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, 1998.
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File No. 333-53467
Pathnet, Inc.
(Exact name of registrant as specified in its charter)
Delaware 52-1941838
(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 March 12, 1999 there were 2,903,324 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 8
Item 3 Legal Proceedings 9
Item 4 Submission of Matters to a Vote of Security Holders 9
PART II
Item 5 Market for Registrant's Common Equity and Related
Stockholder Matters 11
Item 6 Selected Consolidated Financial Data 11
Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 7A Quantitative and Qualitative Disclosures about Market Risk 31
Item 8 Financial Statements and Supplementary Data 31
Item 9 Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 31
PART III
Item 10 Directors and Executive Officers of the Registrant 32
Item 11 Executive Compensation 35
Item 12 Security Ownership of Certain Beneficial Owners and
Management 39
Item 13 Certain Relationships and Related Transactions 41
PART IV
Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K 45
Signatures 48
Index to Financial Statements F-1
2
Certain statements in this Report, in future filings by the Company
with the Securities and Exchange Commission, in the Company's press releases
and in oral statements made by or with the approval of an authorized executive
officer of the Company constitute forward-looking statements, including
statements which can be identified by the use of forward-looking terminology
such as "believes," "anticipates," "expects," "may," "will," or "should" or
the negative of such terminology or other variations on such terminology or
comparable terminology, or by discussions of strategies that involve risks and
uncertainties. All statements other than statements of historical facts in
this Report, including, without limitation, such statements under the caption
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," regarding the Company or any of the transactions described in
this Report or the timing, financing, strategies and effects of such
transaction, are forward-looking statements. Although the Company believes
that the expectations reflected in such forward-looking statements are
reasonable, it can give no assurance that such expectations will prove to be
correct. Important factors that could cause actual results to differ
materially from expectations include, without limitation, those described in
conjunction with the forward-looking statements in this Report, as well as the
amount of capital needed to deploy the Company's network; the Company's
substantial leverage and its need to service its indebtedness; the
restrictions imposed by the Company's current and possible future financing
arrangements; the ability of the Company to successfully manage the
cost-effective and timely completion of its network and its ability to attract
and retain customers for its products and services; the ability of the Company
to implement its newly expanded business plan; the ability of the Company to
retain and attract relationships with the incumbent owners of the
telecommunications assets with which the Company expects to build its network;
the ability of the Company to obtain and maintain rights-of-way for the
deployment of its network; the Company's ability to retain and attract key
management and other personnel as well as the Company's ability to manage the
rapid expansion of its business and operations; the Company's ability to
compete in the highly competitive telecommunications industry in terms of
price, service, reliability and technology; the Company's dependence on the
reliability of its network equipment, its reliance on key suppliers of network
equipment and the risk that its technology will become obsolete or otherwise
not economically viable; and the Company's ability to conduct its business in
a regulated environment. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Risk Factors." The Company
does not intend to update these forward-looking statements.
PART I
ITEM 1. BUSINESS
THE COMPANY
Pathnet, Inc. ("Pathnet" or the "Company") was founded in 1995 and is a
leading "carrier's carrier" providing high-quality, low-cost, digital
telecommunications capacity to under-served and second- and third-tier U.S.
markets. The Company's strategy is to partner with owners of telecommunications
assets, including utility, pipeline and railroad companies ("Incumbents"), to
upgrade and aggregate existing infrastructure to a state-of-the-art SONET
network. The Company currently has approximately 2,000 route miles of completed
network, approximately 5,000 route miles of network under construction and
approximately 10,000 route miles of network under contract. The Company
originally focused its network development efforts on wireless
telecommunications technology.
3
However, as a result of customer demand and market opportunity, the Company
expanded the scope of its existing wireless network business strategy in
February 1999 to include fiber optic technology as part of the Company's overall
digital telecommunications network. As a result, the Company is no longer
limiting the development of its strategic network relationships to incumbents
with wireless assets. The Company's expanded product line will enable it to
deliver high bandwidth services as well as dark and dim fiber to inter-exchange
carriers ("IXCs"), local exchange carriers, Internet service providers ("ISPs"),
Regional Bell Operating Companies ("RBOCs"), cellular operators and resellers
(collectively, "Telecom Service Providers"). The bandwidth and dark and dim
fiber available on selected routes resulting from deployment of Pathnet's
integrated network is intended to enable these Telecom Service Providers to (i)
deliver advanced services to areas that are currently under-served by digital
networks, (ii) aggregate traffic from cities in second- and third-tier markets
and (iii) obtain dedicated network services in such markets. In addition, upon
obtaining the requisite rights-of-way and other required permits and licenses,
the Company will be able to offer customized builds to such Telecom Service
Providers.
The Company has held meetings with over 300 potential strategic
partners who own telecommunications assets. As of December 31, 1998, nine of
these entities have entered into ten binding agreements relating to the initial
design and construction of approximately 10,000 route miles of digital network.
Eight of these binding agreements are long-term Fixed Point Microwave Services
Agreements ("FPM Agreements") with affiliates of Burlington Northern Santa Fe
Railroad, Enron, Idaho Power Company, Northeast Missouri Electric Cooperative,
Northern Indiana Public Service Company, Texaco and with two affiliates of KN
Energy. The ninth agreement is a binding term sheet with American Tower
Corporation, which controls certain telecommunications assets including certain
assets divested by CSX Railroad, ARCO Pipeline and MCI WorldCom, Inc. ("MCI") to
enable the Company to utilize tower assets and other facilities. The tenth
agreement is a tower lease agreement with Titan Towers. In addition to deploying
its wireless and fiber network to serve under-served and second- and third-tier
markets by forming long-term relationships with strategic partners, the Company
may pursue opportunities to acquire or deploy complementary telecommunications
assets or technologies and to serve other markets. See "Risk Factors -- Risks of
Completing the Company's Network; Market Acceptance."
PRODUCTS AND SERVICES
The Company offers dedicated private line access for voice, data and
video transmission in DS-1, DS-3 and OC-3 increments on the wireless portion of
its network and will offer larger increments of dedicated private line access on
the fiber portion of its network. In addition to bandwidth services, the Company
plans to offer dark and dim fiber to customers. Management believes this
flexibility together with the scope of the Company's integrated wireless and
fiber network will appeal to a broad variety of customers.
The Company also offers telecommunications project management,
provisioning services and other customer services. The Company expects to employ
a state-of-the-art operating support system capable of supporting on-line order
entry and remote circuit provisioning. The Company also expects to employ
information systems that permit customers to monitor network quality using
benchmarks such as network uptime, mean time to repair, installation intervals,
timeliness of billing and network operating center ("NOC") responsiveness. The
Company expects that its state-of-the-art "NOC" will permit pro-
4
active service monitoring and system management on a 24 hours per day, seven
days per week basis. The Company expects to combine network management, billing
and customer care on an integrated platform to offer its customers a single
point of contact.
DEVELOPMENT OF THE COMPANY'S NETWORK
The Company is in various stages of evaluating and negotiating several
agreements and arrangements relating to the deployment of its network including,
but not limited to, agreements to obtain rights-of-way, co-development and other
partnering arrangements. There can be no assurance, however, that any of such
potential relationships will result in binding agreements or that any of the
transactions currently being evaluated will be consummated. See "Risk Factors--
Risks of Completing the Company's Network; Market Acceptance."
EQUIPMENT SUPPLY AGREEMENTS
Pursuant to a Master Agreement entered into by the Company and NEC
America, Inc. and it affiliates ("NEC") on August 8, 1997, as amended, the
Company agreed to purchase from NEC by December 31, 2002 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 based on the prices of comparable products in other markets.
However, in the event the Company fails to purchase all of such equipment, NEC
has reserved the right to withdraw such favorable pricing levels. NEC warrants
the equipment against defects for three years and has agreed promptly to repair
or replace defective equipment. NEC will also maintain for the Company's
benefit, 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. In addition, pursuant to a Purchase Agreement between Andrew Corporation
("Andrew") and the Company, the Company agreed exclusively to recommend to the
Incumbents certain products manufactured by Andrew and Andrew agreed to sell
such products to Incumbents and the Company for a three-year period, renewable
for two additional one-year periods at the option of the Company. The Company's
agreement with Andrew generally provides for discounted pricing based on
projected order volume.
Pursuant to a supply agreement entered into by the Company and Lucent
Technologies ("Lucent") on December 18, 1998, the Company agreed that Lucent
would be the Company's exclusive supplier of fiber optic cable for its
nationwide, voice and data network. The agreement is initially valued at $440
million and could grow up to $2.1 billion over the life of the seven-year
agreement. As part of the supply agreement, Lucent will provide a broad level of
support, including fiber optic equipment, network planning and design and
technical and marketing support. Certain material terms of the Company's
agreements with Lucent are currently under review by Lucent and the Company.
There can be no assurance that the transactions contemplated by this supply
agreement will be consummated or consummated on the terms and conditions
described above. Lucent has also agreed to provide equipment financing in
connection with this supply agreement. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Liquidity and Capital
Resources" and "Risk Factors - Reliance on Lucent - Lucent Agreements."
5
INTELLECTUAL PROPERTY
The Company uses the name "Pathnet" as its primary business name and
service mark and has registered that name with the United States Patent and
Trademark Office. On February 26, 1998, the Company filed an application to
register its service mark "A NETWORK OF OPPORTUNITIES" in the United States
Patent and Trademark Office for communications services, namely establishing and
operating a network through the use of fiber optic and high capacity digital
radio equipment. Registration of such service mark is expected by the end of
1999. The Company reasonably believes that the application will mature to
registration, but there can be no assurance that such registration will actually
be issued.
The Company relies upon a combination of licenses, confidentiality
agreements and other contractual covenants to establish and protect its
technology and other intellectual property rights. These rights are critical to
certain aspects of the design, deployment and operation of the Company's
network. The Company currently has no patents or patent applications pending.
There can be no assurance that the steps taken by the Company will be adequate
to prevent misappropriation of its technology or other intellectual property. In
addition, the Company depends on the use of intellectual property of others,
including the hardware and software used to construct, operate and maintain its
network. Although the Company believes that its business as currently conducted
does not infringe on the valid proprietary rights of others, there can be no
assurance that third parties will not assert infringement claims against the
Company or that, in the event of an unfavorable ruling on such claim, a license
or similar agreement to utilize technology relied upon by the Company in the
conduct of its business will be available to the Company on reasonable terms.
The Company's equipment supply contracts with Lucent, NEC and Andrew provide for
indemnification by the supplier to the Company for intellectual property
infringement claims regarding the suppliers' equipment. In the case of the
agreement with Andrew, however, such indemnification is limited to the purchase
price paid for the particular equipment.
CUSTOMERS AND SALES AND MARKETING STRATEGY
The Company primarily targets Telecom Service Providers as well as
smaller carriers and large end-users. The Company's marketing focus is to (i)
offer capacity to fill gaps in its customers' networks, including dedicated
network through the sale of dark fiber; (ii) provide alternative capacity to
incumbent local exchange carriers ("ILECs"), and (iii) capture demand from
Telecom Service Providers for the Company's products, including bandwidth
services, as a lower cost provider. The Company markets its network to major
IXCs such as AT&T Corp. ("AT&T"), MCI and Sprint Corporation ("Sprint") to
satisfy their expanding network requirements. The Company expects that it will
be well positioned to provide capacity to meet demand in diverse geographic
areas.
The Company believes there will be significant opportunities to market
its capacity to RBOCs when they commence long distance service outside of their
current service areas. The Company also plans to market the Company's network to
RBOCs or other ILECs for use within their own service areas. The Company
believes ILECs will be attracted to the Company's ability to provide
supplemental capacity on a leased basis, permitting them to conserve capital and
providing a low-cost redundancy alternative. The Company believes its network
will allow RBOCs and ILECs to focus on larger cities while providing small
communities within their service areas with broadband connectivity.
6
The Company expects that mobile wireless operators will be attracted to
the Company's ability to provide back haul capacity from remote network sites
that connect its mobile switches with backbone transport capacity. The Company
also intends to market its capacity to competitive access providers and
competitive local exchange carriers ("CLECs") who can utilize the Company's
network to interconnect various service areas on an intra-LATA and inter-LATA
basis. Additionally the Company will market capacity to ISPs to facilitate the
creation of additional points of presence ("POPs") for local dial-up
connectivity to the ISPs' customer base, thereby eliminating the ISPs'
dependence on IXCs for capacity.
As of December 31, 1998, the Company was providing commercial
telecommunications service to three customers with several additional customers
awaiting installation. As the Company continues to deploy its nationwide network
and expand its products and services to include dark and dim fiber as well as
high bandwidth services, the Company expects that its customer base will
materially grow. Although the Company currently derives some revenue from the
sale of bandwidth services, the majority of the Company's revenues to date have
been derived from construction management and advisory services. For a statement
of the Company's revenue and operating results for each of the three years ended
December 31, 1998, 1997 and 1996, see "Consolidated Statement of Operations."
COMPETITION
The telecommunications industry is highly competitive. In particular,
price competition in the carrier's carrier market has generally been intense and
is expected to increase. The Company competes and expects to compete with
numerous competitors who have substantially greater financial and technical
resources, long-standing relationships with their customers and potential to
subsidize competitive services from less competitive service revenues and from
federal universal service subsidies. Such competitors may be operators of
existing or newly deployed wireline or wireless telecommunications networks. The
Company will also face intense competition due to an increased supply of
telecommunications capacity, the effects of deregulation and the development of
new technologies, including technologies that will increase the capacity of
existing networks.
The Company anticipates that prices for its carrier's carrier services
will continue to decline over the next several years. The Company is aware that
certain long distance carriers are expanding their capacity and believes that
other long distance carriers, as well as potential new entrants to the industry,
are constructing new long distance transmission networks in the United States.
If industry capacity expansion results in capacity that exceeds overall demand
along the Company's routes, severe additional pricing pressure could develop. As
a result the Company could face dramatic and substantial price reductions. Such
pricing pressure could have a material adverse effect on the business, financial
condition and results of operations of the Company. See "Risk Factors
Competition; Pricing Pressures."
While the Company generally will not compete with Telecom Service
Providers for end-user customers, the Company may compete, on certain routes, as
a carrier's carrier with long distance carriers such as AT&T, MCI and Sprint and
operators of fiber optic systems such as IXC Communications, Inc., The Williams
Companies Inc., Qwest Communications International Inc. and Level 3
Communications Inc., who would otherwise be the Company's customers in
under-served and second- and third-tier markets. The Company will also face
competition increasingly in the long haul market from local exchange carriers,
regional network providers, resellers, satellite carriers, public utilities and
cable companies. In particular, certain ILECs and CLECs are allowed to provide
inter-LATA long distance
7
services. Furthermore, RBOCs will be allowed to provide inter-LATA long distance
services within their regions after meeting certain regulatory requirements
intended to foster opportunities for local telephone competition. Certain RBOCs
have requested regulatory approval to provide inter-LATA data services within
their regions. The RBOCs already have extensive fiber optic cable, switching,
and other network facilities in their respective regions that can be used for
long distance services after a waiting period. In addition, other new
competitors may build additional fiber capacity in the geographic areas served
and to be served by the Company. See "Risk Factors --Competition; Pricing
Pressures."
Furthermore, although the Company believes its strategy will provide it
with a cost advantage, there can be no assurance that technological developments
will not result in competitors achieving even greater cost efficiency and
therefore a competitive advantage. See "Risk Factors -- Risk of Rapid
Technological Changes."
A continuing trend toward business combinations and strategic alliances
in the telecommunications industry may create stronger competitors to the
Company, as the resulting firms and alliances are likely to have significant
technological, marketing and financing resources greater than those available to
the Company. See "Risk Factors -- Competition; Pricing Pressures."
EMPLOYEES
As of December 31, 1998, the Company had 144 employees, none of whom
was represented by a union or covered by a collective bargaining agreement. The
Company believes that its relationship with its employees is good. In connection
with the construction and maintenance of its network and the conduct of its
other operations, the Company uses third party contractors, some of whose
employees may be represented by unions or covered by collective bargaining
agreements.
ITEM 2. PROPERTIES
As part of its network, the Company holds leasehold interests or
licenses in the land, towers, shelters and other facilities located at each
Incumbent's sites at which the Company has an agreement and will have
indefeasible rights to use, leasehold and other real estate interests pursuant
to its agreements with independent tower companies owners of rights-of-way and
other owners of telecommunications assets. The Company expects to lease, license
and obtain additional real estate rights to additional facilities from
Incumbents, owners of rights-of-way and other owners of telecommunications
assets in connection with the planned expansion of its digital network.
The Company leases its corporate headquarters space in Washington, D.C.
from 6715 Kenilworth Avenue General Partnership, a general partnership of which
David Schaeffer, a director of the Company, is General Partner (the "Kenilworth
Partnership"), pursuant to a Lease Agreement between the Company and the
Kenilworth Partnership, dated as of August 9, 1997 (the "Headquarters Lease").
The Headquarters Lease expires on August 31, 1999 and can be renewed at the
option of the Company for two additional one-year periods on the same terms and
conditions. See "Certain Relationships and Related Transactions--Lease from the
Kenilworth Partnership." The Company also leases office space in Richardson,
Texas; Lewiston, Texas; and Independence, Kansas pursuant to leases that expire
in 2003, 2001 and 2000, respectively.
The Company believes that all of its properties are well maintained.
8
ITEM 3. LEGAL PROCEEDINGS
Other than licensing and other regulatory proceedings described under
"Risk Factors--Regulation," the Company is not currently a party to any legal
proceedings, which, individually or in the aggregate, the Company believes will
have a material adverse effect on the Company's financial condition, results of
operations and cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year covered by this Annual
Report on Form 10-K, the Company held a special meeting of the Stockholders on
October 20, 1998. At such meeting, the following matters were approved by
holders of the Company's common stock, par value $.01 per share (the "Common
Stock"), Series A Convertible Preferred Stock, Series B Convertible Preferred
Stock and Series C Convertible Preferred Stock (collectively the "Stockholders")
voting together as a single class, by the votes indicated below:
(i) Approval of several agreements and arrangements made in the ordinary
course of the Company's business: For 17,115,081 Against: 0 Abstain:
1,651,992.
(ii) Approval of the hiring certain new employees: For 17,115,081 Against: 0
Abstain: 1,651,992.
On December 2, 1998, the Company held a special meeting of the
Stockholders where the following matters were approved by the Stockholders,
voting together as a single class, by the votes indicated below:
(i) Approval of a loan agreement with KN Energy: For 14,671,900, Against:
0, Abstain: 4,095,173.
(ii) Approval of a three-way transaction with KN Energy, American Tower
Corporation and the Company. For 14,671,900, Against: 0, Abstain:
4,095,173.
(iii) Approval of a Tower Lease Agreement with Titan Towers. For 11,771,900,
Against: 2,900,000, Abstain: 4,095,173.
(iv) Approval of a fleet leasing arrangement for automobile rentals. For
14,671,900, Against: 0, Abstain: 4,095,173.
(v) Approval of the grant of stock option awards to certain employees of
the Company. For 14,399,344, Against: 0, Abstain: 4,367,729.
(vi) Approval of certain amendments to the Company's Certificate of
Incorporation and Amended and Restated Bylaws of the Corporation. For
11,499,344, Against:2,900,000, Abstain: 4,367,729. See Exhibits 3.1 and
3.2 attached to this Report.
On December 7, 1998, the Company solicited written consents from the
holders of its Series A Convertible Preferred Stock, Series B Convertible
Preferred Stock and Series C Convertible Preferred
9
Stock (collectively, the "Preferred Stockholders") to (i) approve certain
authorized signatories for the transfer and withdrawal of the Company's funds
and (ii) to approve the payment of an invoice for legal services. Effective
December 7, 1998, the Company received written consents approving such proposals
from Preferred Stockholders representing 10,720,610 votes with Preferred
Stockholders representing 5,144,105 votes abstaining.
On December 18, 1998, the Company solicited written consents from the
Preferred Stockholders to approve the supply agreement between the Company and
Lucent and related Commitment Letter by and between the Company and Lucent
signed on December 14, 1998 (the "Commitment Letter") setting forth the proposed
terms of equipment financing by Lucent. See "Business -- Equipment Supply
Agreements." Effective December 18, 1998, the Company received written consents
approving such proposals from Preferred Stockholders representing 13,309,853
votes with Preferred Stockholders representing 2,554,862 votes abstaining.
10
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 March 12, 1999, there were
3 record holders of the Company's Common Stock. As of December 31, 1998, stock
option awards to purchase 2,885,883 shares of Common Stock were outstanding.
Pathnet 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 11 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
The following consolidated balance sheet data as of December 31, 1997
and 1998 and statement of operations data for the twelve months ended December
31, 1996, 1997 and 1998 and the period August 25, 1995 (date of inception) to
December 31, 1998, have been derived from the Company's financial statements and
the notes thereto, included elsewhere in this Annual Report on Form 10-K, which
have been audited by PricewaterhouseCoopers LLP, independent accountants, as
stated in their report included herein. Such summary statement of operations and
balance sheet data should be read in conjunction with such audited financial
statements and the notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations." The following consolidated
balance sheet data as of December 31, 1995 and 1996 and statements of operations
data for the period August 25, 1995 (date of inception) to December 31, 1998
have been derived from the Company's audited financial statements which are not
included in this Annual Report on Form 10-K, which have been audited by
PricewaterhouseCoopers LLP.
11
Period from Period from
August 25, 1995 August 25, 1995
(date of (date of
inception) to inception) to
December 31, Year Ended December 31, December 31,
1995 1996 1997 1998 1998
----------- ------------ ------------ ------------ ------------
Statement of Operation Data:
Revenue .................................... $ -- $ 1,000 $ 162,500 $ 1,583,539 $ 1,747,039
Operating expenses:
Cost of revenue .......................... -- -- -- 7,547,620 7,547,620
Selling, general and administrative ...... 429,087 1,333,294 4,247,101 9,615,867 15,625,349
Depreciation expense ..................... 352 9,024 46,642 732,813 788,831
----------- ------------ ------------ ------------ ------------
Total operating expenses ................... 429,439 1,342,318 4,293,743 17,896,300 23,961,800
Net operating loss ......................... (429,439) (1,341,318) (4,131,243) (16,312,761) (22,214,761
Interest expense (a) ....................... -- (415,357) -- (32,572,454) (32,987,811
Interest income ............................ 2,613 13,040 159,343 13,940,240 14,115,236
Write off of initial public offering costs . -- -- -- (1,354,534) (1,354,534)
Other income (expense), net ................ -- -- (5,500) 2,913 (2,587)
----------- ------------ ------------ ------------ ------------
Net loss ................................... $ (426,826) $ 1,743,635) $ (3,977,400) $(36,296,596) $(42,444,457)
=========== ============ ============ ============ ============
Basic and diluted loss per common share .... $ (0.15) $ (0.60) $ (1.37) $ (12.51) $ (14.63)
=========== ============ ============ ============ ============
Weighted average number of common
shares outstanding ...................... 2,900,000 2,900,000 2,900,000 2,902,029 2,900,605
=========== ============ ============ ============ ============
Balance Sheet Data:
Cash, cash equivalents and marketable
securities (excluding marketable
securities pledged as collateral) ....... $ 82,973 $ 2,318,037 $ 7,831,384 $227,117,417
Property and equipment, net ................ 8,551 46,180 7,207,094 47,971,336
Total assets ............................... 91,524 2,365,912 16,097,688 365,414,129
Total liabilities .......................... 17,350 145,016 5,892,918 366,492,370
Convertible preferred stock ................ 500,000 4,008,367 15,969,641 35,969,639
Stockholders' equity (deficit) ............. $ (425,826) $ (1,787,471) $ (5,764,871) (37,047,880)
- --------------------------
(a) The 1996 expense relates to the beneficial conversion feature of a loan
at December 31, 1996.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company is a leading carrier's carrier providing high-quality,
low-cost, digital telecommunications capacity to under-served and second- and
third-tier U.S. markets.
The Company's business commenced on August 25, 1995 and has been funded
primarily through equity investments by the Company's stockholders and a private
placement (the "Debt Offering") in April 1998 of 350,000 units (the "Units"),
consisting of 12 1/4% Senior Notes (the "Restricted Notes") and warrants (the
"Warrants") to purchase shares of Common Stock. On October 2, 1998, the Company
completed an exchange (the "Exchange Offer") of all outstanding Restricted Notes
for $350,000,000 aggregate principal amount of 12 1/4% Senior Notes due 2008
which have been registered under the
12
Securities Act of 1933, as amended (the "Registered Notes"). The Restricted
Notes and the Registered Notes are collectively referred to herein as the
"Senior Notes."
Due to Pathnet's focus to date on developing its network, the majority
of its revenues reflect certain consulting and project management services in
connection with the design, development and construction of digital microwave
infrastructure. The remaining portion of its revenues has resulted from the sale
of bandwidth services along its network. The Company has also been engaged in
the acquisition of telecommunications network equipment, the development of
operating systems, the design and construction of the NOC, capital raising and
the hiring of management and other key personnel. 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. See "Risk Factors - Substantial Leverage;
Ability to Service Debt; Restrictive Covenants."
NETWORK-RELATED COSTS
The limited incremental cost of operating and maintaining the wireless
portion of Pathnet's network, as well as the financial support of Incumbents who
will be responsible for a significant portion of such operating and maintenance
costs, are expected to enable the Company to enjoy operating leverage with
respect to the wireless portion of Pathnet's network. The Company expects to
maintain similar operating leverage with respect to the fiber portion of its
network through the use of co-development and partnering arrangements, however,
there can be no assurance that the Company will be able to achieve these
operating efficiencies through the use of these arrangements. The Company's
primary network operating costs are expected to be the costs of maintenance,
provisioning of new circuits, interconnection and operation of the NOC. See
"Risk Factors - Risks of Completing the Company's Network; Market Acceptance;
Risks Related to Expansion in Strategy; Need to Obtain and Maintain Rights of
Way; Risks Relating to Interconnection."
COST OF OPERATIONS
Pathnet will incur costs common to all telecommunications providers,
including customer service and technical support, information systems, billing
and collections, general management and overhead expenses. As a facilities-based
carrier's carrier, the Company will differ from non-facilities-based Telecom
Service Providers in the scope and complexity of systems supporting its business
and network. The Company anticipates that the vast majority of its customers
will be Telecom Service Providers purchasing wholesale private line transport
capacity across multiple portions of the Company's network. As such, the Company
believes that it will be able to maintain a relatively low ratio of overhead
expenses to revenues compared to other Telecom Service Providers.
Sales and Marketing Costs. To attract and retain customers for the
Company's digital network, the Company has built a sales team that includes a
direct national accounts sales force, a regional sales force and a sales force
dedicated to alternate channels. In addition, the Company is assembling a
centralized marketing organization to focus on product development, market
analysis and pricing strategies, as well as customer communications, public
relations, and branding.
Administration Costs. The Company's general and administrative costs
will include expenses typical of other telecommunications service providers,
including infrastructure costs, customer care,
13
billing, corporate administration, and human resources. The Company expects that
these costs will grow significantly as it expands operations. See "Risk Factors
- - Significant Capital Requirements; Uncertainty of Additional Financing."
DEPRECIATION AND AMORTIZATION
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 ten 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.
CAPITAL EXPENDITURES
The Company's principal capital requirements for deployment of its
wireless network include the costs of tower enhancement, site preparation work,
base digital wireless equipment and incremental digital wireless equipment. The
Company's goal is to leverage the assets of Incumbents to (i) reduce the capital
costs associated with developing long haul, digital network capacity as compared
to so-called "green field" network expansion and (ii) improve the Company's
speed to market due to the elimination of site preparation activities, including
local permitting, power connection, securing road access and rights-of-way and
tower construction. The actual allocation of costs between the Company and each
Incumbent has varied with each of the Company's agreements with Incumbents
executed to date and is expected to vary, perhaps significantly, in the future
on a case-by-case basis.
The primary capital costs of deploying the Company's fiber network will
include the costs of fiber, rights-of-way, installation and construction work
and optronics equipment used in regeneration facilities and to "light" the
fiber. The portion of these capital costs that will be borne by the Company or
that will be defrayed by consummating dark fiber sales of any fiber network
segment will be determined on a case-by-case basis as the Company evaluates and
enters into co-development and other partnering arrangements to deploy its
nationwide digital network.
BUSINESS DEVELOPMENT, CAPITAL EXPENDITURES AND ACQUISITIONS
From inception through December 31, 1998, expenditures for property,
plant and equipment, including construction in progress, totaled $48.8 million.
In addition, the Company incurred significant other costs and expenses in the
development of its business and has recorded cumulative losses from inception
through December 31, 1998 of $42.4 million. See "Risk Factors--Limited History
of Operations; Operating Losses and Negative Cash Flow."
LIQUIDITY AND CAPITAL RESOURCES
The Company expects to continue to generate cash primarily from
external financing and, as its network matures, from operating activities. The
Company's primary uses of cash will be to fund capital expenditures, working
capital and operations. Deployment of the Company's digital network and
expansion of the Company's operations and services will require significant
capital expenditures. Capital
14
expenditures will be used primarily for continued development and construction
of its network, implementing the Company's sales and marketing strategy and
constructing and improving the Company's NOC.
During the period from August 1995 through June 1997, the Company
raised an aggregate of $6 million through the issuance and sale of its Series A
Convertible Preferred Stock and Series B Convertible Preferred Stock in a series
of private placements. See "Certain Relationships and Related Transactions -
Series A Purchase Transactions" and -- "Series B Purchase Agreement" and Note 9
to the Company's Consolidated Financial Statements that appear elsewhere in this
Annual Report on Form 10-K.
On October 31, 1997, 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, the Company
consummated an additional private offering of 1,879,699 shares of Series C
Convertible Preferred Stock for an aggregate purchase price of approximately
$20.0 million, bringing the total investment by the Company's private equity
investors to $36.0 million.
On April 8, 1998, the Company completed the Debt Offering resulting in
net proceeds to the Company of approximately $339.5 million, after reduction for
offering costs of approximately $10.5 million. In addition to the Senior Notes,
as part of the Debt Offering, the Company issued Warrants to purchase an
aggregate of 1,116,500 shares of Common Stock. The Company used approximately
$81.1 million of the net proceeds of the Debt Offering to purchase securities
(the "Pledged Securities") in an amount sufficient to provide for payment in
full of the interest due on the Senior Notes through April 15, 2000. The Pledged
Securities have been pledged as security for repayment of the Senior Notes. The
Company made its first interest payment of approximately $22.3 million on
October 15, 1998. The Indenture relating to the Senior Notes contains provisions
restricting, among other things, the incurrence of additional indebtedness, the
payment of dividends and the making of restricted payments, the sale of assets
and the creation of liens.
On September 2, 1998, the Company commenced the Exchange Offer to
exchange all outstanding Restricted Notes for Registered Notes. The terms of the
Registered Notes are identical in all material respects to the terms of the
Restricted Notes, except that the Registered Notes have been registered under
the Securities Act of 1933 and are generally freely transferable by holders
thereof and are issued without any covenant upon the Company regarding
registration under the Securities Act of 1933. The Exchange Offer expired on
October 2, 1998 and all outstanding Restricted Notes were exchanged for
Registered Notes.
The net proceeds from the issuance of the Units (after purchasing the
Pledged Securities) and the issuance and sale of the Series C Convertible
Preferred Stock are being used for capital expenditures, working capital and
general corporate purposes, including the funding of operating losses.
On May 8, 1998, the Company filed a registration statement under the
Securities Act of 1933 with the Securities and Exchange Commission, relating to
a proposed initial public offering of the Company's Common Stock (the "Initial
Public Offering"). On August 13, 1998, the Company announced that it would
postpone the Initial Public Offering due to general weakness in the capital
markets. The timing and size of any future initial public offering of the
Company's Common Stock are dependent on market conditions and there can be no
assurance that the Initial Public Offering will be completed.
15
As of December 31, 1998, the Company had capital commitments of
approximately $28 million relating to telecommunications and transmission
equipment. It is anticipated that these will be met with the current resources
of the Company.
As of December 31, 1998, the Company had approximately $227 million
available for the funding of future operations. The Company expects these
resources are sufficient to fund the implementation of the Company's business
plan into 2000. After such time, the Company is expected to be required to
procure additional financing which may include commercial bank borrowings,
additional vendor financing or the sale or issuance of equity or debt
securities. There can be no assurance the Company will be successful in raising
sufficient capital or in obtaining such financing on terms acceptable to the
Company. See "Risk Factors - Significant Capital Requirements; Uncertainty of
Additional Financing."
Pursuant to the Commitment Letter in connection with the supply
agreement between Lucent and the Company, Lucent may provide financing of up to
approximately $400 million for fiber purchases for the construction of the
Company's network and may provide or arrange financing for future phases of such
network. Under the terms of the Commitment Letter, the total amount of financing
provided by Lucent will not exceed $1.8 billion of the $2.1 billion potential
value of the supply agreement. Certain material terms of the Company's
agreements with Lucent, including the terms of the Commitment Letter, are
currently under review by Lucent and the Company. There can be no assurance that
the transactions, including the financing contemplated by Commitment Letter,
will be consummated or consummated on the terms described above. In addition,
the Company may require additional capital in the future to fund operating
deficits and net losses and for potential strategic alliances, joint ventures
and acquisitions. See "Risk Factors Significant Capital Requirements;
Uncertainty of Additional Financing."
Because the Company's cost of rolling out its network and operating its
business, as well as its revenues, will depend on a variety of factors
(including, among other things, the ability of the Company to meet its roll-out
schedules, its ability to negotiate favorable prices for purchases of network
equipment, the number of customers and the services they purchase, regulatory
changes and changes in technology), actual costs and revenues will vary from
expected amounts, possibly to a material degree, and such variations are likely
to affect the Company's future capital requirements. Accordingly, there can be
no assurance that the Company's actual capital requirements will not exceed the
anticipated amounts described above.
RESULTS OF OPERATIONS
COMPARISON OF YEAR ENDED DECEMBER 31, 1998 WITH YEAR ENDED DECEMBER 31, 1997
During the twelve months ended December 31, 1998, the Company continued
to develop relationships with Incumbents, buildout its network and develop its
infrastructure, including hiring key management personnel. The Company also
began marketing and sales efforts, and hired Mr. Bennis to develop and execute
its sales efforts and marketing plan.
REVENUE
Substantially all of the Company's revenues for the year ended December
31, 1998 consisted of fees received in connection with services provided to
Incumbents, including analysis of existing facilities and system performance,
advisory services relating to PCS relocation matters, and turnkey network
16
construction management services. The Company expects substantially all future
revenue to be generated from the sale of telecommunications services. For the
year ended December 31, 1998 the Company generated revenues of approximately
$1.6 million, approximately $1.4 million (89.6%) of which were attributable to
fees received in connection with the continued performance of construction
management services primarily from one customer, and approximately $165,000
(10.4%) were attributable to the sale of telecommunications capacity. For the
year ended December 31, 1997, the Company generated revenues of approximately
$162,500 derived from construction management and advisory services.
OPERATING EXPENSES
For the year ended December 31, 1998 and 1997, the Company incurred
operating expenses of approximately $17.9 million and $4.3 million,
respectively. The increase is primarily as a result of the increased activity in
the buildout of the Company's network and additional staff costs incurred as
part the development of the Company's infrastructure. The Company expects
selling, general and administrative expenses to continue to increase as
additional staff is added in all functional areas, particularly in sales and
marketing. Cost of revenue reflects direct costs associated with performance of
construction, management services and costs incurred in connection with the
provision of telecommunications services. Cost of revenue reflects direct costs
associated with performance of construction management services and costs
incurred for telecommunications services such as network operations, network
interconnections and provisioning of capacity for customers. These costs include
salaries and other employee expenses of the new employees hired during the
second quarter to staff the NOC, costs for leased telecommunications capacity
used to monitor the network, maintenance fees paid to Incumbents and other
overhead expenses.
INTEREST EXPENSE
Interest expense for the year ended December 31, 1998 was approximately
$32.6 million. Interest expense primarily represents interest on the Senior
Notes issued in April 1998 together with financing costs associated with
obtaining debt financing arrangements and the amortization expense related to
bond issuance costs in respect of the Senior Notes. The Company did not incur an
interest expense during 1997.
INTEREST INCOME
Interest income for the year ended December 31, 1998 and 1997 was
approximately $13.9 million and $159,300, respectively. This increase primarily
represents interest earned on the proceeds of the Senior Notes issued in April
1998.
INITIAL PUBLIC OFFERING COSTS
During the third quarter of 1998, the Company recorded a one-time write
off of costs of approximately $1.3 million, associated with the postponed
Initial Public Offering of the Company's Common Stock. These costs consisted
primarily of legal and accounting fees, printing costs, and Securities and
Exchange Commission and Nasdaq Stock Market fees.
17
COMPARISON OF YEAR ENDED DECEMBER 31, 1997 WITH YEAR ENDED DECEMBER 31, 1996
During the year ended December 31, 1997, the Company initiated
construction on the first segment of its network, and additional engineering and
management personnel were recruited, including Mr. Jalkut. The Company's
principal activity through the third quarter of 1996 involved the introduction
of its business plan to Incumbents. As the Company began to enter into formal
relationships with Incumbents in 1996, additional engineering, legal, and
financial personnel were recruited to support the increased workflow and to
negotiate Incumbent contracts.
REVENUE
In establishing relationships with Incumbents, the Company acted as a
provider of services for transitioning the Incumbents from their old network
systems onto the Company's network. These services included analysis of existing
facilities and system performance, advisory services relating to PCS relocation
matters, and turnkey network construction management. Revenues for the year
ended December 31, 1997 consisted of $100,000 derived from construction
management services and $62,500 from PCS relocation advisory services as
compared with revenues for the year ended December 31, 1996 of $1,000 generated
from PCS relocation advisory services.
OPERATING EXPENSES
For the year ended December 31, 1997, the Company incurred operating
expenses of approximately $4.3 million compared to operating expenses of $1.3
million for the year ended December 31, 1996. This increase was directly related
to an increase in selling, general and administrative expenses as the Company
expanded its engineering, technical, legal, finance, and general management
personnel in connection with the continued signing of new Incumbent agreements
and the ongoing construction of the Company's network.
YEAR 2000
The Year 2000 issue exists because many computer systems and software
applications use two digits rather than four digits to designate an applicable
year. As a result, the systems and applications may not properly recognize the
Year 2000, or process data that includes that date, potentially causing data
miscalculations or inaccuracies or operational malfunctions or failures.
In the fourth quarter of 1998, the Company began a corporate-wide
program to ready its technology systems and non-technology systems and software
applications for the Year 2000. The Company's objective is to target Year 2000
compliance for all of its systems, including network and customer interfacing
systems. Due to the development stage status of the Company, few legacy systems
or applications exist. However, the Company is identifying all of its systems
and applications that may need to be modified or reprogrammed in order to
achieve Year 2000 compliance.
As part of its Year 2000 plan, the Company is seeking confirmation from
its communications equipment vendors and other suppliers, financial institutions
and customers that their systems will be Year 2000 compliant. There can be no
assurance that the systems of companies with which the Company does business
will be Year 2000 compliant. If the vendors important to the Company fail to
provide needed products and services, the Company's network buildout and
operations could be affected and thereby have a material adverse effect on the
Company's results of operations, liquidity and financial condition. Moreover, to
the extent that significant customers are not Year 2000 compliant and that
18
affects their network needs, the Company's sales could be lower than otherwise
anticipated.
The Company does not believe its expenditures to implement its Year
2000 strategy will be material. Because its existing systems are relatively new,
it does not expect that it will have to replace any of its systems. To the
extent it would have to replace a significant portion of its technology systems,
its expenditures could have material adverse effect on the Company. The Company
has hired an outside consultant to assist it with its Year 2000 compliance, but
the Company has relied primarily on its existing employees to develop and
implement its Year 2000 compliance strategy. As a result, its expenditures to
ensure Year 2000 compliance have not been material to date. The Company expects
to continue to use existing employees for the significant part of its Year 2000
compliance efforts in the future.
The Company does not currently have a contingency plan in the event
that it or its suppliers or customers are not Year 2000 compliant. However, the
Company expects to develop a contingency plan to deal with potential Year 2000
related business interruptions.
RISK FACTORS
LIMITED HISTORY OF OPERATIONS; OPERATING LOSSES AND NEGATIVE CASH FLOW
The Company was formed in August 1995 to begin development of its
digital network. As of December 31, 1998, the Company had completed
approximately 2,000 route miles of network, an additional approximately 5,000
route miles of network are under construction and approximately 10,000 route
miles of network are under contract. In addition, the Company was only providing
commercial telecommunications service to three customers with several additional
customers awaiting installation. There can be no assurance that the Company will
enter into any additional contracts with Incumbents or other owners of
telecommunications assets to obtain rights-of-way or rights to sites, towers and
other assets for the construction of additional network or with customers for
the purchase and sale of bandwidth services or dark or dim fiber. As a result of
development and operating expenses, the Company has incurred significant
operating and net losses to date. The Company's operations have resulted in
cumulative net losses of $42.4 million and cumulative net losses before interest
income (expense) and income tax benefit of $23.6 million from inception in 1995
through December 31, 1998.
The Company expects to incur significant operating losses, to generate
negative cash flows from operating activities and to invest substantial funds to
construct its digital network during the next several years. There can be no
assurance that the Company will achieve or sustain profitability or generate
sufficient positive cash flow to meet its debt service obligations, capital
expenditure requirements or working capital requirements.
SUBSTANTIAL LEVERAGE; ABILITY TO SERVICE DEBT; RESTRICTIVE COVENANTS
The Company is highly leveraged. As of December 31, 1998, the Company
had $346.2 million of indebtedness outstanding. The Company will likely incur
substantial additional indebtedness (including secured indebtedness) for the
development of its network and other capital and operating requirements. The
level of the Company's indebtedness could adversely affect the Company in a
number of ways. For example, (i) the ability of the Company to obtain necessary
financing in the future for working capital, capital expenditures, debt service
requirements or other purposes may be limited; (ii) the Company's level of
indebtedness could limit its flexibility in planning for, or reacting to,
changes
19
in its business; (iii) the Company will be more highly leveraged than some of
its competitors, which may place it at a competitive disadvantage; (iv) the
Company's degree of indebtedness may make it more vulnerable to a downturn in
its business or the economy generally; (v) the terms of the existing and future
indebtedness restrict, or may restrict, the payment of dividends by the Company;
and (vi) a substantial portion of the Company's cash flow from operations must
be dedicated to the payment of principal and interest on its indebtedness and
will not be available for other purposes.
The Indenture relating to the Senior Notes and certain of the Company's
agreements with Incumbents contain, or will contain, restrictions on the Company
and its subsidiaries that will affect, and in certain cases significantly limit
or prohibit, among other things, the ability of the Company and its subsidiaries
to create liens, make investments, pay dividends and make certain other
restricted payments, issue stock of subsidiaries, consolidate, merge, sell
assets and incur additional indebtedness. There can be no assurance that such
covenants and restrictions will not adversely affect the Company's ability to
finance its future operations or capital needs or to engage in other business
activities that may be in the interest of the Company.
In addition, any future indebtedness incurred by the Company or its
subsidiaries is likely to impose similar restrictions. Failure by the Company or
its subsidiaries to comply with these restrictions could lead to a default under
the terms of the Senior Notes or the Company's other indebtedness
notwithstanding the ability of the Company to meet its debt service obligations.
In the event of such a default, the holders of such indebtedness could elect to
declare all such indebtedness due and payable, together with accrued and unpaid
interest. In such event, a significant portion of the Company's indebtedness may
become immediately due and payable, and there can be no assurance that the
Company would be able to make such payments or borrow sufficient funds from
alternative sources to make any such payments. Even if additional financing
could be obtained, there can be no assurance that it would be on terms that
would be acceptable to the Company.
The successful implementation of the Company's strategy, including
expanding its digital network and obtaining and retaining a sufficient number of
customers, and significant and sustained growth in the Company's cash flow will
be necessary for the Company to meet its debt service requirements. The Company
does not currently, and there can be no assurance that the Company will be able
to, generate sufficient cash flows to meet its debt service obligations. If the
Company is unable to generate sufficient cash flows or otherwise obtain funds
necessary to make required payments, or if the Company otherwise fails to comply
with the various covenants under the terms of its existing or future
indebtedness, it could trigger a default under the terms thereof, which would
permit the holders of such indebtedness to accelerate the maturity of such
indebtedness and could cause defaults under other indebtedness of the Company.
The ability of the Company to meet its obligations will be dependent upon the
future performance of the Company, which will be subject to prevailing economic
conditions and to financial, business, regulatory and other factors.
SIGNIFICANT CAPITAL REQUIREMENTS; UNCERTAINTY OF ADDITIONAL FINANCING
Deployment of the Company's network and expansion of the Company's
operations and services will require significant capital expenditures, primarily
for continued development and construction of its network and implementation of
the Company's sales and marketing strategy. The Company will need to seek
additional financing to fund capital expenditures and working capital to expand
its network further. The Company may also require additional capital for
activities complementary to its currently
20
planned businesses.
The actual amount of the Company's future capital requirements will
depend upon many factors, including the costs of network deployment in each of
its markets, the speed of the development of the Company's network, the extent
of competition and pricing of telecommunications services in its markets, other
strategic opportunities pursued by the Company and the acceptance of the
Company's services. Accordingly, there can be no assurance that the actual
amount of the Company's financing needs will not exceed, perhaps significantly,
the current estimates.
There can be no assurance that the Company will be successful in
raising additional capital or on terms that it will consider acceptable, that
the terms of such indebtedness or other capital will not impair the Company's
ability to develop its business or that all available capital will be sufficient
to service its indebtedness. Sources of additional capital may include equipment
financing facilities and public and private equity and debt financing. Failure
to raise sufficient funds may require the Company to modify, delay or abandon
some of its planned future expansion or expenditures, which could have a
material adverse effect on the Company's business, financial condition and
results of operations.
RISKS OF COMPLETING THE COMPANY'S NETWORK; MARKET ACCEPTANCE
The Company's ability to achieve its strategic objectives will depend
in large part upon the successful, timely and cost-effective completion of its
network, as well as on selling a substantial amount of its products, including
bandwidth services. The successful completion of the Company's network may be
affected by a variety of factors, uncertainties and contingencies, many of which
are beyond the Company's control. The Company has gained experience in budgeting
and scheduling as it has completed segments of its network, and although the
Company believes that its cost estimates and buildout schedules relating to the
currently planned portions of its network are reasonable, only approximately
2,000 route miles under contract have been completed as of December 31, 1998.
There can be no assurance that the Company's network will be completed as
planned at the cost and within the time frame currently estimated, if at all. In
addition, although the Company recently began providing commercial
telecommunications service to three customers with several additional customers
awaiting installation, there can be no assurances that the Company will attract
additional purchasers of its products, including bandwidth services.
The successful and timely construction of the Company's network will
depend upon, among other things, the Company's ability to (i) obtain substantial
amounts of additional capital and financing at reasonable cost and on
satisfactory terms and conditions, (ii) manage effectively and efficiently the
construction of its network, (iii) enter into agreements with Incumbents and
other owners of telecommunications assets that will enable the Company to
leverage the assets of Incumbents and of other owners of telecommunications
assets, (iv) access markets and enter into customer contracts to sell bandwidth
services and other products on its network, (v) integrate successfully such
networks and associated rights acquired in connection with the development of
the Company's network, including cost-effective interconnections, (vi) obtain
necessary Federal Communication Commission ("FCC") licenses and other approvals
and (vii) obtain adequate rights-of-way and other property rights necessary to
install and operate the fiber portions of the Company's network. Successful
construction of the Company's network also will depend upon the timely
performance by third party contractors of their obligations. There can be no
assurance that the Company will achieve any or all of these objectives. Any
failure by the Company to accomplish these objectives may have a material
adverse affect on the
21
Company's business, financial condition and results of operations.
The development of the Company's network and the expansion of the
Company's business may involve acquisitions of other telecommunications
businesses and assets or implementation of other technologies either in lieu of
or as a supplement to the technologies contemplated by the Company's current
business plan. In addition, the Company may enter into relationships with
Telecom Service Providers or other entities to manage existing assets or to
deploy alternative telecommunications technologies. Furthermore, the Company may
seek to serve markets which are not under-served or second- or third-tier and
which may present differing market risks (including as to pricing and
competition). If pursued, these opportunities could require additional
financing, impose additional risks (such as increased or different competition,
additional regulatory burdens and network economics different from those
described elsewhere herein) and could divert the resources and management time
of the Company. There can be no assurance that any such opportunity, if pursued,
could be successfully integrated into the Company's operations or that any such
opportunity would perform as expected. Furthermore, as the Company builds out
its network, there can be no assurance that the Company will enter into
agreements with the best-suited Incumbents or such other owners of
telecommunications assets, as the case may be. Moreover, there can be no
assurance that the resulting network will match or be responsive to the demand
for telecommunications capacity or will maximize the possible revenue to be
earned by the Company. There can be no assurance the Company will be able to
develop and expand its business and enter new markets as currently planned.
Failure of the Company to implement its expansion and growth strategy
successfully could have a material adverse effect on the Company's business,
financial condition and results of operations.
RISKS RELATED TO EXPANSION IN STRATEGY.
On February 3, 1999, the Company announced it had expanded its business
strategy to include construction and deployment of digital networks using both
wireless and fiber optic technologies. The Company has limited experience in
designing and budgeting, deploying, operating and maintaining a fiber network.
In addition, the Company could encounter customers with preferences in employing
one technology over another. There can be no assurance the Company will
effectively design and budget, deploy, operate or maintain such facilities or
that it will be able to address such potential customer preferences. Further,
there can be no assurance that the fiber network deployed by the Company will
provide the expected functionality.
To the extent that the Company enters into co-development or other
partnering arrangements where the Company's partner has primary responsibility
for key network development matters such as perfecting rights-of-way or project
management, there can be no assurance that such partners will perform such tasks
adequately or that any failures in such performance will not adversely effect
the Company's financial condition, business or results of operations.
DEPENDENCE ON RELATIONSHIP WITH INCUMBENTS; RIGHTS OF INCUMBENTS TO
CERTAIN ASSETS
There can be no assurance that existing long-term relationships with
the Company's Incumbents will be maintained or that additional long-term
relationships will result on terms acceptable to the Company, or at all. If the
Company is not successful in negotiating such agreements, its ability to deploy
its network would be adversely affected.
22
The Company does not typically expect to own the underlying sites and
facilities upon which the wireless portion of its network is deployed. Instead,
the Company has entered into and expects to enter into long-term relationships
with Incumbents whereby each such Incumbent agrees to grant to the Company a
leasehold interest in or a similar right to use such Incumbent's facilities and
infrastructure as is required for the Company to deploy its network. In some
cases, system assets may be held by subsidiaries in which both the Company and
the Incumbent own an interest. As a result, the Company will depend on the
facilities and infrastructure of its Incumbents for the operation of its
business. Long-term relationships with Incumbents may expire or terminate if the
Company does not satisfy certain performance targets with respect to sales of
telecommunications capacity or fails to commission an initial communications
system within specified time periods. In such cases, certain equipment relating
to the initial communications system will be transferred to the Incumbent. Any
such expiration of a relationship with an Incumbent, and the resulting loss of
use of the corresponding system and opportunity to utilize such segment of its
network, could result in the Company not being able to recoup its initial
capital expenditure with respect to such segment and could have a material
adverse effect on the business and financial condition of the Company. In
addition, such a loss under certain circumstances could result in an event of
default under the Company's debt financings. There can be no assurance that the
Company will continue to have access to such Incumbent's sites and facilities
after the expiration of such agreements or in the event that an Incumbent elects
to terminate its agreement with the Company. If such an agreement were
terminated or expire and the Company were forced to remove or abandon a
significant portion of its network, such termination or expiration, as the case
may be, could have a material adverse effect on the business, financial
condition and results of operations of the Company.
The Company expects to rely significantly on its Incumbents for the
maintenance and provisioning of circuits on the wireless portion of its network.
The Company has entered into maintenance agreements with six Incumbents and
expects to enter into agreements with additional Incumbents pursuant to which,
among other things, the Company will pay the Incumbent a monthly maintenance fee
and a provisioning services fee in exchange for such Incumbent providing
maintenance and provisioning services for that portion of the Company's network
that primarily resides along such Incumbent's system. Failure by the Company to
enter successfully into similar agreements with other Incumbents or the
cancellation or non-renewal of any of such existing agreements could have a
material adverse effect on the Company's business. To the extent the Company is
unable to establish similar arrangements in new markets with additional
Incumbents or establish replacement arrangements on systems where a maintenance
agreement with a particular Incumbent is canceled or not renewed, the Company
may be required to maintain its network and provision circuits on its network
through establishment of its own maintenance and provisioning workforce or by
outsourcing maintenance and provisioning to a third party. The Company's
operating costs under these conditions may increase.
NEED TO OBTAIN AND MAINTAIN RIGHTS-OF-WAY.
The Company expects to obtain easements, rights-of-way, franchises and
licenses from various private parties, ILECs, utilities, railroads, long
distance companies, state highway authorities, local governments and transit
authorities in order to construct and maintain its fiber optic network. If the
Company were to acquire right-of-way directly from a governmental authority, it
would be directly affected by state and local law. To the extent that the
Company obtains rights-of-way from others, it would be indirectly affected by
state and local law. There is a possibility that disputes may arise with
23
the licensing authority or a competitor, the result of which may favor a
competitor of the Company. Such disputes could impose legal and administrative
costs on the Company, including out-of-pocket expenses and lost market
opportunity because of delays. Further, the Company may be subject to franchise
fees imposed by state and local governments. In addition, the Company may
require pole attachment agreements with utilities and ILECs to operate existing
and future networks, and there can be no assurance that such agreements will be
obtained on reasonable terms.
There can be no assurance that the Company will be able to obtain and
maintain the additional rights and permits needed to build its fiber optic
network and otherwise implement its business plan on acceptable terms. The
failure to enter into and maintain required arrangements for the Company's
network could have a material adverse effect on the Company's business,
financial condition and results of operations. There can be no assurance that,
once obtained, the Company will continue to have access to existing
rights-of-way and franchises after the expiration of such agreements. If a
franchise, license or lease agreement were terminated and the Company were
forced to remove or abandon a significant portion of its network, such
termination could have a material adverse effect on the Company.
MANAGEMENT OF GROWTH AND RISKS ASSOCIATED WITH POSSIBLE ACQUISITIONS,
STRATEGIC ALLIANCES AND JOINT VENTURES.
The Company's expanded business plan may, if successfully implemented,
result in rapid expansion of its operations. Rapid expansion of the Company's
operations may place a significant strain on the Company's management, financial
and other resources. The Company's ability to manage future growth, should it
occur, will depend upon its ability to monitor operations, control costs,
maintain regulatory compliance, maintain effective quality controls and expand
significantly the Company's internal management, technical, information and
accounting systems and to attract and retain additional qualified personnel.
Furthermore, as the Company's business develops and expands, the Company will
need additional facilities for its growing workforce. There can be no assurance
that the Company will successfully implement and maintain such operational and
financial systems or successfully obtain, integrate and utilize the employees
and management, operational and financial resources necessary to manage a
developing and expanding business in an evolving and increasingly competitive
industry which is subject to regulatory change. Any failure to expand these
areas and to implement and improve such systems, procedures and controls in an
efficient manner at a pace consistent with the growth of the Company's business
could have a material adverse effect on the business, financial condition and
results of operations of the Company.
The Company believes that a part of its future growth may come from the
formation of strategic alliances with other telecommunications companies
designed to assist and accelerate the building of the Company's digital network
to provide services to customers of the Company which are complementary to those
provided by the Company. The Company intends to pursue joint ventures with, or
acquisitions of, companies that have an existing network infrastructure or
customer base in order to increase the Company's penetration of its markets or
accelerate entry into new markets. Limitations under the Indenture may
significantly limit the Company's ability to make acquisitions and to incur
indebtedness in connection with acquisitions. Such transactions commonly involve
certain risks, including, among others: the difficulty of assimilating the
acquired operations and personnel; the potential disruption of the Company's
ongoing business and diversion of resources and management time; the possible
inability of management to maintain uniform standards, controls, procedures and
policies; the risks of entering
24
markets in which the Company has little or no direct prior experience; and the
potential impairment of relationships with employees or customers as a result of
changes in management. There can be no assurance that any acquisition or joint
venture will be made, that the Company will be able to obtain additional
financing needed to finance such acquisitions and joint ventures and, if any
acquisitions are so made, that the acquired business will be successfully
integrated into the Company's operations or that the acquired business will
perform as expected. The Company has no definitive agreement with respect to any
acquisition, although it has had discussions with other companies and will
continue to assess opportunities on an ongoing basis.
DEPENDENCE ON KEY PERSONNEL; NEED FOR ADDITIONAL PERSONNEL
The success of the Company will depend to a significant extent upon the
abilities and continued efforts of its senior management, particularly members
of its senior management team, including Richard A. Jalkut, President and Chief
Executive Officer, Kevin J. Bennis, Executive Vice President serving as
President of the Company's Communications Services Division, William R. Smedberg
V, Executive Vice President, Corporate Development, and Michael L. Brooks, Vice
President of Network Development. Other than its Employment Agreement with
Richard A. Jalkut, the Company does not have any employment agreements with, nor
does the Company maintain "key man" insurance on, these employees. The loss of
the services of any such individuals could have a material adverse effect on the
Company's business, financial condition and results of operations. The success
of the Company will also depend, in part, upon the Company's ability to
identify, hire and retain additional key management personnel, including the
senior management, who are also being sought by other businesses. Competition
for qualified personnel in the telecommunications industry is intense. The
inability to identify, hire and retain such personnel could have a material
adverse effect on the Company's results of operations.
COMPETITION; PRICING PRESSURES
The telecommunications industry is highly competitive. In particular,
price competition in the carrier's carrier market has generally been intense and
is expected to increase. The Company competes and expects to compete with
numerous competitors who have substantially greater financial and technical
resources, long-standing relationships with their customers and potential to
subsidize competitive services from less competitive service revenues and from
federal universal service subsidies. Such competitors may be operators of
existing or newly deployed wireline or wireless telecommunications networks. The
Company will also face intense competition due to an increased supply of
telecommunications capacity, the effects of deregulation and the development of
new technologies, including technologies that will increase the capacity of
existing networks. See "Business - Competition."
RELIANCE ON EQUIPMENT SUPPLIERS FOR THE WIRELESS PORTION OF THE
COMPANY'S NETWORK
The Company currently purchases most of its telecommunications
equipment pursuant to an agreement with NEC from whom the Company has agreed to
purchase $200 million of equipment by December 31, 2002 and has entered into an
equipment purchase agreement with Andrew. Any reduction or interruption in
supply from either supplier or any increase in prices for such equipment could
have a disruptive effect on the Company. Currently NEC and Northern Telecom Ltd.
are the only
25
manufacturers of SONET radios that are compatible with the Company's proposed
system design and reliability standards relating to the wireless portion of its
network, although Harris Corporation and Alcatel Alsthom Compagnie Generale
d'Electricite SA are in the process of developing and testing similar and
compatible products. Further, the Company does not manufacture, nor does it have
the capability to manufacture, any of the telecommunications equipment used on
its network. As a result, the failure of the Company to procure sufficient
equipment at reasonable prices and in a timely manner could adversely affect the
Company's successful deployment of its network and results of operations.
RELIANCE ON LUCENT; LUCENT AGREEMENTS.
The Company and Lucent have entered into a supply agreement under which
Lucent will provide and will deploy personnel to assist in, among other things,
the design and marketing of the Company's network. Any failure or inability by
Lucent to perform these functions could cause delays or additional costs in
providing services to customers and building out the Company's network in
specific markets. Any such failure could materially and adversely affect the
Company's financial condition, business and results of operations.
The Company and Lucent have entered into the Commitment Letter which is
contingent upon various conditions, including the execution of a definitive
financing agreement, compliance with financial covenants, completion of due
diligence and the absence of any material adverse change in the Company. There
can be no assurance that a definitive agreement will be executed with respect to
the financing contemplated by the Commitment Letter or that the financing
contemplated by the Commitment Letter will be consummated. Any failure to
consummate the financing contemplated by the Commitment Letter could materially
and adversely effect the Company's financial condition, business and results of
operations.
TECHNICAL LIMITATIONS OF THE WIRELESS NETWORK
The Company will not be able to offer route diversity until such time
as it has completed a substantial portion of its mature network. In addition,
the wireless portion of the Company's network requires a direct line of sight
between two antennae (each such interval comprising a "path") which is subject
to distance limitations, freespace fade, multipath fade and rain attenuation. In
order to meet industry standards for reliability, the maximum length of a single
path similar to those being designed by the Company is generally limited to 40
miles and, as a result, intermediate sites in the form of back-to-back terminals
or repeaters are required to permit digital wireless transmission beyond this
limit based on the climate and topographic conditions of each path. In the
absence of a direct line of sight, additional sites may be required to
circumvent obstacles, such as tall buildings in urban areas or mountains in
rural areas. Topographic conditions of a path and climate can cause reflections
of signals from the ground, which can affect the transmission quality of digital
wireless services. In addition, in areas of heavy rainfall, the intensity of
rainfall and the size of the raindrops can affect the transmission quality of
digital wireless services. Paths in these areas are engineered for shorter
distances to maintain transmission quality and use space diversity, frequency
diversity, adaptive power control and forward error correction to minimize
transmission errors. The use of additional sites and shorter paths to overcome
obstructions, multipath fade or rain attenuation will increase the Company's
capital costs. While these increased costs may not be significant in all cases,
such costs may render digital wireless services uneconomical in certain
circumstances.
26
Due to line of sight limitations, the Company currently installs its
antennae on towers, the rooftops of buildings or other tall structures. Line of
sight and distance limitations generally do not present problems because
Incumbents have already selected, developed and constructed unobstructed
transmission sites. In certain instances, however, the additional frequencies
required for the excess capacity to be installed by the Company may not be
available from Incumbents' existing sites. In these instances, the Company
generally expects to use other developed sites already owned or leased by such
Incumbent. In some instances, however, the Company has encountered, and may in
the future encounter, line of sight, frequency blockage and distance limitations
that cannot be solved economically. While the effect on the financial condition
and results of operations of the Company resulting from such cases has been
minimal to date, there can be no assurance that such limitations will not be
encountered more frequently as the Company expands its network. Such limitations
may have a material adverse effect on the Company's future development costs and
results of operations. In addition, the current lack of compression applications
for wireless technology limits the Company's ability to increase capacity on the
wireless portion of its network without significant capital expenditures for
additional equipment.
RISKS RELATING TO INTERCONNECTION
In order to obtain the necessary access to install its radios, antennae
and other equipment required for interconnection of the Company's network to the
public switched telephone network or to POPs of the Company's customers, the
Company must acquire the necessary rights and enter into the arrangements to
secure such interconnections and deploy and operate such interconnection
equipment. There can be no assurance that the Company will succeed in obtaining
the rights necessary to secure such interconnections and to deploy its
interconnection equipment in its market areas on acceptable terms, if at all, or
that delays in or terms for obtaining such rights will not have a material
adverse effect on the Company's development or results of operations.
DEPENDENCE ON INFORMATION AND PROCESSING SYSTEMS
Sophisticated information and processing systems are vital to the
Company's growth and its ability to monitor network performance, provision
customer orders for telecommunications capacity, bill customers accurately,
provide high-quality customer service and achieve operating efficiencies. As the
Company grows, any inability to operate its billing and information and
processing systems, or to upgrade internal systems and procedures as necessary,
could have a material adverse impact on the Company's ability to reach its
objectives, or on its business, financial condition and results of operations.
RISK OF RAPID TECHNOLOGICAL CHANGES
The telecommunications industry is subject to rapid and significant
changes in technology. Although the Company has expanded its business plan to
include fiber optic technologies, which may diversify the Company's exposure to
the risk of such technological changes, their effect on the business of the
Company cannot be predicted. There can be no assurance that (i) the Company's
network will not be economically or technically outmoded by technology or
services now existing or developed and implemented in the future, (ii) the
Company will have sufficient resources to develop or acquire new technologies or
to introduce new services capable of competing with future technologies or
service offerings or (iii) the cost of the equipment used on its network will
decline as rapidly as that of competitive alternatives. The occurrence of any of
the foregoing events may have a material adverse
27
effect on the operations of the Company.
REGULATION
RISKS RELATING TO REGULATION OF WIRELESS NETWORK. The Company's
arrangements with Incumbents contemplate that the wireless portion of the
Company's digital network will provide largely "common carrier fixed
point-to-point microwave" telecommunications services under Part 101 ("Part
101") of the rules of the FCC, which services are subject to regulation by
federal, state and local governmental agencies. Changes in existing federal,
state or local laws and regulations, including those relating to the provision
of Part 101 telecommunications services, any failure or significant delay in
obtaining (or complying with the terms of) necessary licenses, permits or
renewals, or any expansion of the Company's business that subjects the Company
to additional regulatory requirements could have a material adverse effect on
the Company's business, financial condition, and results of operations.
FCC LICENSE REQUIREMENTS. Prior to applying to the FCC for
authorization to use portions of the 6 GHz band, the Company must coordinate its
use of the frequency with any existing licensees, permittees, and applicants in
the same area whose facilities could be subject to interference as a result of
the Company's proposed use of the spectrum. There can be no assurance in any
particular case that the Company will not encounter other entities and proposed
uses of the desired spectrum that would interfere with the Company's planned
use, and that the Company will be able to coordinate successfully such usage
with such entities. In addition, as part of the requirements of obtaining a Part
101 license, the FCC requires the Company to demonstrate the site owner's
compliance with the reporting, notification and technical requirements of the
Federal Aviation Administration ("FAA") with respect to the construction,
installation, location, lighting and painting of transmitter towers and
antennae, such as those to be used by the Company in the operation of its
network. Furthermore, in order to obtain the Part 101 licenses necessary for the
operation of its network, the Company, and in some cases Incumbents, must file
applications with the FCC for such licenses and demonstrate compliance with
routine technical and legal qualification to be an FCC licensee. The Company
must also obtain FCC authorization before transferring control of any of its
licenses or making certain modifications to a licensed facility. There can be no
assurance that the Company or any Incumbent who desires to be the licensee with
respect to its portion of the Company's network will obtain all of the licenses
or approvals necessary for the operation of the Company's 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 or approval.
RISKS RELATING TO REGULATION OF FIBER NETWORK. Pursuant to the
interconnection provisions of the Telecommunications Act of 1996 (the "1996
Telecom Act"), the FCC identified a minimum list of unbundled network elements
that ILECs must make available to other telecommunications carriers. The FCC
declined to include incumbent ILECs' dark fiber in this list, finding that it
did not have adequate information to determine whether dark fiber qualifies as a
network element. The FCC indicated that is would continue to review or revise
its rules regarding unbundled network elements as necessary. State commissions,
however, have the authority to impose additional unbundling requirements so long
as the requirements are consistent with the 1996 Telecom Act and the FCC's
requirements, which could include requiring incumbent ILECs to unbundle their
dark fiber.
In the recent Supreme Court decision regarding the FCC's
interconnection and unbundling rules,
28
the Supreme Court vacated the FCC's rule establishing the list of unbundled
network elements. The Supreme Court found that the FCC had not interpreted the
terms of the 1996 Telecom Act regarding an incumbent ILEC's duty to provide
network elements in a reasonable fashion. The Supreme Court found that the FCC
had given telecommunications carriers blanket access to unbundled network
elements. The statute, however, limits telecommunications carriers' access to
network elements to those that are "necessary" or to those where failure to have
access would "impair the ability of the telecommunications carrier" to provide
services it seeks to offer. The FCC plans to commence a rulemaking proceeding to
adopt new requirements regarding unbundled network elements that properly
consider the "necessary and impair" standard in the 1996 Telecom Act.
A decision by the FCC or states to require unbundling of incumbent
ILECs' dark fiber could increase the supply of dark fiber and decrease demand
for the Company's dark fiber, and thereby have an adverse effect on the Company'
business, financial condition and results of operations.
GENERAL
PROVISION OF COMMON AND PRIVATE CARRIER SERVICES. The Company is
currently offering, and expects to offer in the future, its services on a
private carrier basis. The Company's private carrier services are essentially
unregulated, while any common carrier offerings would be subject to additional
regulations and reporting requirements including payment of additional fees and
compliance with additional rules and regulations including that any such
services must be offered pursuant to filed tariffs and non-discriminatory terms,
rates and practices. There can be no assurance that the FCC will not find that
some or all of the private carrier services offered by the Company are in fact
common carrier services, and thus subject to such additional regulations and
reporting requirements including the non-discrimination and tariff filing
requirements imposed on common carriers, in which case the Company may be
required to pay additional fees or adjust, modify or cease provision of certain
of its services in order to comply with any such regulations, including offering
such services on the same terms and conditions to all of those seeking such
services, and pursuant to rates made public in tariff filings at the FCC.
FOREIGN OWNERSHIP. As the licensee of facilities designated for common
carriage, the Company is subject to Section 310(b)(4) of the Communications Act
of 1934, as amended (the "Communications Act"), which by its terms restricts the
holding company of an FCC common carrier licensee (the Company is such a holding
company, because it expects to hold all FCC licenses indirectly, through
subsidiaries) to a maximum of 25% foreign ownership and/or voting control. The
FCC has determined that it will authorize a higher level of foreign ownership
(up to 100%) on a streamlined basis where the indirect foreign investment in the
common carrier licensee is by citizens of, or companies organized under the laws
of World Trade Organization ("WTO") member countries. Where the foreign
ownership is by citizens or corporations of non-WTO nations, FCC authorization
to exceed the 25% limitation must be obtained on a non-streamlined basis and the
licensee must meet a more demanding public interest showing. The Company is
presently within the 25% foreign ownership limitation. In connection with any
future financings, the Company will have to monitor foreign investment to ensure
that its foreign ownership does not exceed the 25% limitation. If it appeared
that foreign ownership of the Company was coming close to exceeding this
benchmark, the Company would have to obtain FCC authorization prior to exceeding
the 25% limitation. In addition, if any Incumbent elects to be the licensee on
the portion of the Company's network relating to its system, such Incumbent
would also be subject to such
29
foreign ownership restrictions. If such analysis showed that such Incumbent had
more than 25% foreign ownership, the Incumbents would have to seek authorization
from the FCC to exceed the 25% limitation or it would have to reduce its foreign
ownership.
In the event that an Incumbent were to choose to hold the relevant Part
101 license itself, and not through a holding company, that Incumbent would be
subject to Section 310(b)(3) of the Communications Act, which limits direct
foreign ownership of FCC licenses to 20%. The FCC does not have discretion to
waive this limitation. If an Incumbent exceeded the 20% limitation it would be
required to reduce its foreign ownership in order to obtain or retain its Part
101 license.
STATE AND LOCAL REGULATION. Although the Company expects to provide
most of its services on an interstate basis, in those instances where the
Company provides service on an intrastate basis, the Company may be required to
obtain a certification to operate from state utility commissions in certain of
the states where such intrastate services are provided, and may be required to
file tariffs covering such intrastate services. In addition, the Company may be
required to obtain authorizations from or notify such states with respect to
certain transfers or issuances of capital stock of the Company. The Company does
not expect any such state or local requirements to be burdensome; however, there
can be no assurance that the Company will obtain all of the necessary state and
local approvals and consents or that the failure to obtain such approvals and
consents will not have a material adverse affect on the Company's business,
financial condition and results of operations. In addition, there can be no
assurance that state or local authorities will not impose burdensome taxes,
requirements or conditions on the Incumbent or the Company.
INVESTMENT COMPANY ACT CONSIDERATIONS
The Company has substantial cash, cash equivalents and short-term
investments. The Company has invested and intends to invest the proceeds of its
financing activities so as to preserve capital by investing primarily in
short-term instruments consistent with prudent cash management and not primarily
for the purpose of achieving investment returns. Investment in securities
primarily for the purpose of achieving investment returns could result in the
Company being treated as an "investment company" under the Investment Company
Act of 1940 (the "1940 Act"). The 1940 Act requires the registration of, and
imposes various substantive restrictions on, investment companies that are, or
hold themselves out as being, engaged primarily, or propose to engage primarily
in, the business of investing, reinvesting or trading in securities, or that
fail certain statistical tests regarding the composition of assets and sources
of income and are not primarily engaged in businesses other than investing,
reinvesting, owning, holding or trading securities.
The Company believes that it is primarily engaged in a business other
than investing, reinvesting, owning, holding or trading securities and,
therefore, is not an investment company within the meaning of the 1940 Act. If
the Company were required to register as an investment company under the 1940
Act, it would become subject to substantial regulation with respect to its
capital structure, management, operations, transactions with affiliated persons
(as defined in the 1940 Act) and other matters. Application of the provisions of
the 1940 Act to the Company would have a material adverse effect on the
Company's business, financial condition and results of operations.
30
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable
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.
31
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
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 (1) ...................... 54 President, Chief Executive Officer and Director
Kevin J. Bennis ............................ 45 Executive Vice President, and President,
Communications Services Division
William R. Smedberg, V...................... 37 Executive Vice President, Corporate Development,
Treasurer and Assistant Secretary
Michael A. Lubin ........................... 49 Vice President, General Counsel and Secretary
Michael L. Brooks .......................... 55 Vice President, Network Development
David Schaeffer (1)......................... 42 Director
Peter J. Barris (2) ........................ 47 Director
Kevin J. Maroni (2)(3) ..................... 36 Director
Patrick J. Kerins (3) ...................... 43 Director
Richard K. Prins (2)(3) .................... 41 Director
Stephen A. Reinstadtler .................... 32 Director
- ------------------------------------
(1) Member of Contract Committee.
(2) Member of Compensation Committee.
(3) Member of Audit Committee.
Set forth below is the background of each of the Company's executive
officers and directors.
RICHARD A. JALKUT has served as President, Chief Executive Officer 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. Prior to that, Mr. Jalkut served as President and Chief
Executive Officer of New York Telephone Co. Inc., the predecessor company to
NYNEX Telecommunications Group, from 1991 until 1995. Mr. Jalkut currently
serves as a member of the Board of Directors of Marine Midland Bank, a
commercial bank, Ikon Office Solutions, Inc., a company engaged in wholesale and
retail office equipment, and Home Wireless Networks, a start-up company
developing a wireless product for home and business premises.
KEVIN J. BENNIS has served as Executive Vice President, serving as
President of the Company's Communications Services Division since February 1998.
From 1996 until he joined the
32
Company, Mr. Bennis served as President of Frontier Communications, a long
distance communications company, where he was responsible for the sales,
marketing and customer service activities of 3,500 employees. Prior to that, Mr.
Bennis served in various positions for 21 years at MCI, including as President
of MCI's Integrated Client Services Division from 1995 to 1996, as President and
Chief Operating Officer of Avantel Telecommunications, MCI's joint venture with
Banamex in Mexico, from 1994 to 1995, and as Senior Vice President of Marketing
from 1992 to 1994.
WILLIAM R. SMEDBERG, V joined the Company initially as a consultant in
1996, served as Vice President, Finance and Corporate Development from January
1997 to February 1999 and assumed the position of Executive Vice President,
Corporate Development in March 1999. Prior to joining the Company, Mr. Smedberg
served in various financial and planning positions at the James River
Corporation of Virginia, Inc. ("James River") for nine years. In particular, he
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, from 1991 to 1996, where he was responsible for Jamont's corporate
finance, strategic planning and corporate development. Prior to that, Mr.
Smedberg worked in the defense industry as a consultant and engineer for TRW,
Inc.
MICHAEL A. LUBIN has served as Vice President, General Counsel and
Secretary of the Company since its inception in August 1995. Prior to joining
the Company, Mr. Lubin was an attorney-at-law at Michael A. Lubin, P.C., a law
firm, which he founded in 1985. Mr. Lubin has experience in telecommunications
matters, copyright and intellectual property matters, corporate and commercial
law, construction claims adjudication and trial work. Earlier he served as a
Federal prosecutor with the Fraud Section, Criminal Division, United States
Department of Justice.
MICHAEL L. BROOKS has served as Vice President, Network Development of
the Company since June 1996. Mr. Brooks has extensive experience in voice and
data communications. From 1992 through May 1996, Mr. Brooks served as Vice
President, Engineering for Ikelyn, Inc. Ikelyn provided system design and
technical support for telecommunication systems and support facilities. From
1982 to 1992, Mr. Brooks worked for Qwest Microwave Communications, a
predecessor of Qwest, where he directed the initial construction of a 3,500-mile
digital network.
DAVID SCHAEFFER founded the Company in August 1995 and has been a
director of the Company since its inception. Mr. Schaeffer served as Chairman of
the Board and Treasurer of the Company from August 1997 to February 1999, and
served as President, Chief Executive Officer and Treasurer of the Company from
August 1995 until August 1997. From 1986 to the present, Mr. Schaeffer has also
served as President and Chief Executive Officer of Empire Leasing, Inc., a
specialized mobile radio licensee and operator. In addition, Mr. Schaeffer
founded and, since 1992, has served as President and Chief Executive Officer of
Mercury Message Paging, Inc., a paging company which operates networks in
Washington, D.C., Baltimore and Philadelphia.
PETER J. BARRIS has been a director of the Company since August 1995.
Since 1992, Mr. Barris has been a partner, and, in 1994, was appointed a 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. and pcOrder.com, Inc. each of which are 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 as a
General Partner of Spectrum Equity
33
Investors, L.P., which manages private equity funds focused on growth capital
for telecommunications companies. From 1992 to 1994, he served as Manager,
Finance and Development at Time Warner Telecommunications, where he was involved
in corporate development projects. Mr. Maroni served as a consultant at Harvard
Management Company from 1990 to 1992, where he worked in the private equity
group. Mr. Maroni is also currently on the board of directors of several private
companies and CTC Communications Corp., an integrated communications provider
that is quoted on the Nasdaq National Market.
PATRICK J. KERINS has been a director of the Company since July 1997.
Mr. Kerins has served as Managing Director of Grotech Capital Group, which is
engaged in venture capital and other private equity investments, since March
1997. 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 also a member of the Board of Directors
of CDnow, Inc., an online retailer of compact discs and other music-related
products, which is quoted on the Nasdaq National Market.
RICHARD K. PRINS has been a director of the Company since 1995. Since
1996, Mr. Prins has served as Senior Vice President of Ferris Baker Watts
Incorporated, where he heads the technology and communication practice in the
investment banking division. From 1988 to 1996, he was Senior Vice President and
Managing Director in the investment banking division of Crestar Financial
Corporation. Mr. Prins is currently a director of Startec Global Communications
Corporation, a communications company that is quoted on the Nasdaq National
Market.
STEPHEN A. REINSTADTLER has been a director of the Company since
October 1997. 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, since August 1995. From April 1994 to
July 1995, he served as 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.
DIRECTOR COMPENSATION
Mr. Prins, a director of the Company, was granted options to purchase
70,131 shares of Common Stock in 1995. See "Security Ownership of Certain
Beneficial Owners and Management." Directors of the Company are currently
neither compensated nor reimbursed for their out-of-pocket expenses incurred in
connection with attendance at meetings of, and other activities relating to
serving on, the Board of Directors and any committees thereof. The Company may
consider additional compensation arrangements for its directors from time to
time.
LIMITATION OF LIABILITY AND INDEMNIFICATION
The Restated Certificate of Incorporation of the Company limits, to the
fullest extent permitted by law, the liability of directors to the Company and
its stockholders for monetary damages for breach of directors' fiduciary duty.
This provision is intended to afford the Company's directors benefit of the
Delaware General Corporation Law (the "DGCL"), which provides that directors of
Delaware corporations may be relieved of monetary liability for breach of their
fiduciary duty of care, except under
34
certain circumstances. This limitation on liabilities does not extend to
including any breach of a director's duty of loyalty, acts or omissions not in
good faith or which involve intentional misconduct or a knowing violation of
law, violations of the DGCL regarding the improper payment of dividends or any
transaction from which the director derived any improper personal benefit. In
addition, the Certificate of Incorporation of the Company provides that the
Company will indemnify its directors and officers to the fullest extent
authorized or permitted by law.
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 the four other most highly compensated executive officers of the Company
(the "Named Executive Officers") for services rendered in all capacities in each
of the years ended December 31, 1998 and 1997.
Long - Term
Compensation
Securities
Annual Compensation * Other Underlying
Name And Principal Position Year Salary Bonus Compensation Options Granted
- --------------------------- ---- ------ ----- ------------ ---------------
Richard A. Jalkut 1998 $400,000 $ -- $ 40,289(1) --
President and Chief Executive Officer 1997 166,154(2) -- 9,857(3) 858,754
David Schaeffer 1998 300,000 -- -- --
Chairman of the Board and Treasurer 1997 216,923(4) -- -- 430,413
Kevin J. Bennis 1998 246,353(5) -- 185,602(6) 382,500
Executive Vice President and President 1997 -- -- --
Communications Services
Michael A. Lubin 1998 136,840 5,000 -- 15,000
Vice President, General Counsel and 1997 136,115 -- -- --
Secretary
Michael L. Brooks 1998 102,000 38,780 -- 85,732
Vice President, Network Operations 1997 103,077 -- --
- -----------------------------------
* 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.
(1) Consists of $16,277 for club dues; $7,756 for lodging; $11,685 for
airfare; and $4,571 for other transportation.
(2) Mr. Jalkut commenced employment with the Company in August 1997, and
was compensated at a rate of $400,000 per annum in 1997.
(3) Reimbursement for travel expenses.
(4) Mr. Schaeffer's salary increased to $300,000 per annum from $150,000
per annum in August 1997.
(5) Mr. Bennis joined the Company in February 1998.
(6) 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.
35
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, 1998. 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 ........ -- -- $ -- -- $ -- $ -- $ --
David Schaeffer........... -- -- -- -- -- -- --
Kevin J. Bennis........... 362,500(3) 32.74% 1.13 3/24/2008 1,475,375 2,660,841 4,479,580
20,000(3) 1.81% 5.20 12/2/2008 -- 65,405 165,749
Michael A. Lubin ......... 15,000(3) 1.35% 5.20 12/2/2008 -- 49,054 124,312
Michael L. Brooks ........ 70,732(2) 6.39% 1.13 3/24/2008 287,879 519,191 878,567
15,000(3) 1.35% 5.20 12/2/2008 -- 49,054 124,312
- ------------------------
(1) The information disclosed assumes, solely for purposes of demonstrating
potential realizable value of the stock options, that the fair market
value per share of Common Stock was $5.20 per share (the fair market
value per share of Common Stock approved by the Board of Directors in
connection with stock option awards granted on December 2, 1998 and
January 26, 1999, which awards had an exercise price equal to the fair
market value per share on the date of grant) as of December 31, 1998
and increases at the rate indicated during the option term. See Note 10
to the financial statements included elsewhere in this Report.
(2) The options vest ratably over a three 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.
(3) 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.
Option Exercises and Fiscal Year-End Option Values
None of the Named Executive Officers exercised any options during the
fiscal year ended December 31, 1998. The following table sets forth as of
December 31, 1998, the aggregate number of options held by each of the Named
Executive Officers.
36
FISCAL YEAR-END OPTION VALUES
Number of Securities
Underlying Unexercised Value of Unexercised In-the-
Options at December 31, 1998 Money Options (1)
---------------------------- -----------------
Name Exercisable Unexercisable Exercisable Unexercisable
- ---- ----------- ------------- ----------- -------------
Richard A. Jalkut ......................... 286,251 572,503 $ 1,165,042 $ 2,330,087
David Schaeffer ......................... -- 430,413 (2) -- 658,532
Michael A. Lubin........................... 141,465 15,000 731,374 --
Kevin J. Bennis............................ 90,625 291,875 368,844 1,106,531
Michael L. Brooks.......................... 35,366 50,366 143,940 143,940
- ------------------------------
(1) Based on an assumed market price of the Common Stock of $5.20 per share.
(2) One-half of Mr. Schaeffer's options, or 215,206, would vest on January
1, 1999, at an exercise price of $3.67 per share, in the event that
certain performance criteria related to 1998 earnings have been met. The
Board of Directors' is currently reviewing whether these criteria were
met. See Note 10 to the Company's Consolidated Financial Statements that
appear elsewhere in this Annual Report on Form 10-K.
JALKUT EMPLOYMENT AGREEMENT
The Employment Agreement among the Company and Richard Jalkut (the
"Jalkut Employment Agreement") took effect on August 4, 1997 and expires on
August 4, 2000. The Jalkut Employment Agreement will renew automatically for
successive one-year terms unless terminated by either party. Under the Jalkut
Employment Agreement, Mr. Jalkut is entitled to an annual base salary of
$400,000, subject to increase at the discretion of the Company. In addition, Mr.
Jalkut is entitled to participate in the Company's benefit plans on the same
basis as other salaried employees of the Company and on the same basis as other
senior executives of the Company and is entitled to reimbursement up to a total
of $50,000 per year for certain expenses including an apartment in the
Washington D.C. area, club memberships and the expenses incurred by Mr. Jalkut
commuting between his Washington D.C. and New York residences.
In addition, pursuant to the Jalkut Employment Agreement, on August 4,
1997 Mr. Jalkut received nonqualified stock options on 858,754 shares of Common
Stock at an exercise price of $1.13 per share. Such options will vest ratably
over three years. Under the Jalkut Employment Agreement, upon the election of
Mr. Jalkut within 10 business days after the date of termination of Mr. Jalkut's
employment with the Company, the Company will be required to pay, subject to the
terms of the Indenture, to Mr. Jalkut the aggregate Fair Value (as defined in
the Non-qualified Option Agreement by and between the Company and Mr. Jalkut
dated August 4, 1997) of the options then vested or held by Mr. Jalkut on the
date of such termination of employment with the Company.
The Jalkut Employment Agreement (other than certain restrictive
covenants of Mr. Jalkut that are described below and an obligation of the
company to pay severance for one year following the termination of Mr. Jalkut's
employment with the Company) may be terminated (i) by the Company (a) without
cause by giving 60 days' prior written notice or (b) for cause upon the Board of
Directors' confirmation that Mr. Jalkut has failed to cure the grounds for
termination within 30 days of notice thereof and (ii) by Mr. Jalkut (a) without
cause by giving 180 days' prior written notice and (b) immediately upon a
"Constructive Termination" (as defined below). The Jalkut Employment Agreement
prohibits disclosure by Mr. Jalkut of any of the Company's confidential
information at any time. In
37
addition, while he is employed by the Company and for two year thereafter, Mr.
Jalkut is prohibited from engaging or significantly investing in competing
business activities and from soliciting any Company employee to be employed
elsewhere. The Company has granted Mr. Jalkut registration rights with respect
to the shares he will receive upon exercise of his options. "Constructive
Termination" is defined in the Jalkut Employment Agreement to mean the
occurrence, without Mr. Jalkut's prior written consent, of one or more of the
following events: (1) a reduction in Mr. Jalkut's then current annual base
salary or the termination or material reduction of any employee benefit or
perquisite enjoyed by him (other than as part of an across-the-board reduction
applicable to all executive officers of the Company); (2) the failure to elect
or reelect Mr. Jalkut to the position of chief executive officer or removal of
him from such position; (3) a material diminution in Mr. Jalkut's duties or the
assignment to Mr. Jalkut of duties which are materially inconsistent with his
duties of which materially impair Mr. Jalkut's ability to function as the chief
executive officer of the Company; (4) the failure to continue Mr. Jalkut's
participation in any incentive compensation plan unless a plan providing a
substantially similar opportunity is substituted, or under certain other limited
circumstances; or (5) the relocation of the Company's principal office.
OTHER AGREEMENTS
Messrs. Schaeffer, Lubin, Brooks, Bennis and Smedberg each have entered
into Employee Agreements Regarding Non-Disclosure, Assignment of Inventions and
Non-Competition with the Company in which such persons agreed (i) not to
disclose any of the Company's confidential and proprietary information to third
parties, (ii) to assign all work products to the Company as "works for hire,"
and (iii) not to compete against the Company for a two-year period following the
termination of the respective person's employment with the Company.
In exchange for the non-compete covenant and a restriction on
soliciting any employee of the Company to be employed elsewhere, the Company has
agreed to pay Mr. Bennis a severance payment in the aggregate amount of $275,000
paid over one year if his employment with the Company is terminated for any
reason.
38
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information concerning
beneficial ownership of the capital stock of the Company as of December 31, 1998
by (i) each person known by the Company to be the beneficial owner of more than
five percent of the outstanding capital stock of the Company, (ii) each director
of the Company, (iii) each of the Named Executive Officers and (iv) all
directors and Named Executive Officers of the Company as a group. Unless
otherwise indicated, each of the stockholders listed below has sole voting and
investment power with respect to the shares shown as beneficially owned by them.
Name and Address Series A Preferred Series B Preferred Series C Preferred
Common ------------------ ------------------ ------------------
Stock Shares(2) Percentage Shares(2) Percentage Shares(2) Percentage
----- --------- ---------- --------- ---------- --------- ----------
Spectrum Equity Investors, L.P. (6)..... -- 1,276,000 44.0% 1,134,175 23.7% 1,363,406 16.7%
Spectrum Equity Investors II, L.P. (6).. -- -- -- -- -- 1,363,406 16.7%
New Enterprise Associates VI, Limited
Partnership (7)......................... -- 522,000 18.0% 685,014 14.3% 1,374,051 16.8%
Onset Enterprise Associates II, L.P. (8) -- 522,000 18.0% 463,976 9.7% 817,672 10.0%
Onset Enterprise Associates III, L.P.
(8)..................................... -- -- -- -- -- 272,553 3.3%
Corman Foundation Incorporated (9).. -- 96,668 3.3% 85,924 1.7% -- --
IAI Investment Funds VIII, Inc. (IAI
Value Fund) (10)........................ -- 290,000 10.0% 125,143 2.6% -- --
Thomas Domencich (11)................... -- 145,000 5.0% 62,573 1.3% -- --
FBR Technology Venture Partners L.P.
(12).................................... -- -- -- -- -- 272,556 3.3%
Toronto Dominion Capital (USA) Inc. (13) -- -- -- 884,146 18.5% 1,006,500 12.3%
Grotech Partners IV, L.P. (14).......... -- -- -- 884,146 18.5% 1,006,500 12.3%
Utech Climate Challenge Fund, L.P. (15) -- -- -- 442,076 9.2% 136,276 1.7%
Utility Competitive Advantage Fund, LLC
(15).................................... -- -- -- -- -- 366,980 4.5%
David Schaeffer(16)..................... 2,900,000 -- -- -- -- -- --
Richard A. Jalkut....................... -- -- -- -- -- -- --
Kevin J. Maroni (17).................... -- -- -- -- -- -- --
Peter J. Barris (18).................... -- -- -- -- -- -- --
Patrick J. Kerins (19).................. -- -- -- -- -- -- --
Stephen A. Reinstadtler (20)............ -- -- -- -- -- -- --
Michael A. Lubin........................ -- -- -- -- -- -- --
Kevin Bennis............................ -- -- -- -- -- -- --
Michael L. Brooks....................... -- -- -- -- -- -- --
Richard K. Prins........................ -- -- -- -- -- -- --
All Directors and Named Executive
Officers as a Group ................... 2,900,000 -- -- -- -- -- --
- -------------------
Beneficial Ownership
Name and Address of Common Stock (1)
- ---------------- ------------------- Percentage
Total Percentage on a
Stock ----- ---------- Diluted
Options(3) Shares (4) Basis (5)
---------- ------ --- ---------
Spectrum Equity Investors, L.P. (6)..... -- 3,773,581 56.5% 19.2%
Spectrum Equity Investors II, L.P. (6).. -- 1,363,406 31.7% 6.9%
New Enterprise Associates VI, Limited
Partnership (7)......................... -- 2,581,065 47.1% 13.9%
Onset Enterprise Associates II, L.P. (8) -- 1,803,648 38.3% 9.2%
Onset Enterprise Associates III, L.P.
(8)..................................... -- 272,553 8.6% 1.4%
Corman Foundation Incorporated (9)...... -- 182,592 5.9% 0.9%
IAI Investment Funds VIII, Inc. (IAI
Value Fund) (10)........................ -- 415,143 12.5% 2.1%
Thomas Domencich (11)................... -- 207,573 6.7% 1.0%
FBR Technology Venture Partners L.P. -- 272,556 8.6% 1.4%
(12)....................................
Toronto Dominion Capital (USA) Inc. (13) -- 1,890,646 39.4% 9.6%
Grotech Partners IV, L.P. (14).......... -- 1,890,646 39.4% 9.6%
Utech Climate Challenge Fund, L.P. (15) -- 578,352 16.6% 2.9%
Utility Competitive Advantage Fund, LLC
(15).................................... -- 366,980 11.2% 1.8%
David Schaeffer(16)..................... -- 2,900,000 99.9% 14.7%
Richard A. Jalkut....................... 286,251 286,251 9.0% 1.4%
Kevin J. Maroni (17).................... -- -- -- --
Peter J. Barris (18).................... -- -- -- --
Patrick J. Kerins (19).................. -- -- -- --
Stephen A. Reinstadtler (20)............ -- -- -- --
Michael A. Lubin........................ 141,485 141,485 4.6% 0.7%
Kevin Bennis............................ -- -- -- --
Michael L. Brooks....................... 35,366 35,366 1.2% 0.2%
Richard K. Prins........................ 70,731 70,731 2.4% 0.4%
All Directors and Named Executive
Officers as a Group .................... 528,853 3,433,933 99.9% 17.4%
- -------------------
39
(1) Consists of the sum of the shares of Common Stock owned and shares of
Common Stock issuable upon the exercise of stock options and upon the
conversion of the Series A Convertible Preferred Stock Series, B
Convertible Preferred Stock and Series C Convertible Preferred Stock
that are exercisable or convertible within 60 days after December 31,
1998.
(2) The shares represent the product of a stock split and the numbers shown
here are rounded to the whole number in accordance with the provisions
of the Company's Certificate of Incorporation and stock option plans.
(3) Options exercisable within 60 days after December 31, 1998.
(4) The percentage of beneficial ownership as to each person, entity or
group assume the exercise or conversions of all outstanding options,
warrants and convertible securities held by such person, entity or
group which are exercisable or convertible within 60 days as of
December 31, 1998, but not the exercise or conversion of options,
warrants and convertible securities held by other holders (whether or
not exercisable or convertible within 60 days after December 31, 1998.)
(5) As a percentage of the sum of the post split and rounded Common Stock,
Series A Convertible Preferred Stock, Series B Convertible Preferred
Stock, Series C Convertible Preferred Stock and options granted and
exercisable within 60 days after December 31, 1998. As of December 31,
1998, 915,765 options granted by the Company were exercisable.
(6) The address for Spectrum Equity Investors, L.P. and Spectrum Equity
Investors II, L.P. is One International Place, Boston, MA 02110.
(7) The address of New Enterprise Associates VI, Limited Partnership is
1119 Saint Paul Street, Baltimore, MD 21202.
(8) The address for Onset Enterprise Associates II, L.P. and Onset
Enterprise Associates III, L.P. is 8911 Capital of Texas Highway,
Austin, TX 78759.
(9) The address for Corman Foundation Incorporation is 100 Brookwood Road,
Atmore, AL 36502.
(10) The address for IAI Investment Funds VIII, Inc. (IAI Value Fund) is
3700 First Bank Place, Minneapolis, MN 55440.
(11) The address for Thomas Domencich is 104 Benevolent Street, Providence,
RI 02906.
(12) The address for FBR Technology Venture Partners L.P. is 1001 19th
Street North, Arlington, VA 22209.
(13) The address for Toronto Dominion Capital (USA) Inc. is 31 West 52nd
Street, New York, NY 10019.
(14) The address for Grotech Partners IV, L.P. is 9690 Deereco Road,
Timonium, MD 21093.
(15) The address for Utech Climate Challenge Fund, L.P. and Utility
Competitive Advantage Fund, L.L.C. is c/o Arete Ventures, Two Wisconsin
Circle, Chevy Chase, MD 20815.
(16) One-half of Mr. Schaeffer's options, or 215,206, would vest on January
1, 1999, at an exercise price of $3.67 per share, in the event that
certain performance criteria related to 1998 earnings have been met.
The Board of Directors' is currently reviewing whether these criteria
were met. See Note 10 to the Company's Consolidated Financial
Statements that appear elsewhere in this Annual Report on Form 10-K. In
the event that the Board of Directors determines that these stock
options have vested, Mr. Schaeffer's percentage held on a diluted basis
would be 15.7%.
(17) 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.
(18) 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.
(19) 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.
(20) 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.
40
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
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.
41
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.
42
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.
LEASE FROM THE KENILWORTH PARTNERSHIP
The Company has entered into the Headquarters Lease for approximately
10,195 square feet of office space from the Kenilworth Partnership, a general
partnership of which David Schaeffer, a director of the Company, is general
partner. The rental rate is approximately $20 per square foot, plus fees to
cover the Company's proportional share of real estate taxes and insurance
premiums relating to the
43
building. The Headquarters Lease expires on August 31, 1999 and may be renewed
at the option of the Company for two additional one-year periods on the same
terms and conditions. Rent paid to the Kenilworth Partnership during the year
ended December 31, 1998, was approximately $282,000. Management believes that
the terms and conditions of the Headquarters Lease are at least as favorable to
the Company as those which the Company could have received from an unaffiliated
third party.
44
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, 1998 and 1997
Consolidated Statements of Operations for the years ended December 31,
1998, 1997 and 1996, and for the period August 25, 1995 (date of
inception) to December 31, 1998
Consolidated Statements of Comprehensive Loss for the years ended
December 31, 1998, 1997 and 1996, and for the period August 25, 1995
(date of inception) to December 31, 1998
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996, and for the period August 25, 1995 (date of
inception) to December 31, 1998
Consolidated Statement of Stockholders' Equity (Deficit) for the years
ended December 31, 1998, 1997 and 1996, and for the period August 25,
1995 (date of inception) to December 31, 1998
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 October 6, 1998, the Company filed a report on Form 8-K providing
information under Items 5 and 7. The Report, dated October 6, 1998
announced the expansion of the Company's management team to include three
new additions to its national sales force.
(c) Exhibits.
The following exhibits are filed as a part of this Annual Report on Form
10-K:
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT
3.1(1) Amended and Restated Certificate of Incorporation of the
Company and Certificate of Amendment to such Certificate of
Incorporation.
3.2(1) Amended and Restated Bylaws of the Company.
4.1+ Indenture between the Company and The Bank of New York, as
trustee, dated April 8, 1998.
4.2++ Pledge Agreement by and among the Company, The Bank of New
York, as
45
trustee, and The Bank of New York, as securities intermediary,
dated April 8, 1998.
4.3** Form of New Note.
4.4+ Form of Existing Note (included in Exhibit 4.1).
10.1* Master Agreement by and between the Company and NEC America,
Inc., dated August 8, 1997, as amended by Amendment No. 1,
dated November 9, 1997 and Amendment No. 2, dated April 2,
1998.
10.1.1* Amendment No. 3, dated May 4, 1998 to Master Agreement by and
between the Company and NEC America, Inc.
10.1.2* Amendment No. 4, dated July 10, 1998 to Master Agreement by
and between the Company and NEC America, Inc.
10.1.3(1) Amendment No. 5, dated November 20, 1998 to Master Agreement
by and between the Company and NEC America, Inc.
10.2(2)* EmploymentAgreement by and between the Company and Richard
A.Jalkut, dated August 4, 1997, as amended by Amendment to
Employment Agreement, dated April 6, 1998.
10.3(2)* Non-Disclosure, Assignment of Inventions and Non-Competition
Agreement by and between the Company and Kevin Bennis, dated
February 2, 1998.
10.4(2)* Pathnet, Inc. 1995 Stock Option Plan.
10.5(2)* Pathnet, Inc. 1997 Stock Incentive Plan, as amended by
Amendment No. 1 to 1997 Stock Incentive Plan.
10.6* Notes Registration Rights Agreement by and among the Company
and Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith
Incorporated, Bear, Stearns & Co. Inc., TD Securities (USA)
Inc. and Salomon Brothers Inc (collectively, the "Initial
Purchasers"), dated April 8, 1998.
10.7* Warrant Agreement by and between the Company and The Bank of
New York, as warrant agent, dated April 8, 1998.
10.8* Warrant Registration Rights Agreement by and among the
Company, 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, dated April 8, 1998.
10.9** Investment and Stockholders Agreement, dated as of October 31,
1997 (the "Investment and Stockholders' Agreement"), by and
among the Company and certain stockholders of the Company.
10.9.1** Consent, Waiver and Amendment, dated as of March 19, 1998,
relating to the Investment and Stockholders' Agreement.
46
10.9.2** Amendment No. 1 to the Investment and Stockholders' Agreement,
dated as of April 1, 1998.
10.10* Lease Agreement, by and between 6715 Kenilworth Avenue General
Partnership and the Company, dated August 9, 1997, as amended
by Amendment to Lease, dated March 5, 1998.
10.10.1* Second Amendment to Lease, dated June 1, 1998.
10.10.2(1) Third Amendment to Lease, dated September 1, 1998.
10.11(2)* Non-Qualified Stock Option Agreement by and between the
Company and Richard A. Jalkut, dated August 4, 1997.
10.12(2)* Non-Qualified Stock Option Agreement by and between the
Company and David Schaeffer, dated October 31, 1997.
21.1(1) Subsidiaries of the Company.
27.1(1) Financial Data Schedule for the year ended December 31, 1998.
+ Incorporated by reference to Exhibit 10.19 to the Company's
Registration Statement on Form S-1 (Registration No.
333-52247) filed by the Company with the Securities and
Exchange Commission on May 8, 1998.
++ Incorporated by reference to Exhibit 10.20 to the Company's
Registration Statement on Form S-1 (Registration No.
333-52247) filed by the Company with the Securities and
Exchange Commission on May 8, 1998.
* Incorporated by reference to the corresponding exhibit to the
Company's Registration Statement on Form S-1 (Registration No.
333-52247) filed by the Company with the Securities and
Exchange Commission on May 8, 1998, as amended by Amendment
No. 1 to such Registration Statement filed with the Securities
and Exchange Commission on July 16, 1998, as further amended
by Amendment No. 2 to such Registration Statement filed with
the Securities and Exchange Commission on July 27, 1998, and
as further amended by Amendment No. 3 to such Registration
Statement filed with the Securities and Exchange Commission on
August 10, 1998.
** Incorporated by reference to the corresponding exhibit to the
Company's Registration Statement on Form S-4 (Registration No.
333-53467) filed by the Company with the Securities and
Exchange Commission on May 22, 1998, as amended by Amendment
No. 1 to such Registration Statement.
(1) Filed herewith.
(2) Constitutes management contract or compensatory arrangement.
47
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 16th day of March 1999.
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
Richard A. Jalkut Director March 16, 1999
/s/ William R. Smedberg V Executive Vice-President
- ------------------------- Corporate Development
William R. Smedberg, V (Principal Accounting and
Financial Officer) March 16, 1999
- --------------- Director March , 1999
David Schaeffer
/s/ Peter J. Barris Director March 17, 1999
- -------------------
Peter J. Barris
/s/ Kevin J. Maroni Director March 11, 1999
- -------------------
Kevin J. Maroni
/s/ Patrick J. Kerins Director March 11, 1999
- ---------------------
Patrick J. Kerins
/s/ Richard K. Prins Director March 17, 1999
- --------------------
Richard K. Prins
/s/ Stephen A. Reinstadtler Director March 15, 1999
- ---------------------------
Stephen A. Reinstadtler
48
F-1
PATHNET, INC.
INDEX TO FINANCIAL STATEMENTS
Page
Report of Independent Accountants F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997 F-3
Consolidated Statements of Operations for the years ended December 31,
1998, 1997 and 1996, and for the period August 25, 1995 (date of
inception) to December 31, 1998 F-4
Consolidated Statements of Comprehensive Loss for the years ended
December 31, 1998, 1997 and 1996, and for the period August 25, 1995
(date of inception) to December 31, 1998 F-5
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996, and for the period August 25, 1995 (date of
inception) to December 31, 1998 F-6
Consolidated Statement of Stockholders' Equity (Deficit) for the years
ended December 31, 1998, 1997 and 1996, and for the period August 25,
1995 (date of inception) to December 31, 1998 F-7
Notes to Consolidated Financial Statements F-8
F-1
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 (the Company) at December 31,
1998 and 1997, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 1998 and for the period
August 25, 1995 (date of inception) to December 31, 1998, in conformity with
generally accepted accounting principles. 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 generally accepted auditing
standards, 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 14, 1999
F-2
PATHNET, INC.
(A Development Stage Enterprise)
CONSOLIDATED BALANCE SHEETS
December 31,
-----------------------------
1998 1997
----------- -----------
ASSETS
Cash and cash equivalents $ 57,321,887 $ 7,831,384
Note receivable 3,206,841 -
Interest receivable 3,848,753 -
Marketable securities available for sale, at market 97,895,773 -
Prepaid expenses and other current assets 205,505 48,571
----------- -----------
Total current assets 162,478,759 7,879,955
Property and equipment, net 47,971,336 7,207,094
Deferred financing costs, net 10,508,251 250,428
Restricted cash 10,731,353 760,211
Marketable securities available for sale, at market 71,899,757 -
Pledged marketable securities held to maturity 61,824,673 -
----------- -----------
Total assets $ 365,414,129 $ 16,097,688
=========== ===========
LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY (DEFICIT)
Accounts payable $ 10,708,263 $ 5,592,918
Accrued interest 8,932,294 -
Accrued expenses and other liabilities 639,688 300,000
----------- -----------
Total current liabilities 20,280,245 5,892,918
12 1/4% Senior Notes, net of unamortized bond discount of $3,787,875 346,212,125 -
----------- -----------
Total liabilities 366,492,370 5,892,918
----------- -----------
Series A convertible preferred stock, $0.01 par value, 1,000,000 shares authorized, issued and
outstanding at December 31, 1998 and 1997, 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, 1998 and 1997, 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; 2,819,549
and 939,850 shares issued and outstanding at December 31, 1998 and 1997, respectively
(liquidation preference $30,000,052) 29,961,272 9,961,274
----------- -----------
Total mandatorily redeemable preferred stock 35,969,639 15,969,641
----------- -----------
Common stock, $0.01 par value, 60,000,000 and 7,500,000 shares authorized at
December 31, 1998 and 1997, respectively; 2,902,358 and 2,900,000 shares
issued and
outstanding at December 31, 1998 and 1997, respectively 29,024 29,000
Common stock subscription receivable - (9,000)
Deferred compensation (978,064) -
Additional paid-in capital 6,156,406 381,990
Accumulated other comprehensive income 208,211 -
Deficit accumulated during the development stage (42,463,457) (6,166,861)
----------- -----------
Total stockholders' equity (deficit) (37,047,880) (5,764,871)
----------- -----------
Total liabilities, mandatorily redeemable preferred stock and stockholders' equity (deficit) $ 365,414,129 $ 16,097,688
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
F - 3
PATHNET, INC.
(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,
1998 1997 1996 1998
------------ ------------ ------------ ------------
Revenue $ 1,583,539 $ 162,500 $ 1,000 $ 1,747,039
------------ ------------ ------------ ------------
Operating expenses:
Cost of revenue 7,547,620 -- -- 7,547,620
Selling, general and administrative 9,615,867 4,247,101 1,333,294 15,625,349
Research and development -- -- --
Depreciation expense 732,813 46,642 9,024 788,831
------------ ------------ ------------ ------------
Total operating expenses 17,896,300 4,293,743 1,342,318 23,961,800
------------ ------------ ------------ ------------
Net operating loss (16,312,761) (4,131,243) (1,341,318) (22,214,761)
Interest expense (32,572,454) -- (415,357) (32,987,811)
Interest income 13,940,240 159,343 13,040 14,115,236
Write-off of initial public offering costs (1,354,534) -- -- (1,354,534)
Other income (expense), net 2,913 (5,500) -- (2,587)
------------ ------------ ------------ ------------
Net loss $(36,296,596) $ (3,977,400) $ (1,743,635) $(42,444,457)
============ ============ ============ ============
Basic and diluted loss per
common share $ (12.51) $ (1.37) $ (0.60) $ (14.63)
============ ============ ============ ============
Weighted average number of
common shares outstanding 2,902,029 2,900,000 2,900,000 2,900,605
============ ============ ============ ============
The accompanying notes are an integral part of these
consolidated financial statements.
F - 4
PATHNET, INC.
(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,
1998 1997 1996 1998
------------ ------------ ------------ ------------
Net loss $(36,296,596) $ (3,977,400) $ (1,743,635) $(42,444,457)
Other comprehensive income
Net unrealized gain on marketable
securities available for sale 208,211 -- -- 208,211
------------ ------------ ------------ ------------
Comprehensive loss $(36,088,385) $ (3,977,400) $ (1,743,635) $(42,236,246)
============ ============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
F - 5
PATHNET, INC.
(A Development Stage Enterprise)
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the period
For the year ended August 25, 1995
December 31, (date of inception)
------------------------------------------ to December 31,
1998 1997 1996 1998
------------- ------------ ------------ ------------
Cash flows from operating activities:
Net loss $ (36,296,596) $ (3,977,400) $ (1,743,635) $ (42,444,457)
Adjustment to reconcile net loss to net cash used in operating
activities
Depreciation expense 732,813 46,642 9,024 788,831
Amortization of deferred financing costs 842,790 -- -- 842,790
Loss on disposal of asset -- 5,500 -- 5,500
Write-off of deferred financing costs 581,334 -- -- 581,334
Interest expense resulting from amortization of discount on
the bonds payable 307,125 -- -- 307,125
Stock based compensation 701,295 -- -- 701,295
Interest expense for beneficial conversion feature of
bridge loan -- -- 381,990 381,990
Accrued interest satisfied by conversion of bridge loan to
Series B convertible preferred stock -- -- 33,367 33,367
Changes in assets and liabilities:
Interest receivable (4,846,952) -- -- (4,846,952)
Prepaid expenses and other current assets (156,935) (46,876) (1,695) (205,505)
Accounts payable 6,709 386,106 110,094 507,614
Accrued interest 8,932,294 -- -- 8,932,294
Deferred revenue -- -- -- --
Accrued expenses and other liabilities 339,688 269,783 17,572 639,687
------------- ------------- ------------- -------------
Net cash used in operating activities (28,856,435) (3,316,245) (1,193,283) (33,775,087)
------------- ------------- ------------- -------------
Cash flows from investing activities:
Expenditures for network in progress (33,619,342) (1,739,782) -- (35,359,124)
Expenditures for property and equipment (2,769,076) (381,261) (46,653) (3,205,893)
Purchase of marketable securities available for sale (169,587,319) -- -- (169,587,319)
Purchase of marketable securities - pledged as collateral (83,097,655) -- -- (83,097,655)
Sale of marketable securities - pledged as collateral 22,271,181 -- -- 22,271,181
Restricted cash (9,971,142) (760,211) -- (10,731,353)
Issuance of note receivable to incumbent (3,206,841) -- -- (3,206,841)
Repayment of note receivable 9,000 -- -- 9,000
------------- ------------- ------------- -------------
Net cash used in investing activities (279,971,194) (2,881,254) (46,653) (282,908,004)
------------- ------------- ------------- -------------
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 2,500,000 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 -- -- 300,000 300,000
Proceeds from bond offering 350,000,000 -- -- 350,000,000
Proceeds from bridge loan -- -- 700,000 700,000
Exercise of employee common stock options 81 -- -- 81
Payment of issuance costs for preferred stock offerings -- (38,780) (25,000) (63,780)
Payment of deferred financing costs (11,681,947) (250,428) -- (11,932,375)
------------- ------------- ------------- -------------
Net cash provided by financing activities 358,318,132 11,710,846 3,475,000 374,004,978
------------- ------------- ------------- -------------
Net increase in cash and cash equivalents 49,490,503 5,513,347 2,235,064 57,321,887
Cash and cash equivalents at the beginning of period 7,831,384 2,318,037 82,973 --
------------- ------------- ------------- -------------
Cash and cash equivalents at the end of period $ 57,321,887 $ 7,831,384 $ 2,318,037 $ 57,321,887
============= ============= ============= =============
Supplemental disclosure:
Cash paid for interest $ 22,271,234 $ -- $ -- $ 22,271,234
============= ============= ============= =============
Noncash investing and financing transactions:
Conversion of bridge loan plus accrued interest to
Series B convertible preferred stock $ -- $ -- $ 733,367 $ 733,367
============= ============= ============= =============
Conversion of non-voting common stock to voting common stock $ -- $ -- $ 14,500 $ 500
============= ============= ============= =============
Issuance of voting and non-voting common stock $ -- $ -- $ -- $ 9,000
============= ============= ============= =============
Acquisition of network equipment financed by accounts payable $ 10,200,650 $ 5,092,013 $ -- $ 10,200,650
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
F - 6
PATHNET INC.
(A Development Stage Enterprise)
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
Period from August 25, 1995 (date of inception) to December 31 1995 and
for the years ended December 31, 1996, 1997 and 1998
Deficit
Note Accumulated Accumulated
Receivable Additional Other During
Common Stock From Deferred Paid-in Comprehensive Development
Shares Amount Stockholder Compensation Capital Income Stage Total
--------- --------- ---------- --------- --------- --------- ---------- -----------
Balance at August 25, 1995 -- $ -- $ -- $ -- $ -- $ -- $ -- $ --
Issuance of Voting common stock 1,450,000 14,500 (4,500) -- -- -- (9,500) 500
Issuance of Non-voting common stock 1,450,000 14,500 (4,500) -- -- -- (9,500) 500
Net loss -- -- -- -- -- -- (426,826) (426,826)
--------- --------- --------- --------- --------- --------- ---------- -----------
Balance at December 31, 1995 2,900,000 29,000 (9,000) -- -- -- (445,826) (425,826)
Cancellation of Non-voting common stock (1,450,000) (14,500) -- -- -- -- -- (14,500)
Issuance of Voting common stock 1,450,000 14,500 -- -- -- -- -- 14,500
Interest expense for beneficial conversion --
feature of bridge loan -- -- -- -- 381,990 -- -- 381,990
Net loss -- -- -- -- -- -- (1,743,635) (1,743,635)
--------- --------- --------- --------- --------- --------- ---------- -----------
Balance at December 31, 1996 2,900,000 29,000 (9,000) -- 381,990 -- (2,189,461) (1,787,471)
Net loss -- -- -- -- -- -- (3,977,400) (3,977,400)
--------- --------- --------- --------- --------- --------- ---------- -----------
Balance at December 31, 1997 2,900,000 29,000 (9,000) -- 381,990 -- (6,166,861) (5,764,871)
Exercise of stock options 2,358 24 -- -- 57 -- -- 81
Repayment of note receivable -- -- 9,000 -- -- -- -- 9,000
Deferred compensation expense related to
issuance of employee common stock options -- -- -- (1,679,359) 1,679,359 -- -- --
Compensation expense related to issuance of
employee common stock options -- -- -- 701,295 -- -- -- 701,295
Fair value of warrants to purchase common --
stock -- -- -- -- 4,095,000 -- -- 4,095,000
Net unrealized gain on marketable securities
available for sale -- -- -- -- -- 208,211 -- 208,211
Net loss -- -- -- -- -- -- (36,296,596) (36,296,596)
--------- --------- --------- --------- --------- --------- ---------- -----------
2,902,358 $ 29,024 $ -- $(978,064)$6,156,406 $ 208,211$(42,463,457 $(37,047,880)
========= ========= ========= ========= ========= ========= ========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
F - 7
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY
Pathnet, Inc. (Company) is a leading "carrier's carrier", providing
high-quality, low-cost digital fiber and wireless communications capacity to
under-served and second- and third-tier U.S. markets. The Company's strategy is
to partner with owners of telecommunication assets, including utility, pipeline
and railroad companies (Incumbents), to upgrade and aggregate existing
infrastructure to a state-of-the-art SONET network. As of December 31, 1998, the
Company had approximately 2,000 route miles of completed network, approximately
5,000 route miles of network under construction and approximately 10,000 route
miles of network under contract. Due to demand and opportunity, Pathnet expanded
the scope of its existing business strategy to include fiber. Pathnet offers
telecommunications service to inter-exchange carriers, local exchange carriers,
internet service providers, Regional Bell Operating Companies, cellular
operators and resellers.
The Company's business has been funded primarily through equity
investments by the Company's stockholders and a private placement in April 1998
of units consisting of 12 1/4% Senior Notes due 2008 (Restricted Notes) and
warrants (Warrants) to purchase Common Stock (Debt Offering). On September 2,
1998, the Company commenced an offer to exchange (Exchange Offer) all
outstanding Restricted Notes for up to $350.0 million aggregate principal amount
of 12 1/4% Senior Notes due 2008 (Registered Notes) which have been registered
under the Securities Act of 1933, as amended (Securities Act). The terms of the
Registered Notes are identical in all material respects to the terms of the
Restricted Notes, except that the Registered Notes have been registered under
the Securities Act and are generally freely transferable by holders thereof and
are issued without any covenant upon the Company regarding registration under
the Securities Act. The Exchange Offer expired on October 2, 1998 and all
outstanding Restricted Notes were exchanged for Registered Notes. (The
Restricted Notes and the Registered Notes are collectively referred to herein as
the "Senior Notes".)
A substantial portion of the Company's activities to date has involved
developing strategic relationships with Incumbents and building its network.
Accordingly, a majority of its revenues to date reflect only certain consulting
and advisory services in connection with the design, development and
construction of digital microwave infrastructure. The remainder of its revenues
to date (approximately 10 per cent of its total revenues) was derived from the
sale of bandwidth along the Company's digital network. The Company has also been
engaged in constructing network, developing operating systems, constructing a
network operations center, raising capital and hiring management and other key
personnel. 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
While the Company recently commenced providing telecommunication
services to customers and recognizing the revenue from the sale of such
telecommunication services, its principal activities to date have been securing
contractual alliances with Incumbents, designing and constructing network
F-8
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 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 Finance I, LLC, Pathnet/Idaho
Power License, LLC, Pathnet Fiber Optics, LLC and Pathnet/BNSF 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 2,885,833 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, 1998, 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, 1998, the value of the Company's 12 1/4% Senior
Notes was approximately $245 million.
CASH EQUIVALENTS
The Company considers all highly liquid instruments with an original
maturity of three months or less to be cash equivalents.
F-9
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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,
certificates of deposit and money market funds, and corporate debt securities.
The note receivable is guaranteed by the parent company of the note holder, a
leading utility company. 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 5) 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 non-current 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.
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 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 ten 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
F-10
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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
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 telecommunication 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.
During 1998, one customer accounted for 98 per cent of the Company's total
revenue.
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.
COMPREHENSIVE LOSS
Effective March 31, 1998, the Company adopted Statement of Statement of
Financial Accounting Standards No 130 which requires additional reporting with
respect to certain changes in assets and liabilities that previously were
reported in stockholders' equity (deficit). Accordingly, the Company has
included Consolidated Statements of Comprehensive Loss for the years ended
December 31, 1998, 1997 and 1996, and for the period August 25, 1995 (date of
inception) to December 31, 1998 in the accompanying financial statements.
F-11
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED 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. Realized gains or losses from the sale of marketable
securities are based on the specific identification method.
The following is a summary of the investments in marketable securities
at December 31, 1998:
Gross Unrealized
----------------
Cost Gains Losses Market Value
---- ----- ------ -------------
Available for sale securities:
U.S. Treasury securities and debt securities
of U.S. Government agencies $ 20,684,791 $ 11,436 $ -- $ 20,696,227
Certificates of deposit and money market
funds 7,098,225 116 878 7,097,463
Corporate debt securities 141,804,303 225,972 28,435 142,001,840
-------------- ----------- ------------ -------------
$ 169,587,319 $ 237,524 $ 29,313 $ 169,795,530
============== =========== ============ =============
Proceeds from the sales of available for sale securities and 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 estimated fair value of available for sale
securities by contractual maturity at December 31, 1998 is as follows:
Cost Market Value
Due in one year or less $ 97,863,395 $ 97,895,773
Due after one year through two years 71,723,924 71,899,757
-------------- --------------
$ 169,587,319 $ 169,795,530
============== ==============
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, 1998 pledged marketable securities consisted of U.S. Treasury
securities classified as held to maturity with an amortized cost of
approximately $60.8 million, interest receivable on the pledged marketable
securities of approximately $998,000 and cash and cash equivalents of
approximately $41,000. Approximately $40.1 million of the investments
contractually mature prior to December 31, 1999 and approximately $20.7 million
contractually mature after December 31, 1999 and prior to April 30, 2000.
F-12
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. NOTE RECEIVABLES
Under the terms of a promissory note with an incumbent, the Company
agreed to advance up to $10 million principal for the purpose of funding the
incumbent's equipment expenditures under a Fixed Point Microwave Services
agreement. Expenses are initially incurred by the Company and are recharged at
cost to the incumbent as principal under the promissory note. The principal
amount of the promissory note is due and payable on March 31, 1999. Interest on
the promissory note accrues at the rate of 5 per cent per annum computed from
the date of commissioning of the network, which had not occurred as of December
31, 1998. Commissioning of the network occurs when the network has been
completed and is performing in accordance with agreed upon specifications.
Approximately $3.2 million was outstanding under the promissory note as of
December 31, 1998.
5. PROPERTY AND EQUIPMENT
Property and equipment, stated at cost, is comprised of the following
at December 31, 1998 and 1997:
1998 1997
----------------- ---------------
Network in progress $ 38,669,088 $ 6,831,795
Communications network 6,890,686 --
Office and computer equipment 2,267,647 248,880
Furniture and fixtures 766,013 120,093
Leasehold improvements 166,733 62,344
---------------- ---------------
48,760,167 7,263,112
Less: accumulated depreciation (788,831) (56,018)
----------------- ---------------
Property and equipment, net $ 47,971,336 $ 7,207,094
================== ===============
Network construction costs include all direct material and labor costs
together with related allocable interest costs, necessary to construct
components of a high capacity digital network which is owned and maintained by
the Company. During 1998, a portion of network was completed and made available
for use by the Company, and was transferred from network in process to
communications network. Network construction in progress at December 31, 1998
and 1997 respectively included approximately $10.2 million and $5.1 million,
respectively, of telecommunications equipment not yet paid for by the Company.
Corresponding amounts are included in accounts payable at December 31, 1998 and
1997, respectively.
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, 1998, amortization of the costs of approximately $843,000 was charged to
interest expense.
F-13
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of December 31, 1997, debt-financing costs comprised approximately
$250,000 related to costs incurred in anticipation of obtaining debt-financing
arrangements with a vendor. During the year ended December 31, 1998, these
costs, together with additional debt financing costs incurred during the year of
approximately $364,000, were charged to interest expense as the related
financing arrangements were not consummated.
7. RESTRICTED CASH
Restricted cash comprises amounts held in escrow to collateralize the
Company's obligations under certain of its Fixed Point Microwave Services (FPM)
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,
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 were
allocated to the Senior Notes and approximately $4.1 million were allocated to
the Warrants based upon estimated fair values. The Warrants expire on April 15,
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 $307,000 of expense for the year ended
December 31, 1998, 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. Interest expense, exclusive of the amortization of the discount, for the
year ended December 31, 1998 was $31.3 million. 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
Company made its first interest payment of approximately $22.3 million on
October 15, 1998. 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
F-14
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 28, 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). See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources" for a discussion of the Company's decision to postpone 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.
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
F-15
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
$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
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)
F-16
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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
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.
F-17
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. STOCK OPTIONS
On August 28, 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
period and expire either 30 days after termination of employment or 10 years
after date of grant. As of December 31, 1998, a total of 70,731 non-qualified
stock options and 424,393 incentive stock options were issued 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, 1998,
the options issued at an exercise price of $0.03 had a weighted average
contractual life of 6.68 years. As of December 31, 1998, 490,410 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 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 ending 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 ending 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 ending December 31, 1999 but exceeds 80% of its
F-18
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
revenue and EBITDA budget for the year ending 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 ending 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.
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, 1998, a total of 2,390,707 non-qualified options
were issued and outstanding, 1,523,323 at an exercise price of $1.13 per share,
520,134 at an exercise price of $3.67 per share and 347,250 at an exercise price
of $5.20 per share. Of the options issued at $1.13, 425,790 shares were
exercisable at December 31, 1998. None of the options issued at $3.67 or $5.20
were exercisable at December 31, 1998. As of December 31, 1998, the weighted
average contractual life of the options issued at $1.13, $3.67 and $5.20 was 8.9
and 8.9 and 9.9 years, respectively.
During the year ended December 31, 1998, 667,373 and 89,721 options
were issued at an exercise price of $1.13 and $3.67 per share, respectively. The
estimated fair value of the Company's underlying common stock in each case was
determined to be $1.99 per share and $16.00, respectively. Accordingly, the
Company calculated deferred compensation expense of approximately $1.7 million
related to the options granted during the year and recognized compensation
expense of approximately $701,000. The Company will recognize the balance of the
compensation expense over the remainder of the vesting period of the options.
F-19
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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, 1995 410,248 70,731 $ 0.034 -- -- $ 0.034
Granted 14,147 7,074 $ 0.034 -- -- $ 0.034
Exercised -- -- -- -- -- --
Canceled -- -- -- -- -- --
-------
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
========= ======= =========
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,
--------------------------------------
1998 1997 1996
---- ---- ----
Net loss as reported $36,296,596 $3,977,400 $1,743,635
Pro forma net loss $36,859,594 $3,978,164 $1,747,570
Basic and diluted net loss per
share as reported. $(12.51) $(1.37) $(0.60)
Pro forma basic and diluted net
loss per share $(12.70) $(1.37) $(0.60)
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, 1997 and 1996,
respectively: dividend yield of 0%, expected volatility of 0%, risk-free
interest rate of 6.55% and 6.35% and expected terms of 5.0 and 5.8 years. The
following weighted-average assumptions were used for grants during the year
ended December 31, 1998: dividend yield of 0%, expected volatility of 0%,
risk-free interest rate of 5.18% and expected terms of 5.5 years.
F-20
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of December 31, 1998 and 1997, the weighted average remaining
contractual life of the options is 8.63 years and 9.21 years, respectively. As
of December 31, 1998 and 1997 the pro forma tax effects would include an
increase to the deferred tax asset and the valuation allowance of approximately
$225,000, and $300 respectively; therefore, there is no pro forma tax effect.
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, 1998, the Company had purchased $31.1
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, 1998, no purchases were made by the Company under
this agreement.
12. COMMITMENTS AND CONTINGENCIES
The Company maintains office space in Washington, D.C., Kansas and
Texas. The most significant lease relates to the Company's headquarters facility
in Washington, D.C. The partnership leasing the space in Washington, D.C. is
controlled by a director of the Company. The lease expires on August 31, 1999,
and is renewable by the Company for two additional one-year periods. Rent paid
to this related party during the year ended December 31, 1998, 1997 and 1996,
was $281,890, $60,980 and $0, respectively. The Company has no amounts due to
the related party as of December 31, 1998.
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
F-21
PATHNET, INC.
(A DEVELOPMENT STAGE ENTERPRISE)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 per cent of the rent
then in effect.
The Company's future minimum rental payments under noncancellable
operating leases are as follows:
1999 $ 2,177,440
2000 1,913,822
2001 1,967,214
2002 2,033,577
2003 and thereafter 12,089,432
---------------
Total $ 20,181,485
===============
Rent expense for the years ended December 31 1998, 1997, and 1996 was
$389,969, $114,673 and $4,399, 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 per cent of the rent
then in effect.
In exchange for a non-compete agreement, the Company has agreed to pay
a senior management employee a severance payment of $275,000, if such employee's
employment with the Company is terminated.
As at December 31, 1998, the Company had capital commitments of
approximately $28.0 million relating to telecommunications and transmission
equipment.
13. INCOME TAXES
The tax effect of temporary differences that give rise to significant
portions of the deferred tax asset at December 31, 1998 and 1997, is as follows:
December 31,
1998 1997
---- ----
Deferred revenue $ 949 $ 117,000
Capitalized start-up costs 1,370,937 1,271,227
Capitalized research and development costs 66,111 79,333
Net operating loss carryforward. 15,325,484 754,458
-------------- -----------
16,763,481 2,222,018
Less valuation allowance (16,763,481) (2,222,018)
-------------- ------------
Net deferred tax asset $ -- $ --
============== ===========
F-22
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
against its deferred tax assets as they are long-term in nature and their
ultimate realization cannot be determined.
F-23