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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 001-32264
DSL.NET, INC.
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(Exact name of registrant as specified in its charter)
Delaware 06-1510312
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
545 Long Wharf Drive
New Haven, Connecticut 06511
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(Address of principal executive offices) (Zip Code)
(203) 772-1000
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(Registrant's telephone number, including area code)
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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [_] No [X]
As of October 28, 2004, the registrant had 233,619,817 shares of Common
Stock outstanding.
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DSL.NET, INC.
INDEX
Page
Number
------
Part I - Financial Information
Item 1. Consolidated Financial Statements ...................................2
Consolidated Balance Sheets (unaudited) at September 30,
2004 and December 31, 2003 ...................................2
Consolidated Statements of Operations (unaudited) for the
three and nine months ended September 30, 2004 and 2003........3
Consolidated Statements of Cash Flows (unaudited) for
the nine months ended September 30, 2004 and 2003..............4
Notes to Consolidated Financial Statements.........................5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations..........................................26
Item 3. Quantitative and Qualitative Disclosures about Market Risk..........45
Item 4. Controls and Procedures.............................................45
Part II - Other Information
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.........45
Item 6. Exhibits............................................................46
Signature...................................................................47
Exhibit Index...............................................................48
1
Part I - Financial Information
Item 1. Consolidated Financial Statements
DSL.NET, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
September 30, December 31,
2004 2003
---------- ----------
ASSETS
Current assets:
Cash and cash equivalents $ 4,320 $ 13,779
Accounts receivable (net of allowances of $1,064 and $902
at September 30, 2004 and December 31, 2003, respectively) 6,913 8,054
Inventory 555 477
Deferred costs 542 931
Prepaid expenses and other current assets 931 802
---------- ----------
Total current assets 13,261 24,043
Fixed assets, net 15,583 24,357
Goodwill, net (Note 6) 8,482 8,482
Other intangible assets, net (Note 6) 242 1,010
Other assets 912 1,169
---------- ----------
Total assets $ 38,480 $ 59,061
========== ==========
LIABILITIES, MANDATORILY REDEEMABLE, CONVERTIBLE
PREFERRED STOCK AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,708 $ 3,570
Accrued salaries 1,016 1,046
Accrued liabilities 2,928 7,529
Deferred revenue 5,213 6,068
Current portion of capital leases payable 74 105
---------- ----------
Total current liabilities 12,939 18,318
Capital leases payable -- 50
Notes payable, net of discount (Note 7) 9,012 5,374
---------- ----------
Total liabilities 21,951 23,742
---------- ----------
Commitments and contingencies (Note 8)
Mandatorily redeemable, convertible preferred stock (Note 9):
20,000,000 preferred shares authorized: 20,000 shares designated as Series X,
mandatorily redeemable, convertible preferred stock, $.001 par value; 0 and 20,000
shares issued and outstanding as of September 30, 2004 and December 31, 2003,
respectively; liquidation preference: $0 and $24,660 as of September 30, 2004
and December 31, 2003, respectively -- 16,231
20,000,000 preferred shares authorized: 15,000 shares designated as Series Y,
mandatorily redeemable, convertible preferred stock, $.001 par value; 0 and 1,000
shares issued and outstanding as of September 30, 2004 and December 31, 2003,
respectively; liquidation preference: $0 and $1,211 as of September 30, 2004
and December 31, 2003, respectively -- 788
Stockholders' equity (Notes 3 and 9)
Preferred Stock: 20,000,000 preferred shares authorized: 14,000 shares designated as
Series Z, $.001 par value; 14,000 and 0 shares issued and outstanding as of
September 30, 2004 and December 31, 2003, respectively; liquidation preference:
$15,680 and $0 as of September 30, 2004 and December 31, 2003, respectively 2,630 --
Common stock, 800,000,000 shares authorized: $.0005 par value; 233,619,817 and
105,449,054 shares issued and outstanding as of September 30, 2004 and
December 31, 2003, respectively 117 53
Additional paid-in capital 352,076 337,735
Accumulated deficit (338,294) (319,488)
---------- ----------
Total stockholders' equity 16,529 18,300
---------- ----------
Total liabilities, redeemable preferred stock and stockholders' equity $ 38,480 $ 59,061
========== ==========
The accompanying notes are an integral part of these
consolidated financial statements.
2
DSL.NET, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
2004 2003 2004 2003
------------- ------------- ------------- -------------
Revenue, net $ 16,827 $ 18,227 $ 52,333 $ 53,089
------------- ------------- ------------- -------------
Operating expenses:
Network (excluding $0, $0, $0 and $11
of stock compensation, respectively) 11,404 13,070 35,549 38,412
Operations (excluding $0, $0, $0 and $10
of stock compensation, respectively) 2,380 3,060 8,001 8,935
General and administrative (excluding $0, $0, $0 and $69
of stock compensation, respectively) 3,210 2,618 9,661 8,891
Sales and marketing (excluding $0, $0, $0 and $348
of stock compensation, respectively) 993 2,116 4,515 6,238
Stock compensation -- -- -- 438
Depreciation and amortization 3,355 3,319 9,957 12,654
------------- ------------- ------------- -------------
Total operating expenses $ 21,342 $ 24,183 $ 67,683 $ 75,568
------------- ------------- ------------- -------------
Operating loss $ (4,515) $ (5,956) $ (15,350) $ (22,479)
Interest expense, net (1,412) (728) (3,570) (2,139)
Other income (expense), net 8 (2,427) 114 (2,436)
------------- ------------- ------------- -------------
Net loss $ (5,919) $ (9,111) $ (18,806) $ (27,054)
============= ============= ============= =============
Net loss applicable to common stockholders:
Net loss (5,919) (9,111) (18,806) (27,054)
Dividends on Series X and Y preferred stock (40) (1,045) (950) (3,145)
Accretion of Series X and Y preferred stock (4,812) (5,318) (8,852) (11,339)
Fair value of Series Z preferred stock (2,630) -- (2,630) --
------------- ------------- ------------- -------------
Net loss applicable to common stockholders $ (13,401) $ (15,474) $ (31,238) $ (41,538)
============= ============= ============= =============
Net loss per share, basic and diluted $ (0.06) $ (0.22) $ (0.19) $ (0.62)
============= ============= ============= =============
Shares used in computing net loss per share, basic and diluted 212,218,234 70,161,057 164,442,133 66,726,872
============= ============= ============= =============
The accompanying notes are an integral part of these
consolidated financial statements.
3
DSL.NET, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
Nine Months Ended
September 30,
--------------------------
2004 2003
---------- ----------
Cash flows from operating activities:
Net loss $ (18,806) $ (27,054)
Reconciliation of net loss to net cash provided by (used in)
operating activities:
Depreciation and amortization 9,957 12,654
Bad debt expense 881 1,739
Sales credits and allowances 204 339
Amortization of deferred debt issuance costs and debt discount 3,355 7,165
Stock compensation expense -- 438
Loss on sale/write-off of fixed assets 104 134
Gain on note settlement -- (3,500)
Non-cash interest on lease payoff -- 194
Net changes in assets and liabilities, net of acquired assets:
Decrease / (increase) in accounts receivable 56 (5,692)
Decrease / (increase) in prepaid and other current assets 179 (293)
Decrease in other assets 257 762
Increase / (decrease) in accounts payable 138 (1,006)
(Decrease) / increase in accrued salaries (30) 121
(Decrease) / increase in accrued liabilities (4,318) 5,717
(Decrease) / increase in deferred revenue (855) 1,307
---------- ----------
Net cash used in operating activities (8,878) (6,975)
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment (519) (1,840)
Acquisitions of businesses and customer lines -- (8,743)
Decrease / (increase) in restricted cash 3 (3)
---------- ----------
Net cash used in investing activities (516) (10,586)
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Cash flows from financing activities:
Proceeds from credit facility -- 6,100
Proceeds from common stock issuance 16 2,270
Proceeds from note issuances -- 30,000
Payments on credit facility -- (6,100)
Principal payments under notes and capital lease obligations (81) (4,945)
---------- ----------
Net cash (used) / provided by financing activities (65) 27,325
---------- ----------
Net increase / (decrease) in cash and cash equivalents (9,459) 9,764
Cash and cash equivalents at beginning of period 13,779 11,318
---------- ----------
Cash and cash equivalents at end of period $ 4,320 $ 21,082
========== ==========
Supplemental disclosure:
Cash paid: interest $ 9 $ 776
========== ==========
Supplemental disclosure of non-cash investing activities:
On January 10, 2003, the Company purchased network assets and associated
subscriber lines of Network Access Solutions Corporation (Note 5).
The fair value of the assets acquired was $14,737.
On September 8, 2003, the Company purchased network assets and associated
subscriber lines of TalkingNets Holdings, LLC (Note 5).
The fair value of the assets acquired was $829.
Supplemental disclosure of non-cash financing activities:
During the first and third quarters of 2004, a total of 20,000 shares of
Series X Preferred Stock were converted into 111,111,108 shares of common
stock and $5,600 of accrued dividends pertaining thereto were paid by issuing
14,026,974 shares of common stock (Note 9).
Also during the first quarter 2004, 1,000 shares of Series Y Preferred Stock
were converted into 2,260,910 shares of common stock and $221 of accrued
dividends pertaining thereto were paid by issuing 309,864 shares of common
stock (Note 9).
Also during the first quarter of 2004, the Company issued 413,160 shares of
its common stock upon the exercise of 1,358,025 of stock warrants granted in
connection with certain loan guarantees in a cashless exchange (Note 3).
The accompanying notes are an integral part of these
consolidated financial statements.
4
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. Summary of Significant Accounting Policies
A. Basis of Presentation
The consolidated financial statements ("financial statements") of DSL.net,
Inc. ("DSL.net" or the "Company") at September 30, 2004 and for the three and
nine months ended September 30, 2004 and 2003 are unaudited, but, in the opinion
of management, include all adjustments (consisting only of normal recurring
adjustments) that DSL.net considers necessary for a fair presentation of its
financial position and operating results. Operating results for the three and
nine months ended September 30, 2004 are not necessarily indicative of results
that may be expected for any future periods.
These financial statements have been prepared in accordance with the
instructions to Form 10-Q and the rules and regulations of the Securities and
Exchange Commission ("SEC"). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
instructions, rules and regulations. While management believes the disclosures
presented are adequate to make these financial statements not misleading, these
financial statements should be read in conjunction with the Company's audited
financial statements and related notes included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2003, which has been filed with the
SEC.
Certain prior period amounts have been reclassified to conform to the 2004
presentation.
The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities,
including the recoverability of tangible and intangible assets, disclosure of
contingent assets and liabilities as of the date of the financial statements,
and the reported amounts of revenues and expenses during the reported period.
The markets for the Company's services are characterized by intense competition,
rapid technological development, regulatory and legislative changes, and
frequent new product introductions, all of which could impact the future value
of the Company's assets and liabilities. Actual results may differ from those
estimates.
The Company evaluates its estimates on an on-going basis. The most
significant estimates relate to revenue recognition, goodwill and other
long-lived assets, the allowance for doubtful accounts, taxes, contingencies and
litigation. Such estimates are based on historical experience and on various
other assumptions that the Company believes to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ materially from those estimates.
The Company has one reportable business operating segment under the
requirements of Statement of Financial Accounting Standards ("SFAS") No. 131.
The Company believes the following critical accounting policies affect the
Company's more significant judgments and estimates used in the preparation of
its consolidated financial statements:
5
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
REVENUE RECOGNITION
The Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin ("SAB") No. 104, "REVENUE RECOGNITION." SAB No. 104's primary purpose
is to rescind guidance contained in SAB No. 101 related to multiple element
revenue arrangements, superceded as a result of the issuance of Emerging Issues
Task Force ("EITF") Issue No. 00-21, "REVENUE ARRANGEMENTS WITH MULTIPLE
DELIVERABLES." SAB No. 104's wording has not changed SAB No. 101's four basic
criteria that must be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services have
been rendered; (3) the fee is fixed or determinable; and (4) collectibility is
reasonably assured. Determination of criteria (3) and (4) are based on
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
Revenue is recognized pursuant to the terms of each contract on a monthly
service fee basis, which varies based on the speed of the customer's broadband
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of any leased equipment
installed at the customer's site and other services, as applicable. Revenue that
is billed in advance of the services provided is deferred until the services are
provided by the Company. Revenue related to installation charges is also
deferred and amortized to revenue over 18 months, which is the average customer
life of the existing customer base. Related direct costs incurred (up to the
amount of deferred revenue) are also deferred and amortized to expense over 18
months. Any excess direct costs over installation charges are charged to expense
as incurred. In certain instances, the Company negotiates credits and allowances
for service related matters. The Company establishes a reserve against revenue
for credits of this nature based on historical experience. From time to time the
Company offers sales incentives to its customers in the form of rebates toward
select installation services and customer premise equipment. The Company records
a liability based on historical experience for such estimated rebate costs, with
a corresponding reduction to revenue and deferred revenue, as applicable.
The Company seeks to price its services competitively. The market for
high-speed data communications services and Internet access is rapidly evolving
and intensely competitive. While many competitors and potential competitors may
enjoy competitive advantages over the Company, it is pursuing a significant
market that, it believes, is currently under-served. Although pricing is an
important part of the Company's strategy, management believes that direct
relationships with customers and consistent, high quality service and customer
support will be key to generating customer loyalty. During the past several
years, market prices for many telecommunications services and equipment have
been declining, which is a trend that might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
The Company accounts for its long-lived assets in accordance with SFAS No.
144, "ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED
ASSETS TO BE DISPOSED OF," which requires that long-lived assets and certain
intangible assets be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. If
undiscounted expected future cash flows are less than the carrying value of the
assets, an impairment loss is to be recognized based on the fair value of the
assets.
6
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company accounts for goodwill and other intangible assets in
accordance with SFAS No. 142, "GOODWILL AND OTHER INTANGIBLE ASSETS." This
statement required that the amortization of goodwill be discontinued and instead
an impairment approach be applied. If impairment exists, under SFAS No. 142, the
resulting charge is determined by the recalculation of goodwill through a
hypothetical purchase price allocation of the fair value and reducing the
current carrying value to the extent it exceeds the recalculated goodwill. The
Company has not recorded any goodwill impairment adjustments resulting from its
impairment reviews.
Other long-lived assets, such as identifiable intangible assets and fixed
assets, are amortized or depreciated over their estimated useful lives. These
assets are reviewed for impairment whenever events or circumstances provide
evidence that suggests that the carrying amount of the assets may not be
recoverable, with impairment being based upon an evaluation of the identifiable
undiscounted cash flow. If impaired, the resulting charge reflects the excess of
the asset's carrying cost over its fair value.
If market conditions become less favorable, future cash flows (the key
variable in assessing the impairment of these assets) may decrease and as a
result the Company may be required to recognize impairment charges.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company maintains an allowance for doubtful accounts for estimated
losses resulting from the inability of its customers to make required payments.
The Company principally sells its services directly to end users mainly
consisting of small to medium sized businesses, but the Company also sells its
services to certain resellers, such as Internet service providers ("ISPs"). The
Company believes that it does not have significant exposure or concentrations of
credit risk with respect to any given customer. However, if the country or any
region the Company services experiences an economic downturn, the financial
condition of the Company's customers could be adversely affected, which could
result in their inability to make payments to the Company. This could require
additional provisions for allowances. In addition, a negative impact on revenue
and cash flows related to those customers may occur.
With its acquisition of certain of the assets of Network Access Solutions
Corporation ("NAS") on January 10, 2003, the Company acquired a number of end
users, some of whom it serves indirectly through various ISPs. The Company sells
its services to such ISPs who then resell the services to the end users. The
Company has some increased exposure and concentration of credit risk pertaining
to such ISPs. However, no individual customer accounted for more than 5% of
revenue for the first nine months of either 2004 or 2003 or more than 10% of
accounts receivable at September 30, 2004 or December 31, 2003.
INVENTORY
Inventories consist of modems and routers (generally referred to as
customer premise equipment) that the Company sells or leases to customers and
are required to establish a high speed DSL or T-1 digital connection.
Inventories are stated at the lower of cost or market. Cost of inventory is
determined on the "first-in, first-out" or average cost methods. The Company
establishes inventory reserves for excess, obsolete or slow-moving inventory
based on changes in customer demand, technology developments and other factors.
7
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
INCOME TAXES
The Company uses the liability method of accounting for income taxes, as
set forth in SFAS No. 109, "ACCOUNTING FOR INCOME TAXES." Under this method,
deferred tax assets and liabilities are recognized for the expected future tax
consequences of temporary differences between the carrying amounts and the tax
basis of assets and liabilities and net operating loss carryforwards, all
calculated using presently enacted tax rates.
The Company has not generated any taxable income to date and, therefore,
has not paid any federal income taxes or state taxes based on income since
inception. The Company's state and federal net operating loss carryforwards
begin to expire in tax years 2004 and 2019, respectively. Use of the Company's
net operating loss carryforwards may be subject to significant annual
limitations resulting from a change in control due to securities issuances
including without limitation the Company's sales of its mandatorily redeemable
convertible Series X preferred stock (the "Series X Preferred Stock") and its
mandatorily redeemable convertible Series Y preferred stock (the "Series Y
Preferred Stock") in 2001 and 2002 (Note 9) and from the sale of $30,000 in
notes and warrants in July 2003 (Note 7). The Company is currently assessing the
potential impact on the Company's net operating loss carryforwards resulting
from these transactions. The Company has provided a valuation allowance for the
full amount of the net deferred tax asset since it has not determined that these
future benefits will more likely than not be realized.
LITIGATION
From time to time, the Company may be involved in litigation concerning
claims arising in the ordinary course of its business, including claims brought
by former employees and claims related to acquisitions. The Company records
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on analyses made by internal and external legal counsel who
consider information known at the time. The Company believes it has made
reasonable estimates in the past; however, court decisions and other factors
could cause liabilities to be incurred in excess of estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company has issued various financial debt and/or equity instruments,
some of which have required a determination of their fair value where quoted
market prices were not published or readily available. The Company bases its
fair value determinations on valuation techniques that require judgments and
estimates. From time to time, the Company may hire independent valuation
specialists to perform and or assist in the fair value determination of such
instruments.
B. Earnings (Loss) Per Share
The Company computes net loss per share pursuant to SFAS No. 128,
"EARNINGS PER SHARE." Basic earnings (loss) per share is computed by dividing
income or loss applicable to common stockholders by the weighted average number
of shares of the Company's common stock outstanding during the period, after
giving consideration to shares subject to repurchase.
Diluted earnings per share is determined in the same manner as basic
earnings per share except that the number of shares is increased assuming
exercise of dilutive stock options and warrants using the treasury stock method
and dilutive conversion of the Company's outstanding preferred stock. The
8
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
diluted earnings per share amount is presented herein as the same as the basic
earnings per share amount because the Company had a net loss during each period
presented, and the impact of the assumed exercise of stock options and warrants
and the assumed conversion of preferred stock would have been anti-dilutive.
The following options and warrants and convertible preferred stock were
excluded from the calculation of earnings per share since their inclusion would
be anti-dilutive for all periods presented:
Shares of Common Stock
---------------------------
September 30,
---------------------------
2004 2003
----------- -----------
Options to purchase
common stock 44,671,029 17,993,260
Warrants to purchase
common stock 171,747,621 173,188,960
Preferred Series X stock
convertible to common
stock -- 111,111,111
Preferred Series Y stock
convertible to common
stock -- 11,417,590
----------- -----------
Total 216,418,650 313,710,921
----------- -----------
As of December 31, 2003, the Company had 105,449,054 shares of common
stock issued and outstanding. As of September 30, 2004, the Company had
233,619,817 shares of common stock issued and outstanding. The increase of
128,170,763 shares resulted from 127,708,856 shares of common stock issued in
connection with preferred stock conversions, 413,160 shares of common stock
issued upon the exercise of certain warrants for the purchase of common stock
and 48,747 shares of common stock issued to employees of the Company in
connection with employee stock option exercises and employee stock purchases
under the Company's applicable plans. The weighted average number of shares of
common stock outstanding used in computing earnings per share for the three
months ended September 30, 2004 and 2003 was 212,218,234 and 70,161,057,
respectively. The weighted average number of shares of common stock outstanding
used in computing earnings per share for the nine months ended September 30,
2004 and 2003 was 164,442,133 and 66,726,872, respectively.
C. Incentive Stock Award Plans
As of September 30, 2004, the Company had five stock-based employee
compensation plans, four of which are described more fully in the Company's
audited financial statements and related notes included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2003, and the fifth of
which, the Kirby Pickle Stock Plan (as defined below), is more fully described
below.
In April 2004, as authorized by the Company's Board of Directors, the
Company entered into an employment agreement and related stock option agreement
with Kirby G. Pickle, the Company's new chief executive officer. Under the stock
option agreement for Mr. Pickle (the "Kirby Pickle Stock Plan"), an option to
purchase a total of 10,000,000 shares of the Company's common stock was granted
to Mr. Pickle as an inducement to his employment with the Company. Options
granted under
9
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
the Kirby Pickle Stock Plan vest 16.6% on the date six months following the
grant date, and thereafter vest ratably on a monthly basis over the next thirty
months. Once vested, the options are exercisable at an exercise price of $0.48
per share for ten years from the date of the grant.
The Company accounts for stock-based compensation under the intrinsic
value method in accordance with Accounting Principles Board ("APB") Opinion No.
25, "ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES." Accordingly, compensation
expense is not recognized when options are granted at the fair market value on
the date of grant.
The Company has elected to continue following APB Opinion No. 25 to
account for its stock-based compensation plans. The following table presents the
effect on the Company's net loss and net loss per share as if the Company had
applied the fair value method of accounting for stock-based compensation in
accordance with SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION":
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2004 2003 2004 2003
--------- --------- --------- ---------
Net loss, as reported $ (5,919) $ (9,111) $ (18,806) $ (27,054)
Add stock compensation expense
included in net loss -- -- -- 438
Deduct: total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects (1,553) (915) (4,017) (3,724)
--------- --------- --------- ---------
Pro forma under SFAS No. 123 $(7,472) $ (10,026) $ (22,823) $ (30,340)
Net loss applicable to common stockholders:
As reported $ (13,401) $ (15,474) $ (31,238) $ (41,538)
Pro forma under SFAS No. 123 $ (14,954) $ (16,389) $ (35,255) $ (44,824)
Basic and diluted net loss per common share:
As reported $ (0.06) $ (0.22) $ (0.19) $ (0.62)
Pro forma under SFAS No. 123 $ (0.07) $ (0.23) $ (0.21) $ (0.67)
10
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The estimated fair value at date of grant for options granted during the
three and nine months ended September 30, 2004 ranged from $0.21 to $0.71 per
share, and for the three and nine months ended September 30, 2003 ranged from
$0.49 to $0.69 per share. The minimum value of each option grant is estimated on
the date of grant using the Black-Scholes option pricing model with the
following weighted average assumptions:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- ------------------------
2004 2003 2004 2003
---- ---- ---- ----
Risk free interest rate 2.85 -3.56% 2.15-3.06% 1.96-3.67% 2.15-3.06%
Expected dividend yield None None None None
Expected life of option 3-4 Years 4 Years 3-4 Years 4 Years
Expected volatility 142% 152% 134-145% 152%
As additional options are expected to be granted in future periods, and
the options vest over several years, the above pro forma results are not
necessarily indicative of future pro forma results.
D. Recently Issued Accounting Pronouncements
In September 2004, the EITF issued EITF No. 04-10 "Applying Paragraph 19
of FASB Statement No. 131, "DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND
RELATED INFORMATION," in Determining whether to Aggregate Operating Segments
that do not Meet the Quantitative Thresholds". EITF No. 04-10 presents
guidelines for two alternative approaches in determining whether to aggregate
operating segments and is effective for fiscal years ending after October 13,
2004. The Company has determined that EITF No. 04-10 will not have an impact on
its operating segment disclosures.
2. Liquidity
As reflected in the Company's audited financial statements and related
notes included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2003, the Company incurred operating losses of approximately
$29,631 and negative operating cash flows of approximately $13,715 during the
year ended December 31, 2003. During the nine months ended September 30, 2004,
the Company incurred operating losses of approximately $15,350 and negative
operating cash flows of approximately $8,878. These operating losses and
negative operating cash flows have been financed primarily by proceeds from
equity and note issuances. The Company had accumulated deficits of approximately
$338,294 at September 30, 2004 and approximately $319,488 at December 31, 2003.
The Company expects its operating losses, net operating cash outflows and
capital expenditures to continue throughout 2004 and into 2005. Based on the
Company's current business plan and projections (excluding the proceeds from the
October 7, 2004 $5,000 convertible notes and warrant financing with Laurus
Master Fund, Ltd., a Cayman Islands corporation ("Laurus"), more fully described
in Note 11, below, the withdrawal and use of which are subject to the prior
approval of DB Advisors, L.L.C., as advisor to Deutsche Bank AG London, and
Deutsche Bank Trust Company Americas), the Company believes that its existing
cash and cash expected to be generated from
11
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
operations will be sufficient to fund its operating losses, capital
expenditures, lease payments, and working capital requirements into the fourth
quarter of 2004. Failure to generate sufficient revenues, contain certain
discretionary spending, obtain approval to use the proceeds from the Company's
October 7, 2004 financing, more fully described in Note 11, below, or achieve
certain other business plan objectives could have a material adverse affect on
the Company's results of operations, cash flows and financial position,
including its ability to continue as a going concern.
The Company intends to use its cash resources to finance its capital
expenditures and for working capital and other general corporate purposes. The
Company may also use a portion of its cash resources to pursue strategic
opportunities and may need additional funding to carry out such activities. The
amounts actually expended for these purposes will vary significantly depending
on a number of factors, including market acceptance of the Company's services;
revenue growth; planned capital expenditures; cash generated from operations;
improvements in operating productivity; the availability, timing and feasibility
of strategic opportunities; and the availability and terms of any additional
funding.
There can be no assurance that the Company will be able to achieve its
business plan objectives or that it will achieve or maintain cash flow positive
operating results. If the Company is unable to generate adequate funds from its
operations, or obtain approval to use the proceeds from the October 7, 2004
financing, as more fully described in Note 11, below, or raise additional
capital, the Company may not be able to continue to operate its network, respond
to competitive pressures or fund its operations. As a result, the Company may be
required to significantly reduce, reorganize, discontinue or shut down its
operations. These financial statements do not include any adjustments that might
result from this uncertainty.
3. Stockholders' Equity
During July, 2004, the Company issued 77,777,775 and 11,710,142 shares of
its common stock, respectively, upon the conversion of the remaining balance of
14,000 shares of Series X Preferred Stock and as payment for approximately
$4,040 of accrued dividends on such converted shares of Series X Preferred
Stock. In addition, as part of a Recapitalization Agreement, to induce the
holders of the Series X Preferred Stock to convert the aforementioned shares,
the Company issued to the former holders of the Series X Preferred Stock 14,000
shares of a new Series Z preferred stock, $.001 par value, (the "Series Z
Preferred Stock") with a liquidation preference of $1,120 per share and a fair
value of $2,630, as of the date of issuance (Note 9).
During the first quarter of 2004, the Company issued 33,333,333 and
2,316,832 shares of its common stock, respectively, upon the conversion of 6,000
shares of Series X Preferred Stock and as payment for approximately $1,560 of
accrued dividends on such converted shares of Series X Preferred Stock (Note 9).
Also during the first quarter of 2004, the Company issued 2,260,910 and 309,864
shares of its common stock, respectively, upon the conversion of 1,000 shares of
Series Y Preferred Stock and as payment for approximately $221 of accrued
dividends on such converted shares of Series Y Preferred Stock (Note 9). In
addition, during the first quarter of 2004, the Company issued 413,160 shares of
its common stock upon the cashless exercise of warrants to purchase 1,358,025
shares of the Company's common stock granted in connection with certain loan
guarantees.
During the third quarter of 2003, the Company issued 22,473,078 and
2,445,895 shares of its common stock, respectively, upon the conversion of 9,950
shares of Series Y Preferred Stock and as
12
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
payment for approximately $1,793 of accrued dividends on such converted shares
of Series Y Preferred Stock (Note 9).
The Company also issued 2,778 and 39,910 shares of common stock,
respectively, upon exercises of stock options during the three and nine months
ended September 30, 2004. In addition, the Company issued 2,500 and 6,336 shares
of its common stock during the three and nine months ended September 30, 2004,
respectively, to employees participating in the Company's 1999 Employee Stock
Purchase Plan.
4. Restructuring
In September, 2004, the Company reduced its workforce at its locations in
New Haven, Connecticut; Herndon, Virginia; and Wilmington, North Carolina by 32
employees. As a result, the Company incurred approximately $78 in restructuring
charges pertaining to severance and benefits payments.
In March, 2004, the Company reduced its workforce at its locations in New
Haven, Connecticut; Herndon, Virginia; Minneapolis, Minnesota and Wilmington,
North Carolina by 62 employees. As a result, the Company incurred approximately
$160 in restructuring charges pertaining to severance and benefits payments.
During the three and nine months ended September 30, 2004, the Company
charged approximately $137 and $429, respectively, against its restructuring
reserves which related to facilities expense associated with the Company's
vacated office space in Santa Cruz, California. The Company's restructuring
reserve balance as of September 30, 2004, of approximately $111, represents
estimated costs associated with such vacated facility and was included in the
Company's accrued liabilities.
The following table summarizes the additions and charges to the
restructuring reserve from December 31, 2003 through September 30, 2004, and the
remaining reserve balances at September 30, 2004.
Restructuring Reserve
---------------------------------
Facility
Lease Severance Total
----- --------- -----
Balance December 31, 2003 $ 540 $ -- $ 540
Additions to reserve $ -- $ 238 $ 238
Charges to reserve $(429) $(238) $(667)
---------------------------------
Balance September 30, 2004 $ 111 $ -- $ 111
=================================
5. Acquisitions
In December of 2002, the U.S. Bankruptcy Court for the District of
Delaware approved the Company's bid to purchase certain network assets,
equipment and associated subscriber lines of NAS for $14,000, consisting of
$9,000 in cash and $5,000 in a note payable to NAS. The Company closed the
transaction on January 10, 2003, whereby it acquired certain of NAS' network
assets, equipment in approximately 300 central offices and approximately 11,500
associated subscriber lines (the "NAS Assets") pursuant to an Amended and
Restated Asset Purchase Agreement (the "NAS Asset Purchase
13
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Agreement"). Additionally, on January 10, 2003, the Company hired 78 employees
formerly employed by NAS. No pre-closing liabilities were assumed in connection
with the NAS transaction. The cash portion of the consideration was paid from
the Company's existing cash. In accordance with the NAS Asset Purchase
Agreement, the Company negotiated a $1,083 reduction in the cash paid at the
closing, representing the Company's portion of January revenue that was billed
and collected by NAS, bringing the net cash paid by the Company for the NAS
Assets to $7,917.
NAS provided high-speed Internet and virtual private network services to
business customers using digital subscriber line, frame relay and T-1 technology
via its own network facilities in the Northeast and Mid-Atlantic markets. The
NAS acquisition significantly increased the Company's subscriber base and its
facilities-based footprint in one of the largest business markets in the United
States.
The acquisition has been accounted for under the purchase method of
accounting in accordance with SFAS No. 141, "BUSINESS COMBINATIONS" ("SFAS No.
141"). The results of NAS' operations have been included in the consolidated
financial statements since January 10, 2003 (the acquisition date). The
estimated fair values of the acquired assets at the date of acquisition exceeded
the purchase price and, accordingly, the acquired assets have been written down
on a pro-rata basis by asset group to the purchase price of approximately
$14,737 ($14,000 plus associated direct acquisition costs of approximately $737)
as follows: (i) intangible assets pertaining to approximately 11,500 acquired
subscriber lines of $1,480, (ii) property and equipment of $13,113 and (iii)
inventory of $144. In July 2003, the Company paid $1,500 into escrow for the
negotiated repurchase and cancellation of the $5,000 note issued by the Company
to NAS as part of the purchase price for the NAS Assets. The payment was subject
to approval by the bankruptcy court presiding over NAS' bankruptcy petition. On
August 25, 2003, the court approved the transaction, and the $1,500 held in
escrow was paid to NAS in full satisfaction of the note.
With the acquisition of the NAS Assets on January 10, 2003, the Company
acquired a number of end users, some of whom it serves indirectly through
various ISPs. The Company sells its services to such ISPs who then resell the
services to the end user. Accordingly, the Company has some increased exposure
and concentration of credit risk pertaining to such ISPs, however, no individual
customer accounted for more than 5% of revenue for the three and nine months
ended September 30, 2004 and 2003 or more than 10% of accounts receivable at
September 30, 2004 or December 31, 2003.
On April 8, 2003, the Company entered into an asset purchase agreement
with TalkingNets, Inc. and TalkingNets Holdings, LLC (collectively,
"TalkingNets") pursuant to which the Company agreed to acquire certain assets
and subscribers of TalkingNets (the "TalkingNets Assets") for $726 in cash (the
"TalkingNets Asset Purchase Agreement"). As TalkingNets had filed a voluntary
petition for Chapter 11 reorganization in February 2003, the TalkingNets Asset
Purchase Agreement was subject to the approval of the U.S. Bankruptcy Court for
the Eastern District of Virginia. On April 9, 2003, the TalkingNets Asset
Purchase Agreement and the transactions contemplated thereby were approved by
the Bankruptcy Court. On April 11, 2003, the Company paid the full purchase
price of $726 into escrow.
TalkingNets provided voice and high-speed data services to businesses
utilizing soft switched-based voice over Internet protocol ("VoIP") technology.
The TalkingNets acquisition gave the Company the capability to offer business
customers in the business-intensive Mid-Atlantic and Northeast regions a
carrier-class integrated voice and data service that utilizes VoIP.
14
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
On September 8, 2003, in accordance with the TalkingNets Asset Purchase
Agreement, the Company completed its acquisition of the TalkingNets Assets.
During the transition period, the Company included the net effect of cash
collections from the proposed acquired customers less certain related operating
costs of TalkingNets' operations in its statements of operations. This net
effect for the three and nine months ended September 30, 2003, was approximately
$159 and $394 in expense, respectively.
The TalkingNets acquisition has been accounted for under the purchase
method of accounting in accordance with SFAS No. 141. The results of
TalkingNets' operations have been included in the Company's consolidated
financial statements since September 8, 2003 (the closing date). The estimated
fair values of the acquired assets at the date of acquisition exceeded the
purchase price and, accordingly, the acquired assets have been written down on a
pro-rata basis by asset group to the purchase price of approximately $829 ($726
plus associated direct acquisition costs of approximately $103) as follows: (i)
certain accounts receivables of $55, (ii) intangible assets pertaining to
approximately 90 acquired subscriber lines of $89, and (iii) property and
equipment of $685.
The following table sets forth the unaudited pro forma consolidated
financial information of the Company, giving effect to the acquisition of NAS
customers, as if the transaction had occurred at the beginning of the periods
presented. Inclusion of the TalkingNets Assets would not materially change the
reported unaudited pro forma results. The pro forma table is not applicable for
the nine months ended September 30, 2004, as the results of the Company's
acquisitions have been fully integrated into its operating results for the nine
months ended September 30, 2004.
PRO FORMA
NINE MONTHS ENDED
SEPTEMBER 30, 2003
------------------
Pro forma revenue $ 53,847
Pro forma operating loss $(22,452)
Pro forma net loss $(27,073)
Pro forma net loss applicable to common stockholders $(41,557)
Pro forma net loss per share, basic and diluted $ (0.62)
Shares used in computing pro forma net loss
Per share, basic and diluted 66,726,872
The pro forma results are not necessarily indicative of the actual results
of operations that would have been obtained had the acquisitions taken place at
the beginning of the respective periods or the results that may occur in the
future.
6. Goodwill and Other Intangible Assets
In accordance with SFAS No. 142, "GOODWILL AND OTHER INTANGIBLE ASSETS,"
which became effective January 1, 2002, the Company has ceased to amortize
approximately $8,482 of goodwill. In lieu of amortization, the Company completed
its annual impairment review in December of 2003 and concluded that goodwill was
not impaired. The Company will continue to perform annual impairment reviews
unless a change in circumstances requires a review in the interim.
15
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The Company's identified intangible assets consist of customer lists,
which are amortized over two years. Amortization expense of intangible assets
for the three and nine months ended September 30, 2004 was approximately $211
and $745, respectively. For the three and nine months ended September 30, 2003,
amortization expense was approximately $345 and $2,395, respectively.
Accumulated amortization of customer lists as of September 30, 2004 and 2003 was
$15,241 and $14,136, respectively. The expected future amortization of customer
lists as of September 30, 2004 is $196 for the remainder of 2004 and $46 in
2005.
7. Debt
On January 10, 2003, the Company issued a $5,000 note to NAS in
conjunction with its acquisition of the NAS Assets (Note 5). The Company
negotiated the settlement of the note for $1,500, which settlement was approved
by the bankruptcy court presiding over the sale of the NAS Assets on August 25,
2003 and resulted in a gain of $3,500 included in other income during the third
quarter of 2003.
The Company entered into a Revolving Credit and Term Loan Agreement, dated
as of December 13, 2002 (the "Credit Agreement"), with a commercial bank
providing for a revolving line of credit of up to $15,000 (the "Commitment").
Interest on borrowings under the Credit Agreement was payable at 0.5% percent
above the Federal Funds Rate. The Company's ability to borrow amounts available
under the Credit Agreement was subject to the bank's receipt of a like amount of
guarantees from certain of the Company's investors and/or other guarantors. On
February 3, 2003, the Company borrowed $6,100 under the Credit Agreement. As of
March 3, 2003, certain of the Company's investors had guaranteed $9,100 under
the Credit Agreement. On July 18, 2003, the Company repaid the $6,100
outstanding balance plus accrued interest and terminated the Credit Agreement.
The Company wrote off approximately $184 of the related unamortized balance of
loan origination fees during the second quarter of 2003.
The Company entered into a Reimbursement Agreement (the "Reimbursement
Agreement") and related Security Agreement, dated as of December 27, 2002, with
VantagePoint Venture Partners III (Q), L.P., VantagePoint Venture Partners III,
L.P., VantagePoint Communications Partners, L.P. and VantagePoint Venture
Partners 1996, L.P. (collectively, "VantagePoint") and certain funds affiliated
with Columbia Capital (collectively, "Columbia Capital") and other holders of or
affiliates of holders of the Company's Series X Preferred Stock and Series Y
Preferred Stock (the "Guarantors"). Pursuant to the terms of the Reimbursement
Agreement, on December 27, 2002, VantagePoint and Columbia Capital issued
guarantees in an aggregate amount of $6,100 to support certain obligations of
the Company under the Credit Agreement. On July 18, 2003, in connection with the
termination of the Credit Agreement, the guarantees, Reimbursement Agreement and
related Security Agreement were terminated.
Pursuant to the terms of the Reimbursement Agreement, on December 27,
2002, the Company issued warrants to purchase an aggregate of 12,013,893 shares
of its common stock to VantagePoint and Columbia Capital, in consideration for
their guarantees aggregating $6,100. All such warrants have a ten-year life and
an exercise price of $0.50 per share. On March 26, 2003, the Company issued
additional warrants, exercisable for ten years, to purchase a total of 936,107
shares of its common stock at $0.50 per share to VantagePoint and Columbia
Capital, bringing the total number of warrants issued in connection with the
Reimbursement Agreement to 12,950,000. On February 3,
16
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
2003, the Company borrowed on the Credit Agreement and the Guarantors'
guarantees of the loan under the Credit Agreement became effective.
On February 3, 2003, the Company valued the 12,950,000 warrants issued to
the Guarantors at $0.514 each, with a total value of approximately $6,656. The
Company performed this valuation using a Black-Scholes valuation model with the
following assumptions: (i) a risk free interest rate of 4.01% (the ten-year
Treasury Rate), (ii) a zero dividend yield, (iii) a ten year expected life, (iv)
an expected volatility of 153%, (v) an option exercise price of $0.50 per share
and (vi) a current market price of $0.52 per share (the closing price of the
Company's common stock on February 3, 2003). Since the warrants were issued in
consideration for loan guarantees, which enabled the Company to secure financing
at below market interest rates, the Company recorded their value as a deferred
debt financing cost to be amortized to interest expense over the term of the
loan (approximately 57 months) using the "Effective Interest Method" of
amortization. On July 18, 2003, the Company repaid its outstanding loan balance
that was secured by these loan guarantees and terminated the Credit Agreement.
Accordingly, the Company wrote-off approximately $5,747 of the related
unamortized balance of deferred financing costs to other expense during the
second quarter of 2003.
On March 3, 2003, the Company and certain of the Guarantors entered into
Amendment No. 1 to the Reimbursement Agreement, pursuant to which VantagePoint
increased its guarantee by $3,000 bringing the aggregate guarantees by all
Guarantors under the Reimbursement Agreement, as amended, to $9,100. As
consideration for VantagePoint's increased guarantee, if the Company closed an
equity financing on or before December 3, 2003, it was authorized to issue
VantagePoint additional warrants to purchase the type of equity securities
issued by the Company in such equity financing. The number of such additional
warrants would be determined by dividing the per share price of such equity
securities into a thousand dollars. Accordingly, since the Company closed a
financing on July 18, 2003, the Company issued to VantagePoint, in December
2003, additional warrants with a three year life, to purchase 2,260,909 shares
of its common stock at a per share price of $0.4423.
On July 18, 2003, the Company entered into a Note and Warrant Purchase
Agreement (the "Note and Warrant Purchase Agreement") with Deutsche Bank AG
London, acting through DB Advisors, L.L.C., as Investment Agent ("Deutsche
Bank"), and VantagePoint (collectively, the "Senior Noteholders") relating to
the sale of an aggregate of (i) $30,000 in senior secured promissory notes (the
"2003 Notes") and (ii) warrants to purchase an aggregate of 157,894,737 shares
of the Company's common stock for a period of three years at an exercise price
of $0.38 per share (the "2003 Warrants"). The aggregate purchase price for the
2003 Notes and the 2003 Warrants was $30,000.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, on July 18 2003, the Company issued to the Senior Noteholders the
2003 Notes in the aggregate principal amount of $30,000. Principal on the 2003
Notes is payable in a single payment on July 18, 2006. The 2003 Notes provide
for an annual interest rate of 1.23%, payable in cash quarterly in arrears
commencing on October 31, 2003, unless the Company elects to defer payment of
such interest and pay it together with the principal amount of the 2003 Notes at
maturity on July 18, 2006. Pursuant to the terms of the Agency, Guaranty and
Security Agreement between the Company and certain of its subsidiaries, the
Senior Noteholders and Deutsche Bank Trust Company Americas, as administrative
agent ("DBTCA"), the Company's obligations under the 2003 Notes are secured by a
security interest in a majority of the personal property and assets of the
Company and certain of its subsidiaries. Interest expense accrued on the 2003
Notes for the nine months ended September 30, 2004 approximated $283. Total
accrued interest on the 2003 Notes since inception is included in notes
17
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
payable and approximated $454 at September 30, 2004. Prior to the due date of
the first interest payment, the Company elected to defer all interest payments
until further notice.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, on August 12, 2003, the Company issued Deutsche Bank a warrant to
purchase 12,950,000 shares of its common stock. The Company issued the remaining
2003 Warrants to purchase an aggregate of 144,944,737 shares of its common stock
to Deutsche Bank (105,471,053 shares) and VantagePoint (39,473,864 shares) on or
about December 9, 2003. All of these 2003 Warrants were issued with an exercise
price of $0.38 per share.
On July 18, 2003, the Company recorded the transactions under the Note and
Warrant Purchase Agreement in accordance with APB Opinion No. 14, "ACCOUNTING
FOR CONVERTIBLE DEBT AND DEBT ISSUED WITH STOCK PURCHASE WARRANTS," whereby a
fair value was ascribed to the 157,894,737 2003 Warrants issued to the Senior
Noteholders (related to the Note and Warrant Purchase Agreement) together with
the 2,260,909 warrants issued to VantagePoint (related to VantagePoint's
increased guarantee under Amendment No. 1 to the Reimbursement Agreement) using
a Black-Scholes valuation model with the following assumptions: (i) a risk free
interest rate of 2.24% (three-year Treasury rate), (ii) a zero dividend yield,
(iii) a three-year life, (iv) an expected volatility of 152%, (v) a warrant
option price of $0.38 per share for the 157,894,737 shares of common stock
exercisable under the 2003 Warrants and $0.4423 per share for the 2,260,909
warrants issued in connection with VantagePoint's increased guarantee and (vi) a
then current market price of $0.83 (the closing price of the Company's common
stock on July 18, 2003) per share. A fair value was ascribed to the 2003 Notes
using a present value method with a 19% discount rate. The relative fair value
of the warrants representing 87% of the combined fair value of the warrants and
the 2003 Notes was applied to the $30,000 proceeds to determine a note discount
of approximately $26,063, which was recorded as a reduction to the notes payable
and an increase to additional paid in capital. The note discount is being
amortized to interest expense using the "Effective Interest Method" of
amortization over the 36-month term of the 2003 Notes. For the year ended
December 31, 2003, approximately $1,266 of this note discount had been amortized
to interest expense. For the nine months ended September 30, 2004, approximately
$3,355 of this note discount had been amortized to interest expense and at
September 30, 2004, the remaining unamortized discount was $21,442.
The proceeds from the sale of the 2003 Notes and 2003 Warrants will be
(and portions already have been) used by the Company for general corporate
purposes, including acquisitions, the roll out of the Company's integrated voice
and data service product offering and repayment of certain debt and lease
obligations. The Company paid approximately $10,200 for the complete repayment
of approximately $14,600 of its debt and lease obligations.
On July 18, 2003, in connection with the Note and Warrant Purchase
Agreement, the Company, the Senior Noteholders and certain of the stockholders
of the Company entered into an Amended and Restated Stockholders Agreement,
which provided for rights relating to the election of directors, the
registration of the Company's common stock and certain protective provisions. On
July 22, 2004, the Company and the Senior Noteholders entered into a Second
Amended and Restated Stockholders Agreement in connection with a
recapitalization transaction (Notes 3 and 9). The Second Amended and Restated
Stockholders Agreement provides for the election of directors and grants certain
rights relating to the registration of the Company's common stock.
In February 2004, Columbia Capital exercised the remaining warrants it
held to purchase 1,358,025 shares of the Company's common stock at an exercise
price of $0.50 per share. Columbia
18
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Capital effected this exercise through a cashless exchange that resulted in the
issuance of 413,160 shares of the Company's common stock to Columbia Capital.
The cashless exchange was accomplished by deducting the per share exercise price
from the per share fair market value of the Company's common stock and
multiplying the differential times the total warrants to determine the aggregate
excess of the fair market value over the exercise price; which number was then
divided by the per share fair market value of the Company's common stock to
arrive at the number of shares issued. The fair market value of the Company's
common stock of $0.72 was determined in accordance with the warrant agreement by
calculating the average of the closing prices for the five days immediately
preceding the exercise date.
8. Commitments and Contingencies
COMMITMENTS
In July 2003, the Company paid $2,600 in full settlement of certain
outstanding capital lease obligations approximating $3,728. The difference
between the lease carrying value and the purchase price of the assets,
approximately $1,128, was recorded as a reduction of the carrying value of the
assets acquired under the lease obligation.
Effective May 1, 2003, the Company entered into a 35 month lease for
office space in Herndon, Virginia. Under the Company's facility operating
leases, minimum office facility operating lease payments are approximately $502
for the remainder of 2004, $541 in 2005, $233 in 2006, $169 in 2007 and $28 in
2008. The Company also has long-term purchase commitments with MCI and other
vendors for data transport and other services with minimum payments due even if
its usage does not reach the minimum amounts. Minimum payments under its
long-term purchase commitments are approximately $1,650 in 2004. The amounts
remaining under long-term purchase commitments are $300 as of September 30,
2004.
CONTINGENCIES
In certain markets where the Company has not deployed its own local
broadband equipment, the Company utilizes local facilities of wholesale
providers, including Covad Communications, Inc. ("Covad"), in order to provide
service to its end-user customers. These wholesale providers may terminate their
service with little or no notice. The failure of Covad or any of the Company's
other wholesale providers to provide acceptable service on acceptable terms
could have a material adverse effect on the Company's operations. There can be
no assurance that Covad or other wholesale providers will be successful in
managing their operations and business plans.
The Company transmits data across its network via transmission facilities
that are leased from certain carriers, including Level 3 Communications, Inc.
and MCI. The failure of any of the Company's data transport carriers to provide
acceptable service on acceptable terms could have a material adverse effect on
the Company's operations.
9. Preferred Stock
As more fully described in the Company's audited financial statements and
related notes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2003, the Company entered into a Series X Preferred Stock
Purchase Agreement with VantagePoint on November 14, 2001 (the "Series X
Purchase Agreement"), relating to the sale and purchase of up to an aggregate of
19
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
20,000 shares of Series X Preferred Stock at a purchase price of $1,000 per
share. On December 24, 2001, the Company entered into a Series Y Preferred Stock
Purchase Agreement (the "Series Y Purchase Agreement") with Columbia Capital
Equity Partners III, L.P., Columbia Capital Equity Partners II, L.P., The
Lafayette Investment Fund, L.P., Charles River Partnership X, a Limited
Partnership, and N.I.G. Broadslate (collectively with their assigns, the "Series
Y Investors"), relating to the sale and purchase of up to an aggregate of 15,000
shares of Series Y Preferred Stock at a purchase price of $1,000 per share.
Pursuant to the Series X Purchase Agreement, in 2001 and 2002, the Company
sold an aggregate of 20,000 shares of Series X Preferred Stock to VantagePoint
for total proceeds of $20,000, before direct issuance costs of approximately
$189. Pursuant to the Series Y Purchase Agreement, in 2001 and 2002, the Company
sold an aggregate of 15,000 shares of Series Y Preferred Stock to the Series Y
Investors for an aggregate purchase price of $15,000, before direct issuance
costs of approximately $300.
During the third and fourth quarters of 2003, the Series Y Investors
converted 14,000 shares of Series Y Preferred Stock into 35,140,012 shares of
the Company's common stock (including shares of common stock issued in lieu of
cash to pay accrued dividends on the Series Y Preferred Stock).
In January 2004, VantagePoint converted 6,000 shares of Series X Preferred
Stock into 33,333,333 shares of the Company's common stock at a conversion price
of $0.18 per share and, in accordance with the terms of the Series X Preferred
Stock, the Company elected to pay accrued dividends approximating $1,560 by
issuing 2,316,832 shares of its common stock, calculated based on the average
fair market value for the ten days preceding the conversion of $0.67 per share.
In February 2004, the Series Y Investors converted the remaining 1,000
shares of Series Y Preferred Stock were converted into 2,260,910 shares of the
Company's common stock at a conversion price of $0.4423 per share and, in
accordance with the terms of the Series Y Preferred Stock, the Company elected
to pay accrued dividends approximating $221 by issuing 309,864 shares of its
common stock, calculated based on the average fair market value for the ten days
preceding the conversion of $0.71 per share.
As a result of the above described conversions of 6,000 shares of Series X
Preferred Stock and 1,000 shares of Series Y Preferred stock in 2004, the
Company was required to accelerate the unaccreted beneficial conversion feature
related to such shares, which amounted to an additional $2,850 of preferred
stock accretion charged in the first quarter of 2004.
On July 22, 2004, the Company entered into a Recapitalization Agreement
with VantagePoint, the holder of all of the then remaining issued and
outstanding shares of Series X Preferred Stock (the "Recapitalization
Agreement"). In accordance with the Recapitalization Agreement, the remaining
14,000 shares of Series X Preferred Stock were converted into 77,777,775 shares
of the Company's common stock at a conversion price of $0.18 per share and, in
accordance with the terms of the Series X Preferred Stock, the Company elected
to pay accrued dividends approximating $4,040 by issuing an additional
11,710,142 shares of its common stock at a per share price of $0.345, calculated
based on the average fair market value for the ten days ending three days
preceding the conversion. As a result of these conversions, the Company was
required to accelerate the unaccreted beneficial conversion feature related to
such converted shares, which resulted in $4,812 of preferred stock accretion
charged in the third quarter of 2004.
20
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
For the nine months ended September 30, 2004, there was $7,662 of
additional preferred stock accretion related to the conversion of 20,000 shares
of Series X Preferred Stock and the conversion of 1,000 shares of Series Y
Preferred Stock.
The Series X Preferred Stock and Series Y Preferred Stock activity during
the nine months ended September 30, 2004 is summarized as follows:
MANDATORILY
REDEEMABLE CONVERTIBLE PREFERRED STOCK
--------------------------------------------------
SERIES X SERIES Y
---------------------- ----------------------
SHARES AMOUNT SHARES AMOUNT
-------- -------- -------- --------
Balance December 31, 2003 20,000 $ 16,231 1,000 $ 788
Conversion Series X and Y Preferred Stock
to common stock (20,000) (20,000) (1,000) (1,000)
Payment of dividends on converted Series X and Y
Preferred Stock -- (5,600) -- (221)
Accrued dividends on Series X and Y Preferred Stock -- 940 -- 10
Accretion of beneficial conversion feature of Series X
and Y Preferred Stock -- 8,429 -- 423
-------- -------- -------- --------
Balance September 30, 2004 -- $ -- -- $ --
======== ======== ======== ========
The Series X Preferred Stock and Series Y Preferred Stock activity during the
nine months ended September 30, 2003 is summarized as follows:
MANDATORILY
REDEEMABLE CONVERTIBLE PREFERRED STOCK
--------------------------------------------------
SERIES X SERIES Y
---------------------- ----------------------
SHARES AMOUNT SHARES AMOUNT
-------- -------- -------- --------
Balance December 31, 2002 20,000 $ 8,741 15,000 $ 5,381
Conversion Series Y Preferred Stock to common stock -- -- (9,950) (9,950)
Payment of dividends on converted Series Y
Preferred Stock -- -- -- (1,793)
Accrued dividends on Series X and Y Preferred Stock -- 1,800 -- 1,345
Accretion of beneficial conversion feature of Series X
and Y Preferred Stock -- 4,336 -- 7,003
Preferred stock reclassification -- -- -- 1,394
-------- -------- -------- --------
Balance September 30, 2003 20,000 $ 14,877 5,050 $ 3,380
======== ======== ======== ========
In accordance with the above described Recapitalization Agreement, the
Company issued to VantagePoint 14,000 shares of Series Z Preferred Stock, with a
liquidation preference of $1,120 per share ($15,680 in the aggregate) and a
total fair value of $2,630 (further discussed below). The Series Z Preferred
Stock was issued to VantagePoint in the recapitalization to induce them to
convert their remaining 14,000 shares of Series X Preferred Stock and to
preserve, for a period up to four
21
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
years, VantagePoint's liquidation preference rights, which would otherwise have
terminated upon such conversion. VantagePoint will have the right to a
liquidation preference on the shares of Series Z Preferred Stock it holds in the
event of any liquidation, dissolution or winding up of the Company (including a
transaction approved in advance by the board of directors of the Company for:
(i) the sale of the Company to another entity in a reorganization, merger,
consolidation or otherwise, if following such transaction or series of
transactions the holders of the outstanding voting power of the Company prior to
such transaction would own less than a majority of the voting power of the
surviving entity or (ii) the sale of substantially all of the assets of the
Company). The Series Z Preferred Stock does not contain any conversion or
mandatory redemption provisions, nor does it have any special dividend or
special voting rights. The Series Z Preferred Stock's liquidation preference
will be eliminated, and the shares of Series Z Preferred Stock cancelled, on
July 18, 2008. In addition, the liquidation preference amount shall be reduced
upon the occurrence of the following events:
o if the Company is subject to a petition under the U.S. Bankruptcy Code
and VantagePoint has sold more than 39 million shares, but less than
58 million shares, of the Company's common stock issued in connection
with the transactions contemplated by the Recapitalization Agreement,
then the liquidation preference shall be reduced to $8,680 in the
aggregate;
o upon the first of any of the following, the liquidation preference
shall be reduced to $0 in the aggregate and the Series Z Preferred
Stock shall be cancelled:
o July 18, 2008;
o the Company is subject to a petition under the U.S. Bankruptcy
Code and VantagePoint has sold more than 58 million shares of the
Company's common stock issued in connection with the transactions
contemplated by the Recapitalization Agreement;
o VantagePoint owns more than 50% of the Company's common stock; or
o the Company's common stock closes above $1.50 per share for 45
consecutive trading days.
The Company has recorded the $2,630 fair value of Series Z Preferred Stock
in the equity section of its statement of financial position, and included that
amount as a charge in the calculation of net income available to common
stockholders.
The fair value of the Series Z Preferred Stock of $2,630 was determined
based on a number of factors including, but not limited to: (i) review of the
Recapitalization Agreement and the Certificate of Designation of the Series Z
Preferred Stock, (ii) consideration of the Company's historical financial
results, (iii) review of certain criteria for similar companies obtained from
published sources, and (iv) the use of probability analyses.
10. Related Party Transactions
During the first nine months of 2004, VantagePoint converted 20,000 shares
of Series X Preferred Stock into 125,138,082 shares of the Company's common
stock (inclusive of shares of common stock issued in lieu of cash to pay accrued
dividends on the Series X Preferred Stock). As of September 30, 2004, and as
more fully described in the Company's audited financial statements and related
notes included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2003, VantagePoint held warrants to purchase approximately
53,326,568 shares of the Company's common stock. In addition, as of September
30, 2004, VantagePoint owned 93,070,036 shares of the
22
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Company's common stock. As a result, VanatagePoint beneficially owned the
equivalent of 146,396,604 shares of the Company's common stock as of September
30, 2004. Currently, two affiliates (James Marver and Duncan Davidson) and one
former affiliate (William J. Marshall) of VantagePoint are members of the
Company's Board of Directors. Further, Michael Yagemann, a member of the
Company's Board of Directors through July 7, 2004, was also affiliated with
VantagePoint.
As of September 30, 2004, as a result of the July 2003 $30,000 financing
transaction, and as more fully described in the Company's audited financial
statements and related notes included in the Company's Annual Report on Form
10-K for the year ended December 31, 2003, Deutsche Bank held warrants issued to
acquire approximately 118,421,053 shares of the Company's common stock. William
J. Marshall and Roderick Glen MacMullin, two of the Company's current directors,
are affiliated with entities that provide investment advisory services to
Deutsche Bank. Further, Roger Ehrenberg, a member of the Company's Board of
Directors until September 8, 2004, was formerly affiliated with DB Advisors,
L.L.C.
During the third and fourth quarters of 2003, as more fully described in
the Company's audited financial statements and related notes included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003, the
Series Y Investors (including Columbia Capital) converted 14,000 shares of
Series Y Preferred Stock into 35,140,012 shares of the Company's common stock
(including shares of common stock issued to pay accrued dividends on the Series
Y Preferred Stock). As of December 31, 2003, funds affiliated with one remaining
Series Y Investor (Charles River Partnership, L.P.) owned 1,000 shares of Series
Y Preferred Stock, which were converted into 2,570,774 shares of the Company's
common stock (including shares of common stock issued in lieu of cash to pay
accrued dividends on the Series Y Preferred Stock) in February, 2004 (Note 9).
In addition, in February 2004, Columbia Capital exercised their remaining
warrants to purchase 1,358,025 shares of the Company's common stock at an
exercise price of $0.50 per share in a cashless exchange which resulted in the
issuance of 413,160 shares of the Company's common stock to Columbia Capital
(Note 7). An affiliate of Columbia Capital, Harry Hopper, was a member of the
Company's Board of Directors until August 5, 2003.
11. Subsequent Events
On October 7, 2004, the Company closed a financing transaction with
Laurus, pursuant to which the Company sold to Laurus convertible notes and a
warrant to purchase common stock of the Company. The securities issued to Laurus
were a $4,250 Secured Convertible Minimum Borrowing Note (the "MB Note"), a $750
Secured Revolving Note (the "Revolving Note" and, together with the MB Note, the
"Laurus Notes"), and a Common Stock Purchase Warrant to purchase 1,143,000
shares of the Company's common stock (the "Laurus Warrant"). As part of the
financing transaction with Laurus, the Company paid Laurus a closing fee of
$163. The Company's obligations under the Laurus Notes are secured by a security
interest and first priority lien on certain trade accounts receivable of the
Company.
The Company and Laurus had placed the transactions and funds into escrow
on August 31, 2004, pending the Company's procurement of a waiver of certain
rights of its Senior Noteholders, represented by DBTCA, and agreement from such
noteholders to subordinate their lien on trade accounts receivable of the
Company to the lien granted to Laurus. On October 7, 2004, the Company reached
agreement with Laurus and the Senior Noteholders on subordination terms and the
initial financing proceeds of $4,250 were released from escrow to a Company
account with DBTCA. The
23
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Company's withdrawal and use of such financing proceeds are subject to the prior
approval of DB Advisors L.L.C., as advisor to Deutsche Bank, and DBTCA.
The Laurus Notes mature on August 1, 2006. Annual interest on the Laurus
Notes is equal to the prime rate published in The Wall Street Journal from time
to time, plus two percent, provided, that, such annual rate of interest on the
Laurus Notes may not be less than six percent or more than seven percent.
Notwithstanding the six percent interest rate floor, the interest rate on the
Laurus Notes will be decreased two percent per annum for each 25% increase in
the price of the Company's common stock above $0.28 per share, if, at that time,
the Company has on file with the SEC a registration statement for the shares of
common stock issued or issuable upon conversion of the MB Note and upon exercise
of the Laurus Warrant and, if not, the interest rate will be decreased one
percent per annum for each 25% increase in the price of the Company's common
stock above $0.28 per share. Any change in the interest rate on the Laurus Notes
will be determined on a monthly basis. In no event will the interest rate on the
Laurus Notes be less than 0.00%. Interest on the Laurus Notes is payable monthly
in arrears on the first day of each month during the term of the Laurus Notes.
The initial fixed conversion price under the Laurus Notes is $0.28 per
share. The initial conversion price and the number of shares of the Company's
common stock issuable upon conversion of the each of the Laurus Notes are
subject to adjustment in the event that the Company reclassifies, subdivides or
combines its outstanding shares of common stock or issues additional shares of
its common stock as a dividend on its outstanding shares of common stock. The
fixed conversion price is subject to anti-dilution protection adjustments, on a
weighted average basis, upon the Company's issuance of additional shares of
common stock at a price that is less than the then current fixed conversion
price. Subject to certain limitations, Laurus may, at any time, convert the
outstanding indebtedness of each of the Laurus Notes into shares of the
Company's common stock at the then applicable conversion price. Subject to
certain trading volume and other limitations, the MB Note will automatically
convert at the then applicable conversion price into shares of the Company's
common stock if, at any time while an effective registration statement under the
Securities Act for the resale of the Company's common stock underlying the MB
Note and Laurus Warrant is outstanding, the average closing price of the
Company's common stock for ten consecutive trading days is at least $0.31,
subject to certain adjustments. The Revolving Note is potentially convertible
into more than $750 worth of the Company's common stock, depending upon the
amount of aggregate borrowings by the Company under the Revolving Note and the
amount of conversions by Laurus.
The Laurus Warrant grants Laurus the right to purchase up to 1,143,000
shares of the Company's common stock at an exercise price of $0.35 per share. On
October 7, 2004, the Company also issued a warrant to purchase 178,571 shares of
the Company's common stock at an exercise price of $0.35, and made a cash
payment of approximately $38, to TN Capital Equities, Ltd., as compensation for
TN Capital Equities, Ltd.'s having served as the placement agent in the
financing transaction with Laurus. The Laurus Warrant and the warrant issued to
TN Capital Equities, Ltd. each expire on August 31, 2009. Under the terms of the
Minimum Borrowing Note Registration Rights Agreement, Laurus has been afforded
certain registration rights with respect to the shares of the Company's common
stock underlying the MB Note and the Laurus Warrant. TN Capital Equities, Ltd.
was also afforded piggyback registration rights for the shares of the Company's
common stock underlying the warrant it received. The exercise price and number
of shares of common stock issuable upon exercise of the Laurus Warrant or the
warrant issued to TN Capital Equities, Ltd. are subject to adjustment in the
event that the Company issues additional shares of its common stock as a
dividend or distribution on its outstanding shares of common stock, subdivides
its outstanding shares of common stock or combines its outstanding shares of
common stock into a
24
DSL.NET, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
smaller number of shares of common stock. These warrants do not contain any
economic anti-dilution provision that would otherwise provide for adjustment to
the exercise price or number of shares of common stock into which these warrants
are exercisable in the event of further issuances of the Company's common stock
or securities convertible into common stock for a consideration per share less
than the per share exercise price of these warrants. On November 5, 2004, the
Company filed with the SEC a preliminary registration statement on Form S-3
covering the potential resale of the shares of common stock underlying the MB
Note, Laurus Warrant and the warrant issued to TN Capital Equities, Ltd.
Under American Stock Exchange rules and regulations, the aggregate number
of shares of common stock issuable by the Company upon conversion by Laurus of
the principal and interest due on the Laurus Notes and exercise by Laurus of the
Laurus Warrant may not exceed 19.99% of the total issued and outstanding shares
of the Company's common stock as of October 7, 2004 (the closing date of the
financing transaction), unless the Company's stockholders first approve that
issuance in excess of 19.99%. The agreement pursuant to which Laurus purchased
the Laurus Notes and Laurus Warrant provides that if conversion of the Laurus
Notes and/or exercise of the Laurus Warrant by Laurus would result in the
issuance of more than 19.99% of the outstanding shares of the Company's common
stock, the Company is required to solicit stockholder approval of the issuance
of shares in excess of 19.99% at its then next regularly scheduled stockholder
meeting and the Company is not obligated to issue those shares until such
stockholder approval is obtained.
In exchange for agreement by the Senior Noteholders to subordinate to
Laurus their prior lien on certain of the Company's accounts receivable, the
Company issued warrants to the Senior Noteholders (the "2004 Warrants"),
allocated ratably in accordance with the Senior Noteholders' interests in the
Company's July 2003 note and warrant financing, to purchase up to an aggregate
of 19,143,000 shares of common stock. The 2004 Warrants expire on July 18, 2006
and are exercisable only upon approval by the Company's stockholders and solely
in the event of a change of control of the Company where the price paid per
share of common stock or the value per share of common stock retained by the
Company's common stockholders in any such change of control (the "Change of
Control Price") is less than the then current per share exercise price of the
2003 Warrants. The exercise price of the 2004 Warrants will be calculated at the
time of a qualifying change of control of the Company, if any, and will be equal
to the Change of Control Price. The Senior Noteholders have been afforded
certain registration rights with regard to the 2004 Warrants. However, the
potential resale of the shares underlying the 2004 Warrants have not been
included in the preliminary registration statement filed with the SEC on Form
S-3 on November 5, 2004. As a condition to the Company's issuance of the 2004
Warrants, the Senior Noteholders waived any anti-dilution rights to which they
might otherwise be entitled under all warrants previously issued to the Senior
Noteholders resulting from the issuance or exercise of the 2004 Warrants.
To the knowledge of the Company, neither Laurus nor any of its affiliates
maintains or has maintained in the past any affiliation with the Company or its
officers, directors or affiliates. The Senior Noteholders currently have
representatives serving as directors on the Company's Board of Directors.
Management will finalize its assessment of the accounting impact of the
financing transaction with Laurus and will report on it in its Annual Report on
Form 10-K for the year ending December 31, 2004.
25
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion of the financial condition and results of
operations of DSL.net should be read in conjunction with the financial
statements and the related notes thereto included elsewhere in this Quarterly
Report on Form 10-Q and the audited financial statements and notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations included in our Annual Report on Form 10-K for the year ended
December 31, 2003, which has been filed with the Securities and Exchange
Commission (the "SEC").
OVERVIEW
OUR BUSINESS
We provide high-speed data communications, Internet access, and related
services to small and medium sized businesses and branch offices of larger
businesses and their remote office users, throughout the United States,
primarily utilizing digital subscriber line ("DSL") and T-1 technology. In
September 2003, we expanded our service offerings to business customers in the
Washington, D.C. metropolitan region to include integrated voice and data
services using voice over Internet protocol technology ("VoIP"). In February
2004, we introduced our VoIP and data bundles in the New York City metropolitan
area. Our networks enable data transport over existing copper telephone lines at
speeds of up to 1.5 megabits per second. Our product offerings also include Web
hosting, domain name system management, enhanced e-mail, on-line data backup and
recovery services, firewalls, nationwide dial-up services, private frame relay
services and virtual private networks.
We sell directly to businesses through our own sales force utilizing a
variety of sales channels, including referral channels such as local information
technology professionals, application service providers and marketing partners.
We also sell directly to third party resellers whose end users are typically
business-class customers. We deploy our own local communications equipment
primarily in select first and second tier cities. In certain markets where we
have not deployed our own equipment, we utilize the local facilities of other
carriers to provide our service.
OUR GROWTH STRATEGY
In addition to our sales and marketing efforts, our strategic goals have
historically been focused on accelerating our growth and expanding our network
and customer base through select acquisitions of customer lines, assets and/or
businesses. During 2003, we completed the following strategically significant
acquisitions:
o In January 2003, we acquired the majority of Network Access Solutions
Corporation's ("NAS") operations and assets, including operations and
equipment in approximately 300 central offices extending from Virginia
to Massachusetts, and approximately 11,500 subscriber lines (the "NAS
Assets"). This acquisition significantly increased our
facilities-based footprint in one of the largest business markets in
the United States, providing us with increased opportunities to sell
more higher-margin, facilities-based services. As a result of this
acquisition, we currently operate equipment in approximately 490
central offices located in approximately 340 cities in the United
States.
o In September 2003, we acquired substantially all of the assets and
subscribers of TalkingNets (as defined below), a voice and data
communications provider that offered soft switched-based VoIP and
high-speed data services to businesses. This acquisition gave us the
capability to offer business customers in the business-intensive
Mid-Atlantic and Northeast
26
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
regions a carrier-class integrated voice and data service that
utilizes VoIP.
We continuously identify and evaluate acquisition candidates, and in many
cases engage in discussions and negotiations regarding potential acquisitions.
Acquisition candidates include both subscriber lines and whole businesses. Our
discussions and negotiations may not result in an acquisition. Further, if we
make any acquisitions, we may not be able to operate any acquired businesses
profitably or otherwise successfully implement our expansion strategy. We intend
to continue to seek additional opportunities for further acquisitions, which we
believe represents a distinct opportunity to accelerate our growth. We may need
to obtain additional funding to finance additional acquisitions, and,
accordingly, we continue to engage and pursue discussions with potential
investors.
We also believe there are significant revenue growth opportunities for our
newly introduced VoIP suite of integrated voice and data services. We may also
seek additional funding to expand our voice network in order to accelerate this
growth opportunity.
During the third quarter of 2004, we began the implementation of a new
sales and marketing strategy, re-directing our focus from our historic emphasis
on the telemarketing to small and mid-sized business customers of Internet and
data services by our sales representatives to the sale of Internet access and
data services to multi-line accounts and the sale of higher-margin services,
including our integrated voice and data services, which we hope to further
expand through wholesale VoIP channels in the future.
OUR CASH FINANCINGS AND CONSTRAINTS
We have not been able to finance our operations from cash provided by
operations. Net cash used in our operating activities was approximately $8,878
during the first nine months of 2004 and $13,715 for the full year 2003. We have
reduced our cash used in operating activities over the last three calendar
years. These reductions have been achieved mainly as a result of:
o reduced operational expenses (network, operations, selling, general
and administrative expenses), primarily resulting from our
restructuring and cost containment efforts (discussed below), combined
with;
o increased revenues and related margins, resulting primarily from
acquisitions.
We also have incurred operating losses and net losses for each month since
our formation in 1998. For the first nine months of each of 2004 and 2003, we
had operating losses of approximately $15,350 and $22,479, respectively. As of
September 30, 2004 and December 31, 2003, we had accumulated deficits of
approximately $338,321 and $319,488, respectively.
In addition, our growth strategies have required significant capital and
cash investments. Our operating cash shortfalls and investments have been
financed principally with the proceeds from the sale of stock and from
borrowings, including equipment lease financings. Our most significant recent
financings occurred in October 2004 and July 2003. In October 2004, we closed a
financing transaction, pursuant to which we sold convertible notes and a warrant
to purchase common stock for an aggregate of $5,000, of which $4,250 was
borrowed at closing (the remaining $750 being made available to be drawn down by
us under a revolving credit facility). Our withdrawal and use of the financing
proceeds from this transaction are subject to the prior approval of certain of
our senior secured noteholders. In July 2003, we entered into a note and warrant
purchase agreement for the sale of $30,000 in senior secured promissory notes
and issuance of warrants to purchase 157,894,737
27
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
shares of our common stock at an exercise price of $0.38 per share for an
aggregate purchase price for the notes and warrants of $30,000. We used
approximately $10,200 of the proceeds from this financing to prepay (at a
discount) approximately $14,600 in pre-existing debt and lease obligations.
We expect our operating losses, net operating cash outflows and capital
expenditures to continue throughout 2004 and into 2005. Our business plan
includes additional operational cost savings to be obtained from streamlining
our network and the reduction of discretionary and controllable costs. During
the last quarter of 2003 and the first nine months of 2004, we implemented cost
reduction measures, including a reduction-in-force of 62 employees on March 25,
2004 and a reduction in force of 32 employees on September 21, 2004. Based on
our current business plan and projections (excluding the proceeds from the
October 2004 financing referred to above, the use of which is subject to the
prior approval of certain of our senior secured noteholders), we believe that
our existing cash and cash expected to be generated from operations will be
sufficient to fund our operating losses, capital expenditures, lease payments,
and working capital requirements into the fourth quarter of 2004. Failure to
generate sufficient revenues, contain certain discretionary spending, obtain
approval to use the proceeds from the October 2004 financing referred to above,
or achieve certain other business plan objectives could have a material adverse
affect on our results of operations, cash flows and financial position,
including our ability to continue as a going concern.
We intend to use our cash resources to finance our capital expenditures
and for our working capital and other general corporate purposes. We may also
use a portion of our cash resources to pursue strategic opportunities and may
need additional funding to carry out such activities. The amounts actually
expended for these purposes will vary significantly depending on a number of
factors, including market acceptance of our services, revenue growth, planned
capital expenditures, cash generated from operations, improvements in operating
productivity, the availability, timing and feasibility of strategic
opportunities and the availability and terms of any additional funding.
Our cash requirements may vary based upon the timing and the success of
implementation of our business plan or if:
o demand for our services or our cash flow from operations is less than
or more than expected;
o our plans or projections change or prove to be inaccurate;
o we make strategic acquisitions or pursue other strategic
opportunities;
o we alter the schedule or targets of our business plan implementation;
or
o we curtail and/or reorganize our operations.
Our financial performance, and whether we achieve profitability or become
cash flow positive, will depend on a number of factors, including:
o development of the high-speed data communications industry and our
ability to compete effectively;
o amount, timing and pricing of customer revenue;
o availability, timing and feasibility of strategic opportunities , and
our ability to capitalize on and integrate such opportunities;
28
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
o commercial acceptance of our service and attaining expected
penetration within our target markets;
o our ability to recruit and retain qualified personnel;
o up front sales and marketing expenses;
o cost and utilization of our network components which we lease from
other telecommunications providers, including other competitive
carriers;
o our ability to establish and maintain relationships with marketing
partners;
o successful implementation and management of financial, information
management and operations support systems to efficiently and
cost-effectively manage our operational growth;
o favorable outcome of federal and state regulatory proceedings and
related judicial proceedings, including proceedings relating to the
1996 Telecommunications Act and the new rules expected to be issued by
the Federal Communications Commission (the "FCC"), in respect to those
portions of the FCC's Triennial Review Order vacated and remanded by
the D.C. Circuit Court in March 2004;
o our ability to gain access to the proceeds from our October 2004
convertible notes and warrant financing, the use of which is subject
to the prior approval of certain of our senior secured noteholders;
and
o our ability to raise sufficient additional debt, equity or other
capital on acceptable terms, if at all.
There can be no assurance that we will be able to achieve our business
plan objectives or that we will achieve or maintain cash flow positive operating
results. If we are unable to generate adequate funds from our operations, or
gain access to the proceeds from our October 2004 convertible notes and warrant
financing, the use of which is subject to the prior approval of certain of our
senior secured noteholders, or raise additional capital, we may not be able to
continue to operate our network, respond to competitive pressures or fund our
operations. As a result, we may be required to significantly reduce, reorganize,
discontinue or shut down our operations. Our financial statements do not include
any adjustments that might result from this uncertainty.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RISKS
Management's discussion and analysis of financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles. The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, including the
recoverability of tangible and intangible assets, disclosure of contingent
assets and liabilities as of the date of the financial statements, and the
reported amounts of revenues and expenses during the reported period. The
markets for our services are characterized by intense competition, rapid
technological development, regulatory and legislative changes, and frequent new
product introductions, all of which could impact the future value of our assets
and liabilities.
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
We evaluate our estimates on an on-going basis. The most significant
estimates relate to revenue recognition, goodwill and other long-lived assets,
the allowance for doubtful accounts, taxes, contingencies and litigation. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ materially from those estimates.
The following is a brief discussion of the critical accounting policies
and methods and the judgments and estimates used by us in their application:
REVENUE RECOGNITION
We recognize revenue in accordance with SEC Staff Accounting Bulletin
("SAB") No. 104, "REVENUE RECOGNITION." SAB No. 104's primary purpose is to
rescind guidance contained in SAB No. 101 related to multiple element revenue
arrangements, superceded as a result of the issuance of Emerging Issues Task
Force ("EITF") Issue No. 00-21, "REVENUE ARRANGEMENTS WITH MULTIPLE
DELIVERABLES." SAB No. 104's wording has not changed SAB No. 101's four basic
criteria that must be met before revenue can be recognized: (1) persuasive
evidence of an arrangement exists; (2) delivery has occurred or services
rendered; (3) the fee is fixed or determinable; and (4) collectibility is
reasonably assured. Determination of criteria (3) and (4) are based on
management's judgments regarding the fixed nature of the fee charged for
services rendered and products delivered and the collectibility of those fees.
Revenue is recognized pursuant to the terms of each contract on a monthly
service fee basis, which varies based on the speed of the customer's Internet
connection and the services ordered by the customer. The monthly fee includes
phone line charges, Internet access charges, the cost of the equipment installed
at the customer's site and the other services we provide, as applicable. Revenue
that is billed in advance of the services provided is deferred until the
services are rendered. Revenue related to installation charges is also deferred
and amortized to revenue over 18 months. Related direct costs incurred (up to
the amount of deferred revenue) are also deferred and amortized to expense over
18 months. Any excess direct costs over installation charges are charged to
expense as incurred. In certain instances, we negotiate credits and allowances
for service related matters. We establish a reserve against revenue for credits
of this nature based on historical experience. From time to time we offer sales
incentives to our customers in the form of rebates toward select installation
services and customer premise equipment. We record a liability based on
historical experience for such estimated rebate costs, with a corresponding
reduction to revenue and deferred revenue, as applicable.
We seek to price our services competitively. The market for high-speed
data communications services and Internet access is rapidly evolving and
intensely competitive. While many of our competitors and potential competitors
enjoy competitive advantages over us, we are pursuing a significant market that,
we believe, is currently under-served. Although pricing is an important part of
our strategy, we believe that direct relationships with our customers and
consistent, high quality service and customer support will be key to generating
customer loyalty. During the past several years, market prices for many
telecommunications services and equipment have been declining, a trend that
might continue.
GOODWILL AND OTHER LONG-LIVED ASSETS
We account for our long-lived assets in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, "ACCOUNTING FOR THE IMPAIRMENT
OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF," which
requires that long-lived assets and certain intangible assets be
30
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable. If undiscounted expected future
cash flows are less than the carrying value of the assets, an impairment loss is
to be recognized based on the fair value of the assets.
Effective January 1, 2002, we adopted SFAS No. 142, "GOODWILL AND OTHER
INTANGIBLE ASSETS." This statement requires that the amortization of goodwill be
discontinued and instead an impairment approach be applied. The impairment tests
were performed during December 2003, and will be performed annually hereafter
(or more often if adverse events occur) and are based upon a fair value approach
rather than an evaluation of the undiscounted cash flows. If impairment exists,
under SFAS No. 142, the resulting charge is determined by the recalculation of
goodwill through a hypothetical purchase price allocation of the fair value and
reducing the current carrying value to the extent it exceeds the recalculated
goodwill. We did not record any goodwill impairment adjustments resulting from
our impairment reviews during 2003.
Other long-lived assets, such as identifiable intangible assets and fixed
assets, are amortized or depreciated over their estimated useful lives. These
assets are reviewed for impairment whenever events or circumstances provide
evidence that suggests that the carrying amount of the assets may not be
recoverable, with impairment being based upon an evaluation of the identifiable
undiscounted cash flow. If impaired, the resulting charge reflects the excess of
the asset's carrying cost over its fair value.
If market conditions become less favorable, future cash flows (the key
variable in assessing the impairment of these assets) may decrease and as a
result we may be required to recognize impairment charges.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
primarily sell our services directly to end users mainly consisting of small to
medium sized businesses, but we also sell our services to certain resellers,
such as to Internet service providers ("ISPs"). We believe that we do not have
significant exposure or concentrations of credit risk with respect to any given
customer. However, if the country or any region we service, experiences an
economic downturn, the financial condition of our customers could be adversely
affected, which could result in their inability to make payments to us. This
could require additional provisions for allowances. In addition, a negative
impact on revenue related to those customers may occur.
With the acquisition of the NAS Assets on January 10, 2003, we acquired a
number of end users, some of whom we service indirectly through various ISPs. We
sell our services to such ISP's who then resell such services to the end users.
We have some increased exposure and concentration of credit risk pertaining to
such ISPs. However, no individual customer accounted for more than 5% of revenue
throughout 2003 or during the first nine months of either 2004 or 2003 or more
than 10% of accounts receivable at September 30, 2004 or December 31, 2003.
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
INVENTORY
Inventories consist of modems and routers (generally referred to as
customer premise equipment) that we either sell or lease to customers and are
required to establish a high-speed DSL or T-1 digital connection. Inventories
are stated at the lower of cost or market. Cost of inventory is determined on
the "first-in, first-out" or average cost methods. We establish inventory
reserves for excess, obsolete or slow-moving inventory based on changes in
customer demand, technology developments and other factors.
INCOME TAXES
We use the liability method of accounting for income taxes, as set forth
in SFAS No. 109, "ACCOUNTING FOR INCOME TAXES." Under this method, deferred tax
assets and liabilities are recognized for the expected future tax consequences
of temporary differences between the carrying amounts and the tax basis of
assets and liabilities and net operating loss carryforwards, all calculated
using presently enacted tax rates.
We have not generated any taxable income to date and, therefore, have not
paid any federal income taxes since inception. Our state and federal net
operating loss carryforwards begin to expire in tax years 2004 and 2019,
respectively. Use of our net operating loss carryforwards may be subject to
significant annual limitations resulting from a change in control due to
securities issuances including without limitation our sales of Series X
Preferred Stock and Series Y Preferred Stock in 2001 and 2002 and from the sale
of $30,000 in notes and warrants in July 2003. We are currently assessing the
potential impact on our net operating loss carryforwards resulting from these
transactions. We have provided a valuation allowance for the full amount of the
net deferred tax asset since management has not determined that these future
benefits will more likely than not be realized.
LITIGATION
From time to time, we may be involved in litigation concerning claims
arising in the ordinary course of our business, including claims brought by
current or former employees and claims related to acquisitions. We record
liabilities when a loss is probable and can be reasonably estimated. These
estimates are based on an analysis made by legal counsel who consider
information known at the time. We believe we have made reasonable estimates in
the past; however, court decisions could cause liabilities to be incurred in
excess of estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
We have issued various financial debt and/or equity instruments, some of
which have required a determination of their fair value, where quoted market
prices were not published or readily available. We base our determinations on
valuation techniques that require judgments and estimates. From time to time, we
may hire independent valuation specialists to perform and or assist in the fair
value determination of such instruments.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2004, the Emerging Issues Task Force ("EITF") issued EITF
Issue No. 04-10 "Applying Paragraph 19 of FASB Statement No. 131, 'DISCLOSURES
ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION', in Determining whether
to Aggregate Operating Segments that do not Meet the Quantitative Thresholds".
EITF No. 04-10 presents guidelines for two alternative approaches in determining
whether to aggregate operating segments and is effective for fiscal years ending
after October 13, 2004. We have determined that EITF No. 04-10 will not have an
impact on our operating segment disclosures.
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RESULTS OF OPERATIONS
REVENUE. Revenue is recognized pursuant to the terms of each contract on a
monthly service fee basis, which varies based on the speed of the customer's
broadband connection and the services ordered by the customer. The monthly fee
includes all phone line charges, Internet access charges, the cost of any leased
equipment installed at the customer's site and the other services we provide, as
applicable. Revenue that is billed in advance of the provision of services is
deferred until the services are provided. Revenue related to installation
charges is deferred and amortized to revenue over 18 months, which is
approximately the average customer life of the existing customer base. Related
direct costs incurred (up to the amount of deferred revenue) are also deferred
and amortized to expense over 18 months. Any excess direct costs over
installation charges are charged to expense as incurred. In certain instances,
we negotiate credits and allowances for service related matters. We establish a
reserve against revenue for credits of this nature based on historical
experience. From time to time we offer sales incentives to our customers in the
form of rebates toward select installation services and customer premise
equipment. We record a liability based on historical experience for such
estimated rebate costs, with a corresponding reduction to revenue and deferred
revenue, as applicable.
Revenue for the three months ended September 30, 2004 decreased by 8% to
approximately $16,827, from approximately $18,227 for the three months ended
September 30, 2003. This decrease in revenue was primarily attributable to a
decrease in subscriber lines during the third quarter of 2004. Revenue for the
nine months ended September 30, 2004 decreased by 1% to approximately $52,333
from approximately $53,089 for the nine months ended September 30, 2003, and was
primarily attributable to a decrease in subscriber lines.
NETWORK EXPENSES. Our network expenses include costs related to network
engineering and network field operations personnel, costs for telecommunications
lines between customers, central offices, network service providers and our
network, costs for rent and power at our central offices, costs to connect to
the Internet, costs of customer line installations and the costs of customer
premise equipment when sold to our customers. We lease high-speed lines and
other network capacity to connect our central office equipment and our network.
Costs incurred to connect to the Internet are expected to increase as the volume
of data communications traffic generated by our customers varies.
Network expenses for the three months ended September 30, 2004 decreased
to approximately $11,404, from approximately $13,070 for the three months ended
September 30, 2003. This decrease of approximately $1,666 was primarily
attributable to decreases in telecommunications expenses of approximately
$1,239, decreases in installation subcontractor and outside services expenses of
approximately $326, decreases in personnel expenses of approximately $75,
decreases in other equipment costs of approximately $176 and decreases in other
miscellaneous expenses of approximately $9, partially offset by increases in
other installation costs of approximately $159. For the nine months ended
September 30, 2004, network expenses decreased to approximately $35,549, from
approximately $38,412 for the nine months ended September 30, 2003. This
decrease of approximately $2,863 was primarily attributable to decreases in
telecommunications expenses of approximately $2,825, decreases in other
equipment costs of approximately $242, decreases in installation subcontractor
and outside services expenses of approximately $320 and decreases in other
miscellaneous expenses of approximately $112, partially offset by increases in
other installation costs of approximately $636. The above described reductions
in network expenses for the three and nine months ended September 30, 2004 were
primarily attributable to closure of certain duplicative central office
locations that resulted from the NAS acquisition and decreases in installation
subcontractor expense resulting from a decrease in new subscriber lines.
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Costs incurred for high speed lines that we lease from incumbent local
exchange carriers that connect our central office equipment and our network may
also increase if the impending new rules to be issued by the FCC in respect to
those portions of the FCC's Triennial Review Order vacated and remanded by the
D.C. Circuit Court are unfavorable to us and other competitive local exchange
carriers.
OPERATIONS EXPENSES. Our operations expenses include costs related to
customer care, customer provisioning, customer billing, customer technical
assistance, purchasing, headquarters facilities operations, operating systems
maintenance and support and other related overhead expenses.
Operations expenses for the three months ended September 30, 2004
decreased to approximately $2,380, from approximately $3,060 for the three
months ended September 30, 2003. This decrease of approximately $680 was
primarily attributable to decreases in personnel expenses of approximately $309,
decreases in equipment expenses of approximately $108, decreases in
telecommunication expense of approximately $88, decreases in license expense of
approximately $55, decreases in office expenses of approximately $32 and
decreases in other miscellaneous expenses of approximately $88. For the nine
months ended September 30, 2004, operations expense decreased to approximately
$8,001 from approximately $8,935 for the nine months ended September 30, 2003.
This decrease of approximately $934 was primarily attributable to decreases in
personnel expenses of approximately $516 (resulting from our reduction in force
during the first quarter of 2004), decreases in equipment expenses of
approximately $236, decreases in telecommunication expenses of approximately
$92, decrease in office expenses of approximately $58 and decreases in other
miscellaneous expenses of approximately $157, partially offset by increases in
outside services of approximately $125.
GENERAL AND ADMINISTRATIVE. Our general and administrative expenses
consist primarily of costs relating to human resources, finance, executive,
administrative services, recruiting, insurance, legal and auditing services,
leased office facilities rent and bad debt expenses.
General and administrative expenses were approximately $3,210 for the
three months ended September 30, 2004, compared to approximately $2,618 for the
three months ended September 30, 2003. This increase of approximately $592 was
primarily due to increased professional service fees of approximately $575,
increased personnel expenses of approximately $70, increased travel expense of
approximately $38, increased equipment expense of approximately $64, increased
license expense of approximately $48 and increased other miscellaneous expenses
of approximately $73, partially offset by decreased bad debt expense of
approximately $276. For the nine months ended September 30, 2004, general and
administrative expenses were approximately $9,661 compared to approximately
$8,891 for the nine months ended September 30, 2003. This increase of
approximately $770 was primarily due to increased professional service fees of
approximately $1,236, increased personnel expenses of approximately $111,
increased license expense of approximately $97, increased equipment expense of
approximately $60, increased public reporting expense of approximately $29 and
increased other miscellaneous expenses of approximately $172, partially offset
by decreased bad debt expense of approximately $767, and decreased facilities
expense of approximately $168.
SALES AND MARKETING. Our sales and marketing expenses consist primarily of
expenses for personnel, the development of our brand name, promotional
materials, direct mail advertising and sales commissions and incentives.
Sales and marketing expenses for the three months ended September 30,
2004, were approximately $993, compared to approximately $2,116 for the three
months ended September 30, 2003. This decrease in sales and marketing expenses
of approximately $1,123 was primarily attributable to decreased salaries,
benefits and commissions of approximately $772, decreased advertising expenses
of approximately $299, and decreased other miscellaneous expenses of
34
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
approximately $52. For the nine months ended September 30, 2004, sales and
marketing expenses were approximately $4,515, compared to approximately $6,238
for the nine months ended September 30, 2003. This decrease of approximately
$1,723 was primarily attributable to decreased salaries, benefits and
commissions of approximately $1,178, decreased advertising expense of
approximately $448, and decreased other miscellaneous expenses of approximately
$97.
STOCK COMPENSATION. We incurred non-cash stock compensation expenses
during 2003 and prior years as a result of the granting of stock and stock
options to employees, directors and members of our former board of advisors with
exercise prices per share subsequently determined to be below the fair values
per share of our common stock for financial reporting purposes at the dates of
grant. Stock compensation that was vested was charged immediately to expense,
while non-vested compensation was amortized over the vesting period of the
applicable options or stock, which was generally 48 months for initial grants
and 36 months for subsequent grants. Unvested options for terminated employees
were cancelled and the value of such options was recorded as a reduction of
deferred compensation with an offset to additional paid-in-capital.
Non-cash stock compensation expense was $0 for the three months ended on
each of September 30, 2004 and 2003, respectively. For the nine months ended
September 30, 2004 and 2003, non-cash stock compensation expense was $0 and
approximately $438, respectively. As of December 31, 2003, all non-cash stock
compensation had been fully amortized and there were no remaining balances.
As of September 30, 2004 and December 31, 2003, options to purchase
44,671,029 and 18,671,766 shares of common stock, respectively, were
outstanding, which were exercisable at weighted average exercise prices of $0.71
per share and $1.07 per share, respectively.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization is primarily
attributable to the following: (i) depreciation of network and operations
equipment and Company-owned modems and routers installed at customer sites, (ii)
depreciation of information systems and computer hardware and software, (iii)
amortization and depreciation of the costs of obtaining, designing and building
our co-location space and corporate facilities and (iv) amortization of
intangible capitalized costs pertaining to acquired businesses and customer line
acquisitions.
Depreciation and amortization expenses were approximately $3,355 for the
three months ended September 30, 2004, compared to approximately $3,319 for the
three months ended September 30, 2003. This increase in depreciation and
amortization expenses of approximately $36 was primarily attributable to the
acquisition of certain network assets. For the nine months ended September 30,
2004, depreciation and amortization expenses were approximately $9,957, compared
to approximately $12,654 for the nine months ended September 30, 2003. The
decrease in depreciation and amortization expenses of approximately $2,697 was
primarily attributable to certain intangible and fixed assets having become
fully depreciated and amortized during 2003 and 2004, resulting in a decline in
depreciation and amortization expense of approximately $2,855, which was
partially offset by increased depreciation and amortization expenses relating to
our acquisition of the NAS Assets and TalkingNets Assets (as defined below) of
approximately $158.
Our identified intangible assets consist of customer lists, which are
amortized over two years. Amortization expense of intangible assets for the
three and nine months ended September 30, 2004 was approximately $211 and $745,
respectively. For the three and nine months ended September 30, 2003,
amortization expense of intangible assets was approximately $345 and $2,395.
Accumulated amortization of customer lists as of September 30, 2004 and 2003 was
$15,241 and $14,136, respectively. The expected future amortization of customer
lists as of September 30, 2004 is $196 in 2004 and $46 in 2005.
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Depreciation expense pertaining to assets for our network and operations
was approximately $2,847 and $2,666 for the three months ended September 30,
2004 and 2003, respectively, and approximately $8,347 and $9,279 for the nine
months ended September 30, 2004 and 2003, respectively. Depreciation and
amortization expenses pertaining to assets related to general and administrative
expenses were approximately $297 and $308 for the three months ended September
30, 2004 and 2003, respectively, and approximately $865 and $979 for the nine
months ended September 30, 2004 and 2003, respectively.
INTEREST EXPENSE, NET. Net interest expense of approximately $1,412 for
the three months ended September 30, 2004, included approximately $1,430 of
interest expense, which was partially offset by approximately $18 in interest
income. Net interest expense of approximately $728 for the three months ended
September 30, 2003, included approximately $779 of interest expense, which was
partially offset by approximately $51 of interest income. The increase in
interest expense of approximately $651 was primarily attributable to the
increased amortization of debt discount of approximately $823, which related to
the warrants issued under the Note and Warrant Purchase Agreement (as defined
below), partially offset by decreased other interest expense of approximately
$172 due to lower debt balances.
Net interest expense of approximately $3,570 for the nine months ended
September 30, 2004, included approximately $3,647 of interest expense, which was
partially offset by approximately $77 in interest income. Net interest expense
of approximately $2,139 for the nine months ended September 30, 2003, included
approximately $2,228 of interest expense, which was partially offset by
approximately $89 of interest income. The increase in interest expense of
approximately $1,419 was primarily attributed to the increased amortization of
debt discount of approximately $2,846 which related to the warrants issued under
the Note and Warrant Purchase Agreement (as defined below), partially offset by
a decrease in the amortization of deferred non-cash financing costs of
approximately $909, which related to warrants issued in consideration for loan
guarantees under our Reimbursement Agreement (as defined below) and decreased
other interest expense of approximately $518 due to lower debt balances.
OTHER INCOME (EXPENSE), NET. Net other income for the three and nine
months ended September 30, 2004 was approximately $8 and $114, respectively, and
represented miscellaneous income. For the three and nine months ended September
30, 2003, net other expense was approximately $2,427 and $2,436, respectively,
and represented the write-off of approximately $184 in unamortized loan
origination fees and approximately $5,747 of unamortized deferred non-cash
financing costs which related to the warrants issued in consideration for loan
guarantees under our Reimbursement Agreement (discussed below). These items were
written-off as a result of the loan repayment and cancellation of the Credit
Agreement and Reimbursement Agreement subsequent to our $30,000 financing on
July 18, 2003. These write-offs were partially offset by a non-cash gain of
$3,500 recorded in August 2003, resulting from the $1,500 settlement of the
$5,000 note payable to NAS. Also included in other expense for the three months
ended September 30, 2003, was miscellaneous income of approximately $5. Also
included in other expense for the nine months ended September 30, 2003, was
approximately $114 in net losses on the sale of assets, partially offset by
approximately $109 of miscellaneous income.
RESTRUCTURING. In September 2004, we reduced our workforce by 32 employees
at our locations in New Haven, Connecticut; Herndon, Virginia; and Wilmington,
North Carolina. As a result, we incurred approximately $78 in restructuring
charges pertaining to severance and benefits payments.
In March 2004, we reduced our workforce by 62 employees at our locations
in New Haven, Connecticut; Herndon, Virginia; Minneapolis, Minnesota and
Wilmington, North Carolina. As a
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
result, we incurred approximately $160 in restructuring charges pertaining to
severance and benefits payments. Also, during the first nine months of 2004, we
charged approximately $429 against our restructuring reserves that related to
facilities expense associated with our vacated office space in Santa Cruz,
California. Our restructuring reserve balance as of September 30, 2004, of
approximately $111, represents estimated costs associated with such vacated
facility and was included in our accrued liabilities.
NET LOSS. Net loss was approximately $5,919 and $9,111 for the three
months ended September 30, 2004 and 2003, respectively, and approximately
$18,806 and $27,054 for the nine months ended September 30, 2004 and 2003,
respectively.
LIQUIDITY AND CAPITAL RESOURCES
We have financed our capital expenditures, acquisitions and operations
primarily with the proceeds from the sale of stock and from borrowings,
including equipment lease financings. As of September 30, 2004, we had cash and
cash equivalents of approximately $4,320 and working capital of approximately
$322.
CASH USED BY FINANCING ACTIVITIES. Net cash used by financing activities
for the nine months ended September 30, 2004 was approximately $65 and primarily
related to principal payments under notes and capital lease obligations of
approximately $81, partially offset by proceeds from the sale of our common
stock of $16. From time to time we have entered into equipment lease financing
arrangements with vendors. In the aggregate, there was approximately $74 and
$155 outstanding under capital leases at September 30, 2004 and December 31,
2003, respectively.
We entered into a Revolving Credit and Term Loan Agreement, dated as of
December 13, 2002 (the "Credit Agreement"), with a commercial bank providing for
a revolving line of credit of up to $15,000 (the "Commitment"). Interest on
borrowings under the Credit Agreement was payable at 0.5% percent above the
Federal Funds Rate. Our ability to borrow amounts available under the Credit
Agreement was subject to the bank's receipt of a like amount of guarantees from
certain of our investors and/or other guarantors. On February 3, 2003, we
borrowed $6,100 under the Credit Agreement. As of March 3, 2003, certain of our
investors had guaranteed $9,100 under the Credit Agreement. On July 18, 2003, we
repaid the $6,100 outstanding balance plus accrued interest, and terminated the
Credit Agreement. We wrote off approximately $184 of the related unamortized
balance of loan origination fees.
We entered into a Reimbursement Agreement, dated as of December 27, 2002
(the "Reimbursement Agreement"), with VantagePoint Venture Partners (together
with its affiliated funds as their interests shall appear, "VantagePoint") and
Columbia Capital and other holders of our Series X Preferred Stock and Series Y
Preferred Stock or their affiliates (the "Guarantors"), and a related Security
Agreement of even date therewith. Pursuant to the terms of the Reimbursement
Agreement, on December 27, 2002, VantagePoint and Columbia Capital issued
guarantees in an aggregate amount of $6,100 to support certain of our
obligations under the Credit Agreement. On July 18, 2003, in connection with the
termination of the Credit Agreement, the guarantees, Reimbursement Agreement and
related Security Agreement were terminated.
Pursuant to the terms of the Reimbursement Agreement, on December 27,
2002, we issued warrants to purchase 12,013,893 shares of our common stock to
VantagePoint and Columbia Capital, in consideration for their guarantees
aggregating $6,100. All such warrants have a ten year life and an exercise price
of $0.50 per share. On March 26, 2003, we issued additional warrants,
exercisable for ten years, to purchase a total of 936,107 shares of our common
stock at $0.50 per share to VantagePoint and Columbia Capital, bringing the
total number of warrants issued in connection with
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(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
the Reimbursement Agreement to 12,950,000. On February 3, 2003, we borrowed
$6,100 on the Credit Agreement and the Guarantors' guarantees of the loan under
the Credit Agreement became effective.
On February 3, 2003, we valued the 12,950,000 warrants at $0.514 each,
with a total value of approximately $6,656. We performed this valuation using a
Black-Scholes valuation model with the following assumptions: (i) a risk free
interest rate of 4.01% (ten-year Treasury rate), (ii) a zero dividend yield,
(iii) a ten year expected life, (iv) an expected volatility of 153%, (v) an
option exercise price of $0.50 per share and (vi) a current market price of
$0.52 per share (the closing price of our common stock on February 3, 2003).
Since the warrants were issued in consideration for loan guarantees, which
enabled us to secure financing at below market interest rates, we recorded their
value as a deferred debt financing cost to be amortized to interest expense over
the term of the loan (approximately 57 months) using the "Effective Interest
Method" of amortization. On July 18, 2003, we repaid the outstanding loan
balance that was secured by these loan guarantees and terminated the Credit
Agreement. Accordingly, during the third quarter of 2003, we wrote-off
approximately $5,747 of the related unamortized balance of deferred financing
costs to other expense.
On March 3, 2003, we, along with VantagePoint, entered into Amendment No.
1 to the Reimbursement Agreement, pursuant to which VantagePoint increased its
guarantee by $3,000 bringing the aggregate guarantees by all Guarantors under
the Reimbursement Agreement, as amended, to $9,100. As consideration for
VantagePoint's increased guarantee, if we closed an equity financing on or
before December 3, 2003, we were required to issue VantagePoint additional
warrants to purchase the type of equity securities issued by us in any such
equity financing. The number of such additional warrants would be determined by
dividing the per share price of such equity securities into a thousand dollars.
Accordingly, upon the closing of the financing transaction on July 18, 2003, we
issued to VantagePoint, in December 2003, additional warrants with a three-year
life to purchase 2,260,909 shares of our common stock at a per share price of
$0.4423.
On July 18, 2003, we entered into a Note and Warrant Purchase Agreement
(the "Note and Warrant Purchase Agreement") with Deutsche Bank AG London, acting
through DB Advisors, L.L.C. as Investment Agent ("Deutsche Bank"), VantagePoint
Venture Partners III (Q), L.P., VantagePoint Venture Partners III, L.P.,
VantagePoint Communications Partners, L.P. and VantagePoint Venture Partners
1996, L.P. (collectively, the "Senior Noteholders") relating to the sale and
purchase of an aggregate of (i) $30,000 in senior secured promissory notes (the
2003 Notes") and (ii) warrants to purchase 157,894,737 shares of our common
stock for a period of three years at an exercise price of $0.38 per share (the
"2003 Warrants"). The aggregate purchase price for the 2003 Notes and 2003
Warrants was $30,000.
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, on July 18, 2003, we issued to the Senior Noteholders the 2003 Notes
in the aggregate principal amount of $30,000. Principal on the 2003 Notes is
payable in a single payment on July 18, 2006. The 2003 Notes provide for an
annual interest rate of 1.23%, payable in cash, quarterly in arrears commencing
on October 31, 2003, unless we were to elect to capitalize such interest and pay
it together with the principal amount of the Notes at maturity on July 18, 2006.
Pursuant to the Agency, Guaranty and Security Agreement entered into in
connection with this financing transaction, our obligations under the 2003 Notes
are secured by a security interest in a majority of our personal property and
assets and certain of our subsidiaries. The terms of the 2003 Notes also contain
provisions that limit our ability to incur additional indebtedness and place
other restrictions on our business. Prior to the due date of the first interest
payment, we elected to defer all interest payments on the 2003 Notes until
further notice. Interest expense accrued on the 2003 Notes for the nine months
ended September 30, 2004 approximated $283. Total accrued interest on the 2003
Notes since inception is included in notes payable and approximated at $454 at
September 30, 2004.
38
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Subject to the terms and conditions of the Note and Warrant Purchase
Agreement, on August 12, 2003, we issued Deutsche Bank a warrant to purchase
12,950,000 shares of our common stock. We issued the Senior Noteholders the
remaining warrants to purchase an aggregate of 144,944,737 shares of our common
stock to Deutsche Bank (105,471,053 shares) and VantagePoint (39,473,864 shares)
on December 9, 2003.
On July 18, 2003, we recorded these note and warrant transactions in
accordance with Accounting Principals Board Opinion No. 14, "ACCOUNTING FOR
CONVERTIBLE DEBT AND DEBT ISSUED WITH STOCK PURCHASE WARRANTS," whereby a fair
value was ascribed to the 157,894,737 Warrants to be issued to the Senior
Noteholders (related to the Note and Warrant Purchase Agreement) together with
the 2,260,909 warrants to be issued to VantagePoint (related to VantagePoint's
increased guarantee under Amendment No. 1 to the Reimbursement Agreement) using
a Black-Scholes valuation model with the following assumptions: (i) a risk free
interest rate of 2.24% (three-year Treasury rate), (ii) a zero dividend yield,
(iii) a three-year life, (iv) an expected volatility of 152%, (v) a warrant
option price of $0.38 per share for the 157,894,737 shares of our common stock
exercisable under the 2003 Warrants and $0.4423 per share for the 2,260,909
warrants issued to VantagePoint in connection with the Reimbursement Agreement,
as amended, and (vi) a then current market price of $0.83 per share (the closing
price of our common stock on July 18, 2003). A fair value was ascribed to the
$30,000 Notes using a present value method with a 19% discount rate. The
relative fair value of the warrants representing 87% of the combined fair value
of the 2003 Warrants and 2003 Notes was applied to the $30,000 proceeds to
determine a note discount of approximately $26,063, which was recorded as a
reduction to the 2003 Notes payable and an increase to additional paid in
capital. The note discount is being amortized to interest expense using the
"Effective Interest Method" over the 36-month term of the 2003 Notes. For the
nine months ended September 30, 2004, approximately $3,355 of this note discount
was amortized to interest expense. The unamortized balance of the note discount
at September 30, 2004 is approximately $21,442.
The proceeds from the sale of the 2003 Notes and 2003 Warrants will be
(and portions already have been) used by us for general corporate purposes,
including acquisitions and repayment of certain debt and lease obligations. As
of December 31, 2003, we had paid approximately $10,200 for the complete
repayment (at a discount) of approximately $14,600 of our debt and lease
obligations.
As part of the agreements negotiated in conjunction with our $30,000
financing on July 18, 2003, we and holders of a majority of the Series X
Preferred Stock and Series Y Preferred Stock agreed to extend the redemption
dates of the Series X Preferred Stock and Series Y Preferred Stock from January
1, 2005 to July 18, 2006. Also, as a result of this financing transaction, in
accordance with the terms of the Series Y Preferred Stock, the Series Y
Preferred Stock conversion price was adjusted from $0.50 per share (each share
of Series Y Preferred Stock is convertible into 2,000 shares of common stock) to
$0.4423 per share (each share of Series Y Preferred Stock is convertible into
approximately 2,260.9 shares of common stock). As of September 30, 2004, all
previously issued shares of Series Y Preferred Stock had been converted into
shares of common stock.
In January 2004, 6,000 shares of Series X Preferred Stock were converted
into 33,333,333 shares of our common stock at a conversion price of $0.18 per
share and, in accordance with the terms of the Series X Preferred Stock, we
elected to pay accrued dividends approximating $1,560 by issuing 2,316,832
shares of our common stock, calculated based on the average fair market value
for the ten days preceding the conversion of $0.67 per share.
In February 2004, the remaining 1,000 shares of Series Y Preferred Stock
were converted into 2,260,910 shares of our common stock at a conversion price
of $0.4423 per share and, in accordance with the terms of the Series Y Preferred
Stock, we elected to pay accrued dividends approximating
39
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
$221 by issuing 309,864 shares of its common stock, calculated based on the
average fair market value for the ten days preceding the conversion of $0.71 per
share.
As a result of the above described conversions of 6,000 shares of Series X
Preferred Stock and 1,000 shares of Series Y Preferred stock in 2004, we were
required to accelerate the unaccreted beneficial conversion feature related to
such shares, which amounted to an additional $2,850 of preferred stock accretion
charged in the first quarter of 2004.
On July 22, 2004, we entered into a Recapitalization Agreement with
VantagePoint, the holder of all of the remaining issued and outstanding shares
of Series X Preferred Stock (the "Recapitalization Agreement"). In accordance
with the Recapitalization Agreement, the remaining 14,000 shares of Series X
Preferred Stock held by VantagePoint were converted into 77,777,775 shares of
our common stock at a conversion price of $0.18 per share and, in accordance
with the terms of the Series X Preferred Stock, we elected to pay accrued
dividends approximating $4,040 by issuing an additional 11,710,142 shares of our
common stock at a price per share of $0.345, based on the average fair market
value for the ten days ending three days preceding the conversion. As a result
of these conversions, we were required to accelerate the unaccreted beneficial
conversion feature related to such converted shares, which amounted to an
additional $4,812 of preferred stock accretion charged in the third quarter of
2004.
For the nine months ended September 30, 2004, there was $7,662 of
additional preferred stock accretion related to the conversion of 20,000 shares
of Series X Preferred Stock and the conversion of 1,000 shares of Series Y
Preferred Stock.
Also, in accordance with the above described Recapitalization Agreement,
we issued to VantagePoint 14,000 shares of a new Series Z Preferred Stock, par
value of $0.001 per share (the "Series Z Preferred Stock"), with a liquidation
preference of $1,120 per share ($15,680 in the aggregate). The Series Z
Preferred Stock, with an initial liquidation preference of $15,680 was issued to
induce VantagePoint in the recapitalization to convert the remaining 14,000
shares of Series X Preferred Stock it held and to preserve, for a period up to
four years, VantagePoint's liquidation preference rights, which would otherwise
have terminated upon such conversion. VantagePoint will have the right to its
liquidation preference on the Series Z Preferred Stock it holds in the event of
any liquidation, dissolution or winding up of the Company (which includes a
transaction approved in advance by our board of directors for: (i) the sale of
the Company to another entity in a reorganization, merger, consolidation or
otherwise, if following such transaction or series of transactions the holders
of the outstanding voting power of the Company prior to such transaction would
own less than a majority of the voting power of the surviving entity or (ii) the
sale of substantially all of our assets). The Series Z Preferred Stock does not
contain any conversion or mandatory redemption provisions, nor does it have any
special dividend or special voting rights. The Series Z Preferred Stock's
liquidation preference will be eliminated, and the shares of Series Z Preferred
Stock cancelled, on July 18, 2008. In addition, the liquidation preference
amount shall be reduced upon the occurrence of the following events:
o if we are subject to a petition under the U.S. Bankruptcy Code and
VantagePoint has sold more than 39 million shares, but less than 58
million shares, of our common stock issued in connection with the
transactions contemplated by the Recapitalization Agreement, then the
liquidation preference shall be reduced to $8,680 in the aggregate.
o upon the first of any of the following, the liquidation preference
shall be reduced to $0 in the aggregate and the Series Z Preferred
Stock shall be cancelled:
40
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
o July 18, 2008;
o We are subject to a petition under the U.S. Bankruptcy Code and
VantagePoint has sold more than approximately 58 million shares,
of our common stock issued in connection with the transactions
contemplated by the Recapitalization Agreement;
o VantagePoint owns more than 50% of our common stock; or
o our common stock closes above $1.50 per share for 45 consecutive
trading days.
We have recorded the $2,630 fair value of Series Z Preferred Stock in the
equity section of our statement of financial position, and included it as a
charge in the calculation of net income available to common stockholders.
The fair value of the Series Z Preferred Stock of $2,630 was determined
based on a number of factors including, but not limited to: (i) review of the
Recapitalization Agreement and the Certificate of Designation of the Series Z
Preferred Stock, (ii) consideration of the our historical financial results,
(iii) review of certain criteria for similar companies obtained from published
sources, and (iv) the use of probability analyses.
CASH USED IN OPERATING ACTIVITIES. For the nine months ended September 30,
2004, the net cash used in our operating activities was approximately $8,878.
This cash was used to pay a variety of operating expenses, including salaries,
professional fees, network expenses, operations, sales and marketing and
overhead expenses.
CASH USED IN INVESTING ACTIVITIES. Net cash used in investing activities
for the nine months ended September 30, 2004, was approximately $516. Of this
amount, approximately $519 was used for the purchase of equipment that was
partially offset by approximately $3 related to a decrease in restricted cash
related to deposits held by our 401K plan administrator.
The development and expansion of our business has required significant
capital expenditures. Capital expenditures, including co-location fees, were
approximately $519 and $1,840 for the nine months ended September 30, 2004 and
2003, respectively. The actual amounts and timing of our future capital
expenditures will vary depending on the speed at which we expand and implement
our network and implement service for our customers. Our planned capital
expenditures for 2004 are currently expected to be primarily for the upgrade of
our network to support our integrated voice and data service offerings. We
currently anticipate spending approximately $800 for capital expenditures,
excluding acquisitions, during the year ending December 31, 2004. The actual
amounts and timing of our capital expenditures could differ materially both in
amount and timing from our current plans.
In December of 2002, the U.S. Bankruptcy Court for the District of
Delaware approved our bid to purchase the on-network assets and associated
subscriber lines of NAS for $14,000, consisting of $9,000 in cash and $5,000 in
a note payable to NAS. We closed the transaction on January 10, 2003, whereby we
acquired NAS' operations and network assets, including associated equipment in
approximately 300 central offices and approximately 11,500 associated subscriber
lines. In connection with the closing of the NAS transaction, on January 10,
2003, we hired 78 former NAS employees. No pre-closing liabilities were assumed
in connection with the NAS transaction. The cash portion of the purchase price
was paid from our existing cash. The NAS note had a term of approximately 5
years and carried interest at 12% and was secured by the NAS network assets
acquired. During August 2003, we paid $1,500 to repurchase and cancel the $5,000
note issued by us to NAS. The difference between the $5,000 note and the $1,500
settlement amount was recorded as other income during 2003.
41
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
In connection with the integration of the NAS business, on January 17,
2003, we had a reduction in force of approximately 35 employees at our
headquarters facility in New Haven, Connecticut. We paid approximately $62 in
severance to the terminated employees.
On April 8, 2003, we entered into an asset purchase agreement with
TalkingNets, Inc. and TalkingNets Holdings, LLC (collectively, "TalkingNets")
pursuant to which we agreed to acquire assets and subscribers of TalkingNets
(the "TalkingNets Assets") for $726 in cash (the "TalkingNets Asset Purchase
Agreement"). As TalkingNets had filed a voluntary petition for Chapter 11
reorganization in February 2003, the TalkingNets Asset Purchase Agreement was
subject to the approval of the U.S. Bankruptcy Court for the Eastern District of
Virginia. On April 9, 2003, the TalkingNets Asset Purchase Agreement and the
transactions contemplated thereby were approved by the Bankruptcy Court. On
April 11, 2003, we paid the full purchase price of $726 into escrow.
On September 8, 2003, in accordance with the TalkingNets Asset Purchase
Agreement, we completed our acquisition of the TalkingNets Assets. During the
transition period, we included the net effect of cash collections from the
proposed acquired customers less certain related operating costs of TalkingNets'
operations in our statements of operations. This net effect for the three and
nine months ended September 30, 2003, was approximately $159 and $394 in
expense, respectively.
CASH RESOURCES FOR FUTURE ACTIVITIES. As of September 30, 2004, we had
cash and cash equivalents of approximately $4,320 and working capital of
approximately $322. On March 25, 2004, we reduced our workforce by 62 employees.
As a result of this action, we incurred approximately $160 in restructuring
charges pertaining to severance and benefits payments and we expect to realize
approximately $3,400 in annualized savings in salary and benefit costs.
Additionally, on September 21, 2004, we reduced our workforce by 32 employees.
As a result of this action we incurred approximately $78 in restructuring
charges pertaining to severance and benefits payments and we expect to realize
approximately $2,500 in additional annualized savings in salary and benefit
costs.
We expect our operating losses, net operating cash outflows and capital
expenditures to continue throughout 2004 and into 2005. Based on our current
business plan and projections (excluding the proceeds from our October 2004
convertible notes and warrant financing, the use of which is subject to the
prior approval of certain of our senior secured noteholders), we believe that
our existing cash and cash expected to be generated from operations will be
sufficient to fund our operating losses, capital expenditures, lease payments,
and working capital requirements into the fourth quarter of 2004. Failure to
generate sufficient revenues, contain certain discretionary spending; obtain
approval of our use of the proceeds from our October 2004 convertible notes and
warrant financing, or achieve certain other business plan objectives could have
a material adverse affect on our results of operations, cash flows and financial
position, including our ability to continue as a going concern.
We intend to use our cash resources to finance our capital expenditures
and for our working capital and other general corporate purposes. We may also
use a portion of our cash resources to pursue strategic opportunities and may
need additional funding to carry out such activities. The amounts actually
expended for these purposes will vary significantly depending on a number of
factors, including market acceptance of our services, revenue growth, planned
capital expenditures, cash generated from operations, improvements in operating
productivity, the availability, timing and feasibility of strategic
opportunities, and the availability and terms of any additional funding.
Our cash requirements may vary based upon the timing and the success of
implementation of our business plan or if:
42
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
o demand for our services or our cash flow from operations is less than
or more than expected;
o our plans or projections change or prove to be inaccurate;
o we make strategic acquisitions or pursue other strategic
opportunities;
o we alter the schedule or targets of our business plan implementation;
or
o we curtail and/or reorganize our operations.
There can be no assurance that we will be able to achieve our business
plan objectives or that we will achieve or maintain cash flow positive operating
results. If we are unable to generate adequate funds from our operations, or
gain access to the proceeds from our October 2004 convertible notes and warrant
financing, the use of which is subject to the prior approval of certain of our
senior secured noteholders, or raise additional capital, we may not be able to
continue to operate our network, respond to competitive pressures or fund our
operations. As a result, we may be required to significantly reduce, reorganize,
discontinue or shut down our operations. Our financial statements do not include
any adjustments that might result from these uncertainties.
CONTRACTUAL OBLIGATIONS. Since December 31, 2003, there have been no
material changes outside of the ordinary course of our business to the
contractual obligations presented in our Annual Report on Form 10-K for the year
ended December 31, 2003, pursuant to Item 303 of Regulation S-K promulgated by
the SEC.
LISTING OF OUR COMMON STOCK. On August 4, 2004, the listing and trading of
our common stock moved from the Nasdaq SmallCap Market to the American Stock
Exchange. On such date, our common stock trading symbol changed from "DSLNC" to
"BIZ."
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any off-balance sheet arrangements.
43
FORWARD LOOKING STATEMENTS
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),
and Section 21E of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"). The statements contained in this report, which are not
historical facts, may be deemed to contain forward-looking statements. These
statements relate to future events or our future financial or business
performance, and are identified by terminology such as "may," "might," "will,"
"should," "expect," "scheduled," "plan," "intend," "anticipate," "believe,"
"estimate," "potential," or "continue" or the negative of such terms or other
comparable terminology. These statements are subject to a variety of risks and
uncertainties, many of which are beyond our control, which could cause actual
results to differ materially from those contemplated in these forward-looking
statements. In particular, the risks and uncertainties include, among other
things, those described under "Risk Factors" in our Annual Report on Form 10-K
for the year ended December 31, 2003, which has been filed with the SEC, and (i)
fluctuations in our quarterly operating results, which could adversely effect
the price of our common stock; (ii) our unproven business model, which may not
be successful; (iii) our ability to execute our business plan in a timely manner
to generate the forecasted financial and operating results, which may not be
achieved if our sales force is not able to generate sufficient sales to
customers or if we are not able to install and commence service for customers in
a timely manner; (iv) our failure to generate sufficient revenue, contain
certain discretionary spending, achieve certain other business plan objectives,
or obtain additional debt or equity financing, which could have a material
adverse effect on our results of operations or financial position, or cause us
to restructure our operations to further reduce operating costs; (v) the fact
that our independent auditors have in the past raised questions about our
ability to continue as a going concern and the possibility that they may also do
so in their future reports on our financial statements, which may have an
adverse impact on our ability to raise additional capital and our stock price;
(vi) our ability to raise sufficient additional capital on acceptable terms, or
at all, to finance our operations or growth opportunities, including strategic
transactions; (vii) our ability to comply with the continued listing
requirements of the American Stock Exchange, which failure could adversely
impact the pricing and trading of our common stock; (viii) risks associated with
strategic transactions, including difficulties in identifying and completing
transactions, integrating acquired businesses or assets and realizing the
revenue, earnings or synergies anticipated from any transactions; (ix)
regulatory, legislative, and judicial developments, which could adversely affect
the way we operate our business; (x) risks associated with our reliance on
certain carriers to transmit data across our network; (xi) the challenges
relating to the timely installation of service for customers, including our
dependence on traditional telephone companies to provide acceptable telephone
lines in a timely manner; (xii) our dependence on wholesale providers to provide
us with local broadband facilities in areas where we have not deployed our own
equipment; (xiii) our ability to achieve sustained market acceptance of our
services at desired pricing levels; (xiv) high levels of competition in our
industry; (xv) the difficulty of predicting the new and rapidly evolving
high-speed data communications industry; (xvi) our ability to negotiate, enter
into, amend and renew interconnection and co-location agreements with
traditional telephone companies; (xvii) our ability to recruit and retain
qualified personnel, establish the necessary infrastructure to support our
business, and manage the growth of our operations; and (xviii) our ability to
access the funds we raised in connection with our October 2004 convertible notes
and warrant financing transaction, which funds are currently held in an account
controlled by Deutsche Bank Trust Company Americas and D.B. Advisors, L.L.C., as
advisor to Deutsche Bank AG London, to finance operations or growth
opportunities, including strategic transactions. Existing and prospective
investors are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof. We undertake no obligation,
and disclaim any obligation, to update or revise the information contained in
this report, whether as a result of new information, future events or
circumstances or otherwise.
44
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have no derivative financial instruments in our cash and cash
equivalents. We invest our cash and cash equivalents in investment-grade, highly
liquid investments, consisting of commercial paper, bank money markets and
certificates of deposit and corporate bonds.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
have evaluated our disclosure controls and procedures (as defined in the
Exchange Act, Rules 13a-15(e)) as of the end of the period covered by this
quarterly report on Form 10-Q. Based on this evaluation, the principal executive
officer and principal financial officer concluded that our disclosure controls
and procedures were, as of the end of the period covered by this report,
effective to provide reasonable assurances that material information related to
the Company required to be disclosed in our filings and submissions under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms.
There were no significant changes in our internal controls over financial
reporting that occurred during the last fiscal quarter that materially affected,
or are reasonably likely to materially affect, our internal controls over
financial reporting.
PART II - OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
On July 22, 2004, we entered into the Recapitalization Agreement with
VantagePoint. In accordance with the Recapitalization Agreement, the remaining
14,000 shares of Series X Preferred Stock then held by VantagePoint were
converted into 77,777,775 shares of our common stock at a conversion price of
$0.18 per share and, in accordance with the terms of the Series X Preferred
Stock, we elected to pay accrued dividends approximating $4,040,000 by issuing
to VantagePoint and additional 11,710,142 shares of our common stock at a price
per share of $0.345, calculated based on the average fair market value for the
ten days ending three days preceding the conversion. After the conversion, as of
the close of business on July 22, 2004, we had 233,617,317 shares of common
stock outstanding. Also, in accordance with the Recapitalization Agreement, we
issued to VantagePoint 14,000 shares of Series Z Preferred Stock, with a
liquidation preference of $1,120 per share ($15,680,000 in the aggregate). The
Series Z Preferred Stock, with an initial liquidation preference of $15,680,000
was issued to induce VantagePoint, in the recapitalization, to convert its
remaining 14,000 shares of Series X Preferred Stock and to preserve, for a
period up to four years, VantagePoint's liquidation preference rights that would
otherwise have terminated upon such conversion. VantagePoint will have the right
to a liquidation preference on the Series Z Preferred Stock it holds in the
event of any liquidation, dissolution or winding up of the Company (including a
transaction approved by the board of directors of the Company for: (i) the sale
of the Company to another entity in a reorganization, merger, consolidation or
otherwise, if following such transaction or series of transactions the holders
of the outstanding voting power of the Company prior to such transaction would
own less than a majority of the surviving entity or (ii) the sale of
substantially all of the assets of the Company). The Series Z Preferred Stock
does not contain any conversion or mandatory redemption provisions nor does it
have any special dividend or special voting rights. The Series Z Preferred
Stock's liquidation preference will be eliminated, and the shares of Series Z
45
Preferred Stock cancelled, on July 18, 2008. In addition, the liquidation
preference amount shall be reduced upon the occurrence of certain events.
No underwriters were involved in the foregoing issuances of securities.
Such issuances were made in reliance upon an exemption from the registration
requirements of the Securities Act of 1933, as amended, set forth in Sections
3(a)(9) and 4(2) thereof.
ITEM 6. EXHIBITS
Exhibits.
- ----------- --------------------------------------------------------------------
Exhibit No. Exhibit
- ----------- --------------------------------------------------------------------
3.01 Certificate of Designation of Series Z Preferred Stock (incorporated
by reference to Exhibit 4 of our Form 8-A filed on August 3, 2004)
- ----------- --------------------------------------------------------------------
10.01+ Security Agreement by and between DSL.net and Laurus Master Fund,
Ltd., dated as of August 31, 2004
- ----------- --------------------------------------------------------------------
10.02+ Minimum Borrowing Note Registration Rights Agreement by and between
DSL.net and Laurus Master Fund, Ltd., dated as of August 31, 2004
- ----------- --------------------------------------------------------------------
10.03+ Common Stock Purchase Warrant, dated as of August 31, 2004, by
DSL.net in favor of Laurus Master Fund, Ltd.
- ----------- --------------------------------------------------------------------
10.04+ Common Stock Purchase Warrant, by and between DSL.net and TN Capital
Equities, Ltd., dated as of October 7, 2004
- ----------- --------------------------------------------------------------------
10.05+ Minimum Borrowing Note issued by DSL.net to Laurus Master Fund, Ltd.
on August 31, 2004
- ----------- --------------------------------------------------------------------
10.06+ Secured Revolving Note issued by DSL.net to Laurus Master Fund, Ltd.
on August 31, 2004
- ----------- --------------------------------------------------------------------
10.07+ Form of Common Stock Purchase Warrant issued to certain holders of
DSL.net's senior debt, between DSL.net and each such senior debt
holder, respectively, dated as of October 7, 2004
- ----------- --------------------------------------------------------------------
10.08+ Subordination Agreement by and among DSL.net, Laurus Master Fund,
Ltd., certain holders of DSL.net's senior debt and the
agent of such senior debt holders, dated as of October 7, 2004
- ----------- --------------------------------------------------------------------
10.09 Second Amended and Restated Stockholders Agreement (incorporated by
reference to Exhibit 5 of our Form 8-A filed on August 3, 2004)
- ----------- --------------------------------------------------------------------
11.01* Statements of Computation of Basic and Diluted Net Loss Per Share.
- ----------- --------------------------------------------------------------------
31.1* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
31.2* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
32.1* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
32.2* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
+ Indicates that the exhibit is incorporated by reference to the exhibit of
corresponding number filed on November 5, 2004 with our registration statement
on Form S-3 (No. 333-120264)
* Filed herewith.
46
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.
DSL.NET, INC.
By: /s/ Robert J. DeSantis
----------------------------
Robert J. DeSantis
Chief Financial Officer
(Duly authorized officer and
principal financial officer)
Date: November 15, 2004
47
EXHIBIT INDEX
- ----------- --------------------------------------------------------------------
Exhibit No. Exhibit
- ----------- --------------------------------------------------------------------
3.01 Certificate of Designation of Series Z Preferred Stock (incorporated
by reference to Exhibit 4 of our Form 8-A filed on August 3, 2004)
- ----------- --------------------------------------------------------------------
10.01+ Security Agreement by and between DSL.net and Laurus Master Fund,
Ltd., dated as of August 31, 2004
- ----------- --------------------------------------------------------------------
10.02+ Minimum Borrowing Note Registration Rights Agreement by and between
DSL.net and Laurus Master Fund, Ltd., dated as of August 31, 2004
- ----------- --------------------------------------------------------------------
10.03+ Common Stock Purchase Warrant, dated as of August 31, 2004, by
DSL.net in favor of Laurus Master Fund, Ltd.
- ----------- --------------------------------------------------------------------
10.04+ Common Stock Purchase Warrant, by and between DSL.net and TN Capital
Equities, Ltd., dated as of October 7, 2004
- ----------- --------------------------------------------------------------------
10.05+ Minimum Borrowing Note issued by DSL.net to Laurus Master Fund, Ltd.
on August 31, 2004
- ----------- --------------------------------------------------------------------
10.06+ Secured Revolving Note issued by DSL.net to Laurus Master Fund, Ltd.
on August 31, 2004
- ----------- --------------------------------------------------------------------
10.07+ Form of Common Stock Purchase Warrant issued to certain holders of
DSL.net's senior debt, between DSL.net and each such senior debt
holder, respectively, dated as of October 7, 2004
- ----------- --------------------------------------------------------------------
10.08+ Subordination Agreement by and among DSL.net, Laurus Master Fund,
Ltd., certain holders of DSL.net's senior debt and the
agent of such senior debt holders, dated as of October 7, 2004
- ----------- --------------------------------------------------------------------
10.09 Second Amended and Restated Stockholders Agreement (incorporated by
reference to Exhibit 5 of our Form 8-A filed on August 3, 2004)
- ----------- --------------------------------------------------------------------
11.01* Statements of Computation of Basic and Diluted Net Loss Per Share.
- ----------- --------------------------------------------------------------------
31.1* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
31.2* Certification Pursuant to Rule 13a-14(a) of the Exchange Act, as
Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
32.1* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
32.2* Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------- --------------------------------------------------------------------
+ Indicates that the exhibit is incorporated by reference to the exhibit of
corresponding number filed on November 5, 2004 with our registration statement
on Form S-3 (No. 333-120264)
* Filed herewith.
48