traffic at the time existing interconnection
agreements were negotiated and concluded that it should permit states to
determine whether reciprocal compensation should be paid for calls to ISPs
under existing interconnection agreements.
In light of the FCC's order, state commissions, which previously addressed
this issue and required reciprocal compensation to be paid for ISP traffic may
reconsider and may modify their prior rulings. The FCC order has been appealed
by several parties. No procedural calendar has been established yet. Several
ILECs, including Ameritech, have publicly stated that they will seek to
overturn prior orders that they claim are inconsistent with the FCC's February
26, 1999 order. Relief sought could include repayment of reciprocal
compensation amounts previously paid by the ILECs. In addition, at least one
ILEC has already filed suit seeking a refund from another carrier of
reciprocal compensation the ILEC has paid to that carrier.
We were named as a defendant, along with other parties, in a case filed in
March 1998 in the Supreme Court of the State of New York, County of New York
involving the wrongful death of an electrician who was killed while working at
our leased premises in New York. The plaintiffs, the decedent's wife and his
estate, are seeking damages of $20 million. The decedent was not under
contract with us, nor was he working at our request. We tendered the defense
of this claim to, and it has been accepted by, our insurance carrier. The
aggregate amount of our insurance coverage is $7 million. We do not believe
that we were the cause of the injuries and subsequent death that gave rise to
this lawsuit.
On March 15, 1999, we filed a complaint against Ameritech Michigan seeking
redress from Ameritech Michigan's delay first in executing an interconnection
agreement, then in physically interconnecting its network with ours. We are
seeking expedited treatment of the complaint before the Michigan Public
Service Commission.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
As of December 31, 1998, there was no established market for any class of
our common stock, each par value $.01 per share.
As of December 31, 1998, there were approximately 41 holders of record of
our common stock taken as a single class. We currently have three classes of
equity securities outstanding: Class A common stock, Class B common stock and
Class C common stock. We have not made any distributions on any class of our
common stock at any time.
Recent sales of unregistered securities.
The following summarizes information relating to all equity securities of
Focal sold by us during the period covered by this report that were not
registered under the Securities Act of 1933. On November 23, 1998, we
14
issued 66.667 shares of Class A common stock to Paul G. Yovovich and to Mr.
Yovovich or his wife as custodians for their children for an aggregate purchase
price of $100,000. No underwriters were engaged in connection with these sales,
and these sales were exempt from registration under the Securities Act pursuant
to Section 4(2) thereof, as transactions not involving any public offering.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
The selected consolidated financial and operating data presented below for
the seven month period ended December 31, 1996, and as of and for the years
ended December 31, 1997 and 1998, have been derived from our Consolidated
Financial Statements and the notes related thereto. Our Consolidated Financial
Statements for the seven month period ended December 31, 1996 and as of and for
the years ended December 31, 1996, 1997 and 1998 have been audited by Arthur
Andersen LLP, our independent auditors. The balance sheet data as of December
31, 1996 has been derived from our audited consolidated financial statements
not included in this report. You should read the information in this table in
conjunction with Item 7A, "Quantitative and Qualitative Disclosures About
Market Risk", Item 7, "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and our Consolidated Financial Statements
and the notes related thereto appearing elsewhere in this report.
Period from
Commencement of
Operations
(May 31, 1996) Years Ended December 31,
to December 31, --------------------------
1996 1997 1998
--------------- ------------ ------------
Statement of Operations Data:
Revenues........................... $ -- $ 4,023,690 $ 43,531,846
Expenses:
Customer service and network
operations...................... -- 2,154,980 15,284,641
Selling, general and
administrative.................. 421,777 2,887,372 12,209,821
Depreciation and amortization.... 1,150 615,817 6,670,986
Non-cash compensation............ 108,333 1,300,000 3,069,553
---------- ------------ ------------
Operating income (loss)............ (531,260) (2,934,479) 6,296,845
Interest income (expense), net..... 17,626 67,626 (9,605,832)
Provision for income taxes......... -- -- (4,660,000)
---------- ------------ ------------
Net loss applicable to common
stockholders...................... $ (513,634) $ (2,970,418) $ (7,968,987)
========== ============ ============
Basic and diluted net loss per
share............................. $ (30.22) $ (35.21) $ (91.05)
========== ============ ============
Basic and diluted weighted average
common stock outstanding.......... 16,996 84,373 87,526
========== ============ ============
Other Financial Data:
EBITDA............................. $ (421,777) $ (1,018,662) $ 16,037,384
Capital expenditures............... 82,303 11,655,524 64,229,247
Summary Cash Flow Data:
Net cash provided by (used in)
operating activities.............. $ (152,576) $ (1,634,017) $ 22,596,957
Net cash used in investing
activities........................ (82,303) (11,655,524) (72,189,187)
Net cash provided by financing
activities........................ 4,025,000 11,755,972 173,376,679
Operating Data:
Access lines in service............ -- 7,394 52,011
Minutes of use (millions).......... -- 282 3,568
As of December 31,
------------------------------------------
1996 1997 1998
--------------- ------------ ------------
Balance Sheet Data:
Current assets..................... $3,807,004 $ 4,737,808 $144,637,266
Fixed assets, net.................. 81,153 11,176,774 69,973,120
Total assets....................... 3,888,157 15,914,582 219,574,280
Long-term debt, including current
portion........................... -- 3,536,886 185,295,793
Redeemable Class A Common Stock.... 4,024,653 12,403,218 --
Total stockholders' equity
(deficit)......................... (404,954) (2,075,372) 19,328,412
15
You should not assume that the results of operations above are indicative
of the financial results we can achieve in the future. You should also keep
the following matters in mind when you read this information:
. Non-cash compensation charges are a result of two different transactions
and consist of:
--charges totaling $0.1 million for 1996 and $1.3 million for each of
1997 and 1998, which resulted from the vesting over time of shares of
common stock issued to some of our executive officers in November 1996
--charges of $1.8 million for 1998, which resulted from the vesting and
cancellation of shares of common stock in connection with the September
30, 1998 amendment of vesting agreements with some of our executive
officers and our institutional investors
. The line item, "Redeemable Class A Common Stock," is described in Note 11
to our Consolidated Financial Statements on page F-16.
. EBITDA represents earnings before interest, income taxes, depreciation
and amortization and other non-cash charges, including non-cash
compensation charges. EBITDA is not a measurement of financial
performance under generally accepted accounting principles, is not
intended to represent cash flow from operations, and should not be
considered as an alternative to net loss applicable to common
stockholders as an indicator of our operating performance or to cash
flows as a measure of liquidity. We believe that EBITDA is widely used by
analysts, investors and other interested parties in the
telecommunications industry. EBITDA is not necessarily comparable to
similarly titled measures for other companies. See "Consolidated
Financial Statements--Consolidated Statements of Cash Flows," on page F-
6.
. We count access lines as of the end of the period indicated and on a one-
for-one basis using DS-0 equivalents.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to minimal market risks. We manage sensitivity of our
results of operations to these market risks by maintaining a conservative
investment portfolio, which primarily consists of debt securities, typically
maturing within one year, and entering into long-term debt obligations with
appropriate pricing and terms. We do not hold or issue derivative, derivative
commodity or other financial instruments for trading purposes. Financial
instruments held for other than trading purposes do not impose a material
market risk.
We are exposed to interest rate risk, as additional financing is
periodically needed due to the large operating losses and capital expenditures
associated with establishing and expanding our network coverage. The interest
rate that we will be able to obtain on future debt financings will depend on
market conditions at that time, and may differ from the rates we have secured
on our current debt. Additionally, we are exposed to interest rate risk on
amounts borrowed under our secured equipment term loan facility as of December
31, 1998.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
General. We provide voice and data communications services to large,
telecommunications-intensive users in major cities. We began operations in
1996 and initiated service first in Chicago in May 1997. We currently serve a
total of 12 markets, which encompass a total of 29 metropolitan statistical
areas, or MSAs, and plan to serve 16 markets, or 42 MSAs, by the end of 1999.
As of December 31, 1998, we had sold 68,184 access lines, of which 52,011 were
installed and in service.
Our operating results are expected to change over the next 18 months as a
result of several trends in our business and the regulatory environment.
First, we anticipate that the mix of lines we sell will shift from being
dominated by ISP customer lines to being more evenly balanced among ISP,
corporate and VAR customer lines due to expanded marketing efforts. Second,
the profitability from ISP lines is expected to decline significantly as
reciprocal compensation rates, the primary revenue driver for these lines, are
negotiated downward. Reciprocal
16
compensation rates are expected to decline in discrete steps as our
interconnection agreements in each state in which we operate come up for
renewal. Third, our continued expansion may result in negative operating cash
flow and operating losses for a period of time. As a result, our historical
trend of generating positive operating cash flow on a consolidated basis is
expected to decline and could become negative for a period of time. If this
occurs, we expect to once again produce positive operating cash flows once
these trends stabilize and operating activities in our newer markets mature.
However, if these trends do not stabilize and our operating activities do not
mature as expected, we may continue to sustain negative operating cash flow
and net losses.
Revenue. Our revenue is comprised of monthly recurring charges, usage
charges and initial, non-recurring charges. Monthly recurring charges include
the fees paid by our customers for lines in service, additional features on
those lines, and colocation space. Monthly recurring charges are derived only
from end user customers. Usage charges consist of fees paid by end users for
each call made, fees paid by the ILEC and other CLECs as reciprocal
compensation, and access charges paid by the inter-exchange carriers, or IXCs,
for long distance traffic that we originate and terminate. Non-recurring
revenues are typically derived from fees charged to install new customer
lines.
We earn reciprocal compensation revenue for calls made by customers of
another local exchange carrier to our customers. Conversely, we incur
reciprocal compensation expense to other local exchange carriers for calls by
our customers to their customers. Reciprocal compensation has historically
been a significant component of our total revenue, representing approximately
75% of total revenue in 1998. This is a result of a preponderance of inbound
applications utilized by our customers.
We expect the proportion of revenue represented by reciprocal compensation
to substantially decrease in the future as a result of the expiration and
subsequent renegotiation of our existing interconnection agreements with the
ILECs and as a result of our focus on increasing the percentage of our lines
that are sold to non-ISP customers. We expect the most significant impact of
the reduction in reciprocal compensation to occur during the fourth quarter of
1999, when our existing interconnection agreement with Ameritech Illinois
expires. Although we expect to renew our existing interconnection agreements
on satisfactory terms, we expect that the new agreements will result in lower
negotiated interconnection rates for future reciprocal compensation. Revenues
from reciprocal compensation could also decline as a result of adverse
judicial or regulatory determinations. See Item 1, "Business--Regulation--
Reciprical Compensation" and Item 3, "Legal Proceedings."
We believe we can produce positive return on capital despite a substantial
reduction in reciprocal compensation revenue resulting from lower rates for
reciprocal compensation. The table below represents 1998 fourth quarter
historical selected financial data for the Chicago market reflecting:
. actual results,
. pro forma results with the reciprocal compensation rate adjusted downward
to $0.003 per minute, compared to the current rate of $0.009 per minute
We cannot predict new rates at which reciprocal compensation payments will
be made or the types of traffic eligible for reciprocal compensation. These
rates may be more or less than the rates described in the table below. You
should not assume that the following results are indicative of results we can
achieve in the future.
Pro Forma Results for the
Fourth Quarter of 1998
with the Reciprocal
Actual Results for the Compensation rate set to
Chicago Fourth Quarter of 1998 $0.003 per minute of use
------- ---------------------- -------------------------
($ in millions)
Revenues................. $12.9 $ 7.3
EBITDA (1)............... $ 9.2 $ 3.6
EBITDA Margin............ 71.4% 49.8%
- --------
(1) EBITDA represents earnings before interest, income taxes, depreciation and
amortization and other non-cash charges, including non-cash compensation
charges. EBITDA is not a measurement of financial
17
performance under generally accepted accounting principles, is not intended
to represent cash flow from operations, and should not be considered as an
alternative to net loss applicable to common stockholders as an indicator
of our operating performance or to cash flows as a measure of our
liquidity. We believe that EBITDA is widely used by analysts, investors and
other interested parties in the telecommunications industry. EBITDA is not
necessarily comparable to similarly titled measures for other companies.
See "Consolidated Financial Statements--Consolidated Statements of Cash
Flows."
Operating Expenses. Our operating expenses are categorized as customer
service and network operations, selling, general and administrative,
depreciation and amortization, and non-cash compensation expense. Settlement
costs are a significant portion of customer service and network operations
expense and are comprised of leased transport charges and reciprocal
compensation payments. Leased transport charges are the lease payments we make
for the use of fiber transport facilities connecting our customers to our
switches and for our connection to the ILECs' and other CLECs' networks. Our
strategy of leasing rather than building our own fiber transport facilities
has resulted in our cost of service being a significant component of total
costs. To date, we have been successful in negotiating lease agreements that
match the duration of our customer contracts, thereby allowing us to avoid the
risk of incurring expenses associated with transport facilities that are not
being used by revenue generating customers. We pay reciprocal compensation to
the ILECs and other CLECs for terminating calls made by our customers to
customers of the ILECs or CLECs.
Other customer service and network operations expense consists of the costs
of operating our network and the costs of providing customer care, or customer
service, activities. Major components include wages, rent, power, equipment
maintenance, supplies and contract employees.
Selling, general and administrative expense consists of sales force
compensation and promotional expenses as well as the cost of corporate
activities related to regulatory, finance, human resources, legal, executive,
and other administrative activities. We expect our selling, general and
administrative expense to be lower as a percentage of revenue than our
competitors because we have relatively high sales productivity associated with
our strategy of serving telecommunications-intensive customers. These
customers generally utilize a large number of switched access lines relative
to the average business customer, resulting in more revenue per sale. Further,
fewer sales representatives are required to service the relatively smaller
number of telecommunications-intensive customers in a given region.
We record monthly non-cash compensation expense related to shares issued to
our founders in November 1996, and in connection with the September 30, 1998
amendments to vesting agreements with our founders and some of our
institutional investors. These events are described further in Note 10 to our
Consolidated Financial Statements. We will continue to record non-cash
compensation expense in future periods relating to these events.
Historically, we have chosen to lease, rather than build, our transport
network. To date, this has resulted in capital expenditures which we believe
are lower than those of CLECs of similar size that own their fiber networks.
Our capital expenditures have tended historically to be driven by customer
service demands and projected near-term revenue streams from our established
markets. In addition, we believe that the percentage of these "success-based"
capital expenditures is higher than those of fiber-based CLECs. In contrast,
we incur operating expenses for leased facilities that are proportionately
higher than those incurred by fiber-based CLECs. The margin impact of these
higher, anticipated operating expenses is expected to be mitigated, in part,
by a higher revenue per line, which we anticipate as a result of our focus on
telecommunications-intensive users.
Quarterly Results
The following table sets forth unaudited financial and operating data for
each of the specified quarters of 1997 and 1998. The unaudited quarterly
financial information has been prepared on the same basis as our Consolidated
Financial Statements and, in our opinion, contains all normal recurring
adjustments necessary to
18
fairly state this information. The operating results for any quarter are not
necessarily indicative of results for any future period.
1997 1998
------------------------- ----------------------------------------------------
Third Fourth First Second Third Fourth
Quarter Quarter Quarter Quarter Quarter Quarter
----------- ----------- ----------- ----------- ------------ ------------
Revenues................ $1,226,076 $2,710,706 $5,102,448 $8,078,043 $12,755,293 $17,596,062
EBITDA.................. $ (281,871) $ 423,862 $1,967,930 $3,326,827 $ 4,348,713 $ 6,393,914
Total lines in service
at end of quarter...... 2,965 7,394 14,528 24,357 33,188 52,011
Minutes of use switched
(in millions) during
quarter................ 84 191 402 683 1,039 1,444
Although we have generated positive EBITDA in the most recent five
quarters, we anticipate that as a result of the recent operating and
regulatory trends described above, we may experience negative EBITDA for a
period of time until these trends stabilize and operating activities in our
newer markets mature.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Total revenues for 1998 were $43.5 million compared to $4.0 million for
1997. The significant increase is due to the rapid growth in our Chicago and
New York markets during 1998 and the fact that service was first initiated in
Chicago in May 1997. Customer service and network operations expense was $15.3
million in 1998 compared to $2.2 million during 1997. The increase resulted
from our rapid expansion and the related costs of leased facilities, usage
settlements, customer care and operations personnel, equipment maintenance and
other operating expenses. Selling, general and administrative expense also
increased from $2.9 million for 1997 to $12.2 million for 1998 due to our
expansion. Similarly, depreciation and amortization increased from $0.6
million in 1997 to $6.7 million in 1998 as a result of a significant increase
in the level of fixed assets put into service. Non-cash compensation expense
associated with the vesting over time of shares of common stock issued to our
executive officers in November 1996, and the vesting and cancellation of
shares of common stock in connection with the September 30, 1998 amendments to
vesting agreements with some of our executive officers and our institutional
investors, was $3.1 million for 1998 compared to $1.3 million for 1997. The
increase of $1.8 million is due to the September 30, 1998 amendment to these
vesting agreements.
Interest income increased from $0.2 million in 1997 to $6.5 million for
1998 due primarily to investment of the proceeds received in February 1998
from the sale of the Notes. Interest expense for 1998 was $16.1 million
compared to $0.1 million for 1997. The increase is primarily due to the
amortization of discount on the Notes. Interest on the Notes is not payable in
cash until February 2003.
Year Ended December 31, 1997 Compared to Seven-Month Period Ended December
31, 1996
We had total revenue of $4.0 million in 1997. We had no revenue in 1996.
The increase is due to the recording of our first revenue during May 1997.
Prior to May 1997, we incurred start-up and operating expenses in advance of
revenue as we prepared to launch our network services in the Chicago market.
Customer service and network operations expense increased from zero in 1996 to
$2.2 million in 1997. There were no customer service or network activities
during 1996. Such activities began as we initiated construction of our first
network in January 1997 and as we began to provide service in May 1997.
Selling, general and administrative expense increased from $0.4 million in
1996 to $2.9 million in 1997, largely due to a rapid increase in sales and
administrative personnel in 1997. Depreciation and amortization increased from
less than $.01 million in 1996 to $0.6 million in 1997 due to the increase in
assets put into service during 1997. Non-cash compensation expense associated
with certain shares issued to our founders in November 1996 increased from
$0.1 million in 1996 to $1.3 million in 1997 based on a full year's impact of
this expense during 1997 as compared to one month of non-cash compensation
expense during 1996.
19
Interest income increased from $0.02 million in 1996 to $0.2 million in
1997 as a result of significantly greater cash balances we maintained after
receiving additional equity contributions during 1997. Interest expense was
$0.1 million in 1997 due to debt financing incurred by a subsidiary of Focal
Communications Corporation. We did not have any interest expense during 1996.
Liquidity and Capital Resources
We intend to continue to increase our coverage of major U.S. cities by
expanding our services to four additional markets in 1999. This business plan
will require that we expand our existing networks and services and fund our
initial operating losses, and may include the deployment of our own fiber
capacity in some of our markets where it makes economic sense. These
activities will require significant capital to fund the purchase and
installation of telecommunications switches, equipment, and infrastructure.
These expenditures, together with associated early operating expenses, may
result in our having substantial negative operating cash flow and substantial
net operating losses for the foreseeable future, including in 1999 and 2000.
Although we believe that our cost estimates and the scope and timing of our
build-out are reasonable, we cannot assure you that actual costs or the timing
of the expenditures, or that the scope and timing of our build-out, will not
deviate from current estimates.
Our capital expenditures were approximately $11.7 million in 1997 and $64.2
million in 1998, primarily reflecting capital spending for the build-out of
our first 11 markets. We estimate that our capital expenditures in connection
with our business plan will be approximately $90 million in 1999. The 1999
expenditures are expected to be made primarily for the build-out of additional
markets and the expansion of our existing markets and services. We currently
expect to meet these capital requirements with cash, cash equivalents and
short-term investments currently on hand, additional draw-downs under our $50
million equipment term loan facility, described below, and future cash flows
from ongoing operations.
Our expectations of our future capital requirements and cash flows from
operations are based on current estimates. Our actual capital expenditures and
cash flows could differ significantly from these estimates. If we require
additional capital to complete our budgeted expansion or if customer demand
significantly differs from our current expectations, our funding needs may
increase. In addition, we may be unable to produce sufficient cash flows from
ongoing operations to fund our business plan and future growth. This would
require us to alter our business plan, including delaying or abandoning our
future expansion or spending plans, which could have a material adverse effect
on our business. In addition, we may elect to pursue other attractive business
opportunities, including accelerating the pace or expanding the geographic
scope of our build-out, that could require additional capital investments in
our networks. If any of these events were to happen, we could incur additional
borrowings, issue additional debt or equity securities or enter into joint
ventures.
We cannot assure you that we will be successful in producing sufficient
cash flows or raising sufficient debt or equity capital on terms that we will
consider acceptable. Further, there can be no assurance that expenses will not
exceed our estimates or that the funds needed will not likewise be higher than
estimated. Failure to generate sufficient funds may require us to delay,
abandon or reduce the scope of our future expansion or expenditures, which
could have a material adverse effect on the implementation of our business
plan and our results of operations.
Net cash used in operating activities was $0.2 million for the seven months
ended December 31, 1996 and $1.6 million for 1997. Net cash provided by
operations was $22.6 million in 1998, an increase of $24.2 million from 1997.
The increase was primarily due to an increase in non-cash reconciling items
for depreciation and amortization, non-cash compensation expense, amortization
of discount on the Notes and an increase in accounts payable and accrued
liabilities. Net cash used in investing activities was $0.1 million for the
seven months ended December 31, 1996, $11.7 million for 1997, and $72.2
million for 1998. The increase of $60.5 million from 1997 represents a $52.6
million increase in capital expenditures due to our 1998 expansion into new
markets and the purchase of short-term investments of $8.0 million. Short-term
investments primarily consist of debt
20
securities, which typically mature between three months and one year. Net cash
provided by financing activities consisted of $4.0 million for the seven
months ended December 31, 1996, $11.8 million in 1997, and $173.4 million in
1998. The increase of $161.6 million from 1997 to 1998 is mainly the result of
net proceeds from the Notes offering of $143.9 million, after $6.1 million in
issuance costs and $19.2 million in borrowings under a secured equipment term
loan facility during 1998. We obtained this secured equipment term loan
facility from a third party with a maximum borrowing level of $25 million. The
borrowing level under this term loan facility was increased to $50 million in
March 1999. The term loan facility provides for equipment drawdowns through
December 30, 1999, and requires repayment based on 60 equal monthly
installments of principal and interest.
We have incurred net losses since inception and have an accumulated deficit
of $11.4 million as of December 31, 1998. Most recently, we funded a large
portion of our future operating losses and capital expenditures through the
1998 offering of the Notes and by other financings. On February 18, 1998, we
received $150 million in gross proceeds from the sale of the Notes. The Notes
will accrete to an aggregate stated principal amount of $270 million by
February 15, 2003. As of December 31, 1998, the principal amount of the Notes
had accreted to approximately $166.1 million. No interest is payable on the
Notes prior to August 15, 2003. Thereafter, cash interest will be payable
semiannually on August 15 and February 15 of each year. Our high level of debt
could adversely affect our future prospects by: (1) impairing our ability to
obtain additional financing, (2) requiring us to use a substantial portion of
our cash flow from operations to pay interest
or repay debt which will reduce the funds available to us for our operations,
acquisition opportunities, service offerings and capital expenditures, (3)
placing us at a competitive disadvantage with companies that are less
restricted by their debt agreements and (4) making us more vulnerable in the
event of a downturn in general economic conditions.
Prior to the issuance of the Notes in February 1998, a substantial portion
of our funding needs was met through the private sale of equity securities. In
November 1996, we entered into a stock purchase agreement that provided for
the contribution over time of approximately $26.1 million of equity funding by
a group of investors. As of February 13, 1998, we had received the entire
$26.1 million. In addition, in 1997, our Illinois subsidiary borrowed
approximately $3.5 million under a bank credit facility. We used a portion of
the net proceeds from the issuance of the Notes to repay this indebtedness and
cancel this facility.
Impact of the Year 2000 Issue
The year 2000 issue results from computer programs being written using two
digits rather than four to define the year. Any of our computer programs or
systems or of our suppliers that have date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result
in a system failure or miscalculation causing disruption of operations,
including, among other things:
. A temporary inability to process transactions
. A temporary inability to send invoices
. A temporary inability to engage in similar normal business activities
. Interruptions of customer service
Our Year 2000 compliance program can be divided into several phases. These
phases include:
. Assessing our information systems and certain material hardware for Year
2000 readiness
. Assessing the year 2000 readiness of third parties with whom we have
significant business relationships and on whose systems and hardware we
rely
. Contingency planning
As part of our internal assessment phase, we examined our information
systems, including our DMS-500 SuperNode central office switches and hardware,
to determine whether these systems and hardware are Year 2000 compliant. We
have received assurances from all but one of our major software and hardware
vendors that the products we use are Year 2000 compliant and will function
adequately after December 31, 1999. Our billing system is not Year 2000
compliant. However, an upgrade to the system, which we expect will be
operational by
21
June 1, 1999, is expected to be Year 2000 compliant. We estimate that the
total incremental costs of this upgrade will be approximately $0.5 million. We
did not incur any of these costs in 1998. We are also developing a new billing
system that is Year 2000 compliant, which is expected to be operational by
year-end. We have not nor do we plan to identify, validate as compliant or
remediate, embedded chips in our systems or hardware.
Our services are also dependent on network systems and transport facilities
maintained by other carriers, including ILECs and IXCs. We are in the process
of assessing the Year 2000 compliance status of other carriers with whom we
have material relationships. Our assessment relies, without any independent
verification, on the statements and assumptions underlying the statements
these carriers have made in their periodic reports filed with the Securities
and Exchange Commission. The risks associated with the failure of these
carriers' systems or transport facilities include potential interruption of
service, including blocked calls and delayed call completion. Interruptions of
this type would heavily impact our high-volume corporate customers and, if
prolonged, could have a material adverse effect on our business, financial
condition or results of operations.
Because we currently lease 100% of our transport facilities, we are
dependent on the availability of fiber transport facilities owned by other
carriers. There are few, if any, contingency measures we can take if Year 2000
problems cause these carriers' facilities to fail. We lease transport
facilities from multiple carriers in each
market in which we operate in an attempt to provide redundancy and diversity
in service. However, we can not assure you that there will not be multiple
network failures in a particular market. If our transport vendors experience
facilities failures, our business may be disrupted and we may suffer a
material adverse effect.
We incurred no expenses in 1998 or 1997 related to Year 2000 remediation.
We expect future expenditures to total approximately $0.5 million. All of
these costs will be expensed as they are incurred.
We intend to continue our Year 2000 compliance assessment of our software.
If it comes to our attention that any of our software is not Year 2000
compliant, we intend to develop an action plan and further assess the risks of
non-compliance and the resources that would be required to resolve the
problem. We also intend to develop contingency plans to the extent we believe
those plans would be useful.
Based on our current schedule for completion of our Year 2000 compliance
program, we believe that our planning is adequate to secure Year 2000
readiness of our critical systems. Nevertheless, Year 2000 readiness is
subject to a number of risks and uncertainties, some of which, like the
readiness of other carriers upon whom we rely, are out of our control. We are
not able to predict all the factors that could cause actual results to differ
materially from our current expectations about Year 2000 readiness. The cost
of our Year 2000 compliance program is based upon our management's best
estimates. At this time, we believe that the major risks associated with an
inability of our systems or software to process Year 2000 data correctly are a
system failure or miscalculation causing a disruption of business activities
or interruptions in customer service. If we, or third parties with whom we
have significant business relationships, fail to achieve Year 2000 readiness
with respect to critical systems, there could be a material adverse effect on
our business, financial condition or results of operations.
The discussions in this "Management's Discussion and Analysis of Financial
Condition and Results of Operations" contain forward-looking statements. Our
future performance is subject to a number of risks and uncertainties that
could cause actual results to differ substantially from our projections.
Factors that could impact the variability of future results include those
described on page 1 of this report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements required by Item 8,
together with the notes thereto and the report thereon of the independent
public accountants dated January 22, 1999, are set forth on pages F-1-F-18 of
this report. The financial statement schedule listed under Item 14(a)2,
together with the report thereon of the independent public accountants dated
January 22, 1999, are set forth on pages F-19 and F-20 of this report and
should be read in conjunction with our Consolidated Financial Statements.
22
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The table below contains information about the ages and positions of
Focal's directors and executive officers, and selected key employees, as of
December 31, 1998.
Name Age Position
---- --- --------
EXECUTIVE OFFICERS:
Robert C. Taylor, Jr.... 39 Director, President and Chief Executive Officer
John R. Barnicle........ 34 Director, Executive Vice President and Chief Operating Officer
Joseph A. Beatty........ 35 Executive Vice President and Chief Financial Officer
Brian F. Addy........... 34 Executive Vice President
Renee M. Martin......... 43 Senior Vice President, General Counsel and Secretary
Robert M. Junkroski..... 35 Vice President and Treasurer
Gregory J. Swanson...... 31 Controller
KEY EMPLOYEES:
Leonardo A. Dedo........ 46 Senior Vice President of Marketing and Alternate Channels
Richard J. Metzger...... 50 Vice President of Regulatory Affairs and Public Policy
DIRECTORS:
James E. Crawford III... 53 Director
John A. Edwardson....... 49 Director
Paul J. Finnegan........ 46 Director
Richard D. Frisbie...... 49 Director
James N. Perry, Jr...... 39 Director
Paul G. Yovovich........ 45 Director
Robert C. Taylor, Jr. Mr. Taylor has been President, Chief Executive
Officer and director since August 1996 and is a co-founder of Focal. From 1994
to 1996, Mr. Taylor was the Vice President of Global Accounts for MFS
Communications. At MFS Communications he was responsible for the operations
and management of the Global Services Group, which included MFS
Communications' fifty largest customers. His focus was on developing all
activities in Mexico and Canada. From 1993 to 1994, Mr. Taylor was one of the
original senior executives at McLeod Telecommunications Group, a Cedar Rapids,
Iowa based CLEC. Mr. Taylor has also held management positions with MCI
Communications Corporation (1990-1993) and Ameritech (1985-1990). Mr. Taylor
also serves as the Vice Chairman of the Association for Local
Telecommunications Services, the national trade association for facilities-
based providers of competitive local telecommunications services. Mr. Taylor
received his M.B.A. from the University of Chicago Graduate School of Business
and holds a Bachelor of Science degree in Mechanical Engineering.
John R. Barnicle. Mr. Barnicle has been Executive Vice President, Chief
Operating Officer and director since June 1996. Mr. Barnicle is a co-founder
of Focal and is responsible for day-to-day operations, engineering, marketing
and long-term planning. In 1996, Mr. Barnicle was Vice President of Marketing
for MFS Telecom Companies, a subsidiary of MFS Communications. From 1994 to
1996, Mr. Barnicle was a Vice President of Duff & Phelps Credit Rating Company
and before that held various marketing, operations and engineering positions
with MFS Telecom (1992-1994) and Centel Corporation, a local exchange carrier
(1986-1992). Mr. Barnicle received his M.B.A. with Distinction from DePaul
University and holds a Bachelor of Science degree in Electrical Engineering.
Joseph A. Beatty. Mr. Beatty has been Executive Vice President and Chief
Financial Officer since November 1996 and was also Treasurer from November
1996 through December 1998 and Secretary from November 1996 through April
1998. He was also a director from May 1996 to November 1996. Mr. Beatty is a
co-founder of
23
Focal and is responsible for all financial operations and information systems.
From 1994 to 1996, Mr. Beatty was a Vice President with NationsBanc Capital
Markets, where he was responsible for investment research coverage of the
telecommunications industry. From 1992 to 1994, Mr. Beatty was a Vice
President of Duff & Phelps Credit Rating Company with responsibility for
credit ratings in the telecommunications and electric utility sectors. From
1985 to 1992, Mr. Beatty held various technical management positions with
Centel Corporation's local exchange carrier division. Mr. Beatty received his
M.B.A. with a concentration in Finance from the University of Chicago Graduate
School of Business and is a Chartered Financial Analyst. In addition, Mr.
Beatty holds a Bachelor of Science degree in Electrical Engineering.
Brian F. Addy. Mr. Addy has been Executive Vice President since May 1996.
Mr. Addy is a co-founder of Focal and is responsible for our new market
evaluation and development opportunities. From January 1998 to January 1999,
Mr. Addy directed our market development and construction activities. From
1996 to 1998, he led our sales efforts. He was also a director from May 1996
to November 1996. From 1993 to 1996, Mr. Addy was a Vice President and Officer
of Security Capital Industrial Trust, a real estate investment trust, where he
was responsible for acquisitions, development and national marketing. From
1986 to 1993, Mr. Addy held various management positions with Centel
Corporation's cellular, paging, telephone and telephone systems operating
units. Mr. Addy holds a Bachelor of Science degree in Electrical Engineering.
Renee M. Martin. Ms. Martin has been Senior Vice President, General Counsel
and Secretary since March 1998. Ms. Martin is responsible for our legal,
regulatory, real estate and human resources functions. From 1984 to 1998, Ms.
Martin held various executive positions at Ameritech, most recently as Vice
President and General Counsel Small Business Services where she directed
corporate legal resources to address contract negotiations, employment issues,
regulatory affairs and litigation, and managed outside legal counsel. From
1982 to 1984, Ms. Martin was an attorney at the law firm of Cook and Franke,
S.C. where she concentrated on general business and corporate law. Ms. Martin
received her J.D. from the University of Wisconsin and holds a Bachelor of
Arts degree in Journalism.
Robert M. Junkroski. Mr. Junkroski has been Vice President and Treasurer
since January 1999 and was Controller from January 1997 to January 1999. He is
responsible for all our accounting, revenue assurance, audit, cash and risk
management and customer credit functions. From 1995 to 1997, Mr. Junkroski was
Controller for Brambles Equipment Services, Inc., an equipment leasing
company, where he was responsible for establishing and maintaining the
divisional accounting, financial reporting and budgeting functions. From 1987
to 1994, Mr. Junkroski was Controller for Focus Leasing Corporation, an
equipment leasing company, where he was responsible for the development and
implementation of the accounting and financial reporting functions of several
emerging companies. Mr. Junkroski is a Certified Public Accountant, received
his M.B.A. with honors from Roosevelt University concentrating in Finance and
Accounting and holds a Bachelor of Business Administration degree.
Gregory J. Swanson. Mr. Swanson has been Controller since January 1999 and
is our principal accounting officer. He is responsible for all internal and
external accounting and reporting functions. From June 1998 to December 1998,
Mr. Swanson was Director of External Reporting for Allegiance Corporation, a
health care manufacturing and distribution company. Before that he spent
approximately nine years at Arthur Andersen LLP, a public accounting firm,
where he was responsible for audit and business advisory services to
technology and manufacturing companies. Mr. Swanson is a Certified Public
Accountant and holds a Bachelor of Science degree in Accounting.
Leonardo A. Dedo. Mr. Dedo has been Senior Vice President of Marketing and
Alternate Channels since November of 1998. Mr. Dedo is responsible for
marketing, product development, business analysis, and public relations
activities. From 1997 to 1998, Mr. Dedo was Vice President of Marketing for
Billing Concepts Corporation, a billing solution provider for the
telecommunications industry. From 1985 to 1997, Mr. Dedo held various
executive management positions in sales, marketing and strategic planning with
MCI Communications Corporation. Mr. Dedo received his Masters in Management
from Northwestern University. He also holds a Bachelor of Arts Degree in
Economics.
24
Richard J. Metzger. Mr. Metzger has been Vice President of Regulatory
Affairs and Public Policy since September 1998. He is responsible for our
regulatory and public policy activities. From 1994 to 1998, he served as the
Vice President and General Counsel of the Association for Local
Telecommunications Services. From 1984 to 1993, he held various legal
positions with Ameritech, including serving as Vice President and General
Counsel of Wisconsin Bell and Michigan Bell. From 1976 to 1984, he was
attorney at the law firm of Sidley and Austin. Mr. Metzger received his J.D.
from the University of Chicago and holds a Bachelor of Arts Degree in
Philosophy of Science.
James E. Crawford, III. Mr. Crawford has served as a director of Focal
since November 1996. Since August 1992, he has been a general partner of
Frontenac Company, a venture capital firm. From February 1984 to August 1992,
Mr. Crawford was a general partner of William Blair Venture Management Co.,
the general partner of William Blair Venture Partners III, a venture capital
fund. He was also a general partner of William Blair & Company, an investment
bank and brokerage firm affiliated with William Blair Venture Management Co.,
from January 1987 to August 1992. Mr. Crawford serves as a director of Optika,
Inc., Input Software, Inc., Allegiance Telecom and several private companies.
John A. Edwardson. Mr. Edwardson has served as a director of Focal since
February 1999. He has been President and Chief Executive Officer of Borg-
Warner Security Corp., a security services company, since March 1999. From
1994 to 1998, Mr. Edwardson was Executive Vice President and Chief Operating
Officer of UAL Corporation, the holding company for United Airlines. He
previously held executive positions with Ameritech and Northwest Airlines. Mr.
Edwardson also serves as a director of Household International, Inc.
Paul J. Finnegan. Mr. Finnegan has served as a director of Focal since
November 1996. Since January 1993, Mr. Finnegan has been Managing Director of
Madison Dearborn Partners, Inc., the general partner of Madison Dearborn.
Previously, he served in various positions at First Capital Corporation of
Chicago and its affiliates. Mr. Finnegan currently serves on the Board of
Trustees of The Skyline Fund, and the Board of Directors or Managers, as
applicable, of Omnipoint Corporation, CompleTel LLC and Allegiance Telecom.
Richard D. Frisbie. Mr. Frisbie has served as a director of Focal since
November 1996. Mr. Frisbie is a founder and has been Managing Partner of
Battery Ventures since 1983. He is responsible for management of the Battery
Funds and focuses principally on communications opportunities. Mr. Frisbie
serves as a director of Allegiance Telecom, Conxus Communications, Inc. and
several private companies. He is also a member of the Board of Directors of
the National Venture Capital Association.
James N. Perry, Jr. Mr. Perry has been a director of Focal since November
1996. In January 1993, he became Managing Director of Madison Dearborn
Partners, Inc. Previously, Mr. Perry served in various positions at First
Capital Corporation of Chicago and its affiliates. Mr. Perry currently serves
as a director or manager, as applicable, of Clearnet Communications, Inc.,
Omnipoint Corporation, CompleTel LLC and Allegiance Telecom.
Paul G. Yovovich. Mr. Yovovich has served as a director of Focal since
March 1997. Mr. Yovovich served as President of Advance Ross Corporation, an
international transaction services company, from 1993 to 1996. He is currently
self-employed as a private investor. He served in several executive positions
with Centel Corporation from 1982 to 1992, where his last position was that of
President of its Central Telephone Company unit. Before joining Centel, he was
a Vice President in the investment banking unit of Dean Witter. Mr. Yovovich
also serves as a director of 3Com Corporation, APAC TeleServices, Inc., Van
Kampen Open End Funds, an investment company, Comarco, Inc. and several
private companies.
How Our Directors Are Elected
The Board of Directors consists of eight members. All directors are elected
annually and serve until the next annual meeting of stockholders or until the
election and qualification of their successors.
25
Our existing stockholders are parties to a Stockholders Agreement dated as
of November 27, 1996. Each stockholder has agreed to vote all of their shares
so that our Board of Directors will consist of:
.Two representatives of Madison Dearborn Capital Partners, L.P.
.One representative of Frontenac VI, L.P.
.One representative of Battery Ventures III, L.P.
.Two of Mr. Addy, Mr. Barnicle, Mr. Beatty or Mr. Taylor
.Two non-employee directors
Currently, Mr. Finnegan and Mr. Perry serve as the Madison Dearborn
representatives, Mr. Crawford serves as the Frontenac representative, Mr.
Frisbie serves as the Battery Ventures representative, Mr. Barnicle and Mr.
Taylor serve as the executive representatives and Mr. Edwardson and Mr.
Yovovich serve as the non-employee directors. The terms of the Stockholders
Agreement relating to election of directors will terminate upon completion of
an initial public offering of our securities. Thereafter, each director will
be elected by a plurality vote.
Compliance with Section 16(a) of the Exchange Act.
Not applicable.
ITEM 11. EXECUTIVE COMPENSATION
The table below presents information about compensation earned by our Chief
Executive Officer and each of our four other most highly compensated executive
officers whose combined salary and bonus for 1998 exceeded $100,000 for
services rendered in all capacities for our last three fiscal years. The
officers listed in the following table are referred to as the Named Executive
Officers:
SUMMARY COMPENSATION TABLE
Annual Long-term Compensation
Compensation Awards(1)
----------------- ---------------------- Other
Name and Principal Salary Bonus Securities Underlying Compensation
Position Year ($) ($) Options (#) (2)($)
------------------ ---- -------- -------- --------------------- ------------
Robert C. Taylor, 1996 $ 20,000 $ -- -- $ --
Jr.
Chief Executive 1997 120,000 50,000 -- --
Officer
1998 150,000 100,000 -- --
John R. Barnicle 1996 $ 20,000 $ -- -- $ --
Chief Operating 1997 120,000 47,000 -- --
Officer
1998 140,000 75,000 -- --
Joseph A. Beatty 1996 $ 20,000 $ -- -- $ --
Chief Financial 1997 120,000 45,000 -- 25,000(2)
Officer
1998 140,000 75,000 --
Brian F. Addy 1996 $ 20,000 $ -- -- $ --
Executive Vice 1997 120,000 38,000 -- --
President of
Market Development 1998 125,000 50,000 -- --
Renee M. Martin 1996 $ -- $ -- -- $ --
Senior Vice 1997 -- -- -- --
President
and General Counsel 1998 127,000 45,000 254 --
- --------
(1) Does not include 5,000 shares of Class B common stock issued to each of
Mr. Taylor, Mr. Barnicle, Mr. Beatty and Mr. Addy in 1996 that are subject
to time-vesting requirements set forth in their Employment
26
Agreements with Focal, of which 1,000 shares vested in each of 1996, 1997
and 1998. The remaining 2,000 shares will vest 1,000 in each of 1999 and
2000, subject to acceleration in specified circumstances. These 2,000 shares
were worth $3 million at December 31, 1998. Also does not include 3,677.885
shares of Class C common stock issued to each of Mr. Taylor, Mr. Barnicle,
Mr. Beatty and Mr. Addy in 1996 that were subject to performance-vesting
requirements set forth in their Vesting Agreements with some of our
institutional investors. Of these shares, 3,177.885 were canceled in
connection with September 30, 1998 amendments to these Vesting Agreements.
The remaining 500 shares converted to shares of Class B common stock and are
subject to time-vesting requirements set forth in Restricted Stock
Agreements signed at the time of the September 30, 1998 amendments to these
Vesting Agreements. Of these shares, 400 remain subject to future vesting
requirements. These 400 shares were worth $600,000 at December 31, 1998.
(2) Represents reimbursement of moving expenses.
The table below provides information regarding stock options granted to the
Named Executive Officers during 1998. None of the Named Executive Officers
received SARs. All options referred to below are exercisable to purchase shares
of our Class A common stock.
Potential
Realizable Value
at Assumed Annual
Rates of Stock
Price
Appreciation
for Option
Individual Grants(1) Term(2)
------------------------------------------------------ -----------------
Number of % of Total
Securities of Options
Underlying Granted to Exercise or
Options Employees in Base Price
Name Granted Fiscal Year (per share) Expiration Date 5% 10%
---- ------------- ------------ ----------- --------------- -------- --------
Robert C. Taylor, Jr.... -- -- -- -- -- --
John R. Barnicle........ -- -- -- -- -- --
Joseph A. Beatty........ -- -- -- -- -- --
Brian F. Addy........... -- -- -- -- -- --
Renee M. Martin......... 134 2.2% $1,050 March 31, 2008 $ 88,485 $224,239
120 2.0% $1,500 August 20, 2008 $113,200 $286,874
- --------
(1) The options granted to Ms. Martin were granted under the Company's 1997
Non-Qualified Stock Option Plan (the "1997 Plan"). The 134 options were
granted on April 1, 1998 and vest 25% on the first anniversary of the date
of grant and 12.5% every six months thereafter. The 120 options were
granted on August 21, 1998. Of these options, 20% vested immediately and
10%, 15%, 20%, and 35%, respectively, will vest on the subsequent four
anniversaries of the date of grant.
(2) Based on a ten-year option term and annual compounding, the 5% and 10%
calculations are set forth in compliance with the rules of the Securities
and Exchange Commission. The appreciation calculations do not take into
account any appreciation in the price of the Class A common stock to date
and are not necessarily indicative of future values of stock options or the
Class A common stock.
27
Exercise of Stock Options and Year-End Values
The following table sets forth information regarding the number and value
of unexercised stock options held by each of the Named Executive Officers as
of December 31, 1998. None of the Named Executive Officers exercised stock
options in 1998.
Value of
Number of Unexercised
Unexercised In-the-Money
Options at Options ($) at
Fiscal Year End Fiscal Year End(2)
---------------- ------------------
Exercisable/ Exercisable/
Name Unexercisable(1) Unexercisable
---- ---------------- ------------------
Robert C. Taylor, Jr....................... -- --
John R. Barnicle........................... -- --
Joseph A. Beatty........................... -- --
Brian F. Addy.............................. -- --
Renee M. Martin............................ 24/230 $36,000/$345,000
- --------
(1) These shares represent shares issuable pursuant to stock options granted
under our 1997 Plan and are exercisable to purchase shares of our Class A
common stock.
(2) At December 31, 1998, an estimated market value of $1,500 per share of
Class A common stock was used to determine the value of the in-the-money
options.
Compensation of Our Directors
Except for Mr. Edwardson and Mr. Yovovich, our directors do not receive
directors fees or other compensation for serving as directors or for attending
meetings of the Board of Directors or its committees. In April 1997, Mr.
Yovovich was granted an option to purchase 260 shares of our Class A common
stock under our 1997 Plan. Ten percent of the shares covered by the option
vested immediately and an additional 15% of the shares vest each six months
thereafter. In January 1999, Mr. Yovovich was granted an additional option to
purchase 40 shares of Class A common stock under the 1997 Plan, which has the
same vesting terms as his earlier grant. In February 1999, we granted Mr.
Edwardson an option under our 1997 Plan to purchase 260 shares of our Class A
common stock on the same vesting terms as the options previously granted to
Mr. Yovovich. We reimburse directors for out-of-pocket expenses incurred in
connection with attendance at meetings of the Board of Directors or committees
of the Board.
Employment Agreements
Focal is a party to identical Executive Stock Agreement and Employment
Agreements ( "Employment Agreements") with each of Mr. Taylor, Mr. Barnicle,
Mr. Beatty and Mr. Addy (collectively, the "Executive Investors"). The
Employment Agreements provide that each Executive Investor will receive a
minimum base salary of $120,000 (or any greater amount approved by a majority
of the Board of Directors, including the Madison Dearborn designee and one of
the Frontenac or Battery Ventures designees) and bonuses determined by the
Board of Directors and based upon our achievement of performance goals set in
advance of each year in the sole discretion of the Board of Directors. Unless
he is terminated for cause, each Executive Investor is entitled for a period
of between six and 12 months following termination of his employment with us
(depending on the basis for termination) to continue to receive his salary and
medical benefits, net of any amounts the Executive Investor receives as
compensation for other employment. We entered into an employment agreement
with Ms. Martin on March 20, 1998, on substantially the same employment terms
as the Executive Investors.
Each Employment Agreement and Ms. Martin's agreement also require the
Executive Investor or Ms. Martin, as applicable, to assign to us all
inventions developed in the course of employment, maintain the confidentiality
of our proprietary information and refrain from competing with and soliciting
employees from Focal during his or her employment and for a period of up to
eighteen months after his or her termination. During this period, after any
applicable severance pay period has expired, the Executive Investor or Ms.
Martin, as
28
applicable, is entitled to receive noncompetition compensation equal to his or
her salary and medical benefits (net of any amounts he or she receives as
compensation for other employment), unless he or she breaches his or her non-
disclosure, non-compete or non-solicitation obligations.
Pursuant to the Employment Agreements and in exchange for shares of common
stock held by each of the Executive Investors prior to November 27, 1996:
. 5,000 shares of Class B common stock subject to time-vesting requirements
set forth in the Employment Agreements were issued to each of the
Executive Investors on November 27, 1996
and
. 3,677.885 shares of Class C common stock subject to performance-vesting
requirements set forth in the Vesting Agreements (as defined below) were
issued to each of the Executive Investors on November 27, 1996. Of these
shares, 3,177.885 were canceled in connection with the September 30, 1998
amendments to the Vesting Agreements. The remaining 500 shares converted
to shares of Class B common stock and are subject to time-vesting
requirements set forth in Restricted Stock Agreements signed at the time
of the September 30, 1998 amendments to the Vesting Agreements. See "--
Vesting Agreements"
Of the 5,000 shares of Class B common stock issued on November 27, 1996
that are subject to time-vesting requirements under the Employment Agreements,
1,000 shares vested immediately and the remaining shares vest in equal
installments over a four year period that commenced November 27, 1997 so long
as the Executive Investor remains employed by Focal. Pursuant to this
schedule, 1,000 shares vested on each of November 27, 1997 and 1998. 1,000
shares of the 2,000 shares that remain subject to vesting under the Employment
Agreements will vest on November 27, 1999 and the remaining 1,000 shares will
vest on November 27, 2000, if the Executive Investor remains in our employ.
The Employment Agreements contain provisions that provide for partial
acceleration of vesting upon specific business combinations and the completion
of an initial public offering of our securities and total acceleration of
vesting upon other business combinations or the Executive Investor's death or
disability.
Each Employment Agreement further provides Focal and other existing
stockholders with specified rights if the Executive Investor ceases to be
employed by Focal for any reason.
Vesting Agreements
Pursuant to the original terms of three separate Vesting Agreements (the
"Vesting Agreements"), each dated November 27, 1996, among Focal, the
Executive Investors and each of Madison Dearborn, Frontenac and Battery
Ventures (collectively, the "Institutional Investors"), each of the Executive
Investors was entitled to earn 3,677.885 shares of Class C common stock if
certain financial performance criteria were satisfied. If any shares of Class
C common stock vested, an equal number of shares of Class A common stock held
by the Institutional Investors would be forfeited by the Institutional
Investors.
Pursuant to amendments to the Vesting Agreements, on September 30, 1998,
the Vesting Agreements terminated and:
. The Institutional Investors collectively forfeited 5,000 shares of the
Class A common stock held by them
. The Executive Investors each forfeited 3,177.888 shares of Class C common
stock held by them (or a total of 12,711.54 shares for all Executive
Investors)
. 500 shares of Class C common stock held by each Executive Investor were
vested and converted to 500 shares of Class B common stock and became
subject to new time-vesting requirements based on periods of continuous
service with us (the "Restricted Shares"). Twenty percent of the
Restricted Shares immediately vested and the remaining Restricted Shares
will vest 10% on September 30, 1999, 15% on September 30, 2000, 20% on
September 30, 2001 and 35% on September 30, 2002. The Executive Investors
are entitled to voting, dividend and other ownership rights with respect
to the Restricted Shares, but the Restricted Shares are subject to
restrictions on transfer until they vest. Vesting of the Restricted
29
Shares is accelerated under specified circumstances, including upon a
Change in Control (as defined in our 1997 Plan) or the Executive
Investor's death or disability
Compensation Committee Interlocks and Insider Participation
The Compensation Committee of the Board of Directors currently consists of
five directors, including Mr. Taylor, our President and Chief Executive
Officer. All matters concerning executive compensation in 1998 were addressed
by the full Board of Directors, including Messrs. Taylor and Barnicle, who
were executive officers of Focal during 1998. None of our executive officers
served as a member of the compensation committee or as a director of any other
entity.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The table below sets forth information regarding beneficial ownership of
our Class A common stock and Class B common stock as of March 1, 1999 for:
. Each of the Named Executive Officers
. Each of our directors
. All of our executive officers and directors as a group
. Each other person who we know beneficially owns 5% or more of any class
of our common stock
At March 1, 1999, there were no shares of our Class C common stock
outstanding. Unless otherwise noted, the address of each Named Executive
Officer and director of Focal is 200 North LaSalle Street, Suite 1100,
Chicago, Illinois 60601.
Class A Common Stock Class B Common Stock
----------------------- -----------------------
Number of Number of
Shares Shares
Beneficially Percent of Beneficially Percent of
Owned (1) Shares Owned (1) Shares
Name ------------ ---------- ------------ ----------
Named Executive Officers
Robert C. Taylor, Jr. (2)...... 230.77 * 5,500 25.0%
John R. Barnicle (3)........... 230.77 * 5,361 24.4%
Joseph A. Beatty (4)........... 230.77 * 5,500 25.0%
Brian F. Addy (5).............. 230.77 * 5,500 25.0%
Renee M. Martin (6)............ 57.50 * -- --
Directors
James N. Perry, Jr. (7)........ 43,212.85 57.1% -- --
Paul J. Finnegan (8)........... 43,212.85 57.1% -- --
James E. Crawford III (9)...... 20,165.96 26.7% -- --
Richard D. Frisbie (10)........ 10,082.73 13.3% -- --
Paul G. Yovovich (11).......... 493.44 * -- --
John A. Edwardson (12)......... 326.00 * -- --
All Executive Officers and
Directors as a Group
(13 persons) (13)............. 75,347.56 99.1% 21,861 99.4%
Other 5% Owners
Madison Dearborn Capital
Partnership, L.P. (14)........ 43,212.85 57.1% -- --
Frontenac VI, L.P. (15)........ 20,165.96 26.7% -- --
Battery Ventures III, L.P.
(16).......................... 10,082.73 13.3% -- --
Ad-Venture Capital Partners,
L.P. (17)..................... 230.77 * 2,000 9.1%
Coventry Court Partners, L.P.
(18).......................... -- -- 1,730 7.9%
Mistral Partners, L.P. (19).... 230.77 * 2,000 9.1%
- --------
* Less than 1% of the issued and outstanding shares of our common stock.
30
(1) In accordance with the rules of the Securities and Exchange Commission,
each beneficial owner's holding have been calculated assuming full
exercise of outstanding warrants and options exercisable by the holder
within 60 days after March 1, 1999, but no exercise of outstanding
warrants and options held by any other person. Unless otherwise indicated
below, the persons and entities named in the table have sole voting and
sole investment power with respect to all shares beneficially owned by
them, subject to applicable community property laws.
(2) Includes 2,000 and 400 shares of Class B common stock subject to vesting
provisions contained in the executive's Employment Agreement and
Restricted Stock Agreement, respectively. See Item 11, "Executive
Compensation--Employment Agreements" and "--Vesting Agreements." Also
includes 2,230.77 shares of common stock held by Mistral Partners, L.P.,
a family limited partnership. Mr. Taylor exercises sole voting and
investment power over shares held by this partnership.
(3) Includes 2,000 and 400 shares of Class B common stock subject to vesting
provisions contained in the executive's Employment Agreement and
Restricted Stock Agreement, respectively. See Item 11, "Executive
Compensation--Employment Agreements" and "--Vesting Agreements." Also
includes 700 shares of Class B common stock held by JRB Partners, L.P., a
family limited partnership. Mr. Barnicle exercises sole voting and
investment power over shares held by this partnership.
(4) Includes 2,000 and 400 shares of Class B common stock subject to vesting
provisions contained in the executive's Employment Agreement and
Restricted Stock Agreement, respectively. See Item 11, "Executive
Compensation--Employment Agreements" and "--Vesting Agreements." Also
includes 1,730 shares of Class B common stock held by Coventry Court
Partners, L.P., a family limited partnership. Mr. Beatty exercises sole
voting and investment power over shares held by this partnership.
(5) Includes 2,000 and 400 shares of Class B common stock subject to vesting
provisions contained in the executive's Employment Agreement and
Restricted Stock Agreement, respectively. See Item II, "Executive
Compensation--Employment Agreements" and "--Vesting Agreements." Also
includes 2,230.77 shares of common stock held by Ad-Venture Capital
Partners, L.P., a family limited partnership. Mr. Addy exercises sole
voting and investment power over shares held by this partnership.
(6) Consists of shares of Class A common stock subject to options which are
exercisable within 60 days of March 1, 1999.
(7) Mr. Perry, a director, owns no shares in his own name. Consists of shares
of Class A common stock owned by Madison Dearborn. See footnote 14 below.
Mr. Perry's address is c/o Madison Dearborn Partners, Inc., Three First
National Plaza, Suite 3800, Chicago, IL 60602.
(8) Mr. Finnegan, a director, owns no shares in his own name. Consists of
shares of Class A common stock owned by Madison Dearborn. See footnote 14
below. Mr. Finnegan's address is c/o Madison Dearborn Partners, Inc.,
Three First National Plaza, Suite 3800, Chicago, IL 60602.
(9) Mr. Crawford, a director, owns no shares in his own name. Consists of
shares of Class A common stock owned by Frontenac. See footnote 15 below.
Mr. Crawford's address is c/o Frontenac Company, 135 S. LaSalle Street,
Suite 3800, Chicago, IL 60603.
(10) Mr. Frisbie, a director, owns no shares in his own name. Consists of
shares of Class A common stock owned by Battery. See footnote 16 below.
Mr. Frisbie's address is c/o Battery Ventures, 20 William Street,
Wellesley, MA 02481.
(11) Includes 297.44 shares of Class A common stock and an additional 196
shares of Class A common stock subject to options which are exercisable
within 60 days of March 1, 1999.
(12) Includes 300 shares of Class A common stock and an additional 26 shares
of Class A common stock subject to options which are exercisable within
60 days of March 1, 1999.
(13) Includes 74,982.06 shares of Class A common stock and 21,861 shares of
Class B common stock and an additional 365.5 shares of Class A common
stock subject to options which are exercisable within 60 days of March 1,
1999.
(14) Consists of shares of Class A common stock owned by Madison Dearborn.
Messrs. Perry and Finnegan, directors of the Company, are principals of
Madison Dearborn Capital Partners, Inc., the general partner of Madison
Dearborn. Because of these positions, Messrs. Perry and Finnegan share
voting and investment power with respect to the shares owned by Madison
Dearborn. See Item 13, "Certain Relationships and Related Party
Transactions."
31
(15) Consists of shares of Class A common stock owned by Frontenac. Mr.
Crawford, a director, is a general partner of Frontenac Company, the
general partner of Frontenac. Because of this position, Mr. Crawford
shares voting and investment power with respect to the shares owned by
Frontenac. See Item 13, "Certain Relationships and Related Party
Transactions."
(16) Consists of shares of Class A common stock owned by Battery Ventures. Mr.
Frisbie, a director, is a managing general partner of Battery Ventures.
Because of this position, Mr. Frisbie shares voting and investment power
with respect to the shares owned by Battery Ventures. See Item 13,
"Certain Relationships and Related Party Transactions."
(17) Consists of shares of Class A common stock and Class B common stock owned
by Ad-Venture Capital Partners, L.P., a family limited partnership. Mr.
Addy exercises sole voting and investment power over these shares. The
address of this partnership is 200 North LaSalle Street, Suite 1100,
Chicago, Illinois 60601.
(18) Consists of shares of Class B common stock owned by Coventry Court
Partners, L.P., a family limited partnership. Mr. Beatty exercises sole
voting and investment power over these shares. The address of this
partnership is 200 North LaSalle Street, Suite 1100, Chicago, Illinois
60601.
(19) Consists of shares of Class A common stock and Class B common stock owned
by Mistral Partners, L.P., a family limited partnership. Mr. Taylor
exercises sole voting and investment power over these shares. The address
of this partnership is 200 North LaSalle Street, Suite 1100, Chicago,
Illinois 60601.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
In addition to serving as members of our Board of Directors, Mr. Crawford,
Mr. Finnegan, Mr. Frisbie and Mr. Perry each serve as directors of other
telecommunications services companies and other private companies. As a
result, these four directors may be subject to conflicts of interest during
their tenure on our Board of Directors. Accordingly, they may be periodically
required to inform us and the other companies to which they owe fiduciary
duties of financial or business opportunities We do not currently have any
standard procedures for resolving potential conflicts of interest relating to
corporate opportunities or otherwise.
Mr. Crawford, Mr. Finnegan, Mr. Frisbie and Mr. Perry also serve on the
boards of directors of companies with which we may compete or enter into
agreements. Specifically, these directors are directors of Allegiance Telecom,
a Dallas-based CLEC. Allegiance Telecom is one of our competitors.
The Stock Purchase Agreement and Stockholders' Agreement
We have entered into a Stock Purchase Agreement with some of our
stockholders, dated as of November 27, 1996 and amended after that date.
Pursuant to the Stock Purchase Agreement and additional related agreements,
our existing stockholders were granted put rights, voting rights, and
registration rights described below and elsewhere in this report.
The Stock Purchase Agreement contains standard representations and
warranties by Focal and affirmative and restrictive covenants and permits the
Institutional Investors to force us to liquidate after February 2003. Most of
the affirmative and restrictive covenants in the Stock Purchase Agreement and
the right to force liquidation will terminate upon the completion of an
initial public offering of our securities. However, after completion of such
an offering, we will continue to be required to:
. Deliver financial information to the Institutional Investors and certain
of their transferees in a private sale of shares of common stock
. Provide access by the Institutional Investors, and certain of their
transferees in a private sale of shares of common stock, to our physical
properties, books and records
. Comply with the periodic reporting requirements under the Securities
Exchange Act of 1934 to enable holders of "restricted shares" of common
stock to sell those shares of common stock pursuant to Rule 144 under
the Securities Act of 1933 or a short-form registration statement under
the Securities Act of 1933
32
The Stockholders' Agreement contains provisions relating to:
. Election of our directors (see Item 10, "Directors and Executive
Officers of the Registrant--How We Elect Our Directors")
. Business combinations involving Focal
. Transfer restrictions and rights of first refusal and participation
related to sales of shares of common stock by existing stockholders
All of these provisions and restrictions, other than transfer restrictions
on unvested shares of common stock held by the Executive Investors, will
terminate upon completion of an initial public offering of our securities.
See Item 11, "Executive Compensation--Employment Agreements" and "--Vesting
Agreements" for a more detailed discussion of the various provisions of the
Employment Agreements and Vesting Agreements.
Registration Rights
Focal has granted registration rights to all existing holders of its common
stock. The existing holders of common stock have the benefit of the following
demand registration:
. Subject to minimum dollar amounts, Madison Dearborn may demand two
registrations on Form S-1
. Frontenac and Battery may each demand one registration on Form S-1
. The holders of 8% of all shares of common stock (including shares of
Class A common stock and Class B common stock) subject to the
registration agreement, approximately 7,813.92 shares of common stock
(including shares of Class A common stock and Class B common stock), may
demand an unlimited number of registrations on Form S-2 or Form S-3
In addition, our existing stockholders have unlimited "piggyback"
registration rights under which they have the right to request that we
register their shares of common stock whenever we register any of our
securities under the Securities Act of 1933 and the registration form to be
used may be used for the registration of their shares of common stock. These
piggyback registration rights will not, however, be available:
. If the piggyback registration is in connection with an underwritten
registration and the managing underwriter concludes that including
shares of common stock owned by holders of "piggyback" registration
rights would have an adverse impact on the marketing of the securities
to be sold in the underwritten offering
. For registrations undertaken because of a demand registration
Stock Purchases by Our Directors
In May 1997, Mr. Yovovich purchased 230.77 shares of Class A common stock
for a purchase price of $75,000. In November 1998, he purchased an additional
66.667 shares of Class A common stock for himself and members of his family
for a purchase price of $100,000. In February 1999, Mr. Edwardson purchased
300 shares of Class A common stock for a purchase price of $472,500.
33
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
The consolidated financial statements of Focal Communications Corporation
and Subsidiaries for the year ended December 31, 1998, together with the
Report of Independent Public Accountants, are set forth on pages F-1
through F-18 of this report. The supplemental financial information listed
and appearing hereafter should be read in conjunction with the consolidated
financial statements included in the report.
(2) Financial Statement Schedules
The following are included in Part IV of this report for each of the years
ended December 31, 1996, 1997 and 1998 as applicable:
Report of Independent Public Accountants F-19
Schedule II--Valuation and Qualifying Accounts F-20
Financial statement schedules not included in this report have been omitted
either because they are not applicable or because the required information
is shown in the consolidated financial statements or notes thereto,
included in this report.
(3) The exhibits listed below are filed as part of this report:
Exhibit
Number Exhibit Description
------- -------------------
2.1 Plan of Reorganization and Agreement by and among Focal
Communications Corporation and its Subsidiaries, dated June 12,
1997. (Incorporated by reference to Exhibit No. 2.1 to the
Registrant's Registration Statement on Form S-4 originally filed
with the Securities and Exchange Commission on August 13, 1998
(Registration No. 333-49397) (the "S-4"))
3.1 Certificate of Incorporation. (Incorporated by reference to
Exhibit No. 3.1 of the S-4)
3.2 Amendment to Certificate of Incorporation.
3.3 By-Laws. (Incorporated by reference to Exhibit No. 3.2 of the S-
4)
4.1 Indenture with Harris Trust and Savings Bank, dated February 18,
1998. (Incorporated by reference to Exhibit No. 4.1 of the S-4)
4.2 Initial Global 12.125% Senior Discount Note Due February 15,
2008, dated February 18, 1998. (Incorporated by reference to
Exhibit No. 4.2 of the S-4)
4.3 Stock Purchase Agreement with Madison Dearborn Capital Partners,
L.P., Frontenac VI, L.P., Battery Ventures III, L.P., Brian F.
Addy, John R. Barnicle, Joseph Beatty, and Robert C. Taylor Jr.,
dated November 27, 1996. (Incorporated by reference to Exhibit
No. 4.5 of the S-4)
4.4 Amendment No. 1 to Stock Purchase Agreement with Madison
Dearborn Capital Partners, L.P., Frontenac VI, L.P., Battery
Ventures III, L.P., Brian F. Addy, John R. Barnicle, Joseph
Beatty, and Robert C. Taylor Jr., dated January 23, 1998.
(Incorporated by reference to Exhibit No. 4.6 of the S-4)
34
Exhibit
Number Exhibit Description
------- -------------------
4.5 Amendment No. 2 to Stock Purchase Agreement with Madison
Dearborn Capital Partners, L.P., Frontenac VI, L.P., Battery
Ventures III, L.P., Brian F. Addy, John R. Barnicle, Joseph
Beatty and Robert C. Taylor, Jr., dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.8 to the
Registrant's Quarterly Report on Form 10-Q for the period ending
September 30, 1998, originally filed with the Securities and
Exchange Commission on November 16, 1998 (the "3rd Quarter 10-
Q"))
4.6 Vesting Agreement with Madison Dearborn Capital Partners, L.P.,
Brian F. Addy, John R. Barnicle, Joseph Beatty and Robert C.
Taylor, Jr., dated as of November 27, 1996. (Incorporated by
reference to Exhibit No. 4.1 of the 3rd Quarter 10-Q)
4.7 Vesting Agreement with Frontenac VI, L.P., Brian F. Addy, John
R. Barnicle, Joseph Beatty and Robert C. Taylor, Jr., dated as
of November 27, 1996. (Incorporated by reference to Exhibit No.
4.2 of the 3rd Quarter 10-Q)
4.8 Vesting Agreement with Battery Ventures III, L.P., Brian F.
Addy, John R. Barnicle, Joseph Beatty and Robert C. Taylor, Jr.,
dated as of November 27, 1996. (Incorporated by reference to
Exhibit No. 4.3 of the 3rd Quarter 10-Q)
4.9 Amendment No. 1 to Vesting Agreement and Consent as of August
21, 1998, between Focal Communications Corporation with Madison
Dearborn Capital Partners, L.P., Frontenac VI, L.P., Battery
Ventures III, L.P., Brian F. Addy, John R. Barnicle, Joseph
Beatty and Robert C. Taylor, Jr., dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.4 of the 3rd Quarter
10-Q)
4.10 Amendment No. 1 to Vesting Agreement and Consent as of August
21, 1998, between Focal Communications Corporation with Madison
Dearborn Capital Partners, L.P., Frontenac VI, L.P., Battery
Ventures III, L.P., Brian F. Addy, John R. Barnicle, Joseph
Beatty and Robert C. Taylor, Jr., dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.5 of the 3rd Quarter
10-Q)
4.11 Amendment No. 1 to Vesting Agreement and Consent as of August
21, 1998, between Focal Communications Corporation with Madison
Dearborn Capital Partners, L.P., Frontenac VI, L.P., Battery
Ventures III, L.P., Brian F. Addy, John R. Barnicle, Joseph
Beatty and Robert C. Taylor, Jr., dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.6 of the 3rd Quarter
10-Q)
4.12 Form of Restricted Stock Agreement, dated September 30, 1998
between Focal Communications Corporation and each of Brian F.
Addy, John R. Barnicle, Joseph Beatty, and Robert C. Taylor, Jr.
(Incorporated by reference to Exhibit No. 4.7 of the 3rd Quarter
10-Q)
4.13 Stockholders Agreement with Madison Dearborn Capital Partners,
L.P., Frontenac VI, L.P., Battery Ventures III, L.P., Brian F.
Addy, John R. Barnicle, Joseph Beatty, and Robert C. Taylor Jr.,
dated November 27, 1996. (Incorporated by reference to Exhibit
No. 4.11 of the S-4)
4.14 Amendment No. 1 to Stockholders Agreement with Madison Dearborn
Capital Partners, L.P., Frontenac VI, L.P., Battery Ventures
III, L.P., Brian F. Addy, John R. Barnicle, Joseph Beatty and
Robert C. Taylor, Jr., dated as of July 7, 1998. (Incorporated
by reference to Exhibit No. 4.9 of the 3rd Quarter 10-Q)
4.15 Amendment No. 2 to Stockholders Agreement with Madison Dearborn
Capital Partners, L.P., Frontenac VI, L.P., Battery Ventures
III, L.P., Brian F. Addy, John R. Barnicle, Joseph Beatty and
Robert C. Taylor, Jr., dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.10 of the 3rd
Quarter 10-Q)
35
Exhibit
Number Exhibit Description
------- -------------------
4.16 Amendment No. 3 to Stock Purchase Agreement with Madison
Dearborn Capital Partners, L.P., Frontenac VI, L.P., Battery
Ventures III, L.P., Brian F. Addy, John R. Barnicle, Joseph
Beatty, and Robert C. Taylor, Jr., dated February 16, 1999.
4.17 Executive Stock Agreement and Employment Agreement with Brian F.
Addy, dated November 27, 1996. (Incorporated by reference to
Exhibit No. 4.12 of the S-4)+
4.18 Executive Stock Agreement and Employment Agreement with John R.
Barnicle, dated November 27, 1996. (Incorporated by reference to
Exhibit No. 4.13 of the S-4)+
4.19 Executive Stock Agreement and Employment Agreement with Joseph
A. Beatty, dated November 27, 1996. (Incorporated by reference
to Exhibit No. 4.14 of the S-4)+
4.20 Executive Stock Agreement and Employment Agreement with Robert
C. Taylor, Jr., dated November 27, 1996. (Incorporated by
reference to Exhibit No. 4.15 of the S-4)+
4.21 Amendment No. 1 to Executive Employment Agreement and Consent
with Brian F. Addy, dated as of August 21, 1998. (Incorporated
by reference to Exhibit No. 4.11 of the 3rd Quarter 10-Q)+
4.22 Amendment No. 1 to Executive Employment Agreement and Consent
with John R. Barnicle, dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.12 of the 3rd
Quarter 10-Q)+
4.23 Amendment No. 1 to Executive Employment Agreement and Consent
with Joseph Beatty, dated as of August 21, 1998. (Incorporated
by reference to Exhibit No. 4.13 of the 3rd Quarter 10-Q)+
4.24 Amendment No. 1 to Executive Employment Agreement and Consent
with Robert C. Taylor, dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.14 of the 3rd
Quarter 10-Q)+
4.25 Registration Agreement with Madison Dearborn Capital Partners,
L.P., Frontenac VI, L.P., Battery Ventures III, L.P., Brian F.
Addy, John R. Barnicle, Joseph Beatty, and Robert C. Taylor Jr.,
dated November 27, 1996. (Incorporated by reference to Exhibit
No. 4.16 of the S-4)
4.26 Amendment No. 1 to Registration Agreement with Madison Dearborn
Capital Partners, L.P., Frontenac VI, L.P., Battery Ventures
III, L.P., Brian F. Addy, John R. Barnicle, Joseph Beatty and
Robert C. Taylor, Jr., dated as of August 21, 1998.
(Incorporated by reference to Exhibit No. 4.15 of the 3rd
Quarter 10-Q)
10.1 Interconnection Agreement with Ameritech Information Industry
Services, dated October 28, 1996. (Incorporated by reference to
Exhibit No. 10.1 of the S-4)
10.2 Interconnection Agreement with Ameritech Information Industry
Services, dated October 24, 1997. (Incorporated by reference to
Exhibit No. 10.2 of the S-4)
10.3 Interconnection Agreement with New York Telephone Company, dated
November 10, 1997. (Incorporated by reference to Exhibit No.
10.3 of the S-4)
10.4 Amended and Restated Interconnection Agreement with Ameritech
Information Industry Services, dated March 16, 1998.
(Incorporated by reference to Exhibit No. 10.4 of the 1998 S-4)
36
Exhibit
Number Exhibit Description
------- -------------------
10.5 Interconnection Agreement with Bell Atlantic-Pennsylvania, dated
April 27, 1998. (Incorporated by reference to Exhibit No. 10.26
of the S-4)
10.6 Interconnection Agreement with Bell Atlantic-Delaware, dated
April 27, 1998. (Incorporated by reference to Exhibit No. 10.25
of the S-4)
10.7 Interconnection Agreement with Bell Atlantic-New Jersey, dated
April 27, 1998. (Incorporated by reference to Exhibit No. 10.24
of the S-4)
10.8 Interconnection Agreement with GTE--California, dated June 12,
1998. (Incorporated by reference to Exhibit No. 10.23 of the S-
4)
10.9 Interconnection Agreement with Pacific Bell, dated June 15,
1998. (Incorporated by reference to Exhibit No. 10.22 of the S-
4)
10.10 First Amendment to the Interconnection Agreement with Ameritech
Information Industry Services, dated September 8, 1998.
(Incorporated by reference to Exhibit No. 10.1 of the 3rd
Quarter 10-Q)
10.11 Network Products Purchase Agreement with Northern Telecom Inc.,
dated January 21, 1997. (Incorporated by reference to Exhibit
No. 10.5 of the S-4)
10.12 Amendments No. 1 and No. 2 to Network Products Purchase
Agreement with Northern Telecom Inc., both dated March 6, 1998.
(Incorporated by reference to Exhibit No. 10.6 of the S-4)*
10.13 Software License with DPI/TFS, Inc., dated April 10, 1997.
(Incorporated by reference to Exhibit No. 10.17 of the S-4)*
10.14 Second Amendment to Lease Agreement for property located at 200
North LaSalle, Chicago, IL, dated November 15, 1997.
(Incorporated by reference to Exhibit No. 10.9 of the S-4)
10.15 Lease Agreement for property located at 200 North LaSalle,
Chicago, IL, dated December 31, 1996. (Incorporated by reference
to Exhibit No. 10.7 of the S-4)
10.16 First Amendment to Lease Agreement for property located at 200
North LaSalle, Chicago, IL, dated May 14, 1997. (Incorporated by
reference to Exhibit No. 10.8 of the S-4)
10.17 Loan and Security Agreement with NTFC Capital Corporation dated
December 30, 1998.*
10.18 Third Amendment to Lease Agreement for property located at 200
North LaSalle, Chicago, IL, dated March 2, 1998. (Incorporated
by reference to Exhibit No. 10.10 of the S-4)
10.19 Fourth Amendment to Lease Agreement for property located at 200
North LaSalle, Chicago, IL, dated April 4, 1998. (Incorporated
by reference to Exhibit No. 10.18 of the
S-4)
10.20 Lease Agreement for property located at 32 Old Slip, New York,
NY, dated May 20, 1997. (Incorporated by reference to Exhibit
No. 10.11 of the S-4)
10.21 Lease Agreement for property located at 650 Townsend Street, San
Francisco, CA, dated January 26, 1998. (Incorporated by
reference to Exhibit No. 10.12 of the S-4)
37
Exhibit
Number Exhibit Description
------- -------------------
10.22 Lease Agreement for property located at 701 Market Street,
Philadelphia, Pennsylvania, dated March 10, 1998. (Incorporated
by reference to Exhibit No. 10.13 of the S-4)
10.23 Lease Agreement for property located at 1120 Vermont Avenue,
NW., Washington, D.C., dated as of May 4, 1998. (Incorporated by
reference to Exhibit No. 10.19 of the S-4)
10.24 First Amendment to Lease Agreement for property located at 1120
Vermont, NW, Washington, D.C., dated July 23, 1998.
(Incorporated by reference to Exhibit No. 10.6 of the 3rd
Quarter 10-Q)
10.25 Lease Agreement for property located at 1200 West Seventh
Street, Los Angeles, California, dated as of May 19, 1998.
(Incorporated by reference to Exhibit No. 10.20 of the 1998 S-4)
10.26 First Amendment to Lease Agreement for property located at 1200
West 7th Street, Los Angeles, CA, dated July 8, 1998.
(Incorporated by reference to Exhibit No. 10.5 of the 3rd
Quarter 10-Q)
10.27 Lease Agreement for property located at 1511 6th Avenue,
Seattle, WA, dated August 7, 1998. (Incorporated by reference to
Exhibit No. 10.2 of the 3rd Quarter 10-Q)
10.28 Lease Agreement for property located at 23800 West Ten Mile
Road, Southfield, MI, dated August 31, 1998. (Incorporated by
reference to Exhibit No. 10.3 of the 3rd Quarter 10-Q)
10.29 Lease Agreement for property located at One Penn Plaza, New
York, NY, dated September 25, 1998. (Incorporated by reference
to Exhibit No. 10.4 of the 3rd Quarter 10-Q)
10.30 Employment Agreement with Renee M. Martin, dated March 20, 1998.
(Incorporated by reference to Exhibit No. 10.16 of the S-4)+
10.31 Amendment No. 1 to Executive Employment Agreement with Renee M.
Martin, dated as of August 21, 1998. (Incorporated by reference
to Exhibit No. 10.10 of the 3rd Quarter 10-Q)
10.32 1997 Nonqualified Stock Option Plan, amended and restated as of
August 21, 1998. (Incorporated by reference to Exhibit No. 10.7
of the 3rd Quarter 10-Q)+
10.33 Form of Amended and Restated Stock Option Agreement.+
10.34 1998 Equity and Performance Incentive Plan. (Incorporated by
reference to Exhibit No. 10.8 of the 3rd Quarter 10-Q)+
10.35 1998 Equity Plan for Non-Employee Directors. (Incorporated by
reference to Exhibit No. 10.9 of the 3rd Quarter 10-Q)+
10.36 Agreement for Sale of Real Property between Focal Communications
Corporation and United Air Lines, Inc. dated August 13, 1998.
21.1 Subsidiaries of the Registrant.
23.1 Consent of Arthur Andersen LLP.
27.1 Financial Data Schedule.
- --------
*Portions of these exhibits have been omitted pursuant to a request for
confidential treatment, and the omitted portions have been filed separately
with the Securities and Exchange Commission.
+Management contract or compensatory plan
38
(b) Reports on Form 8-K
The Company filed a report on Form 8-K dated November 16, 1998, which
related to an error made in the calculation of the Company's basic and diluted
loss per share.
(c) Financial Statement Schedules
The financial statement schedules filed as part of this Annual Report on
Form 10-K are as specified in item 14(a)(2) herein.
SUPPLEMENTAL INFORMATION TO BE FILED PURSUANT TO SECTION 15(d) OF THE ACT
BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF
THE ACT.
No annual report or proxy material has been sent to security holders.
39
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, there unto duly authorized.
Focal Communications Corporation
/s/ Robert C. Taylor, Jr.
By: _________________________________
Robert C. Taylor, Jr.
President and Chief Executive
Officer
March 31, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated. Each Director whose
signature appears below authorizes and appoints Robert C. Taylor, Jr., John R.
Barnicle, Joseph A. Beatty and Renee M. Martin, or any of them, as his
attorney-in-fact to sign and file on his behalf any and all amendments to this
report.
Signature Title
--------- -----
/s/ Robert C. Taylor, Jr. President, Chief Executive March 31, 1999
____________________________________ Officer and Director
Robert C. Taylor, Jr. (Principal Executive
Officer)
/s/ John R. Barnicle Executive Vice President, March 31, 1999
____________________________________ Chief Operating Officer, and
John R. Barnicle Director
.
/s/ Joseph A. Beatty Executive Vice President and March 31, 1999
____________________________________ Chief Financial Officer
Joseph A. Beatty (Principal Financial Officer)
/s/ Gregory J. Swanson Controller (Principal March 31, 1999
____________________________________ Accounting Officer)
Gregory J. Swanson
/s/ James E. Crawford, III Director March 31, 1999
____________________________________
James E. Crawford, III
/s/ John A. Edwardson Director March 31, 1999
____________________________________
John A. Edwardson
/s/ Paul J. Finnegan Director March 31, 1999
____________________________________
Paul J. Finnegan
/s/ Richard D. Frisbie Director March 31, 1999
____________________________________
Richard D. Frisbie
/s/ James N. Perry, Jr. Director March 31, 1999
____________________________________
James N. Perry, Jr.
/s/ Paul G. Yovovich Director March 31, 1999
____________________________________
Paul G. Yovovich
40
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS.................................. F-2
CONSOLIDATED FINANCIAL STATEMENTS:
Consolidated Balance Sheets as of December 31, 1997 and 1998............ F-3
Consolidated Statements of Operations for the Period from May 31, 1996
(Commencement of Operations), to December 31, 1996 and for the Years
Ended December 31, 1997 and 1998....................................... F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the Period
from May 31, 1996 (Commencement of Operations), to December 31, 1996,
and for the Years Ended
December 31, 1997 and 1998............................................. F-5
Consolidated Statements of Cash Flows for the Period from May 31, 1996
(Commencement of Operations), to December 31, 1996, and for the Years
Ended December 31, 1997 and 1998....................................... F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS................................ F-7
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS.................................. F-19
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS............................. F-20
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of
Focal Communications Corporation:
We have audited the accompanying consolidated balance sheets of FOCAL
COMMUNICATIONS CORPORATION AND SUBSIDIARIES (a Delaware corporation) as of
December 31, 1997 and 1998, and the related consolidated statements of
operations, stockholders' equity (deficit) and cash flows for the period from
May 31, 1996 (commencement of operations), to December 31, 1996, and for the
years ended December 31, 1997 and 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Focal
Communications Corporation and Subsidiaries as of December 31, 1997 and 1998,
and the results of their operations and their cash flows for the period from
May 31, 1996 (commencement of operations), to December 31, 1996, and for the
years ended December 31, 1997 and 1998, in conformity with generally accepted
accounting principles.
ARTHUR ANDERSEN LLP
Chicago, Illinois
January 22, 1999
F-2
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 1997 and 1998
ASSETS 1997 1998
------ ----------- ------------
Current assets:
Cash and cash equivalents......................... $ 2,256,552 $126,041,001
Short-term investments............................ -- 7,959,940
Accounts receivable, net of allowance for doubtful
accounts of $469,000 and $1,189,000 in 1997 and
1998, respectively............................... 2,355,814 9,792,532
Related-party receivables......................... 34,883 --
Other current assets.............................. 90,559 843,793
----------- ------------
Total current assets............................ 4,737,808 144,637,266
----------- ------------
Fixed assets, at cost:
Buildings and improvements........................ -- 2,350,000
Communications network............................ 7,906,336 44,774,965
Construction in progress.......................... 1,938,236 15,103,564
Computer equipment................................ 941,237 3,503,512
Leasehold improvements............................ 652,173 8,577,724
Furniture and fixtures............................ 355,759 1,790,596
Motor vehicles.................................... -- 19,289
----------- ------------
11,793,741 76,119,650
Less--Accumulated depreciation and amortization... 616,967 6,146,530
----------- ------------
Fixed assets, net............................... 11,176,774 69,973,120
----------- ------------
Other noncurrent assets............................. -- 4,963,894
----------- ------------
$15,914,582 $219,574,280
=========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
----------------------------------------------
Current liabilities:
Accounts payable.................................. $ 1,502,479 $ 8,365,470
Accrued liabilities............................... 367,890 1,941,377
Income taxes payable.............................. -- 4,055,000
Current maturities of long-term debt.............. 943,621 2,887,036
----------- ------------
Total current liabilities....................... 2,813,990 17,248,883
----------- ------------
Long-term debt, net of current maturities........... 2,593,265 182,408,757
----------- ------------
Other noncurrent liabilities........................ 179,481 588,228
----------- ------------
Redeemable common stock:
Class A, $.01 par value; 85,567 shares authorized;
80,307 and 0 shares issued and outstanding at
December 31, 1997 and 1998, respectively......... 12,403,218 --
----------- ------------
Commitments and contingencies
Stockholders' equity (deficit):
Common Stock, Class A, $.01 par value; 85,567
shares authorized; 0 and 75,374 shares issued and
outstanding at December 31, 1997 and 1998,
respectively..................................... -- 753
Common Stock, Class B, $.01 par value; 35,000
shares authorized; 20,000 and 22,000 shares
issued at December 31, 1997 and 1998,
respectively..................................... 200 220
Common Stock, Class C, $.01 par value; 15,000
shares authorized; 14,711 and 0 issued at
December 31, 1997 and 1998, respectively......... 147 --
Additional paid-in capital........................ 5,096,435 35,413,345
Deferred compensation............................. (3,791,667) (4,736,432)
Accumulated deficit............................... (3,380,487) (11,349,474)
----------- ------------
Total stockholders' equity (deficit)............ (2,075,372) 19,328,412
----------- ------------
$15,914,582 $219,574,280
=========== ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Period from May 31, 1996 (Commencement of Operations), to
December 31, 1996, and for the Years Ended December 31, 1997 and 1998
1996 1997 1998
--------- ----------- ------------
Revenues................................. $ -- $ 4,023,690 $ 43,531,846
--------- ----------- ------------
Expenses:
Customer service and network
operations............................ -- 2,154,980 15,284,641
Selling, general and administrative.... 421,777 2,887,372 12,209,821
Depreciation and amortization.......... 1,150 615,817 6,670,986
Non-cash compensation expense.......... 108,333 1,300,000 3,069,553
--------- ----------- ------------
Total expenses....................... 531,260 6,958,169 37,235,001
--------- ----------- ------------
Operating income (loss).............. (531,260) (2,934,479) 6,296,845
--------- ----------- ------------
Other income (expense):
Interest income........................ 17,626 195,696 6,528,541
Interest expense....................... -- (128,070) (16,134,373)
--------- ----------- ------------
Total other income (expense)......... 17,626 67,626 (9,605,832)
--------- ----------- ------------
Loss before income taxes............. (513,634) (2,866,853) (3,308,987)
Provision for income taxes............... -- -- (4,660,000)
--------- ----------- ------------
Net loss................................. (513,634) (2,866,853) (7,968,987)
Accretion to redemption value of class A
common stock............................ -- (103,565) --
--------- ----------- ------------
Net loss applicable to common
stockholders............................ $(513,634) $(2,970,418) $ (7,968,987)
========= =========== ============
Basic and diluted net loss per share of
common stock............................ $ (30.22) $ (35.21) $ (91.05)
========= =========== ============
Basic and diluted weighted average number
of shares of common stock outstanding... 16,996 84,373 87,526
========= =========== ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
For the Period from May 31, 1996 (Commencement of Operations), to
December 31, 1996, and for the Years Ended December 31, 1997 and 1998
Common Stock, $.01 Par Value
---------------------------------------------
Common Stock Class A Class B Class C Additional
-------------- -------------- ------------- --------------- Paid-in Deferred Accumulated
Shares Amount Shares Amount Shares Amount Shares Amount Capital Compensation Deficit
------ ------ ------ ------ ------ ------ ------- ------ ----------- ------------ ------------
May 31, 1996
(commencement of
operations)..... -- $ -- -- $ -- -- $ -- -- $ -- $ -- $ -- $ --
Issuance of
Common Stock.... 1,500 -- -- -- -- -- -- -- -- -- --
Conversion of
Common Stock to
Class B Common.. (1,125) -- -- -- 20,000 200 -- -- -- -- --
Conversion of
Common Stock to
Class C Common.. (375) -- -- -- -- -- 14,711 147 -- -- --
Deferred
compensation.... -- -- -- -- -- -- -- -- 5,200,000 (5,200,000) --
Amortization of
deferred
compensation.... -- -- -- -- -- -- -- -- -- 108,333 --
Net loss........ -- -- -- -- -- -- -- -- -- -- (513,634)
------ ----- ------ ----- ------ ----- ------- ----- ----------- ----------- ------------
BALANCE,
December 31,
1996............ -- -- -- -- 20,000 200 14,711 147 5,200,000 (5,091,667) (513,634)
Accretion of
redeemable
Common Stock.... -- -- -- -- -- -- -- -- (103,565) -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- -- -- -- 1,300,000 --
Net loss........ -- -- -- -- -- -- -- -- -- -- (2,866,853)
------ ----- ------ ----- ------ ----- ------- ----- ----------- ----------- ------------
BALANCE,
December 31,
1997............ -- -- -- -- 20,000 200 14,711 147 5,096,435 (3,791,667) (3,380,487)
Reclassification
resulting from
amendment to
stock purchase
agreement....... -- -- 80,307 803 -- -- -- -- 12,402,415 -- --
Class A Common
capital
contributions... -- -- -- -- -- -- -- -- 13,800,000 -- --
Issuance of
Class A Common
Stock........... -- -- 67 -- -- -- -- -- 100,000 -- --
Cancellation and
conversion of
Common Stock.... -- -- (5,000) (50) 2,000 20 (14,711) (147) 4,014,495 (4,014,318) --
Amortization of
deferred
compensation.... -- -- -- -- -- -- -- -- -- 3,069,553 --
Net loss........ -- -- -- -- -- -- -- -- -- -- (7,968,987)
------ ----- ------ ----- ------ ----- ------- ----- ----------- ----------- ------------
BALANCE,
December 31,
1998............ -- $ -- 75,374 $ 753 22,000 $ 220 -- $ -- $35,413,345 $(4,736,432) $(11,349,474)
====== ===== ====== ===== ====== ===== ======= ===== =========== =========== ============
Total
------------
May 31, 1996
(commencement of
operations)..... $ --
Issuance of
Common Stock.... --
Conversion of
Common Stock to
Class B Common.. 200
Conversion of
Common Stock to
Class C Common.. 147
Deferred
compensation.... --
Amortization of
deferred
compensation.... 108,333
Net loss........ (513,634)
------------
BALANCE,
December 31,
1996............ (404,954)
Accretion of
redeemable
Common Stock.... (103,565)
Amortization of
deferred
compensation.... 1,300,000
Net loss........ (2,866,853)
------------
BALANCE,
December 31,
1997............ (2,075,372)
Reclassification
resulting from
amendment to
stock purchase
agreement....... 12,403,218
Class A Common
capital
contributions... 13,800,000
Issuance of
Class A Common
Stock........... 100,000
Cancellation and
conversion of
Common Stock.... --
Amortization of
deferred
compensation.... 3,069,553
Net loss........ (7,968,987)
------------
BALANCE,
December 31,
1998............ $19,328,412
============
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Period from May 31, 1996 (Commencement of Operations), to
December 31, 1996, and for the Years Ended December 31, 1997 and 1998
1996 1997 1998
---------- ------------ ------------
Cash flows from operating activities:
Net loss............................. $ (513,634) $ (2,866,853) $ (7,968,987)
Adjustments to reconcile net loss to
net cash provided by (used in)
operating activities--
Depreciation and amortization...... 1,150 615,817 6,670,986
Deferred lease costs............... -- 179,481 408,747
Non-cash compensation expense...... 108,333 1,300,000 3,069,553
Amortization of discount on senior
discount notes.................... -- -- 16,080,249
Provision for losses on accounts
receivable........................ -- 469,000 720,000
Changes in operating assets and
liabilities--
Accounts receivable.............. -- (2,824,814) (8,156,718)
Related-party receivables........ (16,883) (18,000) 34,883
Other current assets............. -- (90,559) (753,234)
Accounts payable and accrued
liabilities..................... 268,458 1,601,911 8,436,478
Income taxes payable............. -- -- 4,055,000
---------- ------------ ------------
Net cash provided by (used in)
operating activities.......... (152,576) (1,634,017) 22,596,957
---------- ------------ ------------
Cash flows from investing activities:
Capital Expenditures................. (82,303) (11,655,524) (64,229,247)
Purchases of short-term investments.. -- -- (7,959,940)
---------- ------------ ------------
Net cash used in investing
activities.................... (82,303) (11,655,524) (72,189,187)
---------- ------------ ------------
Cash flows from financing activities:
Loan origination fees................ -- -- (90,000)
Proceeds from issuance of long-term
debt................................ -- 3,697,500 163,103,565
Payments on long-term debt........... -- (216,528) (3,536,886)
Proceeds from the issuance of Class A
Common Stock........................ 4,025,000 8,275,000 13,900,000
---------- ------------ ------------
Net cash provided by financing
activities.................... 4,025,000 11,755,972 173,376,679
---------- ------------ ------------
Net increase (decrease) in cash and
cash equivalents...................... 3,790,121 (1,533,569) 123,784,449
Cash and cash equivalents
beginning of year.................... -- 3,790,121 2,256,552
---------- ------------ ------------
Cash and cash equivalents
end of year.......................... $3,790,121 $ 2,256,552 $126,041,001
========== ============ ============
The accompanying notes are an integral part of these consolidated financial
statements
F-6
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997 and 1998
1. ORGANIZATION AND OPERATIONS
Focal Communications Corporation began operations on May 31, 1996. Focal
Communications Corporation and Subsidiaries (the "Company") is a competitive
local exchange carrier ("CLEC") in the United States and offers a range of
telecommunications services. The Company currently has operations in Illinois,
Los Angeles, San Francisco, Michigan, New York, Pennsylvania, Washington and
Washington D.C. The Company competes with incumbent local exchange carriers
("ILECs") by providing high-quality, local telecommunications services,
primarily over fiber digital networks, to meet the voice and data transmission
needs of its customers. The Company's customers are principally
telecommunications-intensive businesses, other carriers, resellers and
internet service providers.
The Company incurred an accumulated deficit of $11,349,474, from May 31,
1996 (commencement of operations), through December 31, 1998. The Company must
recognize significant sales and obtain additional capital to adequately grow
its operations. Future profitability of the Company is dependent upon
continued market acceptance and the Company continuing to adequately provide
and maintain its services. Management believes that current financial
forecasts, marketing strategies and capital raising plans are adequate to
address these issues.
2. SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The 1997 and 1998 consolidated balance sheets include the accounts of the
Company and all wholly owned subsidiaries. All material intercompany
transactions and balances have been eliminated in consolidation.
Basis of Accounting
The accompanying consolidated financial statements have been prepared on
the accrual basis of accounting.
Use of Estimates and Assumptions
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Risks and Uncertainties
The Company recorded revenues and related accounts receivable of
approximately $1.7 million as of December 31, 1997, from another carrier who
was disputing this obligation to the Company. This dispute was ultimately
ruled on in favor of the Company by the Illinois Commerce Commission ("ICC")
in March, 1998, and by a federal court in July, 1998. During the fourth
quarter of 1998 the Company received substantially all of the disputed amount.
Concentration of Suppliers
The Company currently leases its transport capacity from a limited amount
of suppliers and is dependent upon the availability of fiber transmission
facilities owned by the suppliers. The Company is currently vulnerable to the
risk of renewing favorable supplier contracts, timeliness of the supplier in
processing the Company's orders for customers and is at risk to regulatory
agreements that govern the rates to be charged to the Company.
F-7
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Financial Instruments
The Company considers all liquid interest-earning investments with a
maturity of three months or less at the date of purchase to be cash
equivalents. Short-term investments primarily consist of debt securities,
which typically mature between three months and one year from the purchase
date and are held to maturity and valued at amortized cost, which approximates
fair value. The carrying value for current assets and current liabilities as
of December 31, 1997 and 1998, reasonably approximates fair value due to the
nature of the financial instrument and the short maturity of these items. Fair
value for the Company's long-term debt is based on market quotes, where
available or by discounting expected cash flows at the rates currently offered
to the Company for debt of the same remaining maturities. The fair value of
the Company's long-term debt is approximately $3,500,000 and $165,000,000 as
of December 31, 1997 and 1998, respectively.
Revenue Recognition
Revenue is recognized over the period in which the services are provided.
Monthly recurring charges include fees paid by customers for lines in service,
additional features on those lines and colocation space. These charges are
billed monthly, in advance, and are fully earned during the month. Usage
charges, initial, nonrecurring charges and reciprocal compensation charges are
billed in arrears and are fully earned when billed.
Depreciation and Amortization
Depreciation is provided on a straight-line basis over the estimated useful
lives of the assets as follows:
Asset Description Useful Life
----------------- --------------------------------------
Buildings and improvements......... 20 years
Communications network............. 3-8 years
Computer equipment................. 3 years
Leasehold improvements............. Shorter of asset life or life of lease
Furniture and fixtures............. 2-5 years
Motor vehicles..................... 2-3 years
When depreciable assets are replaced or retired, the amounts at which such
assets were carried are removed from the respective accounts and charged to
accumulated depreciation and any gains or losses on disposition is recorded
currently in the consolidated statements of operations.
Maintenance and repairs are charged to expense as incurred, while major
replacements and improvements are capitalized.
Impairment of Long-Lived Assets
The Company periodically assesses the recoverability of the carrying cost
of its long-lived assets based on a review of its projected undiscounted cash
flows related to the asset held for use. If assets are determined to be
impaired, then the asset is written down to its fair value based on the
present value of the discounted cash flows of the related asset or other
relevant measures (quoted market prices, third-party offers, etc.). Based on
its review, management does not believe that an impairment of the long-lived
assets has occurred.
Income Taxes
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income
Taxes," pursuant to which deferred income tax assets and liabilities are
determined based on the difference between the financial statement and tax
bases of assets and liabilities, using enacted tax rates currently in effect.
State and local taxes may be based on factors other than income.
F-8
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Segment Information
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." SFAS No. 131 supersedes SFAS No. 14,
"Financial Reporting for Segments of a Business Enterprise," replacing the
"industry approach" with the "management approach." The management approach
designates the internal reporting that is used by management for making
operating decisions and assessing performance as the source of the Company's
reportable segments. The adoption of SFAS No. 131 did not affect the Company's
results of operations or financial position but did affect the disclosure of
segment information (Note 13).
Equity incentive
The Company has chosen to account for equity incentive using the intrinsic
value method prescribed in Accounting Principles Board Opinion ("APB") No. 25,
"Accounting for Stock Issued to Employees." Under APB No. 25, the exercise
price of the employee stock options equals the fair value of the underlying
stock on the date of grant and no compensation expense is recorded. The
Company has adopted the disclosure only provisions of the SFAS No. 123,
"Accounting for Equity Incentive."
Accretion to Redemption Value of Class A Common Stock
Accretion to redemption value of redeemable Class A Common Stock represents
the change in the redemption value of all outstanding Class A Common Stock
allocable to each period. The redemption values for all Class A Common shares
are based on fair market value and accretion is calculated using the effective
interest method (Note 11).
Comprehensive Income
In June, 1997, the Financial Accounting Standards Board issued SFAS No.
130, "Reporting Comprehensive Income." SFAS No. 130 established reporting and
disclosure requirements for comprehensive income and its components within the
financial statements. Other than net loss applicable to Common stockholders,
the Company had no comprehensive income components for the period from May 31,
1996, to December 31, 1996, and for the years ended December 31, 1997 and
1998.
Accounting for Derivative Instruments and Hedging Activities
In June, 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No.
133 requires that all derivatives be recognized at fair value as either assets
or liabilities. SFAS No. 133 also requires an entity that elects to apply
hedge accounting to establish the method to be used in assessing the
effectiveness of the hedging derivatives and the measurement approach for
determining the ineffectiveness of the hedge at the inception of the hedge.
The methods chosen must be consistent with the entity's approach to managing
risk. The standard is effective for the Company's 2000 fiscal year. The
Company will adopt SFAS No. 133 during 1999. Adoption of SFAS No. 133 is not
expected to have a material effect on the Company based on the Company not
currently using derivatives or participating in hedging activities.
Reclassifications
Certain prior-year amounts have been reclassified to conform to the fiscal
1998 presentation. These changes had no impact on the Company's previously
reported financial position or results of operations.
F-9
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
3. RELATED-PARTY RECEIVABLES
As part of the stock purchase agreement (Note 10), executive shareholders,
as defined, purchased their Class A Common shares with 90-day promissory
notes. The promissory notes are with recourse to each executive and have a
prepayment provision without penalty. The notes are secured by a pledge of all
Company Common Stock and other assets held by the executives. Interest accrues
on a daily basis at a rate equal to the applicable federal rate for
obligations of similar duration. These notes were paid in January 1998.
4. LONG-TERM DEBT
During September, 1997, the Company entered into a credit facility with a
bank which provides for, among other things, a committed equipment line of up
to a maximum principal amount of $6,000,000. In February, 1998, all amounts
outstanding on this credit facility were repaid and the credit facility was
terminated.
In February, 1998, the Company completed its offering of $270 million
stated principal amount at maturity of its 12.125% senior discount notes due
2008 (the "Notes"), which resulted in gross proceeds of $150,027,606. The
Notes bear interest at the rate of 12.125% per annum (computed on a semiannual
Note equivalent basis). In the period prior to February 15, 2003, interest
will accrue but will not be payable in cash. From February 15, 2003, interest
on the stated principal amount at maturity of the Notes will be payable in
cash semiannually on August 15 and February 15 of each year, beginning on
August 15, 2003.
The Notes are senior unsecured obligations of the Company ranking pari
passu in right of payment with all other existing and future senior
indebtedness of the Company, if any, and will rank senior in right of payment
to all existing and future subordinated indebtedness of the Company, if any.
Holders of secured indebtedness of the Company, however, will have claims that
are prior to the claims of the holders of the Notes with respect to the assets
securing such other indebtedness. The Notes will be effectively subordinated
to all existing and future indebtedness and other liabilities of the Company's
subsidiaries (including accounts payable).
The Notes are redeemable, at the Company's option, in whole or in part, at
any time or from time to time, on or after February 15, 2003, at 106.063% of
their stated principal amount at maturity, plus accrued and unpaid current
interest, declining ratably to 100% of their stated principal amount at
maturity, plus accrued and unpaid current interest, on or after February 15,
2006. In addition, at any time and from time to time, prior to February 15,
2001, the Company may redeem in the aggregate up to 35% of the original
aggregate stated principal amount at maturity of the Notes with the proceeds
from one or more public equity offerings following which there is a public
market, at a redemption price (expressed as a percentage of accreted value on
the redemption date) of 112.125%, plus additional interest, if any; provided
that at least 65% of the original aggregate stated principal amount at
maturity of the Notes remains outstanding after each such redemption.
The Notes indenture contains certain covenants which, among other things,
restrict the ability of the Company and certain of its subsidiaries to incur
additional indebtedness (and, in the case of certain subsidiaries, issue
preferred stock), pay dividends or make distributions in respect of the
Company's or such subsidiaries' capital stock, make other restricted payments,
enter into sale and leaseback transactions, incur liens, cause encumbrances or
restrictions to exist on the ability of certain subsidiaries to pay dividends
or make distributions in respect of their capital stock, issue and sell
capital stock of certain subsidiaries, enter into transactions with
affiliates, sell assets, or amalgamate, consolidate, merge or sell or
otherwise dispose of all or substantially all of their property and assets.
These covenants are subject to exceptions and qualifications. The Company is
in compliance with these covenants as of December 31, 1998.
In December, 1998, the Company obtained a secured equipment term loan (the
"Facility") from a third party with a maximum borrowing level of $25,000,000.
The Facility provides for, among other things, equipment drawdowns through
December 30, 1999, and requires repayment based on 60 equal monthly
installments of
F-10
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
principal and interest for each drawdown. All drawdowns under the Facility
bear interest at the five-year swap rate percent plus additional basis points,
as defined in the Facility. Total drawdowns of $19,192,809 were outstanding
under the Facility as of December 31, 1998. The Facility provides for certain
restrictive financial and nonfinancial covenants. Among other things, these
covenants require the maintenance of minimum cash flow and revenue levels. The
Company was in compliance with these covenants as of December 31, 1998.
Long-term debt at December 31, 1997 and 1998, consists of the following:
1997 1998
---------- ------------
Credit facility with a bank, maximum borrowing
level at $6,000,000................................... $3,480,972 $ --
12.125% senior discount notes due 2008, net of
unamortized discount of $103,897,016.................. -- 166,102,984
Secured equipment term loan, maximum borrowing level at
$25,000,000........................................... -- 19,192,809
Capital leases on equipment with interest at
14.66%, $2,327 due monthly through April, 2000........ 55,914 --
---------- ------------
3,536,886 185,295,793
Less--Current maturities............................... 943,621 2,887,036
---------- ------------
$2,593,265 $182,408,757
========== ============
Aggregate maturities of long-term debt outstanding as of December 31, 1998,
is as follows:
1999......................................................... $ 2,887,036
2000......................................................... 3,442,991
2001......................................................... 3,777,502
2002......................................................... 4,143,053
2003......................................................... 4,544,309
Thereafter................................................... 166,500,902
------------
Total.................................................... $185,295,793
============
5. STOCK OPTIONS
The Company established the Focal Communications Corporation 1997 Non
Qualified Stock Option Plan (the "1997 Plan") effective February 27, 1997. The
1997 Plan is administered by the compensation committee of the Company's Board
of Directors (the "Board"). The Board has sole and complete authority to
select participants and grant options for the Company's Class A Common shares
which shall not exceed 5,260 shares, as defined in the plan. On August 21,
1998, the 1997 Plan was amended and the Board increased the number of shares
available for issuance under the 1997 Plan to up to 17,060.
The Company adopted the Focal Communications Corporation 1998 Equity and
Performance Incentive Plan (the "1998 Plan") on August 21, 1998. The Board has
sole and complete authority to select participants and grant options, and
other equity-based instruments for the Company's Class A Common shares. The
total number of shares authorized for issuance pursuant to the 1998 Plan shall
not exceed 11,500 shares, and is dependent upon, among other things, the
number of shares issued, or reserved for issuance, under the 1997 Plan prior
to the consummation of an initial public offering of Common Stock by the
Company.
On August 21, 1998, the Company also adopted the 1998 Equity Plan for Non-
Employee Directors of Focal Communications Corporation (the "1998 Non-Employee
Plan"). The Board has sole and complete authority to
F-11
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
select participants and grant options for the Company's Class A Common shares
which shall not exceed 300 shares, as defined in the 1998 Non-Employee Plan.
The total number of shares available under the amended 1997 Plan, the 1998
Plan and the 1998 Non-Employee Plan shall not exceed 17,060 shares.
Under the Company's stock option plans, the Board has complete discretion
in determining vesting periods and terms of each participant's options
granted. The options granted to participants under the Company's stock option
plans typically vest at 25% on the first-year anniversary from grant date and
vesting at 12.5% every six months for the remainder of vesting years. The term
of each option has a life of 10 years. In addition, the plans provide for
accelerated vesting upon certain events, as defined.
The following summarizes option activity:
Weighted
Average
Exercise Exercise
Shares Prices Prices
------ ----------- ---------
Outstanding at December 31, 1996................. -- $ -- $ --
Granted during 1997............................ 1,222 290-320 296.61
----- ----------- ---------
Outstanding at December 31, 1997................. 1,222 290-320 296.61
Granted during 1998............................ 6,110 335-1,500 1,229.16
Canceled during 1998........................... (142) 315-1,500 133.80
----- ----------- ---------
Outstanding at December 31, 1998................. 7,190 $290-$1,500 $1,090.06
===== =========== =========
The following table summarizes information about fixed stock options
outstanding at December 31, 1998:
Options Outstanding Options Exercisable
-------------------------------------- -----------------------
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Options Contractual Exercise Options Exercise
Prices Outstanding Life Price Exercisable Price
-------- ----------- ----------- -------- ----------- --------
$290-$335 1,799 8.6 $ 311.01 569 $301
$1,050-$1,500 5,391 9.6 1,350.04 -- --
----- --- --------- --- ----
7,190 9.3 $1,090.06 569 $301
===== === ========= === ====
The Company utilized the Black-Scholes option pricing model to estimate the
fair value of options at the date of grant during 1997 and 1998. Had the
Company adopted SFAS No. 123, pro forma net loss applicable to Common
stockholders and pro forma basic and diluted net loss per share of Common
Stock would have been approximately $(3,010,434) and $(35.68) and $(8,602,554)
and $(98.29) for the years ended December 31, 1997 and 1998, respectively. The
pro forma disclosure is not likely to be indicative of pro forma results which
may be expected in future years because of the fact that options vest over
several years, compensation expense is recognized over the vesting period and
additional awards may also be granted.
The Black-Scholes option model estimated the weighted average fair value at
the date of grant of options granted in 1997 and 1998 to be approximately $167
and $1,114 per option, respectively. The remaining contractual life of all
options was approximately 9 years. Principal assumptions used in applying the
Black-Scholes model were as follows:
1997 1998
--------- ---------
Risk-free interest rates............................ 5.6%-6.7% 4.4%-5.6%
Expected life....................................... 5 years 5 years
Expected volatility................................. 41.67% 142.03%
Expected dividend yield............................. -- --
========= =========
F-12
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
6. INCOME TAXES
There is no current or deferred tax expense for the period from May 31,
1996 (commencement of operations), to December 31, 1996, and for the year
ended December 31, 1997. Valuation allowances were provided which offset the
tax benefits recorded as deferred tax assets relating primarily to operating
loss carryforwards. The state and local taxes, net of the federal tax benefit,
and the change in valuation allowances are the only differences between the
U.S. federal statutory tax rate and the Company's effective tax rate for these
periods.
For the year ended December 31, 1998, the Company recorded an income tax
provision of $4,660,000. Even though the Company is reporting a loss before
income taxes, the Company has a positive taxable income and is paying income
taxes. This is primarily the result of the nondeductibility, for tax purposes,
of the interest accrued on the Company's 12.125% discount Notes. This interest
expense is subject to the high yield discount obligation ("HYDO") rules which
limits the amount of original issue discount ("OID") which can be deducted in
the current taxable period. This interest will become deductible for tax
purposes in the period in which the Notes are redeemed or when the interest is
paid. The deferred tax consequences related to the interest accrued and other
temporary differences in reporting items for financial statement and income
tax purposes are recognized, if appropriate. Realization of future tax
benefits related to the deferred tax assets is dependent on many factors,
including the Company's ability to generate taxable income. Management has
considered these factors and has concluded that a full valuation allowance for
financial reporting purposes is required for the deferred tax assets.
The income tax provision for the year ended December 31, 1998, consists of
the following:
Current taxes--
U.S. federal................................................. $4,100,000
State and local.............................................. 560,000
----------
4,660,000
----------
Deferred taxes--
U.S. federal................................................. --
State and local.............................................. --
----------
--
----------
Income tax provision....................................... $4,660,000
==========
U.S. income tax benefit at the statutory tax rate is reconciled below to
the Company's overall provision for income taxes for the year ended December
31, 1998:
Tax at U.S. federal income tax rate......................... $(1,125,000)
State and local taxes, net of U.S. federal tax benefit...... 560,000
Noncash compensation expense................................ 1,044,000
Change in valuation allowance............................... 4,005,000
Other....................................................... (176,000)
-----------
Provision for income taxes.............................. $ 4,660,000
===========
F-13
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The income tax effect of temporary differences comprising the net deferred
tax assets and tax liabilities as of December 31, 1997 and 1998, consists of
the following:
1997 1998
--------- -----------
Deferred income tax liabilities--
Depreciation................................... $(227,000) $(2,331,000)
Deferred income tax assets--
Net operating loss carryforwards............... 724,000 --
Interest on 12.125% discount notes............. -- 6,432,000
Allowance for doubtful accounts................ 17,500 476,000
Employment related accruals.................... 187,500 130,000
--------- -----------
929,000 7,038,000
Less--Valuation allowance........................ (702,000) (4,707,000)
--------- -----------
Net deferred tax assets...................... $ -- $ --
========= ===========
The Company has an alternative minimum tax ("AMT") credit carryforward as
of December 31, 1998, of approximately $320,000 for tax purposes to offset the
Company's future regular federal income tax liability. The AMT benefit has
been recorded as an asset due to the uncertainty of its realization. The AMT
credit does not expire.
7. LOSS PER SHARE
SFAS No. 128, "Earnings Per Share," requires the Company to calculate its
earnings per share based on basic and diluted earnings per share, as defined.
Basic and diluted loss per share for the period from May 31, 1996
(commencement of operations), to December 31, 1996, and for the years ended
December 31, 1997 and 1998, was computed by dividing net loss applicable to
Common stockholders by the weighted average number of shares of Common Stock
(Class A Common Stock and the vested Class B Common Stock).
The 14,711 Class C Common shares and the Company's 1,222 stock options
granted during 1997 are antidilutive and have been excluded from diluted loss
per share calculation for the year ended December 31, 1997. The Company's
7,190 stock options granted during 1997 and 1998 are antidilutive and have
been excluded from diluted loss per share calculation for the year ended
December 31, 1998.
8. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) Plan (the "Plan") covering substantially all
eligible employees. Under the Plan, participants may make pretax contributions
from 1% to 15% of eligible earnings, as defined. The Company may elect to
contribute to the Plan at its discretion. There have been no Company
contributions to the Plan for the period from May 31, 1996, to December 31,
1996, and for the year ended December 31, 1997. In February, 1998, the Company
elected to match 30% of the first 10% that an employee contributes to the
Plan. The Company's matching contributions totaled approximately $145,000 for
the year ended December 31, 1998.
9. COMMITMENTS AND CONTINGENCIES
Under the terms of various short- and long-term contracts, the Company is
obligated to pay office rents and rent for leasing fiber transmission
facilities. The Company is obligated to pay office rents with its operations
through 2012. The office rent contracts provide for certain scheduled
increases and for possible escalation of basic rentals based on a change in
the cost of living or on other factors. The Company expects to enter into
other contracts for additional office space, other facilities, equipment and
maintenance services in the future. A summary of such fixed commitments at
December 31, 1998, is as follows:
F-14
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Year Amount
---- -----------
1999.......................................................... $ 3,388,548
2000.......................................................... 3,667,922
2001.......................................................... 3,614,522
2002.......................................................... 3,721,598
2003.......................................................... 3,787,627
Thereafter.................................................... 20,438,214
-----------
Total..................................................... $38,618,431
===========
Rent expense under operating leases for office rent and rent for leasing
fiber transmission facilities was approximately $6,488, $651,159 and
$1,522,499, respectively, for the period from May 31, 1996, to December 31,
1996, and for the years ended December 31, 1997 and 1998.
In the ordinary course of business, the Company is involved in various
regulatory matters (Note 2), proceedings and claims. In the opinion of the
Company's management, the outcome of such proceedings will not have a material
adverse effect on the Company's financial position, results of operations or
cash flows.
10. STOCK PURCHASE AGREEMENT
On November 27, 1996, the Company entered into a Stock Purchase Agreement
(the "Agreement") with Institutional Investors and Executives ("Investors"),
as defined. The Agreement resulted in 79,384 shares of Class A Common Stock,
par value $.01 per share being issued for an aggregate purchase price of $4
million, and subsequent transactions in which Investors were required to make
pro rata contributions to the capital of the Company (with no additional
shares being issued) of up to an additional $21.8 million (total investment of
up to $25.8 million). Total capital contributions to the Company for the
issuance of Class A Common were $4,025,000, $8,275,000 and $13,900,000,
respectively, for the period from May 31, 1996, to December 31, 1996, and for
the years ended December 31, 1997 and 1998, respectively.
Subsequent to the closing of the Agreement, the Company sold 77 shares and
846 shares of Class A Common shares to Designees (as defined in the Agreement)
of the Institutional Investors, for a total purchase price of $25,000 and
$275,000, for the period from May 31, 1996, to December 31, 1996, and for the
years ended December 31, 1997, respectively.
As part of the Agreement, the existing Common Stock held by the Executives
was converted into newly issued Class B Common and Class C Common shares (the
"Exchange"). The closing of the Exchange and issuance of Class B Common and
Class C Common shares took place simultaneously with the initial closing of
the issuance of Class A Common shares under the Agreement. In connection with
this transaction, compensation expense totaling approximately $5.2 million
will be charged to income over the vesting period of the Class B Common shares
issued that did not vest immediately. Total compensation expense of $108,333,
$1,300,000 and $1,300,000 was recorded for the period from May 31, 1996, to
December 31, 1996, and for the years ended December 31, 1997 and 1998,
respectively.
The Company amended certain vesting agreements of the Executives and
Institutional Investors on September 30, 1998, which effected the cancellation
of 12,711 shares of the Company's Class C Common Stock then outstanding,
cancellation of 5,000 shares of the Company's Class A Common Stock held by
certain institutional shareholders and the conversion of 2,000 shares of the
Company's Class C Common Stock into Class B Common Stock. The new converted
Class B Common Stock is subject to certain restrictions, and was issued to the
Company's executives (founding shareholders) in satisfaction of the
obligations of the Company and such shareholders set forth in certain vesting
agreements as defined in the Agreement. In connection with such transactions,
compensation expense totaling approximately $4 million will be charged to
income over the
F-15
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
vesting period of the restricted Class B Common shares issued. Total
compensation expense of $1,769,553 was recorded during 1998 relating to this
matter. A summary of the Company's Class A, B and C Common Stock is as
follows:
Class A Common--A total of 85,567 shares have been authorized and 80,307
and 75,374 are issued and outstanding as of December 31, 1997 and 1998,
respectively. Institutional Investors, as defined, who hold Class A Common
shares had the right to put the shares to the Company at fair market value but
the Agreement was amended and the put right was replaced by a provision which
would require the Company to voluntarily liquidate (Note 11). The Class A
Common Stock held by Institutional Investors have demand registration rights;
all Class A Common stockholders have voting rights, piggyback registration
rights, participate in earnings and dividends and other preference features,
as defined.
Class B Common--A total of 35,000 shares have been authorized and 20,000
and 22,000 shares are issued and outstanding as of December 31, 1997 and 1998,
respectively. Class B Common stockholders have demand registration rights,
voting rights, piggyback registration rights, participate in earnings and
dividends and other preference features, as defined. The Class B Common issued
upon the Exchange will vest 20% on the closing of the Agreement and 20% on
each of the four anniversaries of the closing date of the Agreement.
Accelerated vesting will occur on the dates of certain (as defined) events:
(a) qualified sale of the Company; (b) qualified reorganization; and (c)
public offering of the Company's stock. For the Class B Common converted from
Class C Common, the Restricted Stock Agreement ("RSA") provides, among other
things, vesting of 20% at the closing of the RSA (September 30, 1998), 10%,
15%, 20% and 35% on each of the consecutive anniversaries of the closing of
the RSA, respectively, with immediate vesting upon a Change in Control, as
defined in the RSA.
Class C Common--A total of 15,000 shares have been authorized and 14,711
and 0 shares are issued and outstanding as of December 31, 1997 and 1998,
respectively. The Company amended certain vesting agreements of the Executives
and Institutional Investors on September 30, 1998, which effected the
cancellation of 12,711 shares of the Company's Class C Common Stock then
outstanding and the conversion of 2,000 shares of the Company's Class C Common
Stock into Class B Common Stock.
11. REDEEMABLE COMMON STOCK
As defined in the Agreement (Note 10), Institutional Investors which hold
an aggregate of 78,461 shares of Class A Common shares had the right to put
the shares to the Company on or after November 27, 2003, at the greater of the
initial purchase price per share of Class A Common owned by the Institutional
Investors or fair market value, as defined in the Agreement. On January 23,
1998, the Agreement was amended and the aforementioned put right was replaced
by a provision which would allow the Class A Common Institutional Investors,
Executive Investors and Designees of Institutional Investors, as defined, to
require the Company to voluntarily liquidate. The Institutional Investors at
any time and from time to time on or after November 27, 2003, but not after
the consummation of a public offering, shall have the right to require the
Company to voluntarily liquidate the assets of the Company. Upon receipt of
notice of the required liquidation, the Company may elect to purchase all but
not less than all of the Institutional Investors' Class A Common shares.
Although management had not obtained an appraisal of the fair market value
of the Company during 1997, certain public equity transactions have occurred
within the industry upon which management has based its estimate on the
potential redemption value of the aforementioned shares to be $333 per share
as of December 31, 1997. The Company recorded accretion totaling $0 and
$103,565 for the period from May 31, 1996, to December 31, 1996, and for the
year ended December 31, 1997.
F-16
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for interest and non-cash investing and financing activities for
the period from May 31, 1996 (commencement of operations), to December 31,
1996, and for the years ended December 31, 1997 and 1998, was as follows:
1996 1997 1998
-------- -------- --------
Cash paid during the year for interest.............. $ -- $ 94,533 $ 69,079
Fixed assets acquired under capital leases.......... $ -- $ 68,589 $ --
Payments made under capital leases.................. $ -- $ 12,675 $ 51,908
Accretion to redemption value of Class A Common
Stock.............................................. $ -- $103,565 $ --
Cash paid for income taxes.......................... $ -- $ -- $605,000
13. SEGMENT INFORMATION
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." The Company is organized primarily on
the basis of strategic geographic operating segments that provide
telecommunications services in each respective geographic region. The Company
has eight strategic geographic operating segments as of December 31, 1998. The
eight operating segments have been aggregated into one reportable segment,
"Telecommunications Services," for the year and as of December 31, 1998. The
Company has two strategic geographic operating segments as of December 31,
1997, and they have been aggregated into one reportable segment,
"Telecommunications Services," for the year and as of December 31, 1997. For
the period from May 31, 1996, to December 31, 1996, the Company did not
separately track its only geographic operating segment from its corporate
operations, and it is not practicable to restate its results by operating
segment for that period.
The accounting policies of the segments are the same as those described in
the "Summary of Significant Accounting Policies." The Company's chief
operating decision maker views earnings before interest, taxes, depreciation
and amortization ("EBITDA") as the primary measure of profit and loss. The
following represents information about revenues and EBITDA which excludes non-
cash compensation, total assets and capital expenditures for the
Telecommunications Services reportable segment as of and for the years ended
December 31, 1997 and 1998:
1997 1998
----------- -----------
Revenues......................................... $ 4,023,690 $43,531,846
EBITDA........................................... (986,815) 15,161,031
Total assets..................................... 13,006,600 73,436,768
Capital expenditures............................. 11,655,524 64,229,247
=========== ===========
The following reconciles total segment EBITDA to consolidated net loss
before income taxes for the years ended December 31, 1997 and 1998:
1997 1998
----------- ------------
Total EBITDA for reportable segment........... $ (986,815) $ 15,161,031
Corporate EBITDA.............................. (31,847) 876,353
Depreciation and amortization................. (615,817) (6,670,986)
Interest expense.............................. (128,070) (16,134,373)
Interest income............................... 195,696 6,528,541
Noncash compensation.......................... (1,300,000) (3,069,553)
----------- ------------
Net loss before income taxes.............. $(2,866,853) $ (3,308,987)
=========== ============
F-17
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following reconciles segment total assets to consolidated total assets
as of December 31, 1997 and 1998:
1997 1998
----------- ------------
Total assets for reportable segment............. $13,006,600 $ 73,436,768
Cash and short-term investments................. 2,037,861 133,307,515
Other current assets............................ 41,864 1,125,124
Fixed assets, net............................... 828,257 6,740,979
Other noncurrent assets......................... -- 4,963,894
----------- ------------
Total consolidated assets................... $15,914,582 $219,574,280
=========== ============
The Company currently only operates in the United States. Revenues by major
customer for the years ended December 31, 1997 and 1998, are as follows:
1997 1998
---------- -----------
Revenues from major customer A.................... $3,266,853 $25,747,481
Revenues from major customer B.................... -- 6,735,663
14. SELECTED QUARTERLY INFORMATION (UNAUDITED)
1st
Quarter 2nd Quarter 3rd Quarter 4th Quarter
---------- ----------- ----------- -----------
1997--
Revenues.................. $ -- $ 86,908 $ 1,226,076 $ 2,710,706
Loss from operations...... (757,521) (1,145,689) (786,384) (244,885)
Net loss applicable to
Common stockholders...... (740,492) (1,119,257) (791,445) (319,224)
========== =========== =========== ===========
Basic and diluted net loss
per share................ $ (8.87) $ (13.34) $ (9.39) $ (3.72)
========== =========== =========== ===========
1998--
Revenues.................. $5,102,448 $ 8,078,043 $12,755,293 $17,596,062
Income from operations.... 752,059 1,886,430 418,968 3,239,388
Net loss applicable to
Common stockholders...... (341,191) (583,399) (4,653,717) (2,390,680)
========== =========== =========== ===========
Basic and diluted net loss
per share................ $ (3.86) $ (6.61) $ (52.73) $ (28.04)
========== =========== =========== ===========
The Company's net loss applicable to Common stockholders and basic and
diluted net loss per share increased significantly in the third quarter of 1998
from the second quarter of 1998 due primarily to the immediate recognition of
approximately $1,697,000 of non-cash compensation resulting from the amendment
of certain vesting agreements (Note 10). Additionally, the Company determined
that it would become liable for income taxes in the third quarter, and a tax
provision of approximately $2,197,000 was recorded.
15. SUBSEQUENT EVENT
On January 6, 1999, the Company entered into a Purchase Agreement (the
"Agreement") to acquire network assets and associated infrastructure from Level
3 Communications for $7.7 million, as defined in the Agreement
F-18
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Focal Communications Corporation:
We have audited, in accordance with generally accepted auditing standards,
the consolidated financial statements of Focal Communications Corporation and
its Subsidiaries included in this annual report and issued our report thereon
dated January 22, 1999. Our audits were made for the purpose of forming an
opinion on the basic financial statements taken as a whole. The schedule of
Valuation and Qualifying Accounts, is presented for purposes of complying with
the Securities and Exchange Commission's rules and is not a part of the basic
financial statements. This schedule has been subjected to the auditing
procedures applied in the audits of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.
Arthur Andersen LLP
Chicago, Illinois
January 22, 1999
F-19
Schedule II
FOCAL COMMUNICATIONS CORPORATION
VALUATION AND QUALIFYING ACCOUNTS
Balance
at the
Beginning Charged to Charged Balance at
of the Cost and to other the End of
Accounts Period Expense Accounts Deductions the Period
- -------- --------- ---------- -------- ---------- ----------
1996:
Allowance for Doubtful
Accounts................ $ -- $ -- $-- $ -- $ --
1997:
Allowance for Doubtful
Accounts................ $ -- $ 469,000 $-- $ -- $ 469,000
1998:
Allowance for Doubtful
Accounts................ $469,000 $1,348,000 $-- $628,000 $1,189,000
F-20