UNITED STATES
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, 2001,
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________
Commission File Number 0-26707
NETWORK COMMERCE INC.
(Exact name of registrant as specified in its charter)
WASHINGTON 91-1628103
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
411 1st AVENUE SOUTH
SUITE 200 NORTH
SEATTLE, WA 98104
(Address of principal executive offices)
(206) 223-1996
(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 __
As of November 2, 2001, there were 5,617,117 shares outstanding of the
Registrant's common stock.
1
Network Commerce Inc.
Form 10-Q
Index
<Table>
<Caption>
PAGE
PART I FINANCIAL INFORMATION
ITEM 1: Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2001
and December 31, 2000.............................................................. 4
Condensed Consolidated Statements of Operations for the three- and nine-month
periods ended September 30, 2001 and 2000 ......................................... 5
Condensed Consolidated Statements of Cash Flows for the nine-month
periods ended September 30, 2001 and 2000.......................................... 6
Notes to Condensed Consolidated Financial Statements.................................. 7
ITEM 2: Management's Discussion and Analysis of Financial
Condition and Results of Operations................................................ 20
ITEM 3: Quantitative and Qualitative Disclosures about Market Risk............................ 40
PART II OTHER INFORMATION
ITEM 1: Legal Proceedings..................................................................... 41
ITEM 2: Changes in Securities and Use of Proceeds............................................. 42
ITEM 3: Defaults Upon Senior Securities....................................................... 42
ITEM 4: Submission of Matters to a Vote of Security Holders................................... 42
ITEM 5: Other Information..................................................................... 42
ITEM 6: Exhibits and Reports on Form 8-K...................................................... 42
SIGNATURES ...................................................................................... 43
EXHIBITS ...................................................................................... 44
</Table>
2
PART I. FINANCIAL INFORMATION
ITEM 1.
3
Network Commerce Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share amounts)
(unaudited)
<Table>
<Caption>
September 30, December 31,
--------------- -------------
2001 2000
--------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 2,900 $ 11,715
Restricted cash 233 16,599
Short-term investments 3 21,592
Marketable equity securities 2,522 431
Accounts receivable, less allowance for bad debts of $1,199 and $1,195 1,810 19,658
Notes receivable from employees - 2,900
Prepaid expenses and other current assets 3,027 11,363
--------------- -------------
Total current assets 10,495 84,258
Property and equipment, net 5,220 22,580
Goodwill and intangible assets, net 1,563 135,628
Cost-basis investments 1,320 29,481
Other assets, net 1,098 5,773
--------------- -------------
Total assets $ 19,696 $ 277,720
=============== =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 2,256 $ 18,933
Accrued liabilities and other liabilities 4,118 21,502
Current portion of notes and leases payable and line of credit 1,778 24,797
Deferred revenues 927 11,338
--------------- -------------
Total current liabilities 9,079 76,570
Notes and leases payable, less current portion 1,635 1,741
Deferred revenues - 3,703
--------------- -------------
Total liabilities 10,714 82,014
--------------- -------------
Commitments and contingencies (Note 11)
Shareholders' equity:
Convertible preferred stock, $0.001 par value: authorized shares - 5,000,000;
none issued and outstanding - -
Common stock, $0.001 par value: authorized shares - 200,000,000; issued
and outstanding shares - 5,617,117 at September 30, 2001 and 5,214,838
at December 31, 2000 556,406 555,175
Subscriptions receivable (61) (2,421)
Common stock warrants 18,249 18,172
Deferred compensation (3,901) (7,758)
Accumulated other comprehensive loss (110) (130)
Accumulated deficit (561,601) (367,332)
--------------- -------------
Total shareholders' equity 8,982 195,706
--------------- -------------
Total liabilities and shareholders' equity $ 19,696 $ 277,720
=============== =============
</Table>
The accompanying notes are an integral part of these condensed consolidated
balance sheets.
4
Network Commerce Inc.
Condensed Consolidated Statements of Operations
(in thousands, except share amounts)
(unaudited)
<Table>
<Caption>
For the Three Months Ended For the Nine Months Ended
September 30, September 30,
------------------------------- --------------------------------
2001 2000 2001 2000
-------------- -------------- -------------- ---------------
Revenues $ 1,594 $ 33,443 $ 17,982 $ 79,046
Cost of revenues 454 15,191 4,702 38,424
Cost of revenues - unusual item - 5,320 - 5,320
-------------- -------------- -------------- ---------------
Gross profit 1,140 12,932 13,280 35,302
-------------- -------------- -------------- ---------------
Operating expenses:
Sales and marketing 3,151 24,114 27,230 70,246
Research and development 1,299 6,660 8,693 16,070
General and administrative 2,742 3,489 9,899 10,083
Amortization of intangible assets 1,039 23,842 24,378 55,634
Stock-based compensation 498 1,484 1,765 4,626
Restructuring and other impairment charges 3,842 - 65,915 -
Impairment of certain long-lived assets 3,826 - 46,962 -
Unusual item - settlement of claim - - 4,559 -
-------------- -------------- -------------- ---------------
Total operating expenses 16,397 59,589 189,401 156,659
-------------- -------------- -------------- ---------------
Loss from operations (15,257) (46,657) (176,121) (121,357)
-------------- -------------- -------------- ---------------
Nonoperating (expense) income:
(Loss) gain on sale of marketable equity securities - 4,163 (150) 5,542
Interest income 90 1,191 713 4,056
Interest expense (445) (546) (5,985) (1,447)
Other 61 21 22 (27)
Impairment of cost-basis investments (9,407) (2,486) (28,227) (2,486)
-------------- -------------- -------------- ---------------
Total nonoperating expense, net (9,701) 2,343 (33,627) 5,638
-------------- -------------- -------------- ---------------
Loss before income tax benefit and
extraordinary gain (24,958) (44,314) (209,748) (115,719)
Income tax benefit - 15,680 - 39,230
-------------- -------------- -------------- ---------------
Loss before extraordinary gain (24,958) (28,634) (209,748) (76,489)
Extraordinary gain 6,505 - 15,479 -
-------------- -------------- -------------- ---------------
Net loss $ (18,453) $ (28,634) $ (194,269) $ (76,489)
============== ============== ============== ===============
Basic loss per share:
Loss before extraordinary gain $ (4.82) $ (7.15) $ (41.81) $ (20.34)
Extraordinary gain 1.26 - 3.09 -
-------------- -------------- -------------- ---------------
Basic loss per share $ (3.56) $ (7.15) $ (38.72) $ (20.34)
============== ============== ============== ===============
Weighted average shares outstanding used to
compute basic loss per share 5,182,958 4,004,258 5,016,138 3,759,709
============== ============== ============== ===============
</Table>
The accompanying notes are an integral part of these condensed consolidated
balance sheets.
5
Network Commerce Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
<Table>
<Caption>
For the nine months ended
September 30,
----------------------------
2001 2000
----------- -----------
Operating activities:
Net loss $ (194,269) $ (76,489)
Adjustments to reconcile net loss to net cash used in operating activities-
Depreciation and amortization 31,004 63,743
Cost of revenue - unusual item - 5,320
Accretion of promissory note payable 4,671 -
Provision for bad debts 888 -
Amortization of deferred compensation 1,765 4,626
Restructuring and impairment charges 71,347 -
Impairment of certain long-lived assets 46,962 -
Impairment of marketable equity securities and investments 28,228 2,486
Extraordinary gains (15,479) -
Unusual item - settlement of claim 4,559 -
Non-cash consideration received - (5,213)
Realized loss (gain) from sale of marketable equity securities 150 (5,542)
Deferred income tax benefit - (39,230)
Changes in operating assets and liabilities, excluding effects of acquired businesses-
Accounts receivable 13,514 (14,921)
Prepaid expenses and other current assets 1,212 (6,702)
Other assets (105) (703)
Accounts payable and accrued liabilities (24,117) 7,749
Deferred revenue (1,903) (1,105)
----------- -----------
Net cash used in operating activities (31,573) (65,981)
----------- -----------
Investing activities:
Purchases of short-term investments - (130,785)
Sales of short-term investments 38,586 112,883
Proceeds from sale of investments 920 9,243
Purchases of property and equipment (53) (18,232)
Investments in equity and debt securities and other assets (4) (14,954)
Acquisition of businesses, net of cash acquired of $ - in 2001 and $392 in 2000 - (18,051)
----------- -----------
Net cash provided by (used in) investing activities 39,449 (59,896)
----------- -----------
Financing activities:
Borrowings on line of credit, net of loan fees paid - 9,095
Payments on line of credit (10,146) -
Proceeds from debt financing - 20,000
Payments on long-term debt (6,564) (7,502)
Proceeds from sale of common stock and exercise of stock options 16 110,591
Proceeds from collection of subscription receivable 3 -
----------- -----------
Net cash (used in) provided by financing activities (16,691) 132,184
----------- -----------
Net (decrease) increase in cash and cash equivalents (8,815) 6,307
Cash and cash equivalents at beginning of period 11,715 10,660
----------- -----------
Cash and cash equivalents at end of period $ 2,900 $ 16,967
=========== ===========
Supplementary disclosure of cash flow information:
Cash paid during the period for interest $ 714 $ 1,236
=========== ===========
Cash paid during the period for income taxes $ 126 $ -
=========== ===========
Non-cash investing and financing activities:
Common stock, options and warrants issued and liabilities assumed
as part of business and technology acquisitions $ - $ 138,642
=========== ===========
Assets acquired under capital leases $ 160 $ 1,070
=========== ===========
</Table>
The accompanying notes are an integral part of these condensed consolidated
balance sheets.
6
Network Commerce Inc.
Notes To Condensed Consolidated Financial Statements
(unaudited)
Note 1. Organization and Background:
The Company
Network Commerce Inc. (the Company), a Washington corporation, is a technology
infrastructure and services company. The Company provides a comprehensive
technology and business services platform that includes domain registration,
hosting, commerce and online marketing services. The Company's headquarters are
located in Seattle, Washington.
Through December 31, 2000, the Company operated two commerce networks, known as
the Network Commerce Consumer Network, which aggregated merchants and shoppers
over a distributed network of Web sites, and the Network Commerce Business
Network, which was designed to enable businesses to engage in online activities
and transactions with other businesses and an eBusiness Services division, which
provided consulting, custom commerce solutions, and integrated marketing
services for businesses conducting commerce online.
In January 2001, the Company restructured these groups into NCI Marketing and
NCI Hosting and shutdown the eBusiness Services division. NCI Marketing includes
online marketing services and various online marketplaces focused on gaming and
entertainment. The gaming and entertainment online marketplaces were closed in
March 2001. NCI Hosting includes domain registration, hosting, and other
business services. As a result of this restructuring, certain of the Company's
previous business units and offerings were shut down. The restructuring efforts
through September 2001 have resulted in the shutdown of SpeedyClick.com and the
sale of Ubarter, which were components of NCI Marketing, and the sales of GO
Software and Internet Domain Registrars, which were components of NCI Hosting.
The Company's current focus is domain registration, hosting, commerce and online
marketing services as well as licensing certain of its patents.
The Company is subject to the risks and challenges associated with other
companies at a similar stage of development, including dependence on key
management personnel, on successful development and marketing of its products
and services, and the continued acceptance of the Internet. Additional risks
include competition from substitute products and services from companies with
greater financial, technical, management and marketing resources and risks
associated with recent closures of business units. Further, during the period
required to develop commercially viable products, services and sources of
revenues, the Company may require additional funds that may or may not be
readily available.
Going Concern
The Company's condensed consolidated financial statements for the nine months
ended September 30, 2001 have been prepared on a going concern basis, which
contemplates the realization of assets and the settlement of liabilities in the
normal course of business. The Company has incurred net losses of $194.3 million
for the nine-month period ended September 30, 2001 and has accumulated deficits
of $561.6 million as of September 30, 2001. The Company has continuously
incurred net losses from operations and, as of September 30, 2001, has working
capital of $1.4 million. These factors raise substantial doubt about the
Company's ability to continue as a going concern. The consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
The Company believes that its cash reserves and cash flows from operations will
be adequate to fund its operations through December 2001. Consequently, the
Company will require substantial additional funds to continue to operate its
business beyond that period. Many companies in the Internet industry have
7
experienced difficulty raising additional financing in recent months. Additional
financing may not be available to the Company on favorable terms or at all. Even
if additional financing is available, the Company may be required to obtain the
consent of its existing lenders or the party from whom the Company secured its
equity line of credit, which the Company may not be able to obtain. If
additional financing is not available, the Company may need to change its
business plan, sell or merge its business, or file a petition in bankruptcy. In
addition, the issuance of equity or equity-related securities will dilute the
ownership interest of existing stockholders and the issuance of debt securities
could increase the risk or perceived risk of the Company.
The Company's plans to mitigate the risk of this uncertainty include, but are
not limited to, one or more of the following:
o engaging a financial advisor to explore strategic alternatives, which may
include a merger, additional asset sales, or another comparable
transaction;
o raising additional capital to fund continuing operations by private
placements of equity and/or debt securities or through the establishment of
other funding facilities; and
o forming a joint venture with a strategic partner or partners to provide
additional capital resources to fund operations.
Additional cost-cutting measures could include additional lay-offs and/or the
closure of certain business units.
Public Offerings
Effective June 18, 2001, the Company completed a 1-for-15 reverse split of the
Company's outstanding common stock. All common stock share and per share amounts
have been adjusted to reflect the reverse split.
On October 4, 1999, the Company closed its initial public offering (IPO) of
483,334 shares of common stock at $180.00 per share, for proceeds net of
underwriters' fees and commissions of $80.9 million. At closing, all of the
Company's issued and outstanding shares of convertible preferred stock were
converted into shares of common stock on a one-for-one basis. On November 2,
1999, the underwriters of the IPO exercised their over-allotment option and sold
an additional 72,500 shares at $180.00 per share, for proceeds net of
underwriters' fees and commissions of $12.1 million. The combined net proceeds
to the Company, less additional offering costs of approximately $1.9 million,
were $91.1 million. In addition, a $1.0 million promissory note in connection
with the Company's acquisition of GO Software, Inc. (GO) and a $4.0 million
bridge loan with a financial institution plus accrued interest were repaid.
On February 18, 2000, the Company closed a supplemental public offering (SPO) of
527,574 shares of common stock at $217.50 per share, for proceeds net of
underwriters' fees and commissions of $108.7 million. Offering costs incurred by
the Company relating to the SPO were approximately $700,000.
Note 2. Summary of Significant Accounting Policies:
Unaudited Interim Financial Data
The condensed consolidated financial statements are unaudited and have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission. 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 rules and
regulations. These condensed consolidated financial statements should be read in
conjunction with the audited consolidated financial statements and notes thereto
included in the Company's December 31, 2000 Form 10-K as filed with the
Securities and Exchange Commission on April 17, 2001, as amended by Form 10-K/A
on April 30, 2001. The financial information included herein reflects all
adjustments (consisting only of normal recurring adjustments), which are, in the
opinion of management, necessary for a fair presentation of the results for
interim periods. The results of operations for the three-and nine-month periods
ended September 30, 2001 and 2000 are not necessarily indicative of the results
to be expected for the full year.
Principles of Consolidation
The Company's condensed consolidated financial statements include 100% of the
assets, liabilities and results of operations of all subsidiaries in which the
8
Company has a controlling ownership interest of greater than 50%. Equity
investments in which the Company holds less than a 20% ownership interest and
does not exercise significant influence are recorded at cost and are included in
cost-basis investments in the accompanying condensed consolidated balance
sheets. All significant intercompany transactions and balances have been
eliminated.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, the disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Revenue Recognition
Since restructuring in January 2001, the Company derives revenues primarily from
the sale of online marketing services within NCI Marketing and domain
registration, hosting and commerce services within NCI Hosting. Revenues from
online marketing services are recognized as the services are delivered to the
merchants over the term of the agreement, which typically range from one to
three months. Revenues from domain registrations are recognized over the
registration term, which typically range from one to three years. Unearned
revenues are classified as either current or long-term deferred revenues
depending on the future recognition of those revenues. Revenues from hosting and
commerce services are recognized over the term of the agreements, which are
generally twelve months.
Through December 31, 2000, the Company derived substantially all of its revenues
from the Network Commerce Consumer Network, the Network Commerce Business
Network and from providing services to businesses.
Revenues from the Network Commerce Consumer Network were generated primarily
from the sale of online marketing services, leads and orders, advertising and
merchandising. Revenues from these agreements were recognized as the media or
services were delivered to the merchants over the term of the agreements, which
typically ranged from one to twelve months. Where billings exceeded revenues
earned on these agreements, the amounts were included in the accompanying
consolidated balance sheets as deferred revenue. The Company bore the full
credit risk with respect to these sales. In certain circumstances, the Company
offered products directly to shoppers. In these instances where the Company
acted as merchant-of-record, the Company recorded as revenue the full sales
price of the product sold and the full cost of the product to the Company as
cost of revenues, upon shipment of the product. Shipping charges billed to the
customer were included in revenues, and the costs incurred by the Company to
ship the product to the customer were included in cost of sales. The Company has
either sold or shut down the operations of this network with the exception of
online marketing services.
Revenues from the Network Commerce Business Network were derived primarily from
providing domain registration, web-enablement services, commerce-enablement
services, transaction processing, advertising and technology licensing to
businesses. Revenues derived from domain registration fees, which are typically
paid in full at the time of the sale, are recognized over the registration term,
which typically range from one to three years. Unearned revenues are classified
as either current or long-term deferred revenues depending on the future
recognition of those revenues. Revenues from the sale of advertising and
merchandising products and services were recognized similar to those sold on the
Network Commerce Consumer Network. Revenues from transaction fees were earned
from member businesses that transacted over the online exchange system as well
as from products sold to other member merchants of the online exchange system.
Revenues from services were generated principally through development fees,
domain registration fees, hosting fees and sales and marketing services. These
services were purchased as a complete end-to-end suite of services or
separately. The Company recognized revenues from the development of custom
applications and online stores and marketing projects on a percentage of
completion basis over the period of development or the period of the marketing
project. These projects generally ranged from two to twelve months. Hosting
contracts typically had a term of one year, with fees charged and earned on a
monthly basis. The Company bore the full credit risk with respect to these
sales. Anticipated losses on these contracts were recorded when identified.
Contract costs included all direct labor, material, subcontract and other direct
project costs and certain indirect costs related to contract performance.
Changes in job performance, job conditions and estimated profitability,
including those arising from contract penalty provisions and final contract
settlements that may result in revision to costs and income, were recognized in
the period in which the revisions were determined. Unbilled services typically
represented amounts earned under the Company's contracts not billed due to
9
timing or contract terms, which usually consider passage of time, achievement of
certain milestones or completion of the project. Where billings exceeded
revenues earned on contracts, the amounts were included in the accompanying
consolidated balance sheets as customer deposits, as the amounts typically
relate to ancillary services, whereby the Company was acting in an agency
capacity. Fee revenue from ancillary services provided by the services division
was recognized upon completion of the related job by the applicable third party
vendor. The Company has either sold or shutdown the operations of this network
with the exception of domain registration and hosting.
Revenues were also generated from fees paid to the Company by businesses and
merchants who licensed the Company's technology; transaction processing, fraud
prevention, and online payment gateways, as well as other e-commerce enabling
technologies. Revenues included licensing fees, per-transaction fees and, in
certain cases, monthly hosting and maintenance fees, which were recognized in
the period earned. Revenues generated from technology licensing were recognized
in accordance with American Institute of Certified Public Accountants, Statement
of Position 97-2, "Software Revenue Recognition." Where billings exceeded
revenues earned on these contracts, the amounts were included in the
accompanying consolidated balance sheets as deferred revenue. Businesses and
merchants who utilized the Company's payment processing technologies acted as
the merchant-of-record and bore the full credit risk on those sales of goods and
services. The Company sold this business unit during the second quarter 2001.
The Company recognized revenues from barter transactions when earned. The
Company values the barter transactions based on the value of the consideration
received from the customer or from the value of the services provided to the
customer, whichever was more readily determinable.
The Company recognized revenues from sale of online marketing services, leads
and orders, advertising and merchandising in which the Company received equity
in the customer. The Company valued the equity received from these transactions
as cost-basis investments based on the value of the consideration received from
the customer or from the value of the services provided to the customer,
whichever was more readily determinable. The Company monitors these cost-basis
investments for impairment. When cost-basis investments are deemed to be
permanently impaired, the difference between cost and market value is charged to
operations. There can be no assurance that the Company's investments in these
early-stage technology companies will be realized.
Cash, Restricted Cash and Cash Equivalents
For the purposes of consolidated statements of cash flows, the Company considers
investment instruments with an original maturity of three months or less to be
cash equivalents. Cash equivalents are comprised of investments in money market
funds, government mortgage-backed bonds, and highly rated corporate securities.
Approximately $233,000 and $16.6 million of cash as of September 30, 2001 and
December 31, 2000, respectively, is characterized as restricted in order to
secure certain facilities leasing and debt obligations under letters of credit
and another security arrangement. The Company's restricted cash and cash
equivalents are stated at cost, which approximates fair market value.
Short-Term Investments and Marketable Equity Securities
The Company classifies these securities as available-for-sale and they are
stated at fair value in accordance with the Financial Accounting Standards Board
(FASB) Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting
for Certain Investments in Debt and Equity Securities." This statement specifies
that available-for-sale securities are reported at fair value with changes in
unrealized gains and losses recorded directly to shareholders' equity, which are
also reflected in accumulated other comprehensive loss in the accompanying
consolidated statement of changes in shareholders' equity and comprehensive
loss. Fair value is based on quoted market prices. The Company's short-term
investments consist of corporate notes and bonds, commercial paper, municipal
notes and bonds, auction preferreds and US government securities and are stated
at cost, which approximates fair value as of September 30, 2001. Marketable
equity securities consist solely of investments in the common stock of publicly
traded companies and are recorded at fair value. These marketable equity
securities are not highly liquid securities as they are thinly traded. The
Company's primary investment in marketable equity securities is in Return on
Investment Corporation (ROI), which is subject to put and call provisions. The
put provision provides the Company the right to sell its shares in ROI to ROI
should their stock price close less than $2.01 per share and the call provision
10
provides ROI the right to purchase the Company's shares in ROI should their
stock price close above $3.99 per share. Additionally, the ROI common stock
shares are not currently registered with the Securities and Exchange Commission.
Realized gains and losses from the sale of available-for-sale securities are
determined on a specific identification basis. Dividend and interest income are
recognized as earned. Any changes in market values that are considered other
than temporary are recorded as realized gains or losses in current operations.
Stock Compensation
The Company has adopted disclosure-only provisions of the SFAS No. 123,
"Accounting for Stock-Based Compensation", and instead applies Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and
related interpretations. Accordingly, compensation cost for stock options is
measured as the excess, if any, of the market price of the Company's common
stock over the stock option exercise price at the date of grant. Options and
warrants issued to non-employees are accounted for using the fair value method
of accounting as prescribed by SFAS No. 123.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized as income in the period that includes the enactment date.
Recent Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards that require derivative instruments (including certain
derivative instruments embedded in other contracts) to be recorded at fair
value. The statement requires that changes in the derivative's fair value be
recognized currently in operations unless specific hedge accounting criteria are
met. Special accounting for qualifying hedges allows a derivative's gains and
losses to offset related results on the hedged item in the statements of
operations, and requires that a company must formally document, designate, and
assess the effectiveness of transactions that are subject to hedge accounting.
Pursuant to SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities - Deferral of the Effective Date of FASB No. 133 - an Amendment to
FASB Statement No. 133," the effective date of SFAS No. 133 has been deferred
until fiscal years beginning after January 15, 2000. SFAS No. 133 cannot be
applied retroactively. SFAS No. 133 must be applied to (a) derivative
instruments and (b) certain derivative instruments embedded in hybrid contracts
that were issued, acquired, or substantively modified after December 31, 1998
(and, at a company's election, before January 1, 1999). The Company impact of
adopting SFAS No. 133 is not material on the financial statements. However, the
statement could increase volatility in the consolidated statements of operations
and in other comprehensive loss.
In June 2001, the FASB issued SFAS No. 141, "Business Combinations." SFAS No.
141 establishes accounting and reporting standards for business combinations to
use the purchase method. The effective date of SFAS No. 141 is June 30, 2001.
All acquisitions by the Company have been accounted for using the purchase
method. The Company is evaluating the impact of adopting SFAS No. 141.
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." SFAS No. 142 establishes accounting and reporting standards for
acquired goodwill and other intangible assets. The statement eliminates the
amortization of goodwill over its estimated useful life. Rather, goodwill will
be subject to at least an annual assessment for impairment by applying a
fair-value-based test. SFAS No. 142 is effective for fiscal years beginning
after December 14, 2001. The Company is evaluating the impact of adopting SFAS
No. 142.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." SFAS No. 144 establishes accounting and
11
reporting standards for the impairment or disposal of long-lived assets and
supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of." SFAS No. 144 is effective for fiscal
years beginning after December 5, 2001. The Company is evaluating the impact of
adopting SFAS No. 142.
Reclassifications and Reverse Stock Split Adjustments
Certain information reported in previous periods has been reclassified to
conform to the current period presentation. Effective June 18, 2001, the Company
initiated a 1-for-15 reverse split of the Company's outstanding common stock.
All common stock share and per share amounts have been adjusted to reflect the
reverse split.
Note 3. Acquisitions:
In June 1999, the Company acquired GO Software, Inc. GO develops and markets
transaction processing software for personal computers that can function on a
stand-alone basis or can interface with core corporate accounting systems. The
Company paid GO shareholders $4.7 million in cash, issued a $1.0 million
promissory note bearing interest at 10%, and issued 74,917 shares of common
stock, valued at $128.10 per share, for a total purchase price of $15.4 million.
The acquisition was accounted for using the purchase method of accounting. Of
the excess purchase price of approximately $14.4 million, $13.8 million was
allocated to acquired technology and $556,000 was allocated to goodwill, which
were both being amortized over a three-year life. The note bore interest at 10%
and was repaid in full upon completion of the Company's initial public offering
completed in September 1999. In March 2001, the Company recognized an impairment
charge of $1.8 million to write-down the carrying value to the approximate net
realizable value. On May 14, 2001, pursuant to an Agreement and Plan of Merger
and Exchange of Stock dated as of May 11, 2001 (Merger Agreement), the Company
completed the sale of GO to ROI through its wholly-owned subsidiary for $1.0
million in cash and $3.0 million in ROI common stock. As part of the merger
transaction, ROI was required to file with the Securities and Exchange
Commission a registration statement to effect a registration of the common stock
received by the Company in the merger. In third quarter 2001, ROI paid the
Company $500,000, plus interest, pursuant to the terms and provisions of a
promissory note issued by ROI to the Company at the closing of the merger
transaction. In exchange for payment of the promissory note, the Company
returned to ROI 166,667 shares of ROI common stock, valued at $3.00 per share,
received by the Company in the merger transaction.
Also in June 1999, the Company acquired CardSecure, Inc. (CardSecure) for a
purchase price of approximately $3.5 million. CardSecure is a developer of
e-commerce enabled Web sites. The acquisition was accounted for using the
purchase method of accounting. The excess purchase price of approximately $3.5
million was allocated to acquired technology and is being amortized over a
three-year life. In September 2001, the Company recognized an impairment charge
of $526,000 to write-down the carrying value to the approximate net realizable
value.
On November 12, 1999, the Company acquired SpeedyClick, Corp. (SpeedyClick), a
California corporation, for $55.6 million of cash, common stock and common stock
options. SpeedyClick, a privately held company, maintained an Internet Web site
that focused on entertainment and interactivity. Upon effectiveness of the
acquisition, a total of 253,283 shares of common stock valued at $199.65 per
share were issued to the owners of SpeedyClick. Options to purchase SpeedyClick
common stock were assumed by the Company and converted into 10,502 options to
purchase the Company's common stock. The Company also paid cash consideration of
$3.0 million to the owners of SpeedyClick. The Company accounted for this
transaction as a purchase. Of the $55.6 million in consideration paid,
approximately $27.9 million was allocated to proprietary concepts, $14.7 million
to customer lists and $13.0 million to goodwill. These intangible assets were
being amortized over a three-year life. However, in March 2001, the Company
decided to shut down the operations and wrote-off the remaining intangible
assets of $37.2 million.
On December 3, 1999, the Company acquired Cortix, Inc. (Cortix), an Arizona
corporation doing business as 20-20Consumer.com, for $14.4 million of cash and
common stock. Cortix, a privately held company, provided comparison shopping
services including online reviews and ratings for commerce-oriented businesses,
merchants and products. Upon effectiveness of the acquisition, 47,429 shares of
common stock valued at $282.15 per share were issued to the owners of Cortix.
The Company also paid cash consideration of $1.0 million to the owners of
Cortix. The Company accounted for this transaction as a purchase. Of the $14.4
million in consideration paid, approximately $11.3 million was allocated to
acquired technology, $1.6 million to customer lists and $1.3 million to
12
goodwill. These intangible assets were being amortized over a three-year life.
However, in December 2000, the Company decided to shut down the operations and
wrote-off the remaining intangible assets of $9.1 million.
On December 17, 1999, the Company acquired WebCentric Inc. (WebCentric), a
Kansas corporation doing business as bottomdollar.com, for $40.2 million of
common stock, common stock options and approximately $1.4 million of cash.
WebCentric, a privately held company, developed e-commerce integration
technology and applications, including a comparison shopping engine that allowed
consumers to search and compare the products and services of several leading
Internet merchants. Upon effectiveness of the acquisition, a total of 144,127
shares of common stock valued at $253.35 per share were issued to the owners of
WebCentric. In addition, the Company issued replacement stock options to
purchase an aggregate of 8,103 shares of the Company's common stock to certain
employees and owners of WebCentric. The Company accounted for this transaction
as a purchase. Of the $40.2 million in consideration paid, approximately $31.8
million was allocated to acquired technology, $3.3 million to customer lists and
$4.6 million to goodwill. These intangible assets were being amortized over a
three-year life. However, in December 2000, the Company decided to shut down the
operations and wrote-off the remaining intangible assets of $24.3 million.
On January 13, 2000, the Company, through its wholly owned subsidiary 3037952
Nova Scotia Company, a Nova Scotia Company, acquired Pronet Enterprises Ltd.
(Pronet), a Canadian company, for approximately $12.8 million, of which $3.2
million was paid in cash, $2.2 million in non-cash deferred tax liabilities
assumed and $7.4 million in common stock and common stock options issued to
Pronet shareholders. Pronet, a privately held company, operated a
business-to-business portal and marketplace that aggregates businesses that seek
to transact with one another. Upon effectiveness of the acquisition, a total of
10,834 shares of common stock, valued at $264.00 per share, were issued to the
shareholders of Pronet. In addition, the Company issued options to purchase
23,445 shares of common stock to the two principals of Pronet. The Company
accounted for this transaction as a purchase. Of the $12.8 million in
consideration paid, approximately $6.3 million was allocated to acquired
technology, $2.7 million to customer lists and $3.8 million to goodwill. These
intangible assets were being amortized over a three-year life. In January 2001,
management revised its estimated useful life for these assets and amortized the
remaining carrying value of Pronet (approximately $9.1 million as of December
31, 2000) over the first six months of 2001.
On January 18, 2000, the Company acquired AXC Corporation (AXC), a Washington
corporation, for approximately $17.9 million, of which $2.2 million was paid in
cash, $4.1 million in non-cash deferred tax liabilities assumed and $11.6
million in common stock and common stock options issued to AXC shareholders.
AXC, a privately held company, provided e-commerce consulting services to
businesses. Upon effectiveness of the acquisition, a total of 36,020 shares of
common stock valued at $264.00 per share were issued to the owners of AXC. In
addition, the Company issued replacement stock options to purchase an aggregate
of 4,806 shares of the Company's common stock to certain employees and owners of
AXC. The Company accounted for this transaction as a purchase. Of the $17.9
million in consideration paid, approximately $7.2 million was allocated to
assembled workforce, $4.9 million to customer lists, $5.0 million to goodwill
and $800,000 to working capital. These intangible assets were being amortized
over a three-year life. However, in December 2000, the Company decided to shut
down the operations and wrote-off the remaining intangible assets of $14.2
million.
On April 11, 2000, the Company acquired FreeMerchant.com, Inc. (FreeMerchant), a
Delaware corporation, for approximately $38.1 million, of which $2.0 million was
paid in cash, $10.0 million in non-cash deferred tax liabilities assumed,
$500,000 of debt assumed and $25.6 million in common stock and common stock
options issued to FreeMerchant shareholders. FreeMerchant, a privately held
company, has developed online store-builder technology for small- to
medium-sized merchants that seek a low-cost point of entry to e-commerce and
provides hosting services to those merchants. Upon effectiveness of the
acquisition, a total of 171,582 shares of common stock, valued at $132.00 per
share, were issued to the shareholders of FreeMerchant. In addition, the Company
issued options to purchase 19,574 shares of common stock to certain FreeMerchant
shareholders and employees. The Company accounted for this transaction as a
purchase. Of the $38.1 million in consideration paid, approximately $23.0
million was allocated to acquired technology, $4.1 million to assembled
workforce and $11.0 million to goodwill. These intangible assets are being
amortized over a three-year life. In March 2001, the Company recognized an
impairment charge of $22.4 million to write-down the carrying value to the
approximate net realizable value. In September 2001, the Company recognized an
additional impairment charge of $2.6 million to write-down the carrying value to
the approximate net realizable value.
13
On June 2, 2000, the Company effected its acquisition of Ubarter.com Inc.
(Ubarter), a Nevada corporation, pursuant to an agreement and plan of merger
dated January 20, 2000, for approximately $61.7 million, of which $875,000 was
paid in cash, $11.4 million in non-cash deferred tax liabilities assumed,
$978,000 in net liabilities assumed, $7.6 million in the cancellation of debt
between Ubarter and the Company, and $40.8 million in common stock and common
stock warrants issued to Ubarter shareholders and creditors. Ubarter was a
business-to-business e-commerce enterprise, which utilized the Ubarter Dollar as
payment for products and services by its member businesses over its proprietary
barter exchange system. Upon effectiveness of the acquisition, a total of
178,859 shares of common stock valued at approximately $226.50 per share were
issued to the shareholders and creditors of Ubarter. In addition, the Company
issued warrants to purchase 3,457 shares of common stock to certain Ubarter
shareholders, employees and creditors. The Company accounted for this
transaction as a purchase. Of the $61.7 million in consideration paid,
approximately $7.5 million was allocated to acquired technology, $2.5 million to
assembled workforce, $25.1 million to proprietary concept, $2.5 million to
customer lists, and $24.0 million to goodwill. These intangible assets were
being amortized over a three-year life. Early in the fourth quarter 2000, the
Company launched a new user interface and back-end management system for the
Ubarter.com merchant exchange, and executed various marketing efforts to promote
the new system. These efforts did not stimulate growth in the Ubarter economy as
expected, which led to a revision in the Company's original forecasts and
projections for Ubarter. These revised forecasts indicated that future expected
cash flows from this business unit were less than the carrying value of its
intangible assets, thus triggering an impairment event in December 2000. At that
time, the carrying value of Ubarter's intangible assets including goodwill was
$51.6 million. Based on recent comparable sales of other barter exchange
systems, management determined the fair value of Ubarter.com to be approximately
$5 million. As a result, the Company recognized an impairment charge of $46.6
million in December 2000. In February 2001, the Company sold the assets of the
Canadian-based operations of Ubarter and recognized a loss of $2.3 million. In
March 2001, the Company recognized an impairment charge of $4.2 million to
write-down the remaining carrying value to the approximate net realizable value.
In June 2001, the Company sold the assets of the US-based operations of Ubarter
and recognized a loss of $1.2 million on the sale.
On August 24, 2000, the Company acquired Ivebeengood.com, d.b.a. UberWorks
(UberWorks), a wholly owned subsidiary of Trilogy, Inc. (Trilogy), for
approximately $22.8 million, of which $2.4 million was accrued as non-cash
deferred compensation, $5.9 million in non-cash deferred tax liabilities assumed
and $14.5 million in common stock and common stock options issued to UberWorks
shareholders and employees. UberWorks was a developer of multi-merchant
e-commerce purchasing tools and universal shopping cart technology. Upon
effectiveness of the acquisition, a total of 173,438 shares of common stock
valued at approximately $91.95 per share were issued to shareholders of
UberWorks, of which 28,217 are being held back by the Company to be subsequently
released based on time vesting and on certain performance criteria yet to be
achieved (these shares have been excluded from determining the Company's
weighted average shares outstanding used to calculate basic and diluted earnings
per share). The maximum term of the retention is three years from the effective
date of the acquisition. In addition, the Company issued a warrant to Trilogy,
with an exercise price of $0.000015 per share, to purchase additional shares of
the Company's common stock if, on the one-year anniversary date of the
acquisition, the shares currently held by Trilogy are not worth at least $13.1
million. The maximum number of additional shares that Trilogy was entitled to
purchase under the terms of the warrant was 173,334. On August 24, 2001, Trilogy
exercised its right under the warrant and purchased 170,105 shares. The Company
also issued options to purchase 16,545 shares of common stock to certain
UberWorks employees. The Company accounted for this transaction as a purchase.
Of the $22.8 million of consideration paid, approximately $12.3 million was
allocated to acquired technology, $2.4 million to deferred compensation,
$726,000 to assembled workforce and $7.3 million to goodwill. These intangible
assets were being amortized over a three-year life. However, in March 2001, the
Company decided to abandon the technology and wrote-off the remaining intangible
assets of $16.6 million.
On December 8, 2000, the Company acquired ePackets.Net, Inc. (ePackets) for
approximately $270,000, consisting of $150,000 in cash, $37,000 in common stock
and common stock options and $83,000 in net liabilities assumed. ePackets
provided permission-based one-to-one email solutions. In connection with this
acquisition, the Company issued to the shareholders of ePackets a total of 2,222
shares of common stock. The Company accounted for this transaction as a
purchase. The consideration paid was allocated to acquired technology and was
being amortized over a three-year life. However, in March 2001, the Company
decided to shut down the operations and wrote-off the remaining intangible
assets of $255,000.
On December 22, 2000, the Company acquired Internet Domain Registrars
Corporation (IDR), for approximately $23.6 million, consisting of $750,000 in
14
cash, $6.1 million in non-cash deferred tax liabilities assumed, $5.7 million in
common stock and $11.1 million in net liabilities assumed. IDR is a domain name
infrastructure company. In connection with this acquisition, the Company issued
to the shareholders of IDR a total of 510,000 shares of common stock, of which
66,667 were placed in escrow for indemnification purposes. In addition, 218,734
shares were issued and placed in escrow to be released to the former
shareholders and certain employees of IDR upon the achievement of established
future revenue targets over an eighteen month period, and 14,600 shares were
issued to employees of IDR who continued to be employed by IDR after the
acquisition. Finally, 40,000 shares of common stock was issued at the closing to
certain other persons in connection with the settlement of potential claims
against IDR and as consideration of services rendered to IDR in connection with
the acquisition. The closing price of the Company's common stock on December 22,
2000 was $10.35 per share. The Company accounted for this transaction as a
purchase. Of the $23.6 million of consideration paid, approximately $10.5
million was allocated to proprietary concept, $874,000 to domain name, $3.5
million to customer lists, $874,000 to assembled workforce and $7.8 million to
goodwill. These intangible assets were being amortized over a three-year life.
In March 2001, the Company recognized an impairment charge of $17.6 million to
write-down the remaining carrying value to the approximate net realizable value.
In June 2001, the Company sold substantially all of the assets and certain
liabilities of IDR to Verisign Inc. and recognized a gain of $6.3 million on the
sale.
Note 4. Restructuring, Impairment Charges and Extraordinary Gains:
Impairment of Certain Long-Lived Assets
During the first quarter 2001, the Company determined that goodwill and
intangible assets associated with acquired businesses had a carrying value in
excess of the potential sales value of the business units. As a result, the
Company recognized an impairment charge of $43.1 million.
During the third quarter 2001, the Company, due to the continued deterioration
of the stock market, determined that goodwill and intangible assets associated
with acquired businesses had a carrying value in excess of the potential sales
value of the business units. As a result, the Company recognized an additional
impairment charge of $3.8 million.
Restructurings and related impairments
During the first quarter 2001, the Company continued its restructuring efforts,
that commenced in December 2000, including the shutdown of SpeedyClick, the sale
of Ubarter Canada, which resulted in a loss of $2.3 million, the lay off of 245
employees, which resulted in severance and related payroll charges of $580,000,
the write-off of impaired goodwill and intangible assets of $55.0 million, and
of tenant improvements, fixed assets, software and supporting technologies and
infrastructure related to businesses that were shut down of $13.1 million.
During the second quarter 2001, the Company further restructured its operations
by selling Ubarter USA, IDR and GO for total proceeds of $6.0 million cash and 1
million shares of Return on Investment Corporation stock, which is subject to
lockup until November 2001. The Company recorded a gain in the second quarter of
$5.8 million related to these sales. The gains on these sales in the second
quarter resulted from the fact that the Company wrote down these business units
by $23.6 million in first quarter 2001, based on the best available evidence of
fair market value. On an aggregate basis, for the nine months ended September
30, 2001, the Company recognized losses totaling $18.5 million on the sale of
these business units. Additionally, the Company recognized gains totaling $3.1
million, primarily from revising estimates on unused operating leases and
adjustment of other liabilities related to businesses shut down in first quarter
2001.
During the third quarter 2001, the Company continued its restructuring efforts,
including the write-down of additional fixed assets and other items, which
resulted in a charge of $3.8 million.
Extraordinary gains
During the second quarter 2001, the Company negotiated with various creditors to
settle liabilities for less than the recorded invoices. These settlements
resulted in an extraordinary gain of approximately $9.0 million.
15
During the third quarter 2001, the Company restructured and reduced its $11.0
million convertible note from Capital Ventures International (CVI). Under the
terms of the restructuring, the Company paid $2.2 million and issued a $1.5
million convertible promissory note. The promissory note will be due in 18
months and is convertible, at any time, into common stock at an exercise price
of $2.00 at the option of CVI. This settlement resulted in an extraordinary gain
of $6.5 million.
Impairment of cost-basis investments
During the first quarter 2001, the Company determined that certain of its
cost-basis investments were permanently impaired relative to their historical
values. As a result, the Company recognized an impairment charge of $18.8
million, which is included as a component of nonoperating income (expense) in
the accompanying September 30, 2001 consolidated statements of operations.
During the third quarter 2001, the Company, due to the continued deterioration
of the stock market, determined that certain of its cost-basis investments were
permanently impaired relative to their historical values. As a result, the
Company recognized an additional impairment charge of $9.4 million.
Permanent impairments in the Company's cost-basis investments were determined by
examining the operations of each company, and when possible, by reviewing recent
private-placement valuations for comparable companies and by obtaining
professional business valuations.
Note 5. Unusual Item:
In April 2001, the Company settled potential claims held by Mr. Dwayne Walker,
the Company's Chairman and Chief Executive Officer, against the Company arising
from the withdrawal of Mr. Walker's shares of the Company's common stock from
the Company's secondary public offering completed in February 2000. The terms of
the settlement are set forth in a letter agreement dated as of April 5, 2001
between the Company and Mr. Walker.
The settlement provided that the Company purchase 17,467 shares of its common
stock from Mr. Walker in exchange for the tender of a $3.8 million note payable
from the Company (Company Note). In connection with the settlement, the Company
agreed to consolidate all of Mr. Walker's outstanding promissory notes to the
Company, executed by him since September 28, 1999, which totaled $4.5 million as
of December 31, 2000 and were recorded in Notes receivables from employees and
Subscriptions receivable. Principal and interest, at 7% per year, were due on
March 31, 2011. Following the Company's purchase of the 17,467 shares, Mr.
Walker endorsed the Company Note to the Company in partial satisfaction of the
new loan. In addition, Mr. Walker transferred 78,078 shares of Company stock to
the Company as additional payment of the loan. The Company agreed to reduce the
balance of the loan by the fair market value of the 78,078 shares on the date of
the transfer. The Company immediately forgave the remaining obligation of
$537,000 Mr. Walker owed under the promissory note. As a result of the
settlement, the Company recognized a $4.5 million dollar expense in the first
quarter 2001. Mr. Walker also agreed to take on additional responsibilities as
President.
Note 6. Deferred Revenues:
Unearned revenues related to domain registrations represent the unexpired term
of registration fees, net of the referral commissions paid to affiliates and
referral partners, and are recognized ratably over the term of the registration.
Revenues from marketing and professional fees are recognized when services are
delivered, and licensing fees are recognized over the term of the agreement.
Note 7. Debt Obligations:
In March 1999, the Company entered into a loan and security agreement with a
financial institution for a term loan and line of credit. In May 1999, the
agreement was amended and restated to allow the Company to borrow up to $8.5
million at any one time, consisting of a $3.5 million term loan, a $4.0 million
bridge loan and a line of credit of up to $2.5 million. On May 10, 2001, the
Company repaid its obligation under the loan and security agreement. The
obligation was repaid with the cash that had been restricted for this purpose.
In conjunction with the loan and security agreement, the Company issued warrants
to acquire 4,800 shares of common stock at an exercise price of $93.75 per
share. The warrants are exercisable immediately and expire in March 2006. In May
16
1999, the Company issued to the financial institution additional warrants to
acquire 4,667 shares of common stock at an exercise price of $105.00 per share.
The warrants are exercisable immediately and expire in June 2006.
On May 19, 2000, the Company entered into a credit agreement with a commercial
bank, with a maximum commitment amount of $15.0 million to finance the purchase
of equipment, software and tenant improvements. On April 2, 2001, the Company
repaid its obligation under the credit agreement. The obligation was repaid with
the cash that had been restricted for this purpose.
On September 28, 2000, the Company sold $20.0 million of convertible notes
(Convertible Notes) and warrants to CVI pursuant to a securities purchase
agreement (Securities Purchase Agreement). The notes had a one-year term. On
October 26, 2000, the Company filed a registration statement on Form S-3 with
the SEC, which was declared effective on December 4, 2000. Also, the Company
issued warrants to purchase 270,043 shares of common stock to CVI at an exercise
price of $155.55 per share. The warrants were immediately exercisable and
expired five years from closing. These warrants were valued at $9.4 million and
were recorded as common stock warrants in the accompanying December 31, 2000
consolidated balance sheets. The notes were valued at $10.6 million. Immediately
after the effective date, $5.0 million of the notes were converted into common
stock. In May 2001, $4.0 million of the notes were converted into common stock.
The terms of the notes provided for conversion to common stock at a conversion
price of $25.23 per share.
On April 3, 2001, the Company received a notice of default from CVI for an
alleged violation of certain covenants of the Securities Purchase Agreement. The
notice of default demanded that the Company redeem the convertible notes on or
before April 9, 2001 for an amount equal to $17.25 million. The Company
responded to the notice of default on April 4, 2001 and denied that an event of
default occurred under the Convertible Notes. CVI then filed suit against the
Company on May 22, 2001 in the United States District Court for the Southern
District of New York under Civil Action No. 01CV-4390.
On July 25, 2001, the Company entered into a settlement agreement with CVI
(Settlement Agreement) with respect to certain claims arising out of the
Securities Purchase Agreement. As a result of the Settlement Agreement, the $11
million convertible notes and all warrants were retired. The Company paid $2.2
million and delivered a $1.5 million convertible promissory note (Settlement
Note). The Settlement Note has a term of 18 months and is convertible, at any
time, into common stock at an exercise price of $2.00 at the option of CVI. CVI
agreed that, upon the payment of the $2.2 million and the delivery of the
Settlement Note, the Company satisfied all of past, present and future
obligations to CVI under the Securities Purchase Agreement and all related
documents other than the Registration Rights Agreement. However, CVI did not
release its claim against the Company, certain current and former officers and
directors for the alleged security violations and for fraudulent inducement. CVI
agreed not to assert a claim in excess of the principal amount of $20 million
less any value received pursuant to the Settlement Agreement. The Company is
vigorously defending against these claims. Nevertheless, an unfavorable
resolution of these claims could have a material adverse effect on the Company
in one or more future periods.
Note 8. Equity Financing:
On July 10, 2001, the Company entered into a Common Stock Purchase Agreement
(Agreement) with Cody Holdings Inc. (Investor) to provide the Company with up to
$18 million in equity financing (Equity Line). Under the terms of the Agreement,
the Company will have the right, but not the obligation during the 18-month term
of the Agreement, to obtain equity financing through the issuance of common
stock to the Investor in a series of periodic draw downs at a discount to the
market price at the time of sale to the Investor. The maximum available amount
for draw down each period is determined using a formula that utilizes a weighted
average stock price and stock volume over a sixty-day period. The shares of
common stock may be sold to the Investor during this period at times and in
amounts, subject to certain minimum and maximum volumes, determined at the
discretion of the Company. If the Company chooses to draw down on the Equity
Line, it will use the proceeds of the financing for general corporate purposes.
The Company filed a registration statement on Form S-1 to effect the
registration of these shares prior to drawing on this equity line, and the
registration statement was declared effective on September 28, 2001.
In connection with the Equity Line, the Company also issued to the Investor a
warrant to purchase up to 350,000 shares of the common stock at an exercise
price of $0.57 per share (Warrants). The Warrants have a term of five years and
17
the exercise price of the Warrants is subject to antidilution adjustments. The
Company also issued warrants to purchase 350,000 shares of the common stock at
an exercise price of $0.57 per share to a placement agent, and certain of its
affiliates, as a finder's fee (Placement Agent Warrants). The Placement Agent
Warrants also have a term of five years. The Warrant and the Placement Agent
Warrants and the common stock issuable upon the exercise of such warrants were
not registered under the Securities Act of 1933, and were granted pursuant to an
exemption set forth in Section 4(2) thereunder.
Note 9. Segment Information:
The Company's segment information for each of the nine- months ended September
30, 2001 and 2000, (in thousands):
<Table>
<Caption>
Nine months ended September 30,
--------------------------------
2001 2000
------------- --------------
Revenues:
Continuing operations $ 4,726 $ 1,004
Operations closed in 2001 13,256 78,042
-------------- --------------
17,982 79,046
-------------- --------------
Cost of revenues:
Continuing operations 334 56
Operations closed in 2001 4,368 43,688
-------------- --------------
4,702 43,744
-------------- --------------
Gross Profit:
Continuing operations 4,392 948
Operations closed in 2001 8,888 34,354
-------------- --------------
$ 13,280 $ 35,302
============== ==============
</Table>
Note 10. Option Repricing and Exchange Programs and Grants:
In April 2001, the Company repriced options to purchase 302,053 shares issued in
December 2000 from a price of $11.70 to a price of $1.35. This repricing will
result in variable accounting treatment for these stock options. Variable
accounting treatment will result in unpredictable stock-based compensation
dependent on fluctuations in quoted prices for the Company's common stock.
In April 2001, the Company offered a voluntary stock option exchange program to
its employees. The plan allows employees, if they so choose, to exchange three
options for one option priced at $1.35 per share. The vesting period will be
quarterly over the next four quarters. This exercise price change will result in
variable accounting treatment for these stock options. Variable accounting
treatment will result in unpredictable amounts of stock-based compensation
charges dependent on fluctuations in quoted prices for the Company's common
stock.
On July 30, 2001, the Company offered a voluntary stock option exchange program
to its employees. The plan allows employees, if they so choose, to exchange two
options for one option to be priced at market price in August 2001. The vesting
period will be quarterly over the next four quarters. Additionally, the Company
offered 1,560,000 stock options with an exercise price of $0.25 per share to its
employees. The vesting period will be monthly over three quarters. The options
covered under the exchange program and these grants will result in variable
accounting treatment for these stock options. Variable accounting treatment will
result in unpredictable stock-based compensation dependent on fluctuations in
quoted prices for the Company's common stock.
Note 11. Litigation:
On December 20, 2000, an action was initiated in Los Angeles Superior Court
styled Futurist Entertainment, Inc. v. Network Commerce, Inc., Jackie Sutphin,
SpeedyClick.com, Case No. BC242139. In the complaint plaintiff alleged, among
other things, breach of contract and business torts against defendants relating
to a Development and Website Agreement between Futurist Entertainment, Inc.
(Futurist) and Network Commerce dated February 25, 2000. The website was to
serve as the official website for the Jackson 5's upcoming album and world tour.
Plaintiff alleged damages "in an amount yet to be ascertained, but in no event
less than $4,400,000." On July 9, 2001, the Company and Futurist entered into a
Settlement Agreement. Under the terms of the settlement, Futurist and the
Company entered into a mutual release of claims and the lawsuit was dismissed
with prejudice.
18
On May 10, 2001, Jan Sherman and other shareholders filed suit against the
Company and Mr. Walker, the Company's chairman, chief executive officer and
president, alleging violations of federal securities laws. The lawsuit seeks
unspecified damages and certification of a class consisting of purchasers of the
Company's common stock during the period from September 28, 1999 through April
16, 2001. Subsequently, the following similar lawsuits were filed: Joseph
Carreiro v. Network Commerce, Inc. and Dwayne M. Walker, C01-0767L (filed May
25, 2001); Stephen Leong v. Network Commerce, Inc. and Dwayne M. Walker,
C01-0770L (filed May 25, 2001); Alan Danse, et al. v. Dwayne M. Walker and
Network Commerce, Inc., C01-852L (filed June 7, 2001); James Lindsay v. Dwayne
M. Walker and Network Commerce, Inc., C01-0918R (filed June 20, 2001); and Kelly
Christianson v. Dwayne M. Walker and Network Commerce, Inc., C01-1063L (filed
July 11, 2001). Also, a class action lawsuit was filed July 16, 2001 in the U.S.
District Court for the Southern District of California, David Breidenback v.
Dwayne M. Walker and Network Commerce, Inc., Case No. '01 CV 1270 JM (NLS).
Additionally, on September 26, 2001, Jan Sherman, James Michaelson and Jason
Elkin filed a complaint captioned In re: Network Commerce Inc. Securities
Litigation (Case No. C01-0675L) in the United States District Court for the
Western District of Washington. The lawsuit seeks unspecified damages and
certification of a class consisting of purchasers of the Company's common stock
during the period from September 28, 1999 through April 16, 2001. The complaint
names as defendants the Company, Dwayne M. Walker, certain current and former
directors and certain underwriters. The Company is vigorously defending these
lawsuits. Nevertheless, an unfavorable resolution of these lawsuits could have a
material adverse effect on the Company in one or more future periods.
On September 26, 2001 the Company filed a lawsuit against Return on Investment
Corporation ("ROI") in the Superior Court of King County, Washington. In the
complaint the Company alleges ROI's breach of implied duties of good faith and
fair dealing, and breach of warranty arising out of the Agreement and Plan of
Merger and Exchange of Stock dated as of May 11, 2001 which provided for ROI's
acquisition of the Company's subsidiary, GO Software, Inc. The Company is
seeking specific performance of a clause in the Merger Agreement requiring ROI
to register with the Securities and Exchange Commission certain shares of ROI's
Common Stock that were delivered to the Company under the Merger Agreement.
Given the preliminary stage of this proceeding, the Company cannot provide an
evaluation of the likelihood of a favorable outcome for the Company.
Note 12. 1 for 15 Reverse Stock Split:
On June 15, 2001, the Company completed a 1-for-15 reverse split of the
Company's outstanding common stock. Upon the effectiveness of the reverse stock
split, 15 shares of Common Stock were converted and reclassified as one share of
post-split common stock, and each existing stock certificate represented
one-fifteenth the number of shares shown thereon. Fractional shares were rounded
up. The reverse stock split was effective and applied to shareholders of record
immediately prior to the opening of trading on the Nasdaq National Market on
Monday, June 18, 2001.
Note 13. NASDAQ Delisting :
On July 26, 2001 the Company attended a hearing before the Nasdaq Listings
Qualification Panel to appeal the Nasdaq Staff Determination Notice dated June
15, 2001 that informed the Company that the Company's stock would be delisted
from the Nasdaq National Market. As of August 29, 2001, the Company's stock was
delisted from The Nasdaq National Market. The Company's common stock is
presently listed on the OTC Bulletin Board under the symbol "NWKC".
Note 14. Subsequent Events:
Stock Option Grants
During October 2001, the Company granted 2,395,000 stock options with exercise
prices ranging from $0.10 to $0.14 per share to its employees. The options vest
ratably over six months with vesting commencing on the grant date. The stock
options covered under these grants will result in variable accounting treatment.
Variable accounting treatment will result in unpredictable stock-based
compensation dependent on fluctuations in quoted prices for the Company's common
stock.
Equity Financing
In October 2001, the Company initiated a draw down of $25,000 under the terms of
the Company's Agreement with Cody Holdings Inc.
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The matters discussed in this report contain forward-looking statements that
involve known and unknown risks and uncertainties, such as statements of our
plans, objectives, expectations and intentions. Words such as "may," "could,"
"would," "expect," "anticipate," "intend," "plan," "believe," "estimate," and
variations of such words and similar expressions are intended to identify such
forward-looking statements. You should not place undue reliance on these
forward-looking statements, which are based on our current expectations and
projections about future events, are not guarantees of future performance, are
subject to risks, uncertainties and assumptions (including those described
below) and apply only as of the date of this report. Our actual results could
differ materially from those anticipated in the forward-looking statements.
Factors that could cause or contribute to such differences include, but are not
limited to, those discussed below in "Additional Factors That May Affect Future
Results" as well as those discussed in this section and elsewhere in this
report, and the risks discussed in the "Risk Factors" section included in our
December 31, 2000 10-K filed on April 17, 2001, as amended by Form 10-K/A on
April 30, 2001, with the Securities and Exchange Commission.
Overview
We are a technology infrastructure and services company that offers a
comprehensive technology and business services platform that includes domain
registration, hosting, commerce and online marketing services. Through December
31, 2000, we operated two commerce networks, known as the Network Commerce
Consumer Network, which aggregated merchants and shoppers over a distributed
network of Web sites, and the Network Commerce Business Network, which was
designed to enable businesses to engage in online activities and transactions
with other businesses and an eBusiness Services division, which provided
consulting, custom commerce solutions, and integrated marketing services for
businesses conducting commerce online.
In January 2001, we restructured these groups into NCI Marketing and NCI Hosting
and shutdown the eBusiness Services division. NCI Marketing includes online
marketing services and various online marketplaces focused on gaming and
entertainment. The gaming and entertainment online marketplaces were closed in
March 2001. NCI Hosting includes domain registration, hosting, and other
business services. As a result of this restructuring, certain of our previous
business units and offerings were shut down. The restructuring efforts through
September 2001 have resulted in the shutdown of SpeedyClick.com, and the sale of
Ubarter, which were components of NCI Marketing, and the sales of GO Software
and Internet Domain Registrars, which were components of NCI Hosting. Our
current focus is domain registration, hosting, commerce and online marketing
services as well as licensing certain of our software patents.
On June 15, 2001, we completed a 1-for-15 reverse split of our outstanding
common stock. Upon the effectiveness of the reverse stock split, 15 shares of
Common Stock were converted and reclassified as one share of post-split common
stock, and each existing stock certificate represented one-fifteenth the number
of shares shown thereon. Fractional shares were rounded up. The reverse stock
split was effective and applied to shareholders of record immediately prior to
the opening of trading on the Nasdaq National Market on Monday, June 18, 2001.
All common stock share and per share amounts have been adjusted to reflect the
reverse split.
We believe that our cash reserves and cash flows from operations will be
adequate to fund our operations through December 2001. Consequently, we will
require substantial additional funds to continue to operate our business beyond
that period. Many companies in the Internet industry have experienced difficulty
raising additional financing in recent months. Additional financing may not be
available to us on favorable terms or at all. If additional financing is not
available, we may need to change our business plan, sell or merge our business,
or face bankruptcy. In addition, the issuance of equity or equity-related
securities will dilute the ownership interest of existing stockholders and the
issuance of debt securities could increase the risk or perceived risk of our
company.
Our condensed consolidated financial statements for the nine months ended
September 30, 2001 were prepared on a going concern basis, which contemplates
the realization of assets and the settlement of liabilities in the normal course
of business. We have incurred net losses of $194.3 million for the nine-month
period ended September 30, 2001 and have accumulated deficits of $561.6 million
as of September 30, 2001. We have continuously incurred net losses from
operations and, as of September 30, 2001, have working capital of $1.4 million.
These factors raise substantial doubt about our ability to continue as a going
concern. The consolidated financial statements do not include any adjustments
20
that might result from the outcome of this uncertainty. Our plans to mitigate
the risk of this uncertainty include, but are not limited to, one or more of the
following:
o engaging a financial advisor to explore strategic alternatives, which
may include a merger, additional asset sales, or another comparable
transaction;
o raising additional capital to fund continuing operations by private
placements of equity and/or debt securities or through the
establishment of other funding facilities; and
o forming a joint venture with a strategic partner or partners to
provide additional capital resources to fund operations.
Additional cost-cutting measures could include additional lay-offs and/or the
closure of certain business units.
We were incorporated in January 1994 and initially operated as a computer
services company. In 1996, we began to change the focus of our business to
conducting commerce over the Internet. In April 1999, we changed our name from
TechWave Inc. to ShopNow.com Inc. In May 2000, we changed our name to Network
Commerce Inc. We consummated five acquisitions during 1999 and seven additional
acquisitions during 2000. During the fourth quarter 2000, we announced the lay
off of 209 employees through staff reductions and from the closure of Media
Assets, Inc., AXC Corporation, Cortix, Inc. and WebCentric, Inc. In addition, we
initiated a restructuring plan to lower costs and improve profitability, which
has resulted in the shutdown of ShopNow.com and SpeedyClick.com, the sale of
assets of Ubarter.com, Inc. and Internet Domain Registrars Corp. and the
disposition of GO Software Inc.
Since restructuring in January 2001, we derive our revenues primarily from the
sale of online marketing services within NCI Marketing and domain registration,
hosting and commerce services within NCI Hosting. Revenues from online marketing
services are recognized as the services are delivered to the merchants over the
term of the agreement, which typically range from one to three months. Revenues
from domain registrations are recognized over the registration term, which
typically range from one to three years. Unearned revenues are classified as
either current or long-term deferred revenues depending on the future
recognition of those revenues. Revenues from hosting and commerce services are
recognized over the term of the agreements, which are generally twelve months.
Through December 31, 2000, we have derived substantially all of our revenues
from the Network Commerce Consumer Network, the Network Commerce Business
Network and from providing services to businesses.
Revenues from the Network Commerce Consumer Network were generated primarily
from the sale of online marketing services, leads and orders, advertising and
merchandising. Revenues from these agreements were recognized as the media or
services were delivered to the merchants over the term of the agreements, which
typically ranged from one to twelve months. Where billings exceeded revenues
earned on these agreements, the amounts were included as deferred revenue. We
bore the full credit risk with respect to these sales. In certain circumstances
we offered products directly to shoppers. In these instances where we acted as
merchant-of-record, we recorded as revenue the full sales price of the product
sold and the full cost of the product to us as cost of revenues, upon shipment
of the product. Shipping charges billed to the customer were included in
revenues, and the costs incurred by us to ship the product to the customer were
included in cost of sales. We have either sold or shut down the operations of
this network with the exception of online marketing services.
Revenues from the Network Commerce Business Network were derived primarily from
providing domain registration, web-enablement services, commerce-enablement
services, transaction processing, advertising and technology licensing to
businesses. Revenues derived from domain registration fees, which are typically
paid in full at the time of the sale are recognized over the registration term,
which typically range from one to three years. Unearned revenues are classified
as either current or long-term deferred revenues depending on the future
recognition of these revenues. Revenues from the sale of advertising and
merchandising products and services were recognized similar to those sold on the
Network Commerce Consumer Network. Revenues from transaction fees were earned
from member businesses that transacted over the online exchange system as well
as from products sold to other member merchants of the online exchange system.
Revenues from services were generated principally through development fees,
domain registration fees, hosting fees and sales and marketing services. These
services were purchased as a complete end-to-end suite of services or
separately. We recognized revenues from the development of custom applications
and online stores and marketing projects on a percentage of completion basis
over the period of development or the period of the marketing project. These
projects generally ranged from two to twelve months. Hosting contracts typically
have a term of one year, with fees charged and earned on a monthly basis. We
bore the full credit risk with respect to these sales. Anticipated losses on
these contracts were recorded as identified. Contract costs included all direct
labor, material, subcontract and other direct project costs and certain indirect
costs related to contract performance. Changes in job performance, job
21
conditions and estimated profitability, including those arising from contract
penalty provisions and final contract settlements that may result in revision to
costs and income, were recognized in the period in which the revisions were
determined. Unbilled services typically represented amounts earned under our
contracts not billed due to timing or contract terms, which usually consider
passage of time, achievement of certain milestones or completion of the project.
Where billings exceeded revenues earned on contracts, the amounts were included
as customer deposits, as the amounts typically related to ancillary services,
whereby we were acting in an agency capacity. Fee revenue from ancillary
services provided by the services division was recognized upon completion of the
related job by the applicable third party vendor. We have either sold or
shutdown the operations of this network with the exception of domain
registration and hosting.
Revenues were also generated from fees paid to us by businesses and merchants
who licensed our technology; transaction processing, fraud prevention, and
online payment gateways, as well as other e-commerce enabling technologies.
Revenues included licensing fees, per-transaction fees and, in certain cases,
monthly hosting and maintenance fees, which are recognized in the period earned.
Revenues generated from technology licensing were recognized in accordance with
American Institute of Certified Public Accountants, Statement of Position 97-2,
"Software Revenue Recognition." Where billings exceeded revenues earned on these
contracts, the amounts were included as deferred revenue. Businesses and
merchants who utilized our payment processing technologies acted as the
merchant-of-record and bore the full credit risk on those sales of goods and
services. We sold this business unit during the second quarter 2001.
We recognized revenues from barter transactions when earned. We valued the
barter transactions based on the value of the consideration received from the
customer or from the value of the services provided to the customer, whichever
was more readily determinable. During the nine months ended September 30, 2001,
we recognized approximately $1.4 million in revenues on such transactions.
We recognized revenues from sale of online marketing services, leads and orders,
advertising and merchandising in which we received equity in our customer. We
valued the equity received from these transactions as cost-basis investments
based on the value of the consideration received from the customer or from the
value of the services provided to the customer, whichever was more readily
determinable. We monitor these cost-basis investments for impairment. When
cost-basis investments are deemed to be permanently impaired, the difference
between cost and market value is charged to operations. There can be no
assurance that our investments in these early-stage technology companies will be
realized. During the nine months ended September 30, 2001, we recognized
approximately $205,000 in revenues on such equity transactions.
Cost of revenues generated from the Network Commerce Consumer Network included
the portion of our Internet telecommunications connections that were directly
attributable to traffic on the Network Commerce Consumer Network and the direct
labor costs incurred in maintaining and enhancing our network infrastructure. In
order to fulfill our obligations under our registrations, lead and order
delivery advertising programs, we occasionally purchased consumer traffic from
third party networks by placing on their Web sites advertisements that, when
clicked on by a visitor, sent the visitor to the Network Commerce Consumer
Network. Any shopping traffic that we purchased from a third party that was used
to fulfill these obligations was included as cost of revenues. Cost of revenues
on the products that we sold as merchant-of-record included the cost of the
product, credit card fees and shipping costs. Cost of revenues generated from
providing services included all direct labor costs incurred in connection with
the provision of services, as well as fees charged by third-party vendors that
had directly contributed to the design, development and implementation of our
services. Cost of revenues generated from licensing e-commerce enabling
technologies and from our proprietary business-to-business portal consisted
primarily of telecommunications costs and direct labor costs incurred in
maintaining and enhancing our network infrastructure.
22
Acquisitions
In June 1999, we acquired GO Software, Inc. (GO). GO develops and markets
transaction processing software for personal computers that can function on a
stand-alone basis or can interface with core corporate accounting systems. We
paid GO shareholders $4.7 million in cash, issued a $1.0 million promissory note
bearing interest at 10%, and issued 74,917 shares of common stock, valued at
$128.10 per share, for a total purchase price of $15.4 million. The acquisition
was accounted for using the purchase method of accounting. Of the excess
purchase price of approximately $14.4 million, $13.8 million was allocated to
acquired technology and $556,000 was allocated to goodwill, which were both
being amortized over a three-year life. The note bore interest at 10% and was
repaid in full upon completion of our initial public offering completed in
September 1999. In March 2001, we recognized an impairment charge of $1.8
million to write-down the carrying value to the approximate net realizable
value. On May 14, 2001, pursuant to an Agreement and Plan of Merger and Exchange
of Stock dated as of May 11, 2001, we completed the sale of GO to Return on
Investment Corporation (ROI) through its wholly-owned subsidiary for $1.0
million in cash and $3.0 million in ROI common stock. As part of the merger
transaction, ROI was required to file with the Securities and Exchange
Commission a registration statement to effect a registration of the common stock
received by us in the merger. In third quarter 2001, ROI paid us $500,000, plus
interest, pursuant to the terms and provisions of a promissory note issued by
ROI to us at the closing of the merger transaction. In exchange for payment of
the promissory note, we returned to ROI 166,667 shares of ROI common stock,
valued at $3.00 per share, received by us in the merger transaction.
Also in June 1999, we acquired CardSecure, Inc. (CardSecure) for a purchase
price of approximately $3.5 million. CardSecure is a developer of e-commerce
enabled Web sites. The acquisition was accounted for using the purchase method
of accounting. The excess purchase price of approximately $3.5 million was
allocated to acquired technology and is being amortized over a three-year life.
In September 2001, we recognized an impairment charge of $526,000 to write-down
the carrying value to the approximate net realizable value.
On November 12, 1999, we acquired SpeedyClick, Corp. (SpeedyClick), a California
corporation, for $55.6 million of cash, common stock and common stock options.
SpeedyClick, a privately held company, maintained an Internet Web site that
focused on entertainment and interactivity. In connection with this acquisition,
we issued to the shareholders of SpeedyClick 253,283 shares of common stock
valued at $199.65 per share. Options to purchase SpeedyClick common stock were
assumed by us and converted into 10,502 options to purchase our common stock. We
also paid cash consideration of $3.0 million to the owners of SpeedyClick. We
accounted for this transaction as a purchase. Of the $55.6 million in
consideration paid, approximately $27.9 million was allocated to proprietary
concepts, $14.7 million to customer lists and $13.0 million to goodwill. These
intangible assets were being amortized over a three-year life. However, in March
2001, we decided to shut down the operations and wrote-off the remaining
intangible assets of $37.2 million.
On December 3, 1999, we acquired Cortix, Inc. (Cortix), an Arizona corporation
doing business as 20-20Consumer.com, for $14.4 million of cash and common stock.
Cortix, a privately held company, provided comparison shopping services
including online reviews and ratings for commerce-oriented businesses, merchants
and products. In connection with this acquisition, we issued to the shareholders
of Cortix 47,249 shares of common stock valued at $282.15 per share together
with cash consideration of $1.0 million. We accounted for this transaction as a
purchase. Of the $14.4 million in consideration paid, approximately $11.3
million was allocated to acquired technology, $1.6 million to customer lists and
$1.3 million to goodwill. These intangible assets were being amortized over a
three-year life. However, in December 2000, we decided to shut down the
operations and wrote-off the remaining intangible assets of $9.1 million.
On December 17, 1999, we acquired WebCentric Inc. (WebCentric), a Kansas
corporation doing business as bottomdollar.com, for $41.6 million of cash,
common stock, and common stock options. WebCentric, a privately held company,
developed e-commerce integration technology and applications, including a
comparison shopping engine that allowed consumers to search and compare the
products and services of several leading Internet merchants. In connection with
this acquisition, we issued to the shareholders of WebCentric 144,127 shares of
common stock valued at $253.35 per share together with approximately $1.4
million of cash. In addition, we issued replacement stock options to purchase an
aggregate of 8,103 shares of our common stock to certain employees and owners of
WebCentric. We accounted for this transaction as a purchase. Of the $40.2
million in consideration paid, approximately $31.8 million was allocated to
acquired technology, $3.3 million to customer lists and $4.6 million to
goodwill. These intangible assets were being amortized over a three-year life.
However, in December 2000, we decided to shut down the operations and wrote-off
the remaining intangible assets of $24.3 million.
23
On January 13, 2000, through a wholly owned Nova Scotia company, we acquired
Pronet Enterprises Ltd. (Pronet), a Canadian company, for approximately $12.8
million, consisting of $3.2 million in cash, $2.2 million in non-cash deferred
tax liabilities assumed and $7.4 million in common stock and common stock
options issued to Pronet shareholders. Pronet, a privately held company,
operated a business-to-business portal and marketplace that aggregates
businesses that seek to transact with one another. In connection with this
acquisition, we issued to the shareholders of Pronet 10,834 shares of common
stock, valued at $264.00 per share. In addition, we issued options to purchase
23,445 shares of common stock to the two principal shareholders of Pronet. We
accounted for this transaction as a purchase. Of the $12.8 million in
consideration paid, approximately $6.3 million was allocated to acquired
technology, $2.7 million to customer lists and $3.8 million to goodwill. These
intangible assets were being amortized over a three-year life. In January 2001,
we revised our estimated useful life for these assets and amortized the
remaining carrying value of Pronet (approximately $9.1 million as of December
31, 2000) over the first six months of 2001.
On January 18, 2000, we acquired AXC Corporation (AXC), a Washington
corporation, for approximately $17.9 million, consisting of $2.2 million in
cash, $4.1 million in non-cash deferred tax liabilities assumed and $11.6
million in common stock and common stock options issued to AXC shareholders.
AXC, a privately held company, provided e-commerce consulting services to
businesses. In connection with this acquisition, we issued to the shareholders
of AXC 36,020 shares of common stock valued at $264.00 per share. In addition,
we issued replacement stock options to purchase an aggregate of 4,806 shares of
our common stock to certain employees and owners of AXC. We accounted for this
transaction as a purchase. Of the $17.9 million in consideration paid,
approximately $7.2 million was allocated to assembled workforce, $4.9 million to
customer lists, $5.0 million to goodwill and $800,000 to working capital. These
intangible assets were being amortized over a three-year life. However, in
December 2000, we decided to shut down the operations and wrote-off the
remaining intangible assets of $14.2 million.
On April 11, 2000, we acquired FreeMerchant.com, Inc. (FreeMerchant), a Delaware
corporation, for approximately $38.1 million, consisting of $2.0 million in
cash, $10.0 million in non-cash deferred tax liabilities assumed, $500,000 of
debt assumed and $25.6 million in common stock and common stock options issued
to FreeMerchant stockholders. FreeMerchant, a privately held company, has
developed online store-builder technology for small- to medium-sized merchants
who seek a low-cost point of entry e-commerce and provides hosting services to
those merchants. In connection with this acquisition, we issued to the
shareholders of FreeMerchant 171,582 shares of common stock, valued at $132.00
per share. In addition, we issued options to purchase 19,574 shares of common
stock to certain FreeMerchant stockholders and employees. We accounted for this
transaction as a purchase. Of the $38.1 million in consideration paid,
approximately $23.0 million was allocated to acquired technology, $4.1 million
to assembled workforce and $11.0 million to goodwill. These intangible assets
are being amortized over a three-year life. In March 2001, we recognized an
impairment charge of $22.4 million to write-down the carrying value to the
approximate net realizable value. In September 2001, we recognized an additional
impairment charge of $2.6 million to write-down the carrying value to the
approximate net realizable value.
On June 2, 2000, we acquired Ubarter.com Inc. (Ubarter), a Nevada corporation,
pursuant to an agreement and plan of merger dated January 20, 2000, for
approximately $61.7 million, consisting of $875,000 in cash, $11.4 million in
non-cash deferred tax liabilities assumed, $978,000 of net liabilities assumed,
$7.6 million in the cancellation of debt between Ubarter and us, and $40.8
million in common stock and common stock warrants issued to Ubarter stockholders
and creditors. Ubarter was a business-to-business e-commerce enterprise, which
utilized the Ubarter Dollar as payment for products and services by its member
businesses over its proprietary barter exchange system. In connection with this
acquisition, we issued to the stockholders and creditors of Ubarter a total of
178,859 shares of common stock valued at approximately $226.50 per share. In
addition, we issued warrants to purchase 3,457 shares of common stock to certain
Ubarter stockholders, employees and creditors. We accounted for this transaction
as a purchase. Of the $61.7 million in consideration paid, approximately $7.5
million was allocated to acquired technology, $2.5 million to assembled
workforce, $25.1 million to proprietary concept, $2.5 million to customer lists,
and $24.0 million to goodwill. These intangible assets were being amortized over
a three-year life. Early in the fourth quarter 2000, we launched a new user
interface and back-end management system for the Ubarter.com merchant exchange,
and executed various marketing efforts to promote the new system. These efforts
did not stimulate growth in the Ubarter economy as expected, which led to a
revision in our original forecasts and projections for Ubarter. These revised
forecasts indicated that future expected cash flows from this business unit were
less than the carrying value of its intangible assets, thus triggering an
impairment event in December 2000. At that time, the carrying value of Ubarter's
intangible assets including goodwill was $51.6 million. Based on recent
comparable sales of other barter exchange systems, we determined the fair value
of Ubarter.com to be approximately $5 million. As a result, we recognized an
24
impairment charge of $46.6 million in December 2000. In February 2001, we sold
the assets of the Canadian-based operations of Ubarter and recognized a loss of
$2.3 million. In March 2001, we recognized an impairment charge of $4.2 million
to write-down the remaining carrying value to the approximate net realizable
value. In June 2001, we sold the assets of the US-based operations of Ubarter
and recognized a loss of $1.2 million on the sale.
On August 24, 2000, we acquired Ivebeengood.com, d.b.a. UberWorks (UberWorks), a
wholly owned subsidiary of Trilogy, Inc. (Trilogy), for approximately $22.8
million, consisting of $2.4 million accrued as non-cash deferred compensation,
$5.9 million in non-cash deferred tax liabilities assumed and $14.5 million in
common stock and common stock options issued to UberWorks shareholders and
employees. UberWorks was a developer of multi-merchant e-commerce purchasing
tools and universal shopping cart technology. In connection with this
acquisition, we issued to the shareholders of UberWorks a total of 173,438
shares of common stock valued at approximately $91.95 per share. Of the total,
28,217 are being held back by us to be subsequently released based on time
vesting and on certain performance criteria yet to be achieved. The maximum term
of the retention is three years from the effective date of the acquisition. In
addition, we issued a warrant to Trilogy, with an exercise price of $0.000015
per share, to purchase additional shares of our common stock if, on the one-year
anniversary date of the acquisition, the shares currently held by Trilogy are
not worth at least $13.1 million. The maximum number of additional shares that
Trilogy was entitled to purchase under the terms of the warrant was 173,334. On
August 24, 2001, Trilogy exercised its right under the warrant and purchased
170,105 shares. We also issued options to purchase 16,545 shares of common stock
to certain UberWorks employees. We accounted for this transaction as a purchase.
Of the $22.8 million of consideration paid, approximately $12.3 million was
allocated to acquired technology, $2.4 million to deferred compensation,
$726,000 to assembled workforce and $7.3 million to goodwill. These intangible
assets were being amortized over a three-year life. However, in March 2001, we
decided to abandon the technology and wrote-off the remaining intangible assets
of $16.6 million.
On December 8, 2000, we acquired ePackets.Net, Inc. (ePackets) for approximately
$270,000, consisting of $150,000 in cash, $37,000 in common stock and common
stock options and $83,000 in net liabilities assumed. ePackets provided
permission-based one-to-one email solutions. In connection with this
acquisition, we issued to the shareholders of ePackets a total of 2,222 shares
of common stock. We accounted for this transaction as a purchase. The
consideration paid was allocated to acquired technology and was being amortized
over a three-year life. However, in March 2001, we decided to shut down the
operations and wrote-off the remaining intangible assets of $255,000.
On December 22, 2000, we acquired Internet Domain Registrars Corporation (IDR),
for approximately $23.6 million, consisting of $750,000 in cash, $6.1 million in
non-cash deferred tax liabilities assumed, $5.7 million in common stock and
$11.1 million in net liabilities assumed. IDR is a domain name infrastructure
company. In connection with this acquisition, we issued to the shareholders of
IDR a total of 510,000 shares of common stock, of which 66,667 were placed in
escrow for indemnification purposes. In addition, 218,734 shares were issued and
placed in escrow to be released to the former shareholders and certain employees
of IDR upon the achievement of established future revenue targets over an
eighteen month period, and 14,600 shares were issued to employees of IDR who
continued to be employed by IDR after the acquisition. Finally, 40,000 shares of
our common stock were issued at the closing to certain other persons in
connection with the settlement of potential claims against IDR and as
consideration of services rendered to IDR in connection with the acquisition.
The closing price of our common stock on December 22, 2000 was $10.35 per share.
We accounted for this transaction as a purchase. Of the $23.6 million of
consideration paid, approximately $10.5 million was allocated to proprietary
concept, $874,000 to domain name, $3.5 million to customer lists, $874,000 to
assembled workforce and $7.8 million to goodwill. These intangible assets were
being amortized over a three-year life. In March 2001, we recognized an
impairment charge of $17.6 million to write-down the remaining carrying value to
the approximate net realizable value. In June 2001, we sold substantially all of
the assets and certain liabilities of IDR to Verisign, Inc. and recognized a
gain of $6.3 million on the sale.
Results of Operations
Overview. In light of the recent instability within the technology and Internet
infrastructure sectors and our current position within those sectors, we lack
visibility to our future revenues and related costs of revenues. Additionally,
our ability to anticipate future trends in our operating expenses is impaired
due to possible required changes to our business plans or additional reduction
in expenses.
Revenues. Total revenues for the three- and nine- month periods ended September
30, 2001 were $1.6 million and $18.0 million compared to $33.4 million and $79.0
million for the comparable periods in 2000. The decrease was due primarily to
25
the shutdown of ShopNow.com, the elimination of product sales, and the sale of
IDR, GO and Ubarter Canada and USA. Revenue from continuing business units
during the three- and nine- month periods ending September 30, 2001 was $1.5
million and $4.7 million compared to $613,000 and $1.0 million during the
comparable periods in 2000.
Cost of Revenues. The cost of revenues for the three- and nine- month periods
ended September 30, 2001, were $454,000 and $4.7 million compared to $15.2
million and $38.4 million, before the unusual item of $5.3 million recognized
during the third quarter 2000, for the comparable periods in 2000. The decrease
in our cost of revenues was directly attributable to the decrease in revenues
during the same period and due to the shutdown of ShopNow.com, the elimination
of product sales, and the sale of IDR, GO and Ubarter Canada and USA, which were
all low profit margin operations.
Gross Profit. Gross profit for the three- and nine- month periods ended
September 30, 2001, was $1.1 million and $13.3 million compared to $18.3 million
and $40.6 million, before the unusual item of $5.3 million recognized during the
third quarter 2000, for the comparable periods in 2000. As a percent of
revenues, our gross margins were 71.5% and 73.9% compared to 54.6% and 51.4%,
before the unusual item of $5.3 million recognized during the third quarter
2000, for the comparable periods in 2000. This increase in gross profit
percentage was due primarily to the shutdown of ShopNow.com, the elimination of
product sales, and the sale of IDR, GO and Ubarter Canada and USA, which were
all low profit margin operations.
Sales and Marketing. Sales and marketing expenses consist primarily of costs
associated with marketing programs such as advertising and public relations, as
well as salaries and commissions. Sales and marketing expenses for the three-
and nine- month periods ended September 30, 2001 were $3.2 million and $27.2
million compared to $24.1 million and $70.2 million for the comparable periods
in 2000. The decrease was due primarily to elimination of nationwide television,
radio and print advertising during 2001, as well as eliminating the acquisitions
of traffic for our Consumer Network.
Research and Development. Research and development expenses consist primarily of
salaries and related costs associated with the development of new products and
services, the enhancement of existing products and services, and the performance
of quality assurance and documentation activities. Research and development
expenses for the three- and nine- month periods ended September 30, 2001 were
$1.3 million and $8.7 million compared to $6.7 million and $16.1 million for the
comparable periods in 2000. The decrease was primarily due to a decrease in
personnel and related costs during 2001.
General and Administrative. General and administrative expenses consist
primarily of salaries and other personnel-related costs for executive,
financial, human resources, information services and other administrative
personnel, as well as legal, accounting and insurance costs. General and
administrative expenses for the three- and nine- month periods ended September
30, 2001 were $2.7 million and $9.9 million compared to $3.5 million and $10.1
million for the comparable periods in 2000. The decrease was primarily due to a
decrease in personnel and related costs during 2001.
Amortization of Intangible Assets. Amortization of intangible assets resulting
from acquisitions is primarily related to the amortization of customer lists,
domain names, acquired technology, proprietary concepts, assembled workforce and
goodwill. Amortization of intangible assets expense for the three- and nine-
month periods ended September 30, 2001 was $1.0 million and $24.4 million
compared to $23.8 million and $55.6 million for the comparable periods in 2000.
This decrease was due primarily to the decrease in intangible assets and related
amortization expenses from the sale of businesses and the write-down of
intangible assets. Intangible assets acquired in business combinations are
amortized over a three-year period.
Stock-Based Compensation. Stock-based compensation expense is related to the
amortization of deferred compensation resulting from stock option grants to
employees with an option exercise price below the estimated fair market value of
our common stock as of the date of grant. Stock-based compensation expense for
the three- and nine- month periods ended September 30, 2001 was $498,000 and
$1.8 million compared to $1.5 million and $4.6 million for the comparable
periods in 2000. The amount of deferred compensation resulting from these grants
is generally amortized over a one- to three-year vesting period. As of September
30, 2001, we have $3.9 million of deferred compensation to be amortized over
future periods.
Restructuring and Other Impairment Charges. Restructuring and impairment charges
in the three- and nine- month periods ended September 30, 2001 were $3.8 million
26
and $65.9 million, respectively. During the first quarter 2001, we continued our
restructuring efforts, which commenced in December 2000, including the shutdown
of SpeedyClick, the sale of Ubarter Canada, which resulted in a loss of $2.3
million, the lay off of 245 employees, which resulted in severance and related
payroll charges of $580,000, the write-off of impaired goodwill and intangible
assets of $55.0 million, and of tenant improvements, fixed assets, software and
supporting technologies and infrastructure related to businesses that were shut
down of $13.1 million. During the second quarter 2001, we further restructured
our operations by selling Ubarter USA, IDR and GO for total proceeds of $6.0
million cash and 1 million shares of Return on Investment Corporation stock,
which is subject to lockup until November 2001. We recorded a gain in the second
quarter of $5.8 million related to these sales. The gains on these sales in the
second quarter resulted from the fact that we wrote down these business units by
$23.6 million in first quarter 2001, based on the best available evidence of
fair market value. On an aggregate basis, for the nine months ended September
30, 2001, we recognized losses totaling $18.5 million on the sale of these
business units. Additionally, we recognized gains totaling $3.1 million,
primarily from revising estimates on unused operating leases and adjustment of
other liabilities related to businesses previously shut down in first quarter
2001. During the third quarter 2001, we continued our restructuring efforts,
including the write-down of additional fixed assets and other items which
resulted in a charge of $3.8 million.
Impairment of Certain Long-Lived Assets. As part of the restructuring, we
determined that goodwill and intangible assets associated with acquired
businesses had a carrying value in excess of the potential sales value of the
business units. Impairment of certain long-lived assets for the three- and nine-
month periods ended September 30, 2001 were $3.8 million and $47.0 million,
respectively. There were no such charges for the comparable periods last year.
Unusual Item - Settlement of Claim. In April 2001, we settled potential claims
held by Mr. Dwayne Walker, our Company's Chairman, Chief Executive Officer and
President, against us arising from the withdrawal of Mr. Walker's shares of our
common stock from our secondary public offering completed in February 2000.
There were not such settlements in the comparable periods of 2000.
(Loss) Gain on Sale of Marketable Equity Securities. Loss on sale of marketable
equity securities for the three- and nine- month periods ended September 30,
2001 was $0 and $150,000 compared to gains of $4.2 million and $5.5 million for
the comparable periods in 2000.
Interest Income. Interest income is earned on our cash and cash equivalents and
short-term investments. Interest income for the three- and nine- month periods
ended September 30, 2001 was $90,000 and $713,000 compared to $1.2 million and
$4.1 million for the comparable periods in 2000.
Interest Expense. Interest expense is incurred on our outstanding debt
obligations and the accretion of convertible promissory note. Interest expense
for the three- and nine- month periods ended September 30, 2001 was $445,000
million and $6.0 million compared to $546,000 and $1.4 million for the
comparable periods in 2000. Interest expense for the three-month period ended
September 30,2001 decreased due to the decrease in our outstanding debt
obligations. Interest expense increased for the nine-month periods ended
September 30, 2001 due to the accretion of the convertible promissory note.
Impairment of Cost-Basis Investments. Impairment of cost-basis investments
occurs when we determine that certain of our cost-basis investments are
permanently impaired compared to their historical values. Impairment of
cost-basis investments for the three- and nine- month periods ended September
30, 2001 was $9.4 million and $28.2 million compared to $2.5 million and $2.5
million for the comparable periods in 2000.
Income Tax Benefit. The income tax benefit resulted principally from reductions
of deferred tax liabilities created as a result of business combinations. There
was no income tax benefit for the three- and nine- month periods ended September
30, 2001 compared to benefits of $15.7 million and $39.2 million for the
comparable periods in 2000. We do not expect to pay income taxes in the
foreseeable future.
Extraordinary Gains. During the third quarter 2001 we entered into a settlement
agreement with Capital Ventures International (CVI). In exchange for a $2.2
million payment and a $1.5 million promissory note, CVI agreed we had satisfied
all obligations under the Securities Purchase Agreement and all related
documents other than the Registration Rights Agreement, resulting in a $6.5
million gain. During the second quarter 2001, we negotiated with various
creditors to settle liabilities for less than the recorded invoices. These
settlements resulted in a gain of approximately $9.0 million.
27
Net Income (Loss). Net loss for three- and nine- month periods ended September
30, 2001 was $18.5 million and $194.3 million compared to $28.6 million and
$76.5 million for the comparable periods in 2000. The net loss for the three-
and nine- month periods ended September 30, 2001 was due primarily to impairment
charges related to cost-basis investments and intangible assets and
restructuring charges related to closure of business units. We expect to incur
additional net losses in 2001.
Liquidity and Capital Resources
Since inception, we have experienced net losses and negative cash flows from
operations. As of September 30, 2001, we had an accumulated deficit of $561.6
million. We have financed our activities largely through issuances of common and
preferred stock, from the issuance of short- and long-term obligations and from
capital leasing transactions for certain of our fixed asset purchases. Through
September 30, 2001, our aggregate net proceeds have been $272.2 million from
issuing equity securities and $52.3 million from issuing debt securities. As of
September 30, 2001, we had $3.1 million in cash, cash equivalents and short-term
investments, of which $233,000 of such amounts is characterized as restricted
cash to secure our obligations under certain letters of credit. As of September
30, 2001, we had $2.5 million in marketable equity securities. These marketable
equity securities are not highly liquid securities as they are thinly traded.
Our primary investment in marketable equity securities is in ROI, which is
subject to put and call provisions. The put provision provides us the right to
sell our shares in ROI to ROI should their stock price close less than $2.01 per
share and the call provision provides ROI the right to purchase our shares in
ROI should their stock price close above $3.99 per share. Additionally, the ROI
common stock shares are not currently registered with the Securities and
Exchange Commission.
Net cash used in operating activities was $31.6 million for the nine-month
period ended September 30, 2001, compared to $66.0 million for the same period
in 2000.
Net cash provided by investing activities was $39.7 million for the nine-month
period ended September 30, 2001, compared to net cash used in investing
activities of $59.9 million for the same period in 2000. The change was due
primarily to no purchases of short-term investments in the nine-month period
ended September 30, 2001, compared to the purchases of $130.8 million for the
same period in 2000, the decrease in the sales of short-term investments for the
nine-month period ended September 30, 2001 of $38.8 million, compared to $112.9
million for the same period in 2000, the decrease in the proceeds from sales of
investments for the nine-month period ended September 30, 2001 of $920,000,
compared to $9.2 million for the same period in 2000, the decrease in purchases
of property and equipment of $53,000 for the nine-month period ended September
30, 2001, compared to $18.2 million for the same period in 2000, the decrease in
investments in equity and debt securities and other assets of $4,000 for the
nine-month period ended September 30, 2001, compared to $15.0 million for the
same period in 2000, and the decrease in acquisition of businesses of nil for
the nine-month period ended September 30, 2001, compared to $18.1 million for
the same period in 2000.
Net cash used in financing activities was $16.7 million for the nine-month
period ended September 30, 2001, compared to cash provided by financing
activities of $132.2 million for the same period in 2000. The change was due
primarily to the repayment of line of credit of $10.1 million and repayment of
long-term debt obligations of $6.6 million for the period ended September 30,
2001 compared to the closing of our public offering on February 18, 2000 of
527,574 shares of common stock at $217.50 per share, which resulted in proceeds
to us net of underwriters' fees and commissions of $108.7 million, borrowings on
line of credit, net of loan fees paid of $9.1 million and proceeds of $20.0
million in debt financing for the nine-months ended September 30, 2000.
In March 1999, we entered into a loan and security agreement with a financial
institution for a term loan and line of credit. In May 1999, the agreement was
amended and restated to allow us to borrow up to $8.5 million at any one time,
consisting of a $3.5 million term loan (term loan), a $4.0 million bridge loan
and a line of credit of up to $2.5 million. On May 10, 2001, we repaid our
obligation under the loan and security agreement. The term loan balance was $1.4
million as of March 31, 2001. The obligation was repaid with the cash that had
been restricted for this purpose.
On May 19, 2000, we entered into a credit agreement with a commercial bank, with
a maximum commitment amount of $15.0 million to finance the purchase of
equipment, software and tenant improvements. On April 2, 2001, we repaid the
obligation under this credit agreement, which had a balance of $9.1 million as
of March 31, 2001. The obligation was repaid with the cash that had been
restricted for this purpose.
28
On September 28, 2000, we sold $20.0 million of convertible notes (Convertible
Notes) and warrants to CVI, a private institution, pursuant to a securities
purchase agreement (Securities Purchase Agreement). The notes had a one-year
term. The original conversion price for the notes was 95% of the average closing
bid price of our common stock during a 20-day trading period prior to the
conversion date (which automatically occurs upon the effectiveness of a
registration statement filed with the Securities and Exchange Commission),
subject to a maximum conversion price of the lower of our common stock's closing
bid price the day prior to closing or $112.50 per share. On October 26, 2000, we
filed a registration statement on Form S-3 with the Securities and Exchange
Commission, which was declared effective on December 4, 2000. Also at closing,
we issued warrants to purchase 270,043 shares of our common stock to the private
institution at an exercise price of $155.55 per share. The warrants were
immediately exercisable and expired five years from closing. Immediately after
the effective date, $5.0 million of the notes were converted into common stock.
The terms of the notes were also amended such that the conversion price was set
at $25.20 per share. In May 2001, $4.0 million of the notes were converted into
common stock
On April 3, 2001, we received a notice of default from CVI for an alleged
violation of certain provisions of Article VI of the Convertible Notes relating
to the breach of certain negative financial covenants contained in our Credit
Agreement with Imperial Bank and the breach by us of certain material terms of
the Securities Purchase Agreement dated as of September 28, 2000. The notice of
default demanded that we redeem the Convertible Notes on or before April 9, 2001
for an amount equal to $17.25 million, which amount represents 115% of the
aggregate principal amount of the remaining Convertible Notes. We responded to
the notice of default on April 4, 2001 and denied that an event of default
occurred under the Notes. If we become insolvent or enter into a liquidation
proceeding, after payment to our creditors there is likely to be insufficient
assets remaining for any distribution to shareholders.
On July 25, 2001, we restructured the $20 million convertible notes, with a face
value of $11 million and all warrants, with a payment of $2.2 million and
issuance of a $1.5 million non-interest bearing convertible promissory note
(Settlement Note). The Settlement Note has a term of 18 months and is
convertible, at any time, into common stock at an exercise price of $2.00 per
share at the option of the holder. Additionally, the restructuring eliminates
any event of default under the prior convertible notes. Additionally, CVI did
not release its claim against us, certain current and former officers and
directors for the alleged security violations and for fraudulent inducement. CVI
agreed not to assert a claim in excess of the principal amount of $20 million
less any value received pursuant to the Settlement Agreement. We are vigorously
defending against these claims. Nevertheless, an unfavorable resolution of these
claims could have a material adverse effect on us in one or more future periods.
On July 10, 2001, we entered into a Common Stock Purchase Agreement (Agreement)
with Cody Holdings Inc. (Investor) to provide us with up to $18 million in
equity financing (Equity Line). Under the terms of the Agreement, we will have
the right, but not the obligation during the 18-month term of the Agreement, to
obtain equity financing through the issuance of common stock to the Investor in
a series of periodic draw downs at a discount to the market price at the time of
sale to the Investor. The shares of common stock may be sold to the Investor
during this period at times and in amounts, subject to certain minimum and
maximum volumes, determined at our discretion. If we choose to draw down on the
Equity Line, we will use the proceeds of the financing for general corporate
purposes. We filed with the Securities and Exchange Commission a registration
statement on Form S-1 to effect the registration of these shares prior to
drawing on this equity line and the SEC declared the registration statement
effective on September 28, 2001. In October 2001, we initiated a draw down of
$25,000.
In connection with the Equity Line, we also issued to the Investor a warrant to
purchase up to 350,000 shares of the common stock at an exercise price of $0.57
per share (Warrants). The Warrants have a term of five years and the exercise
price of the Warrants is subject to antidilution adjustments. We also issued
warrants to purchase 350,000 shares of the common stock at an exercise price of
$0.57 per share to a placement agent, and certain of its affiliates, as a
finder's fee (Placement Agent Warrants). The Placement Agent Warrants also have
a term of five years. The Warrant and the Placement Agent Warrants and the
common stock issuable upon the exercise of such warrants were not registered
under the Securities Act of 1933, and were granted pursuant to an exemption set
forth in Section 4(2) thereunder.
We believe that our cash reserves and cash flows from operations will be
adequate to fund our operations through December 2001. Consequently, we will
require substantial additional funds to continue to operate our business beyond
that period. Many companies in the Internet industry have experienced difficulty
raising additional financing in recent months. Additional financing may not be
29
available to us on favorable terms or at all. Even if additional financing is
available, we may be required to obtain the consent of our existing lenders or
the party from whom we secured our equity line of credit, which we may not be
able to obtain. If additional financing is not available, we may need to change
our business plan, sell or merge our business, or file a petition in bankruptcy.
In addition, our issuance of equity or equity-related securities will dilute the
ownership interest of existing stockholders and our issuance of debt securities
could increase the risk or perceived risk of our company. Our future capital
requirements depend upon many factors, including, but not limited to:
o the level of revenues in 2001, which we expect to decline from 2000
levels;
o the rate at which we are able to reduce expense levels;
o the extent to which we develop and upgrade our technology and data
network infrastructure;
o the occurrence, timing, size and success of any asset dispositions in
which we may engage; and
o the scope and success of our restructuring efforts, including
reductions in our workforce.
Our plans for financing may include, but are not limited to, the following:
o engaging a financial advisor to explore strategic alternatives, which
may include a merger, additional asset sales, or another comparable
transaction;
o raising additional capital to fund continuing operations by private
placements of equity and/or debt securities or through the
establishment of other funding facilities; and
o forming a joint venture with a strategic partner or partners to
provide additional capital resources to fund operations.
Recent Accounting Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting Standards (SFAS)
No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS
No. 133 establishes accounting and reporting standards that require derivative
instruments (including certain derivative instruments embedded in other
contracts) be recorded at fair value. The statement requires that changes in the
derivative's fair value be recognized currently in operations unless specific
hedge accounting criteria are met. Special accounting for qualifying hedges
allows a derivative's gains and losses to offset related results on the hedged
item in the statements of operations, and requires that a company must formally
document, designate, and assess the effectiveness of transactions that are
subject to hedge accounting. Pursuant to SFAS No. 137, "Accounting for
Derivative Instruments and Hedging Activities - Deferral of the Effective Date
of FASB No. 133 - an Amendment to FASB Statement No. 133," the effective date of
SFAS No. 133 has been deferred until fiscal years beginning after January 15,
2000. SFAS No. 133 cannot be applied retroactively. SFAS No. 133 must be applied
to (a) derivative instruments and (b) certain derivative instruments embedded in
hybrid contracts that were issued, acquired, or substantively modified after
December 31, 1998 (and, at a company's election, before January 1, 1999). The
impact of adopting SFAS No. 133 is not material on our financial statements.
However, the statement could increase volatility in our consolidated statements
of operations and other comprehensive income.
In June 2001, the FASB issued SFAS No. 141, "Business Combinations." SFAS No.
141 establishes accounting and reporting standards for business combinations to
use the purchase method. The effective date of SFAS No. 141 is June 30, 2001.
All acquisitions by the Company have been accounted for using the purchase
method. The Company is evaluating the impact of adopting SFAS No. 141.
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." SFAS No. 142 establishes accounting and reporting standards for
acquired goodwill and other intangible assets. The statement eliminates the
amortization of goodwill over its estimated useful life. Rather, goodwill will
be subject to at least an annual assessment for impairment by applying a
fair-value-based test. SFAS No. 142 is effective for fiscal years beginning
after December 14, 2001. We are evaluating the impact of adopting SFAS No. 142.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." SFAS No. 144 establishes accounting and
reporting standards for the impairment or disposal of long-lived assets and
supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of." SFAS No. 144 is effective for fiscal
years beginning after December 5, 2001. We are evaluating the impact of adopting
SFAS No. 144.
30
Additional Factors That May Affect Future Results
You should carefully consider the risks described below and the other
information in this quarterly report. While we have attempted to identify the
primary known risks and uncertainties that are material to our business,
additional risks that we have not yet identified or that we currently think are
immaterial may also impair our business operations. The trading price of our
common stock could decline due to any of these risks. In assessing these risks,
you should also refer to the other information in this quarterly report,
including the consolidated financial statements and related notes and the risks
discussed in the "Factors Affecting Our Operating Results, Business and Stock
Price" section included in our December 31, 2000 10-K filed on April 17, 2001,
as amended by Form 10-K/A on April 30, 2001, with the Securities and Exchange
Commission.
Risks Related to Our Business
Our future capital requirements are likely to be substantial and we may not be
able to obtain financing on favorable terms, if at all, and we have received a
"Going Concern" opinion from our accountants.
Our future capital requirements depend upon many factors, including, but not
limited to:
o the level of revenues in 2001, which we expect to decline from 2000
levels;
o the rate at which we are able to reduce expense levels;
o the extent to which we develop and upgrade our technology and data
network infrastructure;
o the occurrence, timing, size and success of any asset dispositions in
which we may engage; and
o the scope and success of our restructuring efforts, including
reductions in our workforce.
We believe that our cash reserves and cash flows from operations will be
adequate to fund our present operations through December 2001. However, we will
require substantial additional funds in the future. Our plans for financing may
include, but are not limited to, the following:
o engaging a financial advisor to explore strategic alternatives, which
may include a merger, asset sale, or another comparable transaction;
o raising additional capital to fund continuing operations by private
placements of equity and/or debt securities or through the
establishment of other funding facilities; and
o forming a joint venture with a strategic partner or partners to
provide additional capital resources to fund operations.
We have secured an $18 million equity line of credit, under which we have the
right, but not the obligation during the eighteen month term of the agreement to
obtain equity financing through the issuance of common stock in a series of
periodic draw downs at a discount to the market price at the time of sale. In
October 2001, we initiated a $25,000 draw down. While we have secured such
financing, many companies in the Internet industry have experienced difficulty
raising additional financing in recent months. Additional financing may not be
available to us on favorable terms or at all. Even if additional financing is
available, we may be required to obtain the consent of our existing lenders or
the party from whom we secured our equity line of credit, which we may not be
able to obtain. If additional financing is not available, we may need to change
our business plan, sell or merge our business, or file a petition in bankruptcy.
In addition, our issuance of equity or equity-related securities will dilute the
ownership interest of existing stockholders and our issuance of debt securities
could increase the risk or perceived risk of our company.
Our inability to secure additional financing would have a material adverse
effect on whether we would be able to successfully implement our proposed
business plan and our ability to continue as a going concern. Our independent
accountants have issued a "going concern" opinion in their report to our
financial statements for the year ended December 31, 2000, citing recurring
operating losses, reduced working capital and violation of debt covenants.
Accordingly, those conditions raise substantial doubt about our ability to
continue as a going concern.
31
Failure to restructure payments to our creditors could result in our bankruptcy.
We are receiving pressure for payments from trade creditors and are seeking to
restructure the payment terms; however, there is no assurance that we will be
able to do this. If we are unable to reach agreement with certain trade
creditors regarding the restructuring of payment terms, our creditors may seek
to file a petition in bankruptcy against us, or we may need to seek protection
of the bankruptcy court. Even if we are successful in restructuring our
obligations, we may need additional capital to avoid bankruptcy.
Our OTC Bulletin Board Listing could make it more difficult to raise capital.
On August 29, 2001, our common stock was delisted from the Nasdaq National
Market. Our common Stock is presently listed on the OTC Bulletin Board which is
viewed by most investors as a less desirable and less liquid marketplace. Among
other things, our common stock constitutes "penny stock," which places an
increased regulatory burden upon brokers, making them less likely to make a
market in our common stock. The loss of our Nasdaq National Market status may
make it more difficult for us to raise capital or complete acquisitions and may
also complicate compliance with state blue sky laws.
Furthermore, our continued listing on the OTC Bulletin Board is not assured.
Although the OTCBB does not have any listing requirements per se, to be eligible
for quotation on the OTCBB, we must remain current in our filings with the
Securities and Exchange Commission.
Several of our board members have resigned. Our board currently has three
independent members and one management member. There can be no assurances that
there will not be additional resignations or that suitable replacement board
members can be found.
We have a history of losses.
We incurred net losses of $24.7 million for the year ended December 31, 1998,
$75.9 million for the year ended December 31, 1999, $262.0 million for the year
ended December 31, 2000 and $194.3 million for the nine-months ended September
30, 2001. At September 30, 2001, we had an accumulated deficit of $561.6
million. We have historically invested heavily in sales and marketing,
technology infrastructure and research and development. As a result, we must
generate significant revenues to achieve and maintain profitability. There can
be no assurance that we will ever become profitable on an annual basis. We
expect that our sales and marketing research and development and general and
administrative expenses will decrease in absolute dollars but may increase as a
percentage of revenues.
Additionally, if our remaining cost-basis investments, which are in early-stage
technology companies and acquisitions, are not successful, we will incur
additional losses from asset impairment charges, lease and employee terminations
and other restructuring costs.
Our future revenues are unpredictable and we expect our operating results to
fluctuate from period to period.
Our business model has been applied to the Internet only since the mid-1990's
and continues to evolve. Therefore, we have limited experience in planning the
financial needs and operating expenses of our business. It is difficult for us
to accurately forecast our revenues in any given period. We will not sustain our
recent revenue growth rates and we expect a significant decline in revenues and
as a result we may not achieve profitability or become cash flow positive. If
our revenues in a particular period fall short of our expectations, we will
likely be unable to quickly adjust our spending in order to compensate for that
revenue shortfall.
Our operating results are likely to fluctuate substantially from period to
period as a result of a number of factors, such as:
o declines in the number of businesses and merchants to which we provide
our products and services;
32
o the amount and timing of operating costs and expenditures relating to
expansion of our operations; and
o the mix of products and services that we sell.
In addition, factors beyond our control may also cause our operating results to
fluctuate, such as:
o the announcement or introduction of new or enhanced products or
services by our competitors;
o registration services related to the introduction of new top level
domains;
o a decrease in the growth of Internet usage; and
o the pricing policies of our competitors.
Period-to-period comparisons of our operating results are not a good indicator
of our future performance, particularly in light of recent changes in our
business focus. It is likely that our operating results in some quarters may not
meet the expectations of stock market analysts and investors and this could
cause our stock price to decline.
Our business model is unproven and changing.
We provide technology infrastructure and online business services. We have
limited experience as a company, particularly with these businesses.
Additionally, the Internet, on which our business model relies, is still
unproven as a business medium and has experienced significant industry slow down
in recent months. Accordingly, our business model may not be successful, and we
may need to change it. Our ability to generate sufficient revenues to achieve
profitability or become cash flow positive will depend, in large part, on our
ability to successfully market our technology infrastructure services.
If we fail to effectively manage the rapid change of our operations our business
will suffer.
Our ability to successfully offer our products and services and implement our
business plan in a rapidly evolving market requires an effective planning and
management process. We are diversifying and changing the scope of our
operations. In January 2001, we announced plans to discontinue the ShopNow.com
marketplace that we launched in August 1998. In March 2001, we announced plans
to discontinue our gaming and entertainment site, SpeedyClick.com. In recent
months, we have increasingly focused on developing and providing technology
infrastructure and online business services. Due to the recent shifts in our
business focus, our historical results are likely not indicative of our future
performance and you may have difficulty evaluating our business and prospects.
While our operations have been changing, we have reduced our overall number of
employees from 620 in October 2000 to 80 as of September 30, 2001. These changes
in our business plan and reduction in personnel have placed, and will continue
to place, a significant strain on our management systems, infrastructure and
resources. Simultaneously, the reduction in our workforce may make it more
difficult to execute and implement our business plan. We will need to continue
to improve our financial and managerial controls and reporting systems and
procedures, and will need to continue to train and manage our workforce.
Furthermore, we expect that we will be required to manage an increasing number
of relationships with various customers and other third parties. Any failure to
adapt to any of the foregoing areas efficiently and effectively could cause our
business to suffer.
Our success depends upon achieving adequate market share to increase our
revenues and become profitable.
Our success depends upon achieving significant market penetration and acceptance
of our products and online business services. We have only recently begun to
expand our technology infrastructure services. We may not currently have
adequate market share to successfully execute our business plan. If we are
unable to reach and retain substantial numbers of customers, our business model
may not be sustainable.
To successfully market and sell our products and online business services we
must:
o become recognized as a leading provider of technology infrastructure
and online business services;
o enhance existing products and services;
33
o add new products and services and increase awareness of these products
and services;
o complete projects on time;
o increase the number of businesses and merchants using our products and
online business services; and
o continue to increase the attractiveness of the eHost.com and
Freemerchant.com Web sites.
We face significant competition.
The market for our products and services is highly competitive, and we expect
competition to intensify in the future. Barriers to entry are not significant.
Our failure to compete effectively could result in the following:
o fewer businesses and merchants using our technology infrastructure
products and services;
o the obsolescence of the technology underlying our products and
services;
o a decrease in traffic on our Web sites; and
o a reduction in the prices of or profits on our products and services.
The number of companies providing technology infrastructure services, hosting
services and marketing services is large and increasing at a rapid rate. We
expect that additional companies, which to date have not had a substantial
commercial presence on the Internet or in our markets, will offer competing
products and services. Companies such as InfoSpace Inc., Yahoo! Inc.,
Register.com, Microsoft and Network Solutions offer alternatives to one or more
of our products and services.
Many of our competitors and potential competitors have substantial competitive
advantages as compared to us, including:
o larger customer or user bases;
o the ability to offer a wider array of technology infrastructure
products and solutions;
o greater name recognition and larger marketing budgets and resources;
o substantially greater financial, technical and other resources;
o the ability to offer additional content and other personalization
features; and
o larger production and technical staffs.
These advantages may enable our competitors to adapt more quickly to new
technologies and customer needs, devote greater resources to the promotion or
sale of their products and services, initiate or withstand substantial price
competition, take advantage of acquisition or other opportunities more readily,
or develop and expand their product and service offerings more quickly.
In addition, as the use of the Internet and online products and services
increases, larger well-established and well-financed entities may continue to
acquire, invest in or form joint ventures with providers of e-commerce enabling
solutions, and existing providers may continue to consolidate. Providers of
Internet browsers and other Internet products and services who are affiliated
with providers of Web directories and information services that compete with our
products and services may more tightly integrate these affiliated offerings into
their browsers or other products or services. Any of these trends would increase
the competition we face.
We cannot predict with any certainty the effect that new governmental and
regulatory policies, or industry reactions to those policies, will have on our
domain registration business.
Before April 1999, the domain name registration system for the .com, .net and
.org domains was managed by Network Solutions pursuant to a cooperative
agreement with the U.S. government. In November 1998, the Department of Commerce
recognized the Internet Corporation for Assigned Names and Numbers, commonly
known as ICANN, to oversee key aspects of the Internet domain name registration
system. We cannot predict with any certainty that future measures adopted by the
34
Department of Commerce or ICANN will benefit us or that they will not materially
harm our business, financial condition and results of operations. In addition,
we continue to face the following risks:
o the U.S. government may, for any reason, reassess its decision to
introduce competition into, or ICANN's role in overseeing, the domain
name registration market;
o the Internet community may become dissatisfied with ICANN and refuse
to recognize its authority or support its policies, which could create
instability in the domain name registration system; and
o ICANN may fail to approve our accreditation, or attempt to impose
additional fees on registrars if it fails to obtain funding sufficient
to run its operations.
Our business will suffer if we fail to maintain our strategic business
relationships or are unable to enter into new relationships.
An important element of our strategy involves entering into business
relationships with other companies. Our success is dependent on maintaining our
current contractual relationships and developing new strategic relationships.
These contractual relationships typically involve joint marketing, licensing or
promotional arrangements. Although these relationships are an important factor
in our strategy because they enable us to enhance our product and service
offerings, the parties with which we contract may not view their relationships
with us as significant to their own businesses. Most of these relationships may
be terminated by either party with little notice. Accordingly, in order to
maintain our strategic business relationships with some of these partners we
will need to meet our partners' specific business objectives, which may include
incremental revenue, brand awareness and implementation of specific e-commerce
applications. If our strategic business relationships are discontinued for any
reason, or if we are unsuccessful in entering into new relationships in the
future, our business and results of operations may be harmed.
We may not derive substantial benefits from our strategic relationships.
To date, we have not derived material revenue from our strategic relationships,
and some of these relationships impose substantial obligations on us. It is not
certain that the benefits to us will outweigh our obligations. Several of our
significant business arrangements do not establish minimum performance
requirements but instead rely on contractual best efforts obligations of the
parties with which we contract.
We depend on our key personnel for successful operation of our business.
Our success depends on the skills, experience and performance of our senior
management and other key personnel, specifically including Dwayne Walker, our
Chairman, Chief Executive Officer and President, N. Scott Dickson, our Chief
Financial Officer and Secretary, Sanjay Anand, our Chief Information Officer,
Anne-Marie K. Savage, our Executive Vice President, Joan Wright, our Executive
Vice President, and Joseph Shatara, our Vice President. Many of our executive
officers have joined us within the past three years. If we do not quickly and
efficiently integrate these new personnel into our management and culture, our
business could suffer. If we fail to successfully attract and retain a
sufficient number of qualified executive, technical, managerial, sales and
marketing, business development and administrative personnel, our ability to
manage and expand our business could suffer. Our current financial situation may
make it more difficult to attract and retain key employees.
Our ability to develop and integrate infrastructure technologies is subject to
uncertainties.
We have limited experience delivering our technology infrastructure products and
services. In order to remain competitive, we must regularly upgrade our
technology infrastructure products and services to incorporate current
technology, which requires us to integrate complex computer hardware and
software components. If we do not successfully integrate these components, the
quality and performance of our online offerings may be reduced. While these
technologies are generally commercially available, we may be required to expend
considerable time and money in order to successfully integrate them into our
products and services and this may cause our business to suffer. We must also
35
maintain an adequate testing and technical support infrastructure to ensure the
successful introduction of products and services.
Our computer systems may be vulnerable to system failures.
Our success depends on the performance, reliability and availability of the
technology supporting our products and services. Our revenues depend, in large
part, on the number of businesses and consumers that use our products and
services. This depends, in part, upon our actual and perceived reliability and
performance. Any inability to provide our products and services could cause us
to lose customers and therefore lose revenue. Substantially all of our computer
and communications hardware is located at our facilities in Seattle, Washington.
Our systems and operations are vulnerable to damage or interruption from fire,
flood, power loss, telecommunications failure, break-in, earthquake and similar
events. In addition, due to the ongoing power shortages in California, the
Pacific Northwest may experience power shortages or outages. These power
shortages or outages could cause disruptions to our operations, which in turn
may result in a material decrease in our revenues and earnings and have a
material adverse affect on our operating results. Because we presently do not
have fully redundant systems or a formal disaster recovery plan, a systems
failure could adversely affect our business. In addition, our computer systems
are vulnerable to computer viruses, physical or electronic break-ins and similar
disruptions, which may lead to interruptions, delays, loss of data or inability
to process online transactions for our clients. We may be required to expend
considerable time and money to correct any system failure. If we are unable to
fix a problem that arises, we may lose customers or be unable to conduct our
business at all.
Our business may be harmed by defects in our software and systems.
We have developed custom software for our network servers and have licensed
additional software from third parties. This software may contain undetected
errors or defects. We may be unable to fix defects in a timely or cost-effective
manner.
We will need to expand and upgrade our systems in order to maintain customer
satisfaction.
We must expand and upgrade our technology, transaction processing systems and
network infrastructure if the number of businesses and merchants using our
online business services, or the volume of traffic on our Web sites or our
clients' Web sites, increases substantially. We could experience periodic
capacity constraints, which may cause unanticipated system disruptions, slower
response times and lower levels of customer service. We may be unable to
accurately project the rate or timing of increases, if any, in the use of our
products or services or our Web sites, or when we must expand and upgrade our
systems and infrastructure to accommodate these increases in a timely manner.
Any inability to do so could harm our business.
Our operations from foreign markets involve risks.
We are subject to risks specific to Internet-based companies in foreign markets.
These risks include:
o delays in the development of the Internet as a commerce medium in
international markets;
o restrictions on the export of encryption technology; and
o increased risk of piracy and limits on our ability to enforce our
intellectual property rights.
We may be unable to adequately protect our intellectual property and proprietary
rights.
We regard our intellectual property rights as critical to our success, and we
rely on trademark and copyright law, trade secret protection and confidentiality
and license agreements with our employees, customers and others to protect our
proprietary rights. Despite our precautions, unauthorized third parties might
copy portions of or reverse engineer our software and use information that we
regard as proprietary. We currently have been granted two patents and have six
patent applications pending in the United States Patent and Trademark Office
covering different aspects of our product architecture and technology. However,
36
there is no assurance that any pending patent application will result in an
issued patent, or that our existing patents or any future patent will not be
challenged, invalidated or circumvented, or that the rights granted under any
patent will provide us with a competitive advantage. The laws of some countries
do not protect proprietary rights to the same extent as do the laws of the
United States, and our means of protecting our proprietary rights abroad may not
be adequate. Any misappropriation of our proprietary information by third
parties could adversely affect our business by enabling third parties to compete
more effectively with us.
Our technology may infringe the intellectual property rights of others.
We cannot be certain that our technology does not infringe issued patents or
other intellectual property rights of others. In addition, because patent
applications in the United States are not publicly disclosed until the patent is
issued, applications may have been filed which relate to our software. We may be
subject to legal proceedings and claims from time to time in the ordinary course
of our business, including claims of alleged infringement of the trademarks and
other intellectual property rights of third parties. Intellectual property
litigation is expensive and time-consuming, and could divert our management's
attention away from running our business.
If the security provided by our e-commerce, hosting or marketing services is
breached, we may be liable to our clients and our reputation could be harmed.
A fundamental requirement for e-commerce is the secure transmission of
confidential information of businesses, merchants and shoppers over the
Internet. Among the e-commerce, hosting and marketing services we offer to
merchants are security features such as:
o secure online payment services;
o secure order processing services; and
o fraud prevention and management services.
Third parties may attempt to breach the security provided by our e-commerce,
hosting or marketing products and services or the security of our clients'
internal systems. If they are successful, they could obtain confidential
information about businesses and shoppers using our online marketplaces,
including their passwords, financial account information, credit card numbers or
other personal information. We may be liable to our clients or to shoppers for
any breach in security. Even if we are not held liable, a security breach could
harm our reputation, and the mere perception of security risks, valid or not,
could inhibit market acceptance of our products and services. We may be required
to expend significant capital and other resources to license additional
encryption or other technologies to protect against security breaches or to
alleviate problems caused by these breaches. In addition, our clients might
decide to stop using our e-commerce products and services if their customers
experience security breaches.
Risks Related to Our Industry
We are vulnerable to downturns experienced by other Internet companies or the
Internet Industry in general.
We derive a significant portion of our revenue from strategic marketing and
advertising relationships with other Internet companies and we own equity in a
number of Internet companies. At the current time, some of these companies are
having difficulty generating operating cash flow or raising capital, or are
anticipating such difficulties, and are electing to scale back the resources
they devote to advertising, including on our network. Other companies in the
Internet industry have depleted their available capital and have ceased
operations or filed for bankruptcy protection or may be expected to do so.
Difficulties such as these may affect our ability to collect revenues or
advances against revenues from our existing partners or advertisers as such
amounts become due and may impair the value of the equity we hold in certain of
our partners. If the current environment for Internet companies does not
improve, our business and financial results may suffer.
37
Our success depends on continued increases in the use of the Internet as a
commercial medium.
We depend on the growing use and acceptance of the Internet by businesses,
merchants and shoppers as a medium of commerce. Rapid growth in the use of and
interest in the Internet and online products and services is a recent
development. No one can be certain that acceptance and use of the Internet and
online products and services will continue to develop or that a sufficiently
broad base of businesses, merchants and shoppers will adopt and continue to use
the Internet and online products and services as a medium of commerce.
The Internet may fail as a commercial marketplace for a number of reasons,
including potentially inadequate development of the necessary network
infrastructure or delayed development of enabling technologies, including
security technology and performance improvements. For example, if technologies
such as software that stops advertising from appearing on a Web user's computer
screen gain wide acceptance, the attractiveness of the Internet to advertisers
would be diminished, which could harm our business.
Rapid technological change could negatively affect our business.
Rapidly changing technology, evolving industry standards, evolving customer
demands and frequent new product and service introductions characterize the
market for our products and services. Our future success will depend in
significant part on our ability to improve the performance, content and
reliability of our products and services in response to both the evolving
demands of the market and competitive product and service offerings. Our efforts
in these areas may not be successful. If a large number of our clients adopt new
Internet technologies or standards, we may incur substantial expenditures
modifying or adapting our products and services to remain compatible with their
systems.
We rely on the Internet infrastructure provided by others to operate our
business.
Our success depends in large part on other companies maintaining the Internet
infrastructure. In particular, we rely on other companies to maintain a reliable
network backbone that provides adequate speed, data capacity and security and to
develop products that enable reliable Internet access and service. If the
Internet continues to experience significant growth in the number of users,
frequency of use and amount of data transmitted, the Internet infrastructure of
thousands of computers communicating via telephone lines, coaxial cable and
other telecommunications systems may be unable to support the demands placed on
it, and the Internet's performance or reliability may suffer as a result of this
continued growth. If the performance or reliability of the Internet suffers,
Internet users could have difficulty obtaining access to the Internet. In
addition, data transmitted over the Internet, including information and graphics
contained on Web pages, could reach Internet users much more slowly. This could
result in frustration of Internet users, which could decrease online traffic and
cause advertisers to reduce their Internet expenditures.
Future governmental regulation and privacy concerns could adversely affect our
business.
We are not currently subject to direct regulation by any government agency,
other than regulations applicable to businesses generally, and there are
currently few laws or regulations directly applicable to access to or commerce
on the Internet. However, due to the increasing popularity and use of the
Internet, a number of legislative and regulatory proposals are under
consideration by federal, state, local and foreign governmental organizations,
and it is possible that a number of laws or regulations may be adopted with
respect to the Internet relating to issues such as user privacy, taxation,
infringement, pricing, quality of products and services and intellectual
property ownership. The adoption of any laws or regulations that have the effect
of imposing additional costs, liabilities or restrictions relating to the use of
the Internet by businesses or consumers could decrease growth in the use of the
Internet, which could in turn decrease demand for our products and services,
decrease traffic on our online marketplaces, increase our cost of doing
business, or otherwise have a material adverse effect on our business. Moreover,
the applicability to the Internet of existing laws governing issues such as
property ownership, copyright, trademark, trade secret, obscenity, libel and
personal privacy is uncertain and developing. Any new legislation or regulation,
or new application or interpretation of existing laws, could have a material
adverse effect on our business.
38
The Federal Communications Commission is currently reviewing its regulatory
positions on the privacy protection given to data transmissions over
telecommunications networks and could seek to impose some form of
telecommunications carrier regulation on telecommunications functions of
information services. State public utility commissions generally have declined
to regulate information services, although the public service commissions of
some states continue to review potential regulation of such services. Future
regulation or regulatory changes regarding data privacy could have an adverse
effect on our business by requiring us to incur substantial additional expenses
in order to comply with this type of regulation.
A number of proposals have been made at the federal, state and local level that
would impose additional taxes on the sale of goods and services over the
Internet and certain states have taken measures to tax Internet-related
activities. Foreign countries also may tax Internet transactions. The taxation
of Internet-related activities could have the effect of imposing additional
costs on companies, such as Network Commerce, that conduct business over the
Internet. This, in turn, could lead to increased prices for products and
services, which could result in decreased demand for our solutions.
We could face liability for material transmitted over the Internet by others.
Because material may be downloaded from Web sites hosted by us and subsequently
distributed to others, there is a potential that claims will be made against us
for negligence, copyright or trademark infringement or other theories based on
the nature and content of this material. Negligence and product liability claims
also potentially may be made against us due to our role in facilitating the
purchase of some products, for example firearms. Although we carry general
liability insurance, our insurance may not cover claims of these types, or may
not be adequate to indemnify us against this type of liability. Any imposition
of liability, and in particular liability that is not covered by our insurance
or is in excess of our insurance coverage, could have a material adverse effect
on our reputation and our operating results, or could result in the imposition
of criminal penalties on us.
We do not currently collect sales tax from all transactions.
We do not currently collect sales or other similar taxes on products sold by us
and delivered into states other than Washington and California. However, one or
more states or foreign countries may seek to impose sales, value added or other
tax collection obligations on out-of-state or foreign companies engaging in
e-commerce. In addition, any new operation in states outside of those for which
we currently collect sales tax could subject shipments into these states to
state or foreign sales taxes. A successful assertion by one or more states or
any foreign country that we should collect sales, value added or other similar
taxes on the sale of merchandise or services could result in liability for
penalties as well as substantially higher expenses incurred by our business.
39
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We currently have instruments sensitive to market risk relating to exposure to
changing interest rates and market prices. We do not enter into financial
instruments for trading or speculative purposes and do not currently utilize
derivative financial instruments. Our operations are conducted primarily in the
United States and as such are not subject to material foreign currency exchange
rate risk.
The fair value of our investment portfolio or related income would not be
significantly impacted by either a 100 basis point increase or decrease in
interest rates due mainly to the short-term nature of the major portion of our
investment portfolio. All of the potential changes noted above are based on
sensitivity analyses performed on our investment portfolio balances as of
September 30, 2001.
40
PART II. OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
On May 22, 2001, Capital Ventures International ("CVI") filed suit against the
Company in the United States District Court for the Southern District of New
York under Civil Action No. 01CV-4390 ("Complaint"). On July 25, 2001, the
Company entered into a settlement agreement with CVI ("Settlement Agreement")
with respect to certain claims arising out of the Securities Purchase Agreement
dated as of September 28, 2000 between the Company and CVI, and all amendments
thereto, and all documents (other than the Registration Rights Agreement)
executed in connection therewith (collectively referred to as the "Contract").
Pursuant to the Settlement Agreement, CVI released the Company, and the Company
released CVI, from all claims, demands and causes of action, whether direct or
indirect, known or unknown, which either CVI or the Company owned or held
against the other based upon the Contract. However, CVI did not release (a)
CVI's claim against the Company for an alleged violation of section 10(b) of the
Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, stated
in count I of its Complaint, (b) CVI's claim against certain individual officers
and current and former directors mentioned in the Complaint (the "individual
defendants") for an alleged violation of section 20(a) of the Securities
Exchange Act of 1934, stated in count II of the Complaint, and (c) CVI's claim
for fraudulent inducement set forth in count III of the Complaint. CVI agreed
that in partial consideration for its receipt of a $2.2 million cash payment and
a $1.5 million convertible promissory note, CVI would not, in prosecuting its
claims against the Company and the Individual Defendants preserved under the
Settlement Agreement, assert a claim in excess of the principal amount of $20
million less any value received (and not returned, paid-over or disgorged as
more fully described in the Settlement Agreement) pursuant to the Settlement
Agreement. The parties agreed to promptly execute and file a stipulated order of
dismissal with prejudice of counts IV through VI of the Complaint.
On December 20, 2000, an action was initiated in Los Angeles Superior Court
styled Futurist Entertainment, Inc. v. Network Commerce, Inc., Jackie Sutphin,
SpeedyClick.com, Case No. BC242139. In the complaint plaintiff alleged, among
other things, breach of contract and business torts against defendants relating
to a Development and Website Agreement between Futurist Entertainment, Inc.
("Futurist") and Network Commerce dated February 25, 2000. The website was to
serve as the official website for the Jackson 5's upcoming album and world tour.
Plaintiff alleged damages "in an amount yet to be ascertained, but in no event
less than $4,400,000." On July 9 2001, the Company and Futurist entered into a
Settlement Agreement. Under the terms of the settlement, Futurist and the
Company entered into a mutual release of claims and the lawsuit was dismissed
with prejudice.
On September 26, 2001 the Company filed a lawsuit against Return on Investment
Corporation ("ROI") in the Superior Court of King County, Washington. In the
complaint the Company alleges ROI's breach of implied duties of good faith and
fair dealing, and breach of warranty arising out of the Agreement and Plan of
Merger and Exchange of Stock dated as of May 11, 2001 ("Merger Agreement") which
provided for ROI's acquisition of the Company's subsidiary, GO Software, Inc.
The Company is seeking specific performance of a clause in the Merger Agreement
requiring ROI to register with the Securities and Exchange Commission certain
shares of ROI's Common Stock that were delivered to the Company under the Merger
Agreement. Given the preliminary stage of this proceeding, the Company cannot
provide an evaluation of the likelihood of a favorable outcome for the Company.
On September 26, 2001, Jan Sherman, James Michaelson and Jason Elkin filed a
complaint captioned In re: Network Commerce Inc. Securities Litigation (Case No.
C01-0675L) in the United States District Court for the Western District of
Washington. The complaint was filed under the same cause number as the original
complaint filed on May 10, 2001 by Jan Sherman against the Company and the other
defendants named therein. The lawsuit seeks unspecified damages and
certification of a class consisting of purchasers of the Company's common stock
during the period from September 28, 1999 through April 16, 2001. The complaint
names as defendants the Company, Dwayne M. Walker, certain current and former
directors and certain underwriters. The Company is vigorously defending this
lawsuit. Nevertheless, an unfavorable resolution of these lawsuits could have a
material adverse effect on the Company in one or more future periods.
41
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
Between June 30, 2001 and September 30, 2001, the Company issued and sold
unregistered securities as set forth below:
On July 10, 2001, the Company entered into a Common Stock Purchase Agreement
("Agreement") with Cody Holdings Inc. ("Investor") to provide the Company with
up to $18 million in equity financing ("Equity Line"). Under the terms of the
Agreement, the Company will have the right, but not the obligation during the
18-month term of the Agreement, to obtain equity financing through the issuance
of common stock to the Investor in a series of periodic draw downs at a discount
to the market price at the time of sale to the Investor. The shares of common
stock may be sold to the Investor during this period at times and in amounts,
subject to certain minimum and maximum volumes, determined at our discretion. If
the Company chooses to draw down on the Equity Line, the Company will use the
proceeds of the financing for general corporate purposes. The Company filed with
the Securities and Exchange Commission a registration statement on Form S-1 to
effect the registration of these shares prior to drawing on this equity line,
and the SEC declared the registration statement effective on September 28, 2001.
In connection with the Equity Line, the Company also issued to the Investor a
warrant to purchase up to 350,000 shares of the Company's common stock at an
exercise price of $0.57 per share ("Warrants"). The Warrants have a term of five
years and the exercise price of the Warrants is subject to antidilution
adjustments. The Company also issued warrants to purchase 350,000 shares of the
common stock at an exercise price of $0.57 per share to a placement agent, and
certain of its affiliates, as a finder's fee ("Placement Agent Warrants"). The
Placement Agent Warrants also have a term of five years.
No underwriters were engaged in connection with these issuances and sales. These
securities were issued in transactions exempt from registration under the
Securities Act of 1933 in reliance upon Section 4(2) of the Securities Act and
Regulation D promulgated thereunder. Between July 1, 2001 and September 30,
2001, the Company issued no shares of common stock in conjunction with the
exercise of options granted under the Company's stock option plans. No options
were granted outside of the Company's stock option plans. These securities were
issued in transactions exempt from registration under the Securities Act of 1933
in reliance upon Rule 701 promulgated under the Securities Act of 1933. Where
Rule 701 was not available, the securities were issued in transactions exempt
from registration under the Securities Act of 1933 in reliance upon Section 4(2)
of the Securities Act of 1933.
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY SHAREHOLDERS
None.
ITEM 5: OTHER INFORMATION
None.
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Number Description
10.1 Offer of Employment for N. Scott Dickson dated August 6, 2001.
(b) Reports on Form 8-K
Form 8-K filed July 2, 2001
Form 8-K filed July 16, 2001
Form 8-K filed July 31, 2001
Form 8-K/A filed July 31, 2001
Form 8-K filed August 7, 2001
42
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NETWORK COMMERCE INC.
Date: November 14, 2001
By: /s/ Dwayne M. Walker
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Dwayne M. Walker
Chief Executive Officer
By: /s/ N. Scott Dickson
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N. Scott Dickson
Chief Financial Officer
43
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EXHIBIT INDEX
Number Description
10.1 Offer of Employment for N. Scott Dickson dated August 6, 2001.
44