UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1999.
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 No. 0-24745
Pathnet, Inc.
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(Exact name of registrant as specified in its charter)
DELAWARE 52-1941838
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1015 31ST STREET, N.W.
WASHINGTON, DC 20007
- --------------------- -----
(Address of principal executive offices) (Zip Code)
(202) 625-7284
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
As of February 15, 2000 there were 3,068,218 shares of the Issuer's common
stock, par value $.01 per share, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
None
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business 3
Item 2. Properties 25
Item 3. Legal Proceedings 25
Item 4. Submission of Matters to a Vote of Security Holders 25
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 26
Item 6. Selected Consolidated Financial Data 26
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 29
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 55
Item 8. Financial Statements and Supplementary Data 55
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 55
PART III
Item 10. Directors and Executive Officers of the Registrant 56
Item 11. Executive Compensation 61
Item 12. Security Ownership of Certain Beneficial Owners and
Management 65
Item 13. Certain Relationships and Related Transactions 67
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 74
Signatures 79
Index to Financial Statements F-1
2
THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES INCLUDING, WITHOUT LIMITATION, STATEMENTS RELATING TO OUR COMPANY
AND OUR BUSINESS UNITS' PLANS, STRATEGIES, OBJECTIVES, EXPECTATIONS, INTENTIONS
AND RESOURCES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED
IN FORWARD-LOOKING STATEMENTS AS A RESULT OF VARIOUS FACTORS, INCLUDING THOSE
DESCRIBED IN THE SECTION OF THIS ANNUAL REPORT ON FORM 10-K ENTITLED "RISK
FACTORS." UNLESS WE INDICATE OTHERWISE, REFERENCES TO OUR CURRENT OR FUTURE
BUSINESS, STRATEGIES OR PLANS ARE REFERENCES TO OUR CONSOLIDATED BUSINESS,
STRATEGIES OR PLANS, INCLUDING OUR OTHER FUTURE SUBSIDIARIES.
PART I
ITEM 1. BUSINESS
THE COMPANY
We were founded in 1995 and are a wholesale telecommunications provider
building a nationwide network designed to provide other wholesale and retail
telecommunications service providers with access to underserved and second and
third tier markets throughout the United States. We partnered with owners of
telecommunications assets, including utility, pipeline and railroad companies
("Incumbents") to upgrade and aggregate wireless infrastructure to a microwave
network using high capacity Synchronous Optical Network Technology, also known
as "SONET" network. Through 1998, we signed agreements with eight Incumbents and
had over 6,000 miles of wireless network under development.
In early 1999, we expanded the scope of our business strategy to include
fiber optic technology to enable us to deliver high bandwidth services as well
as dark and dim fiber to inter-exchange carriers ("IXCs"), local exchange
carriers ("ILECs"), Internet service providers ("ISPs"), Regional Bell Operating
Companies ("RBOCs"), cellular operators and resellers. Our network will enable
our customers to offer additional services to new and existing customers in
these markets without having to expend their own resources to build, expand, or
upgrade their own networks. In addition to serving unique markets, we plan to
differentiate our network by:
o Its ability to provide a complete access solution in our target
markets, including collocations in ILEC central offices and intercity
transport, and
o Its advanced network architecture that will allow our customers to
offer the latest voice, video, and data services across a single
network at very high speeds
In November 1999, we entered into agreements providing for strategic
investments from Colonial Pipeline Company, Burlington Northern and Santa Fe
Corporation and CSX Corporation (the "Transaction"). Upon the closing of the
Transaction, we will form a new holding company, Pathnet Telecommunications,
Inc. ("PTI") that will receive the right to develop over 12,000 miles of the
investors' rights of way holdings in return for preferred stock. Colonial
Pipeline will also contribute - in two separate tranches - an aggregate of $68
million in cash in return for preferred stock, an option to purchase preferred
stock, an option to purchase up to 10% of the number of shares that Pathnet
Telecommunications, Inc. actually issues in an underwritten initial public
offering at a price equal to 90% of the price that Pathnet Telecommunications,
Inc. charges for the sale of its shares in the offering and a single fiber optic
conduit along a portion of the Colonial right of way corridors or other
telecommunications assets of equal value.
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The structure of the proposed contribution and reorganization transaction
requires Pathnet to obtain waivers and consents from the holders of a majority
in principal amount of Pathnet's notes. In consideration for the required
consents, (1) PTI is offering its guarantees for all of the notes (the
"Guarantee"), (2) Pathnet will make a consent payment of $25.00 per $,1000 in
face amount of the notes to each of the consenting noteholders who held notes on
the record date of the consent solicitation and (3) Pathnet will purchase and
pledge to the indenture trustee, for the benefit of the noteholders, additional
United States Treasury securities as security covering the October 2000 interest
payment on the notes following the consummation of the Transaction
The new investors collectively will receive an approximate one-third equity
stake in the holding company, as well as proportionate representation on the
holding company board. Closing of the Transaction is subject to the satisfaction
on or before March 31, 2000, of certain conditions, including consent of the
holders a majority of the principal amount of our outstanding bonds. There is no
assurance that these conditions will be satisfied by that date. IN THIS REPORT,
THE WORDS "WE," "US" AND "OUR" REFER TO PATHNET INC. FOR PERIODS PRIOR TO THE
CLOSING OF THE TRANSACTION AND TO THE NEW HOLDING COMPANY AND ITS SUBSIDIARIES
(INCLUDING PATHNET INC.) FOR PERIODS AFTER THE CLOSING OF THE TRANSACTION.
We expect our nationwide network to grow to approximately 20,000 route miles
utilizing fiber and high capacity Synchronous Optical Network Technology, also
known as "SONET" microwave. We intend to continue to develop our backbone on a
"smart-build" basis by prioritizing route development along corridors with high
demand for dark fiber and conduit or partnering with established companies in
the joint development of those routes. We expect our network will terminate in
central offices in our target markets where we intend to collocate and use ILEC
unbundled network elements or other third party local network assets in the
provision of service to our customers.
As of December 31, 1999, our network consisted of over 6,300 wireless route
miles providing wholesale transport services to 30 cities and 500 miles of
installed fiber. We are constructing an additional 600 route miles of fiber
network, which is scheduled for completion in the first half of 2000. We have
also entered into two additional co-development agreements for the construction
of an additional 750 route miles of fiber optic network. We expect to develop
additional backbone network from a pool of over 12,000 route miles of right of
way received in the Transaction -- 8,000 of which will have some form of
exclusivity. These additional route miles will provide us with the opportunity
to develop unique and diverse paths connecting our target markets back to major
tier one metropolitan areas.
In addition to building our network, since inception we have:
o Obtained state regulatory certification or otherwise been authorized
to provide our planned telecommunications services in 13 states, with
applications pending in an additional 8 states, which will allow us to
obtain unbundled network elements from the ILECs;
o Executed interconnection agreements with three existing local
telephone companies; US West, Ameritech and Southwestern Bell;
o Executed agreements providing for collocations with US West and
BellSouth;
o Launched our Alliance Program under which we expanded our virtual
network to reach additional markets by reselling portions of two other
carriers' networks;
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o Signed Master Service Agreements with the three largest U.S. IXCs;
o Completed our fully operational Network Operations Center, providing
twenty-four hours a day, seven days-a-week coverage; and
o Entered into a leased fiber agreement for an indefeasible right to use
(sometimes referred to as an "IRU") a portion of our dark fiber
capacity on our fiber route currently being constructed from Chicago,
Illinois to Aurora (a suburb of Denver), Colorado.
MARKET OPPORTUNITY
INDUSTRY OVERVIEW
We believe that the following five factors create a substantial market
opportunity for our products and services:
o Increasing demand for high capacity access and transport services to
accommodate unprecedented consumer demand for Internet access and
related services;
o Growing disparity, sometimes referred to as the "digital divide,"
between telecommunications services available in the largest markets
and those services available in second and third tier markets due to
our telecommunications service provider customers' nearly exclusive
focus of resources and product offerings on first tier domestic and
global markets;
o Rapid development of new technologies such as Digital Subscriber Line
services ("DSL") that allow carriers to exploit existing local network
infrastructure to deliver multiple media (including voice, data, video
and Internet) at high speed over a single physical local access
connection to a network;
o Rapid migration from circuit-based network architectures to fast
packet-based network technologies that allow for the efficient
integration of multiple customers across a common backbone network
infrastructure; and
o Adoption of the Telecommunications Act and certain state regulatory
initiatives that provide increased opportunities in the
telecommunications marketplace by opening local markets to competition
and requiring ILECs to provide additional direct interconnection and
collocation to their competitors.
We intend to exploit these developments and employ emerging convergent
technologies in the deployment of our backbone network and local access
platform. We believe the emergence and acceptance of advanced
convergence-supporting technologies at the user premise will significantly
increase our abilities to provide low cost solutions to our carrier customers in
underserved and second and third tier markets that have been overlooked by other
emerging telecommunications service providers.
ADDRESSABLE MARKET
We worked with The Yankee Group on an addressable market study for the
products and services we expect to bring to the marketplace in the near term.
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The study found that the communications market is currently a $270 billion
market in the U.S. and is expected to grow at over 10% annually for the next
five years. According to The Yankee Group, the sections of the market that we
expect to address -- backbone infrastructure services, inter-city and local
wholesale transport services and local access services -- are among the most
rapidly growing components of the current telecommunications landscape which The
Yankee Group forecasts to grow at approximately 18% annually for the next five
years. The Yankee Group estimates that the addressable market for these products
and services in the United States to be $30 billion in 1999, expanding to $80
billion by 2005.
We plan to serve second and third tier markets with populations between
600,000 and 50,000, of which there are over 200, with backbone infrastructure
services, long haul wholesale transport and local access services. We also
expect to capture a portion of the long haul wholesale transport services
segment between first tier markets with populations over 600,000. We estimate
that the addressable market for these products and services is $13 billion in
1999, growing to $27 billion in 2004.
BUSINESS STRATEGY
Our business objective is to become the preferred facilities-based wholesale
telecommunications provider to customers in our target markets. To achieve this
goal, we plan to:
o Concentrate our focus on the needs of telecommunications service
providers and their customers;
o Focus on underserved and second and third tier markets;
o Enter and roll-out service rapidly in our target markets;
o Design, build and acquire a low-cost network;
o Provide superior customer service and service quality; and
o Pass to our customers savings from the deployment of our local network
access program.
Each of these strategies is discussed in more detail below:
o CONCENTRATE OUR FOCUS ON THE NEEDS OF TELECOMMUNICATIONS SERVICE
PROVIDERS AND THEIR CUSTOMERS. Our customers are companies in the
business of selling communications services to end user customers. We
believe that these companies are investing considerable sums to
connect as many customers as possible to keep pace with the rapidly
evolving telecommunications marketplace and that these carriers would
like to find the means to maximize the return on their investments and
deployment of resources. We further believe that these challenges are
magnified when they consider serving customers in second and third
tier markets. Very few of these telecommunications service providers
operate at a scale that justifies significant investment in building
their own network in smaller markets. The alternative -- re-selling
ILEC local networks -- has limited appeal because it can be expensive
and, in many cases, the ILEC network components lack the broadband
capabilities that these telecommunications service providers need to
compete effectively in the marketplace. We believe that our customers
will be able to effectively "timeshare" our products and services.
This will enable them to access second and third tier markets to serve
their customers without incurring high capital expenditures, or many
of the franchising and licensing fees and long lead times that are
usually associated with building their own networks and establishing a
meaningful local collocation presence in these markets.
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o FOCUS ON UNDERSERVED AND SECOND AND THIRD TIER MARKETS. We plan to
serve second and third tier markets with populations between 600,000
and 50,000, of which there are over 200, as well as a portion of the
first tier markets with populations over 600,000. We believe our
customers will value our backbone network because, for the most part,
it will be built along unique rights of way offering route separation
and diversity in the event of a network system failure. Also, unlike
others backbone networks that bypass second and third tier markets, we
will construct and design our backbone to interconnect into these
markets. We seek to be among the first to market advanced wholesale
transport and local access services in many of our markets. By
pioneering in second and third tier markets, we hope to capitalize on
escalating demand for high capacity bandwidth services that is a
product of the current unprecedented demand for Internet access and
related services.
o ENTER AND ROLL OUT SERVICE RAPIDLY IN OUR TARGET MARKETS. We seek to
become the first emerging carrier to enter and roll out our products
and services broadly in our targeted underserved and second and third
tier markets by:
o Securing central office space before our competitors do;
o Obtaining and retaining customers before significant competition
for our products and services in these markets arises; and
o Maintaining advantages over our competitors by offering superior
coverage and high customer satisfaction.
o DESIGN, BUILD AND ACQUIRE A LOW-COST NETWORK. Consistent with our
conservative capital expenditure program, one of our key strategies
since inception has been to establish strategic relationships with
owners of existing telecommunications infrastructure, to reduce our
capital costs and time to market. As of December 31, 1999, we had
entered into strategic relationships with eight companies who have
provided the foundation for our existing 6,300-route mile wireless
network. We have also entered into three co-development agreements
relating to the construction of 1,850 fiber route miles. After
completing the Transaction through our strategic relationships with
BNSF, CSX and Colonial, we will have access to over 12,000 miles of
valuable rights of way, 8,000 miles of which will have some form of
exclusivity.
We are developing our network using a "smart build" approach.
Under this approach, we attempt to reduce the risk of building our
network by obtaining one or more co-development partners to share in
the costs. We also determine the level of customer demand before
construction by obtaining direct customer input regarding the
attractiveness of a route and, in certain cases, entering into
pre-construction sales of dark fiber and conduit. As a result, we
expect that the cost of our retained nationwide backbone network will
be significantly less than a comparable network built or acquired at
market rates. We intend to continue this low cost approach in
providing our local access services. We plan to secure CLEC status in
each state that we provide service and we anticipate signing
interconnection agreements with all of the relevant ILECs. These
interconnection agreements allow us to construct our microwave
tributary routes directly to the ILEC central office facility,
allowing us to use the existing central office as our point of
presence in the market, and avoid the cost of separate facilities.
This will enable us to obtain and use unbundled network elements from
the ILECs at favorable rates and terms, including space in the ILEC's
central offices that are necessary to establish our collocations.
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o PROVIDE SUPERIOR CUSTOMER SERVICE AND SERVICE QUALITY. As part of our
strategy to obtain and retain business and telecommunications service
provider customers, we intend to provide superior service and customer
care. We will aim to provide high quality services by offering what we
believe to be state-of-the-art networking solutions and superior
customer service. These networking solutions include end-to-end
proactive network monitoring and management through our Network
Operations Center, 24 hours a day, seven days-a-week. We also offer
multiple security features and we have completed implementing our Year
2000 readiness program to ensure that our networks and systems are
Year 2000 compliant. See "RISK FACTORS -- RISKS RELATING TO OUR
COMPANY OPERATIONS" and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- YEAR 2000 READINESS
DISCLOSURE." We plan to provide superior customer service to promote a
high level of customer satisfaction, achieve customer loyalty and
accelerate the use of our products and services. In addition, we have,
and will continue to install, a technologically advanced network that
we believe provides the high level of reliability, security and
flexibility that our customers demand. Our fiber and wireless network
is designed to meet industry standards for delivering network
reliability of 99.999% per network segment.
o PASS TO OUR CUSTOMERS SAVINGS FROM THE DEPLOYMENT OF OUR LOCAL NETWORK
ACCESS PLATFORM. We plan to deploy a convergent local network access
platform. In other words, we intend to combine, or enable the
combination of, all multiple customer applications onto a single
physical local access connection, which will travel on our fast
packet-based capable backbone infrastructure. Using this convergent
platform we believe that our telecommunications service provider
customers will be able to launch their own services to better serve
their end user customers.
PROJECTED DEVELOPMENT OF BUSINESS PLAN
With the funds and other assets received in the Transaction, and
additional equity financings, we plan to complete the first phase of our long
term business plan. Our long term business plan calls for us to develop an
approximately 20,000 mile network and provide services to over 200 second and
third tier markets. In the first phase of this plan, we expect to complete
development of approximately 12,500 route miles of network and approximately 400
collocations by the end of 2002. We project the development of our network
through the end of 2000 to be:
PROJECTED PROJECTED PROJECTED
NETWORK ROUTE COLLOCATIONS ACCESSED
MILES COMPLETED DEVELOPED CITIES
As of December 31, 1999... 6,800 40 30
End of Second Quarter 2000 7,600 85 50
End of Fourth Quarter 2000 9,100 150 80
End of Second Quarter 2001 10,500 230 120
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We plan on drawing on the following sources of cash to fund the first phase
of our long term business plan:
o our current cash resources;
o the anticipated proceeds (after associated expenses) from both
tranches of Colonial's investment in our shares of series E
convertible preferred stock as part of the contribution and
reorganization transaction;
o borrowings under senior secured vendor financing that we propose to
execute in connection with the purchase of fiber optic cable and
associated network equipment;
o payments from our co-development partners and sales to infrastructure
and bandwidth services customers; and
o additional equity investment(s) of at least $100 million.
STRATEGIC RELATIONSHIPS
FIBER CO-DEVELOPMENT PARTNERS
WORLDWIDE FIBER. In March 1999, we entered into a co-development agreement
with Worldwide Fiber, Inc. for the design, engineering and construction by
Worldwide Fiber of a multiple conduit fiber-optic system. One of the conduits
will contain a fiber optic cable consisting of a specified number of fiber optic
strands. The conduits and any installed strands will be equally divided between
Pathnet and Worldwide Fiber, and the costs to construct the route will be shared
equally by the partners. In addition, Pathnet will pay Worldwide Fiber a
management fee equal to 10% of Pathnet's share of the development costs. The
system will be approximately 1,100 route miles long, between Aurora, Colorado (a
suburb of Denver) and Chicago, Illinois. The first segment, Chicago, Illinois to
Omaha, Nebraska, is scheduled to be completed in the fourth quarter 1999, and
the second segment, Omaha to Aurora, is scheduled to be completed by the end of
the first quarter of 2000. In connection with the co-development agreement, we
entered into a joint marketing agreement with Worldwide Fiber under which both
Worldwide Fiber and we will attempt to sell certain inactive fiber optic strands
on the route, and will share the revenues from such sales. The joint marketing
agreement also permits each party to retain fiber optic strands for its own use,
subject to certain restrictions on resale, and to swap a certain number of fiber
optic strands to third parties.
TRI-STATE. In August 1999, we entered into a co-development agreement with
Tri-State Generation and Transmission Association, Inc. and four regional
electric cooperatives for our design, engineering and construction of an aerial
fiber system, approximately 420 route miles long, between Albuquerque, New
Mexico and Grand Junction, Colorado. This system, constructed on power
transmission lines, will contain a specified number of fiber optic strands. The
cost to construct the system will be borne equally between Pathnet and the other
parties. In connection with the co-development agreement, we entered into a
joint marketing agreement under which each party will reserve a portion of the
fiber strands for its own operations, a subset of which will be available for
9
swaps with third parties. The remaining fiber strands will be jointly sold, with
Pathnet as the exclusive marketing agent. Any revenues derived from the sale of
those fiber strands will be shared equally between Pathnet and Tri-State, after
deduction of a Pathnet marketing fee. We expect this system to be completed in
the second half of 2000.
ALLIANCE PROGRAM. We have entered into capacity purchase agreements with two
other carriers, IXC and Frontier, enabling us to resell capacity on their
networks. This allows us to extend our network reach to POPs throughout the
markets reached by Frontier's and IXC's networks and pre-sell capacity along
routes we intend to develop.
WIRELESS CO-DEVELOPMENT PARTNERS
FIXED POINT MICROWAVE SERVICES AGREEMENTS. We have entered into several
fixed point microwave services agreements with co-development partners who own
existing wireless telecommunications assets. Typically, under these agreements
we lease an interest in the co-development partner's sites and facilities on
which our network is built and in return we provide the co-development partner
with capacity on such network for its own internal use. We typically pay the
co-development partner a portion of the revenue derived from our selling the
excess bandwidth on that co-development partner's route. Generally, the
co-development partner receives up to 20% of the revenues earned after the
systems have been in place for 48 months. In addition, these agreements
generally require the co-development partner to make capital investments toward
the upgrade of its systems infrastructure to make it suitable for installation
of the equipment used in our digital network which, in most cases, includes
significant modifications to structures, towers, battery plants and equipment
shelters. These agreements generally provide for a five or ten year term that is
subject to renewal by us upon the occurrence of certain events, for up to a
25-year term. As of February 15, 2000, we had entered into fixed point microwave
services agreements with these co-development partners:
o Idaho Power Company;
o Northern Indiana Public Service Company;
o The Burlington Northern and Santa Fe Railway Company;
o Kinder Morgan, Inc. (formerly KN Energy, Inc.);
o Kinder Morgan, Inc. (formerly KN Telecommunications, Inc.);
o Texaco Pipeline;
o Northern Border Pipeline Company; and
o Northeast Missouri Electric Power Cooperative.
TOWER LEASE AGREEMENTS. We entered into a leasing arrangement with American
Tower Corporation under which American Tower granted us a 25-year license to use
certain of its towers to deploy several wireless portions of our network.
PRODUCTS AND SERVICES
We plan to offer the following products and services:
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o DARK FIBER AND CONDUIT FOR SALE OR GRANT OF LONG LEASE TERMS. We sell
rights for dark fiber and related services as well as rights to conduit.
Dark fiber consists of fiber strands contained within a fiber optic
cable which has been laid but does not yet have its transmission
electronics installed. A sale or grant of an indefeasible right to use
our dark fiber typically has a term which approximates the economic life
of a fiber optic strand (generally 20 to 30 years). Purchasers of dark
fiber rights typically install their own electrical and optical
transmission equipment. Substantially all of our current and planned
builds include laying spare conduits, and we may sell rights to use
them. A purchaser of conduit rights typically lays its own cable inside
the conduit. Related services for both sales of rights for dark fiber
and conduits may include installation of customer equipment at the
locations where we have installed transmission equipment and network
equipment and maintenance of the purchased fiber or conduit. Generally,
we expect our customers to pay for dark fiber rights and conduit at the
time of delivery and acceptance of the fiber or conduit, although other
payment options may be available. In addition, depending upon the nature
of our contractual terms, we will treat our sales of dark fiber and
conduit as sales-type leases or operating leases. We typically require
our customers to make ongoing payments for maintenance services.
o DARK FIBER FOR LEASE OR LEASE TO PURCHASE. We will also lease dark fiber
for a term less than the period for which the indefeasible usage rights
are typically granted. Leases will be typically structured with monthly
payments over the term of the lease. Generally, we expect to realize a
premium in lease pricing for bearing the risk that the lease will not be
renewed for the balance of the life of the asset. We plan to offer
customers the option to lease to purchase.
o WAVELENGTH LEASE. In our network, we intend to use Dense Wavelength
Division Multiplexing, or DWDM, a technology that allows multiple
optical signals to be combined so that they can be aggregated as a group
and transported over a single fiber to increase capacity. This will
allow us to sell a customer exclusive long-term use of a portion of the
transmission capacity of a fiber optic strand rather than the entire
strand. We expect that the installation of the necessary transmission
equipment to provide these services along our first completed fiber
route from Chicago to Denver will be complete in the first half of 2000.
We expect to be able to derive up to 160 individual wavelength channels
at either OC-48 or OC-192 per fiber pair.
o INTER-CITY WHOLESALE TRANSPORT SERVICES. Our inter-city transport
services are focused on second and third tier markets and are comprised
of point-to-point services offered as Time Division Multiplexing, or
TDM, which is an electronic process that combines multiple communication
channels into a single, higher-speed channel by interleaving portions of
each in a consistent manner over time-based private lines at high speed
including DS-1, DS-3, OC-3, OC-12, OC-48 and OC-192. We believe that our
services will be particularly attractive to our customers because of our
low cost backbone transport and low cost local loops (attributable to
our collocation in the ILEC's central office and our use of unbundled
network element transport). We believe that we offer more flexible
commitment levels with higher reliability than are currently available
on traditional multiplexed services. As of December 31, 1999, we offered
inter-city wholesale transport services on our 6,300 route mile-wireless
network as well as via our Alliance Program.
o LOCAL WHOLESALE TRANSPORT SERVICES. Once we establish collocation in the
ILEC's central offices in second and third tier markets, we believe that
we will be able to deliver local transport between central offices or to
connect those central offices to our backbone or a telecommunications
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service provider customer backbone. We plan to offer local transport
services, such as xDSL-based private lines or TDM-based private lines at
high rates of speed including DS-0, DS-1, DS-3, OC-3, OC-12, OC-48. We
expect our customers to use these services to reduce charges for
inter-office transport or to provide end office trunking.
o LOCAL ACCESS SERVICES. We plan to deliver our local access services from
network presences we have established by collocating with the ILECs in
second tier and third tier markets and through the local networks we
have established using a combinations of unbundled network elements and
other network components from other communications carriers.
o VIRTUAL POINTS OF PRESENCE (VPOP). We plan to bundle our wholesale
transport services and local access services to offer our virtual points
of presence service, sometimes referred to as VPOP. Through this bundle
of services, we intend to offer our customers the ability to establish a
virtual point of presence for their networks using our facilities, thus
avoiding the need to place any equipment at a collocation site. We will
focus this VPOP service on second and third tier markets. We expect that
our VPOP service will allow our customers to virtually extend the reach
of their networks while expending less resources and incurring far less
risk than if that customer had expanded and built its own network.
SALES AND MARKETING STRATEGY
Our wholesale customers tend to be very knowledgeable about the nature of
the services and technology available in the marketplace. As a result, our
marketing efforts are largely limited to ensuring that our products and services
are visible and well represented in the market. As part of our marketing
strategy, we attempt to position ourselves as the provider of choice for
telecommunication service providers because of the quality of our service, the
control we provide customers over their service platforms, the reliability of
our services and our low cost position. We believe our cost advantages allow us
to sell our services on our network at prices that represent potentially
significant savings for our large-volume customers relative to their other
alternatives.
We sell our services to large regional and national telecommunications
service providers through our direct sales team on a national account basis.
Since we sell primarily to other telecommunications service providers, we expect
that our sales and marketing department will remain relatively small and
focused, resulting in strong customer relationships and lower operating costs.
Our sales team consists of senior level management personnel and experienced
sales representatives with extensive knowledge of the industry and our products.
This team also has key industry contacts at various levels within many
telecommunications service provider organizations.
CUSTOMERS
We have defined a range of products and services designed to meet the unique
needs of our customers and, as a result, we intend to offer several types of
services to these types of customers:
o Full service IXCs: we intend to provide low cost DSL-based transport,
used to deliver broadband access. We expect to provide lower cost
access and short haul transport to reduce the cost of delivering
traditional voice, private line or data services;
o CLECs and competitive IXCs: we can extend reach to new markets by
providing a more efficient means for CLECs to originate or terminate
voice traffic and a lower cost source of inter-city wholesale
transport or infrastructure services;
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o ISPs: we intend to offer low cost DSL to deliver broadband access. We
expect to be able to extend ISPs reach to new markets. We plan to
provide low cost infrastructure services and wholesale transport
services. We expect to provide direct access to the locations at which
ISPs exchange each other's traffic.
o ILECs: we expect to provide lower cost network services within the
ILEC's own region and wholesale transport services and local access
services out of region as ILECs become permitted to provide these
services;
o Wireless and cable providers (including cellular companies): we plan
to provide backhaul services, head end distribution services and
wholesale transport services; and
o Resellers: we expect to provide low cost termination for switched
traffic.
THE PATHNET NETWORK
BACKBONE NETWORK
We plan to create an approximately 20,000 route mile nationwide network.
Tributaries using either fiber or wireless technology will connect our backbone
to our targeted markets. We believe that connecting the second and third tier
markets to a national backbone is the key to funneling traffic between these
markets and first tier markets.
NETWORK ROUTE SELECTION AND SMARTBUILD APPROACH. In order to utilize capital
effectively, we employ a "smart-build" approach. This means that we seek to
reduce our risks in undertaking the build by:
o Obtaining one or more co-development partners to share in the costs;
o Determining the levels of customer demand before construction (by
obtaining direct customer input on the route); and
o In certain cases, seeking to effect pre-construction sales of dark
fiber and conduit.
Before deciding to construct or acquire a network to serve particular
markets, we review the demographic, economic, competitive and telecommunications
demand characteristics of the markets along proposed routes, including their
location, the concentration of potential business, government and institutional
end-user customers, the economic prospects for the area, available data
regarding transport demand and actual and potential competitive
telecommunications company competitors. We estimate market demand on the basis
of market research performed by us and others, utilizing a variety of data
including estimates of the number of interstate access and intrastate private
lines in the market based primarily on FCC reports and commercial databases.
We expect to enter into a co-development relationship with one or more
partners to share the costs of building the route as well as the dark fiber
revenue from each constructed route. We recently employed this approach in
developing our fiber routes from Chicago, Illinois to Aurora (a suburb of
Denver, Colorado), and from Albuquerque, New Mexico to Grand Junction, Colorado
with our partners, Worldwide Fiber and Tri-State. Typically, independent
contractors selected through a competitive bidding process provide our
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construction and installation services. In certain of our network builds, we
provide project management services, including contract negotiation and
supervision of the construction, testing and certification of our facilities.
FIBER CURRENCY, SWAPS AND ACQUISITIONS. When determining the fiber optic
cable and conduit sizing for a particular route, we take into account these
considerations:
o Fiber strands required for our retained network;
o Fiber strands required by our co-development partner's network;
o Projected sales of fiber strands and conduits along the route;
o Quantity of fiber strands to be retained and allocated for swaps to
obtain fiber strands on routes owned by others; and
o Retained empty conduit in the event we desire to deploy different or
advanced technologies.
We believe fiber has a "currency" value depending upon the value of the
route to specific telecommunications service providers. Once we determine a
particular route has a high currency value, we expect to capitalize on this by
using excess fibers and conduit to enable advantageous fiber swaps and sales of
fiber and conduit. If we determine that a particular route is being sufficiently
served by existing fiber, we will not build our own network along that route,
but instead we will use our fiber "currency" to swap for existing fiber along
those routes or we will acquire dark fiber that is already installed by another
company. In this way, swaps will allow us to leverage our network, gain more
geographical coverage and decrease our time to market.
In order to connect our network with our customers, we develop
interconnections from our backbone network into our targeted underserved and
second and third tier markets. We design and install our interconnections using
the most cost effective technology to meet the market's needs that may include
building fiber optic cable, acquiring existing fiber, installing wireless
components, or combinations of these technologies.
LOCAL ACCESS CONVERGENT PLATFORM
We believe establishing a local presence in our target markets will position
us to deploy a convergent local network access platform that will enable
multiple customer applications to be combined at a single physical local access
connection and then travel onto our advanced, fast packet-based backbone
infrastructure. From this convergent platform, we expect to enable our
telecommunications service provider customers to launch their own services to
better serve their customers.
We intend to obtain state certification or authorization as a CLEC in each
state in which we are required to do so, and to sign interconnection agreements
with the relevant ILECs in our target markets. Once we have obtained the
appropriate state authorization and entered into interconnection agreements with
the ILECs, we will be able to construct our central office collocation
facilities at the premises of, and obtain and use network elements from, the
existing local telephone companies. As of February 15, 2000, we were authorized
to provide our products and services in 13 states and have several
interconnection agreements in negotiation with the ILECs.
As of December 31, 1999, we had 40 collocations, which are environmentally
controlled, secure sites designed to house transmission, routing and other
equipment. We are designing our collocations with an average of 100 square feet
in order to provide our customers direct local access via our access platform to
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those markets. We intend to expand our network to include multiple collocations
in ILEC central offices within our target markets in order to provide the
platform for our end-to-end service offerings for our customers.
Once our collocations are established, we plan to link these collocations
together within the market using unbundled network element transport from the
ILECs in order to provide our products and services throughout the market. In
addition to these unbundled network elements, there are other possible
alternatives for us to employ in linking these central offices. For instance, we
may lease or purchase dark fibers from a third party provider, use wireless
connections or possibly even lay our own local fiber if warranted based upon
demand.
EQUIPMENT SUPPLIER RELATIONSHIPS
We have agreed upon an exclusive vendor agreement with Lucent Technologies
which provides for discounted pricing on the fiber that we purchase from Lucent
as well as marketing and engineering support in connection with the expansion of
our network. The effectiveness of this agreement is conditioned on the execution
of documents relating to the financing by Lucent of such purchases of fiber and
the execution of these financing documents is, in turn, conditioned on the
closing of theTransaction.
Under a Master Agreement between us and NEC, dated August 8, 1997, we agreed
to purchase from NEC certain equipment, services and licensed software for us to
use in our network under pricing and payment terms the we believe are favorable.
In addition, NEC has agreed, subject to certain conditions, to warranty
equipment that we purchase from NEC for three years, if defective, to repair or
replace certain equipment promptly and to maintain a stock of critical spare
parts for up to 15 years. This agreement with NEC provides for fixed prices
during the first three years of its term.
We have also entered into a Purchase Agreement with the Andrew Corporation
in which we agreed exclusively to recommend to our co-development partners
certain products manufactured by Andrew. In return, Andrew agreed to sell those
products to our co-development partners and to us for a three year period,
renewable for two additional one-year periods at our option. The agreement
generally provides for discounted pricing based on projected order volume.
PROPOSED CREDIT FACILITY WITH LUCENT
We have been negotiating with Lucent Technologies, Inc., over the terms of
a senior secured credit facility that would provide us with vendor financing for
fiber optic cable purchases. The credit facility would be executed in connection
with a fiber optic cable purchase agreement where we agree to make Lucent our
exclusive provider of fiber optic cable. Neither party has signed the definitive
agreements governing the proposed financing, but we expect to execute definitive
agreements in the next several weeks. We describe below the material terms of
the proposed Lucent credit facility, based on the current drafts of the
agreements. We cannot assure you that we will enter into any financing
agreements with Lucent, or that any agreements that we execute will be on these
terms. However, we currently expect that we will enter into a vendor financing
agreement with Lucent on terms similar to those outlined below.
The first tranche of the proposed facility will be $60 million and will be
available to be drawn after the facility becomes effective until January 31,
2001. The proceeds of any loans by Lucent must be used to finance fiber optic
cable that we purchase under the fiber optic cable purchase agreement between us
and Lucent. The loans will not cover the entire invoice cost of those purchases.
15
Under the Lucent credit facility, we will be required to pay various customary
arrangement, commitment and other fees. To preserve exclusivity, Lucent must
offer additional tranches on similar terms to the first tranche.
If executed as currently drafted, we expect the proposed credit facility
with Lucent to have these terms:
o The first tranche loans would mature on December 31, 2005;
o Mandatory prepayments are required in connection with dark fiber sales
and other dispositions;
o Lucent's obligation to loan any funds under the facility is
conditioned on, among other things:
-- We must purchase and pay for a specified minimum dollar value of
Lucent products;
-- A newly-formed vendor financing subsidiary of Pathnet or Pathnet
Telecom would be the borrower under the credit facility and must
be capitalized with assets having a value of at least $60
million;
-- We must obtain the necessary permits (including any required
rights of way) required to build the network segment in which the
financed fiber will be installed; and
o The loans would bear interest at floating rates based on an index plus
a specified margin.
The indebtedness outstanding under the Lucent credit facility is expected to
be guaranteed by the borrower (a newly formed vendor financing subsidiary of
ours or Pathnet Telecommunications, Inc.). The indebtedness will be secured by
all property and assets owned by, and all capital stock of and inter-company
indebtedness owed to, the borrower.
We anticipate that the Lucent credit facility will contain various covenants
typical for facilities of this nature. Some of those covenants will restrict the
vendor financing subsidiary and its subsidiaries, if any, from, among other
things:
o Incurring indebtedness;
o Entering into merger or consolidation transactions;
o Disposing of their assets;
o Acquiring assets; and
o Making certain restricted payments;
o Paying interest or principal on the Notes if excess cash is available
at PTI or us for Note repayment;
o Creating any liens on its assets;
o Making investments;
o Entering into sale and leaseback transactions; and
o Entering into non-arms'-length basis transactions with affiliates.
As currently drafted, the Lucent credit facility also requires that the
vendor financing subsidiary comply with various customary financial covenants,
including required ratios for:
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o Consolidated Indebtedness to Total Capitalization;
o Consolidated Indebtedness to Consolidated EBITDA;
o Consolidated EBITDA to Consolidated Debt Service;
o Consolidated EBITDA to Consolidated Interest Expense; and
o Minimum annual revenues to the vendor financing subsidiary.
The draft Lucent credit facility contains a number of events of default,
including:
o Nonpayment of principal, interest, fees or other amounts;
o The occurrence of a default on other material indebtedness of the
vendor financing subsidiary and its subsidiaries (if any) and, in
certain circumstances, of Pathnet Telecommunications, Inc. and its
subsidiaries including a termination by Lucent as the result of our
default on the fiber supply agreement with Lucent;
o Failure to comply with certain covenants, conditions or provisions
under the credit facility;
o The existence of certain judgments;
o The occurrence of any default under material agreements that could
result in a material adverse effect on the vendor financing
subsidiary;
o The breach of representations or warranties;
o Commencement of reorganization, bankruptcy, insolvency or similar
proceedings;
o The occurrence of certain ERISA events; and
o A change of control of Pathnet Telecommunications, Inc. or the vendor
financing subsidiary.
If the borrowing subsidiary defaults on its obligations under the Lucent
credit facility, all of those obligations could be declared to be immediately
due and payable. Upon a payment default or upon any acceleration of the
obligations under the Lucent credit facility, assuming those obligations
exceeded $7.5 million, any amounts then owing under the Notes would become
immediately due and payable.
Under the Lucent credit facility, the vendor financing subsidiary is not
permitted to offer any guarantee of any indebtedness of Pathnet
Telecommunications, Inc. or us. In addition to the Lucent credit facility, we
intend to enter into similar financing arrangements with other of our equipment
vendors. We expect that other vendor financing participants will demand similar
restrictions.
NETWORK RELIABILITY
We have constructed our network operations center in Washington, D.C. This
network operations center, currently provides real-time, end-to-end monitoring
of our network operations 24 hours a day, seven days-a-week, as well as
pro-active customer care for all of our customers' services. The network
operations center ensures the efficient and reliable performance of the network
through pro-active early identification and prevention of potential network
disruptions. In addition, our network operations center enables us to schedule
and conduct maintenance of our network while minimizing interference with the
use of the network by our customers. Specific features provided by our network
operations center include network fault and event management, network and
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service level performance management and analysis as well as remote
configuration of all network elements. our network operations center has full
fallback capability and it appears to be Year 2000 compliant.
COMPETITION
Competition in the telecommunications industry is intense. In our target
markets, we expect to face increasing competition in the areas of price and
performance, transmission quality, breadth and reliability of our network,
customer service and support, brand recognition and critical relationships with
third parties such as Internet service providers. While we generally will not
compete with telecommunications service providers for end user customers, we may
compete as a "carriers' carrier" with certain of those providers including IXCs
(such as AT&T Corp., MCI WorldCom, Inc. and Sprint Corporation), wholesale
providers (such as Qwest Communications International Inc., Williams
Communications Group, Inc., DTI Holdings, Inc., Global Crossing Ltd and Level 3
Communications, Inc.), ILECs (such as US West, BellSouth, Bell Atlantic, SBC and
GTE Corporation) and CLECs (such as GST Communications, Inc., ITC/Deltacom, Inc.
and Metromedia Fiber Network, Inc.) who would otherwise be our customers in our
target markets. Other entities which may become our competitors in this regard
include communications service providers, cable television companies, electric
utilities, wireless telephone operators, microwave carriers, satellite carriers,
and large end users with private networks.
Initially, in second and third tier markets our most significant competitors
will be ILECs and other CLECs. Many of the largest ILECs will begin offering in
the near future some of the products and services we plan to offer and some have
already begun to do so. These companies are able to draw upon established
networks, well-known brand names, customer loyalty, a pre-existing base of
management and employees, and greater access to capital than will likely be
available to us. Moreover, many ILECs own the telephone wires they use, and can
bundle digital data services, for example, without having to incur the costs of
negotiating interconnection agreements. As other industry participants also seek
to enter these markets, we will face increasing competition.
Industry consolidation and strategic alliances between participants in the
telecommunications industry will also increase the level of competition we will
face, particularly as the demand for bundling of services surges. New
technologies, further deregulation and other changes in our regulatory
environment will create further competitive pressures as we enter our target
markets.
GOVERNMENT REGULATION
OVERVIEW. Our telecommunications businesses are subject to varying degrees
of federal, state and local regulation. We are a telecommunications carrier
under the terms of the federal Communications Act. As a telecommunications
carrier, we are subject to FCC and state utility commission regulation of our
activities. Local authorities also may regulate the permitting and construction
of our telecommunications facilities.
The Telecommunications Act created a uniform national policy in favor of
competition in all telecommunications market segments. As described below, the
rules and policies implementing the Telecommunications Act remain subject to
agency action and litigation at both the federal and state level. We nonetheless
believe that the national policy in favor of competition that was created by the
Telecommunications Act will lead to increased market opportunities for us.
Because these opportunities require additional agency action before the
Telecommunications Act is fully implemented, and because these actions may be
18
subject to court review, we cannot predict the pace at which the law will be
fully implemented.
We are required to file federal and state tariffs describing the prices,
terms and conditions of our services, and these tariffs are subject to varying
degrees of regulatory oversight and approval. We must also comply with state and
local license or permit requirements relating to the installation and operation
of our network. Burdensome license, permit or other regulatory requirements or
developments could make it more difficult for us to comply with these laws and
regulations.
The FCC and state public service commissions generally have the right to
impose sanctions, forfeitures, or other penalties mandating refunds if a carrier
fails to comply with applicable rules. We cannot assure you that regulators or
such third parties will determine that we have complied with all applicable laws
and regulations. Any proceedings against us could have a material adverse effect
on our business, financial condition, or results of operations.
FEDERAL REGULATION. The FCC regulates interstate and international
telecommunications services, and it also regulates the holders of radio
licenses. We are subject to FCC regulation as a common carrier, which means that
we are subject to longstanding general requirements that our rates be "just and
reasonable" and that we not engage in "unjust or unreasonable discrimination" in
serving the public. As a common carrier, we also must file certain periodic
reports and applications with the FCC, and the FCC has jurisdiction to act on
certain complaints for failure to comply with regulatory obligations. We also
are required to file basic tariffs at the FCC for our provision of
telecommunications services generally, although those tariffs are not subject to
pre-effective review and can be amended on one day's notice. We are subject to
the licensing processes of the FCC for the use of our microwave licenses. We
also generally must apply to the FCC for its consent before assigning a radio
license or transferring control (for example, through the sale of stock) of any
company holding radio licenses or common carrier authorizations.
We are not, however, subject to the particular laws and FCC regulations
imposed by the Telecommunications Act on ILECs, which are the existing local
telephone companies including, among others, the former Bell operating companies
and GTE. These regulations have provided, and we believe they will continue to
provide, significant opportunities for us to compete with ILECs for the
provision of competitive telecommunications services. These laws and regulations
require ILECs to:
o Provide "physical collocation" to competitors, a requirement that
permits us and other similarly licensed common carriers to install and
maintain our own network termination equipment at ILEC central offices;
o "Unbundle" components of their local service networks in a
nondiscriminatory manner so that we and other new competitors can obtain
network facilities, equipment, features, functions and capabilities at
cost-based prices (which may include a reasonable profit);
o Permit us and other competitors to "interconnect" with ILEC facilities
at any technically feasible point within their networks, at prices based
on cost (which may include a reasonable profit);
o Engage in "reciprocal compensation" for the exchange of
telecommunications traffic, an obligation that requires ILECs and new
competitors to complete calls originated by competing carriers under
reciprocal arrangements at prices based on a reasonable approximation of
incremental cost, or through the mutual exchange of traffic without
explicit payment;
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o Establish wholesale prices for their services to promote resale of
services and facilities by new competitors;
o Establish "number portability" so that customers can maintain their
existing phone numbers when they switch from one telecommunications
provider to another without impairing quality, reliability or
convenience;
o Establish "dialing parity" so that customers will not detect a
difference in quality or complexity in dialing telephone numbers or
accessing operators and emergency services; and
o Provide nondiscriminatory access to telephone poles, ducts, conduits
and rights of way.
Applicable FCC regulations require ILECs to negotiate in good faith with
carriers requesting any of the above arrangements. If the negotiating carriers
cannot reach agreement in a prescribed time, either carrier may request binding
arbitration of the disputed issues by a state regulatory commission. This set of
obligations provides significant market opportunity for new competitors, but, as
discussed below, we cannot assure you that the various government agencies
responsible for implementing these pro-competitive policies and requirements
will do so in a timely and effective manner.
The Telecommunications Act requires the FCC to establish rules and
regulations to implement its local competition provisions. In August 1996, the
FCC issued rules governing interconnection, resale, unbundled network elements,
the pricing of those facilities and services, and the negotiation and
arbitration procedures that would be utilized by states to implement those
requirements. These rules, which were generally favorable to new competitors,
were vacated in part by a July 1997 ruling of the United States Court of Appeals
for the Eighth Circuit. On January 25, 1999, the United States Supreme Court
issued an opinion upholding the authority of the FCC to establish rules,
including pricing rules, to implement statutory provisions governing both
interstate and intrastate services under the Telecommunications Act. The Court
also upheld rules allowing carriers to select provisions from among different
interconnection agreements approved by state commissions for the carriers' own
agreements (the "pick-and-choose" rule) and a rule allowing carriers to obtain
combinations of unbundled network elements.
The Supreme Court, however, vacated the FCC rule setting forth the specific
unbundled network elements that ILECs must make available, finding that the FCC
had failed to apply the appropriate statutory standard. On November 5, 1999, the
FCC responded to the Court's decision by issuing a decision that maintains
competitors' access to a wide variety of unbundled network elements. Six of the
seven unbundled elements the FCC had originally required carriers to provide in
its 1996 order implementing the Telecommunications Act remain available to
competitors. These elements are loops, including loops used to provide
high-capacity and advanced telecommunications services; network interface
devices; local circuit switching, subject to restrictions in major urban
markets; dedicated and shared transport; signaling and call-related databases;
and operations support systems. The FCC removed access to operator and directory
assistance service from the list of available unbundled network elements. In
addition, the FCC added to its list certain unbundled network elements that were
not at issue in 1996. These elements include subloops, or portions of loops, and
dark fiber loops and transport. The FCC did not, however, require ILECs to
unbundle facilities used to provide Digital Subscriber Line service (packet
switches and digital subscriber line access multiplexers). The FCC did not
decide, but sought additional information on, the question of whether carriers
20
may combine certain unbundled network elements to provide special access
services to compete with those provided by the ILECs. The ability to obtain
unbundled network elements is an important element of our business, and we
believe that the FCC's actions in this area have generally been positive.
However, we cannot predict the extent to which the existing rules will be
sustained in the face of additional legal action and the scope of the rules that
are yet to be crafted by the FCC. For example, the FCC may restrict the use of
unbundled network elements for the provision of services affording long distance
companies access to local telephone networks, which would reduce our competitive
price advantage and limit the market opportunities in that segment of the
telecommunications market.
The rates charged for interconnection and unbundled network elements we
require vary greatly. These rates are subject to the approval of state
regulatory commissions, through approval processes that typically involve a
lengthy review of the rates proposed by the ILECs in each state. The final rates
approved typically depend on the ILECs' initial rate proposals and the policies
of the state public utility commission. These rate approval proceedings are
time-consuming and expensive. Recurring and non-recurring charges for telephone
lines and other unbundled network elements may increase based on the rates
proposed by the ILECs and approved by state regulatory commissions from time to
time, which would have a material adverse effect on the results of our
operations. Moreover, because the cost-based methodology for determining these
rates is still subject to judicial review, there is great uncertainty about how
these rates will be determined in the future.
Underthe rules adopted by the FCC pursuant to the Telecommunications Act,
we have entered into collocation agreements with two major ILECs (BellSouth and
USWest) covering 17 states. These agreements include the provision of unbundled
network elements to be used in connection with competitive telecommunication
services. We have also entered into a collocation agreement with another
existing ILEC, BellSouth, covering 9 states. We expect these collocation
agreements to be part of the more comprehensive interconnection agreements with
these ILECs that are currently under negotiation. In addition, we are
negotiating additional collocation agreements in other states. We have
negotiated with two ILECs for the provision of unbundled network elements to be
used in connection with competitive telecommunications services. We expect the
pace of these negotiations to continue for the foreseeable future. Although we
expect, based on our experience thus far, that such negotiations will yield
acceptable agreements that will permit us to implement our business plan on
schedule, we cannot predict the extent to which ILECs interpreting the FCC
regulations may seek to frustrate our collocation plans or the extent to which
we will need to seek arbitration or commence litigation to achieve our goal. If
we are unable to enter into, or experience a delay in obtaining, interconnection
agreements, this inability or delay may materially and adversely affect our
business and financial prospects.
The FCC has been reviewing the policies and practices of the ILECs with the
goal of facilitating the efforts of telecommunications companies to obtain
access to central office space and other network facilities more easily and on
more favorable terms. On March 31, 1999, the FCC adopted rules to make it easier
and less expensive for telecommunications companies to obtain central office
space and to require ILECs to make new alternative arrangements for providing
central office space. However, the FCC's new rules have not been uniformly
implemented in a timely manner and may not ultimately enhance our ability to
obtain central office space. Difficulties we experience in obtaining access to
and interconnection with the ILECs' facilities can negatively impact our future
plans for providing certain services.
Our expected provision of DSL is largely unregulated by the
Telecommunications Act or the FCC because we, and the telecommunications
21
companies that are our customers, are not ILECs. Moreover, our customers
providing DSL service to end users, such as Internet service providers, are
unregulated "information services providers." The FCC affirmed in a report
adopted on April 10, 1998, that Internet service providers will not be subject
to regulation as telecommunications carriers under the Telecommunications Act.
They thus will not be subject to universal service subsidies and other
regulations. We cannot, however, assure you that neither Congress nor the FCC
will alter that regulatory scheme in the future. Further, in August 1998, the
FCC proposed new rules that would allow ILECs to provide their own DSL services
through separate affiliates that are not subject to ILEC regulation. Although
the FCC recently decided some of the other issues raised in that proceeding, the
question of whether ILECs can provide unregulated DSL services through a
separate affiliate remains unresolved. Some members of Congress also have
expressed interest in giving ILECs additional pricing flexibility for high speed
data services and expanding the geographic area in which ILECs may offer these
services to their customers. Any expansion of ILECs' ability to offer high speed
data and Internet services may have an adverse impact on our business. On
November 18, 1999, the FCC decided to require ILECs to share telephone lines
with DSL providers, an action that may foster competition by allowing
competitors to offer DSL services without the purchase their customers to having
to a second telephone line. Whether this development will be implemented in an
effective way remains to be seen. Moreover, it is impossible to predict whether
the FCC or Congress may change the rules under which these services are offered
and, if such changes are made, the extent of the impact of such changes on our
business.
The Telecommunications Act obligates the FCC to establish "universal
service" mechanisms to ensure that certain subscribers living in rural and
high-cost areas, as well as certain low-income subscribers, continue to have
access to telecommunications and information services at prices reasonably
comparable to those charged for similar services in urban areas. These
mechanisms also are meant to foster the provision of advanced telecommunications
services to schools, libraries and rural health-care facilities. Under the rules
adopted by the FCC to implement these requirements, we and all other
telecommunications providers will be required to contribute to a fund to support
universal service. The amount that we must contribute to the federal universal
service subsidy will be based on our share of specified defined
telecommunications end-user revenues. Therefore, it is difficult to predict in
advance the precise contributions that we will be required to make.
The FCC regulates the fees that local telephone companies charge long
distance companies for access to their local networks. These fees are commonly
called access charges. The FCC is currently considering a proposal, supported by
parts of both the local and long distance telephone industries, that would
restructure and most likely significantly reduce access charges. Changes in the
access charge structure could fundamentally change the economics of some aspects
of our business. Any material reduction in the access charges imposed by local
telephone companies could significantly reduce our price advantage in the market
for services affording long distance companies access to local telephone
networks.
As an enhancement to our local access services, during the second half of
2000, we expect to begin marketing and selling DSL services to our second and
third tier markets. To provide unbundled DSL capable lines to connect each
customer to our equipment, we will use networks owned by ILECs. The terms upon
which we connect our network to ILECs' networks are specified in interconnection
agreements that we must negotiate with the ILECs operating in our existing and
target markets. Federal law requires ILECs to provide access to their networks
through interconnection agreements and to offer network elements to other
telecommunications carriers at rates which generally must be cost-based and
22
nondiscriminatory. However, we may be unable to negotiate interconnection
agreements on favorable terms. The failure of ILECs to comply with their
obligations under these interconnection agreements could result in customer
dissatisfaction and the loss of potential customers.
We also are regulated by the FCC as the holder of a substantial number of
common carrier fixed point-to-point microwave licenses that we use on the
wireless portion of our network. Under the FCC's rules, we must coordinate our
proposed frequency use with other existing users of the spectrum to prevent
interference. After completing that process, we (and, in some cases, our co-
development partners) must apply to the FCC for the issuance of a license to
permit us to transmit information on the frequencies we desire to use. To obtain
a license we must demonstrate that the owner of the transmission site has
complied with the reporting, notification and technical requirements of the
Federal Aviation Administration for the construction, installation, location,
lighting and painting of transmitter towers and antennae like ours. Once the
license is obtained, we must make routine regulatory filings and obtain the
FCC's prior consent for any assignment of the license or any substantial change
in control of the entity holding the license and for certain modifications to a
licensed facility. We cannot assure you that we, or any of our co-development
partners who desire to be the licensee for their portion of our network, will
obtain all of the licenses or approvals necessary for the operation of our
business, the transfer of any license or the modification of any facility, or
that the FCC will not impose burdensome conditions or limitations on any such
license, transfer or approval.
Our ownership also is regulated by the FCC to ensure that we do not exceed
the foreign ownership restrictions imposed by the Communications Act. Under the
Act, we cannot increase our foreign ownership to a level greater than 25%
without obtaining prior FCC consent. The FCC has determined that it will
authorize a higher level of foreign ownership, up to 100%, on a streamlined
basis where the foreign ownership is by citizens of, or companies organized
under the laws of, World Trade Organization member states. (A more demanding
public interest showing is required by proposals to increase foreign ownership
by citizens or countries of non-WTO member states.) We currently comply with the
25% cap on foreign ownership, and we will monitor foreign investment to ensure
that we do not exceed that benchmark without obtaining appropriate FCC consent.
These requirements may, in some circumstances, be applied to our co-development
partners as well. If a co-development partner were to choose to hold the
relevant license itself, and not through a holding company, that co-development
partner would be subject a provision that limits direct foreign ownership of FCC
licenses to 20%. The FCC does not have discretion to waive this limitation. If a
co-development partner exceeded the 20% limitation it would be required to
reduce its foreign ownership in order to obtain or retain its license.
STATE REGULATION. The Telecommunications Act preempts state statutes and
regulations that restrict the provision of competitive local telecommunications
services. State commissions can, however, impose reasonable terms and conditions
upon the provision of telecommunications service within their respective states.
States also can require that telecommunications providers apply for and obtain a
certificate of public convenience and necessity or other authorization prior to
commencing service in their respective states. We are in the process of becoming
certified, to the extent such certification is required, in the 48 contiguous
states and the District of Columbia as a competitive local exchange carrier
("CLEC") or other competitive telecommunications carrier under the regulations
of each state's regulatory commission. We currently are authorized or permitted
to provide at least a portion of our proposed services in thirteen states:
Colorado, Florida, Idaho, Indiana, Iowa, Michigan, Minnesota, Montana, Nebraska
23
(local access services only), Oregon and Texas, Wisconsin and Wyoming (long
distance services only). We have pending applications before an additional eight
state commissions. Although we do not anticipate any issues that would prevent
us from obtaining authorization as a competitive telecommunications carrier in
each of the states in which we will apply, we cannot assure you that all
required state authorizations will be granted.
In most states, we are required to file tariffs setting forth the general
terms, conditions and prices for services classified as intrastate by the
particular state commission in question. Most states require us to list the
services provided and the specific rate for each service. Under various states'
rules, however, we have regulatory flexibility to set price ranges for specific
services and, in some cases, prices can be set on an individual customer basis.
We also may be required to file applications with some states for the assignment
of our state certifications to any other entity and for any transfer of
substantial control that we decide to undertake in the future. Some states also
may require a filing prior to the issuance of substantial debt or equity
securities or other transactions that would result in a lien upon the property
we use to provide intrastate telecommunications services. States generally
require us to file various reports and pay certain fees, including state
universal service subsidies. Like the FCC, most state commissions are empowered
to consider complaints filed against carriers subject to their jurisdiction. We
cannot assure you that our state certificates will not be revoked or amended by
state commissions.
LOCAL REGULATION. We may be required to obtain local permits for street
opening and construction permits to install and expand fiber optic networks.
Local zoning authorities often regulate our use of towers for microwave and
other telecommunications sites. We also are subject to general regulations
concerning building codes and local licensing. The Telecommunications Act
requires that fees charged to telecommunications carriers be applied in a
competitively neutral manner, but there can be no assurance that ILECs and
others with whom we will be competing will bear costs similar to those we will
bear in this regard.
OTHER LAWS AND REGULATIONS. Although the foregoing discussion provides an
overview of the major regulatory issues that confront our business, this
discussion does not attempt to describe all current and proposed federal, state
and local rules and initiatives affecting the telecommunications industry. Other
federal and state laws and regulations are currently the subject of judicial
proceedings and proposed additional legislation. In addition, some of the FCC's
rules implementing the Telecommunications Act will be subject to further
judicial review and could be altered or vacated by courts in the future. We
cannot predict the ultimate outcome of any such further proceedings or
legislation.
INTELLECTUAL PROPERTY
We use the name "Pathnet" as our primary business name and service mark, and
have registered that name with the United States Patent and Trademark Office. In
addition, we have registered our service mark "A NETWORK OF OPPORTUNITIES" and
our logo with the United States Patent and Trademark Office.
We regard our products, services and technology as proprietary and we
attempt to protect them with patents, copyrights, trademarks, trade secret laws,
restrictions on disclosure and other methods. These methods may not be
sufficient to protect our technology. We also enter into confidentiality or
license agreements with our employees and consultants, and generally control
access to and distribution of our documentation and other proprietary
information. Despite these precautions, it may be possible for a third party to
copy or otherwise obtain and use our products, services or technology without
24
authorization, or to develop similar technology independently.
We currently have a patent application pending and we intend to prepare
additional applications and seek patent protection for our systems to the extent
possible. These patents may not be issued to us, and if issued, they may not
protect our intellectual property from competition that could seek to design
around or invalidate these patents.
EMPLOYEES
As of January 31, 2000, we employed 126 people. As needed, we also hire
temporary employees and independent contractor computer programmers. In
connection with our growth strategy, we anticipate hiring a significant number
of additional personnel in sales and other areas of our operations in the near
future. Our employees are not unionized, and we believe our relations with our
employees are good. Our success will continue to depend in part on our ability
to attract and retain highly qualified employees. See "RISK FACTORS -- RISKS
RELATING TO OUR COMPANY OPERATIONS."
ITEM 2. PROPERTIES
Our network and our component assets are the principal properties that
we own. Our installed fiber optic cable is laid on rights of way held by us or
our co-development partners, and our digital wireless network is constructed on
our leasehold interests in telecommunications infrastructure.
Our corporate headquarters are located in Washington, D.C., and we
lease this space from 6715 Kenilworth Avenue General Partnership, under a Lease
Agreement dated August 9, 1997. Recently, we executed a lease with 11720
Sunrisecorp., L.L.C. for approximately 40,000 square feet of office space in
Reston, Virginia which will become our new headquarters in the first half of
2000. We also lease office space in Richardson, Texas under a lease that expires
in 2003.
We believe that all of our properties are well maintained.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we are a party to routine litigation and proceedings
in the ordinary course of business. We are not aware of any current or pending
litigation to which we are or may be a party that we believe could materially
adversely affect our financial position, results of operations or cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year covered by this Report on
Form 10-K, on December 31, 1999, the Company solicited written consents from the
holders of the Company's Series A Convertible Preferred Stock, Series B
Convertible Preferred Stock and Series C Convertible Preferred Stock
(collectively the "Stockholders") to (i) approve all actions taken by the Board
of Directors of the Company during the period from May 1, 1999 through December
31, 1999 and (ii) approve and ratify certain agreements and arrangements entered
into by the Company in the ordinary course of business during the period from
July 1, 1999 through December 31, 1999. Effective December 31, 1999, the Company
received written consents approving such proposals from Stockholders
representing 10,784,279 votes with Stockholders representing 5,080,436 votes
abstaining.
25
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company has authorized 60,000,000 shares of Common Stock for which
there is no established public trading market. As of February 15, 2000 there
were 7 record holders of the Company's Common Stock. As of December 31, 1999,
stock option awards to purchase 2,675,597 shares of Common Stock were
outstanding.
The Company has not paid any cash dividends on its Common Stock in the past
and does not anticipate paying any cash dividends on its Common Stock in the
foreseeable future. Further, the terms of the Indenture by and between the
Company and The Bank of New York, dated April 8, 1998 (the "Indenture") relating
to the Company's 12 1/4% Senior Notes due 2008 restrict the ability of the
Company to pay dividends on the Common Stock, as described in Management's
Discussion and Analysis of Financial Condition and Results of Operations, as
well as in Note 8 to the Company's Financial Statements included in Item 14
elsewhere in this Annual Report on Form 10-K.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
We present below selected historical consolidated financial information
for Pathnet and the pro forma balance sheet data for Pathnet Telecom. The
summary historical statements of operations data for the years ended December
31, 1997, 1998 and 1999 and for the period from August 25, 1995 (the date of
Pathnet's inception) to December 31, 1999 and the summary historical balance
sheet as of December 31, 1999 have been derived from our audited financial
statements that are included elsewhere in this Annual Report on Form 10-K. The
summary historical statement of operations data for the period from August 25,
1995 (date of our inception) to December 31, 1995 and for the year ended
December 31, 1996 and the balance sheet data as of December 31, 1995, 1996 and
1997 have been derived from Pathnet's audited financial statements that are not
included elsewhere in this Annual Report on Form 10-K. The unaudited pro forma
balance sheet data as of December 31, 1999 gives effect to the contribution and
reorganization transaction as if it occurred on January 1, 1999. We have
provided the unaudited pro forma balance sheet data for informational purposes
only.
26
PERIOD FROM PERIOD FROM
AUGUST 25, 1995 AUGUST 25, 1995
(DATE OF (DATE OF
INCEPTION) TO YEAR ENDED DECEMBER 31, INCEPTION) TO
DECEMBER 31, ------------------------------------------------------------ DECEMBER 31,
1995 1996 1997 1998 1999 1999
----------- ----------- ----------- ------------ ------------- -------------
STATEMENTS OF
OPERATIONS DATA:
Revenue........................ $ -- $ 1,000 $ 162,500 $ 1,583,539 $ 3,311,096 $ 5,058,135
Operating expenses:
Cost of revenue.............. -- -- -- 7,547,620 12,694,909 20,242,529
Selling, general and
administrative............. 429,087 1,333,294 4,247,101 9,615,867 14,669,747 30,295,096
Contribution and
Reorganization expenses.... -- -- -- -- 1,022,998 1,022,998
Depreciation and
amortization expense....... 352 9,024 46,642 732,813 6,204,381 6,993,212
---------- ----------- ----------- ----------- ------------- -------------
Total operating expenses....... 429,439 1,342,318 4,293,743 17,896,300 34,592,035 58,553,835
Net operating loss............. (429,439) (1,341,318) (4,131,243) (16,312,761) (31,280,939) (53,495,700)
Interest expense(a)............ -- (415,357) -- (32,572,454) (41,010,069) (73,997,880)
Interest income................ 2,613 13,040 159,343 13,940,240 13,111,953 27,227,189
Write off of initial public
offering costs................ -- -- -- (1,354,534) -- (1,354,534)
Other income (expense), net... -- -- (5,500) 2,913 142,743 140,156
---------- ----------- ----------- ----------- ------------- -------------
Net loss....................... $ (426,826) $(1,743,635) $(3,977,400) $(36,296,596) $ (59,036,312) $(101,480,769)
========== =========== =========== =========== ============= =============
Basic and diluted loss
per common share............. $ (0.15) $ (0.60) $ (1.37) $ (12.51) $ (20.14)
Weighted average number
of common shares outstanding... 2,900,000 2,900,000 2,900,000 2,902,029 2,931,644
AS OF DECEMBER 31
-----------------------------------------------------------------------------------------
1995 1996 1997 1998 1999 1999
---------- ----------- ----------- ----------- ------------- -------------
HISTORICAL PRO FORMA (b)
(UNAUDITED)
BALANCE SHEET DATA:
Cash, cash equivalents and
Marketable securities
excluding marketable
securities pledged as
collateral (b)............... $ 82,973 $ 2,318,037 $ 7,831,384 $227,117,417 $ 138,402,131 $ 170,448,726
Property and equipment, net ... 8,551 46,180 7,207,094 47,971,336 131,928,365 131,928,365
Intangible assets - right of
way ......................... -- -- -- -- -- 187,275,006
Total assets .................. 91,524 2,365,912 16,097,688 365,414,129 320,535,987 547,188,488
Long-term obligations (c)...... -- -- -- 346,212,125 349,714,404 353,989,404
Total liabilities ............. 17,350 145,016 5,892,918 366,492,370 380,303,073 383,074,949
Redeemable preferred stock .... 500,000 4,008.387 15,969,641 35,969,639 35,969,639 37,871,959
Stockholders' equity (deficit). (425,826) (1,787,471) (5,764,871) (37,047,880) (95,736,725) 125,566,854
- --------------------------
(a) The 1996 expense relates to the beneficial conversion feature of a loan at
December 31, 1996.
(b) The unaudited pro forma balance sheet data as of December 31, 1999 gives
effect to the contribution and reorganization transaction as if it occurred
on January 1, 1999. The unaudited pro forma balance sheet was derived by
adjusting Pathnet's historical balance sheet as of December 31, 1999 to
reflect the transaction described below:
o Contribution of over 12,000 route miles of rights of way with an
estimated value of $187 million for 8,511,607 shares of our series D
convertible preferred stock.
o Receipt of $38 million in cash at the initial closing for 1,729,631
shares of our Series E redeemable preferred stock. Another $25 million
in cash (which is excluded from our above pro forma balance sheet
data) will be received in exchange for 1,137,915 shares of our Series
E redeemable preferred stock (conditioned upon the completion of a
fiber optic network segment build that we expect to complete during
the first calendar quarter of 2000);
27
o Exchange of 2,977,593 shares of outstanding Pathnet common stock for
2,977,593 shares of PTI's common stock;
o Exchange of 5,470,595 shares of Pathnet mandatorily redeemable
preferred stock into 15,864,715 shares of PTI's convertible preferred
stock;
o Receipt of $1 million in cash for options to purchase 1,593,082 shares
of PTI's Series E redeemable preferred stock at $21.97 per share and
shares of PTI's common stock at an initial public offering;
o Receipt of $4 million in cash for PTI's sale to Colonial of rights in
a specified number of conduit miles of PTI's future network;
o Receipt of $275,000 in rights of way for PTI's sale to Colonial of
rights in a specified number of conduit miles of PTI's future network;
and
o Our payment of a 2.5% consent fee to holders of the notes (assuming
all holders of notes consent to the contribution and reorganization
transaction) of approximately $8.8 million in the aggregate.
(c) Cash, cash equivalents and marketable securities include investments in
marketable securities available for sale.
(d) Long term obligations include other non-current liabilities of $3,092,779.
(e) We have not included unaudited pro forma statement of operations
information to give effect to the contribution and reorganization
transaction as if it occurred on January 1, 1999. An unaudited pro forma
statement of operations would reflect only amortization expense of
approximately $939,000 of deferred financing cost attributable to the
consent fee that we plan to pay in connection with the contribution and
reorganization transaction and approximately $2,278,000 of anticipated
transaction costs, of which $1,898,000 will be expensed as incurred and the
remainder offset against stockholders' equity (deficit). The deferred
financing cost will be amortized and charged to interest expense over the
remaining life of the notes. Generally, we do not begin amortizing rights
of way used in our network until the network is completed and available for
use. As of December 31, 1999, none of the rights of way contemplated by the
contribution and reorganization transaction were used in our fiber optic
network. Because the amortization of the deferred financing cost and
expensed transaction costs would have represented the only pro forma
adjustments to the statement of operations data, we have not presented
unaudited pro forma statement of operations data. Instead, we have adjusted
our pro forma deficit accumulated during the development stage to account
for these expenses.
28
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN
FORWARD-LOOKING STATEMENTS MADE IN THIS SECTION AS A RESULT OF VARIOUS FACTORS,
INCLUDING THOSE DESCRIBED IN THE SECTION OF THIS ANNUAL REPORT ON FORM 10-K
ENTITLED "RISK FACTORS." YOU SHOULD ASSUME FOR PURPOSES OF THIS SECTION THAT ALL
REFERENCES TO OUR BUSINESS, OUR ACTIONS OR CONDITIONS AFFECTING US PRIOR TO THE
DATE OF THIS PROSPECTUS ARE REFERENCES TO PATHNET'S BUSINESS, ACTIONS OR
CONDITIONS AFFECTING PATHNET. UNLESS WE INDICATE OTHERWISE, REFERENCES TO OUR
FUTURE BUSINESS, STRATEGIES, OR PLANS, ARE REFERENCES TO OUR CONSOLIDATED
BUSINESS, STRATEGIES OR PLANS, INCLUDING PATHNET TELECOMMUNICATIONS, INC. AND
ITS OTHER FUTURE SUBSIDIARIES. YOU SHOULD READ THE FOLLOWING DISCUSSION AND
ANALYSIS IN CONJUNCTION WITH OUR COMBINED FINANCIAL STATEMENTS AND RELATED NOTES
INCLUDED IN THIS ANNUAL REPORT ON FORM 10-K. YOU CAN FIND ADDITIONAL INFORMATION
CONCERNING OUR BUSINESSES AND STRATEGIC INVESTMENTS AND ALLIANCES IN THE SECTION
OF THIS ANNUAL REPORT ON FORM 10-K ENTITLED "BUSINESS."
OVERVIEW
Since our inception on August 25, 1995, our principal activities have
included:
o Entering into strategic relationships with owners of telecommunications
assets and co-development partners;
o Developing and constructing our digital backbone network;
o Negotiating collocation and interconnection agreements and installing
collocations and interconnections off our backbone network;
o Designing and developing our network architecture and operations support
systems, including the buildout and launch of our 24-hour network
operations center;
o Raising capital and hiring management and other key personnel;
o Developing "leading edge" products and services; and
o Procuring governmental authorizations.
In November 1999 we signed a contribution and reorganization transaction
with three new investors, The Burlington Northern and Santa Fe Railway Company,
CSX Transportation Company, Inc. and Colonial Pipeline Company. If the
conditions to closing are satisfied and the Transaction is concluded, we expect
to develop additional backbone network from a pool of right of way miles
received in the Transaction -- 8,000 of which will have some form of
exclusivity. These additional route miles would provide us with the opportunity
to develop unique and diverse paths connecting our target markets back to major
tier one metropolitan areas.
As of December 31, 1999, our network consisted of over 6,300 wireless route
miles providing wholesale transport services to 30 cities and 500 miles of
installed unlit fiber. We are constructing an additional 600 route miles of
fiber optic network scheduled for completion in the first half of 2000. We have
also entered into two additional co-development agreements for the construction
of an additional 750 route miles of fiber optic network. During 2000, we intend
to deploy additional products and services including bundled wholesale transport
and local access services.
29
We have experienced operating losses since our inception, and we expect
these operating losses to continue as we expand our operations. Implementing our
business plan will require significant capital expenditures. See "RISK FACTORS
- -- RISKS RELATING TO OUR FINANCING." Our financial performance will vary from
market to market, and the time when we will achieve positive earnings before
interest, taxes, depreciation and amortization, if at all, will depend on the:
o Size of our target markets;
o Timely completion of backbone routes, collocations and interconnections;
o Cost of the necessary infrastructure;
o Timing of and barriers to market entry; and
o Commercial acceptance of our services.
SOURCES OF REVENUE
INFRASTRUCTURE SERVICES. We employ a "smart build" approach in the
development of our network that includes determining the level of customer
demand on a route before construction and, in certain cases, entering into
pre-construction sales of dark fiber and conduit. We can sell indefeasible
rights of use or leases of fiber or conduit along a segment of our network at a
fixed price. Under our dark fiber and conduit sales agreements, we expect to
receive all of the proceeds relating to the sale of the dark fiber and conduits
upon completion of the route and acceptance by the customer. Our dark fiber and
conduit sale business is becoming increasingly competitive as other carriers
build and expand their networks. To expedite infrastructure development and
decrease development risk, we have sought, and in the future will continue to
seek, co-developers to share the project construction costs. We have pursued
co-marketing arrangements to facilitate selling the assets along network
segments and we may continue to do so in the future.
MANAGEMENT SERVICES. To date, we have generated revenues primarily from
services related to the construction of our digital network. We expect to
continue construction of our digital network with co-development partners when
these projects will allow us to retain bandwidth, fiber or conduit assets on
routes that complement and reduce the costs of completing our network. We
anticipate that the percentage of revenues that we receive from management
services will decline as we near the completion of our network.
WHOLESALE TRANSPORT AND LOCAL ACCESS SERVICES. We provide inter-city and
local wholesale transport services and local access services to our customers on
a long-term or month-to-month basis. We plan to bundle local access services
with our wholesale transport services to provide low cost, end-to-end solutions
for our customers. Our service agreements with customers are generally leases of
capacity which provide for monthly payments due in advance on a fixed-rate
basis. We price our customer contracts according to the capacity, the length of
the circuit used, the term of the contract and the extent of value added
services provided. Nonrecurring revenues include installation and activation
charges for new customers. We seek to price our services competitively in
relation to those of the ILECs and other competitive telecommunications
companies in our targeted underserved and second and third tier markets.
Although pricing will be an important part of our strategy, we believe that
30
customer relationships, customer care and consistent quality will be the key to
generating customer loyalty. During the past several years, market prices for
many telecommunications services have been declining -- a trend we believe will
likely continue. As prices decline for any given service, we expect that the
total number of customers and the proportion of our customers purchasing our
bundled services will increase.
OPERATING EXPENSES
COST OF REVENUE. The primary components of our cost of services to date have
been costs relating to network engineering, operations and maintenance. With
expected growth of our bundled wholesale transport and local access services we
expect components such as access costs (including fees for use of the local
loop, rent, power and other fees charged by ILECs, competitive
telecommunications companies and other providers) and costs associated with the
provision of services to comprise a greater portion of our costs of service.
SELLING, OPERATIONS AND ADMINISTRATION. We are building a small and focused
sales and marketing department that should allow us to maintain a low ratio of
overhead expenses to revenues compared to other telecommunications service
providers. Our general and administrative costs include expenses typical of
other telecommunications service providers, including office leases, customer
care, billing, corporate administration and human resources. We expect that
these costs will grow significantly as we expand our operations and that our
administrative overhead will be a large portion of these expenses. However, we
expect these expenses to decline as a percentage of our revenue as we build our
customer base and increase the number of customers connected to our network.
DEPRECIATION AND AMORTIZATION. Because we are primarily a facilities-based
wholesale provider, expenses associated with depreciation of property, plant and
equipment will be a substantial ongoing expense for us. We expect depreciation
and amortization expense to increase significantly as more of our network
becomes operational and as we increase capital expenditures to expand our
network. Depreciation and amortization expense will include:
o Depreciation of network infrastructure equipment;
o Depreciation of improvements to central offices, other collocations
and related equipment;
o Depreciation of network control center facilities, furniture, fixtures
and corporate facilities;
o Amortization of rights of way; and
o Amortization of software.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
During the year ended December 31, 1999, we continued to focus on :
o developing relationships and strategic alliances with owners of
valuable telecommunications assets such as rights of way and with
co-development partners,
o building out our network,
o obtaining the regulatory status and entering into interconnection
agreements in each of our target markets to enable us to obtain
31
unbundled network elements and central office space from the ILECs,
and
o developing our infrastructure including the hiring of key management
personnel.
REVENUE. For the twelve months ended December 31, 1999 and 1998, we
generated revenues of approximately $3.3 million and $1.6 million, respectively.
This increase is attributable to revenues from our sales of telecommunications
services, which were $2.4 million in 1999 compared with approximately $165,000
in 1998. We expect that a substantial portion of our future revenue will be
generated from our sale of wholesale transport services, local access services
and backbone infrastructure services.
OPERATING EXPENSES. For the twelve months ended December 31, 1999 and 1998,
we incurred operating expenses of approximately $34.6 million and $17.9 million,
respectively. The increase is primarily a result of additional staff costs
incurred in developing our infrastructure, depreciation expenses as more of our
network came on line and administrative costs related to obtaining regulatory
status. Cost of revenue reflects direct costs we incurred in performing
construction and management services and providing telecommunications services.
INTEREST EXPENSE. Interest expense for the twelve months ended December 31,
1999 and 1998 was approximately $41.0 million and $32.6 million, respectively.
Interest expense primarily represents interest on the notes issued in April 1998
together with the amortization expense related to bond issuance costs in respect
of the notes and the amortization expense related to deferred financing costs.
INTEREST INCOME. Interest income for the twelve months ended December 31,
1999 and 1998 was approximately $13.1 million and $13.9 million, respectively.
The decrease in interest income reflects a decrease in cash and cash equivalents
and marketable securities as those funds were used in building our network,
funding operations, and making interest payments on our notes in April and
September of 1999.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
During the twelve months ended December 31, 1998, we focused on (1)
developing relationships and strategic alliances with owners of valuable
telecommunications assets such as rights of way and with co-development
partners, (2) building out our network, and (3) hiring key management and other
personnel.
REVENUE. Substantially all of our revenue for the year ended December 31,
1998 consisted of fees received for services we provided to our wireless
co-development partners, including analysis of existing facilities and system
performance, advisory services relating to personal communication system (or
PCS) provider spectrum relocation matters, and turnkey network construction and
management services. For the years ended December 31, 1998 and 1997, we
generated revenue of approximately $1.6 million and $162,500, respectively. This
increase was attributable to fees we received for performing construction and
management services primarily for one customer.
OPERATING EXPENSES. For the twelve months ended December 31, 1998 and 1997,
we incurred operating expenses of approximately $17.9 million and $4.3 million,
respectively. This increase results primarily from accelerating the buildout of
32
our network and additional staff costs incurred in developing our
infrastructure. Cost of revenue reflects direct costs we incurred in performing
construction and management services and providing telecommunications services.
INTEREST EXPENSE. Interest expense for the twelve months ended December 31,
1998 was approximately $32.6 million. We had no interest expense for the twelve
months ended December 31, 1997. Interest expense primarily represents interest
on the notes together with the amortization expense related to bond issuance
costs in respect of the notes.
INTEREST INCOME. Interest income for the twelve months ended December 31,
1998 and 1997 was approximately $13.9 million and $159,300, respectively. The
increase in interest income represents interest earned on the proceeds of the
notes issued in April, 1998.
CAPITAL EXPENDITURES
We have invested a significant amount of capital constructing and deploying
our digital network. We intend to continue to expand our network coverage. We
plan to add a bundled product comprised of local access and wholesale transport
to our existing products. These efforts will require us to fund our operating
losses and we will require significant capital to:
o Continue construction and development of our nationwide network
infrastructure;
o Purchase and install electronics, transmission and interconnection
equipment and other components along the network and as needed to
establish the platform for our local access and bundled services;
o Procure, design and construct central office and other collocation and
interconnection sites; and
o Continue development of our corporate infrastructure.
Capital expenditures were approximately $80.2 million for the twelve months
ended December 31, 1999. We expect that our capital expenditures will be
substantially higher in future periods in connection with the expansion of our
network and services in our target markets.
As of December 31, 1999, we had capital commitments of approximately $89.9
million relating to the development of our network pursuant to existing
agreements. From December 31, 1999 until December 31, 2000 we intend to:
o Complete the construction and lighting of network segments to which we
are currently committed, including Chicago, Illinois to Aurora (a suburb
of Denver), Colorado, Grand Junction, Colorado to Alberquerque, New
Mexico and Alberquerque to El Paso, Texas;
o Begin perfection and pre-engineering of selected network segments from
the right of way acquired under the Contribution and Reorganization
Transaction; and
o Commence construction on up to three additional fiber routes;
o Continue interconnecting and collocating in 60 to 80 of our targeted
33
underserved and second and third tier markets.
LIQUIDITY AND CAPITAL RESOURCES
From inception through December 31, 1999, we financed our operations
primarily through private placements of $36 million of equity securities and
$338.7 million of net proceeds raised from the issuance of the Senior Notes in
April 1998. As of December 31, 1999, we had approximately $138.4 million of
cash, cash equivalents and marketable securities to fund future operations. In
connection with the Transaction, Colonial is to contribute an aggregate
(including both tranches) of $68 million in cash to us in exchange for shares of
our series E convertible preferred stock, rights to a single conduit along the
Colonial rights of way and an option to purchase additional shares of PTI's
capital stock. The Transaction will bring the total cash equity investment in
PTI and its subsidiaries to $100 million, including $25 million to be received
upon the completion of a fiber optic network during the second calendar quarter
of 2000.
In addition, we expect to finance the cost of some of our equipment through
vendor financing arrangements. We have negotiated with Lucent a proposed credit
facility in which Lucent will, subject to certain conditions (including the
closing of the Transaction), provide us with financing for fiber optic cable
that we purchase from them. For a description of the terms and conditions of the
proposed financing transaction with Lucent see "BUSINESS -- PROPOSED CREDIT
FACILITY WITH LUCENT."
We estimate that our current available resources, together with those to be
received in the contribution and reorganization transaction, will be sufficient
to fund the implementation of ourlong term business plan, as currently
contemplated, including the capital commitments described above, operating
losses in new markets and working capital needs through the fourth quarter of
2000. In the event the strategic investment from Colonial is not consummated or
is consummated on different terms, this projection of available resources may
change. After such time, we expect we will require additional financing, which
may include commercial bank borrowings, additional vendor financing or the sale
or issuance of equity or debt securities.
Our expectations of our future capital requirements and cash flows from
operations are based on current estimates. If our plans or assumptions change or
prove to be inaccurate, we may require additional sources of capital or
additional capital sooner than anticipated. See "RISK FACTORS -- RISKS RELATING
TO OUR FINANCING."
YEAR 2000 READINESS DISCLOSURE
The Year 2000 issue exists because many computer systems and software
applications use two, rather than four, digits to designate a particular year.
As a result, these systems and applications may not properly recognize the Year
2000, or process data that includes that date, potentially causing data
miscalculations or inaccuracies, operational malfunctions or failures.
OVERVIEW OF OUR YEAR 2000 PROGRAM. In the fourth quarter of 1998, we began
a corporate-wide program to ready technology systems, non-technology systems and
software applications for the Year 2000. We identified all systems and
34
applications that we believe needed to be modified or reprogrammed to achieve
Year 2000 compliance and implemented the necessary changes.
In December 1999, we completed the inventory, assessment and remediation of
mission critical hardware systems and software applications, including network
computing and network systems engineering. We developed and tested contingency
plans for the event that certain of our suppliers or service providers may not
have been Year 2000 compliant.
In preparation for the Year 2000 transition, we provided 24 hour coverage
from December 31, 1999 through January 3, 2000 in our network operating center
and corporate data center. No year 2000 related problems were encountered and no
interruption of service occurred.
As part of our Year 2000 plan, we requested confirmation from our
communications equipment vendors and other key suppliers, financial institutions
and customers that their systems would be Year 2000 compliant. Responses
received indicated a high level of Year 2000 compliance at these companies.
Although we have incurred no Year 2000 problems to date, we cannot assure you
that the systems of companies with which we do business are Year 2000 compliant.
If the vendors important to us fail to provide needed products and services, our
network buildout and operations could be affected and thereby have a material
adverse effect on our results of operations, liquidity and financial condition.
We hired outside consultants to assist us with our Year 2000 compliance,
but we relied primarily on our own employees to develop and implement our Year
2000 compliance strategy. Because our existing systems are relatively new, we
have not replaced any significant portion of them. As a result our expenditures
to implement our Year 2000 plan were not material to date and we do not believe
our future expenditures on this matter will be material (remediation costs
incurred to date have been less than $100,000). Such expenditures represented
less than 1% of 1999 projected capital expenditures and were funded out of cash
flow from operations. To the extent we will have to replace a significant
portion of our technology systems, which currently appears unlikely, our
expenditures could have material adverse effects on us. As a result, our
expenditures to ensure Year 2000 compliance have not been material to date. We
expect to continue to use existing employees for the significant part of our
Year 2000 compliance efforts.
Due to the general uncertainty inherent in the Year 2000 problem, resulting
in large part from the uncertainty of the Year 2000 readiness of third parties,
we cannot ensure our ability to timely and cost effectively resolve problems
associated with the Year 2000 issue that may adversely affect our operations and
business or expose us to third party liability and we have been unable to fully
determine the risks associated with the reasonably likely worst case scenario.
RISK FACTORS
The extent to which the risk factors described in this "RISK FACTORS"
section will affect us depend at least in part on the disposition of the
contribution and reorganization transaction. If the contribution and
reorganization transaction is completed, we and Pathnet Telecommunications Inc.
will operate the business on a consolidated basis. We will become a wholly-owned
subsidiary of Pathnet Telecommunications, Inc. As a result, risk factors that
relate to future business plans would apply to Pathnet Telecommunications, Inc.
as well as to us. If the contribution and reorganization transaction is not
completed, the risk factors, to the extent they relate to rights of way to be
contributed to us in that transaction, will not apply.
35
RISKS RELATING TO OPERATIONS
IF WE FAIL TO SATISFY THE CONDITIONS TO CLOSING UNDER THE CONTRIBUTION
AGREEMENTS WITH BNSF, CSX AND COLONIAL AND THE TRANSACTION DOES NOT TAKE PLACE,
THE COMPANY'S BUSINESS PLAN AND FINANCIAL CONDITION WILL BE ADVERSELY AFFECTED.
The obligations of BNSF, CSX and Colonial to close on the Transaction are
subject to a variety of conditions. Among these conditions is the requirement
that the holders of a majority of the outstanding amount of the Company's notes
consent to the transaction. If these conditions are not satisfied on or before
March 31, 2000, than the parties to the Transaction have the right to terminate
the agreements. If we are unable to obtain the necessary noteholder consent or
fail to satisfy any of the other conditions on or before March 31, 2000, and if
the transaction is terminated as a result, the Company will lose access to the
additional assets and cash to be contributed in the Transaction, and the
Company's current business plan will need to be substantially modified.
IF WE ARE UNABLE TO DEVELOP THE RIGHTS OF WAY THAT WE WILL RECEIVE IN THE
CONTRIBUTION AND REORGANIZATION TRANSACTION, OR IF THE DEVELOPMENT COSTS MORE OR
TAKES LONGER THAN WE ANTICIPATE, WE MAY NOT BE ABLE TO DEVELOP ALL PORTIONS OF
OUR NETWORK OR GENERATE THE REVENUES NECESSARY TO BECOME PROFITABLE.
Several factors could interfere with our ability to develop or even prevent
us from developing the rights of way or portions of those rights of way that are
the subject of the contribution and reorganization transaction:
o our inability to obtain property rights from third parties where BNSF, CSX
and Colonial do not own outright much of the property over which they are
granting us rights of way;
o restrictions imposed by BNSF, CSX, and Colonial to minimize or prevent
interference with their primary business operations;
o physical or engineering restrictions;
o terms of existing contractual arrangements between BNSF, CSX or Colonial
and third parties, including our competitors; and
o competitive factors, including potential oversupply of communications
bandwidth along the segments that we wish to develop.
We cannot assure you that we will obtain the necessary property rights and
access to the segments that we wish to develop. If we fail to obtain these
rights, we may not be able to develop these rights of way for our network, and
our business plans would be impaired. In addition, we cannot predict with
certainty the costs of developing segments of our network on these rights of
way. These costs could be significantly higher than we anticipate and may be
prohibitively expensive.
IF WE ARE UNABLE TO COMPLETE CONSTRUCTION OF THE NETWORK ROUTE SEGMENT ON WHICH
COLONIAL HAS CONDITIONED THE $25 MILLION SECOND TRANCHE OF ITS INVESTMENT IN OUR
SERIES E CONVERTIBLE PREFERRED STOCK, WE MAY NOT RECEIVE THOSE FUNDS FROM
COLONIAL AS PLANNED.
Our contribution agreement with Colonial requires us to complete
construction of the Chicago, Illinois to Aurora, a suburb of Denver, Colorado,
36
as a condition to our receiving the second tranche of the Colonial investment.
We may be unable to complete this construction within the time frame allotted
under the agreement. If we are unsuccessful in building this portion of the
network in a timely manner, we will forfeit $25 million of the funds that we
expect to receive in the contribution and reorganization transaction. A loss of
these funds could hinder our ability to implement our business plan as currently
contemplated.
WE HAVE AGREED TO INDEMNIFY BNSF, CSX AND COLONIAL FROM CERTAIN LOSSES AND
LIABILITIES IN DEPLOYING AND OPERATING OUR NETWORK, AND THESE LOSSES AND
LIABILITIES COULD BE SIGNIFICANT.
In the agreements by which we obtain our rights of way we have agreed to
release and indemnify BNSF, CSX and Colonial from claims, losses or liabilities
resulting from damage to property, personal injury to personnel, and many other
circumstances while we construct and operate our network. In some cases, our
release and indemnity apply even to circumstances outside of our control,
including where the claim, loss or liability arises from the negligence or gross
negligence of BNSF, CSX, Colonial or their employees or contractors within their
control. While we intend to obtain insurance to address these issues, we cannot
ensure that insurance coverage will be available or, if it is available,
adequate to cover all of these risks. If our insurance coverage is inadequate,
or if coverage is not available for some of these risks, we could be exposed to
significant losses and liabilities.
OUR TELECOMMUNICATIONS NETWORK WILL BE CONSTRUCTED ON RIGHTS OF WAY USED FOR
RAILROAD AND PIPELINE PURPOSES AND COULD BE DAMAGED OR DELAYED BY OTHER BUSINESS
OPERATIONS CONDUCTED ALONG THOSE RIGHTS OF WAY.
BNSF, CSX and Colonial use the rights of way on which we intend to install
our telecommunications network for railroad and pipeline purposes. Events could
occur, including the derailment of a train, the breach of a pipeline or damage
resulting from track or pipeline maintenance or construction, that could
interrupt telecommunications services on or otherwise damage our network. If any
of those events occur, our ability to provide telecommunications services to our
customers could be compromised, and our relationship with those customers could
be seriously damaged.
IF WE CANNOT SUCCESSFULLY COORDINATE OUR NETWORK CONSTRUCTION AND OPERATIONS
WITH OUR RIGHTS OF WAY PROVIDERS' EXISTING OPERATIONS AS REQUIRED UNDER OUR
AGREEMENTS, WE MAY NOT BE ABLE TO DEVELOP OR OPERATE OUR NETWORK AS PLANNED AND
OUR REVENUES COULD BE MATERIALLY IMPAIRED.
The lease and access agreements we will enter into with BNSF, Colonial, CSX
and our other rights of way providers require that we coordinate our network
design, construction, deployment, operation and maintenance with the rail,
pipeline, utility and other operations of the applicable rights of way
providers. Those agreements generally provide that the rights of many providers'
operational needs take precedence over our own in terms of scheduling, access
time, personnel and other rights. Scheduling conflicts could increase our
development or operational costs on particular segments of rights of way, or
make deployment along the affected segment commercially impracticable. If we
cannot coordinate these activities successfully with the rights of way
providers, the development, design, construction, deployment, operation and
maintenance of the affected segments of our network could be delayed or become
prohibitively expensive.
WE ARE UNDERTAKING A MAJOR EXPANSION OF THE BUSINESS AND WE MAY NOT BE ABLE TO
MANAGE THIS EXPANSION EFFECTIVELY GIVEN OUR LIMITED PAST OPERATING EXPERIENCE.
37
Pathnet was incorporated in August 1995 and is a development stage company
with only a limited operational history. As of December 31, 1999, we had
constructed approximately 6,300 wireless route miles and 500 fiber route miles
of our digital network and had completed construction of 40 collocations. To
achieve our business plan, we will need to expand our fiber network
substantially and at a much faster rate than in prior years.
The success of this expansion will depend upon, among other things, our
ability successfully to:
o implement our sales and marketing strategy;
o evaluate markets for our products and services;
o acquire additional rights of way;
o identify profitable network routes;
o secure additional financing for our network deployment;
o reach agreement with a sufficient number of appropriate co-development
partners to develop the network necessary to complete our business
plan;
o install facilities;
o obtain required government authorizations;
o interconnect to, and collocate with, facilities owned by existing
local telephone companies; and
o obtain appropriately priced unbundled network elements and wholesale
services from existing local telephone companies.
We must accomplish these activities in a timely manner, at reasonable cost
and on satisfactory terms and conditions. As we increase our product and service
offerings and expand our network into our targeted markets, there will be
additional demands on operating support systems, sales and marketing,
administrative resources and network infrastructure. We cannot assure you that
we will be able to manage our growth successfully, and if we are unsuccessful in
doing so, our business, results of operations and financial condition will be
negatively affected. Moreover, because we are expanding our business plan into
new markets and technologies not previously used by us, we may not be able to
identify and manage all of the material risks that may arise as we pusue this
new business plan.
DEVELOPING AND EXPANDING OUR BUSINESS MAY SUBJECT US TO ADDED MARKET AND
REGULATORY RISKS.
The rights of way acquired in connection with the contribution and
reorganization transaction may significantly expand our business, making us more
vulnerable to competition from major telecommunications companies and more
likely to become the subject of regulatory scrutiny. Increased competition or
regulatory burdens could interfere with our ability to capitalize on the
expansion of our business.
OUR BUSINESS PLANS REQUIRE US TO MAKE SIGNIFICANT INVESTMENTS IN A RAPIDLY
EVOLVING INDUSTRY AND OUR BUSINESS AND FINANCIAL PERFORMANCE MAY SUFFER IF
MARKET AND TECHNOLOGICAL DEVELOPMENTS RENDER OUR CHOSEN TECHNOLOGIES AND
38
STRATEGIES OBSOLETE OR UNRESPONSIVE TO MARKET DEMAND.
Our business strategy is to provide an integrated bundle of
telecommunications services and expand our operations and network. To implement
this strategy will be investing heavily in a rapidly evolving industry. As a
result our investments will be subject to a variety of factorsin addition to
those described in the other "risk factors" set forth in this Annual Report on
Form 10-K. These additional risks include:
o market pricing pressures for the services and products we offer;
o changes in expenses associated with the construction and expansion of
our network and services;
o operating and technical problems;
o availability of additional capital on acceptable terms; and
o variations in market growth rates for our products and services;
These factors could adversely affect our business strategies by increasing
the cost and difficulty of implementing our business plans, or making it more
difficult for us to generate adequate revenues.
WE MAY BE UNABLE TO HIRE AND RETAIN SUFFICIENT QUALIFIED PERSONNEL, AND THE LOSS
OF ANY OF OUR KEY EMPLOYEES COULD MATERIALLY ADVERSELY AFFECT OUR ABILITY TO
CONSTRUCT OUR NETWORK, CONDUCT OUR NETWORK OPERATIONS AND IMPLEMENT OUR SALES
STRATEGY.
Our products and services are technical in nature, and the market for
employees in the telecommunications industry is competitive and dynamic. As a
result, our future success will depend in large part on our ability to attract
and retain a substantial number of highly skilled, knowledgeable, sophisticated
and qualified managerial, professional and technical personnel. We have
experienced, and we expect to continue to experience, significant and increasing
competition from other companies in attracting and retaining personnel who
possess the skills that we are seeking. We therefore may be unable to attract
and retain senior management, other key employees, or other skilled personnel in
the future. We depend on these employees to implement our business plan and
manage our planned growth successfully, and losing key employees could have a
material adverse effect on our ability to implement the essential components of
our business plan.
THE LOSS OR INTERRUPTION OF RELATIONSHIPS WITH OR SERVICES FROM KEY SUPPLIERS
AND THIRD PARTY CONTRACTORS COULD DELAY AND INCREASE COSTS ASSOCIATED WITH THE
CONSTRUCTION OF OUR NETWORK.
We depend on third party suppliers for a number of components and parts
used in our network. We may be unable to obtain supplies or services from our
usual suppliers for reasons beyond our control. Although there may be
alternative suppliers of components for all of the components and transmission
equipment contained in our network or required to offer our products and
services, but those alternatives may not be available to us on as favorable
terms. Any nationwide shortage, or extended interruption in the supply of any of
the key components, change in the pricing arrangements with our suppliers and
manufacturers or delay in transitioning a replacement supplier's product into
the network could disrupt our operations.
We also use third party contractors to build various segments of our
network. If any of these relationships is terminated or a supplier or contractor
fails to provide reliable services or equipment, and we are unable to reach
suitable alternative arrangements quickly or on favorable terms, we may
39
experience significant delays and additional costs. The failure of our
contractors to complete their activities in a timely manner, within anticipated
budgets and in accordance with our quality standards and performance criteria,
could also delay the completion of our network or make it more costly to
construct.
OUR FAILURE TO IDENTIFY, DEPLOY AND MAINTAIN SOPHISTICATED BILLING, CUSTOMER
SERVICE AND INFORMATION SYSTEMS COULD HAVE A NEGATIVE EFFECT ON OUR PRODUCT AND
SERVICE OFFERINGS, CUSTOMER RELATIONS AND REVENUES.
We will depend on sophisticated information and processing systems to grow,
monitor costs, bill customers, service customer orders and achieve operating
efficiencies. As we expand our services and increase our customer base, our need
for enhanced billing and information systems will increase. If we are unable to
adequately identify our information and processing needs or develop or upgrade
systems as necessary, we may not be able to offer services or products that our
customers require, our customer relations could be damaged, and our ability to
reach our financial and operational objectives could be compromised.
OUR YEAR 2000 COMPLIANCE EFFORTS MAY NOT ULTIMATELY PROVE TO BE SUCCESSFUL,
WHICH COULD MATERIALLY INTERFERE WITH OUR NETWORK AND OTHER BUSINESS OPERATIONS.
The Year 2000 issue is the result of computer programs using two digits,
rather than four, to define the applicable year. Because of this programming
convention, software, hardware or firmware may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in system failures,
miscalculations or errors causing disruptions of operations or other business
problems, including, among others, an inability to process transactions, send
invoices, or engage in similar normal business activities. As of February 22,
2000, we have not experienced any significant Year 2000 issues. However, we will
not be able to fully asses the impact of Year 2000 issues on our business and
operations until later this year. If we or our major vendors, other key service
providers or customers fail to address adequately their respective Year 2000
issues in a timely manner, we could experience, among other things,
interruptions in our network and a decline in sales which would adversely affect
our business. The Year 2000 issues and our Year 2000 readiness program are
described in further detail above in "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- YEAR 2000 READINESS
DISCLOSURE."
IF WE DO NOT SUCCESSFULLY MANAGE ACQUISITIONS, STRATEGIC ALLIANCES AND JOINT
VENTURES THAT WE MAY NEED TO IMPLEMENT OUR BUSINESS PLAN, OUR FINANCIAL AND
OPERATIONAL PERFORMANCE MAY BE ADVERSELY AFFECTED.
To expand and deploy our network in a timely manner, we may need to acquire
other businesses, form strategic alliances or enter into joint ventures that
will complement our existing business markets or accelerate our entry into our
target markets. These transactions may:
o pose challenges in assimilating the acquired operations and personnel;
o disrupt our ongoing business;
o divert resources;
o create difficulties in maintaining uniform standards, controls,
procedures and policies;
40
o impede management of our growth and information systems;
o present challenges where entering markets in which we have little
experience; or
o impair relationships with employees or customers.
We currently have no definitive acquisition agreement in place, although we
have had discussions with other companies and will continue to assess
opportunities on an ongoing basis. Our failure to implement our expansion and
growth strategy successfully would have a material adverse effect on our
business, results of operations and financial condition.
RISKS RELATING TO OUR FINANCING
WE EXPECT NEGATIVE OPERATING CASH FLOWS AND SUBSTANTIAL OPERATING LOSSES FOR THE
FORESEEABLE FUTURE.
We have incurred operating losses and negative cash flow since inception.
From August 25, 1995 through December 31, 1999, our operations have resulted in
cumulative net losses of $101.5 million. We expect to incur continued operating
losses and negative cash flow as we build our network, offer additional products
and services and increase our customer base. These losses will reduce our
ability to meet working capital needs and increase our need for external
financing to support our objectives. Until and unless we develop an adequate
customer base and revenue stream, our capital and other operating expenditures
will result in negative cash flow and operating losses. We expect these
expenditures to increase as we develop our customer base in existing markets,
expand into new markets and diversify our service offerings. We may never
develop an adequate customer base, sustain profitability or generate sufficient
cash flow to meet our obligations on the guarantees, debt or fund our other
business needs. We therefore cannot assure you that we will become profitable in
the future.
WE WILL BE GUARANTEEING AND/OR INCURRING A SUBSTANTIAL AMOUNT OF DEBT THAT MAY
INCREASE OUR OPERATING COSTS AND COULD IMPAIR OUR ABILITY TO RAISE ADDITIONAL
REQUIRED FUNDS, INVEST IN OUR OPERATIONS OR WITHSTAND A DECLINE IN PROJECTED
REVENUES.
We currently have, and after the contribution and reorganization transaction
has closed we will have, a substantial amount of debt in relation to our
stockholders' equity. As of December 31, 1999, we had approximately $380.3
million of indebtedness outstanding and total stockholders' equity (deficit) of
($95.7) million. We plan to incur additional indebtedness in developing our
business.
The amount of our debt could adversely affect our future prospects by:
o impairing our ability to borrow additional money;
o requiring us to use a substantial portion of our cash flows from
operations to pay interest or repay debt which will reduce the funds
available to us for our operations, acquisition opportunities and
capital expenditures;
o placing us at a competitive disadvantage with companies that are less
restricted by their debt arrangements; and
o making us more vulnerable in the event of a downturn in general
economic conditions or upon the occurrence of any risks described in
this section.
41
WE MAY NOT HAVE SUFFICIENT FUNDS FROM OUR OWN CASH FLOW OR OTHER SOURCES TO
SERVICE OUR DEBT.
We cannot assure you that we will be able to meet our debt obligations under
the guarantees, our notes or otherwise. If we are unable to generate sufficient
cash to meet our obligations or if we fail to satisfy the requirements of our
debt agreements, we will be in default. A default under the notes, which may
include a material default under other indebtedness, would permit the holders of
the notes (and other debt for which we will be directly or indirectly
responsible) to require payment before the scheduled due date of the debt,
resulting in further financial strain on us and causing additional defaults
under our other indebtedness.
OUR INABILITY TO OBTAIN ADDITIONAL FINANCING NEEDED IN THE FUTURE MAY DELAY OR
PREVENT THE COMPLETION OF OUR NETWORK AND THE ROLL OUT OF OUR PRODUCTS AND
SERVICES TO OUR CUSTOMERS.
We expect to need significant additional capital to complete the buildout of
our planned network and fulfill our long-term business strategies. We may be
unable to produce sufficient cash flows from ongoing operations to fund our
business plan and future growth. This could require us to alter our business
plan, including delaying, reducing or abandoning our expansion or spending
plans, which could have a material adverse effect on our future revenue
prospects or our business.
In addition, we may elect to pursue other business opportunities that could
require additional capital investments in our network. If any of these events
were to occur, we could be required to sell assets, borrow more money than we
currently anticipate, issue additional debt or equity securities, refinance or
restructure our debt or enter into joint ventures.
Our ability to arrange financing depends upon many factors, including:
o general economic and capital markets conditions, especially the
non-investment grade debt market;
o conditions in the telecommunications industry;
o regulatory, technological or competitive developments;
o investor confidence and credit availability from banks or other
lenders;
o the success of our network and demand for our products and services;
o cost overruns and unforeseen delays; and
o provisions of tax and securities laws that affect capital raising
activities.
Our inability to raise additional funds would have an adverse effect on our
ability to complete our network. If we decide to raise additional funds by
incurring more debt, we may become subject to additional or more restrictive
financial covenants. These covenants or other terms of the additional financing
may place significant limits on our financial and operating flexibility, or may
not be acceptable to us. Our failure to raise sufficient funds when needed and
on reasonable terms may require us to modify or significantly curtail our
business expansion plans. These modifications could have a material adverse
impact on our growth and ability to compete and to service our existing debt.
ALTHOUGH THE COMPANY NOTES ARE REFERRED TO AS "SENIOR NOTES" THEY ARE, AND WILL
CONTINUE TO BE, EFFECTIVELY SUBORDINATED TO OUR SECURED DEBT AND THE SECURED AND
UNSECURED DEBT OF OUR SUBSIDIARIES.
42
The notes are unsecured and therefore are and will following the closing of
the transaction, continue to be effectively subordinated to any secured debt we
may incur to the extent of the value of the assets securing that debt. In the
event of a default, foreclosure, bankruptcy or similar proceeding involving us,
our assets that serve as collateral will be available to satisfy the obligations
under any secured debt before any payments are made on the notes. If there is
any shortfall after the foreclosure on these assets, our secured creditors would
have a claim for that shortfall ranking equally with the noteholder's claim
against us under the guarantees. In addition we may secure any additional debt
with our assets or borrow through subsidiaries. Those secured assets, or the
assets of our borrowing subsidiaries, will be available to other creditors
before they are available to the noteholders.
FOLLOWING THE CLOSING OF THE TRANSACTION WE WILL DEPEND ON PAYMENTS FROM OUR
SUBSIDIARIES TO REPAY OUR DEBTS, AND OTHER CREDITORS OF OUR SUBSIDIARIES OTHER
THAN PATHNET WILL HAVE CLAIMS AGAINST THE ASSETS OF THOSE SUBSIDIARIES THAT ARE
SENIOR TO THE NOTES.
After the contribution and reorganization transaction has closed, we will be
a holding company that receives a substantial part of our revenues from our
subsidiaries. Our ability to obtain payments from our subsidiaries may be
restricted by the profitability and cash flows of our subsidiaries and laws
relating to the payment of dividends by a subsidiary to its parent company. If
our subsidiaries are unable to pay dividends, we may be unable to service our
debt, including our obligations under the supplemental indenture and the
guarantees. If any of our subsidiaries experiences a bankruptcy, liquidation or
reorganization, its creditors will generally be entitled to payment of their
claims from the assets of that subsidiary before any assets are made available
for distributions to us, except to the extent we may also have a claim as a
creditor. In that situation, creditors of our subsidiaries and future holders of
preferred stock, if any, of our subsidiaries, would have claims on the assets of
the subsidiaries with priority over our claims.
OTHER THAN PATHNET, THE HOLDING COMPANY'S SUBSIDIARIES, INCLUDING SUBSIDIARIES
THAT WE MAY FORM IN THE FUTURE, WILL NOT FOLLOWING THE CLOSING OF THE
TRANSACTION, GUARANTEE OR OTHERWISE BE RESPONSIBLE FOR MAKING FUNDS AVAILABLE TO
US OR TO PATHNET TO MAKE PAYMENTS ON THE NOTES OR GUARANTEES.
Like the notes, the rights under the guarantees to be issued in the
Transaction will be structurally subordinated to both secured and unsecured
debts of our subsidiaries other than Pathnet. Under the terms of the existing
indenture, Pathnet has formed new subsidiaries that are separate legal entities
with no obligations under the notes. The supplemental indenture will extend this
structure to us. If we incorporate additional subsidiaries, whether new
subsidiaries of Pathnet or "sister" companies to Pathnet, these new subsidiaries
also will be separate legal entities. They will have no obligation under the
supplemental indenture or the guarantees to make payments or to provide
dividends or other funds to us or Pathnet to permit us to make payments on the
notes or guarantees.
We have concluded that revising the Indenture to provide for these
guarantees would interfere with our ability to obtain equipment and other
financing necessary in connection with the future development of our network. As
a result, the notes are and will continue to be, and the guarantees will be,
effectively subordinated to the debts of our subsidiaries other than Pathnet.
43
VENDOR FINANCING ARRANGEMENTS WILL LIKELY REQUIRE PATHNET TELECOMMUNICATIONS,
INC. TO FORM SUBSIDIARIES WITH SUBSTANTIAL ASSETS THAT WILL NOT BE OBLIGATED TO
GUARANTEE THE NOTES.
Pathnet Telecommunications, Inc. expects to take advantage of vendor
financing in constructing our network. Pathnet Telecommunications, Inc.'s
proposed vendor financing agreement with Lucent specifically requires Pathnet
Telecommunications, Inc., if it wishes to take advantage of the Lucent
financing, to form a new subsidiary and to contribute to this new subsidiary a
substantial portion of Pathnet Telecommunications, Inc.'s assets. This
contribution of assets would include the rights of way relating to the segments
of our network that we plan to construct with fiber for which Lucent provides
vendor financing, and could include additional cash contributions. This new
subsidiary will not guarantee the notes. See "BUSINESS-PROPOSED CREDIT FACILITY
WITH LUCENT."
PATHNET TELECOMMUNICATIONS, INC.'S INDEBTEDNESS WILL CONTAIN RESTRICTIVE
COVENANTS, WHICH COULD EXPOSE IT TO ADDITIONAL DEFAULTS AND RESTRICT ITS
OPERATIONS.
By entering into the supplemental indenture, Pathnet Telecommunications,
Inc. will become subject to a number of restrictive covenants parallel to those
contained in the indenture and applicable to Pathnet. These restrictions affect,
and, in certain cases significantly limit (and in some cases prohibit), among
other things, our ability and the ability of our subsidiaries to:
o incur additional indebtedness;
o create liens;
o make investments;
o pay dividends;
o issue stock; and
o sell assets.
For example, the indenture restricts and the supplemental indenture will
restrict Pathnet Telecommunications, Inc.'s ability to incur indebtedness other
than indebtedness to finance the acquisition of equipment, inventory or network
assets and other specified indebtedness. In addition, if and when Pathnet
Telecommunications, Inc. (or its subsidiaries) borrow funds under its proposed
credit facility with Lucent or under other credit facilities with other vendors
or third parties who may provide financing, PTI may be required to maintain
specified financial ratios. We cannot assure you that Pathnet
Telecommunications, Inc. will be able to maintain those required ratios after
each borrowing, and its failure to do so or comply with other covenants could
lead to a default on those facilities and a foreclosure against any assets
securing the facilities. These restrictive covenants may also adversely affect
our ability to finance our future operations or capital needs, or to engage in
other business activities that may be in our interest.
PROVISIONS IN PATHNET TELECOMMUNICATION, INC.'S CERTIFICATE OF INCORPORATION AND
BYLAWS, THE STOCKHOLDERS AGREEMENT TO WHICH IT WILL BECOME A PARTY AND THE TERMS
OF THE INDENTURE AND SUPPLEMENTAL INDENTURE COULD DELAY OR PREVENT OUR CHANGE OF
CONTROL, EFFECTIVELY HINDERING ITS ACCESS TO ADDITIONAL EQUITY FINANCING.
Pathnet Telecommunications, Inc.'s certificate of incorporation, bylaws and
44
stockholders agreement contain provisions that will make any acquisition of us
or investment in Pathnet Telecommunications, Inc. more difficult, including
restrictions on removal of directors and limitations on the ability of
stockholders to call special meetings. The terms of its indenture and
supplemental indenture may also restrict and discourage attempts to change
control of it. Our ability to attract future equity investment may be hindered
because of these provisions, thereby limiting our access to additional capital.
RISKS RELATING TO OUR NETWORK BUSINESS
DIFFICULTIES THAT WE MAY EXPERIENCE IN EXPANDING OUR NETWORK COULD INCREASE OUR
ESTIMATED COSTS AND DELAY SCHEDULED COMPLETION OF OUR NETWORK.
We plan to expand our existing network, enter new markets and broaden our
product and service offerings -- all of which are significant undertakings.
These activities will require us to install and operate additional facilities
and equipment, and develop, introduce and market new products and services. To
deploy these additional services we will need to modify and add to our existing
network architecture. We will also need to obtain and install our equipment in
the existing local telephone companies' central office collocation space as
described in further detail below. We may encounter administrative, technical,
operational, regulatory and other problems as a result of our expansion. Many of
these factors and problems are beyond our control. If we experience difficulties
in addressing and solving these problems, we may not be able to complete our
network buildout or expand our products and services as planned or in accordance
with our current cost or time estimates.
WE MAY PURSUE OTHER RELATIONSHIPS WITH TELECOMMUNICATIONS PROVIDERS AND OTHER
BUSINESS OPPORTUNITIES THAT COULD EXPOSE US TO ADDITIONAL RISKS OR DELAY THE
CONSTRUCTION AND OPERATION OF OUR NETWORK.
We may enter into relationships with long distance telephone companies,
existing local telephone companies, Internet Service Providers, competitive
telecommunications companies or other entities to manage existing assets or to
deploy alternative telecommunications products and services. We may also seek to
serve markets in addition to underserved or second or third tier markets and
customers in addition to telecommunications service providers. Pursuing these
other opportunities could require additional financing, pose additional risks
(such as increased or different competition, additional regulatory burdens and
network economics and pricing different from our currently planned network and
products and services) and divert our resources and management time. We cannot
assure you that we will successfully integrate any new opportunity into our
operations or that the opportunity would perform as expected.
WE MAY NOT BE ABLE TO OBTAIN OR MAINTAIN APPROPRIATE RIGHTS OF WAY AND OTHER
ACCESS RIGHTS THAT WE MAY NEED TO BUILD AND OPERATE OUR NETWORK WHICH WOULD
LIMIT OUR ABILITY TO IMPLEMENT OUR BUSINESS PLAN, DEPRIVING US OF A SOURCE OF
REVENUE NECESSARY TO IMPLEMENT OUR BUSINESS PLAN.
In addition to the rights of way, to which we will gain access as a result
of the contribution and reorganization transaction, we expect that we will need
to obtain and maintain additional rights of way to construct and develop our
network. We cannot assure you, however, that we will continue to have access to
existing rights of way, leases and licenses after the expiration of our current
agreements, or that we will obtain additional rights necessary to extend our
network on reasonable terms. In addition, if a franchise, license or lease
agreement is terminated and we are forced to remove or abandon a significant
45
portion of our network, our business, results of operations, and financial
condition will be materially adversely affected.
THIRD PARTY CHALLENGES TO OUR USE OF RIGHTS OF WAY OBTAINED FROM OTHERS MAY
DELAY, HINDER OR OTHERWISE LIMIT THE DEVELOPMENT AND OPERATION OF OUR NETWORK,
DEPRIVING US OF THE REVENUES NECESSARY TO IMPLEMENT OUR BUSINESS PLAN.
To construct and maintain our fiber optic and wireless network, we have
obtained and will obtain easements, leases, rights of way, franchises and
licenses from various private parties, including railroads, pipelines,
utilities, actual and potential competitors and local governments. Some of our
agreements with right of way providers require us to acknowledge that others who
question the right of way providers' ownership claim to the easement or property
right may challenge our claim to the rights of way being granted. Third parties
have challenged, and we expect in the future that third parties may challenge,
our use of rights of way obtained by or from others, including the rights of way
we will obtain upon the closing of the contribution and reorganization
transaction. If we are unable to resolve any of these challenges, or if the cost
of addressing them is higher than we contemplate, these challenges may hinder or
delay our business plans.
IF WE ARE UNABLE TO OBTAIN ADDITIONAL PERMITS AND AGREEMENTS NECESSARY TO
OPERATE AND EXPAND OUR NETWORK, WE MAY BE UNABLE TO DEVELOP OUR NETWORK OR
GENERATE SUFFICIENT REVENUES.
We may require additional pole attachment or conduit use agreements with
existing local telephone companies, utilities or other local exchange carriers.
We cannot guarantee that we, or our operating companies or partners, will be
able to obtain new or maintain existing permits, pole attachment and conduit use
agreements needed to develop and operate and expand our network and provide our
planned products and services. Our failure to obtain or maintain necessary
permits, pole attachments and conduit use agreements could have a material
adverse effect on our ability to operate and expand our network.
IF WE ARE UNABLE TO OBTAIN AND MAINTAIN ON GOOD TERMS, THE LEASEHOLD ACCESS OR
OTHER SERVICES AND MAINTENANCE AGREEMENTS ON WHICH WE RELY TO OPERATE THE
WIRELESS PORTION OF OUR NETWORK, IT MAY BECOME MORE EXPENSIVE, OR WE MAY EVEN BE
UNABLE, TO OPERATE THOSE PORTIONS OF OUR NETWORK.
We do not own, and we do not expect to own in the future, the underlying
sites and facilities upon which our current wireless digital network is
deployed. Instead, we (or our affiliated companies) have entered into long term
fixed point microwave services agreements with certain of our co-development
partners such as Kinder Morgan, formerly KN Energy. Under these agreements, each
co-development partner has agreed to grant us a leasehold interest in, or a
similar right to use, their facilities and infrastructure as required for us to
deploy our network. As a result, we depend and will continue to depend on the
facilities and infrastructure of our co-development partners for the operation
of our business. In many cases, we also rely on our co-development partners for
the maintenance and provisioning of circuits on our network. We have entered
into maintenance agreements with some of these co-development partners where
they perform maintenance and provisioning services for us in return for a
monthly fee. The cancellation or non-renewal of any of these arrangements or
agreements could have a material adverse effect on our business.
DISAGREEMENTS WITH OUR CO-DEVELOPMENT PARTNERS OR DIFFICULTIES WE MAY EXPERIENCE
46
IN OUR OTHER STRATEGIC RELATIONSHIPS COULD HINDER THE DEVELOPMENT OF OUR NETWORK
AND OUR EXPANSION INTO TARGET MARKETS.
As part of our "smart build" strategy and the contribution and
reorganization transaction, we have formed and plan to continue in the future to
pursue strategic alliances and relationships which would allow us to enter
certain markets for telecommunications services sooner than if we had made the
attempt independently. As our network is further developed, we will be dependent
on some of these arrangements in order to expand our network into target
markets.
Any disagreements with our co-development partners or companies with which
we have a strategic alliance could impair or adversely effect our ability to
conduct our business. In addition, the bankruptcy or insolvency of a
co-development partner could result in the termination of its agreement with us
and any related right of way agreements. The effect of those terminations or the
failure of a co-development partner to make required capital contributions would
have a material adverse effect on us.
WE MAY BE UNABLE TO OBTAIN ACCESS TO AND INTERCONNECTION WITH THE FACILITIES OF
EXISTING LOCAL TELEPHONE COMPANIES ON FAVORABLE TERMS WHICH COULD DELAY,
INCREASE THE COST OF OR PREVENT US FROM PROVIDING LOCAL ACCESS SERVICE IN OUR
TARGET MARKETS.
Our ability to provide local access services depends upon our securing
access to existing local telephone companies' networks, including the physical
or virtual collocation of our equipment in the existing local telephone
companies' central offices in our target markets.
Challenges we may face in obtaining central office space from the existing
local telephone companies include:
o limitations on the availability of central office space in high demand
target markets where other competitive telecommunications companies
are seeking or have obtained central office space to offer services;
o delays when existing local telephone companies fail to promptly
address our requests for central office space; and
o expenditure of time and money to pursue negotiations, regulatory
disputes, and legal actions for resolution of disputes regarding lack
of sufficient central office space.
We expect that these challenges may delay our attempts to obtain central
office space, which would slow down our deployment of our network and our
ability to increase the number of our customers.
IF EXISTING LOCAL TELEPHONE COMPANIES ON WHOM WE DEPEND FOR INTERCONNECTION AND
OTHER NETWORK ELEMENTS REFUSE TO COOPERATE OR FAIL TO PERFORM THEIR AGREEMENTS
WITH US, WE MAY BE DELAYED IN OR EVEN PREVENTED FROM COMPLETING OUR NETWORK AND
OFFERING COMPETITIVE SERVICES TO OUR CUSTOMERS.
We will interconnect with and use existing local telephone companies'
networks to provide local access services to our customers. This strategy
presents a number of challenges because we depend on existing local telephone
companies to:
o allow us to use their technology and capabilities of their networks to
service our customers;
o cooperate with us to provide and repair facilities; and
47
o provide the services and network components that we order, for which
they depend significantly on unionized labor. Labor issues have in the
past and may in the future hurt the existing local telephone
companies' performance.
Our dependence on existing local telephone companies may cause us to
encounter delays in establishing our network and rolling out our products and
services. We must also establish satisfactory billing and payment arrangements
with existing local telephone companies. We may not be able to do these things
in a manner that will allow us to retain and grow our customer base.
IF THE QUALITY, AVAILABILITY AND MAINTENANCE OF EXISTING LOCAL TELEPHONE
COMPANIES' NETWORKS IS UNSATISFACTORY, OUR NETWORK MAY NOT BE SUFFICIENTLY
AVAILABLE OR RELIABLE TO MEET OUR BUSINESS PLAN OR CUSTOMER EXPECTATIONS.
We may not be able to obtain the facilities and the services we need from
existing local telephone companies at satisfactory quality levels, rates, terms
and conditions. Our inability to do so could delay the expansion of our network
and degrade the quality of our services to our customers.
WIRELESS PATH FAILURES OR CABLE CUTS ON OUR NETWORK COULD INTERFERE WITH OUR
NETWORK OPERATIONS, DAMAGE OUR RELATIONSHIPS WITH OUR CUSTOMERS OR EXPOSE US TO
LIABILITY.
We do not have route diversity on our digital network to maintain services
if a wireless path failure or fiber cable cut occurs. If we were to suffer a
deterioration in the perceived quality or reliability of our service as a result
of a path failure, cable cut, or other network outage, our customer relations
would be materially adversely affected and we could be exposed to liability
claims.
RISKS RELATING TO OUR INDUSTRY
OUR BUSINESS AND INDUSTRY ARE VERY COMPETITIVE AND INCREASED COMPETITION COULD
REQUIRE US TO LOWER OUR PRICES OR PROVIDE MORE EXPENSIVE SERVICE THAT WOULD
ADVERSELY AFFECT OUR FINANCIAL PERFORMANCE.
The telecommunications industry is extremely competitive, particularly with
regard to price and service. Many of our existing and potential competitors have
significantly greater financial, personnel, marketing and other resources than
we do. For example, some of our competitors have already made substantial
long-term investments in the construction of wireless and fiber optic networks
and the acquisition of bandwidth. Many of our competitors also have the added
competitive advantage of an established network and existing customer base. For
example, some communications carriers and local cable companies have extensive
networks in place that could be upgraded to fiber optic cable. Those companies
also have more employees and more substantial capital resources to begin those
upgrades. If communications carriers and local cable companies decide to equip
their existing networks with fiber optic cable, they could become significant
competitors of ours in a short period of time.
IF WE ENCOUNTER INCREASED COMPETITION FROM EXISTING AND FUTURE
TELECOMMUNICATIONS SYSTEMS ON ROUTES WHERE WE PLAN TO PROVIDE INFRASTRUCTURE
SERVICES AND WHOLESALE TRANSPORT SERVICES, WE MAY BE UNABLE TO COMPETE
EFFECTIVELY FOR THOSE SERVICES OR WE MAY NEED TO REDUCE OUR PRICES IN A MANNER
THAT ADVERSELY AFFECTS OUR FINANCIAL PERFORMANCE.
48
Other companies may choose to compete with us in our current or planned
markets by selling or leasing network assets or wholesale transport services to
our targeted customers. This competition could have a material adverse effect on
our business. Our competitors for these products and services include:
o long distance companies, such as AT&T Corp., MCI WorldCom, Inc. and
Sprint Corporation;
o wholesale providers, such as Qwest Communications International Inc.,
Williams Communications Group, Inc., IXC Communications, Inc., DTI
Holdings, Inc., Global Crossing Ltd. and Level 3 Communications, Inc.;
o existing local telephone companies, such as US West, BellSouth, Bell
Atlantic, SBC and GTE Corporation, which currently dominate their
local telecommunications markets and have sought or may soon seek or
obtain authority to provide long distance services in their local
markets;
o competitive telecommunications companies often referred to as such as
GST Telecommunications, Inc., ITC/Deltacom, Inc. and Metromedia Fiber
Network, Inc.; and
o potential competitors capable of offering services similar to those we
offer, such as communications service providers, cable television
companies, electric utilities, microwave carriers, satellite carriers,
wireless telephone operators and large end users with private
networks.
ADDITIONAL COMPETITION FROM LOCAL TELEPHONE COMPANIES OR OTHER
TELECOMMUNICATIONS SERVICE PROVIDERS AS THEY BEGIN TO PROVIDE OR EXPAND THEIR
LOCAL ACCESS SERVICES IN THE MARKETS THAT WE HAVE TARGETED, MAY PREVENT US FROM
ACHIEVING OUR SALES GOALS.
Our principal competitor in the provision of local access services in each
of our markets is the existing local telephone company. Although recent federal
legislation and rule-making proceedings afford us increased opportunities to
compete in providing these services, some aspects of these proceedings also
benefit existing local telephone companies. Potential changes in the regulation
of telecommunications services could deprive us of some competitive advantages
that we now enjoy, which could harm our business.
In addition to the existing local telephone companies, other
telecommunications service providers, such as Covad Communications Group, Inc.,
NorthPoint Communications Group, Inc. and Rhythms Netconnections, Inc., have
recently begun providing some local services. Other competitors and potential
entrants in the market for the provision of these services include long distance
companies, cable television companies, electric utilities, microwave carriers,
wireless telephone system operators, data service companies and operators of
private networks. Significant new competitors also could enter the local market
through consolidation and strategic alliances in the industry, foreign carriers
being allowed to compete in the U.S. market, technological advances, and further
deregulation and other regulatory initiatives. The introduction of any of these
new competitors into our markets for local services could materially and
adversely affect our business. See "BUSINESS -- COMPETITION."
WE DO NOT PLAN TO OFFER A BROAD RANGE OF PRODUCTS OR SERVICES IN THE IMMEDIATE
FUTURE, AND THIS LIMITATION COULD INCREASE OUR VULNERABILITY TO CHANGING TRENDS
IN OUR INDUSTRY OR INCREASED COMPETITION. AT THE SAME TIME, OUR FUTURE SUCCESS
WILL DEPEND ON GROWTH IN THE DEMAND FOR LOCAL ACCESS SERVICES WE PLAN TO
CONTINUE TO OFFER.
We have planned to undertake only a narrow scope of activities in the
49
immediate future, which could limit potential revenues and result in lower
revenues than competitors who now provide a wide range of services. Although we
have recently commenced marketing local access services to telecommunications
service providers, we cannot assure you that we will be successful in entering
this business. If the markets for these services fail to develop, grow more
slowly than anticipated or become saturated with competitors, our business
prospects, operating results and financial condition could be materially
adversely affected.
OUR PRODUCT AND SERVICE OFFERINGS ARE SUBJECT TO RISKS OF INDUSTRY OVER-CAPACITY
AND RESULTING DOWNWARD PRICING PRESSURES.
Since shortly after the AT&T divestiture in 1984, the long distance
transmission industry generally has experienced over-capacity and declining
prices. These trends have exerted downward pricing pressures on a number of
telecommunications services, including our wholesale transport services, and we
anticipate that prices for these services will continue to decline over the next
several years because:
o existing long distance carriers and potential new carriers are
constructing new fiber optic and other long distance transmission
networks;
o regulatory changes may permit the existing local telephone companies
to provide long-distance services out-of-region;
o expansion and new construction of transmission networks, particularly
fiber optic cable networks, are likely to create substantial excess
capacity relative to demand in the short or medium term; and
o recent technological advances may greatly expand the capacity of
existing and new fiber optic cable.
Dramatic and substantial price reductions in the long distance industry
could require us to reduce our prices significantly or to revise the mix of
products and services we plan to offer. Either of these results could adversely
affect our business. Also, an increase in the capacity of any of our competitors
to provide transport services could adversely affect our business even if we are
also able to increase our capacity.
INCREASED SUPPLY OF FIBER OPTIC CABLE IN THE INDUSTRY MAY LEAD TO LOWER PRICES.
The supply of fiber optic cable that is already buried in conduits but has
none of the associated transmission electronics installed has increased,
resulting in downward pricing pressure on sales of fiber optic strands. The FCC
recently issued an order requiring existing local telephone companies to make
inactive fiber optic strands and other transport facilities available to other
telecommunications carriers at cost-based nondiscriminatory prices. This
requirement could further increase the supply of and decrease demand for fiber
optic strands that we sell, adversely affecting our business, financial
condition and results of operations.
IF WE FAIL TO RECOGNIZE OR MAKE THE INVESTMENTS NECESSARY TO KEEP PACE WITH
RAPID TECHNOLOGICAL CHANGES, OUR SERVICES MAY BECOME LESS DESIRABLE OR OBSOLETE
AND WE MAY FACE HIGHER COSTS OR BE UNABLE TO COMPETE EFFECTIVELY.
50
The telecommunications industry is characterized by rapid and significant
changes in technology. We cannot predict the effect of technological changes on
our business. The introduction of new products or technologies may reduce the
cost or increase the supply of services similar to those that we plan to
provide, or could render those services and our network assets less desirable or
even obsolete. As a result, new entrants in the communications services industry
may become our most significant competitors in the future. These new entrants
may not be burdened by an installed base of outdated equipment and the resulting
competition they may provide could have a material adverse effect on our ability
to meet our sales targets.
RISKS RELATING TO REGULATION
REGULATORY CHANGES COULD REQUIRE US TO POSTPONE OR MODIFY OUR BUSINESS PLANS OR
DEPRIVE US OF THE MEANS TO ESTABLISH OUR NETWORK IN OUR TARGET MARKETS.
Communications services are subject to significant regulation at the
federal, state and local levels. Our business plans require us to exploit new
opportunities afforded by recent regulatory changes. However, the regulatory
environment could adversely affect us in a number of ways, including:
o delays in receiving required regulatory approvals or the imposition of
onerous conditions for these approvals;
o difficulties in completing and obtaining regulatory approval of
interconnection agreements with existing local telephone companies;
and
o enactment of new and adverse legislation or regulatory requirements or
changes in the interpretation of existing laws or regulations.
Many regulatory proceedings regarding issues that are important to our
business are currently underway or are being contemplated by federal and state
authorities. Changes in regulations or future regulations adopted by federal,
state or local regulators, or other legislative or judicial initiatives relating
to the telecommunications industry could cause our pricing and business models
to fluctuate dramatically or otherwise or otherwise have a material adverse
effect on us.
THE FCC MAY IMPLEMENT THE PROVISIONS OF THE TELECOMMUNICATIONS ACT OF 1996 IN A
MANNER THAT IS ADVERSE TO OUR BUSINESS PLAN AND STRATEGIES.
The Telecommunications Act of 1996 was intended, among other things, to
foster competition in the local telephone market. However, the FCC and the
states are still implementing many of its rules and policies and it remains
uncertain how successfully the Telecommunications Act will promote competition.
Moreover, the Telecommunications Act and other recent federal laws regarding the
U.S. telecommunications industry remain subject to judicial review and
additional FCC rule-making proceedings. Our business strategy involves taking
advantage of some of the competitive opportunities advanced by the
Telecommunications Act, and the FCC may promulgate regulations implementing the
Telecommunications Act that are adverse to our business.
OUR ABILITY TO OFFER LONG DISTANCE COMPANIES LOCAL ACCESS SERVICE AT COMPETITIVE
RATES MAY BE LIMITED BY NEW REGULATIONS AND LEGISLATIVE INITIATIVES.
Like most companies in the communications industry, we must comply with many
51
regulatory requirements. However, unlike some of our competitors, particularly
the existing local telephone companies, we are not currently subject to some of
the burdensome regulations federal law imposes on the telecommunications
industry. Our ability to compete in the provision of local access services will
depend upon a continued favorable, pro-competitive regulatory environment. New
regulations or legislation affording greater flexibility and regulatory relief
to our competitors could adversely affect us by increasing competition in the
provision of local services.
The FCC is currently considering an industry proposal to restructure the
fees that existing local telephone companies charge long distance companies to
use their local networks. These fees are referred to as access charges. Changes
in the access charge structure could fundamentally affect the economic
environment in which we and our customers operate. If the FCC reduces the access
charges imposed by existing local telephone companies, it would significantly
reduce our price advantage in the market for local access services used by long
distance companies to access the existing local telephone companies' local
networks.
The FCC is also considering whether to impose limits on certain uses of
selected portions of the local telecommunications networks, sometimes called
"unbundled network elements", we purchase from the existing local telephone
companies. If the FCC limits our ability to offer long distance companies a
package of unbundled network elements that can be used to reach end users, our
ability to offer our local access services at competitive rates may be harmed.
PENDING REGULATORY INITIATIVES MAY MAKE IT EASIER FOR EXISTING LOCAL TELEPHONE
COMPANIES AND THEIR AFFILIATES TO OFFER DIGITAL SUBSCRIBER LINE SERVICES TO
CUSTOMERS IN OUR TARGET MARKETS INCREASING THE COMPETITION THAT WE FACE FOR
CUSTOMERS SEEKING THESE SERVICES.
In August 1998, the FCC proposed new rules that would allow existing local
telephone companies to provide Digital Subscriber Line services through separate
affiliates not subject to existing local telephone company regulation. The FCC
recently decided some of the other issues raised in that proceeding, but the
question of whether existing local telephone companies can provide unregulated
Digital Subscriber Line services through a separate affiliate remains
unresolved. Any decision that would permit an existing local telephone company
affiliate to offer Digital Subscriber Line services without being subject to
regulation imposed on existing local telephone companies could have a material
adverse effect on us by, for example, increasing the competition we face in the
provision of Digital Subscriber Line services.
IF WE ARE UNABLE TO OBTAIN AND MAINTAIN THE NECESSARY FCC LICENSES, WE MAY BE
UNABLE TO OPERATE THE WIRELESS PORTIONS OF OUR NETWORK.
Portions of our network are wireless, meaning that we provide access
services via over-the-air microwave transmissions instead of through fiber optic
cables. Our arrangements with certain of our wireless co-development partners
contemplate that the wireless portion of our digital network will largely
provide "common carrier fixed point-to-point microwave" telecommunications
services under Part 101 of the FCC's rules. These services are subject to
regulation by federal, state and local governmental agencies. Changes in
existing laws and regulations governing our provision of these services could
have a material adverse effect on our business, financial condition, and results
of operations.
52
IF WE DO NOT ACCURATELY PREDICT THE COST OF COMPLYING WITH FEDERAL AND STATE AND
OTHER SURCHARGES ON OUR SERVICES WE MAY NOT ACCURATELY ANTICIPATE THE COST OF
PROVIDING OUR SERVICES TO CUSTOMERS, AND OUR EARNINGS AND CUSTOMER RELATIONSHIPS
COULD BE ADVERSELY AFFECTED.
As a telecommunications provider, we must pay a variety of surcharges and
fees on our gross revenues from interstate services and intrastate services.
Interstate surcharges include fees for Federal Universal Service and common
carrier obligations, number administration, the provision of telecommunications
services to the disabled and other miscellaneous FCC requirements. State
regulators impose similar surcharges and fees on intrastate services. The
division of our services between interstate services and intrastate services is
a matter of interpretation, and FCC or relevant state commission authorities may
in the future contest how we allocate our charges. If this allocation is
changed, our payment obligations for the relevant surcharges could increase.
Periodic revisions by state and federal regulators of the applicable surcharges
may also increase the surcharges and fees we currently pay.
For more information on these and other risks posed by regulatory
initiatives, see "BUSINESS -- GOVERNMENT REGULATION."
WE MAY BE REQUIRED TO REGISTER AS AN INVESTMENT COMPANY, WHICH WOULD SUBJECT US
TO SIGNIFICANT ADDITIONAL REGULATORY BURDENS AND INTERFERE WITH OUR ABILITY TO
HOLD INVESTMENTS OR RAISE FINANCING FOR OUR BUSINESS.
We have, and after the consummation of the contribution and reorganization
transaction PTI will have, substantial cash balances and short-term investments
on a consolidated basis. As a result, we may be considered an "investment
company" under the Investment Company Act of 1940. The Investment Company Act
requires companies that are engaged primarily in the business of investing,
reinvesting, owning, holding or trading in securities, or that fail numerical
tests regarding composition of assets and sources of income and that are not
primarily engaged in a business other than investing, reinvesting, owning,
holding or trading in securities, to register as "investment companies." Various
substantive restrictions are imposed on investment companies by the Investment
Company Act.
We are primarily engaged in a business other than investing, reinvesting,
owning, holding or trading securities. However, we could be deemed an investment
company within the meaning of the Investment Company Act. If we are required to
register as an investment company under the Investment Company Act, we would
become subject to substantial regulation of our capital structure, management,
operations, transactions with "affiliated persons," as defined in the Investment
Company Act, and other matters. To avoid having to register as an investment
company, we may have to hold a portion of our liquid assets as cash or
government securities instead of as investment securities. Having to register as
an investment company or holding a material portion of our liquid assets as cash
or government securities to avoid registration could have a material adverse
effect on us.
THIS ANNUAL REPORT ON FORM 10-K CONTAINS "FORWARD-LOOKING STATEMENTS" AND
INFORMATION RELATING TO OUR BUSINESS AND US THAT ARE NOT HISTORICAL FACTS.
We make statements in this Annual Report on Form 10-K that are not
historical facts. You can identify these forward-looking statements by our use
of terminology such as "believes," "expects," "may," "will," "should" or
"anticipates" or comparable words. These forward-looking statements include,
among others, statements concerning:
53
o Our business strategy and competitive advantages;
o Our anticipated potential revenues from designated markets;
o The growth of the telecommunications industry and our business;
o The markets for our services and products;
o Forecasts of when we will enter particular markets or begin offering
particular services;
o Our anticipated capital expenditures and future funding requirements,
including the role of vendor and other sources of financing for
equipment and related asset purchases; and
o Anticipated regulatory developments.
These statements are only predictions. You should be aware that these
forward-looking statements are subject to risks and uncertainties, including
financial and regulatory developments, industry trends, and projections that
could cause actual events or results to differ materially from those expressed
or implied by the statements. Should one or more of these risks or uncertainties
materialize, or should our underlying assumptions about them prove incorrect,
our actual results, our performance or our proposed activities may vary
materially from those expressed or implied by these forward-looking statements.
We disclose factors that could cause our actual results to differ materially
from our descriptions in this "RISK FACTORS" section and elsewhere in this
annual Report on Form 10-K including the sections under the "MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS," and
"BUSINESS" captions. Please read the entire Annual Report on Form 10-K for a
description of some of these risks, including competitive, financial,
developmental, operational, technical, regulatory and other risks associated
with our business. You should not place undue reliance on the forward-looking
statements in this annual Report on Form 10-K, which speak only as of the date
of this Annual Report on Form 10-K. We undertake no obligation, and do not
intend, to update or revise any forward-looking statements, whether as a result
of new information, future events or otherwise.
54
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to minimal market risks. We manage sensitivity of our
results of operations to these risks by maintaining a conservative investment
portfolio, (which primarily consists of debt securities, that typically mature
within one year), and entering into long-term debt obligations with appropriate
pricing and terms. We do not hold or issue derivative, derivative commodity or
other financial instruments for trading purposes. Financial instruments held for
other than trading purposes do not impose a material market risk on us.
We are exposed to interest rate risk. We periodically need additional
debt financing due to our large operating losses, and capital expenditures
associated with establishing and expanding our network coverage increase our
financing needs. The interest rate that we will be able to obtain on debt
financing will depend on market conditions at that time, and may differ from the
rates we have obtained on our current debt.
Although all of our long-term debt bears fixed interest rates, the fair
market value of our fixed rate long-term debt is sensitive to changes in
interest rates. We have no cash flow or earnings exposure due to market interest
rate changes for our fixed long-term debt obligations.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's financial statements and supplementary data, together
with the report of the independent accountants, are included or incorporated by
reference elsewhere herein. Reference is made to the "Index to Financial
Statements" following the signature pages hereto.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
55
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS AND EXECUTIVE OFFICERS
The table below sets forth certain information concerning the directors
and executive officers of the Company. Directors of the Company are elected at
the annual meeting of stockholders. Executive officers of the Company generally
are appointed at the Board of Directors' first meeting after each annual meeting
of stockholders.
NAME AGE POSITION(S) WITH COMPANY
Richard A. Jalkut .......................... 55 President, Chief Executive Officer and Director
Robert A. Rouse ............................ 50 Executive Vice President, Chief Operating
Officer and President, Network Services
James M. Craig ............................. 43 Executive Vice President, Chief Financial
Officer and Treasurer
William R. Smedberg, V...................... 38 Executive Vice President, Corporate Development
Michael A. Lubin ........................... 50 Vice President, General Counsel and Secretary
Shawn F. O'Donnell ......................... 34 Senior Vice President of Engineering and
Construction
Peter J. Barris ............................ 47 Director
Kevin J. Maroni ............................ 37 Director
Patrick J. Kerins .......................... 44 Director
Stephen A. Reinstadtler .................... 33 Director
- ------------------------------------
RICHARD A. JALKUT has served as President, CEO and director of the Company
since August 1997. Mr. Jalkut has over 30 years of telecommunications
experience. From 1995 to August 1997, he served as President and Group Executive
of NYNEX Telecommunications Group, where he was responsible for all activities
of the NYNEX Telecommunications Group, an organization with over 60,000
employees. From 1991 until 1995, Mr. Jalkut served as President and CEO of New
York Telephone Co. Inc., the predecessor company to NYNEX Telecommunications
Group. Mr. Jalkut currently serves as a member of the board of directors of HSBC
Bank USA, a commercial bank; Ikon Office Solutions, Inc., a company engaged in
wholesale and retail office equipment; Digex Incorporated; and Home Wireless
Networks, a start-up company developing a wireless product for home and business
premises.
ROBERT A. ROUSE has served as the Company's Executive Vice President,
President of Network Services since April 1999 and, since September 1999, as The
Company's Chief Operating Officer. Mr. Rouse joined the Company with over 30
years experience in the telecommunications industry. Before joining the Company,
from October 1996 to November 1998, Mr. Rouse was Executive Vice President,
Engineering, Systems and Operations of Intermedia, responsible for network
services, engineering and systems. Before that, from October 1986 to October
1996, he served in several positions at MCI beginning as the Director of New
York City Operations and spending the last three as Senior Vice President of
Network Services for MCI/Concert. As senior Vice President of Network Services,
he was responsible for integrating the network and product functionality between
56
MCI and British Telecom as well as building global networks. From March 1986
until September 1986, Mr. Rouse served as the Regional Vice President for
Eastern Operations for US West. In addition, Mr. Rouse spent 17 years, from June
1969 until March 1986, with Frontier Communications, Inc. where he was involved
in a series of unregulated start-up business ventures, and he played a key role
in developing Frontier's long distance company.
JAMES M. CRAIG has served as Executive Vice President, Chief Financial
Officer and Treasurer of the Company since April 1999. Mr. Craig has 22 years of
accounting and finance experience, including 15 years specifically in the
communications industry. From February 1997 to April 1999, Mr. Craig served as
the Senior Director Treasury Management for Omnipoint Communications, where he
was was responsible for corporate planning and forecasting. In this position, he
also served as a point of contact for investment banks, sell-side analysts and
rating agencies. Before that, Mr. Craig assisted in the launch of two start-up
telecommunications companies, from February 1996 to February 1997 at UniSite and
from September 1995 to February 1997 at National Telecom PCS, Inc. While with
UniSite, he established regional and national alliances between UniSite and
telecommunications tower owners. Mr. Craig also spent a total of 11 years, from
1983 to 1995, with MCI, holding positions such as Director of Wireless
Communications, Director of Corporate Development, Director of
Telecommunications Group Planning and Director of Corporate Treasury Group. From
1982 through 1983 and from 1977 through 1980, Mr. Craig served a s a Senior
Accountant at the Cowper Group and from 1980 to 1982 he practiced as a certified
public accountant with Touche Ross and Co.
WILLIAM R. SMEDBERG, V joined the Company initially as a consultant in
1996, served as Vice President, Finance and Corporate Development of the Company
from January 1997 to February 1999 and assumed the position of Executive Vice
President, Corporate Development of the Company in March 1999. Before joining
the Company, Mr. Smedberg served as Director, Strategic Planning and Corporate
Development for Jamont, a European consumer products joint venture among Nokia
Oy, Montedison S.p.A. and James River Corporation of Virginia, Inc., from 1991
to 1996, where he was responsible for Jamont's corporate finance, strategic
planning and corporate development.
MICHAEL A. LUBIN has served as Vice President, General Counsel and
Secretary of the Company since its inception in August 1995. Before joining the
Company, Mr. Lubin was an attorney-at-law at Michael A. Lubin, P.C., a law firm
he founded in 1985. Mr. Lubin has experience in telecommunications, copyright
and intellectual property matters, corporate and commercial law, construction
claims adjudication and trial work. From 1976 until 1981, he served as a Federal
prosecutor with the Fraud Section, Criminal Division, United States Department
of Justice.
SHAWN O'DONNELL has served as Senior Vice President of Engineering and
Construction of the Company since August 1999. Mr. O'Donnell has more than 14
years of engineering experience in the telecommunications industry. Before
joining the Company, Mr. O'Donnell served as Director of Transmissions and
Facility Standards and Engineering with MCI WorldCom from November 1996 to
August 1999. In that position, he was in charge of a 340+ person team that was
responsible for overall transmission and facility engineering for local, long
distance and Internet networks. From April 1988 to November 1996, he also held a
variety of other positions at MCI WorldCom, including Senior Manger of
Transmission Engineering Implementation and Senior Manager of Switched Network
Planning. Before joining MCI WorldCom, from June 1986 to April 1988, Mr.
57
O'Donnell was a Control Engineer with Potomac Edison. While there, he was
responsible for the management of communications networks associated with high
voltage control systems.
PETER J. BARRIS has been a director of the Company since August 1995. Since
1992, Mr. Barris has been a partner; in 1994, was appointed a General Partner;
and, in 1999, was appointed Managing General Partner of New Enterprise
Associates, a firm that manages venture capital investments. Mr. Barris is also
a member of the board of directors of Mobius Management Systems, Inc.,
PcOrder.com, Inc. and Careerbuilder, Inc., each of which is quoted on the NASDAQ
National Market.
KEVIN J. MARONI has been a director of the Company since August 1995. Since
1994, Mr. Maroni has been a principal, and, in 1995, was appointed a General
Partner of Spectrum Equity Investors, which manages private equity funds focused
on growth capital for Telecommunications companies. Prior to Spectrum, Mr.
Maroni worked at Time Warner and Harvard Management Company. Mr. Maroni is
currently on the board of directors of several private companies and CTC
Communications Corp (which is quoted on the NASDAQ National Market).
PATRICK J. KERINS has been a director of the Company since July 1997. Since
March 1997, Mr. Kerins has served as Managing Director of Grotech Capital Group,
which is engaged in venture capital and other private equity investments. From
1987 to March 1997, he worked in the investment banking division of Alex Brown &
Sons, Incorporated, including serving as Managing Director beginning in January
1994. Mr. Kerins is a member of the board of directors of CD Now, Inc., an
online retailer of compact discs and other music related projects which is
quoted on the NASDAQ National Market.
STEPHEN A. REINSTADTLER has been a director of Pathnet since October 1997.
Since August 1995, Mr. Reinstadtler has served as Vice President and Director at
Toronto Dominion Capital (U.S.A) Inc., where he has been involved in private
equity and mezzanine debt investments. From April 1994 to July 1995, he was
Manager at The Toronto-Dominion Bank, where he was involved in commercial
lending activities to the telecommunications industry. From August 1992 to April
1994, Mr. Reinstadtler also served as Associate at Kansallis-Osake-Pankki, where
he was involved in commercial lending activities to the telecommunications
industry.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
We have a compensation committee of our board of directors, which currently
consists of two of our directors, Messrs. Maroni and Barris. Prior to the
resignation of Richard Prins from our board of directors in 1999, we had a three
member compensation committee, consisting of Messrs. Maroni, Barris and Prins.
Our compensation committee was established to, among other things, administer
our stock incentive plans, review and make recommendations to the board of
directors concerning the compensation of executive officers, and consider
existing and proposed employment agreements between us and our executive
officers.
During the fiscal year ended December 31, 1999, none of our executive
officers served as a member of our compensation committee or as a director of
any entity of which any of directors served as an executive officer. No member
of our compensation committee is currently our employee.
58
DIRECTOR COMPENSATION
Currently, our directors do not receive directors' fees or other
compensation and they are not compensated or reimbursed for their out-of-pocket
expenses incurred in serving as directors or for attending meetings of the board
of directors or its committees.
LIMITATION OF LIABILITY AND INDEMNIFICATION
We are incorporated under the laws of the State of Delaware.
Section 102(b)(7) of the Delaware General Corporation Law permits a
provision in the certificate of incorporation of each corporation organized
thereunder, eliminating or limiting, with certain exceptions, the personal
liability of a director to the corporation or its stockholders for monetary
damages for certain breaches of fiduciary duty as a director.
Our certificate of incorporation limits, to the fullest extent permitted by
law, the liability of our directors to us and our stockholders for monetary
damages for breach of their fiduciary duty. This provision is intended to afford
our directors the benefit of the Delaware General Corporation Law. This
limitation on liability does not extend to:
o Any breach of a director's duty of loyalty to us or our stockholders;
o Acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
o Violations of the Delaware General Corporation Law regarding the
improper payment of dividends; or
o Any transaction from which the director derived any improper personal
benefit.
Section 145 of the Delaware General Corporation Law, in summary, empowers a
Delaware corporation, within certain limitations, to indemnify its officers,
directors, employees and agents against expenses (including attorneys' fees),
judgments, fines and amounts paid in settlement, actually and reasonably
incurred by them in connection with any suit or proceeding other than by or on
behalf of the corporation, if they acted in good faith and in a manner
reasonably believed to be in or not opposed to the best interest of the
corporation, and, with respect to a criminal action or proceeding, had no
reasonable cause to believe their conduct was unlawful.
With respect to actions by or on behalf of the corporation, Section 145 of
the Delaware General Corporation Law permits a corporation to indemnify its
officers, directors, employees and agents against expenses (including attorneys'
fees) actually and reasonably incurred in connection with the defense or
settlement of such action or suit, provided such person meets the standard of
conduct described in the preceding paragraph, except that no indemnification is
permitted in respect of any claim where such person has been found liable to the
corporation, unless the Court of Chancery or the court in which such action or
suit was brought approves such indemnification and determines that such person
is fairly and reasonably entitled to be indemnified.
Our certificate of incorporation requires us to indemnify our directors and
officers to the extent not prohibited by law for actions or proceedings arising
because of their positions as directors or officers.
Our stockholders agreement provides for indemnification of us, our
directors and officers, and persons who control us within the meaning of Section
15 of the Securities Act or Section 20 of the Exchange Act for certain
liabilities, including liabilities under the Securities Act.
59
In addition, Pathnet maintains, and we will maintain, standard directors'
and officers' insurance policies.
60
ITEM 11..EXECUTIVE COMPENSATION
The following table sets forth certain information concerning the cash and
non-cash compensation earned by or awarded to the Chief Executive Officer and
each of the six other Named Executive Officers of the company for services
rendered in all capacities in each of the last three fiscal years. The officers
listed in the table below are referred to as the Named Executive Officers:
------ LONG - TERM
COMPENSATION * OTHER COMPENSATION
-------------- ANNUAL SECURITIES UNDERLYING
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION * OPTIONS GRANTED **
- --------------------------- ---- ------ ----- -------------- ---------------------
Richard A. Jalkut 1999 $400,000 $300,000 $ 40,733 (1) --
President and Chief Executive 1998 400,000 -- 40,289 (2) --
Officer 1997 166,154 (3) -- 9,857 (4) 858,754
Michael A. Lubin 1999 135,019 47,120 -- --
Vice President, General Counsel 1998 136,840 5,000 -- 15,000
and Secretary 1997 136,115 -- -- --
William R. Smedberg V 1999 182,886 139,000 -- 50,000
Executive Vice President, 1998 111,250 28,267 -- 78,656
Corporate Development 1997 100,384 -- -- --
James M. Craig 1999 122,206 (5) 78,750 -- 125,000
Executive Vice President, Chief
Financial Officer and Treasurer
Shawn F. O'Donnell 1999 58,739 (6) 52,500 -- 50,000
Senior Vice President of
Engineering and Construction
Robert A. Rouse 1999 239,276 (7) 133,751 36,943 (8) 350,000
Executive Vice President, Chief
Operating Officer and President,
Network Services
Kevin J. Bennis 1999 207,138 (9) 27,500 -- --
Executive Vice President and 1998 246,353 (10) -- 185,602 (6) 382,500
President Communications
Services
- -----------------------------------
* Except as stated herein, none of the above Named Executive Officers
received perquisites or other personal benefits in excess of the lesser of
$50,000 or 10% of such individual's salary plus annual bonus.
** We have not issued any stock appreciation rights or long-term incentive
plans.
(1) Consists of $7,227 for club dues; $13,368 for lodging; $15,090 for airfare;
and $5,048 for other transportation.
(2) Consists of $16,277 for club dues; $7,756 for lodging; $11,685 for airfare;
and $4,571 for other transportation.
(3) Mr. Jalkut commenced employment with the Company in August 1997, and was
compensated at a rate of $400,000 per annum in 1997.
(4) Reimbursement for travel expenses.
(5) Mt Craig began his employment with Pathnet on April 19, 1999, and his
salary was $175,000 per annum in 1999.
(6) Mr. O'Donnell began his employment with Pathnet on August 9, 1999, and his
salary was $150,000 per annum in 1999.
(7) Mr. Rouse began his employment with Pathnet on April 26, 1999, and his
salary was $325,000 per annum in 1999.
(8) Reimbursement for moving expenses.
(9) Mr. Bennis' employment with Pathnet was terminated on September 17, 1999.
(10) Mr. Bennis began his employement with the Company on February 9, 1998 and
his salary was $275,000 per annum.
(11) Consists of $48,093 in residence settlement charges in Georgia; $99,319 in
residence settlement charges in Virginia; $22,780 in other moving expenses;
and $15,410 in rent.
61
STOCK OPTION GRANTS AND EXERCISES
The following table sets forth the aggregate number of stock options
granted to each of the Named Executive Officers during the fiscal year ended
December 31, 1999. Stock options are exercisable to purchase Common Stock of the
Company.
OPTION GRANTS IN LAST FISCAL YEAR
NUMBER OF PERCENT OF POTENTIAL REALIZABLE VALUE AT
SECURITIES TOTAL OPTIONS ASSUMED ANNUAL RATE OF STOCK
UNDERLYING GRANTED TO EXERCISE PRICE APPRECIATION FOR THE OPTION
OPTIONS EMPLOYEES IN PRICE EXPIRATION TERM
GRANTED FISCAL YEAR $/SHARE DATE 0% 5% 10%
------- ----------- ------- ---------- ---- ------ ------
Richard A. Jalkut ........ -- -- % $ -- -- $ -- $ -- $ --
Michael A. Lubin.......... -- -- % $ -- -- $ -- $ -- $ --
William R. Smedberg ...... 50,000 6.88 5.20 5/13/2009 0 163,513 414,373
James M. Craig............ 125,000 17.21 5.20 5/13/2009 0 408,782 1,035,933
Shawn F. O'Donnell........ 50,000 6.88 5.20 8/5/2009 0 163,513 414,373
Robert A. Rouse........... 350,000 48.18 5.20 5/13/2009 0 1,144,588 2,900,611
Kevin J. Bennis........... -- -- --
-- -- -- --
- ------------------------
(1) The information disclosed assumes, solely for purposes of demonstrating
potential realizable value of the stock options, that the estimated
fair market value per share of Common Stock was $5.20 per share as of
December 31, 1999 and increases at the rate indicated during the option
term.
(2) The options vest ratably over a four year period. The option may be
transferred only by will or by the laws of descent and distribution.
Upon a change of control of the Company and termination of optionee's
employment without cause, the options that would otherwise become
vested within one year will be deemed vested immediately before such
optionee's termination.
62
OPTION EXERCISES AND FISCAL YEAR-END OPTION VALUES
None of the Named Executive Officers exercised any options during the
fiscal year ended December 31, 1999. The following table sets forth as of
December 31, 1999, the aggregate number of options held by each of the Named
Executive Officers.
FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES UNDERLYING
SHARES UNEXERCISED OPTIONS AT
ACQUIRED ON VALUE -------------------------------- VALUE OF UNEXERCISED
EXERCISE REALIZED DECEMBER 31, 1999 IN-THE-MONEY OPTIONS (1)
-------- -------- ------------------ ------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- ----------- ------------- ----------- -------------
Richard A. Jalkut ........ -- -- 572,502 286,252 $ 5,650,595 $ 2,825,307
Michael A. Lubin.......... -- -- 145,215 11,250 1,573,621 65,250
William R. Smedberg ...... -- -- 58,686 69,970 513,093 492,191
James M. Craig.......... -- -- 0 125,000 0 725,000
Shawn F. O'Donnell........ -- -- 0 50,000 0 290,000
Robert A. Rouse........... -- -- 0 350,000 0 2,030,000
Kevin J. Bennis........ 90,625 $894,469 0 0 0 0
- ------------------------------
(1) Based on an assumed market price of the Common Stock of $11.00 per share as
of December 31, 1999.
SCHAEFFER BOARD RESIGNATION
In October 1997, Mr. Schaeffer was our employee and was granted an option
to purchase 148,418 shares of common stock under our 1997 Plan; the number of
shares and ther exercise price were subsequently adjusted in a stock split. Mr.
Schaeffer is no longer an officer or director of the company. In a letter
agreement dated November 4, 1999, in which Mr. Schaeffer resigned from his
position as a director of Pathnet, we agreed with Mr. Schaeffer agreed that Mr.
Schaeffer holds options for a total of 107,389 shares of our common stock, which
are fully vested at an exercise price of $3.67 per share. PI will assume these
option grants and convert them to options for shares of its common stock at
closing of the Transaction.
JALKUT EMPLOYMENT AGREEMENT
We are currently a party to an employment agreement with Mr. Jalkut. Under
this employment agreement, Mr. Jalkut will receive a minimum annual base salary
of $400,000 (or any greater amount approved by a majority of the board of
directors), bonuses and other benefits determined by the board of directors.
Additionally, Mr. Jalkut is entitled to receive reimbursement of certain
expenses, all of which expenses may not exceed $50,000 per year. In accordance
with his employment agreement, on August 4, 1997, Mr. Jalkut received
nonqualified stock options for 296,122 shares of common stock at an exercise
price of $3.28 per share; the number of shares and the option price were
subsequently adjusted in a stock split. These options vest ratably over three
years. We have granted Mr. Jalkut registration rights for the shares he will
receive upon exercise of his options. If we terminate Mr. Jalkut's employment he
may elect, within 10 business days of his termination, to have us pay him,
subject to the terms of the Indenture and the Supplemental Indenture, the
63
aggregate fair value of his options then vested or held by him. We will be
required to make any payments in accordance with his employment agreement.
During his employment and for two years after his termination, Mr. Jalkut's
employment agreement requires him to refrain from investing in businesses or
activities that compete with us, soliciting our employees or otherwise competing
with us, by, for example, working with or for one of our competitors. Mr.
Jalkut's employment agreement also prevents him from disclosing or using our
confidential or proprietary information at any time.
Other than the restrictions on Mr. Jalkut described above and our
obligation to pay severance for one year following the termination of Mr.
Jalkut's employment (depending on the basis for his termination), Mr. Jalkut's
employment agreement will terminate in the event of his death and may be
terminated:
o By us:
(a) Without cause (as defined in his employment agreement), by giving
60 days' prior written notice; or
(b) For cause, generally subject to a 30-day written notice of the
board's intention to terminate him for cause;
(c) Upon Mr. Jalkut's disability (as defined in his employment
agreement); and
o By Mr. Jalkut:
(a) Without cause, by giving 180 days' prior written notice; and
(b) Immediately, upon a constructive termination (as defined in his
employment agreement).
Unless we terminate Mr. Jalkut's employment for cause, or Mr. Jalkut
terminates his employment without cause, Mr. Jalkut is entitled to continue to
receive his salary for 12 months following the termination of his employment
with us.
OTHER AGREEMENTS
Messrs. Schaeffer, Lubin, O'Donnell, Rouse, Craig and Smedberg each have
entered into an agreement withus. which requires each of them to (1) assign to
us all inventions developed by them during their employment, (2) maintain the
confidentiality of Pathnet proprietary information, and (3) refrain from working
with or for a competitor of ours for two years after his termination.
64
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The table below provides some information regarding beneficial ownership of
our capital stock as of December 31, 1999 for:
o Each of the Named Executive Officers.
o Each of our directors.
o All of our executive officers and directors as a group.
o Each other person, entity or group who we know beneficially owns 5% or
more of any class of our stock. All share amounts in the table have
been adjusted and are presented assuming that the Contribution and
Reorganization Transaction was closed as of December 31, 1999. Unless
otherwise noted, the address of each of our Named Executive Officers
and directors is 1015 31st Street, N.W., Washington, D.C. 20007.
ISSUED AND OUTSTANDING
COMMON STOCK
STOCKHOLDER (a) SERIES A PREFERRED SERIES B PREFERRED
- --------------- ------------------ ------------------
PERCENTAGE PERCENTAGE PERCENTAGE
---------- ---------- ----------
SHARES OF CLASS SHARES OF CLASS SHARES OF CLASS
------- -------- ------- -------- ------- --------
Spectrum Equity Investors, L.P. (d). -- -- 1,372,668 47.3% 1,220,099 25.5%
Spectrum Equity Investors II, L.P. (d) -- -- -- -- -- --
New Enterprise Associates VI, Limited
Partnership (e)..................... -- -- 522,000 18.0% 685,014 14.3%
Onset Enterprise Associates II, L.P. (f) -- -- 522,000 18.0% 463,976 9.7%
Onset Enterprise Associates III, L.P. -- -- -- -- -- --
(f).................................
Paul Capital Partner Funds (g)...... -- -- 245,989 8.5% 125,144 2.6%
Thomas Domencich (h)................ -- -- 145,000 5.0% 62,573 1.3%
Toronto Dominion Capital (USA) Inc. (i) -- -- -- -- 884,146 18.5%
Grotech Partners IV, L.P. (j)....... -- -- -- -- 884,146 18.5%
Utech Climate Challenge Fund, L.P. (k) -- -- -- -- 442,076 9.2%
Utility Competitive Advantage Fund, LLC -- -- -- -- -- --
(l).................................
David Schaeffer(m).................. 2,900,000 94.5% -- -- -- --
Richard A. Jalkut (n)............... -- -- -- -- -- --
Michael A. Lubin (o)............... -- -- -- -- -- --
William R. Smedberg (p)............. -- -- -- -- -- --
Kevin J. Maroni (q)................. -- -- 1,372,668 47.3% 1,220,099 25.5%
Peter J. Barris (r)................. -- -- 522,000 18.0% 685,014 14.3%
Patrick J. Kerins (s)............... -- -- -- -- 884,146 18.5%
Stephen A. Reinstadtler (t)......... -- -- -- -- 884,146 18.5%
All Directors and Named Executive
Officers as a Group (n) (o) (p) (q) (r) -- -- 1,894,668 65.3% 3,673,405 76.7%
- -------------------
BENIFICIAL OWNERSHIP OF
STOCKHOLDER (a) SERIES C PREFERRED STOCK COMMON STOCK
- --------------- ------------------ OPTIONS (b) ------------
PERCENTAGE ---------- TOTAL PERCENTAGE
---------- ------ ----------
SHARES OF CLASS SHARES (c)
------- -------- ------ ---
Spectrum Equity Investors, L.P. (d). 1,363,406 16.7% -- 3,956,173 56.3%
Spectrum Equity Investors II, L.P. (d) 1,363,406 16.7% -- 1,363,406 30.8%
New Enterprise Associates VI, Limited
Partnership (e)..................... 1,374,051 16.8% -- 2,581,065 45.7%
Onset Enterprise Associates II, L.P. (f) 817,672 10.0% -- 1,803,648 37.0%
Onset Enterprise Associates III, L.P. 272,553 3.3% -- 272,553 8.2%
(f).................................
Paul Capital Partner Funds (g)...... 136,275 1.7% -- 507,573 5.9%
Thomas Domencich (h)................ -- -- -- 207,573 6.3%
Toronto Dominion Capital (USA) Inc. (i) 1,006,500 12.3% -- 1,890,646 38.1%
Grotech Partners IV, L.P. (j)....... 1,006,500 12.3% -- 1,890,646 38.1%
Utech Climate Challenge Fund, L.P. (k) 136,276 1.7% -- 578,352 15.9%
Utility Competitive Advantage Fund, LLC 366,980 4.5% -- 366,980 10.7%
(l).................................
David Schaeffer(m).................. -- -- 107,389 3,007,389 94.7%
Richard A. Jalkut (n)............... -- -- 572,502 572,502 15.7%
Michael A. Lubin (o)............... -- -- 145,215 145,215 4.5%
William R. Smedberg (p)............. -- -- 128,656 128,656 4.0%
Kevin J. Maroni (q)................. 2,726,812 33.4% -- 5,319,579 63.4%
Peter J. Barris (r)................. 1,374,051 16.8% -- 2,581,065 45.7%
Patrick J. Kerins (s)............... 1,006,500 12.3% -- 1,890,646 38.1%
Stephen A. Reinstadtler (t)......... 1,006,500 12.3% -- 1,890,646 38.1%
All Directors and Named Executive
Officers as a Group (n) (o) (p) (q) (r) 6,113,863 74.8% 903,172 12,585,108 80.4%
(s) (t).............................
- -------------------
65
(a) In accordance with the rules of the Securities and Exchange Commission,
each beneficial owner's holding has been calculated assuming full exercise
of outstanding warrants and options exercisable or convertible by the
holder within 60 days after December 31, 1999.
(b) Only Options exercisable within 60 days after December 31, 1999 are listed.
(c) The pro forma percentages of beneficial ownership of common stock as to
each beneficial owner assumes the exercise or conversion into common stock
of all outstanding options, warrants and convertible securities held by
such owner that are exercisable or convertible within 60 days of December
31, 1999, but not the exercise or conversion of options, warrants and
convertible securities held by others shown in the table.
(d) Spectrum Equity Investors, L.P.'s and Spectrum Equity Investors II, L.P.'s
address is One International Place, Boston, Massachusetts, 02110.
(e) New Enterprise Associates VI, Limited Partnership's address is 1119 Saint
Paul Street, Baltimore, Maryland, 21202.
(f) Onset Enterprise Associates II, L.P.'s and Onset Enterprise Associates III,
L.P.'s address is 8911 Capital of Texas Highway, Austin, Texas, 78759.
(g) The Paul Capital Partner Funds are five funds that constitute a "group"
under Section 13(d) of the Exchange Act. Each fund's address is: c/o Paul
Capital Partners, 50 California Street, Suite 3000, San Francisco,
California, 94111. The five funds are Paul Capital Partners V L.P., Paul
Capital Partners V (Domestic Annex Fund) L.P., Paul Capital Partners V
International, L.P., Paul Capital Partners VI, L.P. and PCP Associates,
L.P.
(h) Thomas Domencich's address is 104 Benevolent Street, Providence, Rhode
Island, 02906.
(i) Toronto Dominion Capital (USA) Inc.'s address is 31 West 52nd Street, New
York, New York, 10019.
(j) Grotech Partners IV, L.P.'s address is 9690 Deereco Road, Timonium,
Maryland, 21093.
(k) Utech Climate Challenge Fund, L.P.'s and Utility Competitive Advantage
Fund, L.L.C.'s address is c/o Arete Ventures, Two Wisconsin Circle, Chevy
Chase, Maryland 20815.
(l) Utility Competitive Advantage Fund L.L.C.'s address is c/o William T.
Heflin, Managing Director, Kinetic Ventures, L.L.C., 2 Wisconsin Circle,
Suite 620, Chevy Chase, Maryland 20815.
(m) Mr. Schaeffer is no longer an officer or director of Pathnet.
(q) Mr. Maroni, who is a limited partner of the general partner of Spectrum and
a general partner of the general partner of Spectrum Equity Investors II,
L.P., disclaims beneficial ownership of the shares owned by Spectrum Equity
Investors, L.P. and Spectrum Equity Investors II, L.P.
(r) Mr. Barris, who is general partner of the general partner of New Enterprise
Associates VI, Limited Partnership, disclaims beneficial ownership of the
shares owned by New Enterprise Associates VI, Limited Partnership.
(s) Mr. Kerins, Managing Director of the general partner of Grotech Partners
IV, LP, disclaims beneficial ownership of the shares owned by Grotech
Partners IV, LP.
(t) Mr. Reinstadtler, Vice President and Director of Toronto Dominion Capital
(USA) Inc., disclaims beneficial ownership of the shares owned by Toronto
Dominion Capital (USA) Inc.
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ITEM 13..CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
EXISTING PATHNET, INC. AGREEMENTS
SERIES A PURCHASE AGREEMENT
Pursuant to an Investment and Stockholders' Agreement, dated as of
August 28, 1995 (the "Series A Purchase Agreement"), by and among the Company
and Spectrum Equity Investors, L.P., New Enterprise Associates VI, Limited
Partnership, Onset Enterprise Associates II, L.P., IAI Investment Funds VIII,
Inc., Thomas Domencich, Dennis R. Patrick and the Corman Foundation
Incorporated, (together, the "Series A Purchasers") and David Schaeffer, the
Series A Purchasers made their initial investments in the Company. The Series A
Purchasers (i) agreed, subject to the satisfaction of certain conditions, to
purchase in the aggregate 1,000,000 shares of Series A Convertible Preferred
Stock for an aggregate purchase price of $1.0 million, (ii) purchased 500,000
shares of such 1,000,000 shares of Series A Convertible Preferred Stock for an
aggregate purchase price of $500,000 and (iii) agreed to make available to the
Company, under certain circumstances, bridge loans in an aggregate principal
amount of $500,000 (the "Bridge Loan Commitment"). Pursuant to Amendment No. 1
to the Investment and Stockholders' Agreement, dated as of February 8, 1996, the
Series A Purchasers purchased the remaining 500,000 shares of Series A
Convertible Preferred Stock for an aggregate purchase price of $500,000.
Pursuant to Amendment No. 2 to the Investment and Stockholders' Agreement dated
as of August 2, 1996, the Series A Purchasers, among other things, increased the
amount of the Bridge Loan Commitment to an aggregate principal amount of
$700,000 and advanced such amount to the Company, such loans being evidenced by
bridge loan notes (collectively, the "Bridge Loan Notes"). The Bridge Loan Notes
carried an interest rate of 12% per annum and were due and payable in full on
the earlier to occur of the first anniversary of the issuance of the Bridge Loan
Notes or the closing date of the Company's next equity financing. The Bridge
Loan Notes were to be convertible into any future equity security issued by the
Company at 73% of the price to be paid for such security by other investors. In
addition, the Series A Purchasers agreed to make available to the Company, upon
the occurrence of certain events, additional bridge loans in an aggregate
principal amount of $300,000 (the "Additional Bridge Loan Commitment").
SERIES B PURCHASE AGREEMENT
The Company, each of the Series A Purchasers and several additional
purchasers (together, the "Series B Purchasers") and Mr. Schaeffer entered into
an Investment and Stockholders' Agreement, dated as of December 23, 1996 (the
"Series B Purchase Agreement"), pursuant to which, among other things, the
Series B Purchasers agreed to acquire in the aggregate 1,651,046 shares of
Series B Convertible Preferred Stock for an aggregate purchase price of $5.0
million. Of these amounts, 609,756 shares of Series B Convertible Preferred
Stock were purchased on December 23, 1996, for an aggregate purchase price of
$2.0 million. In addition, the $700,000 principal amount of Bridge Loan Notes,
plus $33,367 of accrued interest, were converted into 306,242 shares of Series B
Convertible Preferred Stock. At the same time, the Series A Purchasers paid
$300,000 representing the committed but undrawn portion of the Additional Bridge
Loan Commitment to the Company for the sale of 125,292 shares of Series B
Convertible Preferred Stock. The Series B Purchasers purchased the remaining
609,756 shares of Series B Convertible Preferred Stock subject to the Series B
Purchase Agreement for $2.0 million on June 18, 1997. See Note 9 to the
financial statements included elsewhere in this Report.
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SERIES C PURCHASE AGREEMENT
The Company, the Series A Purchasers, the Series B Purchasers and one
additional purchaser (together the "Series C Purchasers") and Mr. Schaeffer
entered into the Investment and Stockholders' Agreement, dated October 31, 1997,
as amended (the "Investment and Stockholders' Agreement"), pursuant to which,
among other things, the Series C Purchasers agreed to acquire 2,819,549 shares
of Series C Convertible Preferred Stock for an aggregate purchase price of $30.0
million. The Series C Purchasers purchased 939,850 shares of Series C
Convertible Preferred Stock for an aggregate purchase price of $10.0 million on
October 31, 1997, and purchased an additional 1,879,699 shares of Series C
Convertible Preferred Stock for an aggregate purchase price of $20.0 million
simultaneously with the closing of the Debt Offering. In connection with the
Investment and Stockholders' Agreement, the Company, the holders of Preferred
Stock (collectively, the "Investors") and Mr. Schaeffer agreed to amend and
restate, in part, the Series A Purchase Agreement and the Series B Purchase
Agreement. These amendments restated the provisions of such agreements relating
to affirmative and negative covenants, transfer restrictions, rights to purchase
and registration rights. These sections of each of the Series A Purchase
Agreement, the amendments thereto, and the Series B Purchase Agreement were
similar in all material respects. In order to remove any doubt as to this fact,
to simplify matters and for convenience (to have in one agreement the material
provisions that survive the purchase and sale of the Series A Convertible
Preferred Stock, Series B Convertible Preferred Stock and Series C Convertible
Preferred Stock (collectively the "Series Preferred Stock") and the closing of
an initial public offering), the aforementioned sections were amended and
restated in the Investment and Stockholders' Agreement. See "--Investment and
Stockholders' Agreement."
TERMS OF THE SERIES PREFERRED STOCK
Each share of Series Preferred Stock will automatically be converted
into Common Stock immediately upon the closing of a qualified public offering of
capital stock of the Company. A qualified public offering is defined as: (i) the
Company is valued on a pre-money basis at greater than $50,000,000, (ii) the
gross proceeds received by the Company exceed $20,000,000, and (iii) the Company
uses a nationally recognized underwriter approved by holders of a majority
interest of the Series Preferred Stock. As of December 31, 1998, the Series
Preferred Stock was convertible into an aggregate of 15,864,715 shares of Common
Stock.
Each share of Series Preferred Stock entitles its holder to a number of
votes equal to the number of shares of Common Stock into which such share of
Series Preferred Stock is convertible. With respect to the Board of Directors of
the Company, prior to the completion of a qualified public offering (i) the
holders of Series A Convertible Preferred Stock are entitled to vote separately
as a class to elect two directors of the Company (the "Series A Investor
Directors"), (ii) the holders of Series B Convertible Preferred Stock are
entitled to vote separately as a class to elect one director (the "Series B
Investor Director"), (iii) the holders of the Series C Convertible Preferred
Stock are entitled to vote separately as a class to elect one director (to
"Series C Investor Director"), (iv) the holders of the Common Stock are entitled
to vote separately as a class to elect two directors (the "Common Stock
Directors"), (v) the chief executive officer (the "CEO") of the Company is
appointed by the affirmative vote of the Common Stock Directors and the Series A
Investor Directors, Series B Investor Director and Series C Investor Director,
voting together, and (vi) the CEO will be elected to the Board of Directors of
the Company by the holders of Common Stock and Series Preferred Stock, voting
together.
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The holders of the Series Preferred Stock are entitled to receive
dividends in preference to and at the same rate as dividends are paid with
respect to the Common Stock. In the event of any liquidation, dissolution,
winding up or deemed liquidation of the Company, whether voluntary or
involuntary, each holder of a share of Series Preferred Stock outstanding is
entitled to be paid before any payment may be made to the holders of any class
of Common Stock or any stock ranking on liquidation junior to the Series
Preferred Stock, an amount, in cash, equal to the original purchase price paid
by such holder, appropriately adjusted for stock splits, stock dividends and the
like, plus any declared but unpaid dividends.
The Series A Convertible Preferred Stock, Series B Convertible
Preferred Stock and Series C Convertible Preferred Stock A, Series B and Series
C Preferred Stock were $1,000,000, $5,033,367, and $30,000,052, respectively, as
of December 31, 1998. In the event the assets of the Company are insufficient to
pay liquidation preference amounts, all of the assets available for distribution
shall be distributed to each holder of Series Preferred Stock PRO RATA in
proportion to the number of shares of Series Preferred Stock held by such
holder.
Shares of the Series Preferred Stock may be converted at any time, at
the option of the holder, into shares of Common Stock. The number of shares of
voting Common Stock to be received upon conversion is subject to adjustment in
the event of stock dividends and subdividends, certain combinations of Common
Stock, and issuances of Common Stock and of securities convertible into Common
Stock that have a dilutive effect. As of December 31, 1998, each share of Series
Preferred Stock was convertible into 2.9 shares of Common Stock.
INVESTMENT AND STOCKHOLDERS' AGREEMENT
Pursuant to the terms of the Investment and Stockholders' Agreement,
the Investors and Mr. Jalkut are entitled to certain registration rights with
respect to securities of the Company. On any three occasions at the option of
the holders, the holders of a majority of the securities registrable under the
terms of the Investment and Stockholders' Agreement ("Registrable Securities")
may require the Company to effect a registration under the Securities Act of
1933 of their Registrable Securities, subject to the Company's right to defer
such registration for a period of up to 60 days. In addition, if the Company
proposes to register securities under the Securities Act of 1933 (other than a
registration relating either to the sale of securities to employees pursuant to
a stock option, stock purchase or similar plan or a transaction under Rule 145
of the Securities Act), then any of the holders of Registrable Securities have
the right (subject to certain cut-back limitations) to request that the Company
register such holder's Registrable Securities. All registration expenses of the
Investors (exclusive of underwriting discount and commissions) up to $60,000 per
offering will be borne by the Company. The Company has agreed to indemnify the
Investors against certain liabilities in connection with any registration
effected pursuant to the foregoing terms, including liabilities arising under
the Securities Act.
PATHNET TELECOMMUNICATIONS INC. STOCKHOLDERS AGREEMENT
Following the closing of the Transaction, the Pathnet Inc. stockholders
agreement will terminate, and a new Pathnet Telecommunications, Inc.,
stockholders agreement will go into effect. We summarize in this section
selected materials of the new stockholders agreement. For a more complete
description, we refer you to the copy of Pathnet Telecommunications, Inc's
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stockholders agreement filed as an exhibit to the Pathnet Telecommunications,
Inc.'s Registration Statement on Form S-1 (Registration No. 333-91469) filed by
Pathnet Telecommunications, Inc. with the Securities and Exchange Commission
(the "Commission") on November 22, 1999
If there is an inconsistency between this summary and the stockholders
agreement, the stockholders agreement will control.
OVERVIEW
Upon closing of the various contribution agreements comprising the
Transaction, PTI will enter into a stockholders agreement with CSX, Colonial,
BNSF, our other preferred stockholders and David Schaeffer. The stockholders
agreement will put in place at the Pathnet Telecom level many of the provisions
that currently apply under Pathnet's existing Investment and Stockholders
Agreement. Pathnet's existing Investment and Stockholders Agreement will be
terminated after the Transaction.
In accordance with the stockholders agreement, each stockholder will
agree to vote in favor of the election of a board of directors consisting of 10
members:
o Two designees of the Series A Preferred Stockholders (initially, a
designee of Spectrum Equity Investors L.P. and the other will
initially be a designee of New Enterprise Associates VI Limited
Partnership);
o One designee of the Series B Preferred Stockholders (initially, a
designee of Grotech Partners IV, L.P.);
o One designee of the Series C Preferred Stockholders (initially, a
designee of Toronto Dominion Capital (U.S.A.), Inc.) who may not be a
partner or associate of Spectrum, New Enterprise Associates or Grotech
for so long as they have designation rights under our stockholders
agreement;
o Three designees of the Series D and E Preferred Stockholders (one
designated by BNSF, one by CSX and one by Colonial);
o PTI's CEO;
o One independent "outside" director, who is neither a member of
management nor an affiliate of any stockholder; and
o One director who will be elected by all voting stockholders voting
together as a single class, as provided by our certificate of
incorporation.
Under the stockholders agreement, PTI will be subject to covenants
substantially similar to those in effect under Pathnet's Investment and
Stockholders Agreement. For so long as at least 25% of the shares of preferred
stock outstanding immediately after the closing of the Transaction remain
outstanding, these covenants will require that PTI obtain the approval of the
holders of two-thirds of the outstanding shares of preferred stock (all voting
as a single class) before Pathnet Telecommunications, Inc. undertake certain
fundamental actions, including mergers, dispositions, acquisitions, amendments
to our certificate of incorporation and bylaws, affiliated transactions, and
certain issuances of securities. In addition, certain actions that would
adversely affect the rights of a single series of preferred stock relative to
any other series of preferred stock would require the majority vote of each
adversely affected series.
70
Each party to the stockholders agreement will represent and warrant to the
other stockholders that they, he or it (1) has no present intention or plan,
formally or informally, on the closing date to transfer or dispose of any of the
shares received by such party under their, his or its contribution agreement,
and (2) intends for their, his or its contribution of Pathnet shares or other
property to us in accordance with their, his or its contribution agreement to be
treated as part of a single integrated transaction in which gain or loss will
not be recognized for tax purposes. Each existing Pathnet stockholder who
participates will represent and warrant to the other parties that it intends its
contribution of Pathnet shares to us to qualify as a tax-free reorganization
under Section 368(a)(1)(B) of the Internal Revenue Code, pursuant to which gain
or loss will not be recognized.
REGISTRATION RIGHTS
In the stockholders agreement, PTI. will grant registration rights to its
preferred stockholders and to Mr. Jalkut and Mr. Schaeffer. These registration
rights will be substantially similar to the registration rights granted to these
same holders in the Pathnet Investment and Stockholders Agreement, except that
Mr. Schaeffer will be granted registration rights. The holders of securities
subject to registration rights will have both "demand" and "piggy back"
registration rights.
DEMAND RIGHTS
Pathnet Telecommunications, Inc. will grant "demand" registration rights
for two separate groups of our equity securities. The groups are broadly
distinguished by the identity of the holders who can demand that Pathnet
Telecommunications, Inc. register their shares under the Securities Act. The
first group consists of the holders of:
o Shares of common stock issued to Pathnet Telecommunications, Inc.'s
preferred stockholders, or issuable to Pathnet Telecommunications,
Inc.'s preferred stockholders upon the conversion of their shares of
preferred stock; and
o Shares of common stock issued or issuable to Mr. Jalkut upon the
exercise of his options.
Pathnet Telecommunications, Inc. refer to these groups of shares as
"registrable securities." On three separate occasions, by the vote of the
holders of the applicable percentage of the registrable securities outstanding
in this first group, the holders of the shares in this group may require PTI to
use its best efforts to file a registration statement with the SEC in respect of
their registrable securities. Before Pathnet Telecommunications, Inc. make an
initial "Qualified Public Offering" (which the stockholders agreement defines as
a public offering of more than $75 million in value of our securities at a per
share price that implies a valuation in excess of $600 million for all of the
shares of our capital stock), the holders of at least 67% of the total number of
outstanding registrable securities must affirmatively vote to exercise any of
these demand rights. After Pathnet Telecommunications, Inc. makes an initial
Qualified Public Offering, the holders of 20% of the total number of outstanding
registrable securities may make the demand. Although Pathnet Telecommunications,
Inc. does not include Mr. Schaeffer's shares in calculating the percentages for
purposes of the demand by this group, he will be entitled to participate on a
proportional basis in any registration demanded by this group of our
stockholders.
Separately, PTI. will grant Mr. Schaeffer a single right to demand that PTI
register his shares of its common stock under the Securities Act. Mr. Schaeffer
will have the right to exercise his demand registration right if: (1) Pathnet
Telecommunications, Inc. complete an initial Qualified Public Offering, and (2)
its registration statement filed in respect of that initial offering either:
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o Does not include Mr. Schaeffer's shares of its common stock that he
proposes to register; or
o Has ceased to be effective within the thirty-day period following the
expiration of a mandatory "lock-up" period applicable to all of the
holders of our securities with registration rights. (The lock-up
provisions of our stockholders agreement will prohibit sales of our
securities by the parties to our stockholders agreement for a period
up to 180 days following the completion of an initial public
offering.)
Although they may not initiate a "demand" under this provision, the holders
of Pathnet Telecommunications, Inc.'s registrable securities identified above
may participate on a proportional basis in any registration demanded by Mr.
Schaeffer under this provision of the stockholders agreement.
In exercising these demand registration rights, the stockholders must in
all cases have selected an underwriter reasonably acceptable to us who is
prepared to underwrite the offering of the shares on a firm commitment basis.
Pathnet Telecommunications, Inc. will have additional obligations to assist in
the registration and underwriting of any shares that these holders seek to sell
pursuant to their registration rights. Pathnet Telecommunications, Inc. will
have a right to defer each of those demand registrations for up to 60 days, if
our legal counsel has advised us that filing a registration statement relating
to such a demand registration would require us either (1) to disclose a material
impending transaction and Pathnet Telecommunications, Inc. have determined in
good faith that the disclosure would have a material adverse effect on us, or
(2) to conduct a special audit.
Pathnet has separate "demand registration" obligations under a Warrant
Registration Rights Agreement executed in conjunction with Pathnet 's Note and
warrant offering in April 1998. Under that agreement, the holders of a majority
of the Pathnet warrants may require Pathnet on one occasion after an initial
public offering to register under the Securities Act their shares of common
stock received upon the exercise of their warrants, subject to Pathnet's right
to defer the registration of those shares for up to 60 days in similar
circumstances. In connection with the transaction, PTI expects to propose to the
holders of these rights that it assume Pathnet 's obligations under this Warrant
Registration Rights Agreement. If the requisite holders of the Pathnet's
warrants consent to the proposed amendments, PTI may be required by the terms of
the Warrant Registration Rights Agreement to register additional shares of our
common stock upon the exercise of these warrants.
PIGGYBACK RIGHTS
Pathnet Telecommunications, Inc will also grant to each of these groups of
its stockholders (and, if it assumes Pathnet's obligations to the holders of its
warrants, then also to those warrant holders) so-called "piggyback" registration
rights, under which they can require Pathnet Telecommunications, Inc. to
register their shares of common stock whenever it registers any of its equity
securities under the Securities Act. These piggyback registration rights will be
subject to underwriter "cutbacks," which means that Pathnet Telecommunications,
Inc.'s managing underwriter may decide to limit the number of shares added to a
registration that it initiate because the underwriter has concluded that
including the additional "piggyback" shares would have an adverse impact on the
marketing of the securities to be sold in the underwritten offering. These
piggyback registration rights will not apply to any registration relating to a
public offering pursuant to demand registration rights granted to Pathnet
warrantholders, to the registration of securities with our employee benefit
plans, on any SEC form that does not permit secondary offerings, or to
securities we issue in a merger, exchange offer or similar transaction.
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Pathnet Telecommunications, Inc.'s will be required to bear up to $60,000
of registration expenses for each demand registration under its stockholders
agreement. In addition, it will agree to indemnify the registration rights
holders against, and provide contribution for, liabilities under the Securities
Act, the Securities Exchange Act of 1934 or other federal or state laws
regarding the registration of our securities. However, it will not indemnify the
registration rights holders against, or provide them contribution for, any
untrue statements or omissions made by us in reliance on and in conformity with
information furnished to us in writing by the registration rights holders.
PREEMPTIVE RIGHTS
Under the stockholders agreement, each of Pathnet Telecommunications,
Inc.'s preferred stockholders and Mr. Schaeffer will have the right to
participate in certain of our sales of securities. Specifically, on each
occasion between the closing of the Contribution and Reorganization Transaction
and an initial "Qualified Public Offering" that it issues shares of its capital
stock (or other securities convertible or exchangeable for our capital stock),
PTI's preferred stockholders and Mr. Schaeffer will have the right to purchase
their pro rata share of the newly issued securities. In addition, in the event
that any of our preferred stockholders or Mr. Schaeffer elects not to purchase
his or its pro rata share of the newly issued securities, the remaining
preferred stockholders and Mr. Schaeffer will have the right to purchase those
shares as well.
TRANSFER RESTRICTIONS
Mr. Schaeffer's ability to transfer his shares of our capital stock will be
subject to restrictions under our stockholders agreement. He is prohibited from
making any transfers other than specifically enumerated "Permitted Transfers."
Those Permitted Transfers include:
o Transfers made in accordance with specified provisions of our
stockholders agreement which, among other things, grant a right of
first refusal to our preferred stockholders with respect to the shares
Mr. Schaeffer proposes to transfer.
o Transfers by Mr. Schaeffer to his spouse or his children, to a trust
he establishes for his spouse or children, upon his death, to a trust
established under his will and other similar transfers, provided that
the transferee enters into an enforceable written agreement that is
satisfactory to us and to a majority of our preferred stockholders,
providing that the shares transferred by Mr. Schaeffer remain subject
to our stockholders agreement.
o Transfers that constitute a bona fide pledge or other granting of a
security interest in Mr. Schaeffer's shares of our stock to secure a
loan for borrowed money, subject to specified restrictions, including
limitations on the purpose of any such loan, the minimum net assets of
the lending institution, and a review of the applicable loan documents
by our outside counsel for compliance with the terms of our
stockholders agreement.
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PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS REPORT:
(1) Financial Statements
Consolidated Balance Sheets as of December 31, 1999 and 1998
Consolidated Statements of Operations for the years ended December 31,
1999, 1998 and 1997, and for the period August 25, 1995 (date of
inception) to December 31, 1999
Consolidated Statements of Comprehensive Loss for the years ended
December 31, 1999, 1998 and 1997, and for the period August 25, 1995
(date of inception) to December 31, 1999
Consolidated Statements of Cash Flows for the years ended December 31,
1999, 1998 and 1997, and for the period August 25, 1995 (date of
inception) to December 31, 1999
Consolidated Statement of Stockholders' Equity (Deficit) for the years
ended December 31, 1999, 1998, 1997 and 1996, and for the period August
25, 1995 (date of inception) to December 31, 1997
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
All schedules are omitted because they are not applicable or not
required or because the required information is incorporated herein by
reference or included in the financial statements or notes thereto
included elsewhere in this report.
(B) REPORTS ON FORM 8-K.
On November 9, 1999, the company announced that it had entered into
agreements providing for strategic investments from Colonial Pipeline
Company, Burlington Northern and Sante Fe Corporation (BNSF) and CSX
Corporation.
(C) EXHIBITS.
The following exhibits are filed as a part of this Annual Report on Form
10-K:
EXHIBIT NUMBERDESCRIPTION OF DOCUMENT
ITEM 14 EXHIBITS
3.1 (ii) Amended and Restated Certificate of Incorporation of Pathnet, Inc.
and Certificate of Amendment to such Certificate of Incorporation.
3.2 (ii) Amended and Restated Bylaws of Pathnet Telecommunications, Inc.
4.1 (i) Indenture, dated as of April 8, 1998, between Pathnet, Inc.
and The Bank of New York, Inc. as Trustee
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4.4 (i) Form of Note
4.5 (i) Pledge Agreement, dated as of April 8, 1998, among Pathnet,
Inc., The Bank of New York as Trustee and The Bank of New
York as the Securities Intermediary
10.1 (i) (2) Pathnet, Inc. 1995 Stock Option Plan
10.2 (i) (2) Pathnet, Inc. 1997 Stock Incentive Plan as amended by Amendment No. 1
to 1997 Stock Incentive Plan.
10.3 (v) Contribution Agreement, dated as of November 2, 1999, by and
among Pathnet Telecommunications, Inc., Pathnet, Inc. and
The Burlington Northern Santa Fe Railway Company
10.4 (v) Contribution Agreement, dated as of November 2, 1999, by and
among Pathnet Telecommunications, Inc., Pathnet, Inc. and
Colonial Pipeline Company
10.5 (v) Contribution Agreement, dated as of November 2, 1999, by and
among Pathnet Telecommunications, Inc., Pathnet, Inc. and
CSX Transportation, Inc.
10.6 (v) Contribution Agreement, dated as of November 2, 1999, by and
among Pathnet Telecommunications, Inc., Pathnet, Inc. and
The Preferred Stockholders of Pathnet, Inc.
10.7 (v) Contribution Agreement, dated as of November 2, 1999, by and
among Pathnet Telecommunications, Inc., Pathnet, Inc. and
Common Stockholders of Pathnet, Inc.
10.8 (v) Contribution Agreement, dated November 4, 1999, by and among
Pathnet Telecommunications, Inc., Pathnet, Inc. and David
Schaeffer
10.9 (i) Warrant Agreement, dated as of April 8, 1998, between
Pathnet, Inc. and The Bank of New York, as warrant agent
10.10 (i) Warrant Registration Rights Agreement, dated as of April 8,
1998, among Pathnet, Inc., Spectrum Equity Investors, L.P.,
New Enterprise Associates VI, Limited Partnership, Onset
Enterprise Associates II, L.P., FBR Technology Venture
Partners, L.P., Toronto Dominion Capital (U.S.A.) Inc.,
Grotech Partners IV, L.P., Richard A. Jalkut, David
Schaeffer and the Initial Purchasers
10.11 (i) Lease Agreement, dated August 9, 1997, by and between
Pathnet, Inc. and 6715 Kenilworth Avenue General Partnership
relating to Pathnet Inc.'s offices in Georgetown, including
Amendment to Lease Agreement dated March 5, 1998, and Second
Amendment to Lease dated June 1, 1998
10.12 (iii) Amendment No. 3 to Lease Agreement, dated September 1, 1998,
by and between Pathnet, Inc. and 6715 Kenilworth Avenue
General Partnership
10.13 (i) Notes Registration Rights Agreement, dated April 8, 1998, by
and among Pathnet, Inc. and Merrill Lynch & Co., Merrill
Lynch, Pierce, Fenner & Smith Incorporated, Bear Stearns &
Co. Inc., TD Securities (USA) Inc. and Salomon Brothers
10.14 (i) (2) Employment Agreement, dated August 4, 1997, by and between
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Pathnet, Inc. and Richard A. Jalkut, as amended by Amendment
to Employment Agreement, dated April 6, 1998
10.15 (vi) (2) Letter Agreement, dated April 7, 1999, between Pathnet, Inc.
and Robert Rouse, relating to Mr. Rouse's employment with
Pathnet, Inc.
10.16 (i) (2) Non-Disclosure, Assignment of Inventions and Non Competition
Agreement, dated February 2, 1998, by and between Pathnet,
Inc. and Kevin Bennis.
10.17 (viii) Assignment and Acceptance, by and between Pathnet, Inc. and
Pathnet Telecommunications, Inc.
10.18 (i) (2) Non-Qualified Stock Option Agreement, dated August 4, 1997,
by and between Pathnet, Inc. and Richard A. Jalkut
10.19 (i) (2) Non-Qualified Stock Option Agreement, dated October 31,
1997, by and between Pathnet, Inc. and David Schaeffer
10.20 (viii) (3) IXC Master Services Agreement, dated June 17, 1999, by and
between IXC Communications Services, Inc. and Pathnet, Inc.,
as amended by Amendment No. 1 dated August 26, 1999 and
Amendment No. 2, dated October 13, 1999
10.21 (viii) (3) Capacity Agreement, dated August 10, 1999, between Frontier
Communications of the West, Inc. and Pathnet, Inc.
Collocation and Interconnection Agreements:
10.22 (viii) Collocation Agreement, dated July 29, 1999, by and between
BellSouth Telecommunications, Inc. and Pathnet, Inc.
10.23 (viii) Interim Collocation Agreement, dated August 12, 1999,
between U S West Communications, Inc. and Pathnet, Inc.
Equipment Supply Contracts:
10.24 (i) Master Agreement, dated August 8, 1997, between Pathnet,
Inc. and NEC America, Inc. as amended by Amendment No. 1 to
Master Agreement, dated November 9, 1997, Amendment No. 2 to
Master Agreement, dated April 2, 1998, Amendment No. 3 to
Master Agreement, dated May 4, 1998, and Amendment No. 4 to
Master Agreement, dated July 10, 1998
10.25 (iii) Amendment No. 5 to Master Agreement, dated November 20,
1998, by and between Pathnet, Inc. and NEC America, Inc.
10.26 (i) Purchase Agreement, dated July 1, 1995, between Andrew
Corporation and Path Tel, Inc., as amended by Amendment One,
dated September 16, 1996 and Amendment Two, dated July 1,
1997
10.27 (v) Agreement, dated March 31, 1999, between Pacific Fiber Link,
LLC and Pathnet, Inc.
10.28 (v) Marketing Agreement, dated March 31, 1999,
between Pacific Fiber Link, LLC and Pathnet, Inc.
10.29 (v) Dark Fiber Network Agreement, dated August 5, 1999, by and
among Pathnet, Inc., Tri-State Generation and Transmission
Association, Inc., Empire Electric Association, Inc., La
Plata Electric Association, Inc., Delta-Montrose Electric
Association, Inc. and San Miguel Power Association, Inc.
10.30 (viii) Form of Letter agreement, dated November 4, 1999, by and
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among Pathnet, Inc., David Schaeffer, Spectrum Equity
Investors, L.P., Spectrum Equity Investors II, L.P., New
Enterprise Associates VI, Limited Partnership and Grotech
Partners IV, L.P.
10.31 (viii) Licence of Marks, dated November 10, 1999, by and between
Pathnet, Inc. and Pathnet Telecommunications, Inc.
10.32.1 (vii) Investment and Stockholders Agreement, dated as of
October 31, 1997 (the "Investment and Stockholders Agreement")
by and among Pathnet, Inc. and certain stockholders of Pathnet, Inc.
10.32.2 (vii) Consent Waiver and Amendment, dated as of March 19, 1998,
relating to the Investment and Stockholders Agreement
10.32.3 (vii) Amendment No. 1 to the Investment and Stockholders Agreement
dated as of April 1, 1998.
21.1 (1) List of Subsidiaries of Pathnet Telecommunications, Inc.
27.1 (1) Financial Data Schedule
99.1 (viii) Consent of the Yankee Group
- ----------
(i) Incorporated by reference to the corresponding exhibit to Pathnet,
Inc.'s Registration Statement on Form S-1 (Registration No. 333-52247)
filed by Pathnet, Inc. with the Securities and Exchange Commission
(the "Commission") on May 8, 1998, as amended by Amendment No. 1 to
such Registration Statement filed with the Commission on July 16,
1998, and as further amended by Amendment No. 2 to such Registration
Statement filed with the Commission on July 27, 1998, and as further
amended by Amendment No. 3 to such Registration Statement filed with
the Commission on August 10, 1998.
(ii) Incorporated by reference to Pathnet, Inc.'s Form 10-K (File No.
000-24745) filed by Pathnet, Inc. with the Commission on March 18,
1999.
(iii)Incorporated by reference to Pathnet, Inc.'s Form 10-Q (File No.
000-24745) filed by Pathnet, Inc. with the Commission on May 17, 1999.
(iv) Incorporated by reference to Pathnet, Inc.'s Form 10-Q (File No.
000-24745) filed by Pathnet, Inc. with the Commission on August 9,
1999.
(v) Incorporated by reference to Pathnet, Inc.'s Form 10-Q (File No.
000-24745) filed by Pathnet, Inc. with the Commission on November 15,
1999.
(vi) Incorporated by reference to Pathnet, Inc.'s Form 8-K (File No.
000-24745) filed by Pathnet, Inc. with the Commission on April 29,
1999.
(vii)Incorporated by reference to the corresponding exhibit to Pathnet,
Inc.'s Registration Statement on Form S-4 (Registration No. 333-53467)
filed by Pathnet, Inc. with the Commission on May 22, 1998, as amended
by Amendment No. 1 to such Registration Statement filed with the
Commission on August 12, 1998, and as further amended by Amendment No.
2 to such Registration Statement filed with the Commission on August
21, 1998, and as further amended by Amendment No. 3 to such
Registration Statement filed with the Commission on August 31, 1998.
(viii) Incorporated by reference to the corresponding exhibit to
Pathnet Telecommunications, Inc.'s Registration Statement on Form S-1
(Registration No. 333-91469) filed by Pathnet Telecommunications, Inc.
with the Securities and Exchange Commission (the "Commission") on
November 22, 1999, as amended by Amendment No. 1 to such Registration
Statement filed with the Commission on December 16, 1999, and as
further amended by Amendment No. 2 to such Registration Statement
77
filed with the Commission on February 22, 2000.
(1) Filed herewith.
(2) Constitutes management contract or compensatory arrangement.
(3) Certain portions of this exhibit have been omitted based on a request
for confidential treatment filed separately with the Commission.
78
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, in the District of
Columbia on this 22nd day of February 2000.
PATHNET, INC.
By: /s/ Michael A. Lubin
------------------------
Name: Michael A. Lubin
Title: Vice President, General Counsel And
Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
/s/ Richard A. Jalkut Chief Executive Officer and February 22, 2000
- ---------------------- Director
Richard A. Jalkut
/s/ James M. Craig Executive Vice-President February 22, 2000
- --------------------- Chief Financial Officer
James M. Craig and Treasurer (Principal
Financial Officer and
Controller
/s/ Peter J. Barris Director February 22, 2000
- ----------------------
Peter J. Barris
/s/ Kevin J. Marconi Director February 22, 2000
- ----------------------
Kevin J. Maroni
/s/ Patrick J. Kerins Director February 22, 2000
- ----------------------
Patrick J. Kerins
/s/ Stephen A. Reinstadtler Director February 22, 2000
- ----------------------------
Stephen A. Reinstadtler
79
PATHNET, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
PAGE
----
Report of Independent Accountants F-2
Consolidated Balance Sheets as of December 31, 1999 and 1998 F-3
Consolidated Statements of Operations for the years ended December 31,
1999, 1998 and 1997, and for the period August 25, 1995 (date of
inception) to
December 31, 1999 F-4
Consolidated Statements of Comprehensive Loss for the years ended
December 31, 1999, 1998 and 1997, and for the period August 25, 1995
(date of inception) to December 31, 1999 F-5
Consolidated Statements of Cash Flows for the years ended December 31,
1999, 1998 and 1997, and for the period August 25, 1995 (date of
inception) to
December 31, 1999 F-6
Consolidated Statement of Stockholders' Equity (Deficit) for the years
ended December 31, 1999, 1998, 1997 and 1996, and for the period
August 25, 1995
(date of inception) to December 31, 1999 F-7
Notes to Consolidated Financial Statements F-8
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
Pathnet, Inc.
In our opinion, the consolidated financial statements listed in
the accompanying index present fairly, in all material respects, the financial
position of Pathnet, Inc. and its subsidiaries (a development stage enterprise)
(the Company) at December 31, 1999 and 1998, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 1999 and for the period August 25, 1995 (date of inception) to December 31,
1999, in conformity accounting principles with generally accepted in the United
States. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States,
which require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
McLean, VA
February 22, 2000
PATHNET, INC. AND SUBSIDIARIES
A Development Stage Enterprise
CONSOLIDATED BALANCE SHEETS
December 31, December 31,
1999 1998
------------ ------------
ASSETS
Cash and cash equivalents $ 90,661,837 $ 57,321,887
Note receivable - 3,206,841
Interest receivable 1,048,417 3,848,753
Marketable securities available for sale, at market 42,651,836 97,895,773
Prepaid expenses and other current assets 1,437,464 205,505
------------ ------------
Total current assets 135,799,554 162,478,759
Property and equipment, net 131,928,365 47,971,336
Deferred financing costs, net 9,649,680 10,508,251
Restricted cash 16,452,916 10,731,353
Marketable securities available for sale, at market 5,088,458 71,899,757
Pledged marketable securities held to maturity 21,265,206 61,824,673
Other assets 351,808 -
------------ ------------
Total assets $320,535,987 $ 365,414,129
============ ============
LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY (DEFICIT)
Accounts payable $ 18,543,195 $ 10,708,263
Accrued interest 8,932,293 8,932,294
Accrued expenses and other current liabilities 3,113,181 639,688
------------ ------------
Total current liabilities 30,588,669 20,280,245
Commitments and contingences
12 1/4% Senior Notes, net of unamortized bond discount of $3,378,375 and $3,787,875
respectively 346,621,625 346,212,125
Other noncurrent liabilities 3,092,779 -
------------ ------------
Total liabilities 380,303,073 366,492,370
------------ ------------
Series A convertible preferred stock, $0.01 par value, 1,000,000 shares authorized, issued
and outstanding at December 31, 1999 and 1998, respectively (liquidation preference
$1,000,000) 1,000,000 1,000,000
Series B convertible preferred stock, $0.01 par value, 1,651,046 shares authorized, issued
and outstanding at December 31, 1999 and 1998, respectively (liquidation preference
$5,033,367) 5,008,367 5,008,367
Series C convertible preferred stock, $0.01 par value, 2,819,549 shares authorized, issued
and outstanding at December 31, 1999 and 1998, respectively (liquidation preference
$30,000,052) 29,961,272 29,961,272
------------ ------------
Total mandatorily redeemable preferred stock 35,969,639 35,969,639
------------ ------------
Common stock, $0.01 par value, 60,000,000 shares authorized, 3,068,218 and 2,902,358
shares issued and outstanding 30,682 29,024
Deferred compensation (441,760) (978,064)
Additional paid-in capital 6,264,362 6,156,406
Accumulated other comprehensive (loss) income (90,240) 208,211
Deficit accumulated during the development stage (101,499,769) (42,463,457)
------------ ------------
Total stockholders' equity (deficit) (95,736,725) (37,047,880)
------------ ------------
Total liabilities, mandatorily redeemable preferred stock and stockholders'
equity (deficit) $320,535,987 $365,414,129
============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE
CONSOLIDATED FINANCIAL STATEMENTS.
F - 3
PATHNET, INC. AND SUBSIDIARIES
A Development Stage Enterprise
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE PERIOD
FOR THE YEAR ENDED AUGUST 25, 1995
DECEMBER 31, (DATE OF INCEPTION)
--------------------------------------------- TO DECEMBER 31,
1999 1998 1997 1999
------------ ------------ ------------ -------------
Revenue $ 3,311,096 $ 1,583,539 $ 162,500 $ 5,058,135
------------ ------------ ------------ -------------
Operating expenses:
Cost of revenue 12,694,909 7,547,620 -- 20,242,529
Selling, general and administrative 14,669,747 9,615,867 4,247,101 30,295,096
Contribution and reorganization expenses 1,022,998 -- -- 1,022,998
Depreciation expense 6,204,381 732,813 46,642 6,993,212
------------ ------------ ------------ -------------
Total operating expenses 34,592,035 17,896,300 4,293,743 58,553,835
------------ ------------ ------------ -------------
Net operating loss (31,280,939) (16,312,761) (4,131,243) (53,495,700)
Interest expense (41,010,069) (32,572,454) -- (73,997,880)
Interest income 13,111,953 13,940,240 159,343 27,227,189
Write-off of initial public offering costs -- (1,354,534) -- (1,354,534)
Other income (expense), net 142,743 2,913 (5,500) 140,156
------------ ------------ ------------ -------------
Net loss $(59,036,312) $(36,296,596) $ (3,977,400) $(101,480,769)
============ ============ ============ =============
Basic and diluted loss per
common share $ (20.14) $ (12.51) $ (1.37)
============ ============ ============
common shares outstanding 2,931,644 2,902,029 2,900,000
============ ============ ============
ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE
CONSOLIDATED FINANCIAL STATEMENTS.
F - 4
PATHNET, INC. AND SUBSIDIARIES
A Development Stage Enterprise
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
FOR THE PERIOD
FOR THE YEAR ENDED AUGUST 25, 1995
DECEMBER 31, (DATE OF INCEPTION)
--------------------------------------------- TO DECEMBER 31,
1999 1998 1997 1999
------------ ------------ ------------ -------------
Net loss $(59,036,312) $(36,296,596) $ (3,977,400) $ 101,480,769)
Other comprehensive (loss) income:
Net unrealized (loss) gain on marketable
securities available for sale (298,451) 208,211 -- (90,240)
------------ ------------ ------------ -------------
Comprehensive loss $(59,334,763) $(36,088,385) $ (3,977,400) $(101,571,009)
============ ============ ============ =============
ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE
CONSOLIDATED FINANCIAL STATEMENTS.
F - 5
PATHNET, INC. AND SUBSIDIARIES
A Development Stage Enterprise
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE PERIOD
AUGUST 25, 1995
FOR THE YEAR ENDED (DATE OF INCEPTION)
DECEMBER 31, TO DECEMBER 31,
------------------------------------------ ---------------
1999 1998 1997 1999
-------------- ------------- ------------- ---------------
Cash flows from operating activities:
Net loss $ (59,036,312)$ (36,296,596) $ (3,977,400) $ (101,480,769)
Adjustment to reconcile net loss to net cash used in
operating activities:
Depreciation expense 6,204,381 732,813 46,642 6,993,212
Amortization of deferred financing costs 1,138,722 842,790 - 1,981,512
Loss on sale of equipment 17,370 - 5,500 22,870
Gain on sale of marketable securities (157,983) - - (157,983)
Write-off of deferred financing costs - 581,334 - 581,334
Interest expense resulting from amortization of discount on
the bonds payable 409,500 307,125 - 716,625
Amortization of premium on pledged securities 537,251 - - 537,251
Amortization of deferred compensation 536,304 701,295 - 1,237,599
Interest expense for beneficial conversion feature of
bridge loan - - - 381,990
Accrued interest satisfied by conversion of bridge loan to
Series B convertible preferred stock - - - 33,367
Changes in assets and liabilities:
Interest receivable 3,370,552 (4,846,952) - (1,476,400)
Prepaid expenses and other assets (1,583,767) (156,935) (46,876) (1,789,272)
Accounts payable 689,533 6,709 386,106 1,197,147
Accrued interest - 8,932,294 - 8,932,294
Accrued expenses and other liabilities 2,816,674 339,688 269,783 3,456,361
-------------- ------------- ------------- ---------------
Net cash used in operating activities (45,057,775) (28,856,435) (3,316,245) (78,832,862)
-------------- ------------- ------------- ---------------
Cash flows from investing activities:
Expenditures for network in progress (79,378,740) (33,619,342) (1,739,782) (114,737,864)
Expenditures for property and equipment (910,668) (2,769,076) (381,261) (4,116,561)
Proceeds on sale of equipment 5,624 - - 5,624
Sale and maturity of marketable securites available for sale 170,446,259 51,542,384 - 221,988,643
Purchase of marketable securities available for sale (48,531,491) (221,129,703) - (269,661,194)
Purchase of marketable securities pledged as collateral - (83,097,655) - (83,097,655)
Sale of pledged marketable securities held to maturity 39,452,000 22,271,181 - 61,723,181
Restricted cash (5,721,563) (9,971,142) (760,211) (16,452,916)
Issuance of note receivable - (3,206,841) - (3,206,841)
Repayment of note receivable 3,206,841 9,000 - 3,215,841
-------------- ------------- ------------- ---------------
Net cash provided by (used in) investing activities 78,568,262 (279,971,194) (2,881,254) (204,339,742)
-------------- ------------- ------------- ---------------
Cash flows from financing activities:
Issuance of voting and non-voting common stock - - - 1,000
Proceeds from sale of preferred stock - 19,999,998 12,000,054 35,000,052
Proceeds from sale of Series B convertible preferred stock
representing the conversion of committed but undrawn portion
of bridge loan to Series B convertible preferred stock - - - 300,000
Proceeds from bond offering - 350,000,000 - 350,000,000
Proceeds from bridge loan - - - 700,000
Exercise of employee common stock options 109,614 81 - 109,695
Payment of issuance costs for preferred stock offerings - - (38,780) (63,780)
Payment of deferred financing costs (280,151) (11,681,947) (250,428) (12,212,526)
-------------- ------------- ------------- ---------------
Net cash provided by (used in) financing activities (170,537) 358,318,132 11,710,846 373,834,441
-------------- ------------- ------------- ---------------
Net increase in cash and cash equivalents 33,339,950 49,490,503 5,513,347 90,661,837
Cash and cash equivalents at the beginning of period 57,321,887 7,831,384 2,318,037 -
-------------- ------------- ------------- ---------------
Cash and cash equivalents at the end of period $ 90,661,837 $ 57,321,887 $ 7,831,384 $ 90,661,837
============== ============= ============= ===============
Supplemental disclosure:
Cash paid for interest $ 43,081,220 $ 22,271,234 $ - $ 65,352,454
============== ============= ============= ===============
Noncash investing & financing transactions:
Conversion of bridge loan plus accrued interest to
Series B preferred stock $ - $ - $ - $ 733,367
============== ============= ============= ===============
Conversion of non-voting common stock to voting common stock $ - $ - $ - $ 500
============== ============= ============= ===============
Issuance of voting and non-voting common stock $ - $ - $ - $ 9,000
============== ============= ============= ===============
Acquisition of network equipment financed by accounts
payable $ 20,095,646 $ 10,200,650 $ 5,092,013 $ 20,095,646
============== ============= ============= ===============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
STATEMENTS.
F - 6
PATHNET INC. AND SUBSIDIARIES
A Development Stage Enterprise
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
NOTE ACCUMULATED
RECEIVABLE ADDITIONAL OTHER
COMMON STOCK FROM DEFERRED PAID-IN COMPREHENSIVE
SHARES AMOUNT STOCKHOLDER COMPENSATION CAPITAL LOSS
--------- --------- ----------- ------------ ---------- -------------
Balance at August 25, 1995 (date of inception) -- $ -- $ -- $ -- $ -- $ --
1,450,000 14,500 (4,500) -- -- --
Issuance of Non-voting common stock 1,450,000 14,500 (4,500) -- -- --
Net loss -- -- -- -- -- --
-- -- -- -- -- --
Balance at December 31, 1995 2,900,000 29,000 (9,000) -- -- --
Cancellation of Non-voting common stock (1,450,000) (14,500) -- -- -- --
Issuance of Voting common stock 1,450,000 14,500 -- -- -- --
Interest expense for beneficial conversion
feature of bridge loan -- -- -- -- 381,990 --
Net loss -- -- -- -- -- --
--------- --------- ----------- ------------ ---------- -------------
Balance at December 31, 1996 2,900,000 29,000 (9,000) -- 381,990 --
Net loss -- -- -- -- -- --
--------- --------- ----------- ------------ ---------- -------------
Balance at December 31, 1997 2,900,000 29,000 (9,000) -- 381,990 --
Exercise of stock options 2,358 24 - -- 57 --
Repayment of note receivable -- -- 9,000 -- -- --
Deferred compensation expense related to issuance
of employee common stock options -- -- -- (1,679,359) 1,679,359 --
Amortization of compensation expense related to
issuance of employee common stock options -- -- -- 701,295 -- --
Fair value of warrants to purchase common
stock -- -- -- -- 4,095,000 --
Net unrealized gain on marketable securities
available for sale -- -- -- -- -- 208,211
Net loss -- -- -- -- -- --
--------- --------- ----------- ------------ ---------- -------------
Balance at December 31, 1998 2,902,358 $ 29,024 $ -- $ (978,064) $ 6,156,406 $ 208,211
Exercise of stock options 165,860 1,658 -- -- 107,956 --
Amortization of compensation expense related to
issuance of employee common stock options -- -- -- 536,304 -- --
Net unrealized gain on marketable securities
available for sale -- -- -- -- -- (298,451)
Net loss -- -- -- -- -- --
--------- --------- ----------- ------------ ---------- -------------
Balance at December 31, 1999 3,068,218 $ 30,682 $ -- $ (441,760)$ 6,264,362 $ (90,240)
========= ========= =========== ============ ========== =============
DEFICIT
ACCUMULATED ACCUMULATED
OTHER DURING
COMPREHENSIVE DEVELOPMENT
STAGE TOTAL
------------- -----------
Balance at August 25, 1995 (date of inception) $ -- $ --
(9,500) 500
Issuance of Non-voting common stock (9,500) 500
Net loss (426,826) (426,826)
------------- ------------
Balance at December 31, 1995 (445,826) (425,826)
Cancellation of Non-voting common stock -- (14,500)
Issuance of Voting common stock -- 14,500
Interest expense for beneficial conversion
feature of bridge loan -- 381,990
Net loss (1,743,635) (1,743,635)
------------- -------------
Balance at December 31, 1996 (2,189,461) (1,787,471)
Net loss (3,977,400) (3,977,400)
------------- ------------
Balance at December 31, 1997 (6,166,861) (5,764,871)
Exercise of stock options -- 81
Repayment of note receivable -- 9,000
Deferred compensation expense related to issuance
of employee common stock options -- --
Amortization of compensation expense related to
issuance of employee common stock options -- 701,295
Fair value of warrants to purchase common
stock -- 4,095,000
Net unrealized gain on marketable securities
available for sale -- 208,211
Net loss (36,296,596) (36,296,596)
------------- ------------
Balance at December 31, 1998 $ (42,463,457) $(37,047,880)
Exercise of stock options -- 109,614
Amortization of compensation expense related to
issuance of employee common stock options -- 536,304
Net unrealized gain on marketable securities
available for sale -- (298,451)
Net loss (59,036,312) (59,036,312)
------------- ------------
Balance at December 31, 1999 $(101,499,769) $(95,736,725)
============= ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL
STATEMENTS.
F - 7
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
1. THE COMPANY
Pathnet, Inc. (Company) is wholesale telecommunications provider building a
nationwide network designed to provide other wholesale and retail
telecommunications service providers with access to underserved and second and
third tier markets throughout the United States. The Company's network will
enable its customers including ILECs, IXCs, ISPs, CLECs, cellular operators and
resellers to offer additional services to new and existing customers in these
markets without having to expend their own resources to build, expand, or
upgrade their own networks.
During 1999, Pathnet continued to construct and deploy digital networks
utilizing both wireless and fiber-optic technologies. Pursuant to its agreement
with Worldwide Fiber USA (WFI), the Company began to construct and market a
multi-conduit fiber-optic network between Chicago, Illinois and Denver, Colorado
during the second quarter. In August 1999, the Company announced it will
co-develop a 400 mile fiber network connecting Grand Junction, Colorado to
Albequerque, New Mexico with Tri State Generation and Transmission Association,
Inc. (Tri-State). In November 1999, Pathnet signed an agreement with Caprock
Communications (CapRock) to construct a 350 mile multi-conduit, fiber network
between Albuquerque, New Mexico and El Paso, Texas.
As of December 31, 1999, the Company's network consisted of over 6,300
wireless route miles providing wholesale transport services to 30 cities and 500
miles of installed fiber. The Company is constructing an additional 600 route
miles of fiber network, which is scheduled for completion in the first half of
2000.
Since inception, the Company's business has been funded primarily through
equity investments by the Company's stockholders and $350.0 million aggregate
principal amount of 12 1/4% Senior Notes due 2008 (Senior Notes) which have been
registered under the Securities Act of 1933, as amended.
A substantial portion of the Company's initial activities involved
developing strategic relationships with co-developers such as railroads,
pipelines and utilities and building its network. Accordingly, most of its
earlier revenues reflected only project management and advisory services in
connection with the design, development and construction of its network.
Revenues derived from the sale of telecommunication services along the Company's
digital network are approximately 51% to date. The Company has experienced
significant operating and net losses and negative operating cash flow to date
and expects to continue to experience operating and net losses and negative
operating cash flow until such time as it is able to generate revenue sufficient
to cover its operating expenses
2. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF ACCOUNTING
The Company recently commenced providing telecommunication services to
customers and recognizing the revenue from the sale of such telecommunication
services. The Company's principal activities to date have been securing
contractual alliances with its co-development partners, designing and
constructing network path segments, obtaining capital and planning its proposed
service. Accordingly, the Company's consolidated financial statements are
presented as a development stage enterprise, as prescribed by Statement of
Financial Accounting Standards No. 7, "Accounting and Reporting by Development
F - 8
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Stage Enterprises." As a development stage enterprise, the Company has been
relying on the issuance of equity and debt securities, rather than recurring
revenues, for its primary sources of cash since inception.
CONSOLIDATION
The consolidated financial statements include the accounts of Pathnet, Inc.
and its wholly-owned subsidiaries, Pathnet/Idaho Power License, LLC, Pathnet
Fiber Optics, LLC and Pathnet/Idaho Power Equipment, LLC. All material
intercompany accounts and transactions have been eliminated in consolidation.
USE OF ESTIMATES
The preparation of the 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 at the
date of the financial statements and the reported amounts of revenues and
expenses during the reported period. The estimates involve judgments with
respect to, among other things, various future factors which are difficult to
predict and are beyond the control of the Company. Actual amounts could differ
from these estimates.
LOSS PER SHARE
Basic earnings (loss) per share is computed by dividing net income (loss)
by the weighted average number of shares of Common Stock outstanding during the
applicable period. Diluted earnings (loss) per share is computed by dividing net
income (loss) by the weighted average common and potentially dilutive common
equivalent shares outstanding during the applicable period. For each of the
periods presented, basic and diluted loss per share are the same. The exercise
of 2,675,597 employee Common Stock options, the exercise of warrants to purchase
1,116,500 shares of Common Stock, and the conversion of 5,470,595 shares of
Series A, B and C convertible preferred stock into 15,864,715 shares of Common
Stock as of December 31, 1999, which could potentially dilute basic earnings per
share in the future, were not included in the computation of diluted loss per
share for the periods presented because to do so would have been antidilutive in
each case.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company believes that the carrying amount of certain of its financial
instruments, which include cash equivalents and accounts payable, approximate
fair value due to the relatively short maturity of these instruments. As of
December 31, 1999, the fair value of the Company's 12 1/4% Senior Notes was
approximately $220.5 million.
CASH EQUIVALENTS
The Company considers all highly liquid instruments with an original
maturity of three months or less to be cash equivalents.
CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject the Company to
concentrations of credit risk consist of cash and cash equivalents, marketable
securities and associated interest receivable, note receivable, and restricted
cash. Marketable securities and associated interest receivable include U.S.
Treasury securities and debt securities of U.S. Government agencies,
F- 9
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
certificates of deposit and money market funds, and corporate debt securities.
The Company has invested its excess cash in a money market fund with a
commercial bank. The money market fund is collateralized by the underlying
assets of the fund. The Company's restricted cash is maintained in an escrow
account (see note 7) at a major bank. The Company has not experienced any losses
on its cash and cash equivalents and restricted cash.
MARKETABLE SECURITIES
Management determines the appropriate classification of its investments in
marketable securities at the time of purchase and reevaluates such
determinations at each balance sheet date. Debt securities are classified as
held to maturity when the Company has the positive intent and ability to hold
the securities to maturity. The Company has classified certain securities as
held to maturity pursuant to a pledge agreement. Held to maturity securities are
stated at amortized cost. Debt securities for which the Company does not have
the intent or ability to hold to maturity are classified as available for sale,
along with any investments in equity securities. Securities are classified as
current or noncurrent based on the maturity date. Securities available for sale
are carried at fair value based on quoted market prices at the balance sheet
date, with unrealized gains and losses reported as part of accumulated other
comprehensive income (loss).
The amortized cost of debt securities is adjusted for amortization of
premiums and accretion of discounts to maturity. Such amortization and interest
are included in interest income or expense. Realized gains and losses are
included in other income (expense), net in the consolidated statements of
operations. The cost of securities sold is based on the specific identification
method. The Company's investments in debt and equity securities are diversified
among high credit quality securities in accordance with the Company's investment
policy.
PROPERTY AND EQUIPMENT
Property and equipment, consisting of network in progress, communications
network, office and computer equipment, furniture and fixtures and leasehold
improvements, is stated at cost. Network in progress costs incurred during
development, including interest, are capitalized. Depreciation of the completed
communications network commences when the network equipment is ready for its
intended use and is computed using the straight-line method with estimated
useful lives of network assets ranging between three to twenty years.
Depreciation of the office and computer equipment and furniture and fixtures is
computed using the straight-line method, generally over three to five years,
based upon estimated useful lives, commencing when the assets are available for
service. Leasehold improvements are amortized over the lesser of the useful
lives of the assets or the lease term. Expenditures for maintenance and repairs
are expensed as incurred. When assets are retired or disposed, the cost and the
related accumulated depreciation are removed from the accounts, and any
resulting gain or loss is recognized in operations for the period.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company periodically evaluates the recoverability of its long-lived
assets. This evaluation consists of a comparison of the carrying value of the
assets with the assets' expected future cash flows, undiscounted and without
interest costs. Estimates of expected future cash flows represent management's
best estimate based on reasonable and supportable assumptions and projections.
If the expected future cash flow, undiscounted and without interest charges,
exceeds the carrying value of the asset, no impairment is recognized. Impairment
losses are measured as the difference between the carrying value of long-lived
F - 10
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
assets and their fair value.
DEFERRED INCOME TAXES
The Company uses the liability method of accounting for income taxes.
Deferred income taxes result from temporary differences between the tax bases of
assets and liabilities and their financial reporting amounts at each year-end,
based on enacted laws and statutory tax rates applicable to the periods in which
the differences are expected to affect taxable income. Valuation allowances are
established when necessary, to reduce net deferred tax assets to the amount
expected to be realized. The provision for income taxes consists of the
Company's current provision for federal and state income taxes and the change in
the Company's net deferred tax assets and liabilities during the period.
REVENUE RECOGNITION
The Company earns revenue from the sale of telecommunications capacity and
for project management and consulting services. Revenue from the sale of
telecommunications capacity is earned when the service is provided. Revenue for
project management and consulting services is recognized over the related
project period as milestones are achieved. The Company defers revenue when
contractual payments are received in advance of the performance of services.
Revenue from the sale of telecommunications capacity includes revenue
earned under indefeasible right to use agreements. The Company recognizes
revenue earned under such agreements on a straight-line basis over their term.
DEFERRED FINANCING COSTS
The Company has incurred costs related to the Debt Offering together with
costs associated with obtaining future debt financing arrangements. Such costs
are amortized over the term of the debt or financing arrangement other than when
financing has not been obtained, in which case, the costs are expensed
immediately.
SEGMENT REPORTING
In June 1997, the Financial Accounting Standards Board issued SFAS No.131,
"Disclosures About Segments of an Enterprise and Related Information"(SFAS No.
131). SFAS No. 131 changes the way public companies report segment information
in annual financial statements and also requires those companies to report
selected segment information in interim financial reports to stockholders. It
also establishes standards for related disclosures about products and services,
geographic areas, and major customers. Management believes the Company's current
operations comprise only one segment, the sale of telecommunications capacity,
and as such, adoption of SFAS No. 131 does not impact the disclosures made in
the Company's financial statements.
3. MARKETABLE SECURITIES
The Company's marketable securities are considered "available for sale,"
and, as such, are stated at market value. The net unrealized gains and losses on
marketable securities are reported as part of accumulated other comprehensive
income (loss). Realized gains or losses from the sale of marketable securities
are based on the specific identification method.
F - 11
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The following is a summary of the investments in marketable securities at
December 31, 1999:
GROSS UNREALIZED
COST GAINS LOSSES MARKET VALUE
---- ----- ------ ------------
Available for sale securities:
U.S. Treasury securities and debt securities
of U.S. Government agencies $ 19,363,417 $ -- $ 59,490 $ 19,303,927
Corporate debt securities 26,959,695 8,800 30,088 26,938,407
Debt Securities issued by foreign
governments 1,507,422 -- 9,462 1,497,960
------------------ ----------- ------------ ------------------
$ 47,830,534 $ 8,800 $ 99,040 $ 47,740,294
================== =========== ============ ==================
Gross realized gains on sales of available for sale securities were
approximately $158,000 during the year ended December 31, 1999. Gross realized
gains and gross realized losses on sales of available for sale securities were
immaterial during the year ended December 31, 1998.
The amortized cost and market value of available for sale securities by
contractual maturity at December 31, 1999 is as follows:
COST MARKET VALUE
Due in one year or less $ 42,688,416 $ 42,651,835
Due after one year through two years 5,142,118 5,088,459
-------------- ------------
$ 47,830,534 $ 47,740,294
============== ============
Expected maturities may differ from contractual maturities because the
issuers of the securities may have the right to prepay obligations without
prepayment penalties.
In addition to marketable securities, the Company has investments in
pledged marketable securities that are pledged as collateral for repayment of
interest on the Company's Senior Notes through April 2000 (see note 8) and are
classified as non-current assets on the consolidated balance sheet. As of
December 31, 1999, pledged marketable securities consisted of U.S. Treasury
securities classified as held to maturity with an amortized cost of
approximately $20.8 million, interest receivable on pledged marketable
securities of approximately $356,000 and cash and cash equivalents of
approximately $112,000. All of the investments contractually mature by March 31,
2000.
4. NOTE RECEIVABLE
In 1998, under the terms of a promissory note with an incumbent, the
Company agreed to advance up to $10.0 million principal for the purpose of
funding the incumbent's equipment expenditures under a Fixed Point Microwave
Services agreement. Equipment expenditures initially incurred by the Company
were recharged at cost to the incumbent as principal under the promissory note.
The principal amount of the promissory note was paid during 1999.
F - 12
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
5. PROPERTY AND EQUIPMENT
Property and equipment, stated at cost, is comprised of the following at
December 31, 1999 and 1998:
1999 1998
----------------- ---------
Network in progress $ 63,123,322 $ 38,669,088
Communications network 71,604,029 6,890,686
Office and computer equipment 2,262,935 2,267,647
Furniture and fixtures 1,555,771 766,013
Leasehold improvements 337,181 166,733
---------------- ---------------
138,883,238 48,760,167
Less: accumulated depreciation (6,954,873) (788,831)
------------------ ---------------
Property and equipment, net $ 131,928,365 $ 47,971,336
================== ===============
Network in progress includes (i) all direct material and labor costs
together with related allocable interest costs, necessary to construct
components of a high capacity digital wireless and fiber optic network, and (ii)
network related inventory parts and equipment. The network in progress balance
as of December 31, 1999 includes approximately $36.8 million for costs incurred
under the Company's agreement with WFI to construct a digital fiber optic
network and $2.7 million for a right of use under an agreement with Northern
Border Pipeline for microwave access. When a portion of the network has been
completed and made available for use by the Company, the accumulated costs are
transferred from network in progress to communications network and depreciated.
6. DEFERRED FINANCING COSTS
During 1998, the Company incurred total issuance costs of approximately
$11.3 million in connection with the Debt Offering. For the year ended December
31, 1999 and 1998, amortization of the costs of approximately $1.1 million and
$843,000 was charged to interest expense, respectively.
7. RESTRICTED CASH
Restricted cash comprises amounts held in escrow to collateralize the
Company's obligations under certain of its development agreements. The funds in
each escrow account are available only to fund the projects to which the escrow
is related. Generally, funds are released from escrow to pay project costs as
incurred. During the year ended December 31, 1999, the Company deposited
approximately $13.4 million in escrow and $7.7 million was released from escrow.
During the year ended December 31, 1998, the Company deposited approximately
$10.3 million in escrow and no funds were released from escrow.
8. LONG-TERM DEBT
During 1998, the Company completed the Debt Offering for total gross
proceeds of $350.0 million less total issuance costs of approximately $11.3
million. Upon issuance, approximately $345.9 million of the gross proceeds was
allocated to the Senior Notes and approximately $4.1 million was allocated to
the Warrants based upon estimated fair values. The Warrants expire on April 15,
F - 13
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
2008. The estimated value attributed to the Warrants has been recorded as a
discount on the face value of the Senior Notes and as additional paid-in
capital. This discount is amortized as an increase to interest expense and the
carrying value of the debt over the related term using the interest method. The
Company has recorded approximately $410,000 and $307,000 of expense for the
years ended December 31, 1999 and 1998, respectively, related to the
amortization of this discount. Interest on the Senior Notes accrues at an annual
rate of 12 1/4 %, payable semiannually, in arrears, beginning October 15, 1998,
with principal due in full on April 15, 2008. For the years ended December 31,
1999 and 1998, interest on the Senior Notes was approximately $42.9 million and
$31.3 million, respectively, of which approximately $3.6 million and $362,000,
respectively, was capitalized as network under development. The Company used
approximately $81.1 million of the proceeds related to the Debt Offering to
purchase U.S. Government debt securities, which are restricted and pledged as
collateral for repayment of all interest due on the Senior Notes through April
15, 2000. The Senior Notes are redeemable, in whole or part, at any time on or
after April 15, 2003 at the option of the Company, at the following redemption
prices plus accrued and unpaid interest (i) on or after April 15, 2003; 106% of
the principal amount, (ii) on or after April 15, 2004; 104% of the principal
amount, (iii) on or after April 15, 2005; 102% of the principal amount and (iv)
on or after April 15, 2006; 100% of the principal amount. In addition, at any
time prior to April 15, 2001, the Company may redeem within sixty days, with the
net cash proceeds of one or more public equity offerings, up to 35% of the
aggregate principal amount of the Senior Notes at a redemption price equal to
112.25% of the principal amount plus accrued and unpaid interest provided that
at least 65% of the original principal amount of the Senior Notes remain
outstanding. Upon a change in control, as defined, each holder of the Senior
Notes may require the Company to repurchase all or a portion of such holder's
Senior Notes at a purchase price of cash equal to 101% of the principal amount
plus accrued and unpaid interest and liquidated damages if any.
The Senior Notes contain certain covenants which restrict the activities of
the Company including limitations of indebtedness, restricted payments,
issuances and sales of capital stock, affiliate transactions, liens, guarantees,
sale of assets and dividends.
9. CAPITAL STOCK TRANSACTIONS
COMMON STOCK
The initial capitalization of the Company, on August 25, 1995, occurred
through the issuance by the Company of 1,450,000 shares of voting common stock
and 1,450,000 shares of non-voting common stock.
On May 8, 1998, the Company filed a Registration Statement with the
Securities and Exchange Commission for an initial public offering of common
stock (Initial Public Offering). The Company's susequently postponed the Initial
Public Offering. In relation to the postponement of the Initial Public Offering,
the Company wrote off approximately $1.4 million in expenses, consisting
primarily of legal and accounting fees, printing costs, and Securities and
Exchange Commission and Nasdaq Stock Market fees. On July 24, 1998, the
Company's stockholders approved a 2.9-for-1 stock split which was effected on
August 3, 1998, the record date. All share information has been adjusted for
this stock split for all periods presented.
F - 14
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
PREFERRED STOCK
As part of its initial capitalization on August 25, 1995, the Company
initiated a private offering of 1,000,000 shares of Series A convertible
preferred stock for $1,000,000. Pursuant to the terms of the Investment and
Stockholders' Agreement by and among the Company and certain stockholders of the
Company (Investment and Stockholders' Agreement), the offering closed in two
phases of $500,000 each. As of the signing of the Investment and Stockholders'
Agreement, the Company received $500,000, representing the first closing on this
offering in 1995. In addition, the offering provided for a convertible bridge
loan in the amount of $1,000,000. The bridge loan carried an interest rate of
12% per annum and was due and payable in full on the earlier to occur of the
anniversary date of the bridge loan issuance or the closing date of the
Company's next equity financing. The bridge loan was converted into Series B
preferred stock at 73% of the price of the Series B convertible preferred stock
issued in the next equity financing.
In February 1996, the Company issued 500,000 shares of Series A convertible
preferred stock to the original investors in exchange for $500,000, representing
the second closing under the Investment and Stockholders' Agreement. In August
1996, the Company drew $700,000 on a bridge loan with the original investors.
On December 23, 1996, the Company consummated a private offering of 609,756
shares of Series B convertible preferred stock for $2,000,000 less issuance
costs of $25,000 pursuant to the Investment and Stockholders' Agreement. In
addition, simultaneously, the $700,000 bridge loan plus $33,367 of accrued
interest was converted into 306,242 shares of Series B convertible preferred
stock. The Company recognized $271,107 of interest expense to account for the
beneficial conversion feature of the bridge loan. In addition, $300,000
representing the committed but undrawn portion of the bridge loan, was paid to
the Company for the sale of 125,292 shares of Series B convertible preferred
stock at a discounted rate. The Company recognized $110,883 of interest expense
to account for the beneficial conversion feature of the committed but undrawn
bridge loan. On June 18, 1997, pursuant to the Investment and Stockholders'
Agreement, the Company received an additional $2,000,000 in a second closing in
exchange for 609,756 shares of Series B convertible preferred stock. There were
no issuance costs associated with the second closing.
On October 31, 1997, pursuant to the Investment and Stockholders'
Agreement, the Company consummated a private offering of 939,850 shares of
Series C convertible preferred stock for approximately $10 million, less
issuance costs of $38,780. On April 8, 1998, pursuant to the Investment and
Stockholders' Agreement, the Company consummated a second closing of 1,879,699
shares of Series C convertible preferred stock for an aggregate purchase price
of approximately $20.0 million. There were no issuance costs associated with the
second closing.
Each share of Series A, Series B and Series C convertible preferred stock
entitles each holder to a number of votes per share equal to the number of
shares of Common Stock into which each share of Series A, Series B and Series C
convertible preferred stock is currently convertible.
The holders of the Series A, Series B and Series C convertible preferred
stock are entitled to receive dividends in preference to and at the same rate as
dividends are paid with respect to the common stock. In the event of any
liquidation, dissolution or winding up of the Company, whether voluntary or
involuntary, holders of each share of Series A, Series B and Series C
convertible preferred stock outstanding are entitled to be paid before any
payment shall be made to the holders of any class of common stock or any stock
F - 15
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
ranking on liquidation junior to the convertible preferred stock, an amount, in
cash, equal to the original purchase price paid by such holder plus any declared
but unpaid dividends.
In the event the assets of the Company are insufficient to pay liquidation
preference amounts, then all of the assets available for distribution shall be
distributed pro rata so that each holder receives that portion of the assets
available for distribution as the number of shares of convertible preferred
stock held by such holder bears to the total number of shares of convertible
preferred stock then outstanding.
Shares of the Series A, Series B, and Series C convertible preferred stock
may be converted at any time, at the option of the holder, into voting common
stock. The number of shares of voting common stock entitled upon conversion is
the quotient obtained by dividing the face value of the Series A, Series B and
Series C convertible preferred stock by the Applicable Conversion Rate, defined
as the Applicable Conversion Value of $0.34, $1.13 or $3.67 per share,
respectively.
Each share of convertible preferred stock shall automatically be converted
into the number of shares of voting common stock which such shares are
convertible upon application of the Applicable Conversion Rate immediately upon
the closing of a qualified underwritten public offering covering the offer and
sale of capital stock which is defined as: (i) the Company is valued on a
pre-money basis at greater than $50,000,000, (ii) the gross proceeds received by
the Company exceed $20,000,000, and (iii) the Company uses a nationally
recognized underwriter approved by holders of a majority interest of the Series
A, Series B and Series C convertible preferred stock voting together.
If the Company issues any additional shares of common stock of any class at
a price less than the Applicable Conversion Value, in effect for the Series A,
Series B or Series C convertible preferred stock immediately prior to such
issuance or sale, then the Applicable Conversion Value shall be adjusted
accordingly.
In the event a qualified public offering has not occurred prior to December
23, 2000, the holder of shares of Series A or Series B preferred stock can
require the Company to redeem the shares of Series A and Series B convertible
preferred stock. After receipt from any one holder of an election to have any
shares redeemed, the Company is required to send a notice to the Series A and
Series B preferred stockholders on December 24, 2000 of the redemption price. If
after sending the redemption notice to Series A and Series B preferred
stockholders, the Company receives requests for redemption on or prior to
January 11, 2001, from the holders of at least 67% of the Series A and Series B
convertible preferred stock taken together, the Company must redeem all shares
of Series A and Series B convertible preferred stock. Payment of the redemption
price is due on January 23, 2001, for a cash price equal to the original
purchase price paid by such holders for each share of Series A and Series B
convertible preferred stock as adjusted for any stock split, stock distribution
or stock dividends with respect to such shares. The successful completion of a
qualified public offering is not within the control of the Company. Therefore,
the Company does not present the Series A and Series B preferred stock as a
component of stockholders' equity.
In the event that a qualified public offering has not occurred prior to
November 3, 2001, the holder of shares of Series C preferred stock can require
the Company to redeem the shares of Series C convertible preferred stock. After
receipt from any one holder of an election to have any shares redeemed, the
Company is required to send a notice to the Series C preferred stockholders on
F - 16
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
November 4, 2001 of the redemption price. If after sending the redemption notice
to Series C preferred stockholders, the Company receives requests for redemption
on or prior to November 21, 2001, from the holders of at least 67% of the Series
C convertible preferred stock, the Company must redeem all shares of Series C
convertible preferred stock. Payment of the redemption price is due on December
3, 2001 for a cash price equal to the original purchase price paid by such
holders for each share of Series C convertible preferred stock as adjusted for
any stock split, stock distribution or stock dividends with respect to such
shares. The successful completion of a qualified public offering is not within
the control of the Company. Therefore, the Company does not present the Series C
preferred stock as a component of stockholders' equity.
Notwithstanding the provisions for optional redemption described above,
pursuant to a Consent Waiver and Amendment effective March 24, 1998 among the
Company and certain stockholders of the Company, the holders of the Series A,
Series B and Series C convertible preferred stock agreed that no optional
redemption of the Series A, Series B or Series C convertible preferred stock may
be made by the Company prior to 90 days after (i) the final maturity dated of
the Senior Notes (ii) or such earlier date (after the redemption date specified
for such preferred stock) as the Senior Notes shall be paid in full.
10. STOCK OPTIONS
On August 25, 1995, the Company adopted the 1995 Stock Option Plan (1995
Plan), under which incentive stock options and non-qualified stock options could
be granted to the Company's employees and certain other persons and entities in
accordance with law. The Compensation Committee, which administers the 1995
Plan, determined the number of options granted, the vesting period and the
exercise price of each award made under the 1995 Plan. The 1995 Plan will
terminate August 28, 2005 unless terminated earlier by the Board of Directors.
During 1998, the Compensation Committee determined that no further awards would
be granted under the 1995 Plan.
Options granted to date under the 1995 Plan generally vest over a three
year period and expire either 30 days after termination of employment or 10
years after date of grant. As of December 31, 1999, a total of 70,731
non-qualified stock options and 353,662 incentive stock options were issued and
outstanding at an exercise price of $0.03 per share, an amount estimated to
equal or exceed the per share fair value of the common stock at the time of
grant. As of December 31, 1999, the options issued at an exercise price of $0.03
had a weighted average contractual life of 5.7 years. As of December 31, 1999,
424,393 of the options issued at an exercise price of $0.03 were exercisable.
On August 1, 1997, the Company adopted the 1997 Stock Incentive Plan (1997
Plan), under which incentive stock options, non-qualified stock options, stock
appreciation rights, restricted stock, performance awards and certain other
types of awards may be granted to the Company's employees and certain other
persons and entities in accordance with the law. To date, only non-qualified
stock options have been granted under the 1997 Plan. The Compensation Committee,
which administers the 1997 Plan, determines the number of options granted, the
vesting period and the exercise price of each award granted under the 1997 Plan.
The 1997 Plan will terminate July 31, 2007 unless earlier terminated by the
Board of Directors.
Options granted under the 1997 Plan generally vest over a three to seven
year period and expire: (1) ten years after the date of grant, (2) two years
after the date of the participant's termination without cause, disability or
F - 17
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
death, (3) three months after the date of the participant's resignation, (4) on
the date of the participant's termination with cause or (5) on the date of any
material breach of any confidentiality or non-competition covenant or agreement
entered into between the participant and the Company.
The options issued on October 31, 1997, at $3.67, vest on October 31, 2004
provided, however (i) if the Company has met 80% of its revenue and Earnings
Before Interest, Taxes, Depreciation and Amortization (EBITDA) budget for the
calendar year ended December 31, 1998, which budget is approved by the Board of
Directors of the Company, 50% of the shares covered by the options shall vest
and become exercisable on January 1, 1999, (ii) if the Company has met 80% of
its revenue and EBITDA budget for the calendar year ended December 31, 1999,
which budget is approved by the Board of Directors of the Company, the remaining
50% of the shares covered by the options shall vest and become exercisable on
January 1, 2000, and (iii) in the event that the first 50% of the shares covered
by the options did not vest on January 1, 1999 as set forth in (i) above and the
Company not only meets 80% of its revenue and EBITDA budget for the year ended
December 31, 1999 but exceeds 80% of its revenue and EBITDA budget for the year
ended December 31, 1999, which budget is approved by the Board of Directors of
the Company, in an amount at least equal to the deficiency that occurred in the
year ended December 31, 1998, 100% of the shares covered by the options shall
vest and become exercisable on January 1, 2000. Unvested and uncancelled options
issued at $3.67 immediately become fully vested and exercisable upon a change of
control or a qualified public offering, as defined in the option agreement. In
an agreement dated November 4, 1999, 107,389 options became fully vested at
$3.67 per share and the remaining options were cancelled.
The options issued at $1.13 vest ratably over three or four consecutive
years subject to certain acceleration provisions set forth in an employment
agreement such as the immediate vesting upon a change in control or a qualified
initial public offering. Under certain circumstances and subject to the terms of
the Senior Notes, upon the election of the employee upon termination of
employment, the Company will be required to pay the employee the fair value of
the vested options held on the date of such termination.
As of December 31, 1999, a total of 2,251,204 non-qualified options were
issued and outstanding, 1,119,957 at an exercise price of $1.13 per share,
197,110 at an exercise price of $3.67 per share and 934,137 at an exercise price
of $5.20 per share. As of December 31, 1999, a total of 976,785 non-qualified
options were exercisable, 761,921 at an exercise price of $1.13 per share,
129,818 at an exercise price of $3.67 per share and 85,046 at an exercise price
of $5.20 per share. As of December 31, 1999, the weighted average contractual
life of the options issued at $1.13, $3.67 and $5.20 was 7.7, 8.1 and 9.2 years,
respectively.
During the year ended December 31, 1998, 667,373, 89,721 and 350,000
options were issued at an exercise price of $1.13, $3.67 and $5.20 per share,
respectively. The estimated fair value of the Company's underlying common stock
in each case was determined to be $1.99, $16.00 and $5.20 per share,
respectively. Accordingly, the Company calculated deferred compensation expense
of approximately $1.7 million related to these options to be recognized as
compensation expense over their vesting period. The compensation expense
recognized during the years ended December 31, 1999 and 1998 was approximately
$536,000 and $701,000, respectively.
During the year ended December 31, 1999, 726,450 options were issued at an
exercise price of $5.20 per share representing the estimated fair value of the
Company's underlying common stock.
F - 18
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Stock option activity was as follows:
1995 PLAN 1997 PLAN
----------------------------------- ----------------
NON- NON- WEIGHTED
INCENTIVE QUALIFIED QUALIFIED AVERAGE
STOCK STOCK STOCK EXERCISE
OPTIONS OPTIONS PRICE OPTIONS PRICE PRICE
------- ------- ----- ------- ----- -----
Options outstanding, December 31, 1996 424,395 77,805 $ 0.034 -- -- $ 0.034
Granted -- -- -- 1,289,167 $1.13-$3.67 $ 1.980
Exercised -- -- -- -- -- --
Canceled -- -- -- -- -- --
------- -------- ---------
Options outstanding, December 31, 1997 424,395 77,805 $0.034 1,289,167 $1.13-$3.67 $ 1.430
Options granted -- -- -- 1,107,094 $1.13-$5.20 $ 2.622
Options exercised -- (2,358) $0.034 -- -- --
Options cancelled -- (4,716) $0.034 (5,554) $1.13-$5.20 $ 3.145
------- ------- ---------
Options outstanding at December 31, 1998 424,395 70,731 $0.034 2,390,707 $1.13-$5.20 $ 1.888
Options granted -- -- -- 726,450 $5.20 $ 5.2000
Options exercised (70,733) -- $0.034 (95,127) $0.03-$1.13 $ 0.6609
Options cancelled -- -- -- (770,826) $1.13-$5.20 $2.9313
------- -------- ---------
Options outstanding at December 31, 1999 353,662 70,731 $0.034 2,251,204 $1.13-$5.20 $2.5636
======= ======== =========
The Company measures compensation expense for its employee stock-based
compensation using the intrinsic value method and provides pro forma disclosures
of net loss as if the fair value method had been applied in measuring
compensation expense. Under the intrinsic value method of accounting for
stock-based compensation, when the exercise price of options granted to
employees is less than the fair value of the underlying stock on the date of
grant, compensation expense is to be recognized over the applicable vesting
period.
YEAR ENDED DECEMBER 31,
1997 1998 1999
---- ---- ----
Net loss as reported $59,036,312 $36,296,596 $3,977,400
Pro forma net loss $59,222,962 $36,859,594 $3,978,164
Basic and diluted net loss per
share as reported. $(20.14) $(12.51) $(1.37)
Pro forma basic and diluted net
loss per share $(20.20) $(12.70) $(1.37)
The fair value of each option is estimated on the date of grant using a
type of Black-Scholes option pricing model with the following weighted-average
assumptions used for grants during the years ended December 31, 1998 and 1997,
respectively: dividend yield of 0%, expected volatility of 0%, risk-free
interest rate of 5.18 % and 6.55% and expected terms of 5.5 and 5.0 years. The
following weighted average assumptions were used for grants during the year
ended December 31, 1999: dividend yield of 0%, expected volatility of 0%,
risk-free interest rate of 5.16% and expected terms of 5.8 years.
F - 19
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
As of December 31, 1999 and 1998, the weighted average remaining
contractual life of the options is 7.9 years and 8.6 years, respectively.
11. VENDOR AGREEMENTS
Pursuant to a Master Agreement entered into by the Company and NEC on
August 8, 1997, as amended, the Company has the option to acquire, by March 31,
2003, a total of $200 million worth of certain equipment, services and licensed
software to be used by the Company in its network under pricing and payment
terms that the Company believes are favorable. In addition, NEC has agreed,
subject to certain conditions, to warranty equipment purchased by the Company
from NEC for three years, if defective, to repair or replace certain equipment
promptly and to maintain a stock of critical spare parts for up to 15 years. The
Company's agreement with NEC provides for fixed prices during the first three
years of its term. As of December 31, 1999, the Company had purchased $51.9
million of equipment under this agreement.
Pursuant to a supply agreement entered into by the Company and Lucent
Technologies (Lucent) on December 18, 1998, the Company agreed that Lucent
should be its exclusive supplier of fiber optic cable for its nationwide, voice
and data network. Lucent may provide financing of up to approximately $400
million of fiber purchases for the construction of the Company's network and may
provide or arrange financing for future phases of the fiber portion of the
Company's network. The total amount of financing over the life of this
seven-year agreement is not to exceed $1.8 billion. Certain material terms of
the Company's transactions with Lucent are currently under review by Lucent and
the Company. There can be no assurance that the financing contemplated by the
supply agreement will be consummated or, if consummated, consummated on the
terms and conditions described above. The supply agreement provides that Lucent
will provide the Company with a broad level of support, including fiber optic
equipment, network planning and design, technical and marketing support, and
financing. As of December 31, 1999, no purchases were made by the Company under
this agreement.
12. COMMITMENTS AND CONTINGENCIES
The Company maintains office space in Washington, D.C., Virginia, Kansas
and Texas. The most significant leases relate to the Company's new headquarters
facilities in Reston Virginia and in Washington, D.C.
On December 30, 1998, the Company entered into a lease agreement for the
lease of tower site space, sufficient to perform its obligations under a fixed
point microwave agreement (FPMA) with an incumbent. Under the terms of the
lease, the Company is obligated to rent of $130,000 per month for a period
expiring on the later of (i) the expiration of the FPMA as to that site, or (ii)
ten years from the effective date of the agreement. The agreement provides for
an increase in the rent payable commencing on December 1, 1999 and on each
succeeding year thereafter to December 1, 2008, by an amount equal to 4 percent
of the rent then in effect.
The Company's future minimum rental payments under noncancellable operating
leases are as follows:
F - 20
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
2000 $ 3,388,583
2001 3,216,376
2002 3,284,920
2003 3,205,368
2004 and thereafter 19,097,648
-------------
Total $ 32,192,895
=============
Rent expense for the years ended December 31, 1999, 1998 and 1997 was
approximately $821,000, $390,000 and $115,000, respectively.
The Company earns microwave telecommunication capacity revenue under an
indefeasible right of use (IRU) agreement dated December 1, 1998, of $137,000
per month commencing December 1998 and expiring on the later of (i) the
expiration of the FPMA as to that site, or (ii) ten years from the effective
date of the agreement. The IRU agreement provides for an increase in the rent
receivable commencing on December 1, 1999 and on each succeeding year thereafter
to December 1, 2008, by an amount equal to 4 percent of the rent then in
effect.
As of December 31, 1999, the Company had capital commitments of
approximately $89.9 million relating to purchases of telecommunications and
transmission equipment and its agreement with WFI, Tri-State and CapRock (see
note 14).
During 1999, the Company entered into a contractual agreement that provided
for extended payment terms over a four-year period for the purchase of
approximately $2.7 million in network equipment. Accordingly, such amount has
been included in other noncurrent liabilities in the Company's consolidated
balance sheet as of December 31, 1999.
From time to time, the Company is subject to claims arising in the ordinary
course of business. In the opinion of management, no such matter individually or
in the aggregate, exists which is expected to have a material effect on the
results of operations, cash flows or financial position of the Company.
13. INCOME TAXES
The tax effect of temporary differences that give rise to significant
portions of the net deferred tax asset at December 31, 1999 and 1998, is as
follows:
DECEMBER 31,
1999 1998
---- ----
Deferred revenue $ 3,646 $ 949
Capitalized start-up costs 1,005,353 1,370,937
Capitalized research and development costs 48,482 66,111
Depreciation (2,844,859) --
Net operating loss carryforward 40,571,930 15,325,484
Other timing differences 110,078 --
-------------- -----------
38,894,630 16,763,481
Less valuation allowance (38,894,630) (16,763,481)
-------------- -----------
Net deferred tax asset $ -- $ --
============== ===========
Capitalized costs represent expenses incurred in the organization and
start-up of the Company. For federal income tax purposes, these costs are being
amortized over sixty months.
The ultimate realization of deferred tax assets is dependent upon the
generation of future taxable income in the periods in which those temporary
differences are deductible. The Company has provided a valuation allowance
F - 21
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
against its deferred tax assets as they are long-term in nature and their
ultimate realization cannot be determined.
14. FIBER AGREEMENTS
In March 1999, the Company entered into a co-development agreement with WFI
for the design, engineering and construction by WFI of a multiple conduit
fiber-optic system. One of the conduits will contain a fiber optic cable
consisting of a specified number of fiber optic strands. The conduits and any
installed strands will be equally divided between the parties, and the cost to
construct the route will be shared equally by the Company and WFI. In addition,
the Company will pay WFI a management fee equal to 10% of the Company's share of
the development costs. The total shared projected costs for the project is in
excess of $100 million. The system will be approximately 1,100 route miles long,
between Aurora, Colorado (a suburb of Denver) and Chicago, Illinois. The first
segment, Chicago, Illinois to Omaha, Nebraska, was completed in the fourth
quarter 1999, and the second segment, Omaha to Aurora, is scheduled to be
completed by the end of the second quarter of 2000. In connection with the
co-development agreement, the Company entered into a joint marketing agreement
with WFI under which both WFI and the Company will attempt to sell certain
inactive fiber optic strands on the route, and will share the revenues from such
sales. The joint marketing agreement also permits each party to retain fiber
optic strands for its own use, subject to certain restrictions on resale, and to
swap a certain number of the fiber optic strands to third parties.
In August 1999, the Company entered into a co-development agreement with
Tri-State and four regional electric cooperatives for design, engineering and
construction of an aerial fiber system, approximately 420 route miles long,
between Albuquerque, New Mexico and Grand Junction, Colorado. This system,
constructed on power transmission lines, will contain a specified number of
fiber optic strands. The cost to construct the system will be borne equally
between the Company and the other parties. The total projected combined cost for
this route is approximately $48 million. In connection with the co-development
agreement, the Company entered into a joint marketing agreement under which each
party will reserve a portion of the fiber strands for its own operations, a
subset of which will be available for swaps with third parties, the remaining
fiber strands will be jointly sold, with the Company as the exclusive marketing
agent.
Any revenues derived from the sale of those fiber strands will be shared
equally between the Company and Tri-state, after deduction of a Company
marketing fee. We expect this system to be completed in the second half of 2000.
In December 1999, the Company announced a co-development agreement with
CapRock to construct a multi-conduit, fiber network between Albuquerque, New
Mexico and El Paso, Texas. The total projected cost for this 350- mile network
segment is approximately $40 million with a scheduled completion date of
year-end 2000.
15. CONTRIBUTION AND REORGANIZATION
On November 4, 1999, the Company, together with Pathnet Telecommunications
Inc. (PTI) a Delaware company formed on November 1, 1999, entered into
agreements providing for strategic investments from Colonial Pipeline Company,
Burlington Northern and Santa Fe Corporation and CSX Corporation to PTI. Upon
the closing of this transaction, PTI will receive the right to develop over
F - 22
PATHNET, INC. AND SUBSIDIARIES
A DEVELOPMENT STAGE ENTERPRISE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
12,000 miles of the investors' rights of way with an estimated value of $187.0
million in return for 8,511,607 shares of PTI's Series D convertible preferred
stock. In addition to providing a portion of the right of way access, Colonial
Pipeline will pay $68.0 million of cash to PTI comprised of $38.0 million at the
initial closing for 1,729,631 shares of PTI's Series E redeemable preferred
stock, $25.0 million for 1,137,915 shares of PTI's Series E redeemable preferred
stock (upon the completion of a fiber optic network segment build that the
Company expects to complete during the second calendar quarter of 2000), $1.0
million for the issuance of an option to purchase 1,593,082 shares of PTI's
Series E redeemable preferred stock for $21.97 per share and shares of PTI's
common stock in connection with an initial public offering and $4.0 million for
rights in 2,200 conduit miles of our future network. Further, upon the closing
of this transaction, all of the Company's common stock will be exchanged for
common stock of PTI resulting in the Company becoming a wholly-owned subsidiary
of PTI. In addition, all of the Company's 5,470,595 shares of mandatorily
redeemable preferred stock will be converted into 15,864,715 of PTI's
convertible preferred stock. The new investors collectively will receive an
approximate one-third equity stake in PTI, as well as proportionate
representation on the PTI Board of Directors. As part of this transaction and
the reconstitution of the Pathnet Board, Dave Schaeffer, former Chairman of
Pathnet and an existing director, resigned from the Company's Board of Directors
effective November 4, 1999.
The terms of the strategic investment transaction require that consents be
obtained from the holders of a majority of the Company's existing Senior Notes
in exchange for a proposed payment of approximately $8.8 million. As a result,
on November 22, 1999, PTI filed a preliminary prospectus with the Securities and
Exchange Commission, to offer all holders of the Senior Notes a guarantee of the
obligations of the Company to make interest and principal payments. Concurrent
with this offer, the Company is seeking consents from the holders of the Senior
Notes to the waiver and the amendment of certain provisions of the Indenture. On
February 22, 2000, the Company expects to file an amendment to its preliminary
prospectus with the Securities and Exchange Commission. The Company expects to
close this transaction immediately following receipt of the required consents
and other required regulatory approvals. For the year ended December 31, 1999,
the Company had expensed $1,022,998 of fees related to this transaction.
F - 23