UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

Interland, Inc.

303 Peachtree Center Avenue, Suite 500, Atlanta, GA 30303
(Address, including Zip Code, of principal executive offices)

(404) 720-8301
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Registered on The Nasdaq National Market

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, and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [  ]

The number of outstanding shares of the registrant’s Common Stock on November 30, 2004 was 16,092,602.

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PART I. Financial Information

Item 1. Financial Statements

Interland, Inc.

Consolidated Statements Of Operations

(In thousands except per share amounts)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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Interland, Inc.

Consolidated Balance Sheets

(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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Interland, Inc.

Consolidated Statements of Cash Flows

(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements

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Interland, Inc.

Notes To Consolidated Financial Statements

1.

General

Business — Interland, Inc. together with its subsidiaries (collectively the “Company”), is a leader in efficiently packaging, distributing, and supporting business-class, online marketing solutions to small and medium business (“SME”) owners, both directly and through partners, enabling those businesses to gain new relationships and better support communication with their existing customers locally and around the world. Interland operates as one reporting segment and continues to offer a broad range of products and services, including shared and dedicated hosting services, e-commerce, application hosting, website development, marketing, and optimization tools.

History of operating losses — The Company’s Web hosting business has historically incurred net losses and losses from operations. The Company’s future operation is dependent upon its ability to achieve and sustain positive cash flow prior to the depletion of cash resources. The Company plans to reduce its level of cash requirements through a decrease in capital purchases and by improving sales and reducing customer churn. The Company will have reduced cash outlays for payments associated with prior integration and discontinued operation liabilities and reduced debt payments because of the buyout of capital lease obligations during fiscal 2004. The Company expects to continue to have negative cash flows for at least the next three quarters as it continues to execute on its business plan. There can be no assurance that Interland’s continuing efforts to stabilize or increase its revenue will be successful and the Company will be able to continue as a going concern. If the Company is unable to successfully execute its business plan, it may require additional capital, which may not be available on suitable terms. Nonetheless, management believes it has adequate cash and liquid resources to fund operations and planned capital expenditures through at least the next 12 months.

2.

Significant Accounting Policies

Interim Unaudited Financial Information — The accompanying unaudited consolidated financial statements for the three-month periods ended November 30, 2004 and November 30, 2003, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. In management’s opinion, these statements include all adjustments necessary for a fair presentation of the results of the interim periods shown. All adjustments are of a normal recurring nature unless otherwise disclosed. Operating results for the three-month period ended November 30, 2004 are not necessarily indicative of the results that may be expected for the full fiscal year.

Basis of Presentation – This report on Form 10-Q (“10-Q”) for the first quarter ended November 30, 2004 should be read in conjunction with the Company’s Form 10-K (“10-K”) for the fiscal year ended August 31, 2004. The financial statements include the accounts of Interland, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Stock-based employee compensation — The Company accounts for stock-based compensation issued to employees using the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and has adopted the disclosure requirements of SFAS No. 123 and SFAS 148.

If the Company had elected to adopt the optional recognition provisions of SFAS No. 123, which uses the fair value based method for stock-based compensation, and amortized the fair value of the options to compensation expense on a straight-line basis over the vesting period of the options, the following table illustrates the effect on net loss and loss per share:

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Interland, Inc.
Notes To Consolidated Financial Statements (Continued)

3.

Restructuring And Facility Exit Costs

2001 Plan

During the fourth quarter of 2001, the Company approved and implemented a restructuring program in connection with its acquisition of Interland-Georgia (“the 2001 Plan”). This restructuring plan provided for the consolidation of the Company’s operations and elimination of duplicative facilities obtained as a result of previous business acquisitions and has expected payments through December 2009. In accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity,” the restructuring costs, excluding asset impairments, were recognized as liabilities at the time management committed to the plan. Management determined that these costs provided no future economic benefit, they were incremental to other costs incurred by the Company prior to the restructuring, or were contractual obligations that existed prior to the date the plan was approved and were either continued after the exit plan was completed with no economic benefit to the Company or could not be cancelled without penalty; and they were incurred as a direct result of the plan to exit the identified activities. The asset impairments were accounted for in accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of”. The Company recorded a charge of approximately $110.3 million related to employee termination benefits, facility closure costs, asset disposals and other exit costs.

The following table shows a reconciliation of the beginning and ending restructuring liability balances from inception through November 30, 2004 related to all restructuring activities recorded by the Company under the 2001 Plan. During the fiscal quarter ended November 30, 2004, cash payments were made related to the monthly lease obligations for lease abandonments leaving an outstanding liability of $3.1 million as of November 30, 2004.

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Interland, Inc.
Notes To Consolidated Financial Statements(Continued)

2003 Plan

During the second quarter of 2003, the Company approved and initiated a program to exit certain facilities and consolidate those operations into other existing facilities (“the 2003 Plan”). This restructuring plan was part of management’s continued plan to streamline the Company’s operations and to reduce long-term operating costs. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” costs associated with these activities have been recognized and measured at their fair value in the period in which the liabilities are incurred. One-time termination benefits for employees required to render services until they are terminated in order to receive termination benefits were recognized ratably over the future service period. The plan provided for the closure of three data center facilities, a reduction of related workforce of approximately 171 employees, and the termination of bandwidth and data connectivity contracts in place at these and other facilities. The 2003 Plan charges consisted of $2.1 million in lease termination costs, $1.9 million in bandwidth termination costs, $1.3 million in employee termination benefits, and $1.3 in fixed asset related charges. These charges were partially offset by $0.2 million of various adjustments, including the settlement of certain data connectivity contract obligations for amounts less than the original estimates. There was also a charge for $0.9 million to property, plant and equipment representing the write down of remaining book value of fixed assets originally written down to their estimated salvage value included in the restructuring charge recorded in the 2003 Plan charges.

The following table shows a reconciliation of the beginning and ending liability balances from inception through November 30, 2004 related to all restructuring activities recorded by the Company under the 2003 Plan. The $0.5 million balance at November 30, 2004 represents the remaining bandwidth termination liabilities, which the Company expects to have final resolution during fiscal year 2005.

2004 Plan

In March 2004, the Company decided to change its approach to distributing its mainstream market hosting solutions from reliance upon a direct field sales force to an indirect channel approach (“the 2004 Plan”). Due to this decision, the Company implemented a restructuring program to reduce its cost structure. These restructuring charges include $0.3 million for lease commitments and $0.8 million for employee severance and benefits expense.

The following table shows a reconciliation of the beginning and ending liability balances from inception through November 30, 2004 related to all restructuring activities recorded by the Company under the 2004 Plan. During the fiscal quarter ended November 30, 2004, cash payments were made related to the monthly lease obligations that have a remaining liability of $0.1 million to be paid out by April 2005, and the final employee termination payments.

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Interland, Inc.
Notes To Consolidated Financial Statements(Continued)

4.

Purchase Business Combination Liabilities

In connection with the acquisition of Interland-Georgia in 2001, INNERHOST in 2002, and Trellix in 2003 the Company accrued certain liabilities representing estimated costs of exiting certain facilities, termination of bandwidth contracts and involuntary termination of employees in accordance with EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” The liability balances and annual activity from inception through August 31, 2004 are disclosed in the 2004 10-K. The following table shows the changes in the accrual from August 31, 2004 through November 30, 2004:

During the fiscal quarter ended November 30, 2004, the Company continued to make its monthly lease payment and collect from its sub tenants for its lease abandonment obligations according to the contractual agreements ending in 2009.

5.

Other Liabilities

In December 2004, the Company received a revised tax assessment regarding a sales and use tax audit from the state of Virginia relating to the discontinued PC Systems business segment. This revised assessment was substantially lower than the prior assessment and resulted in a reduction to a previously recorded sales tax reserve by $0.8 million. The sales tax reserve of $1.2 million at August 31, 2004 was reduced to $0.4 million at November 30, 2004 to record this change in estimate. The Company has recognized this gain through discontinued operations during the quarter ended November 30, 2004.

The Company continues to be a party to numerous sales and use tax assessments and audits related to the discontinued operations and have an established reserve of $0.4 million and $1.2 million as of November 30, 2004 and August 31, 2004, respectively. The Company has also established an accrual for income tax liabilities of $1.5 million and $1.6 million as of November 30, 2004 and August 31, 2004, respectively.

6.

Discontinued Operations

In fiscal 2001 the Company discontinued the operations of its PC Systems business segment, which was accounted for as discontinued operations in accordance with Accounting Principles Board Opinion (APB) No. 30, “Reporting the Results

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Interland, Inc.
Notes To Consolidated Financial Statements(Continued)

of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” During the first quarter 2005, the Company recognized a gain of $0.6 million from discontinued operations. This gain consisted of a reduction to a previously recorded sale reserve by $0.8 million, offset by $0.2 million of required legal fees in defense and settlement of Micron PC legal matters. The Company has a sales and use tax assessments and audit reserve of $0.5 million, $0.7 million in contingent liabilities, $0.2 million in legal expenses and $0.3 for other liabilities related to the disposal of discontinued operations as of November 30, 2004.

7.

Contingencies

In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr. Gabriel Murphy, one of the former principals of Interland’s subsidiary, CommuniTech.Net, Inc. (“Communitech”), which was acquired by Interland in February 2002. The Company’s lawsuit claims, among other things, that Mr. Murphy breached certain covenants under his employment agreement and also demands payment from Mr. Murphy’s two promissory notes (one of which was “non-recourse” while the other was “recourse”). In March 2004, Interland retired the 273,526 shares of stock held as collateral and wrote off the $2,000,000 non-recourse promissory note, which had been carried as Stockholder’s Equity. The other $735,000 full recourse promissory note remains outstanding and continues to be a subject of the Cobb County litigation noted above. Mr. Murphy has asserted various counterclaims in response.

In February 2003, Mr. Heitman, also a former principal of Interland’s subsidiary Communitech, and Mr. Murphy filed a lawsuit against Interland, its Chief Executive Officer, Mr. Joel Kocher, and Communitech, in Jackson County, Missouri claiming, among other things, that Interland acted unreasonably in failing to have the S-3 registration statement declared effective by the SEC on a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in connection with Interland’s acquisition of Communitech. The complaint sought compensatory and punitive damages in an unspecified amount. Interland believes that these claims are without merit and will not have a material adverse effect on Interland and is vigorously defending the claims. The Interland parties have filed motions to dismiss all of the claims against them and those motions are pending.

In February 2004, the Company initiated a lawsuit in the United States District Court for the Northern District of Georgia against the representatives of the former shareholders of Hostcentric (the “Hostcentric Shareholders”), seeking a declaratory judgment that it will be entitled to reimbursement from the escrow fund established as part of the Hostcentric acquisition for any amounts over $180,000 that it may be required to pay to the landlord for a leased facility in Farmingdale, New York, in accordance with the acquisition agreement between the Company and Hostcentric and its shareholders. The representatives of the Hostcentric Shareholders have denied Interland’s claims and have attempted to assert various counterclaims. The Company, has in turn, brought additional claims based on facts learned in discovery. Correspondence between the parties has also discussed the possibility of other claims, but these claims have not yet been asserted in litigation. Interland believes its claims in this case are meritorious, that the counterclaims of the former Hostcentric shareholders are without merit, plans to continue to contest the matter vigorously and believes that no material adverse effect on Interland will occur as a result of this litigation.

In February 2004, the Company, through its Hostcentric subsidiary, has also initiated a lawsuit in United States District Court for Southern District of New York against the landlord for the same Farmingdale, New York facility. The Company believes that it and the landlord have reached an agreement in principle to settle the litigation and has petitioned the court to enforce the agreement. Interland believes that no material adverse effect on Interland will occur as a result of this litigation.

Interland is also defending a case entitled Novell, Inc. v. Micron Electronics, Inc. filed in August 1999 in state court in Utah County, Utah. Novell claims that it was underpaid for royalties on sales of several versions of its NetWare software purportedly distributed by Interland’s predecessor, Micron Electronics, between 1996 and 1998. In addition, Novell also believes it is entitled additional royalties for sales of the software purportedly distributed by NetFrame between 1993 and 1997. Micron Electronics acquired NetFrame in 1997. Novell is seeking an accounting and damages. Interland believes it has meritworthy defenses to Novell’s claims. The litigation is still in the discovery phase.

Periodically, the Company is made aware that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has evaluated all such claims and, if necessary and appropriate, sought to obtain licenses for the use of such technology. If the Company or its suppliers were unable to obtain licenses necessary to use intellectual property in its discontinued operation’s products or processes, it may be forced to defend

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Interland, Inc.
Notes To Consolidated Financial Statements(Continued)

legal actions taken against it relating to allegedly protected technology. The Company evaluates all such claims and has accrued a liability and charged discontinued operations for the estimated costs of settlement or adjudication of claims for alleged infringement as of the respective dates of the balance sheets included in this report.

The Company is also a defendant in a number of other lawsuits that the Company regards as unlikely to result in any material payment; nonetheless, the outcome of litigation may not be assured, and the Company’s cash balances could be materially affected by an adverse judgment. In accordance with SFAS No. 5 “Accounting for Contingencies,” the Company believes it has adequately reserved for the contingencies arising from the above legal matters where an outcome was deemed to be probable and the loss amount could be reasonably estimated. As such, the Company does not believe that the anticipated outcome of the aforementioned proceedings will have a materially adverse impact on its results of operations, its financial condition or its cash flows.

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Interland, Inc.

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Statements contained in this Form 10-Q that are not purely historical are forward-looking statements and are being provided in reliance upon the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding Interland’s expectations of its future liquidity needs, its expectations regarding its future operating results including its planned increase in its revenue levels and the actions the Company expects to take in order to maintain its existing customers and expand its operations and customer base. All forward-looking statements are made as of the date hereof and are based on current management expectations and information available to it as of such date. The Company assumes no obligation to update any forward-looking statement. It is important to note that actual results could differ materially from historical results or those contemplated in the forward-looking statements. Forward-looking statements involve a number of risks and uncertainties, and include risks associated with our target markets and risks pertaining to our ability to successfully integrate the operations and personnel of the recent acquisitions. Factors that could cause actual results to differ materially from expected results are identified in “Risk Factors” below, and in the Company’s annual report on Form 10-K for the year ended August 31, 2004 and in the Company’s other filings with the Securities and Exchange Commission. All quarterly references are to the Company’s fiscal periods ended November 30, 2004, or November 30, 2003, unless otherwise indicated. All annual references are also on a fiscal August 31st year-end basis, unless otherwise indicated. All tabular dollar amounts are stated in thousands.

Overview

Interland is a leader in making the power of the Internet available to small- and medium-sized enterprises (“SMEs”). In addition to providing traditional web-hosting and electronic commerce services to those who desire mere presence on the World Wide Web, Interland offers products and services designed to permit an SME to utilize a website as an alternative communication channel with its clients and potential clients. The Company’s offerings make it possible and efficient for SMEs to find leads, make sales, and to service their clients online.

Interland offers to provide website marketing, design and management, as well as management of hosted application services through both its shared and dedicated lines of business. (The shared line of business provides services to customers whose needs are compatible with being hosted on a server that hosts hundreds of other similar customers; the dedicated line of business serves customers who require a server or servers exclusively devoted to their needs.) Interland periodically assesses the value of both existing and contemplated service offerings to customers through extensive marketing research directed to its existing customers, with special focus on customers who appear to be successful in using online resources.

Interland’s products are sold directly and through distribution partners, for both shared and dedicated hosting business lines. Interland assembles, bundles and tailors its products to meet the requirements of the distribution partners’ targeted markets, taking into account the respective mechanisms of distribution and branding. Interland provides applications on Linux and Microsoft Windows platforms, which may be used while the customer is an Interland hosting customer. Among these services are website marketing services, website creation and management services, electronic commerce services, email services, and hosting services. In the dedicated line of business Interland provides applications on dedicated servers, as well as network and hardware reliability and security products, marketing services, and bundles supporting outsourcing of specific web-based applications. The lack of technical sophistication of many SMEs, coupled with the relatively high cost of maintaining dedicated servers in-house makes Interland’s dedicated offerings attractive to this market. Larger enterprises use Interland’s dedicated services to develop and host specific activities, often those that are specialized or developmental in nature. A smaller portion of Interland’s dedicated business serves larger enterprises that require managed services provided through multiple servers.

Interland has acquired and developed proprietary software for the efficient integration, packaging and support of new technologies and services into its basic hosting products. The software or technology may be developed by the Company, acquired, or licensed from third parties. The Company’s web design products are largely derived from, or influenced by software and related technology obtained through the acquisition of Trellix Corporation in early 2003. These tools can be configured to enable only modestly-trained SME business personnel to design a website with great functionality in a fraction of the time and at a fraction of the cost charged by website development firms. The tools can also be configured to provide additional functionality designed to be used by professional web designers who can thereby gain high productivity, enabling the Company to provide professional-quality websites at modest cost. The Company’s growing experience in designing

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websites for a large number of types of businesses further contributes to efficiency. Using the website development tools as a base, the Company is continuing to develop a broad range of products and services, collectively known as “Business Solutions”, designed to help mainstream businesses attract and serve customers through websites supplied by Interland designers using its proprietary design software. During 2003, the Company tested and marketed products based on the use of these software tools. Based on initial results, the Company, in several stages, increased the number of direct salespeople, web designers and support personnel dedicated to this effort in order to further test the ability of the distribution and provisioning models to perform profitably at increasingly larger scales.

At the end of February 2004, however, management concluded that despite the fact that many of the assumptions underlying the business plan were being proven, certain aspects of the business were not performing to the standard required to justify continued high levels of investment. Accordingly, in early March 2004 the Company announced that it would substantially reduce its investment level and concentrate the website and software development teams in Atlanta for greater interaction with the rest of the Company. At the same time, the Company recognized that the costs of acquiring customers through a directly-employed sales force would substantially retard market penetration and accordingly shifted its customer acquisition efforts to an indirect sales model.

Interland’s distribution partners enable it to acquire new customers at a lower cost relative to revenue than would be possible through direct marketing and sales. Interland’s distribution partners now include telecommunications companies, Yellow Pages publishers, credit card companies, as well as local resellers, which also often provide other technology services to their clients. Interland intends to expand and grow its relationships with these partners.

DISCONTINUED OPERATIONS

PC Systems

In fiscal 2001 the Company discontinued the operations of its PC Systems business segment, which was accounted for as discontinued operations in accordance with Accounting Principles Board Opinion (APB) No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” During the first quarter 2005, the Company recognized a gain of $0.6 million from discontinued operations. This gain consisted of a reduction to a previously recorded sale reserve by $0.8 million, offset by $0.2 million of required legal fees in defense and settlement of Micron PC legal matters. The Company has a sales and use tax assessments and audit reserve of $0.5 million, $0.7 million in contingent liabilities, $0.2 million in legal expenses and $0.3 for other liabilities related to the disposal of discontinued operations as of November 30, 2004.

Results Of Continuing Operations

The Company’s consolidated financial information presents the net effect of discontinued operations separate from the results of the Company’s continuing operations.

Comparison Of The Quarters Ended November 30, 2004 And 2003

The loss from continuing operations decreased $4.2 million, or 52.4% to $3.8 million for the quarter ended November 30, 2004 from $8.0 million for the quarter ended November 30, 2003. The basic and diluted loss per share decreased $0.25 per share, or 51.0% for the quarter ended November 30, 2004 when compared to the same period of the prior fiscal year.

Revenues

Total revenues decreased $3.6 million, or 13.6%, to $23.1 million for the quarter ended November 30, 2004 from $26.7 million for the quarter ended November 30, 2003.

Hosting revenues decreased $3.3 million, or 13.1% to $21.9 for the quarter ended November 30, 2004 from $25.3 million for the quarter ended November 30, 2003. Hosting revenues are comprised of shared, dedicated, mainstream market, application hosting services and domain name registrations. The decrease in hosting revenues is primarily attributable to account cancellations, net of new sales. These cancellations may occur as a result of: a) customer action; b) termination by the Company for non-payment; or c) termination by the Company as a result of a decision to no longer provide a particular service. Although the Company intends to stabilize the revenue of its acquired Web hosting business by focusing on improving customer retention and increasing sales of hosting services, management believes that the mainstream market will be the primary source of future growth.

Other revenues decreased $0.2 million or 1.8% to 1.2 million for the quarter ended November 30, 2004 from $1.4 million for the quarter ended November 30, 2004. The decrease is primarily related to lower co-location revenues. Other revenues are primarily comprised of consulting, bandwidth transfer coverage billings, Internet connectivity fees, and co-location services.

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As of November 30, 2004, the Company had approximately 173,000 paid shared hosting customer accounts and continues to manage approximately 9,200 dedicated servers, many of which host multiple web sites, compared to approximately 196,000 paid shared hosting customer accounts and nearly 9,200 dedicated servers as of November 30, 2003. The decrease in shared hosting customer accounts is primarily due to customer churn during the year. As customers leave the Company these servers are removed from the data center and taken out of operations until they can be re-utilized by a new customer.

The Company’s revenues are highly correlated with the net change in the total of the monthly recurring charges associated with all customer accounts. The term “Monthly Recurring Charges” or “MRC”, does not include one-time or variable charges customers may incur, nor is it the same as the actual amount of revenue recognized because, among other things, MRC ignores deferred revenue, and instead uses the charge that applies to a full month. (For revenue recognition purposes a customer who initiates service during the month contributes to revenue the same percentage of the nominal monthly charge as the percentage of the month remaining at inception; a customer who terminates service during the month contributes to revenue the same percentage of the nominal monthly charge as the percentage of the month that elapsed prior to termination. An initiating customer’s entire nominal monthly charge is included in MRC as of the end of the month, but no portion of a terminating customer’s nominal monthly charge is included in MRC as of the end the month during which termination occurs.) MRC, therefore, is not a measure of historical revenues but rather a metric for valuing the revenue potential of the entire customer base as of the end of a period. The Company believes that MRC is useful as a reflection of changes in the base of revenue-generating customers and, consequently, as a predictor of the direction of revenue in the future. It is unlikely that Interland’s future revenues will increase unless Net MRC Change is positive, and the Company does not have a recent history of positive Net MRC Change aside from mergers and acquisitions.

During the first quarter of fiscal year 2005 the MRC of the Company’s Shared line of business declined from $4,353,000 at August 31, 2004 to $4,137,000 at November 30, 2004, or 5.0%. MRC Churn (MRC of terminating customers as a percentage of beginning MRC) averaged 2.5% per month during the quarter ended November 30, 2004 compared to an average of 2.8% during the quarter ended August 31, 2004. The Company believes that this improvement in churn reflects the Company’s investments in improving reliability and customer service that has also led to improved customer satisfaction as measured by surveys. Sales produced New Shared MRC, which averaged $66,000 per month for the quarter ended November 30, 2004, resulting in an average negative Net MRC Change of $48,000 per month during the same quarter compared to sales producing New Shared MRC, which averaged $67,000 per month for the quarter ended August 31, 2004, resulting in an average negative Net MRC Change of $68,000 per month during the same quarter. The Company believes that it is unlikely that Shared MRC Churn can be reduced below 2.0%, but believes that its current strategy of increasing new sales through indirect distribution of enhanced products and services has the potential to generate enough new business to exceed the amount of MRC Churn and result in positive Net MRC Change and revenue growth.

During the first quarter of fiscal year 2005 the MRC of the Company’s Dedicated line of business declined from $2,998,000 at August 31, 2004 to $2,927,000 at November 30, 2004, or 2.4%. MRC Churn averaged 3.7% during the quarter ended November 30, 2004 compared to an average of 4.6% during the quarter ended August 31, 2004. New Dedicated sales averaged $101,000 per month for the quarter ended November 30, 2004, resulting in an average negative Net MRC Change of $29,000 per month during the same quarter compared to sales producing New Dedicated MRC, which averaged $101,000 per month for the quarter ended August 31, 2004, resulting in an average negative Net MRC Change of $47,000 per month during the same quarter. The Dedicated line of business revenue has been affected, and is likely to continue to be affected, by a general reduction in pricing in the industry. MRC Churn in the dedicated line also is driven by rapid changes in server technology, creating in the customer a desire to seek the latest technology at the lowest price in a highly competitive market. Due to recent increases in MRC Churn and price competition, the Company is re-evaluating the profitability of its Dedicated products and seeking alternatives to maximize the Company’s returns in this market. The Company is now offering many of the products and services it has developed primarily for the Shared market to Dedicated customers. Due to the capital cost required to service a new Dedicated customer, the relationship with dedicated customers must be profitable from an operating standpoint and it must remain in place long enough for the Company to recoup its investment and provide a satisfactory return on assets employed.

Overall, the average monthly negative Net MRC change improved from $115,000 during the previous fiscal quarter to $77,000 during the quarter ended November 30, 2004, an improvement of 33.0%

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Operating Costs And Expenses

Network Operating Costs

Network operating costs decreased 19.9% to $5.7 million for the quarter ended November 30, 2004 from $7.1 million in the same period of the prior year. The decrease in network operating costs is most directly related to the data center consolidation, which was a critical part of the Company’s restructuring and integration initiative in fiscal 2003. The impact of this initiative had a $0.5 million reduction in bandwidth connectivity costs, a $0.1 million reduction in maintenance contract costs, and a $0.6 million reduction in labor costs. In addition the Company reduced operating lease costs by $0.1 million as a result of purchasing the underlying leased equipment.

Sales and Marketing

Sales and marketing expenses decreased 23.8% to $4.0 million for the quarter ended November 30, 2004 from $5.2 million in the same period of the prior year. This decrease in sales and marketing expenses is primarily due to the elimination of additional marketing expenditures related to the direct mainstream market initiative of $0.2 million and additional commissions, salaries and benefits of $0.9 million during the quarter ended November 30, 2003 that were eliminated when the Company publicly announced it would be substantially reducing its investment in direct marketing and sales initiatives in March 2004.

Technical Support

Technical support expenses decreased 20.6% to $3.8 million for the quarter ended November 30, 2004 and $4.8 million in the same period of the prior year. The Company enhanced its technical support efforts by implementing an automated scheduling tool system resulting in a decrease of customer contacts requiring multiple calls. These operational efficiencies yielded a $0.7 million decrease in contract labor and consultants and a $0.3 million decrease in salaries and benefits.

General and Administrative

General and administrative expenses decreased 12.2% to $7.1 million for the quarter ended November 30, 2004 from $8.1 million in the same period of the prior year. The primary factor causing the decrease in general and administrative expenses in the first quarter of fiscal 2005 was a $2.0 million decrease in salaries and benefits associated with the reduction of headcount compared to prior year. Partially offsetting this decrease were increases in legal expense of $0.4 million and a $0.6 million increase in professional fees primarily related to Sarbanes-Oxley certification contractors and consultants.

Bad Debt Expense

Bad debt expense decreased $0.7 million, or 61.1%, to $0.4 million for the quarter ended November 30, 2004 from $1.1 million in the same period of the prior year. The decrease in bad debt expense is attributable to a decline in customer account write-offs due to our more stringent collection and customer account termination policies for non-payment, resulting in a lower trade accounts receivable balance.

Depreciation and Amortization

Depreciation and amortization expenses decreased 28.2% to $5.9 million for the quarter ended November 30, 2004 from $8.2 million in the same period of the prior year. The amortization expense decreased due to the impairment adjustments made to the Company’s intangible assets in May 2004. The decrease in depreciation expense is a result of the continued decline in capital expenditures and the expiration of leases during the fiscal year 2004 used to purchase capital equipment.

Interest Income (Expense), net

Interest income (expense), net consists of interest income earned on the Company’s combined cash and cash equivalents, short-term investments, and restricted investments less interest expense on debt (primarily capital leases). The net expense of $0.1 during the quarter ended November 30, 2003 went to a $41,000 net income for the quarter ended November 30, 2004 primarily due to the reduction in interest expense relating to the maturing and termination of debt and leases for capital equipment prior to the quarter ended November 30, 2004.

Net Cash Used in Operating Activities and Earnings from Continuing Operations Before Interest, Taxes, Depreciation and Amortization (EBITDA)

EBITDA is defined as net income (loss) less (i) provision for income taxes, (ii) interest income or expense, and (iii) depreciation and amortization. EBITDA is not an indicator of financial performance under generally accepted accounting

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principles and may not be comparable to similarly captioned information reported by other companies. In addition, it does not replace net income (loss), operating income (loss), or cash flows from operating activities as indicators of operating performance. The effect of taxes and interest on Interland’s net loss is not significant, but depreciation and amortization, primarily as a result of acquisitions, is significant. The Company believes that measuring the performance of the business without regard to non-cash depreciation and amortization can make trends in operating results more readily apparent, and when considered with other information, assist investors and other users of the Company’s financial statements who wish to evaluate the Company’s ability to generate future cash flows.

The following table reflects the calculation of EBITDA from continuing operations and a reconciliation to net cash provided by (used in) operating activities:

For the quarter ended November 30, 2004, the Company’s EBITDA increased $1.7 million to $2.0 million as compared to $0.3 million in the same period of the prior year. This increase is primarily due to the cost savings from the integration and restructuring efforts during fiscal year 2003 and the decrease in bad debt expense attributed to the more stringent collection and customer account termination policies.

Liquidity and Capital Resources

As of November 30, 2004, the Company had $23.2 million in cash and cash equivalents, $3.0 million in short-term unrestricted investments and $10.3 million in short- and long-term restricted investments representing a total cash and investment position of $36.5 million. This represents a decrease of $2.1 million or 5.4% decrease from the total cash and investment position of $38.6 million at August 31, 2004.

On a comparative basis cash used in operating activities of continuing operations decreased $2.1 million or 95.1% to $0.1 million for the quarter ended November 30, 2004 versus the $2.2 million of cash used in operating activities for the same period in the prior year. The reduction in cash used in continuing operations is reflective of the Company’s integration initiatives that reduced facility, bandwidth connectivity and employee related costs. Cash (used in) provided by investing activities decreased $9.4 million to ($0.8) million used for the three months ended November 30, 2004 versus $8.6 million of cash provided by investing activities for the same period in the prior year. The decrease in cash generated from investing activities is primarily related to a reduction in the investments that were liquidated in order to fund daily cash requirements. Cash used in financing activities decreased $2.5 million or 73.2% to $0.9 million for the quarter ended November 30, 2004 versus the $3.5 million of cash used in financing activities for the same period of prior year. The decrease in cash used in financing activities is primarily due to the reduction of overall debt and capital lease obligations. Cash used in discontinued operations decreased $0.4 million or 64% to $0.2 million for the quarter ended November 30, 2004 versus the $0.6 million of cash used to fund discontinued operations during the same period of the prior year. The primary reason for the decrease in

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cash used in discontinued operations is changes in the period cost of litigation, primarily legal fees, associated with the discontinued operations.

In February 2004, the Company executed a five-year promissory note with US Bancorp Oliver-Allen Technology Leasing for $4.8 million. As of November 30, 2004, the principal balance on the promissory note was $4.0 million. The Company has pledged $5.0 million as collateral for this promissory note; this amount will gradually decrease until the agreement terminates in February 2009. As of November 30, 2004, the amount of collateral is $4.3 million. These restrictions prevent the Company from utilizing the related cash and cash equivalents until all of its obligations under the note are satisfied. The new promissory note bears an interest rate of 6.75% and requires monthly payments of $93,000 over the next five years.

During the first fiscal quarter of 2005, the Company spent $0.8 million in capital expenditures primarily related to servers and server components. The Company expects to spend somewhere between $4.0 million and $7.0 million in capital expenditures during fiscal 2005, primarily related to purchases of servers and data center equipment on an as-needed basis with as much re-utilization of equipment from cancelled customers as possible. The Dedicated line of business is particularly sensitive to capital expenditures since each new customer must be provided with a server, either newly-purchased, or one which had been provided to a former customer. To the extent that the dedicated business experiences net growth in customers, additional capital expenditures will be required. In determining whether to purchase new Dedicated servers the Company will balance the cost of the investment against the revenue expected, the operating costs necessary to serve the customer, and the likely duration of the relationship with the customer. Consequently, decreases in market pricing and increases in MRC Churn make it more difficult to justify investment.

The Company’s Web hosting business has historically incurred net losses and losses from operations. The Company’s future operation is dependent upon its ability to achieve and sustain positive cash flow prior to the depletion of cash resources. The Company plans to reduce its level of cash requirements through a decrease in capital purchases and by improving sales and reducing churn. The Company also will have reduced cash outlays for payments associated with prior integration and discontinued operation liabilities and will have reduced debt payments because of the buyout of capital lease obligations during 2004. The Company expects to continue to have negative cash flows for at least the next three quarters as it continues to execute on its business plan. There can be no assurance that Interland’s continuing efforts to stabilize or increase its revenue will be successful and the Company will be able to continue as a going concern. If the Company is unable to successfully execute its business plan, it may require additional capital, which may not be available on suitable terms. Nonetheless, management believes it has adequate cash and liquid resources to fund operations and planned capital expenditures through at least the next 12 months.

Risk Factors

You should carefully consider the following factors and all other information contained in this Form 10-Q and the Company’s recently filed Form 10-K for the fiscal year ended August 31, 2004 before you make any investment decisions with respect to the Company’s securities. The risks and uncertainties described below are not the only risks the Company faces.

Interland has incurred losses since inception and could incur losses in the future.

Interland has incurred net losses and losses from operations for all but one of each quarterly period from its inception through the first quarter of fiscal 2005. A number of factors could increase its operating expenses, such as:

•		Adapting network infrastructure and administrative resources to accommodate additional customers and future growth;
•		Developing products, distribution, marketing, and management for the mainstream market;
•		Broadening customer technical support capabilities; and
•		Improving network security features.

To the extent that increases in expenses are not offset by increases in revenues, operating losses will increase.

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Ours is a recurring-revenue subscriber business and as such the effects of a net loss of monthly recurring revenue are magnified.

A large majority of our revenue is derived from the monthly recurring charges (“MRC”) incurred by owners of hosted websites. Accordingly, the termination of a single account paying $30.00 per month will affect revenue every month in the future. The loss of such a customer at the beginning of a fiscal year will result in a twelve-fold reduction in revenue for that fiscal year, and the loss of even one such customer each month of the fiscal year will result in a diminution of 78 times the monthly recurring revenue, or $2,340 over the entire fiscal year. Absent the addition of customers through acquisitions, Interland has consistently incurred a net loss in MRC, and this situation may continue with material negative effects on reported revenue and net income. Although reductions in MRC may be offset for a time by increases in revenue derived from one-time or non-recurring charges, the compounding effect of MRC losses will almost certainly eventually result in a meaningful reduction of reported revenue. Moreover, because of Interland’s relatively low percentage of variable costs, a concomitantly high percentage of the amount of revenue loss results in a loss of EBITDA and of net income. There can be no assurance that Interland’s continuing efforts to stabilize or increase its MRC and revenue will be successful. If revenue continues to decline, the Company may eventually require additional capital, which may not be available on suitable terms. Although the Company can reduce spending to some degree, there can be no assurance in such an event that the Company would be able to continue indefinitely as a going concern.

Unfavorable results of existing litigation may cause Interland to have additional expenses or operating losses that could exceed the Company’s ability to pay.

The Company is defending a number of matters in active litigation (See Item 3, “Legal Proceedings”). The cost of defending lawsuits, regardless of their merit, can be substantial. The Company spent $3.0 million during 2004 to defend lawsuits. Although the Company has favorably resolved a number of lawsuits through rulings, verdicts, and minimal settlements, and although the Company may be successful in defending ongoing litigation, the costs of defense cannot be expected to be avoided. The Company believes it has appropriately established reserves for the contingency of adverse verdicts. In order for a loss contingency to be reserved for in the financial statements, GAAP requires that the information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements, it is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss and the amount of loss can be reasonably estimated. Therefore, the Company has not reserved for all of its pending lawsuits. Consequently lawsuits for which there is no reserve nonetheless pose a risk of substantial loss which would have a material effect on the Company’s financial position. Additionally, even in those cases where a reserve has been established, the amount of the reserve is necessarily an estimate and the actual result may differ materially. Reserves are established only for the damages that may be assessed, and do not take into account the costs of litigation. Even in those instances where Interland may ultimately prevail on appeal, an adverse verdict in a substantial amount may damage the reputation of the Company, may require the Company to post an appeal bond in an amount which deprives the Company of cash, and require additional expenditures for the cost of appeal. The outcome of litigation is unpredictable, and an adverse final verdict could exceed the Company’s ability to pay.

Because Interland’s historical financial information is not representative of its future results, investors and analysts will have difficulty analyzing Interland’s future earnings potential.

Because the Company has grown through acquisition and its past operating results reflect the costs of integrating these acquisitions, historical results are not representative of future expected operating results. The Company has recognized very sizeable charges and expenditures in the past for impairment charges, restructuring costs, network enhancements, and exploration of the mainstream market. Because these items are not necessarily recurring, it is more difficult for investors to predict future results.

Interland has a limited operating history and its business model is still evolving, which makes it difficult to evaluate its prospects.

Interland’s limited operating history makes evaluating its business operations and prospects difficult. Its range of service offerings has changed since inception and its business model is still developing. Interland has changed from being primarily a seller of personal computers and related accessories to being primarily a Web hosting and Web based value added business solutions provider to small- and medium-sized businesses company. Because some of its services are new, the market for them is uncertain. As a result, the revenues and income potential of its business, as well as the potential benefits of its acquisitions, may be difficult to evaluate.

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Quarterly and annual operating results may fluctuate, which could cause Interland’s stock price to be volatile.

Past operating results have fluctuated significantly on a quarterly and an annual basis. Quarterly and annual operating results may continue to significantly fluctuate due to a wide variety of factors. Because of these fluctuations, comparing operating results from period to period is not necessarily meaningful, and it would not be meaningful to rely upon such comparisons as an indicator of future performance. Factors that may cause its operating results to fluctuate include, but are not limited to:

•		Demand for and market acceptance of the Company’s services and products;
•		Introduction of new services or enhancements by Interland or its competitors;
•		Costs of implementing new network security features, CRM systems, and billing modules;
•		Technical difficulties or system downtime affecting the Internet generally or its hosting operations specifically;
•		Customer retention;
•		Increased competition and consolidation within the Web hosting and applications hosting markets;
•		Changes in its pricing policies and the pricing policies of its competitors;
•		Gains or losses of key strategic partner relationships;
•		Impairment charges;
•		Restructuring charges;
•		Merger and integration costs;
•		Litigation expenses;
•		Insurance expenses;
•		Marketing expenses; and
•		Seasonality of customer demand

Interland cannot provide any assurances that it will succeed in its plans to increase the size of its customer base, the amount of services it offers, or its revenues during the next fiscal year and beyond. In addition, relatively large portions of its expenses are fixed in the short term, and therefore its results of operations are particularly sensitive to fluctuations in revenues. Also, if it cannot continue using third-party products in its service offerings, its service development costs could increase significantly.

Interland’s stock price may be volatile which could cause an investment in its common stock to decrease significantly.

The market price of its common stock has experienced a significant decline. The price has been and is likely to continue to be highly volatile. The following are examples of factors or developments that would likely cause the Company’s stock price to continue to be volatile:

•		Variations in operating results and analyst earnings estimates;
•		The volatility of stock within the sectors within which it conducts business;
•		Announcements by Interland or its competitors regarding introduction of new services;

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•		General decline in economic conditions;
•		Reductions in the volume of trading in its common stock, and;
•		The Company’s inability to reduce the rate of account cancellations, or to increase the rate of account additions, or both.

During the 52 weeks ended November 30, 2004 the high and low closing price for Interland common stock on NASDAQ was $7.36 and $2.67, respectively.

Interland operates in a new and evolving market with uncertain prospects for growth and may not be able to generate and sustain growth in its customer base.

Interland operates in a new and evolving market with uncertain prospects for growth and may not be able to achieve and sustain growth in its customer base or to maintain its average revenue per customer account. The market for Web hosting and applications-hosting services for small- and medium-sized businesses, and especially the mainstream market, has only recently begun to develop and is evolving rapidly. The market for Interland’s services may not develop further, consumers may not widely adopt its services and significant numbers of businesses or organizations may not use the Internet for commerce and communication. If this market fails to develop further or develops more slowly than expected, or if Interland’s services do not achieve broader market acceptance, Interland will not be able to grow its customer base. In addition, Interland must be able to differentiate itself from its competition through its service offerings and brand recognition. These activities may be more expensive than Interland anticipates, and Interland may not succeed in differentiating itself from its competitors, achieving market acceptance of its services, or selling additional services to its existing customer base.

Because Interland’s target markets are volatile, the Company may face a loss of customers or a high level of non-collectible accounts.

The Company intends to continue to concentrate on serving the small- and medium-sized business market. This market contains many businesses that may not be successful, and consequently present a substantially greater risk for non-collectible accounts receivable and for non-renewal. Moreover, a significant portion of this target market is highly sensitive to price, and may be lost to a competitor with a lower pricing structure. Because few businesses in this target market employ trained technologists, they tend to generate a high number of customer service and technical support calls. The expense of responding to these calls is considerable, and the call volume is likely to increase in direct proportion to revenue, potentially limiting the scalability of the business. Additionally, if the customer becomes dissatisfied with the Company’s response to such calls, cancellation, non-payment, or non-renewal becomes more likely. Interland’s strategy for minimizing the negative aspects of its target market include:

•		Increased expenditures on sales and marketing programs to replace failing customers;
•		Capitalizing on infrastructure efficiencies to become a profitable provider at the lowest sustainable price;
•		Automating customer care and technical support to reduce the cost per call, and to minimize the time spent by Company personnel;
•		Intensive training and supervision of customer care and technical support personnel to maximize customer satisfaction; and,
•		Increasing the number and breadth of services to differentiate the Company from competition.

The Company can give no assurance, however, that any of these measures will be successful, and the Company’s failure to manage these risks could decrease revenues and profitability.

Interland could incur liabilities in the future relating to its PC Systems business, which could cause additional operating losses.

Interland could incur liabilities from the sale of the PC Systems business to GTG PC. According to the terms of its agreement with GTG PC, it retained liabilities relating to the operation of the PC systems business prior to the closing of the transaction

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including liabilities for taxes, contingent liabilities and liabilities for accounts payable accrued prior to the closing. It also agreed to indemnify GTG PC and its affiliates for any breach of its representations and warranties contained in the agreement for a period of two years, or for the applicable statute of limitations for matters related to taxes. Its indemnification obligation is capped at $10.0 million. Except for claims for fraud or injunctive relief, this indemnity is the exclusive remedy for any breach of its representations, warranties and covenants contained in the agreement with GTG PC. Accordingly, it could be required in the future to make payments to GTG PC and its affiliates in accordance with the agreement, which could adversely affect its future results of operations and cash flows. To date it has not had to satisfy any such claims.

Because Interland faces intense competition, it may not be able to operate profitably in its markets.

The Web hosting and applications hosting markets are highly competitive, which could hinder Interland’s ability to successfully market its products and services. The Company may not have the resources, expertise or other competitive factors to compete successfully in the future. Because there are few substantial barriers to entry, the Company expects that it will face additional competition from existing competitors and new market entrants in the future. Many of Interland’s current and potential competitors have greater name recognition and more established relationships in the industry and greater resources. As a result, these competitors may be able to:

•		Develop and expand their network infrastructures and service offerings more rapidly;
•		Adapt to new or emerging technologies and changes in customer requirements more quickly;
•		Devote greater resources to the marketing and sale of their services; and,
•		Adopt more aggressive pricing policies than the Company can.

Current and potential competitors in the market include Web hosting service providers, applications hosting providers, Internet service providers, telecommunications companies, large information technology firms and computer hardware suppliers. These competitors may operate in one or more of these areas and include companies such as Yahoo!, NTT/Verio, Affinity Internet, and Earthlink.

Impairment of Interland’s intellectual property rights could negatively affect its business or could allow competitors to minimize any advantage that Interland’s proprietary technology may give it.

The Company currently has no patented technology that would preclude or inhibit competitors from entering the Web hosting market that it serves. While it is the Company’s practice to enter into agreements with all employees and with some of its customers and suppliers to prohibit or restrict the disclosure of proprietary information, the Company cannot be sure that these contractual arrangements or the other steps it takes to protect its proprietary rights will prove sufficient to prevent illegal use of its proprietary rights or to deter independent, third-party development of similar proprietary assets.

Effective copyright, trademark, trade secret and patent protection may not be available in every country in which its products and services are offered. Interland currently is, and in the future may be, involved in legal disputes relating to the validity or alleged infringement of its intellectual property rights or those of a third party. Intellectual property litigation is typically extremely costly and can be disruptive to business operations by diverting the attention and energies of management and key technical personnel. In addition, any adverse decisions could subject it to significant liabilities, require it to seek licenses from others, prevent it from using, licensing or selling certain of its products and services, or cause severe disruptions to operations or the markets in which it competes which could decrease profitability.

Periodically, it is made aware of claims, or potential claims, that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has accrued a liability and charged operations for the estimated costs of settlement or adjudication of several asserted and unasserted claims for alleged infringement relating to its discontinued operations prior to the balance sheet date. Resolution of these claims could be costly and decrease profitability.

If Interland is unable to attract and retain key personnel, it may not be able to compete effectively in its market.

The future success of Interland will depend, in part, on its ability to attract and retain key management, technical, and sales and marketing personnel. The Company attempts to enhance its management and technical expertise by recruiting qualified individuals who possess desired skills and experience in certain targeted areas. The Company experiences strong competition

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for such personnel in the Web hosting industry. The Company’s inability to retain employees and attract and retain sufficient additional employees, information technology, engineering, and technical support resources could adversely affect its ability to remain competitive in its markets. The Company has and may continue to face the loss of key personnel, which could limit the ability of the Company to develop and market its products and services.

Interland depends on its reseller sales channel to market and sell many of its services. Interland does not control its resellers, and if it fails to develop or maintain good relations with resellers, it may not achieve the growth in customers and revenues that it expects.

An element of the strategy for the Company’s growth is to further develop the use of third parties that resell or recommend its services. Many of these resellers are Web development or Web consulting companies that also sell Interland’s Web hosting services, but that generally do not have established customer bases to which they can market these services. The Company is not currently dependent on any one reseller to generate a significant level of business, but it has benefited and continues to significantly benefit from business generated by the reseller channel. Although Interland attempts to provide its resellers with incentives such as price discounts on its services that the resellers seek to resell at a profit, the failure of its services to be commercially accepted in some markets, whether as a result of a reseller’s performance or otherwise, could cause its current resellers to discontinue their relationships with the Company. The Company also is developing relationships with larger distribution partners, and although the percentage of the Company’s current revenues generated by any of these relationships is currently small, if the Company’s strategy is successful, future revenue growth will be dependent on the success and maintenance of these relationships.

Interland is vulnerable to system failures, which could harm its reputation, cause its customers to seek reimbursement for services, and cause its customers to seek another provider for services.

The Company must be able to operate the systems that manage its network around the clock without interruption. Its operations will depend upon its ability to protect its network infrastructure, equipment and customer files against damage from human error, fire, earthquakes, hurricanes, floods, power loss, telecommunications failures, sabotage, intentional acts of vandalism and similar events. The Company’s networks are currently subject to various points of failure. For example, a problem with one of its routers (devices that move information from one computer network to another) or switches could cause an interruption in the services the Company provides to a portion of its customers. In the past, the Company has experienced periodic interruptions in service. The Company has also experienced, and in the future it may continue to experience, delays or interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees, or others. Any future interruptions could:

•		Cause customers or end users to seek damages for losses incurred;
•		Require the Company to replace existing equipment or add redundant facilities;
•		Damage the Company’s reputation for reliable service;
•		Cause existing customers to cancel their contracts; or
•		Make it more difficult for the Company to attract new customers.

Interland’s data centers and network vulnerability to security breaches could cause disruptions in its service, liability to third parties, or loss of customers.

A significant barrier to electronic commerce and communications is the need for secure transmission of confidential information over public networks. Some of the Company’s services rely on security technology licensed from third parties that provides the encryption and authentication necessary to effect the secure transmission of confidential information. Despite the design and implementation of a variety of network security measures by the Company, unauthorized access, computer viruses, accidental or intentional actions and other disruptions could occur. In addition, inappropriate use of the network by third parties could also potentially jeopardize the security of confidential information, such as credit card and bank account numbers stored in the Company’s computer systems. These security problems could result in the Company’s liability and could also cause the loss of existing customers and potential customers.

Although the Company continues to implement industry-standard security measures, third parties may be able to overcome any measures that it implements. The costs required to eliminate computer viruses and alleviate other security problems could

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be prohibitively expensive and the efforts to address such problems could result in interruptions, delays or cessation of service to customers, and harm the Company’s reputation and growth. Concerns over the security of Internet transactions and the privacy of users may also inhibit the growth of the Internet, especially as a means of conducting commercial transactions.

Disruption of Interland’s services caused by unknown software or hardware defects could harm its business and reputation.

The Company’s service offerings depend on complex software and hardware, including proprietary software tools and software licensed from third parties. Complex software and hardware may contain defects, particularly when first introduced or when new versions are released. The Company may not discover software or hardware defects that affect its new or current services or enhancements until after they are deployed. Although Interland has not experienced any material software or hardware defects to date, it is possible that defects may exist or occur in the future. These defects could cause service interruptions, which could damage its reputation or increase its service costs, cause it to lose revenue, delay market acceptance or divert its development resources.

Providing services to customers with critical websites and Web-based applications could potentially expose Interland to lawsuits for customers’ lost profits or other damages.

Because the Company’s Web hosting and applications hosting services are critical to many of its customers’ businesses, any significant interruption in those services could result in lost profits or other indirect or consequential damages to its customers as well as negative publicity and additional expenditures for it to correct the problem. Although the standard terms and conditions of the Company’s customer contracts disclaim liability for any such damages, a customer could still bring a lawsuit against it claiming lost profits or other consequential damages as the result of a service interruption or other website or application problems that the customer may ascribe to it. A court might not enforce any limitations on its liability, and the outcome of any lawsuit would depend on the specific facts of the case and legal and policy considerations even if the Company believes it would have meritorious defenses to any such claims. In such cases, it could be liable for substantial damage awards. Such damage awards might exceed its liability insurance by unknown but significant amounts, which would seriously harm its business.

Interland could face liability for information distributed through its network.

The law relating to the liability of online services companies for information carried on or distributed through their networks is currently unsettled. Online services companies could be subject to claims under both United States and foreign law for defamation, negligence, copyright or trademark infringement, violation of securities laws or other theories based on the nature and content of the materials distributed through their networks. Several private lawsuits seeking to impose such liability upon other entities are currently pending against other companies. In addition, organizations and individuals have sent unsolicited commercial e-mails from servers hosted by service providers to massive numbers of people, typically to advertise products or services. This practice, known as “spamming,” can lead to complaints against service providers that enable such activities, particularly where recipients view the materials received as offensive. The Company may, in the future, receive letters from recipients of information transmitted by its customers objecting to such transmission. Although the Company prohibits its customers by contract from spamming, it cannot provide assurances that its customers will not engage in this practice, which could subject it to claims for damages. In addition, the Company may become subject to proposed legislation that would impose liability for or prohibit the transmission over the Internet of some types of information. Other countries may also enact legislation or take action that could impose liability on the Company or cause it not to be able to operate in those countries. The imposition upon the Company and other online services of potential liability for information carried on or distributed through its systems could require it to implement measures to reduce its exposure to this liability, which may require it to expend substantial resources, or to discontinue service offerings. The increased attention focused upon liability issues as a result of these lawsuits and legislative proposals also could affect the rate of growth of Internet use.

Interland’s business operates in an uncertain legal environment where future government regulation and lawsuits could restrict Interland’s business or cause unexpected losses.

Due to the increasing popularity and use of the Internet, laws and regulations with respect to the Internet may be adopted at federal, state and local levels, covering issues such as user privacy, freedom of expression, pricing, characteristics and quality of products and services, taxation, advertising, intellectual property rights, information security and the convergence of traditional telecommunications services with Internet communications. The Company cannot fully predict the nature of future legislation and the manner in which government authorities may interpret and enforce such legislation. As a result, Interland

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and its customers could be subject to potential liability under future legislation, which in turn could have a material adverse effect on the Company’s business. The adoption of any such laws or regulations might decrease the growth of the Internet which in turn could decrease the demand for the Company’s services, or increase the cost of doing business. In addition, applicability to the Internet of existing laws governing issues such as property ownership, copyright and other intellectual property issues, taxation, libel, obscenity and personal privacy is uncertain. These laws generally pre-date the advent of the Internet and related technologies and, as a result, do not consider or address the unique issues of the Internet and related technologies.

Substantial future sales of shares by shareholders could negatively affect Interland’s stock price.

A number of groups of investors hold substantial numbers of Interland shares, including the former shareholders of acquired companies, and hedge funds reported to have investment styles that lead to short-term holdings. Substantial sales by these holders may adversely affect Interland’s stock price.

Item 3. Quantitative And Qualitative Disclosures About Market Risk

Substantially all of the Company’s liquid investments and a majority of its debt are at fixed interest rates, and therefore the fair value of these instruments is affected by changes in market interest rates. As of November 30, 2004, approximately 98% of the Company’s liquid investments mature within three months and 2% mature within one year. As of November 30, 2004, management believes the reported amounts of liquid investments and debt to be reasonable approximations of their fair values. Generally, the fair market value of fixed interest rate investment securities will increase as interest rates fall and decrease as interest rates rise. The Company does not use derivative financial instruments in its investment portfolio. The portfolio has been primarily comprised of commercial paper rated A1/P1, bank certificates rated AA or better, and corporate medium-term notes rated AA or better. At November 30, 2004, the Company’s investment portfolio included fixed rate securities with an estimated fair value of $31.0 million. The interest rate changes affect the fair market values but do not impact earnings or cash flows. The fair market value of long-term fixed interest rate debt is also subject to interest rate risk. Generally, the fair market of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of the Company’s long-term debt at November 30, 2004 was $4.8 million.

Item 4. Controls and Procedures

The Company’s management, including its chief executive officer, chief financial officer and chief accounting officer evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13(a) – 14(c), and 14(d)) as of November 30, 2004. Based on this review, the chief executive officer, chief financial officer and chief accounting officer concluded that Interland’s disclosure controls and procedures were effective to provide reasonable assurances that such disclosure controls and procedures satisfy their objectives and that the information required to be disclosed by the Company in its periodic reports is accumulated and communicated to management, including its chief executive officer, chief financial officer and chief accounting officer, as appropriate to allow timely decisions regarding disclosure and is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms.

Nevertheless, the Company’s management, including its chief executive officer, chief financial officer and chief accounting officer, do not expect that the Company’s disclosure controls and procedures will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdown can occur because of simple error or mistake. In particular, many of the Company’s current processes rely upon manual reviews and processes to ensure that neither human error nor system weakness has resulted in erroneous reporting of financial data.

The Company considers a change in its internal control over financial reporting to be material only when the failure to effectuate such change would have been expected to result in a substantial likelihood of a material misstatement of the Company’s financial statements. While we continued to make incremental improvements to our internal controls over

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financial reporting during the fiscal quarter, there were no changes in the Company’s internal control over financial reporting which management considered to be material.

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Interland, Inc.

PART II. – OTHER INFORMATION

Item 1. Legal Proceedings

In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr. Gabriel Murphy, one of the former principals of Interland’s subsidiary, CommuniTech.Net, Inc. (“Communitech”), which was acquired by Interland in February 2002. The Company’s lawsuit claims, among other things, that Mr. Murphy breached certain covenants under his employment agreement and also demands payment from Mr. Murphy’s two promissory notes (one of which was “non-recourse” while the other was “recourse”). In March 2004, Interland retired the 273,526 shares of stock held as collateral and wrote off the $2,000,000 non-recourse promissory note, which had been carried as Stockholder’s Equity. The other $735,000 full recourse promissory note remains outstanding and continues to be a subject of the Cobb County litigation noted above. Mr. Murphy has asserted various counterclaims in response.

In February 2003, Mr. Heitman, also a former principal of Interland’s subsidiary Communitech, and Mr. Murphy filed a lawsuit against Interland, its Chief Executive Officer, Mr. Joel Kocher, and Communitech, in Jackson County, Missouri claiming, among other things, that Interland acted unreasonably in failing to have the S-3 registration statement declared effective by the SEC on a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in connection with Interland’s acquisition of Communitech. The complaint sought compensatory and punitive damages in an unspecified amount. Interland believes that these claims are without merit and will not have a material adverse effect on Interland and is vigorously defending the claims. The Interland parties have filed motions to dismiss all of the claims against them and those motions are pending.

In February 2004, the Company initiated a lawsuit in the United States District Court for the Northern District of Georgia against the representatives of the former shareholders of Hostcentric (the “Hostcentric Shareholders”), seeking a declaratory judgment that it will be entitled to reimbursement from the escrow fund established as part of the Hostcentric acquisition for any amounts over $180,000 that it may be required to pay to the landlord for a leased facility in Farmingdale, New York, in accordance with the acquisition agreement between the Company and Hostcentric and its shareholders. The representatives of the Hostcentric Shareholders have denied Interland’s claims and have attempted to assert various counterclaims. The Company, has in turn, brought additional claims based on facts learned in discovery. Correspondence between the parties has also discussed the possibility of other claims, but these claims have not yet been asserted in litigation. Interland believes its claims in this case are meritorious, that the counterclaims of the former Hostcentric shareholders are without merit, plans to continue to contest the matter vigorously and believes that no material adverse effect on Interland will occur as a result of this litigation.

In February 2004, the Company, through its Hostcentric subsidiary, has also initiated a lawsuit in United States District Court for Southern District of New York against the landlord for the same Farmingdale, New York facility. The Company believes that it and the landlord have reached an agreement in principle to settle the litigation and has petitioned the court to enforce the agreement. Interland believes that no material adverse effect on Interland will occur as a result of this litigation.

Interland is also defending a case entitled Novell, Inc. v. Micron Electronics, Inc. filed in August 1999 in state court in Utah County, Utah. Novell claims that it was underpaid for royalties on sales of several versions of its NetWare software purportedly distributed by Interland’s predecessor, Micron Electronics, between 1996 and 1998. In addition, Novell also believes it is entitled additional royalties for sales of the software purportedly distributed by NetFrame between 1993 and 1997. Micron Electronics acquired NetFrame in 1997. Novell is seeking an accounting and damages. Interland believes it has meritworthy defenses to Novell’s claims. The litigation is still in the discovery phase.

Periodically, the Company is made aware that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has evaluated all such claims and, if necessary and appropriate, sought to obtain licenses for the use of such technology. If the Company or its suppliers were unable to obtain licenses necessary to use intellectual property in its discontinued operation’s products or processes, it may be forced to defend legal actions taken against it relating to allegedly protected technology. The Company evaluates all such claims and has accrued a liability and charged discontinued operations for the estimated costs of settlement or adjudication of claims for alleged infringement as of the respective dates of the balance sheets included in this report.

The Company is also a defendant in a number of other lawsuits that the Company regards as unlikely to result in any material payment; nonetheless, the outcome of litigation may not be assured, and the Company’s cash balances could be materially

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affected by an adverse judgment. In accordance with SFAS No. 5 “Accounting for Contingencies,” the Company believes it has adequately reserved for the contingencies arising from the above legal matters where an outcome was deemed to be probable and the loss amount could be reasonably estimated. As such, the Company does not believe that the anticipated outcome of the aforementioned proceedings will have a materially adverse impact on its results of operations, its financial condition or its cash flows.

Item 2. Unregistered Sale of Equity Securities and Use of Proceeds

Not Applicable

Item 3. Defaults Upon Senior Securities

Not Applicable

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

Not Applicable

Item 5. Other Information

Not Applicable

Item 6. Exhibits

Exhibits:

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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Interland, Inc. (Registrant)

Dated: December 27, 2004	/s/ Allen L. Shulman
	Allen L. Shulman
	Senior Vice President, Chief Financial Officer, and Executive Counsel (Principal Financial Officer)

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