-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, FM+BOsM9zjc/qP4pEfD4wLx9qJPkkjGWZ5UbFNb5gdZLZ/MzVcL+a7RJQxID387s 0VInMkd7NUQ1F7jt/llLHA== 0001047469-99-012884.txt : 19990402 0001047469-99-012884.hdr.sgml : 19990402 ACCESSION NUMBER: 0001047469-99-012884 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: EARTHLINK NETWORK INC /DE/ CENTRAL INDEX KEY: 0001061566 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER PROGRAMMING, DATA PROCESSING, ETC. [7370] IRS NUMBER: 582389244 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 333-52507 FILM NUMBER: 99582172 BUSINESS ADDRESS: STREET 1: 3100 NEW YORK DR CITY: PASADENA STATE: CA ZIP: 91107 MAIL ADDRESS: STREET 1: 3100 NEW YORK DR CITY: PASADENA STATE: CA ZIP: 91107 10-K405 1 FORM 10-K405 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 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 / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934. FOR THE TRANSITION PERIOD FROM TO . COMMISSION FILE NUMBER 000-20799 ------------------------ EARTHLINK NETWORK, INC. (Exact name of registrant as specified in its charter) DELAWARE 58-2389244 (State of incorporation) (I.R.S. Employer Identification Number) 3100 NEW YORK DRIVE, PASADENA, CALIFORNIA 91107 (Address of principal executive offices, including zip code) (626) 296-2400 (Registrant's telephone, including area code) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 par value ------------------------ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. /X/ The aggregate market value of the Registrant's outstanding Common Stock held by non-affiliates of the Registrant on March 9, 1999 was $1.1 billion. There were 31,813,504 shares of Common Stock outstanding as of March 9, 1999. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EARTHLINK NETWORK, INC. ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 TABLE OF CONTENTS PART I Item 1. Business...................................................................... 1 Item 2. Properties.................................................................... 10 Item 3. Legal Proceedings............................................................. 10 Item 4. Submission of Matters to a vote of Security-Holders........................... 10 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters......... 11 Item 6. Selected Financial Data....................................................... 12 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................................... 13 Item 8. Financial Statements and Supplementary Data................................... 24 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................................ 24 PART III Item 10. Directors and Executive Officers of the Registrant........................... 25 Item 11. Executive Compensation....................................................... 25 Item 12. Security Ownership of Certain Beneficial Owners and Management............... 25 Item 13. Certain Relationships and Related Transactions............................... 25 PART IV Item 14. Exhibits, Financial Statements and Reports on Form 8-K....................... 26 SIGNATURES............................................................................ 30 INDEX OF FINANCIAL STATEMENTS......................................................... F-1 EXHIBIT INDEX......................................................................... E-1
i THIS REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. ACTUAL EVENTS AND RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS. SEE ITEM 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--SAFE HARBOR STATEMENT". PART I ITEM 1. BUSINESS. OVERVIEW EarthLink is a leading Internet service provider, or ISP, providing reliable nationwide Internet access and related value-added services to our individual and business members. Our member base grew from approximately 420,000 members on December 31, 1997 to approximately 1,000,000 paying members on December 31, 1998, making us one of the world's leading ISPs. We believe our growth has resulted from our efforts to enhance our members' Internet experience through simple, rapid and reliable access to the Internet, high quality service, and member education and support. As a result, we believe we have a high member retention rate for our industry. We receive significant benefits from the size of our member base, including bargaining power with Internet content providers, online advertisers and retailers, and network providers. We generate our members through a combination of innovative and cost-conscious marketing programs. We market our services and products through referrals, online advertising and magazine, radio and television advertisements. Our affinity marketing and membership referral programs are also valuable components of our marketing strategy. We have over 500 affinity marketing partners, including prominent retailers, print publishers, and software and hardware companies. Leading affinity marketing partners include CompUSA, Novus Service's Discover Card, MacMillan Digital Publishing USA, SAM's Club, Sony Entertainment and Warner Bros. In the fourth quarter of 1998 we added Apple and Packard Bell to our family of distribution partners. In June 1998, we entered into a strategic alliance with Sprint, which is another important driver of our member growth. As a part of this alliance, Sprint transferred approximately 130,000 members to us and is committed to generating at least 150,000 new members for us during each of the next 5 years through their channels. Additionally, we are now co-branded as Sprint's exclusive consumer Internet access provider, and we have exclusive access to certain dial-up modem ports in Sprint's network. We also have access to Sprint's marketing and distribution channels and the right to use Sprint's widely recognized brand name. As a result of this relationship, we recently added Sprint PCS and Radio Shack as affinity partners. EarthLink provides highly reliable Internet access through a nationwide telecommunications network of leased, high-speed, dedicated data lines and over 1,700 dial-up access sites, or POPs. We own and operate POPs in Southern California and lease POPs from UUNET, Sprint, and PSINet nationwide. Over 90% of the U.S. population can access our Internet service through a local telephone call. We also provide Internet connections by cable, ADSL, ISDN, frame relay and other high-speed access technologies. Our standard $19.95 per month dial-up Internet service provides our members with unlimited access to the Internet, email, a Web browser, six megabytes for a personal web site, a Personal Start Page, BLINK (our member news magazine), toll-free 24-hour technical support and access to Internet newsgroups. We also offer premium services to consumers and small businesses, including electronic commerce solutions, Web hosting and high-speed Internet connections. Our address is 3100 New York Drive, Pasadena, California 91107, and our telephone number is (626) 296-2400. 1 EARTHLINK'S STRATEGY Our objectives are to be the leading nationwide ISP and to provide our members with a high-quality Internet experience. Key elements of our strategy include: MAXIMIZE MEMBERS' OVERALL EXPERIENCE. We want to provide our members with a superior online experience. The following points illustrate our efforts to do so: - Superior Member Service: We believe that an integral part of the EarthLink experience is fast, polite, and helpful member service. Accordingly, we invest significant resources in supporting our members. We view member support as another opportunity to interface directly with our members to educate them on how to get the most out of the Internet. We have scaled our highly-trained member support staff in line with member growth to minimize member hold times and solve each individual problem in the most expeditious manner. Our member care center is available seven days a week, 24 hours a day via a toll free call. - Reliable Access: We currently use UUNET, PSINet and Sprint, as well as our own facilities, to provide nationwide dial-up access and network telecommunications services. Our members can access our service through over 1,700 POPs. As a result, our members are able to navigate the Internet with few delays, timeouts and disruptions. - Easy to Use Solution: Users may encounter numerous difficulties using the Internet because of its size and complexity. Therefore, we focus significant resources on retaining members by providing them with reliable and easy to use Internet access. We designed our TotalAccess software (which includes software and documentation for both Windows and Macintosh users) to make it easy for members to register and configure their system for Internet access. We constantly work to develop new services, content and features to enhance that user experience. - Personal Start Page: We provide a customizable personal start page user interface that allows members to closely match their needs. Members may select from a number of browsers, navigation engines and sources of news headlines. - Member sign-up: From marketing and promotional materials to registration and access software, we have carefully crafted the sign-up process to be easy-to-use and to engender loyalty. - Broad Service Offering: Our members receive six megabytes of space on our Web server and special tools to create their own Web page. We recently introduced a "Click-N-Build" Web construction tool, an e-commerce solution and cable access. Going forward, we will continue to offer our members leading Internet and communication products and services. RAPIDLY EXPAND OUR MEMBER BASE. We believe that a key to our success in the competitive ISP market is to rapidly expand our member base. This will allow us to amortize our assets over a larger revenue base and enhance our ability to enter into favorable arrangements with network service providers, affinity marketing partners, online advertisers and content providers. We have accelerated efforts and financial commitments to attract new members, while continuing to provide high-quality service to ensure member retention. Historically, we have capitalized on our reputation for high-quality service and have obtained a significant portion of our new members from existing member referrals. We recently added Apple and Packard Bell to our family of over 500 affinity partners plus numerous other channel partners. We plan to continue to expand our marketing program, to maintain a presence at national, regional and local trade shows, and to offer economic incentives to members who refer new members. Our access to Sprint's high-speed data network and marketing channels further enhances our ability to add new members. CAPITALIZE ON SPRINT ALLIANCE. We intend to maximize the opportunities presented by our alliance with Sprint to attract new members nationwide and to further enhance our position as a leading ISP. We believe that the substantial increase in members and other financial and operational resources resulting from the 2 Sprint alliance will enable us to achieve our strategic objectives on a cost-effective and accelerated basis. We also believe that new members will be generated by the Sprint relationship at a lower cost than we would spend to add these members on our own. Therefore, we intend to take full advantage of Sprint's recognized brand image, extensive distribution channels (including Radio Shack and Sprint PCS) and approximately 16 million long-distance and local telephone customers. To that end, our brand is jointly marketed with Sprint's widely-recognized brand in connection with consumer Internet services. Additionally, we expect to further benefit from our exclusive access to certain dial-up modem ports in Sprint's high-speed data network. INCREASE MARKETING AND EXPAND DISTRIBUTION. We continue to expand our targeted marketing programs and distribution efforts to increase our member base, nationwide presence and brand recognition. To achieve these objectives, we continue to increase our investments in a wide-ranging marketing and distribution program, including expanded affinity partners, print publications, radio, television, billboards and direct mail. We closely monitor the results of these marketing programs as part of our ongoing effort to increase the cost-effectiveness of our marketing efforts. LEVERAGE THIRD PARTY SERVICE PROVIDERS. We leverage the infrastructure of others by leasing POP capacity from UUNET, PSINet and Sprint. This allows us to maintain focus on our members' needs while benefiting from the continuing decrease in telecommunications services costs. Not only does this approach lower our required capital expenditures, it also gives us flexibility to rapidly expand service coverage. Moreover, access to multiple networks provides members with increased service quality resulting from redundant network access. We will continue pursuing this strategy so that we can devote our principal resources to sales and marketing efforts and to improving members' Internet experience. DERIVE INCREMENTAL REVENUES. We leverage our growing member base and user traffic to increase revenues from sources other than those that are access related such as advertising and electronic commerce. Our Premiere Partnership Program is the principal component of this strategy. Through the Premiere Partnership Program we sell promotional packages that provide advertisers, retailers and content providers with access to the multiple points of contact we have with our members. We also sell advertising space on our various online properties like the Personal Start Page and our news magazine, BLINK. The EarthLink Mall and branded Personal Start Pages are further sources of incremental revenues. MANAGE INFRASTRUCTURE TO MEET MEMBER GROWTH. Our membership has grown rapidly since inception. To continue to effectively add new members and continue to offer high-quality service, we have made significant capital investments, including expansion of our network hub, accounting and billing systems and customer care systems. We believe our current infrastructure is adequate to manage a significant increase in our member base. EARTHLINK'S SERVICES We provide a wide variety of competitively priced Internet services. Our TotalAccess software incorporates a telephone dialer and email program with several leading third-party Internet access tools, including the latest browsers from Netscape and Microsoft. This software provides a functional, easy-to-use Internet access solution for Windows 3.1, Windows 95 and Macintosh platforms. The TotalAccess software automatically installs these and other software applications on member computers. The simple point-and-click functionality of TotalAccess, combined with its easy-to-use multimedia registration system, permits online credit card registration, allowing both our novice and experienced members to quickly set up access to the Internet. 3 Our service offerings include: STANDARD INTERNET SERVICES EMAIL Publications WEB BROWSER Member and Technical Support 6MB WEB SPACE FOR A PERSONAL WEB SITE EarthLink Web Site PERSONAL START PAGE Newsgroups Nationwide POPs The EarthLink Online Mall
PREMIUM SERVICES BUSINESS WEB SITE HOSTING DOMAIN NAME SERVICE NATIONAL ISDN STAR EMAIL ADDRESSING NATIONAL LAN ISDN INTERNATIONAL ROAMING SERVICE NATIONAL FRAME RELAY 800 SERVICE TOTALACCESS GOLD INTERNET ROOMS ADDITIONAL MAILBOXES ELECTRONIC COMMERCE SOLUTION
EMERGING ACCESS SERVICES CABLE FIBER TO THE CURB ADSL SATELLITE/WIRELESS ACCESS (IN DEVELOPMENT)
EARTHLINK'S STANDARD INTERNET SERVICES. We provide our members with a core set of features through our standard Internet service. This standard service allows unlimited access to the Internet and the World Wide Web as well as other features and services for a monthly fee of $19.95 and a one-time set up fee (which is frequently waived). We include the following features in our standard Internet service: EMAIL. Each member receives an electronic mailbox which enables members to exchange an unlimited number of multimedia, text, graphics, audio and video messages with other online and Internet users. WEB BROWSER. We provide members with a free Web browser. Currently, we offer Netscape Communicator or Microsoft Internet Explorer. Members may also use any other browser of their choice. 6MB WEB SPACE FOR A PERSONAL WEB SITE. We provide each member with six free megabytes of space on our Web server to create a personal Web site. We recently introduced our "Click-N-Build" web site creation tool which enables members to build their sites without having to learn complex programming languages. We also provide tutorials and tools to help members develop their sites. This enables members to participate in the Internet community by personally adding content to the World Wide Web. PERSONAL START PAGE. Each member receives a Personal Start Page, an enhanced default start page for members that first appears when they log on to the EarthLink Network. Members can customize their start page. For example, a member may select from a number of browsers, navigation engines and sources of news headline. Members also have the option to view stock quotes, and weather reports and are provided with a personal reminder system, as well as a place to list their own personal Web links and links to EarthLink member and technical support resources. Our Premiere Partners on our member's Personal Start Page include ABCNews.com, American Greetings, AccuWeather, CNN Interactive, Excite, GoTo.com, Infoseek, Lycos, MiningCo.com, Snap, PC Quote, Travelscape.com and Wired Digital. 4 NATIONWIDE POPS. EarthLink members can access their accounts through a nationwide network of over 1,700 POPs. PUBLICATIONS. We mail our bi-monthly printed news magazine, BLINK, to each member. BLINK provides useful information, such as tips on how to search for certain categories of information on the Internet, information regarding new EarthLink service offerings, pointers to new Internet sites and other items of interest. BLINK is also available online on the EarthLink home page. Additionally, we provide new members with an orientation booklet called "Getting the Most Out of the Internet," written by our founder, Sky Dayton. MEMBER AND TECHNICAL SUPPORT. We currently provide the following member and technical support services: (i) toll-free, live telephone assistance available seven days a week, 24 hours a day; (ii) email-based assistance available seven days a week, 24 hours a day; (iii) help sites and Internet guide files on the EarthLink Web site; (iv) automated "fax back" and "fax on demand" assistance; and (v) printed reference material. Additionally, we provide dedicated support for business members through dedicated member care support personnel who are specially trained for business products and services such as business Web sites and local area network ISDN. EARTHLINK WEB SITE. We maintain a Web site at www.earthlink.net that contains content and links to third-party content and services. Our in-house staff actively seeks out interesting content from across the World Wide Web and organizes it into areas of interest on our Web site under topics such as "Arts & Entertainment," "Sports," "Travel," "News," "Finance," and "Games." Our Web site provides a road map to the abundant information and services available on the Internet. The site also contains Web pages dedicated to online member assistance including technical support, account maintenance and service updates. NEWSGROUPS. "Newsgroups," one of the most popular areas of the Internet, facilitate ongoing online discussions of specific areas of interest. EarthLink aggregates and provides access to thousands of these newsgroups, enabling its members to participate in realtime public discussions of a myriad of topics. THE EARTHLINK ONLINE MALL. Our online electronic shopping mall provides users with a one-stop gateway to some of the top retailers on the Web, using a familiar mall map interface. Retailers such as The Disney Store, BarnesandNoble.com and 1-800-FLOWERS "lease" space in the Mall. EARTHLINK'S PREMIUM SERVICES. In addition to our standard service, we offer a variety of premium services, including the following: BUSINESS WEB SITE HOSTING. We provide a Web hosting service for business members. Monthly fees for business Web sites range from $89 to $455, plus one-time set up fees of $179 to $479, depending on the size of the site and whether the site is a shared or unique address. A wide variety of options is available for an extra fee. Additional charges may apply for excess site traffic. We also offer an introductory service for small businesses, STARTERSITE, which is a ten megabyte, unique-domain Web site priced at $19.95 per month, plus a one-time set up fee of $25. NATIONAL ISDN. Our nationwide high-speed ISDN access service provides significantly higher access speeds than conventional analog modems. The monthly charge for ISDN is $34.95 for the first 100 channel hours and $0.99 for each additional channel hour, plus a one-time set up fee of $50. NATIONAL LAN ISDN. Small to medium-sized businesses can connect their existing LAN to the Internet at ISDN speed with LAN ISDN. This nationwide service costs $99.95 per month for 160 channel hours and four email boxes. The set up fee of $149 is waived for current EarthLink members, and additional channel hours cost $0.85 per hour. 5 NATIONAL FRAME RELAY. Frame relay enables companies to connect their LANs to the Internet via a direct, continuous connection at speeds ranging from 56 Kbps to 1.5 Mbps. Frame relay connections, available nationwide, range from $240 to $1,460 per month depending on access speeds, data throughput, etc. One-time set up fees range from $495 to $1,995. TOTALACCESS GOLD. TotalAccess Gold is a value-added package, which includes an additional email box, priority technical support with a guaranteed 5-minute maximum wait time, and a quarterly CD-ROM containing software tools and plug-ins. The package adds $9.95 to the monthly price of a standard dialup or ISDN account. ADDITIONAL MAILBOXES. Additional electronic mailboxes are available for a per-mailbox fee of $4.95 per month and a $9.95 set up fee. DOMAIN NAME SERVICE. We provide unique domain names for those members who prefer an individualized address or plan to establish a business Web site. These unique domain names allow consumers and businesses to customize their email and Web site addresses. EarthLink charges a one-time fee of $75 to set up domain name service and assist members in establishing their unique domain names. Members then pay an annual renewal fee to an Internet domain registration agency. STAR EMAIL ADDRESSING. EarthLink members desiring an unlimited choice of email addresses (for example "sales@domain.com" or "webmaster@domain.com") can purchase star addressing. With star addressing, all email goes into a central mailbox, for easy processing to individual addresses at the same domain. There is a one-time set up fee of $125, but no monthly fee for maintaining the service. INTERNATIONAL ROAMING SERVICE. We offer international roaming services so that members who travel outside the United States can access their EarthLink accounts and the Internet. The fee for international roaming is $0.15 per minute plus applicable fees, if any, charged by local and long distance carriers. 800 SERVICE. EarthLink provides 800 number dial-up service for members who do not have access to a local POP. EarthLink charges members $24.95 per month for five hours of 800 number service plus a one-time set up fee of $25.00. Additional hours are $4.95 per hour. ELECTRONIC COMMERCE SOLUTION. We recently introduced our electronic commerce solution for businesses. The software components allow businesses to build and operate an online "storefront" and process online credit card transactions. In conjunction with our hosting services, businesses can conveniently establish their electronic commerce presence. EARTHLINK'S EMERGING ACCESS SERVICES. In response to feedback from our members, we are developing the next generation of Internet access services targeted at consumers and small businesses. These services offer access speeds several times faster than ISDN connections utilizing a variety of emerging connectivity technologies. CABLE. We currently offer high-speed cable connections to the Internet for consumers and small businesses in selected service areas, through partnerships with cable providers such as Charter Communications. ADSL. We are testing Asymetric Digital Subscriber Line, or ADSL, service that provides a continuous high-speed connection through existing telephone lines. This service is in the pilot phase and has not yet been priced. FIBER TO THE CURB. We are conducting a technology trial utilizing "fiber to the curb" technology, an emerging broadband-capable technology alternative to both twisted pair copper lines and coaxial cable. This service is in the pilot phase and has not yet been priced. 6 SATELLITE/WIRELESS ACCESS. EarthLink is currently evaluating opportunities to offer Internet access service delivery through both satellite and ground-based wireless technologies. MEMBER AND TECHNICAL SUPPORT We believe that reliable member and technical support is critical to retaining existing members and attracting new members. We currently provide the following member and technical support services: (i) toll-free, live telephone assistance available seven days a week, 24 hours a day; (ii) email-based assistance available seven days a week, 24 hours a day; (iii) help sites and Internet guide files on the EarthLink Web site; (iv) automated "fax back" and "fax on demand" assistance; and (v) printed reference material. Additionally, we provide dedicated support for business members. Our call center currently handles an average of over 130,000 member and technical support calls a week. We also contract with a vendor of call center services whose EarthLink-trained employees provide additional technical support assistance. We believe the center's technology and systems are scaleable to accommodate call volume growth. We actively evaluate our call center facilities in order to deliver more effective and efficient services to our members. SALES AND MARKETING Our sales and marketing efforts consist of the following programs: ORIGINAL EQUIPMENT MANUFACTURER CHANNELS. EarthLink has marketing arrangements with a number of leading hardware and software manufacturers to include our TotalAccess software pre-installed on or included with their products. Our OEM partners include, among numerous others, Apple, Packard Bell and Gateway. AFFINITY MARKETING PROGRAM. Affinity marketing partners typically bundle our TotalAccess software with their own goods or services to create a package that promotes EarthLink to potential members. Our affinity marketing partners include, among numerous others: COMPUSA. CompUSA includes TotalAccess software pre-loaded on each of its private-label computer systems, as well as offering TotalAccess software to its customers through in-store displays. DISCOVER CARD. EarthLink and NOVUS Services' Discover Card division offer the Discover Connection, an Internet access package, with exclusive features and awards for Discover Cardmembers. MACMILLAN DIGITAL PUBLISHING USA. EarthLink is the exclusive national Internet access provider included in the Internet Starter Kit CD-Rom which MacMillan publishes. SAM'S CLUB. SAM's Club co-brands and co-offers TotalAccess software through direct mail and catalog promotions to SAM's Club members. SONY ENTERTAINMENT. Sony bundles TotalAccess software on its enhanced music CDs. SPRINT ALLIANCE. Our alliance with Sprint includes a marketing agreement and distribution arrangement that provides us access to Sprint's branded marketing and distribution channels in the United States, the right to use Sprint's brand for a minimum of ten years and a five-year commitment from Sprint to deliver a minimum of 150,000 new members annually through Sprint's channels. Additionally, Sprint promotes EarthLink as Sprint's exclusive consumer Internet access provider. MEMBER REFERRAL PROGRAM. We believe that our existing members are among our most important marketing tools. We currently waive one month of standard access service fees for each member who refers a new member to our service. These referrals generate a significant percentage of our new membership. 7 ADVERTISING. We advertise our services in print, electronic and broadcast media. We also maintain a presence at national trade shows such as Internet World and MacWorld, as well as numerous local and regional trade shows. Additionally, we market through computer, Internet and related publications and bundle our TotalAccess software with certain of these publications. PREMIERE PARTNERSHIPS. As part of our strategy to generate incremental revenue through third party electronic commerce, advertising and content, we leverage our current properties (such as our Web site and Personal Start Page) through our Premiere Partnership Program. The Premiere Partnership Program focuses on third parties having a natural affinity to and benefit for our member base. The program generates revenues through (1) sales of banner and other online ads; (2) fees generated through revenue sharing arrangements with online retailers who are accessed through our properties; and, (3) payments for placing links from our properties to third-party content TECHNICAL DEVELOPMENT AND SERVICE ENHANCEMENT We place significant emphasis on expanding and refining our services to enhance member Internet experience. Our technical staff is engaged in a variety of technical development and service enhancement activities and continuously reviews new third-party software products and technology for potential incorporation into our systems and services. The redesigned and enhanced version of TotalAccess, version 2.3, is a recent product of these efforts. The new version places a premium on ease of use, and incorporates a variety of powerful features that reduce the number and types of challenges faced by new members using the Internet for the first time. We also regularly update and expand the online services provided through the EarthLink Web site, organize Web content and develop online guides, help screens and other user services and resources. POPS AND NETWORK INFRASTRUCTURE We provide our members with Internet access primarily through third-party network POPs. Our use of third parties to provide Internet connectivity enables us to increase port capacity without the significant capital requirements necessary to build and maintain a network. It also gives us the flexibility necessary to adapt to changing technology such as cables. Over 90% of the U.S. population can access our Internet service through a local telephone call. Members located in a geographic area not currently serviced by a local POP can access the Internet through an 800 service. Our POP sites are connected to the Internet primarily through our Pasadena network hub. That hub is in turn connected directly to the Internet by redundant high-speed fiber optic data lines obtained from various vendors. We have invested in measures to minimize the effects of damage from fire, earthquake, power loss, telecommunications failure, computer viruses, security breaches and similar events or backup Internet services or backbone facilities or other redundant computing or telecommunications facilities. We do not currently maintain redundant network hub facilities. COMPETITION We operate in the Internet services market, which is extremely competitive. Our current and prospective competitors include many large companies that have substantially greater market presence, financial, technical, marketing and other resources than we have. We compete directly or indirectly with the following categories of companies: - established online services, such as America Online, the Microsoft Network and Prodigy; - local, regional and national ISPs, such as MindSpring, Rocky Mountain Internet and Internet America Inc.; - national telecommunications companies, such as AT&T and GTE; 8 - regional Bell operating companies, such as BellSouth and SBC Communications Corp; and - online cable services, such as At Home and Roadrunner. Our competition is likely to increase. We believe this will probably happen as large diversified telecommunications and media companies acquire ISPs and as ISPs consolidate into larger, more competitive companies. Diversified competitors may bundle other services and products with Internet connectivity services, potentially placing us at a significant competitive disadvantage. In addition, competitors may charge less than we do for Internet services, causing us to reduce (or preventing us from raising) our fees. As a result, our business may suffer. PROPRIETARY RIGHTS GENERAL. We rely on a combination of copyright, trademark, patent and trade secret laws and contractual restrictions to establish and protect our technology and proprietary rights and information. We require employees and consultants and, when possible, suppliers and distributors, to sign confidentiality agreements. However, we cannot assure you that our steps will be sufficient to prevent misappropriation of our technology and proprietary rights and information or that our competitors will not independently develop technologies that are substantially equivalent or superior to ours. From time to time, third parties have alleged that certain of our trademarks infringe their trademarks. None of these claims has had an adverse effect on our ability to market and sell its services. However, we cannot assure you that those claims will not have an adverse effect in the future or that others will not assert infringement claims against us in the future. LICENSES. We have licenses to distribute third-party software incorporated in our TotalAccess software. Applications which we license for distribution include Netscape Communicator (this license automatically renews each December for additional one-year terms unless either party terminates the license on 120 days notice), Microsoft Internet Explorer (this license expires in August 1999 and thereafter automatically renews for additional one-year terms, although either party may terminate the license at any time on 30 days notice), and MacTCP software from Apple (this license renews each December for additional one-year terms unless either party terminates the license on twelve-month notice). The only software in the TotalAccess package that we developed is the front-end and installation/registration program. We intend to maintain or negotiate renewals of existing software licenses and authorizations. We may also want or need to license other applications in the future. Our inability to renew existing software licenses or to license additional applications could have a material adverse effect on us. EMPLOYEES As of December 31, 1998, we employed 1,343 people, including 217 sales and marketing personnel, 998 operations and member and technical support representatives and 128 administrative personnel. None of our employees are represented by a labor union, and we have no collective bargaining agreement. 9 ITEM 2. PROPERTIES. Our corporate headquarters and call center are located in a 93,000 square-foot facility in Pasadena, California. Base rent is currently $73,000 per month. We have an option to extend this lease for an additional five years at the then-prevailing market rate following its expiration in September 2007. Our data center and primary data hub are housed in a 110,000 square foot facility adjacent to our headquarters with rent of $92,000 per month, subject to yearly increases. The lease for this space expires February 2007, with an option to extend for an additional ten year term. ITEM 3. LEGAL PROCEEDINGS. We are not currently involved in any legal proceedings that we believe could have, either individually or in the aggregate, a materiel adverse effect on our business or financial condition. There are proceedings pending before the FCC that could adversely affect the ISP industry and the means by which ISPs conduct business and the cost structure for ISP services. The Company is not a party to these proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. 10 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. PRICE RANGE OF COMMON STOCK Our common stock has been traded on the Nasdaq National Market under the symbol "ELNK" since our initial public offering on January 22, 1997. The following table shows the high and low closing sales price as reported by the Nasdaq National Market for each quarter since we have been public (as adjusted for our 2-for-1 stock split effected on July 21, 1998).
SALES PRICE -------------------- HIGH LOW --------- --------- 1997 First Quarter (from the date of the Company's initial public offering, January 22, 1997)........................................................ $ 10.13 $ 5.06 Second Quarter............................................................. 6.75 4.31 Third Quarter.............................................................. 9.75 5.13 Fourth Quarter............................................................. 12.88 8.00 1998 First Quarter.............................................................. $ 28.22 $ 12.25 Second Quarter............................................................. 38.38 25.00 Third Quarter.............................................................. 44.13 26.50 Fourth Quarter............................................................. 71.88 33.88
The last reported sale price of the Company's common stock on The Nasdaq National Market on March 9, 1999 was $57.00 per share. There were approximately 310 holders of the Company's Common Stock. DIVIDENDS We have never paid or declared any cash dividends. We currently expect to retain future earnings, if any, to finance the growth and development of our business, including potential acquisitions. Therefore, we do not anticipate paying cash dividends in the foreseeable future, except as required pursuant to the terms of our convertible preferred stock owned by Sprint. RECENT SALES OF UNREGISTERED SECURITIES In connection with the consummation of our strategic relationship with Sprint, we sold to Sprint 4.1 million shares of our newly created Series A convertible preferred stock, convertible into 8.2 million shares of common stock (assuming the acceleration of certain rights). 11 ITEM 6. SELECTED FINANCIAL DATA. The following consolidated selected financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere in this Report.
INCEPTION (MAY 26, 1994) THROUGH YEAR ENDED DECEMBER 31, DECEMBER 31, ------------------------------------------ 1994 1995 1996 1997 1998 --------------- --------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) CONSOLIDATED STATEMENT OF OPERATIONS DATA Revenues: Recurring revenues............................................. $ 53 $ 2,422 $ 27,606 $ 74,657 $ 164,723 Other revenues................................................. 58 606 5,624 6,231 6,547 Incremental revenues........................................... -- -- -- -- 4,671 ------ --------- --------- --------- --------- Total revenues............................................... 111 3,028 33,230 80,888 175,941 ------ --------- --------- --------- --------- Operating costs and expenses: Cost of recurring revenues..................................... 4 1,024 17,717 36,716 76,643 Cost of other revenues......................................... 12 328 2,066 1,349 685 Sales and marketing............................................ 37 3,763 17,363 25,971 42,732 General and administrative..................................... 168 2,062 10,534 14,406 21,042 Operations and member support.................................. 38 1,869 15,808 30,900 54,443 Amortization and transaction costs (1)......................... -- -- -- -- 42,635 ------ --------- --------- --------- --------- Total operating costs and expenses........................... 259 9,046 63,488 109,342 238,180 ------ --------- --------- --------- --------- Loss from operations........................................... (148) (6,018) (30,258) (28,454) (62,239) Interest income................................................ -- 34 150 637 4,424 Interest expense............................................... -- (136) (1,041) (2,099) (1,967) ------ --------- --------- --------- --------- Net loss..................................................... (148) (6,120) (31,149) (29,916) (59,782) Deductions for accretion dividends (2)........................... -- -- -- -- (7,601) ------ --------- --------- --------- --------- Net loss attributable to common stockholders..................... $ (148) $ (6,120) $ (31,149) $ (29,916) $ (67,383) ------ --------- --------- --------- --------- ------ --------- --------- --------- --------- Basic and diluted net loss per share (3)......................... $ (0.05) $ (0.80) $ (2.57) $ (1.50) $ (2.58) ------ --------- --------- --------- --------- ------ --------- --------- --------- --------- Weighted average shares (3)...................................... 3,100 7,674 12,138 20,002 26,157 ------ --------- --------- --------- --------- ------ --------- --------- --------- --------- Other operating data: EBITDA (4)..................................................... $ (141) $ (5,713) $ (26,105) $ (19,077) $ (7,513) Cash flows from Operating activities......................................... (146) (3,643) (16,222) (21,290) 26,597 Investing activities......................................... (97) (4,266) (18,361) (16,095) (9,239) Financing activities......................................... 243 8,199 38,286 49,842 107,056
DECEMBER 31, ----------------------------------------------------------- 1994 1995 1996 1997 1998 --------------- --------- --------- --------- --------- BALANCE SHEET DATA: Cash and cash equivalents........................................ $ -- $ 290 $ 3,993 $ 16,450 $ 140,864 Total assets..................................................... 186 4,874 27,119 46,887 266,341 Long-term debt................................................... -- 355 6,088 8,218 7,701 Total liabilities................................................ 89 4,584 34,367 40,812 68,997 Accumulated deficit.............................................. (148) (5,007) (36,156) (66,072) (133,454) Stockholders' equity (deficit)................................... 97 290 (21,261) 6,075 197,344
- ------------------------ (1) Amortization and transaction costs represent $41,238,000 in amortization of intangible assets acquired and a one time transaction cost, in June 1998, of $1,397,000 resulting from our strategic alliance with Sprint. (2) Reflects the accretion of liquidation dividends on Series A convertible preferred stock at 3% compounded quarterly and the accretion of a dividend related to the beneficial conversion feature in accordance with EITF D-60. 12 (3) See Note 1 of Notes to Consolidated Financial Statements for an explanation of the determination of the number of weighted average shares outstanding in the net loss per share computation. (4) Represents earnings (loss) before depreciation and amortization, interest income and expense and income tax expense. EBITDA is not determined in accordance with generally accepted accounting principles, is not indicative of cash used by operating activities and should not be considered in isolation from, as an alternative to, or more meaningful than measures of performance determined in accordance with generally accepted accounting principles. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED ELSEWHERE IN THIS REPORT. OVERVIEW We are a leading Internet service provider, or ISP, providing reliable nationwide Internet access and related value-added services to our individual and business members. Our member base has grown rapidly, making us one of the world's leading ISPs. We believe this growth is the result of our efforts to enhance our members' Internet experience through simple, rapid and reliable access to the Internet, high quality service and member support and enhanced services. We provide our members with a core set of features through our standard Internet service, which provides unlimited Internet access and several related services for a $19.95 monthly fee. We also offer a variety of premium services to both our individual and business members. Recurring revenues, which are generally paid for in advance with credit cards, consist of monthly fees charged to members for Internet access and other ongoing services including business Web site hosting, national ISDN, LAN ISDN, and frame relay connections and, in certain areas, cable access. We derive incremental revenues by leveraging the value of our member base and user traffic through promotional and content partnerships, online advertising, and electronic commerce. We recognize access fees and certain incremental revenues ratably over the period services are provided. Other revenues generally represent one-time, non-refundable set up fees and are recorded as earned. Cost of recurring revenues principally includes telecommunications costs and depreciation expense on equipment used in network operations for ongoing member services. Fees paid to UUNET, PSINet and Sprint for local dial-up access to their respective nationwide systems of POPs are included in telecommunications costs. Cost of other revenues principally includes expenses associated with new member registration and cost of products sold. Cost of incremental revenues is immaterial. We have experienced net losses since we began operations. As of December 31, 1998, we had an accumulated deficit of $133.5 million (inclusive of $7.6 million accretion representing dividends on Series A convertible preferred stock). We expect we will continue to incur net losses as we continue to expend substantial resources on sales and marketing to rapidly increase our member base. We believe that a key to our success in the competitive ISP market is to rapidly expand our member base. This will allow us to amortize our assets over a larger revenue base and enhance our ability to enter into favorable arrangements with network service providers, affinity marketing partners, online advertisers and content providers. While we have experienced a trend of continuing improvement in our net loss and earnings before interest, taxes, depreciation and amortization ("EBITDA") we anticipate investing heavily in obtaining new members and expect to have negative EBITDA for the foreseeable future. EBITDA is not determined in accordance with generally accepted accounting principles and is not indicative of cash used by operating activities. You should not consider EBITDA in isolation from, as an alternative to, or more meaningful than measures of performance determined in accordance with generally accepted accounting principles. 13 SPRINT TRANSACTION On June 5, 1998, we entered into a very important strategic alliance with Sprint in the area of consumer Internet access and related services. In connection with the formation of that relationship, Sprint tendered for and purchased 2.5 million shares of our common stock for $22.50 per share. At the close of the tender offer, we issued Sprint approximately 4.1 million shares of our newly created Series A convertible preferred stock, convertible into approximately 8.2 million shares of our common stock (assuming the acceleration of certain rights). In return, Sprint: (1) transferred approximately 130,000 members to us; (2) paid us approximately $24 million in cash; and (3) granted us the exclusive right to use certain dial-up modem ports in their high-speed data network for four years. Additionally, we entered into a five-year marketing and distribution agreement with Sprint. The following are highlights from that agreement: (a) Sprint must deliver a minimum of 150,000 new members per year for five years through its own marketing channels; (b) we are Sprint's exclusive provider of consumer Internet access services for at least ten years; and, (c) we can use Sprint's brand and distribution network for at least ten years. Sprint also provided us with a $25 million line of credit (increasing to $100 million over three years) in the form of convertible senior debt. We also entered into a governance agreement with Sprint. This agreement establishes certain terms and conditions concerning our corporate governance, the acquisition and disposition of our equity securities by Sprint (including certain preemptive rights in favor of Sprint), the rights of Sprint to make offers to purchase all outstanding shares of our common stock and rights of our Board of Directors to receive and entertain offers to effect certain business combinations. EarthLink, and certain of our stockholders, have also entered into an agreement with Sprint which obligates such stockholders, under certain terms and conditions, to take action in support of our obligations to Sprint under the governance agreement. Sprint can appoint (1) one person to our Board of Directors so long as Sprint owns at least 10% of our capital stock on a fully diluted basis, and (2) an additional person to our Board of Directors so long as Sprint owns at least 20% of our capital stock on a fully diluted basis. As a result of these transactions, Sprint now owns approximately 27% of our capital stock on a fully diluted basis (this assumes the conversion of Sprint's convertible preferred stock into common stock and assumes acceleration of certain dividend rights and the exercise by Sprint of certain preemptive rights), of which approximately 10% is voting stock. Sprint has the right to maintain (but not exceed) these ownership levels by purchasing from us additional common stock equivalent shares, with up to 75% of these common stock equivalents being in the form of convertible preferred stock. The Series A convertible preferred stock owned by Sprint accrues dividends for the first five years by increasing its liquidation value at a rate of 3% annually. Thereafter the convertible preferred stock will pay a cash dividend of 3% of the liquidation value during years six through 20. The cash dividend will increase to 8% in year 21 and increase to 12% by year 23. 14 RESULTS OF OPERATIONS The following table sets forth the percentage of total revenues represented by certain items in our statements of operations for the periods indicated:
YEAR ENDED DECEMBER 31, ------------------------------------- 1996 1997 1998 ----------- ----------- ----------- Revenues: Recuring revenues................................................................... 83% 92% 93% Other revenues...................................................................... 17 8 4 Incremental revenues................................................................ -- -- 3 --- --- --- Total revenues.................................................................... 100% 100% 100% --- --- --- Operating costs and expenses: Cost of recurring revenues.......................................................... 53 46 44 Cost of other revenues.............................................................. 6 2 1 Sales and marketing................................................................. 52 32 23 General and administrative.......................................................... 32 18 13 Operations and member support....................................................... 48 38 31 Amortization and transaction costs (1).............................................. -- -- 23 --- --- --- Total operating costs and expenses................................................ 191 136 135 Loss from operations................................................................ (91) (36) (35) Interest income..................................................................... -- 1 2 --- --- --- Interest expense.................................................................... (3) (3) (1) --- --- --- Net loss.......................................................................... (94%) (38%) (34%) --- --- --- --- --- ---
- ------------------------ (1) Amortization and transaction costs represent $41,238,000 in amortization of intangible assets acquired and a one time transaction cost, in June 1998, of $1,397,000 resulting from the strategic alliance with Sprint. 1998 COMPARED TO 1997 RECURRING REVENUES We experienced substantial growth in revenues during 1998. The increase in recurring revenues of 120% from $74.7 million in 1997 to $164.7 million in 1998 was primarily due to an increase in our member base from approximately 420,000 at December 31, 1997 to approximately 1 million at December 31, 1998. In June 1998 we acquired approximately 130,000 members and gained access to Sprint's marketing and distribution channels as part of our strategic relationship with Sprint. In addition to those channels, we aggressively expanded into the OEM arena by securing relationships with Apple, Packard Bell, NEC and Comp USA. We also added several key affinity marketing partners, Sam's Club, Discover Card and AAA of Southern California. 15 OTHER REVENUES
YEAR ENDED DECEMBER 31, --------------------------------- INCREASE 1997 1998 (DECREASE) --------- --------- ----------- (IN THOUSANDS) Dial-up set up fees........................................... $ 3,478 $ 2,853 $ (625) Non dial-up set up fees....................................... 2,753 3,694 941 --------- --------- ----- Total other revenues.......................................... $ 6,231 $ 6,547 $ 316 --------- --------- ----- --------- --------- -----
The decrease in dial-up set up fees is primarily due to our increased willingness to waive set up fees for dial-up members acquired through certain marketing programs in response to competitive pressures. We expect this trend to continue for dial-up set up fees. We have continued to expand our sales of premium services such as business Web site hosting, national ISDN, LAN ISDN, frame relay connections and cable connections. Set up fees for these services are generally not waived, and, as such, one-time fees for the set up of non-dial-up accounts has increased. INCREMENTAL REVENUES In the first quarter of 1998 EarthLink began reporting incremental revenues derived from advertising, content and electronic commerce fees that leverage the value of our growing member base and user traffic. The principal component of our strategy is our Premiere Partnership Program, through which we offer and sell promotional packages that provide advertisers with access to the multiple points of contact we have with our members. We also sell advertising and content space on our various online properties, such as the Personal Start Page and the Mall, and through our news magazine, BLINK. We generally charge transaction fees on electronic commerce activities we facilitate. Incremental revenues were $4.7 million in 1998. COST OF RECURRING REVENUES
YEAR ENDED DECEMBER 31, --------------------------------------------------- PERCENT OF PERCENT OF RECURRING RECURRING 1997 REVENUES 1998 REVENUES --------- ------------- ---------- ------------- (IN THOUSANDS, EXCEPT PERCENTAGES) Recurring revenues............................. $ 74,657 100% $ 164,723 100% Cost of recurring revenues..................... 36,716 49 76,643 47
Cost of recurring revenues increased 109% during 1998 as compared 1997, primarily due to the increase in our member base. The decrease in the cost of recurring revenues as a percentage of recurring revenues is attributable to: (a) more effective management of our network, (b) the addition of Sprint to our family of POP providers, and (c) our increasing ability to negotiate more favorable commercial arrangements with our telecommunications service providers as we leverage our growing member base. 16 COST OF OTHER REVENUES
YEAR ENDED DECEMBER 31, -------------------------------------------------- PERCENT PERCENT OF OTHER OF OTHER 1997 REVENUES 1998 REVENUES --------- ------------- --------- ------------- (IN THOUSANDS, EXCEPT PERCENTAGES) Royalties............................................ $ 930 15% $ 158 2% Other................................................ 419 7 527 8 --------- --- --------- --- Total cost of other revenues......................... $ 1,349 22% $ 685 10% --------- --- --------- --- --------- --- --------- ---
Cost of other revenues decreased 49% in 1998 as compared to 1997. The decrease was primarily due to a reduction in royalty expense. The increase in the remaining components of cost of other revenues is primarily due to the increase in the rate of member growth during 1998. SALES AND MARKETING Sales and marketing expenses consist primarily of third-party bounties, advertising, sales commissions, salaries, referral credits, direct communication costs associated with trial accounts and the cost of promotional material. Sales and marketing expenses increased from $26.0 million in 1997 to $42.7 million in 1998. The increase was primarily due to increased third-party bounty payments, increased emphasis on marketing, including expanded sales and marketing efforts on a nationwide basis, increased sales commissions and increased marketing personnel headcount. We do not defer sales, marketing or other direct costs associated with the acquisition of members. We expense these costs as incurred. GENERAL AND ADMINISTRATIVE General and administrative expenses consist primarily of costs associated with the accounting and human resources departments, professional expenses, rent, bad debt and compensation. General and administrative expenses increased 46% from $14.4 million in 1997 to $21.0 million in 1998. The increase was primarily due to an increase in credit card processing fees and an increase in bad debt expense. The increase in credit card processing fees was due to the increase in our member base. As a percentage of total revenues, general and administrative expenses decreased from 18% in 1997 to 13% in 1998. OPERATIONS AND MEMBER SUPPORT Operations and member support expenses consist primarily of costs associated with technical support and member service, as well as customer information systems. Operations and member support expenses increased 76% from $30.9 million in 1997 to $54.4 million in 1998. However, as a percentage of total revenues Operations and member support expenses decreased from 38% in 1997 to 31% in 1998. We focus on retaining existing members by providing superior services and devoting significant resources to expanding technical support staff and network operations capabilities. We had 565 employees engaged in operations and member support activities on December 31, 1997 and 998 on December 31, 1998. We continue to improve member service functions by investing in training programs, hardware and software. INTEREST EXPENSE Interest expense decreased from $2.1 million in 1997 to $2.0 million during 1998 due to repayment of approximately $4 million in notes payable, the conversion of $5 million in debt to equity and a reduction in interest rates paid to lessors. The above was offset by the increase in capitalized lease obligations. 17 INTEREST INCOME Interest income increased from $637,000 in 1997 to $4.4 million 1998. The increase was primarily due to an increase in average cash balances available for investment as a result of our public follow on common stock offering completed in June 1998. 1997 COMPARED TO 1996 RECURRING REVENUES Recurring revenues increased $47.1 million or 171% from $27.6 million in 1996 to $74.7 million in 1997 due to the significant increase in our member base during 1997. OTHER REVENUES
YEAR ENDED DECEMBER 31, --------------------------------- INCREASE 1996 1997 (DECREASE) --------- --------- ----------- (IN THOUSANDS) Dial-up set up fees........................................... $ 4,563 $ 3,478 $ (1,085) Non dial-up set up fees....................................... 1,061 2,753 1,692 --------- --------- ----------- Total other revenues.......................................... $ 5,624 $ 6,231 $ 607 --------- --------- ----------- --------- --------- -----------
Other revenues increased $607,000 or 11% from 1996 to 1997. Due to competitive pricing and other pressures, we waived set up fees for dial-up members acquired through certain marketing partnerships. This caused a decrease in dial-up set up fees earned during 1997. We expect this trend to continue for dial-up set up fees. During 1997, we began to aggressively promote Web hosting and nationwide high speed access services. The decline in dial-up set up fees was offset by increases in the other set up fees and revenues attributable to our Web hosting, high speed access services and cost of products sold. COST OF RECURRING REVENUES Cost of recurring revenues increased from $17.7 million in 1996 to $36.7 million in 1997 because our member base increased, but decreased from 64% of recurring revenues in 1996 to 49% of recurring revenues in 1997. The decrease from 1996 to 1997 was primarily due to our ability to effectively manage communications costs and economies of scale to reduce per member costs as the total member base expanded. Until October 1996, we paid UUNET a fixed monthly fee per member plus a variable amount based on member usage in excess of a threshold number of hours per month. Our network services agreement with UUNET was amended as of October 1996 to change the cost basis from per member to peak port hours. In June 1997, UUNET agreed to waive monthly revenue minimums, excess hours fees and peak service user targets for the remaining six months of 1997. In return, EarthLink agreed not to invoke its early termination right prior to September 1998. If usage becomes more concentrated during peak times, the fees we pay to UUNET will increase, thereby adversely affecting our operating margins. Under our agreement with PSINet, we pay PSINet a fixed monthly fee for each member accessing our services through a PSINet POP. 18 COST OF OTHER REVENUES
YEAR ENDED DECEMBER 31, -------------------------- INCREASE 1996 1997 (DECREASE) ------ ------ ---------- (IN THOUSANDS) Royalties................................................... $1,907 $ 930 $(977) Other....................................................... 159 419 260 ------ ------ ----- Total cost of other revenues................................ $2,066 $1,349 $(717) ------ ------ ----- ------ ------ -----
Cost of other revenues decreased $717,000 or 38% from $2.1 million in 1996 to $1.3 million in 1997. The decrease was due to the renewal of various contracts under more favorable terms. SALES AND MARKETING Sales and marketing expenses increased $8.6 million or 49% from $17.4 million in 1996 to $26.0 million 1997. The increase was primarily due to our emphasis on marketing services, expanding sales and marketing efforts nationwide, increased sales commissions, marketing personnel headcount, third-party bounties and referral credits. We do not defer sales, marketing or other direct costs associated with the acquisition of members; rather, we expense these costs as they are incurred. GENERAL AND ADMINISTRATIVE General and administrative expenses increased $3.9 million or 37% from $10.5 million in 1996 to $14.4 million in 1997 due to increases in bad debt, payroll, rent, depreciation expenses and credit card fees. Bad debt expense was $2.5 million or 7.5% of total revenues in 1996 due to difficulties in billing and in disconnecting late-paying members on a timely basis. Bad debt expense was $3.5 million or 4.3% of total revenues in 1997. Bad debt decreases were due to our review and elimination of accounts with questionable payment history and the compression of our collection cycle. The rise in payroll costs was primarily due to growth in headcount. Personnel engaged in general and administrative activities increased from 92 to 110 during 1997. Depreciation expense rose because of the acquisition of office equipment and the build-out of leasehold improvements. Credit card processing fees increased primarily because our member base increased. OPERATIONS AND MEMBER SUPPORT Operations and member support expenses increased $15.1 million or 96% from $15.8 million in 1996 to $30.9 million in 1997 reflecting our efforts to retain existing members by devoting significant resources to expanding technical support and network operations capabilities. Employees engaged in operations and member support activities increased from 401 to 565 during 1997. During 1997, we created a new call center and invested in training programs and hardware and software to solve member problems. INTEREST EXPENSE Interest expense increased from $1.0 million in 1996 to $2.1 million in 1997 primarily due to our increased borrowings and capital lease obligations to finance our expansion of network infrastructure and capital equipment acquisitions. INTEREST INCOME Interest income increased from $150,000 in 1996 to $637,000 in 1997 primarily because of the increase in average cash balances available for investment. 19 LIQUIDITY AND CAPITAL RESOURCES Our operating activities used $16.2 million and $21.3 million in cash during the years ended December 31, 1996 and 1997, respectively. In all three years, the Company's net loss was the primary component of cash used in operating activities. In 1998, however, the Company's net loss was offset by significant non-cash depreciation and amortization expenses relating to the Company's network and intangible assets. Our operating activities provided $26.6 million of cash during the year ended December 31, 1998, primarily because of the increase in accounts payable and accrued liabilities of $31.7 million. Our investing activities, used cash of approximately $18.4 million, $16.1 million and $9.2 million in 1996, 1997 and 1998, respectively. Capital equipment purchases were $18.8 million, $14.5 million and $24.3 million during the three years then ended. During 1997, we purchased the rights to subscribers and related assets of Internet in a Mall, Inc., a Tarzana, California based ISP, at a cost of approximately $1.4 million. Net cash received in the Sprint transaction of $23.8 million was partially offset by Sprint transaction costs of $9.9 million for the year ended December 31, 1998. Financing activities provided approximately $38.3 million, $49.8 million and $107.1 million in cash during 1996, 1997 and 1998, respectively. We raised $8.7 million and $15.4 million in private sales of equity securities during 1996 and 1997, respectively. In the first quarter of 1997, we sold 4.6 million shares of common stock in our initial public offering and generated approximately $26.2 million in net proceeds. We completed a follow on public offering in June 1998 of 3.8 million shares of common stock. Our net proceeds were approximately $106.3 million. During 1996, 1997 and 1998, we financed the acquisition of data processing and office equipment amounting to approximately $11.3 million, $10.5 million and $9.3 million, respectively, through equipment leases and sale leaseback agreements. We record sale leaseback transactions at cost, which approximates the fair market value of the property, and, therefore, no gains or losses are recorded. We continue to depreciate the property and record a financing obligation representing the proceeds based upon payments under the lease agreement. On December 31, 1998, we had approximately $140.9 million in cash and cash equivalents. We believe our available cash is sufficient to meet our operating expenses and capital requirements for the next 12 months. We also have a $25 million credit facility from Sprint in the form of convertible senior debt, increasing to $100 million over a three-year period, at an interest rate of 6% per annum. Our capital requirements depend on numerous factors, including the rate of market acceptance of our services, our ability to maintain and expand our member base, the rate of expansion of our network infrastructure, the size and types of acquisitions in which we may engage and the level of resources required to expand our marketing and sales programs. We cannot accurately predict the timing and amount of capital requirements. We may require additional financing sooner than anticipated if capital requirements vary materially from those currently planned. We have no commitments for any additional financing other than the line of credit from Sprint, and we cannot be sure that we can obtain additional commitments on favorable terms, if at all. Additional equity financing may dilute our stockholders, and debt financing, if available, may restrict our ability to declare and pay dividends and raise future capital. If we are unable to obtain additional needed financing, we may be required to reduce the scope of operations or anticipated expansion, which could materially and adversely affect us. YEAR 2000 RISKS MAY ADVERSELY AFFECT US Many existing computer programs use only two digits to identify a year. These programs were designed and developed without addressing the impact of the upcoming change in the century. If not corrected, many computer software applications could fail or create erroneous results by, at or beyond the year 2000. We utilize software, computer technology and other services internally developed and provided by third-party vendors that may fail due to the year 2000 phenomenon. For example, we are dependent on the institutions involved in processing our members' credit card payments for Internet services. We are also dependent on telecommunications vendors and leased POP vendors to maintain network reliability. 20 We are continuing to assess the year 2000 readiness of our third-party supplied software, computer technology and other services. Based upon the results of this assessment, we will develop and implement, if necessary, a remediation plan with respect to third-party software, computer technology and services which may fail to be year 2000 compliant. We have assessed our proprietary software and internal systems and determined them to be year 2000 compliant. We anticipate that our systems, including components thereof provided by third-party vendors, will be year 2000 compliant by 2000. The failure of our software and computing systems and our third-party vendors to be year 2000 compliant could have a material adverse effect on us. The most reasonably likely worst-case year 2000 scenario would be for one or more of our network service providers to fail thereby making it difficult or impossible for members to dial-up and access the Internet; however, we maintain agreements with several nationwide network service providers including UUNET, Sprint and PSINet, and have the ability to switch our members among the networks of these providers. Therefore, should any of these providers be unable to provide our members with Internet access as a result of year 2000 problems, we believe our redundant network arrangements will adequately accommodate our dial up access needs. Total costs incurred in connection with our year 2000 compliance efforts are expected to be minimal. 21 QUARTERLY RESULTS The following table sets forth certain unaudited quarterly consolidated financial data for the eight quarters ended December 31, 1998. In the opinion of the Company's management, this unaudited information has been prepared on the same basis as the audited consolidated financial statements contained herein and includes all adjustments (consisting of normal recurring adjustments) necessary to present fairly the information set forth therein when read in conjunction with the Consolidated Financial Statements and Notes thereto. The operating results for any quarter are not necessarily indicative of results for any future period.
MAR. 31 JUN. 30 SEPT. 30 DEC. 31 MAR. 31 JUN. 30 SEPT. 30 DEC. 31 1997 1997 1997 1997 1998 1998 1998 1998 ------- ------- -------- ------- ------- -------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) CONSOLIDATED STATEMENT OF OPERATIONS DATA: Revenues: Recurring revenues.................... $14,540 $17,880 $19,450 $22,787 $27,856 $ 35,224 $ 46,877 $54,766 Other revenues........................ 1,632 1,367 1,559 1,673 1,578 1,620 1,699 1,650 Incremental revenues (1).............. -- -- -- -- 392 1,146 1,248 1,885 ------- ------- -------- ------- ------- -------- -------- ------- Total revenues...................... 16,172 19,247 21,009 24,460 29,826 37,990 49,824 58,301 Operating costs and expenses: Cost of recurring revenues............ 7,601 8,876 9,271 10,968 14,087 17,555 20,619 24,382 Cost of other revenues................ 406 429 281 233 36 120 252 277 Sales and marketing................... 6,261 6,125 6,756 6,829 7,566 8,281 10,644 16,241 General and administrative............ 3,519 3,467 3,529 3,891 4,537 5,018 5,871 5,616 Operations and member support......... 6,422 7,791 7,970 8,717 9,540 11,630 15,078 18,195 Amortization and transaction costs (2)................................. -- -- -- -- -- 7,208 17,754 17,673 ------- ------- -------- ------- ------- -------- -------- ------- Total operating costs and expenses:......................... 24,209 26,688 27,807 30,638 35,766 49,812 70,218 82,384 Loss from operations.................... (8,037 ) (7,441) (6,798) (6,178) (5,940 ) (11,822) (20,394) (24,083) Interest expense........................ (507 ) (444) (516) (632) (687 ) (621) (353) (306) Interest income......................... 165 135 116 221 223 426 1,919 1,856 ------- ------- -------- ------- ------- -------- -------- ------- Net loss.............................. (8,379 ) (7,750) (7,198) (6,589) (6,404 ) (12,017) (18,828) (22,533) Deductions for accretion dividends (3)................................... -- -- -- -- -- (1,054) (3,276) (3,271) ------- ------- -------- ------- ------- -------- -------- ------- Net loss attributable to common stockholders.......................... $(8,379) $(7,750) $(7,198) $(6,589) $(6,404) $(13,071) $(22,104) $(25,804) ------- ------- -------- ------- ------- -------- -------- ------- ------- ------- -------- ------- ------- -------- -------- ------- Basic and diluted net loss per share (4)................................... $(0.46 ) $ (0.40) $ (0.36) $ (0.29) $(0.28 ) $ (0.53) $ (0.78) $ (0.89) ------- ------- -------- ------- ------- -------- -------- ------- ------- ------- -------- ------- ------- -------- -------- ------- Weighted average shares (4)............. 18,188 19,476 19,864 22,482 22,746 24,586 28,458 28,838 ------- ------- -------- ------- ------- -------- -------- ------- ------- ------- -------- ------- ------- -------- -------- -------
- ------------------------ (1) We began reporting incremental revenues in the first quarter of 1998. (2) Amortization and transaction costs represent $41,238,000 in amortization of intangible assets acquired and a one time transaction cost, in June 1998, of $1,397,000 resulting from the strategic alliance with Sprint. (3) Represents the accretion of liquidation dividends on Series A convertible preferred stock at 3% compounded quarterly and the accretion of a dividend related to the beneficial conversion feature in accordance with EITF D-60. (4) SFAS No. 128, Earnings per Share ("EPS"), and Staff Accounting Bulletin No. 98 require companies, such as EarthLink, that incorporated the SAB 83 concept of "cheap stock" in determining pre-initial public offering EPS data to restate EPS data to conform to SFAS No. 128. Basic EPS now represents the weighted average number of shares divided into net income during a 22 given period. Potential common stock items, options, warrants or convertible instruments are not included in the calculation of EPS due to their anti-dilutive effect.
MAR. 31 JUN. 30 SEPT. 30 DEC. 31 MAR. 31 JUN. 30 SEPT. 30 DEC. 31 1997 1997 1997 1997 1998 1998 1998 1998 ------- ------- -------- ------- ------- ------- -------- ------- (AS A PERCENTAGE OF TOTAL REVENUES) CONSOLIDATED STATEMENT FO OPERATIONS DATA Revenues: Recurring revenues.................... 90% 93% 93% 93% 94% 93% 94% 94% Other revenues........................ 10 7 7 7 5 4 3 3 Incremental revenues (1).............. -- -- -- -- 1 3 3 3 ------- ------- --- ------- ------- ------- --- ------- Total revenues...................... 100 100 100 100 100 100 100 100 Operating costs and expenses: Cost of recurring revenues............ 47 46 44 45 47 46 41 42 Cost of other revenues................ 2 2 1 1 -- -- 1 -- Sales and marketing................... 39 32 32 28 26 22 21 28 General and administrative............ 22 18 17 16 15 13 12 10 Operations and member support......... 40 41 38 35 32 31 30 31 Amortization and transaction costs (2)................................. -- -- -- -- -- 19 36 30 ------- ------- --- ------- ------- ------- --- ------- Total operating costs and expenses.......................... 150 139 132 125 120 131 141 141 Loss from operations.................... (50) (39) (32) (25) (20) (31) (41) (41) Interest expense...................... (3) (2) (2) (3) (2) (2) (1) (1) Interest income....................... 1 1 1 1 1 1 4 3 ------- ------- --- ------- ------- ------- --- ------- Net loss............................ (52) (40) (33) (27) (21) (32) (38) (39) Deductions for accretion dividends(3)... -- -- -- -- -- (2) (6) (5) ------- ------- --- ------- ------- ------- --- ------- Net loss attributable to common stockholders.......................... (52)% (40)% (33)% (27)% (21)% (34)% (44)% (44)% ------- ------- --- ------- ------- ------- --- ------- ------- ------- --- ------- ------- ------- --- -------
- ------------------------ (1) We began reporting incremental revenues in the first quarter of 1998. (2) Amortization and transaction costs represent $41,238,000 in amortization of intangible assets acquired and a one time transaction cost, in June 1998, of $1,397,000 resulting from the strategic alliance with Sprint. (3) Represents the accretion of liquidation dividends on Series A convertible preferred stock at 3% compounded quarterly and the accretion of a dividend related to the beneficial conversion feature in accordance with EITF D-60. SAFE HARBOR STATEMENT The following "Safe Harbor Statement" is made pursuant to the Private Securities Litigation Reform Act of 1995. Certain of the statements contained in the body of this Report are forward-looking statements (rather than historical facts) that are subject to risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. With respect to such forward-looking statements, the Company seeks the protections afforded by the Private Securities Litigation Reform Act of 1995. These risks include, without limitation, (1) that the Company will not retain or grow its member base, (2) that the Company will fail to be competitive with existing and new competitors, (3) that the Sprint Transactions will fail to close, (4) that if the Sprint Transactions close, they will not be as beneficial to the Company as management anticipates, (5) that the Company will not be able to sustain its current growth, (6) that the Company will not adequately respond to technological developments impacting the Internet, and (7) that needed financing will not be available to the Company if and as needed. This list is intended to identify certain of the principal factors that could cause actual results to differ materially from those described in the forward-looking statements included elsewhere herein. These factors are not intended to represent a complete list of all risks and uncertainties inherent in the Company's business, and should be read in conjunction with the more detailed cautionary statements included elsewhere in recent SEC filings. 23 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this item appears in a subsequent section of this Report. (See Item 14(a)(1) and (2)). ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 24 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to management's nominees for directors of the Company will be set forth under the captions "Proposal 1--Election of Directors--Nominees" and "Proposal 1--Election of Directors-- Information Regarding Nominees for Director" in the Company's Proxy Statement for its 1999 Annual Meeting of Shareholders or in a subsequent amendment to this Report. Such information is incorporated herein by reference. Information relating to the executive officers of the Company will be set forth under the caption "Executive Officers" in the above-referenced Proxy Statement or amendment. Such information is incorporated herein by reference. Information regarding compliance by directors and executive officers of the Company and owners of more than ten percent of the Company's Common Stock with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934, as amended, will be set forth under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the above-referenced Proxy Statement or amendment. ITEM 11. EXECUTIVE COMPENSATION Information relating to management compensation will be set forth under the captions "Proposal 1-- Election of Directors--Director Compensation" and "Executive Compensation" in the Company's Proxy Statement referred to in Item 10 above or in a subsequent amendment to this Report. Such information is incorporated herein by reference, except for the information set forth under the captions "Executive Compensation--Audit and Compensation Committee Report on Executive Compensation" and "Stock Performance Graph," which specifically is not so incorporated by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding ownership of the Company's $0.01 par value Common Stock by certain persons is set forth under the captions "Beneficial Ownership of Common Stock" in the Company's Proxy statement referred to in Item 10 above or in a subsequent amendment to this Report. Such information is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and transactions between the Company and certain of its affiliates is set forth under the caption "Compensation Committee Interlocks and Insider Participation" in the Company's Proxy Statement referred to in Item 10 above or in a subsequent amendment to this Report. Such information is incorporated herein by reference. 25 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) DOCUMENTS FILED AS PART OF THIS REPORT. 1. FINANCIAL STATEMENTS Report of Independent Accountants Consolidated Balance Sheet as of December 31, 1997 and 1998 Consolidated Statement of Operations for the three years ended December 31, 1998 Consolidated Statement of Stockholders' Equity (Deficit) for the three years ended December 31, 1998 Consolidated Statement of Cash Flows for the three years ended December 31, 1998 Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULE The Financial Statement Schedule(s) described in Regulation S-X are omitted from this Report because they are either not required or are immaterial. 3. EXHIBITS
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- 2.1 Investment Agreement dated as of February 10, 1998, with Sprint Corporation and Sprint Communications Company L.P. (incorporated by reference to Exhibit 2.1 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 3.1 Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-4--File No. 333-52507). 3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-4--File No. 333-52507). 3.3 Form of Certificate of Designation, Preferences and Rights of the Company's Series A Convertible Preferred Stock (incorporated by reference to Exhibit 10.2 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 3.4 Certificate of Designation, Preferences and Rights of the Company's Series B Convertible Preferred Stock and amendment thereto. 4.1 See Exhibits 3.1, 3.2, 3.3 and 3.4 for provisions of the Certificate of Incorporation, Bylaws and Certificates of Designation, Preference and Rights of Series A and B Convertible Preferred Stock. 4.2 Specimen Stock Certificate (incorporated by reference to Exhibit 4.2 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 4.3 Form of Warrant Agreement (incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 4.4 Agreement and Plan of Merger between Newco, Inc. and EarthLink Network, Inc. dated as of February 10, 1998 and entered into in connection with the Sprint Transaction (incorporated by reference to Exhibit 4.4 to the Company's Registration Statement on Form S-4--File No. 333-52507).
26
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- 10.1 1995 Stock Option Plan and forms of Stock Option Agreement and Stock Purchase Agreement (incorporated by reference to Exhibit 10.1 to Registration Statement of EarthLink Network, Inc. on form S-1--File No. 333-15781). 10.2 Amended and Restated Stock Option Plan for Directors (incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.3 Lease Line Agreement, dated January 30, 1996, between the Company and Boston Financial & Equity Corporation (incorporated by reference to Exhibit 10.4 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.4 Master Lease Agreement, dated September 1, 1995, between the Company and LINC Capital Management (incorporated by reference to Exhibit 10.5 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.5 Netscape Communications Corporation Internet Service Provider Navigator Distribution Agreement dated May 31, 1996, between the Company and Netscape Communications Corporation (incorporated by reference to Exhibit 10.6 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (a) Amendment No. 1 to Netscape Communications Corporation Internet Service Provider Agreement (incorporated by reference to Exhibit 10.6(a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (b) Amendment No. 2 to Netscape Communications Corporation Internet Service Provider Agreement incorporated by reference to (Exhibit 10.6(b) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.6 Network Services Agreement dated May 31, 1996, between the Company and UUNET Technologies, Inc. incorporated by reference to (Exhibit 10.7 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (a) Addendum No. 1 to Network Services Agreement (incorporated by reference to Exhibit 10.7 (a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.7 Software Distribution Agreement (MacTCP), dated October 2, 1995, between the Company and Apple Computer, Inc. (incorporated by reference to Exhibit 10.8 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.8 Employment Agreement, dated January 15, 1996, between the Company and Charles G. Betty (incorporated by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1--File No. 333-15781). (a) Amendment to Employment Agreement (incorporated by reference to Exhibit 10.9(a) to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997) (b) First Amendment to Employment Agreement (incorporated by reference to Exhibit 10.9 to the Company's Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997) (c) Second Amendment to Employment Agreement (incorporated by reference to Exhibit 10.9(c) to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997)
27
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- (d) Amended and Restated Employment Agreement (incorporated by reference to Exhibit 10.8(d) to the Company's Registration Statement on Form S-1--File No. 333-53063). 10.9 Standard Industrial/Commercial Multi-Tenant Lease, dated December 1, 1995, between the Company and Becton Dickinson and Company (incorporated by reference to Exhibit 10.12 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.10 Business Loan Agreement, dated June 15, 1995, and Promissory Note in the original principal amount of $250,000 between the Company and California United Bank (incorporated by reference to Exhibit 10.13 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.11 Production and Distribution Agreement, dated May 6, 1996, between the Company and National Media Corporation (incorporated by reference to Exhibit 10.16 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (a) Amendment No. 1 to Production and Distribution Agreement (incorporated by reference to Exhibit 10.16(a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.12 Internet Wizard Sign-Up Agreement between the Company and Microsoft Corporation, dated August 16, 1996 (incorporated by reference to Exhibit 10.19 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.13 Network Access Agreement between the Company and PSINet, Inc., dated July 22, 1996 and Amendment No. 1 to Network Access Agreement (incorporated by reference to Exhibit 10.20 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.14 Office Lease by and between The Mutual Life Insurance Company of New York, as Landlord, and the Company, as Tenant, dated September 20, 1996 (incorporated by reference to Exhibit 10.21 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.15 Standard Office Lease by and between Glen Feliz Properties, as Landlord, and the Company, as Tenant, dated July 2, 1996 (incorporated by reference to Exhibit 10.22 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.16 Amended and Restated Note Purchase Agreement between the Company and UUNET Technologies, Inc., dated October 31, 1996 (incorporated by reference to Exhibit 10.23 to the Company's Registration Statement on Form S-1--File No. 333-15781). (a) $5,000,000 Convertible Note (incorporated by reference to Exhibit 10.23(a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (b) Addendum to Amended and Restated Registration Rights Agreement (incorporated by reference to Exhibit 10.23(c) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.17 Amended and Restated Convertible Securities Vesting Plan (incorporated by reference to Exhibit 10.18 to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997). 10.18 Key Employee Compensation Continuation Plan (incorporated by reference to Exhibit 10.19 to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997). (a) Amendment to Key Employee Compensation Continuation Plan (incorporated by reference to Exhibit 10.19(a) to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997).
28
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- 10.19 Governance Agreement, dated as of February 10, 1998, (incorporated by reference to Exhibit 10.1 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.20 Credit Agreement, dated as of February 10, 1998, with Sprint Corporation as the Lender (incorporated by reference to Exhibit 10.3 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.21 Registration Rights Agreement, dated as of February 10, 1998, with Sprint Corporation, and Sprint Communications Company L.P., (incorporated by reference to Exhibit 99.1 to the Form 8-K by EarthLink Network, Inc. filed on February 10, 1998). 10.22 Stockholders Agreement, dated as of February 10, 1998, among EarthLink Network, Inc., Sprint Corporation, Sprint Communications Company L.P., and the persons identified on Schedule 1 thereto (incorporated by reference to Exhibit 99.2 to the Form 8-K of EarthLink Network, Inc. filed on February 10, 1998). 10.23 Agreement to Vote Stock, dated as of February 10, 1998, among the Granting Stockholders named on Schedule A thereto, Sprint Corporation and Sprint Communications Company L.P. (incorporated by reference to Exhibit 99.3 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.24 Agreement to Vote and Tender Stock, dated as of February 10, 1998, among the Granting Stockholders named on Schedule A thereto, Sprint Corporation, and Sprint Communications Company, L.P. (incorporated by reference to Exhibit 99.4 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.25 Marketing and Distribution Agreement, dated as of February 10, 1998, Sprint Corporation, and Sprint Communications Company L.P. (incorporated by reference to Exhibit 10.26 of the Company's Registration Statement on Form S-4, filed May 13, 1998, File No. 333-52507). 10.26 Third Amendment to the lease agreement between WHMNY Real Estate Limited Partnership, a Delaware limited partnership ("Landlord"), and EarthLink Network, Inc. (incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q filed on November 16, 1998. 22.1 Significant Subsidiaries (incorporated by reference to Exhibit 22.1 to the Company's Registration Statement on Form S-1, filed May 19, 1998, File No. 333-53063). 23.1 Consent of Independent Accountants. 24.1 Power of Attorney (set forth on the signature page to the Registration Statement). 27.1 Financial Data Schedule.
(B) REPORTS ON FORM 8-K. On February 10, 1998, the Company filed a Current Report on Form 8-K (the "Form 8-K"). The Form 8-K reported that, on February 10, 1998 the Company announced a long-term strategic alliance with Sprint Corporation as more thoroughly described elsewhere in this report. See "Business--Sprint Transaction". On August 14, 1998 the Company filed a Current Report on Form 8-K describing the Company's recently completed strategic alliance with Sprint Corporation and related transactions. 29 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. EARTHLINK NETWORK, INC. /s/ CHARLES G. BETTY --------------------------------------------- Charles G. Betty PRESIDENT, CEO Date: March 30, 1999 Each person whose signature appears below hereby constitutes and appoints Charles G. Betty and Grayson L. Hoberg the true and lawful attorneys-in-fact and agents of the undersigned, with full power of substitution and resubstitution, for and in the name, place and stead of the undersigned, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Commission, and hereby grants to such attorneys-in-fact and agents full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as the undersigned might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof. 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 Company and in the capacities and on the dates indicated.
SIGNATURE TITLE - -------------------------------------------------------- -------------------------------------------------------- /s/ CHARLES G. BETTY -------------------------------------------- Date: March 30, 1999 Charles G. Betty, President, Chief Executive Officer and Director /s/ GRAYSON L. HOBERG -------------------------------------------- Date: March 30, 1999 Grayson L. Hoberg, Sr. Vice President-- Finance and Administration and Chief Financial Officer /s/ RICHARD A. QUIROGA -------------------------------------------- Date: March 30, 1999 Richard A. Quiroga, Vice President-- Corporate Controller /s/ SKY D. DAYTON Date: March 30, 1999 -------------------------------------------- Sky D. Dayton, Chairman of the Board /s/ SIDNEY AZEEZ Date: March 30, 1999 -------------------------------------------- Sidney Azeez, Director /s/ ROBERT M. KAVNER Date: March 30, 1999 -------------------------------------------- Robert M. Kavner, Director /s/ PAUL MCNULTY Date: March 30, 1999 -------------------------------------------- Paul McNulty, Director
30
SIGNATURE TITLE - -------------------------------------------------------- -------------------------------------------------------- /s/ KEVIN M. O'DONNELL Date: March 30, 1999 -------------------------------------------- Kevin M. O'Donnell, Director /s/ REED E. SLATKIN Date: March 30, 1999 -------------------------------------------- Reed E. Slatkin, Director /s/ LINWOOD A. LACY Date: March 30, 1999 -------------------------------------------- Linwood A. Lacy, Director /s/ WILLIAM T. ESREY Date: March 30, 1999 -------------------------------------------- William T. Esrey, Director
31 EARTHLINK NETWORK, INC. INDEX TO FINANCIAL STATEMENTS
PAGE ----- Report of Independent Accountants.......................................................................... F-2 Consolidated Balance Sheet as of December 31, 1997 and 1998................................................ F-3 Consolidated Statement of Operations for the three years ended December 31, 1998........................... F-4 Consolidated Statement of Stockholders' Equity (Deficit) for the three years ended December 31, 1998....... F-5 Consolidated Statement of Cash Flows for the three years ended December 31, 1998........................... F-6 Notes to Consolidated Financial Statements................................................................. F-7
F-1 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of EarthLink Network, Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of stockholders' equity (deficit) and of cash flows present fairly, in all material respects, the financial position of EarthLink Network, Inc. and its subsidiary (the "Company") at December 31, 1997 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended 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 Century City, California February 16, 1999, except as to Note 14, which is as of February 24, 1999 F-2 EARTHLINK NETWORK, INC. CONSOLIDATED BALANCE SHEET
DECEMBER 31, -------------------- 1997 1998 --------- --------- (IN THOUSANDS) ASSETS Current assets: Cash and cash equivalents............................................ $ 16,450 $ 140,864 Restricted short-term investment..................................... 1,250 -- Accounts receivable, net of allowance of $165,000 and $405,000 at December 31, 1997 and 1998, respectively........................... 2,520 4,779 Prepaid expenses..................................................... 1,109 4,147 Other assets......................................................... 753 775 --------- --------- Total current assets............................................... 22,082 150,565 Other long-term assets................................................. 449 564 Property and equipment, net (Notes 1 and 3)............................ 23,398 35,206 Intangibles, net (Note 4).............................................. 958 80,006 --------- --------- $ 46,887 $ 266,341 --------- --------- --------- --------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable............................................... $ 6,472 $ 14,818 Accrued payroll and related expenses................................. 2,316 8,934 Other accounts payable and accrued liabilities....................... 3,717 20,372 Current portion of capital lease obligations (Note 11)............... 7,112 8,341 Notes payable (Note 5)............................................... 9,387 -- Deferred revenue..................................................... 3,590 8,831 --------- --------- Total current liabilities.......................................... 32,594 61,296 Long-term debt (Note 11)............................................... 8,218 7,701 --------- --------- Total liabilities.................................................. 40,812 68,997 Commitments and contingencies (Note 11) Stockholders' equity: Preferred stock, $0.01 par value, 25,000,000 shares authorized, nil and 4,102,941 shares issued and oustanding as Series A convertible preferred stock at December 31, 1997 and 1998, respectively (Note 7)................................................................. -- 41 Common stock, $0.01 par value, 50,000,000 shares authorized, 22,500,744 and 29,069,827 shares issued and outstanding at December 31, 1997 and 1998, respectively.................................... 225 291 Stock subscriptions receivable....................................... -- (1,041) Additional paid-in capital........................................... 70,829 330,911 Warrants to purchase common stock (Note 9)........................... 1,093 597 Accumulated deficit.................................................. (66,072) (133,455) --------- --------- Total stockholders' equity......................................... 6,075 197,344 --------- --------- $ 46,887 $ 266,341 --------- --------- --------- ---------
The accompanying notes are an integral part of these consolidated financial statements F-3 EARTHLINK NETWORK, INC. CONSOLIDATED STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1997 1998 --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenues: Recurring revenues.......................................... $ 27,606 $ 74,657 $ 164,723 Other revenues.............................................. 5,624 6,231 6,547 Incremental revenues........................................ -- -- 4,671 --------- --------- --------- Total revenues............................................ 33,230 80,888 175,941 Operating costs and expenses: Cost of recurring revenues.................................. 17,717 36,716 76,643 Cost of other revenues...................................... 2,066 1,349 685 Sales and marketing......................................... 17,363 25,971 42,732 General and administrative.................................. 10,534 14,406 21,042 Operations and member support............................... 15,808 30,900 54,443 Amortization and transaction expenses (Note 4).............. -- -- 42,635 --------- --------- --------- Total operating costs and expenses........................ 63,488 109,342 238,180 --------- --------- --------- Loss from operations.......................................... (30,258) (28,454) (62,239) Interest income............................................... 150 637 4,424 Interest expense.............................................. (1,041) (2,099) (1,967) --------- --------- --------- Net loss................................................ (31,149) (29,916) (59,782) Deductions for accretion dividends (Note 8)................... -- -- (7,601) --------- --------- --------- Net loss attributable to common stockholders.................. $ (31,149) $ (29,916) $ (67,383) --------- --------- --------- --------- --------- --------- Basic and diluted net loss per share.......................... $ (2.57) $ (1.50) $ (2.58) --------- --------- --------- --------- --------- --------- Weighted average shares....................................... 12,138 20,002 26,157 --------- --------- --------- --------- --------- ---------
The accompanying notes are an integral part of these consolidated financial statements F-4 EARTHLINK NETWORK, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
PREFERRED STOCK COMMON STOCK STOCK ADDITIONAL TOTAL -------------- ------------- SUBSCRIPTIONS PAID-IN WARRANTS ACCUMULATED STOCKHOLDERS' SHARES AMOUNT SHARES AMOUNT RECEIVABLE CAPITAL ISSUED DEFICIT EQUITY (DEFICIT) ------ ------ ------ ------ ------------- ---------- -------- ----------- ---------------- (IN THOUSANDS) Balance at December 31, 1995........................ 10,114 $101 $ 5,072 $ 124 $ (5,007) $ 290 Issuance of common stock...... 1,846 18 8,642 -- -- 8,660 Issuance of common stock for services.................... 85 1 462 -- -- 463 Warrants issued in connection with equipment leases and other financings (Note 9)... -- -- -- 475 -- 475 Net loss...................... -- -- -- -- (31,149) (31,149) ------ ------ ------ ------ ------------- ---------- -------- ----------- -------- Balance at December 31, 1996........................ 12,045 120 14,176 599 (36,156) (21,261) Initial public offering, net of expenses................. 4,570 46 26,180 -- -- 26,226 Conversion of redeemable preferred stock into common stock....................... 2,727 27 13,986 -- -- 14,013 Conversion of debt to common stock....................... 112 1 724 -- -- 725 Issuance of common stock in connection with private placement................... 2,920 30 15,379 -- -- 15,409 Issuance of common stock pursuant to exercise of stock options............... 127 1 384 -- -- 385 Warrants issued in exchange for services (Note 9)....... -- -- -- 494 -- 494 Net loss...................... -- -- -- -- (29,916) (29,916) ------ ------ ------ ------ ------------- ---------- -------- ----------- -------- Balance at December 31, 1997........................ 22,501 225 70,829 1,093 (66,072) 6,075 Issuance of preferred stock... 4,103 $41 -- -- 134,959 -- -- 135,000 Accretion of convertible preferred stock............. -- -- 7,601 -- (7,601) -- Follow on offering, net of expenses (Note 6)........... -- -- 3,763 38 106,271 106,309 Conversion of debt to common stock....................... -- -- 783 8 5,035 -- -- 5,043 Notes receivable from stock sales....................... 18 $(1,041) 1,041 -- -- -- Issuance of common stock for services.................... 20 -- 130 -- -- 130 Issuance of common stock pursuant to exercise of stock options............... -- -- 1,224 12 3,647 -- -- 3,659 Warrants issued in conjunction with marketing agreement.... 91 91 Warrants issued in exchange for services................ -- -- -- -- -- 60 -- 60 Issuance of common stock pursuant to exercise of warrants.................... 761 8 1,398 (647) 759 Net loss...................... -- -- -- -- -- -- (59,782) (59,782) ------ ------ ------ ------ ------------- ---------- -------- ----------- -------- Balance at December 31, 1998........................ 4,103 $41 29,070 $291 $(1,041) $330,911 $ 597 $(133,455) $197,344 ------ ------ ------ ------ ------------- ---------- -------- ----------- -------- ------ ------ ------ ------ ------------- ---------- -------- ----------- --------
The accompanying notes are an integral part of these consolidated financial statements F-5 EARTHLINK NETWORK, INC. CONSOLIDATED STATEMENT OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1997 1998 --------- --------- --------- (IN THOUSANDS) Cash flows from operating activities: Net loss..................................................... $ (31,149) $ (29,916) $ (59,782) Adjustments to reconcile net loss to net cash provided by (used in) operating activities, net of effect from acquisition: Depreciation and amortization.............................. 4,153 9,377 54,726 Issuance of common stock in exchange for professional services................................................. 50 -- 130 Issuance of common stock in exchange for termination of consulting agreement..................................... 413 -- -- Issuance of warrants in exchange for professional services................................................. -- 494 60 Increase in net accounts receivable........................ (1,507) (180) (2,260) Increase in prepaid expenses and other assets.............. (2,353) (413) (3,176) Increase (decrease) in accounts payable and accrued liabilities.............................................. 12,373 (2,232) 31,658 Increase in deferred revenue............................... 1,798 1,580 5,241 --------- --------- --------- Net cash provided by (used in) operating activities............ (16,222) (21,290) 26,597 --------- --------- --------- Cash flows from investing activities: Purchases of property and equipment.......................... (18,774) (14,528) (24,316) Purchases of intangible assets............................... -- (1,404) (9) Transaction costs............................................ -- -- (9,914) Cash acquired from acquisition............................... -- -- 23,750 Purchase of restricted short-term investment................. (1,087) (200) -- Liquidation of restricted short-term investment.............. 1,500 37 1,250 --------- --------- --------- Net cash used in investing activities...................... (18,361) (16,095) (9,239) --------- --------- --------- Cash flows from financing activities: Proceeds from issuance of notes payable...................... 7,950 4,387 200 Repayment of notes payable................................... (1,494) (2,225) (4,583) Proceeds from capital lease obligations...................... 11,348 10,544 9,275 Principal payments under capital lease obligations........... (2,191) (4,884) (8,563) Proceeds from issuance of mandatorily redeemable preferred stock (Note 6)............................................. 14,013 -- -- Proceeds from private placements of common stock............. 8,660 15,409 -- Proceeds from public stock offerings......................... -- 26,226 106,309 Proceeds from warrants exercised............................. -- 759 Proceeds from stock options exercised........................ -- 385 3,659 --------- --------- --------- Net cash provided by financing activities.................. 38,286 49,842 107,056 --------- --------- --------- Net increase in cash and cash equivalents...................... 3,703 12,457 124,414 Cash and cash equivalents, beginning of year................... 290 3,993 16,450 --------- --------- --------- Cash and cash equivalents, end of year......................... $ 3,993 $ 16,450 $ 140,864 --------- --------- --------- --------- --------- --------- Acquisition, net of cash acquired (Note 2): Issuance of convertible preferred stock...................... $ 135,000 Transaction costs............................................ 9,914 Intangible assets............................................ (121,164) --------- Cash acquired from acquisition............................... $ 23,750 --------- ---------
The accompanying notes are an integral part of these consolidated financial statements F-6 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION EarthLink Network, Inc. ("EarthLink" or the "Company") is an Internet service provider that was formed to help members derive meaningful benefits from the extensive resources of the Internet. The Company has experienced operating losses since inception as a result of efforts to build its network infrastructure and internal staffing, develop its systems, and expand into new markets. The Company expects that it will continue to incur net losses as it continues to expend substantial resources on sales and marketing as it attempts to rapidly increase its market share. There can be no assurance that the Company will achieve or sustain profitability or positive cash flow from its operations. BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of EarthLink Network, Inc. and its wholly-owned subsidiary EarthLink Operations, Inc. (Note 2). All intercompany transactions and balances have been eliminated in the consolidated financial statements. REVENUES Recurring revenues consists of monthly fees charged to members for Internet access and other ongoing services from monthly Internet service and are recognized over the period services are provided. Other revenues generally represent one-time non-refundable set up fees. Incremental revenues are derived from advertising, content and electronic commerce fees that leverage the value of the Company's member base and user traffic. Such revenues are recorded as earned. CASH AND CASH EQUIVALENTS All short-term, highly liquid investments with an original maturity of three months or less at the date of acquisition are classified as cash equivalents. ACCOUNTS RECEIVABLE AND DEFERRED REVENUES The Company bills for Internet service generally one month in advance. Accordingly, these non-cancelable advanced billings are included in both accounts receivable and deferred revenue. CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations or credit risk consist principally of cash investments and trade receivables. The Company's cash investment policies limit investments to short-term, investment grade instruments. Concentrations of credit risk with respect to trade receivables are limited due to the large number of members comprising the Company's member base. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated using the straight-line method over the estimated useful life of the assets, which is generally three years for computers and computer related equipment and five years for other non-computer furniture and equipment. Leasehold improvements are F-7 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) amortized using the straight-line method over the shorter of their estimated lives or the term of the lease, ranging from one to ten years. EQUIPMENT UNDER CAPITAL LEASE The Company leases certain of its data communications and other equipment under capital lease agreements. The assets and liabilities under capital lease are recorded at the lesser of the present value of aggregate future minimum lease payments, including estimated bargain purchase options, or the fair value of the assets under lease. Assets under capital lease are amortized over the lesser of their estimated useful lives of three to five years or the term of the lease. INTANGIBLES Intangible assets consist primarily of rights to customer lists, long-term marketing agreements, goodwill, deferred financing and other items. The costs assigned to intangible assets are being amortized on a straight-line basis over the estimated useful lives of the assets, which range from one to ten years. The Company regularly reviews the recoverability of intangible assets based on estimated undiscounted future cash flows from operating activities compared with the carrying values of the intangibles. ADVERTISING AND CUSTOMER ACQUISITION COSTS Advertising and customer acquisition costs are included in sales and marketing. Such costs are expensed as incurred. Advertising expenses were $3.2 million, $5.1 million and $8.8 million in 1996, 1997 and 1998, respectively. INCOME TAXES Income taxes are accounted for under the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting basis and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. NET LOSS PER SHARE The Company adopted Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share" (EPS) and Staff Accounting Bulletin (SAB) No. 98. SAB No. 98 states that companies, such as EarthLink, that completed an initial public offering ("IPO") within the past 5 years and incorporated the SAB No. 83 concept of "cheap stock" in determining pre-IPO EPS data must restate all EPS data to conform to SFAS No. 128. Accordingly, all EPS data have been restated to conform to SFAS No. 128. SFAS No. 128 requires a dual presentation of basic and diluted EPS. Basic EPS represents the weighted average number of shares divided into net income during a reported period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. However, the Company did not include potential common stock in the calculation of EPS since inception as such inclusion would have an anti-dilutive effect. F-8 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. COMMON STOCK BASED COMPENSATION The Company continues to account for its employee stock based compensation using the intrinsic value method in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and provides pro forma disclosures in the notes to the consolidated financial statements (Note 9), as if the measurement provisions of SFAS No. 123 had been adopted. RECLASSIFICATION Certain amounts in the prior year financial statements have been reclassified to conform to current year presentation. STOCK SPLIT In July 1998 the Company effected a two-for-one stock split. The accompanying consolidated financial statements and related notes have been retroactively adjusted to give effect to the stock split. 2. STRATEGIC ALLIANCE WITH SPRINT CORPORATION On February 10, 1998, EarthLink entered into certain agreements to establish a broad strategic relationship (the "Strategic Alliance") with Sprint Corporation ("Sprint") in the area of consumer Internet access and related services. In connection with the Strategic Alliance, on June 5, 1998, Sprint consummated a tender offer for 2.5 million shares of the Company's common stock at a price per share of $22.50 in cash to each tendering stockholder (the "Offer"). Immediately following the closing of the Offer, Sprint received approximately 4.1 million shares of the Company's Series A convertible preferred stock which has been valued at $135 million, in exchange for (i) transfer to the Company of Sprint's approximately 130,000 Sprint Internet Passport subscribers, (ii) aggregate cash consideration of approximately $24 million and (iii) the exclusive right to use certain ports within Sprint's high-speed data network for four years. EarthLink and Sprint also entered into a Marketing and Distribution Agreement which includes a commitment by Sprint to deliver a minimum of 150,000 new subscribers per year for five years through its own channels, EarthLink's right to be Sprint's exclusive provider of consumer Internet access services for at least ten years and the right to use Sprint's brand and distribution network for at least ten years. Sprint has also provided EarthLink with a credit facility of up to $25 million (increasing to $100 million over three years) in the form of convertible senior debt. Collectively, the above is referenced to as the "Sprint Transaction". In connection with the Sprint Transaction, a newly-formed subsidiary of the Company was merged with and into the former EarthLink Network, Inc. (the "Merger"), pursuant to which (i) the former EarthLink became a wholly-owned subsidiary of the Company and (ii) each outstanding share of former F-9 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. STRATEGIC ALLIANCE WITH SPRINT CORPORATION (CONTINUED) EarthLink common stock was converted into one share of common stock of the Company. EarthLink Operations, Inc. ("EarthLink Operations"), the corporation surviving the Merger, is now a wholly-owned subsidiary of the Company. All references in these financial statements to EarthLink or the Company related, collectively, to both EarthLink Network, Inc. and EarthLink Operations, Inc. The Company accounted for the acquisition of the Sprint Internet Passport business ("SIP") as a purchase and, accordingly, the results of operations of SIP for the period from June 5, 1998 are included in the accompanying consolidated financial statements. Intangible assets acquired in the Sprint Transaction are valued as follows:
(IN THOUSANDS) -------------- Member base................................................................... $ 65,000 Marketing and distribution agreement.......................................... 20,000 Goodwill...................................................................... 36,164 -------------- $ 121,164 -------------- --------------
The assets are being amortized on a straight-line basis over the estimated useful lives as follows: member base amortized over 18 months, the Marketing and Distribution Agreement amortized over 5 and 10 years, which are the life of the portion of the contract related to Sprint's provision of additional customers and the overall contract life relative to the co-branding feature, respectively, and the excess of consideration over the fair value of net asserts acquired (goodwill) over 18 months. As such, the member base and goodwill will be fully amortized by December 31, 1999. The following unaudited pro forma consolidated results of operations for the two years ended December 31 1998, assume the acquisition occurred on January 1, 1997 and 1998, respectivley. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that actually would have resulted had the acquisition occurred on the date indicated, or which may result in the future.
YEAR ENDED DECEMBER 31, -------------------- 1997 1998 --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Total revenues......................................... $ 95,377 $ 187,063 Net loss............................................... (153,935) (99,348) Deductions for accretion dividends (Note 8)............ (13,099) (13,099) Net loss attributable to common stockholders........... (167,034) (112,447) Basic and diluted net loss per share................... $ (8.35) $ (4.30)
F-10 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. PROPERTY AND EQUIPMENT Property and equipment consist of:
DECEMBER 31, -------------------- 1997 1998 --------- --------- (IN THOUSANDS) Data communications equipment........................... $ 17,056 $ 29,274 Office and other equipment.............................. 12,196 21,863 Leasehold improvements.................................. 5,013 8,771 Construction in progress................................ 1,901 541 --------- --------- 36,166 60,449 Less accumulated depreciation and amortization.......... (12,768) (25,243) --------- --------- $ 23,398 $ 35,206 --------- --------- --------- ---------
Property under capital lease, primarily data communications equipment included above, aggregated $22.5 million and $31.7 million at December 31, 1997 and 1998, respectively. Included in accumulated depreciation and amortization are amounts related to property under capital lease of $8.5 million and $15.7 million at December 31, 1997 and 1998, respectively. Depreciation expense charged to operations was $3.9 million, $8.5 million and $12.5 million in 1996, 1997, and 1998, respectively, and included $2.8 million, $5.6 million and $7.1 million, respectively, pertaining to property under capital lease. 4. INTANGIBLE ASSETS Intangible assets consist of:
DECEMBER 31, -------------------- 1997 1998 --------- --------- (IN THOUSANDS) Member base............................................. $ -- $ 65,000 Marketing and distribution agreement.................... -- 20,000 Goodwill................................................ -- 36,164 Rights to client lists.................................. 1,414 10 Other................................................... 618 245 --------- --------- 2,032 121,419 Less accumulated amortization........................... (1,074) (41,413) --------- --------- $ 958 $ 80,006 --------- --------- --------- ---------
5. NOTES PAYABLE In June 1996, the Company issued to 17 investors, 10% Promissory Notes aggregating $2,950,000. Certain of the investors were directors and stockholders of the Company. As described in Note 9, the Company issued warrants valued at $116,000 to the note holders. The fair value of the warrants was recorded as deferred financing costs and amortized as interest expense over the life of the notes. Upon consummation of the Company's initial public offering on January 22, 1997, the holders of $725,000 of the 10% Promissory Notes converted their indebtedness into 111,534 shares of Common Stock. In January 1997, the Company repaid the $2,225,000 balance remaining on the 10% Promissory Notes. F-11 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. NOTES PAYABLE (CONTINUED) On March 31, 1998, the Company's $5.0 million Convertible Note payable to UUNET Technologies Inc., and related accrued interest, were converted into 783,030 shares of Common Stock at a conversion price of $6.44 per share. The Company's note payable to PSINet, $4.4 million at December 31, 1997, was also paid off during 1998. 6. CAPITAL STOCK AND MANDATORILY REDEEMABLE EQUITY SECURITIES INITIAL PUBLIC OFFERING On January 22, 1997 the Company commenced its initial public offering. The offering consisted of 4,000,000 shares of common stock issued at $6.50 per share. Net proceeds to the Company were approximately $22.8 million. Upon consummation of the offering 2,727,273 shares of the Company's Series A redeemable convertible preferred stock were converted to 2,727,248 shares of common stock. In February 1997, the Underwriter exercised its over-allotment option and purchased 569,500 shares at the initial public offering price of $6.50. Net proceeds to the Company were approximately $3.4 million. CONVERSION OF MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK On September 10, 1996, the Company issued 2,727,273 shares of its Series A redeemable convertible preferred stock to investors including among others, certain directors, stockholders and the Underwriter associated with the Company's initial public offering and certain of its associates for $15 million. Stock issuance costs of $987,000 have been charged to redeemable convertible preferred stock. Each two shares of the Series A redeemable convertible preferred stock was automatically converted into one share of common stock upon consummation of the initial public offering of the Company's common stock on January 22, 1997. COMMON STOCK On September 19, 1997, the Company closed a private placement of 2,919,518 shares of its unregistered restricted common stock. Net proceeds from the offering were approximately $15.4 million. FOLLOW ON PUBLIC OFFERING In June 1998 the Company completed a follow on public offering of 3.8 million shares of its common stock at $30 per share. The offering consisted of 3.0 million shares, including 490,000 shares sold to Sprint in accordance with its preemptive rights under the Sprint Alliance, and an underwriter's over-allotment of 720,000 shares. Net proceeds to the Company were approximately $106.3 million. COMMON STOCK ISSUANCES FOR OTHER THAN CASH In May 1996, the Company issued 10,244 shares of common stock at $4.88 per share, to a sub-contractor in lieu of cash for services provided to the Company. In September 1996, the Company issued 75,000 shares of common stock at $5.50 per share as consideration for the termination of a consulting agreement. In January 1998, the Company issued 20,000 shares of its common stock to a Consultant in lieu of cash for services provided pursuant to a consulting agreement. The fair value of the shares was recorded as prepaid professional services and amortized ratably over the term of the contract. Under this agreement the Company issued 20,000 additional shares of its common stock in January 1999. F-12 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. CONVERTIBLE PREFERRED STOCK All issued and outstanding shares of Series A convertible preferred stock are held by Sprint (Note 2). The Series A convertible preferred stockholders receive dividends at a rate per annum of 3% of the Liquidation Value (as defined below), compounded quarterly. For a period of five years from June 1998, such dividends are payable "in kind" by way of an increase in the Liquidation Value of the shares. Beginning in June 2003, holders of Series A convertible preferred stock will receive cumulative quarterly cash dividends of 3% annually. Beginning in June 2018, holders of the Series A convertible preferred stock are entitled to cumulative quarterly cash dividends of 8% of the Liquidation Value per share, increasing annually to a maximum rate of 12%. The holders of Series A convertible preferred stock will receive, prior to any payment or distribution in respect of other shares of the Company's capital stock, an amount per share equal to the average market value of the common stock measured over the thirty day period ended June 5, 1998 (the "Average Stock Price"), plus all accrued and unpaid dividends on such share, whether in cash or in kind (such amount, the "Liquidation Value"). Beginning in June 1999, each share of Series A convertible preferred stock is convertible into such number of shares of common stock as is determined by dividing the Liquidation Value by the "Conversion Price" in effect at such time. For the five year period following June 1998, the Conversion Price is equal to the Average Stock Price multiplied by 116.118%. Thereafter, the Conversion Price is increased annually by 6%, accruable quarterly. The Conversion Price is also subject to adjustment based on changes in capitalization of the common stock. Although conversion of the Series A convertible preferred stock is at the holder's option, conversion is required in the event the Company consummates certain business combination transactions. Beginning in June 2001, the Company may elect to redeem the outstanding shares of Series A convertible preferred stock at a redemption price per share equal to the Liquidation Value of such shares, including the acceleration of certain dividends, multiplied by a specified percentage. The specified percentage is initially equal to 103%, and will be reduced by 1% annually in each of the subsequent three years, and thereafter will be equal to 100%. The Series A convertible preferred stockholders do not possess general voting rights together with holders of common stock. However, the Series A convertible preferred stockholders are separately entitled to elect two of the Company's directors. This right terminates as to one of the directors if Sprint fails to maintain at least a 20% equity interest in EarthLink (on a fully diluted basis, subject to adjustment) for any three consecutive months, and will terminate as to both of the directors if Sprint fails to maintain at least a 10% equity interest over the same period. A separate vote of 66.67% of the then-outstanding shares of Series A convertible preferred stock is required in certain limited situations, including liquidation, dissolution or winding up of the Company, or taking certain actions which would adversely affect the rights of the holders of the Series A convertible preferred stock as a class. 8. DEDUCTIONS FOR DIVIDENDS ON CONVERTIBLE PREFERRED STOCK Dividends on convertible preferred stock are reflected as an increase to net loss attributable to common stockholders. This adjustment reflects the liquidation dividend of $4.3 million based on a 3% dividend (Note 7) and the accretion of a $3.3 million dividend related to the beneficial conversion feature of the Series A convertible preferred stock in accordance with EITF Topic No. D-60 based upon the rate at which the preferred stock becomes convertible. F-13 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS AND WARRANTS 1995 STOCK OPTION PLAN In September 1995, the Company established the EarthLink Network 1995 Stock Option Plan (the "1995 Plan"). The 1995 Plan provides for the grant of incentive stock options to purchase shares of common stock to employees of the Company and non-qualified stock options to employees, officers, directors and consultants of the Company. During 1998, the Plan was amended to increase the number of available options from 2,500,000 to 5,700,000. The Plan is administered by a committee appointed by the Board of Directors which determines the terms of the options granted, including the exercise price, the number of shares subject to option, and the option vesting period. The exercise price of all options granted under the plan must be at least 100% of the fair market value on the date of grant. Options generally have a maximum term of ten years and vest in equal quarterly increments over a five year period. As of December 31, 1998, there were 1,493,176 shares available for issuance under the 1995 Plan. DIRECTORS STOCK OPTION PLAN In September 1995, the Company established the EarthLink Directors Stock Option Plan (the "Directors Plan"). The Directors Plan, as amended and restated in December 1996, provides for the grant of options to purchase an aggregate of 125,000 shares of common stock to directors who do not also serve as employees of the Company and do not beneficially own, nor are employees, directors or officers of any entity which owns 5% or more of the outstanding shares of the Company's capital stock. Under the Directors Plan, grants of options to purchase 20,000 and 5,000 shares of common stock are automatically made to each non-management director at such time as the person first becomes a member of the Board of Directors and at the beginning of each fiscal year, respectively. Options generally have a maximum term of ten years and vest in equal quarterly increments over a five year period. As of December 31, 1998, there were no outstanding options to purchase shares of common stock under the Directors Plan. NON-QUALIFIED OPTION GRANTS In addition to the options granted under the plans described above, the Company granted non-qualified stock options to certain employees, officers and directors. Non-qualified options generally have a maximum term of ten years and generally vest in equal quarterly increments over a five-year period. VALUE OF OPTIONS GRANTED TO EMPLOYEES For disclosure purposes, the fair value of all stock options granted is estimated using the Black-Scholes option-pricing model with the following weighted average assumptions used for stock options granted:
YEAR ENDED DECEMBER 31, -------------------- 1997 1998 --------- --------- Annual dividends.................................... zero zero Expected volatility................................. 69% 83% Risk free interest rate............................. 6.49% 5.28% Expected life....................................... 6.6 years 6.6 years
F-14 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS AND WARRANTS (CONTINUED) For 1996, the fair value of each option grant is estimated on the date of grant using the minimum value method with the following assumptions used for grants during both periods: dividend yield of 0.0%, risk free interest rate of 5.83% and expected option term of 10 years. Had compensation cost been determined on the basis of fair value pursuant to SFAS No. 123, net loss and net loss per share would have been increased as follows:
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1997 1998 --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net loss attributable to common stockholders As reported.............................. $ 31,149 $ 29,916 $ 67,383 --------- --------- --------- --------- --------- --------- Pro forma................................ $ 31,477 $ 30,737 $ 104,577 --------- --------- --------- --------- --------- --------- Basic and diluted net loss per share As reported.............................. $ 2.57 $ 1.50 $ 2.58 --------- --------- --------- --------- --------- --------- Pro forma................................ $ 2.60 $ 1.54 $ 4.00 --------- --------- --------- --------- --------- ---------
WARRANTS The Company has issued to certain Board members, consultants, lessors, creditors and others warrants to purchase shares of the Company's common stock. In January 1996, certain stockholders guaranteed a $1.5 million lease for networking equipment. The Company issued warrants to purchase 200,000 shares of common stock at $2.42 per share. The fair value of the warrants has been included in intangible assets. These warrants expire January 11, 2001. In January 1996, the Company issued warrants to purchase 200,000 shares of common stock at $2.42 to Board members. The warrants vest quarterly over five years. As these warrants were issued for service on the Board of Directors they are accounted for under APB No. 25 and as such are included in the summary of non-qualified options and are not included in the summary of warrant grants. In January 1996, LINC Capital Partners, Inc. ("LINC") provided a $1.5 million lease line for equipment. The Company issued warrants to LINC to purchase 100,000 shares of common stock at $2.42 per share. The fair value of the warrants has been included in intangible assets. These warrants expire January 18, 2006. In February 1996, Boston Financial & Equity Corporation ("Boston Financial") provided a $700,000 lease line for equipment. The Company issued warrants to Boston Financial to purchase 10,000 shares of common stock at $4.88 per share. The fair value of the warrants has been included in intangible assets. These warrants expire February 15, 2006. In May 1996, the Company issued warrants to purchase 90,954 shares of common stock at $4.88 per share to various lessors in return for lease lines and other services to the Company. The fair value of the warrants has been included in intangible assets. The warrants expire on May 10, 2006. F-15 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS AND WARRANTS (CONTINUED) In May 1996, in connection with the amendment and restatement of the UUNET Agreement, the Company agreed to issue warrants to purchase 20,000 shares of common stock at an exercise price of $10.00 per share. The fair value of the warrants has been included in intangible assets. In connection with the issuance of 10% Promissory Notes aggregating $2,950,000, the Company issued to the lenders warrants to purchase an aggregate of 196,680 shares of common stock at an exercise price of $5.50 per share, as adjusted. The fair value of the warrants has been included in intangible assets. In connection with the execution of the PSINet, Inc. ("PSINet") agreement in July 1996 (Note 11), the Company issued warrants to purchase 200,000 shares of Common Stock at an exercise price of $10.00 per share. The fair value of the warrants has been included in intangible assets. In connection with the private placement of Series A redeemable convertible preferred stock, described in Note 6, the Company granted to certain purchasers of the convertible preferred stock warrants to purchase 200,000 shares of common stock at $5.50 per share. WARRANTS ISSUED FOR SERVICES In May 1996, the Company entered into an agreement with NMC, a producer of infomercials and commercials, pursuant to which NMC agreed to produce and broadcast commercials for EarthLink's services in exchange for warrants. Upon completion of the infomercial in April 1997, the Company issued warrants to NMC to purchase 100,000 shares of common stock, having an exercise price of $4.88 per share. In September 1997, the parties orally agreed to rescind the agreement. The rescission agreement included the return of the 100,000 warrants and the cancellation of any future obligations of either party. However, the rescission agreement was never executed and thus may be considered non-operative. The fair value of the warrants, $76,000, has been recorded as prepaid advertising and will be expensed upon airing of the infomercials. In January 1997 and October 1997, the Company issued warrants to purchase 12,000 and 50,000 shares, respectively, of the Company's common stock to certain consultants. The respective exercise prices of the warrants were $6.50 and $8.88. The fair value of the warrants is reflected as prepaid consulting fees and amortized ratably over the life of the consulting agreement. Consulting expense recorded with respect to warrants issued to consultants was $23,340 during 1997. In September 1996, the Company issued warrants to purchase 15,000 shares of the Company's common stock at $5.50 per share to each of the three members of the Company's Technology Advisory Council. The warrants vest quarterly over two years. The fair value of the warrants is reflected as deferred professional services expense and amortized ratably over the member's two year term of service in the Technology Advisory Council. In March 1997 and October 1997, the Company issued warrants to purchase 15,000 shares of the Company's c common stock to each of two new members of the Company's Technology Advisory Council. The warrants have an exercise price of $5.25 per share and $8.88 per share, respectively, and vest quarterly over two years. The fair value of the warrants is reflected as deferred professional services expense and amortized ratably over the member's two year term of service in the Technology Advisory Council. F-16 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS AND WARRANTS (CONTINUED) Following is a summary of stock option and warrant activity during the three years ended December 31, 1998:
NUMBER OF SHARES OF COMMON STOCK ------------------------------------- WEIGHTED INCENTIVE NON-QUALIFIED AVERAGE STOCK STOCK EXERCISE OPTIONS OPTIONS WARRANTS PRICE ---------- ------------- ---------- ----------- Balance at December 31, 1995.............. 465,000 729,582 520,660 $ 1.50 Granted................................... 1,612,500 350,000 1,182,634 $ 4.58 Forfeited................................. (21,000) -- -- $ 4.88 ---------- ------------- ---------- ----------- Balance at December 31, 1996.............. 2,056,500 1,079,582 1,703,294 $ 3.45 Granted................................... 691,250 100,000 92,000 $ 6.92 Exercised................................. (97,914) (29,582) -- $ 2.82 Forfeited................................. (422,614) -- -- $ 4.51 ---------- ------------- ---------- ----------- Balance at December 31, 1997.............. 2,227,222 1,150,000 1,795,294 $ 4.01 Granted................................... 1,817,400 -- 7,306 $ 26.35 Exercised................................. (774,720) (494,034) (712,392) $ 2.82 Forfeited................................. (85,712) -- -- $ 14.79 Surrendered in cashless exercise.......... -- (7,966) (148,776) $ 8.77 ---------- ------------- ---------- ----------- Balance at December 31, 1998.............. 3,184,190 648,000 941,432 $ 12.14 ---------- ------------- ---------- ----------- ---------- ------------- ---------- ----------- Exercisable at December 31, 1996.......... 168,312 194,584 1,538,294 ---------- ------------- ---------- ---------- ------------- ---------- Exercisable at December 31, 1997.......... 598,710 417,500 1,673,840 ---------- ------------- ---------- ---------- ------------- ---------- Exercisable at December 31, 1998.......... 583,497 145,500 874,257 ---------- ------------- ---------- ---------- ------------- ----------
The weighted average fair values of the options granted during the three years ended December 31, 1998, were $1.01, $4.98 and $20.47, respectively. The weighted average fair values of warrants granted during the three years ended December 31, 1998 were $0.86, $6.46 and $22.56, respectively. Following is a summary of stock options and warrants outstanding as of December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE --------------------------------------- ---------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE AVERAGE RANGE OF NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE - -------------------- ----------- ------------- ----------- --------- ----------- $ 0.91 $ 0.91 615,000 6.23 $ 0.91 435,000 $ 0.91 $ 2.42 $ 2.42 964,910 6.97 $ 2.42 454,410 $ 2.42 $ 4.88 $ 5.75 1,004,128 7.67 $ 5.24 373,865 $ 5.23 $ 6.50 $ 16.06 1,080,734 8.85 $ 12.29 135,699 $ 11.99 $ 22.38 $ 39.19 1,108,850 9.56 $ 32.94 204,280 $ 23.84 ----------- --------- $ 0.91 $ 39.19 4,773,622 8.05 $ 12.14 1,603,254 $ 6.21 ----------- --------- ----------- ---------
F-17 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. INCOME TAXES At December 31, 1997 and 1998, the Company had net operating loss carryforwards for federal income tax purposes totaling approximately $61.0 million, and $106.8 million, respectively, which begin to expire in 2010. At December 31, 1997 and 1998, the Company had net operating loss carryforwards for California income tax purposes totaling approximately $48.0 million and $70.0 million, respectively, which begin to expire in 2001. The Internal Revenue Code of 1986, as amended, includes provisions which may limit the net operating loss carryforwards available for use in any given year if certain events occur, including significant changes in ownership. Due to the Company's initial public offering and other issuances of common stock and common stock equivalents, utilization of the Company's net operating loss carryforwards to offset future income may be limited. The net operating loss includes $24.0 million related to the exercise of employee stock options. Any benefit resulting from the utilization of this portion of the net operating loss will be credited directly to equity. Deferred tax assets and liabilities include the following:
DECEMBER 31, -------------------- 1997 1998 --------- --------- (IN THOUSANDS) Gross deferred tax liabilities: Member base........................................... $ -- $ (17,414) Other................................................. -- (819) --------- --------- -- (18,233) --------- --------- Gross deferred tax assets: Net operating loss carryforwards...................... 24,584 42,625 Other................................................. 642 948 --------- --------- 25,226 43,573 --------- --------- Valuation allowance..................................... (25,226) (25,340) --------- --------- $ -- $ -- --------- --------- --------- ---------
Because management believes sufficient uncertainty exists regarding realizability, a full valuation allowance has been established. The following table summarizes the significant differences between the U.S. Federal statutory tax rate and the Company's effective tax rate for financial statement purposes:
DECEMBER 31, -------------------- 1997 1998 --------- --------- (IN THOUSANDS) Federal income tax (benefit) at statutory rate.......... $ (10,171) $ (20,923) Nondeductible goodwill.................................. -- 4,922 Nondeductible expenses.................................. -- 54 Net valuation allowance................................. 10,171 15,947 --------- --------- $ -- $ -- --------- --------- --------- ---------
F-18 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. COMMITMENTS AND CONTINGENCIES LEASES The Company leases its facilities and certain equipment under non-cancelable operating leases expiring in various years through 2008. Total rent expense in 1996, 1997 and 1998 for all operating leases amounted to $914,000, $1.9 million and $2.4 million, respectively. The Company also leases equipment, primarily data communications equipment, under non-cancelable capital leases. Most of the Company's capital leases include purchase options at the end of the lease term. During the three years ended December 31, 1998, the Company financed the acquisition of data processing and office equipment amounting to approximately $11.3 million, $10.5 million and $9.3 million, respectively, by entering into a number of leases and agreements for the sale and leaseback of equipment. The sale leaseback transactions are recorded at cost, which approximates the fair market value of the property and, therefore, no gains or losses have been recorded. The property remains on the books and continues to be depreciated. A financing obligation representing the proceeds is recorded and reduced based upon payments under the lease agreement. The Company's corporate headquarters and call center are located in a 93,000 square-foot facility in Pasadena, California. Base rent is currently $73,000 per month. The Company has an option to extend this lease for an additional five years at the then-prevailing market rate following its expiration in September 2007. The data center and primary data hub are housed in a 110,000 square foot facility adjacent to the headquarters with rent of $92,000 per month, subject to yearly increases. The lease for this space expires February 2007, with an option to extend for an additional ten year term. Minimum lease commitments under non-cancelable leases at December 31, 1998 are as follows:
YEAR ENDING CAPITAL OPERATING DECEMBER 31, LEASES LEASES - ------------------------------------------------------------------------ --------- ----------- (IN THOUSANDS) 1999.................................................................... $ 10,048 $ 2,606 2000.................................................................... 7,109 2,967 2001.................................................................... 2,287 2,740 2002.................................................................... 183 2,865 2003.................................................................... 38 2,881 Thereafter.............................................................. 8 10,312 --------- ----------- Total minimum lease payments............................................ 19,673 $ 24,371 ----------- ----------- Less amount representing interest....................................... (3,631) --------- Present value of future lease payments.................................. 16,042 Less current portion.................................................... (8,341) --------- $ 7,701 --------- ---------
SIGNIFICANT AGREEMENTS Access to the Internet for members outside of the Company's California regional base is provided through points of presence ("POP") capacity leased from UUNET and PSINet. EarthLink is, in effect, buying this capacity in bulk at a discount, and providing access to EarthLink's member base at EarthLink's normal rates. At December 31, 1998, $4.0 million and $4.1 million in amounts due to UUNET were F-19 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. COMMITMENTS AND CONTINGENCIES (CONTINUED) recorded in accounts payable and other accrued liabilities, respectively, and $4.7 million in amounts due PSINet were recorded in other accrued liabilities. Minimum commitments under non-cancelable network service agreements from UUNET and PSINet are as follows:
YEAR ENDING DECEMBER 31, IN MILLIONS - ---------------------------------------------------------------------------------- ----------- 1999.............................................................................. $ 36.0 2000.............................................................................. 40.8 2001.............................................................................. 43.0 2002.............................................................................. 47.0 ----------- Total............................................................................. $ 166.8 ----------- -----------
EarthLink licensed Netscape Communicator software ("Netscape Communicator") from Netscape Communications Corporation, and Microsoft Internet Explorer software ("Internet Explorer") from Microsoft Corporation. These licenses permit the Company to distribute Netscape Communicator and Internet Explorer in the EarthLink Network TotalAccess software package. Management believes that contract renewal for this browser software under conditions acceptable to EarthLink, is probable. 12. PROFIT SHARING PLAN Effective January 1997, the Company implemented a profit sharing plan (the Plan) pursuant to Section 401(k) of the Internal Revenue code, whereby participants may contribute a percentage of compensation, but not in excess of the maximum allowed under the Code. The Company makes a discretionary matching contribution of 25% up to a maximum of 6% of the participant's total eligible compensation. The Company's matching contributions vest over four years from the participant's date of hire. Total contributions for 1997 and 1998 were $84,000 and $285,000, respectively. 13. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1997 1998 --------- --------- --------- (IN THOUSANDS) Cash paid during the year for interest.............. $ 1,041 $ 1,965 $ 2,101 Cash paid during the year for income taxes.......... 1 1 1 Non cash transactions related to the conversion of notes payable to equity........................... -- 725 5,043 Common stock subscription........................... -- -- 1,041 Non cash adjustments related to accretion dividends of Series A convertible preferred stock........... -- -- 7,601
14. SUBSEQUENT EVENTS In January 1999 the Company completed a follow on public offering of 2.4 million shares of its common stock at $73.63 per share. The offering consisted of 2.3 million shares and an underwriter's F-20 EARTHLINK NETWORK, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. SUBSEQUENT EVENTS (CONTINUED) over-allotment of 99,000 shares exercised in February 1999. Net proceeds to the Company were approximately $170 million. In conjunction with the offering, Sprint exercised its preemptive rights to maintain its existing ownership level in the Company. Accordingly, Sprint purchased 770,000 shares of which 192,000 were common stock and 578,000 were Series B convertible preferred stock. Series B convertible preferred stock has the same rights and privileges as Series A convertible preferred stock, as described in Note 7, except that each Series B share is convertible into only one share of the Company's common stock. Proceeds from the sale of shares to Sprint were $54.1 million. In February 1999, Sprint exercised its preemptive rights to maintain its ownership in the Company after the exercise of the underwriter's over-allotment granted in connection with the aforementioned follow on public offering. Accordingly, Sprint purchased 38,000 shares of which 9,000 were common stock and 29,000 were Series B convertible preferred stock. Proceeds from the sale of stock to Sprint were $2.7 million. F-21 EXHIBIT INDEX
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- 2.1 Investment Agreement dated as of February 10, 1998, with Sprint Corporation and Sprint Communications Company L.P. (incorporated by reference to Exhibit 2.1 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 3.1 Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-4--File No. 333-52507). 3.2 Bylaws (incorporated by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-4--File No. 333-52507). 3.3 Form of Certificate of Designation, Preferences and Rights of the Company's Series A Convertible Preferred Stock. (incorporated by reference to Exhibit 10.2 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 3.4 Certificate of Designation, Preferences and Rights of the Company's Series B Convertible Preferred Stock and amendment thereto. 4.1 See Exhibits 3.1, 3.2, 3.3 and 3.4 for provisions of the Certificate of Incorporation, Bylaws and Certificates of Designation, Preference and Rights of Series A and B Convertible Preferred Stock. 4.2 Specimen Stock Certificate (incorporated by reference to Exhibit 4.2 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 4.3 Form of Warrant Agreement (incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 4.4 Agreement and Plan of Merger between Newco, Inc. and EarthLink Network, Inc. dated as of February 10, 1998 and entered into in connection with the Sprint Transaction (incorporated by reference to Exhibit 4.4 to the Company's Registration Statement on Form S-4--File No. 333-52507). 10.1 1995 Stock Option Plan and forms of Stock Option Agreement and Stock Purchase Agreement (incorporated by reference to Exhibit 10.1 to Registration Statement of EarthLink Network, Inc. on form S-1--File No. 333-15781). 10.2 Amended and Restated Stock Option Plan for Directors (incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.3 Lease Line Agreement, dated January 30, 1996, between the Company and Boston Financial & Equity Corporation (incorporated by reference to Exhibit 10.4 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.4 Master Lease Agreement, dated September 1, 1995, between the Company and LINC Capital Management (incorporated by reference to Exhibit 10.5 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.5 Netscape Communications Corporation Internet Service Provider Navigator Distribution Agreement dated May 31, 1996, between the Company and Netscape Communications Corporation (incorporated by reference to Exhibit 10.6 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781).
E-1
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- (c) Amendment No. 1 to Netscape Communications Corporation Internet Service Provider Agreement (incorporated by reference to Exhibit 10.6(a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (d) Amendment No. 2 to Netscape Communications Corporation Internet Service Provider Agreement incorporated by reference to (Exhibit 10.6(b) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.6 Network Services Agreement dated May 31, 1996, between the Company and UUNET Technologies, Inc. incorporated by reference to (Exhibit 10.7 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (a) Addendum No. 1 to Network Services Agreement (incorporated by reference to Exhibit 10.7 (a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.7 Software Distribution Agreement (MacTCP), dated October 2, 1995, between the Company and Apple Computer, Inc. (incorporated by reference to Exhibit 10.8 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.8 Employment Agreement, dated January 15, 1996, between the Company and Charles G. Betty (incorporated by reference to Exhibit 10.9 to the Company's Registration Statement on Form S-1--File No. 333-15781). (e) Amendment to Employment Agreement (incorporated by reference to Exhibit 10.9(a) to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997) (f) First Amendment to Employment Agreement (incorporated by reference to Exhibit 10.9 to the Company's Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997) (g) Second Amendment to Employment Agreement (incorporated by reference to Exhibit 10.9(c) to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997) (h) Amended and Restated Employment Agreement (incorporated by reference to Exhibit 10.8(d) to the Company's Registration Statement on Form S-1--File No. 333-53063). 10.9 Standard Industrial/Commercial Multi-Tenant Lease, dated December 1, 1995, between the Company and Becton Dickinson and Company (incorporated by reference to Exhibit 10.12 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.10 Business Loan Agreement, dated June 15, 1995, and Promissory Note in the original principal amount of $250,000 between the Company and California United Bank (incorporated by reference to Exhibit 10.13 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.11 Production and Distribution Agreement, dated May 6, 1996, between the Company and National Media Corporation (incorporated by reference to Exhibit 10.16 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (a) Amendment No. 1 to Production and Distribution Agreement (incorporated by reference to Exhibit 10.16(a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781).
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EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- 10.12 Internet Wizard Sign-Up Agreement between the Company and Microsoft Corporation, dated August 16, 1996 (incorporated by reference to Exhibit 10.19 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.13 Network Access Agreement between the Company and PSINet, Inc., dated July 22, 1996 and Amendment No. 1 to Network Access Agreement (incorporated by reference to Exhibit 10.20 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.14 Office Lease by and between The Mutual Life Insurance Company of New York, as Landlord, and the Company, as Tenant, dated September 20, 1996 (incorporated by reference to Exhibit 10.21 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.15 Standard Office Lease by and between Glen Feliz Properties, as Landlord, and the Company, as Tenant, dated July 2, 1996 (incorporated by reference to Exhibit 10.22 to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.16 Amended and Restated Note Purchase Agreement between the Company and UUNET Technologies, Inc., dated October 31, 1996 (incorporated by reference to Exhibit 10.23 to the Company's Registration Statement on Form S-1--File No. 333-15781). (a) $5,000,000 Convertible Note (incorporated by reference to Exhibit 10.23(a) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). (b) Addendum to Amended and Restated Registration Rights Agreement (incorporated by reference to Exhibit 10.23(c) to the Registration Statement on Form S-1 of EarthLink Network, Inc.--File No. 333-15781). 10.17 Amended and Restated Convertible Securities Vesting Plan (incorporated by reference to Exhibit 10.18 to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997). 10.18 Key Employee Compensation Continuation Plan (incorporated by reference to Exhibit 10.19 to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997). (a) Amendment to Key Employee Compensation Continuation Plan (incorporated by reference to Exhibit 10.19(a) to the Report on Form 10-K of EarthLink Network, Inc. for the fiscal year ended December 31, 1997). 10.19 Governance Agreement, dated as of February 10, 1998, (incorporated by reference to Exhibit 10.1 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.20 Credit Agreement, dated as of February 10, 1998, with Sprint Corporation, a Kansas corporation, as Lender (incorporated by reference to Exhibit 10.3 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.21 Registration Rights Agreement, dated as of February 10, 1998, with Sprint Corporation, and Sprint Communications Company L.P., (incorporated by reference to Exhibit 99.1 to the Form 8-K by EarthLink Network, Inc. filed on February 10, 1998). 10.22 Stockholders Agreement, dated as of February 10, 1998, among EarthLink Network, Inc., Sprint Corporation, Sprint Communications Company L.P., and the persons identified on Schedule 1 thereto (incorporated by reference to Exhibit 99.2 to the Form 8-K of EarthLink Network, Inc. filed on February 10, 1998). 10.23 Agreement to Vote Stock, dated as of February 10, 1998, among the Granting Stockholders named on Schedule A thereto, Sprint Corporation, a Kansas corporation and Sprint Communications Company L.P., a Delaware limited partnership (incorporated by reference to Exhibit 99.3 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998).
E-3
EXHIBIT DESCRIPTION - ----------- --------------------------------------------------------------------------------------------------------- 10.24 Agreement to Vote and Tender Stock, dated as of February 10, 1998, among the Granting Stockholders named on Schedule A thereto, Sprint Corporation, and Sprint Communications Company, L.P., (incorporated by reference to Exhibit 99.4 to the Form 8-K filed by EarthLink Network, Inc. on February 10, 1998). 10.25 Marketing and Distribution Agreement, dated as of February 10, 1998, Sprint Corporation, and Sprint Communications Company L.P., (incorporated by reference to Exhibit 10.26 of the Company's Registration Statement on Form S-4, filed May 13, 1998, File No. 333-52507). 10.26 Third Amendment to the lease agreement between WHMNY Real Estate Limited Partnership, a Delaware limited partnership ("Landlord"), and EarthLink Network, Inc. (incorporated by reference to Exhibit 10.1 to the Company's Form 10-Q filed on November 16, 1998. 22.1 Significant Subsidiaries (incorporated by reference to Exhibit 22.1 to the Company's Registration Statement on Form S-1, filed May 19, 1998, File No. 333-53063). 23.1 Consent of Independent Accountants. 24.1 Power of Attorney (set forth on the signature page to the Registration Statement). 27.1 Financial Data Schedule.
E-4 EX-3.4 2 EXHIBIT 3.4 EARTHLINK NETWORK, INC. CERTIFICATE OF DESIGNATION, PREFERENCES AND RIGHTS OF SERIES B CONVERTIBLE PREFERRED STOCK ----------------------------------------- PURSUANT TO SECTION 151 OF THE GENERAL CORPORATION LAW OF THE STATE OF DELAWARE ------------------------------------------ EarthLink Network, Inc. (the "Corporation"), certifies that pursuant to the authority contained in Article IV of its Certificate of Incorporation, and in accordance with the provisions of Section 151 of the General Corporation Law of the State of Delaware, its Board of Directors has adopted the following resolution creating a series of the Preferred Stock, $.01 par value, designated as Series B Convertible Preferred Stock: RESOLVED, that a series of the class of Preferred Stock, $.01 par value, of the Corporation be hereby created, and that the designation and amount thereof and the voting powers, preferences, and relative, participating, optional and other special rights of the shares of such series, and the qualifications, limitations or restrictions thereof are set forth in this Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stock (the "Certificate of Designation") as follows: 1. DESIGNATION AND AMOUNT. Preferred Stock of the Corporation created and authorized for issuance hereby shall be designated as "Series B Convertible Preferred Stock" (herein referred to as "Series B Preferred Stock"), having a par value per share equal to $.01, and the number of shares constituting such series shall be 600,000. The Corporation shall only originally issue shares of Series B Preferred Stock to Sprint Corporation, a Kansas corporation ("Sprint"), and its successors and Affiliates. 2. RANK. The Series B Preferred Stock shall, with respect to any and all rights and preferences set forth herein, including without limitation, dividend rights and rights upon liquidation, winding up or dissolution, whether voluntary or involuntary, rank immediately junior to that certain series of preferred stock of the Corporation designated as Series A Convertible Preferred Stock (the "Series A Stock") in the Certificate of Designation, Preferences and Rights of the Series A Stock which was filed with the Secretary of State of the State of Delaware on June 5, 1998. The Series B Preferred Stock will rank junior only to the Series A Stock, and shall, with respect to dividend rights and rights upon liquidation, winding up or dissolution, whether voluntary or involuntary, rank prior to the Common Stock (as defined in Section 10 hereof) and all classes or series of preferred stock, preference stock or any other capital stock or equity securities of the Corporation, whether now issued or hereafter created, other than the Series A Stock; PROVIDED, HOWEVER, that if the Corporation hereafter issues a series of the equity securities of the Corporation that rank immediately junior to the Series A Preferred Stock and that are Alternative Securities issued pursuant to the Governance Agreement (as defined in Section 7 herein), such issuance shall in no event be interpreted to violate this Certificate of Designation, shall be interpreted in all respects to be consistent with this Certificate of Designation, and such additional Alternative Securities shall be designated as PARI PASSU with the Series B Preferred Stock in all applicable rights, preferences and terms. All equity securities of the Corporation to which the Series B Preferred Stock ranks prior, including the Common Stock, are collectively referred to herein as the "Junior Securities." 3. DIVIDEND PROVISIONS. (a) DIVIDENDS. (i) LIQUIDATION ACCRETION DIVIDENDS. On and before the fifth anniversary of the Purchase Date, the Corporation shall pay, and the holders of outstanding shares of Series B Preferred Stock ("Holders") shall be entitled to receive on each Dividend Payment Date, a dividend on each share of Series B Preferred Stock at a rate per annum equal to three percent (3.00%) of the Liquidation Value (as then increased, as provided in Section 4(a)) per share of Series B Preferred Stock, accruable and compounded quarterly on each of the Dividend Accrual Dates, which dividend shall be in the form of an increase in the Liquidation Value in such amount (each such increase is referred to as a "Liquidation Accretion Dividend"). All dividends shall accrue quarterly in arrears and shall compound on each Dividend Accrual Date, commencing on the first Dividend Accrual Date after the date of issuance of the applicable shares of Series B Preferred Stock. The Board of Directors shall declare and pay such accrued dividends on each Dividend Payment Date and the Corporation shall take all further actions necessary to cause such dividend to be paid to the Holders in the form and manner prescribed herein. Notwithstanding the foregoing, upon the first date of the consummation of a Business Combination, or an Optional Redemption by the Corporation pursuant to Section 6(a), the Corporation shall pay, and the Holders of outstanding shares of Series B Preferred Stock shall be entitled to receive, a dividend on each share of Series B Preferred Stock in the form of an aggregate increase in the Liquidation Value in an amount equal to the amount by which the Liquidation Value would have increased pursuant to this Section 3(a)(i) if such Holder had held such shares of Series B Preferred Stock, until the first Dividend Payment Date on or following the fifth anniversary of the Purchase Date. (ii) CASH DIVIDENDS. After the fifth anniversary of the Purchase Date, the Corporation shall pay, and the Holders of outstanding shares of Series B Preferred Stock shall be entitled to receive, when, as and if declared by the Board of Directors, out of funds legally available therefor, cumulative dividends on each share of Series B Preferred Stock at a rate per annum equal to three percent (3.00%) of the Liquidation Value per share of Series B Preferred Stock, accruable quarterly on each of the Dividend Accrual Dates, payable only in cash; provided, however, that after the twentieth anniversary of the Purchase Date, the Corporation shall pay, and the Holders of outstanding shares of Series B Preferred Stock shall be entitled to receive, when, as and if declared by the Board of Directors, out of funds legally available therefor, cumulative dividends on each share of Series B Preferred Stock at a rate per annum equal to 8% of the Liquidation Value per share of Series B Preferred Stock, accruable quarterly on each of the Dividend Accrual Dates, payable only in cash, which rate shall increase by 200 basis points on each anniversary of the Purchase Date thereafter, but not to exceed a maximum rate of 12%. All cash dividends shall be cumulative, whether or not declared, on a daily basis from the fifth anniversary of the Purchase Date or the date of issuance, whichever is later, and shall accrue quarterly in arrears on each Dividend Accrual Date, commencing on the first Dividend Accrual Date after the fifth anniversary of the Purchase Date or the date of issuance, whichever is later. The Board of Directors shall 2 declare and pay such accrued dividends at such time and to the extent permitted by law. (iii) GENERAL PROVISIONS. Each distribution in the form of a cash dividend shall be payable to Holders of record as they appear on the stock books of the Corporation on such record date, not less than 10 nor more than 60 days preceding the relevant Dividend Payment Date, as shall be fixed by the Board of Directors of the Corporation. For any period during which any share of Series B Preferred Stock is outstanding less than a full quarterly dividend period ending on a Dividend Accrual Date, the dividends payable shall be computed on the basis of a 360 day year consisting of twelve 30-day months and the actual number of days elapsed in the period for which the dividends are payable. If any Dividend Payment Date for a dividend payable in cash occurs on a day that is not a Business Day, any accrued dividends otherwise payable on such Dividend Payment Date shall be paid on the next succeeding Business Day. (b) CERTAIN OTHER NON-CASH DISTRIBUTIONS. If the Corporation shall at any time, or from time to time, after the Purchase Date, declare, order, pay or make a dividend or other distribution (including, without limitation, any distribution or issuance of stock or other securities or property or rights or warrants to subscribe for securities of the Corporation or any of its Subsidiaries by way of dividend or spinoff or rights to purchase Common Stock or other Junior Securities) on its Common Stock, other than (i) dividends payable in cash in an aggregate amount in any fiscal year which, when declared, are not expected to exceed the net income of the Corporation during such year from continuing operations before extraordinary items, as determined in accordance with generally accepted accounting principles consistently applied in accordance with past practice, or (ii) any dividend or distribution described in Section 5(c)(i), Section 5(c)(ii) or Section 5(c)(iii), then, and in each such case (a "Triggering Distribution"), each Holder of shares of Series B Preferred Stock shall be entitled to receive from the Corporation, with respect to the shares of Series B Preferred Stock held by such Holder, the same dividend or distribution that such Holder would have received if immediately prior to the earlier of such Triggering Distribution or any record date therefor (i) a Business Combination had occurred causing the last sentence of Section 3(a)(i) to be effected, and (ii) such Holder converted all of such Holder's shares of Series B Preferred Stock into shares of Common Stock. Any such dividend, distribution or issuance shall be declared, ordered, paid or made on the Series B Preferred Stock at the same time such dividend, distribution or issuance is declared, ordered, paid or made on the Common Stock. (c) LIMITATION ON DIVIDENDS AND OTHER DISTRIBUTIONS. Unless full cumulative dividends, if any, accrued on all outstanding shares of the Series B Preferred Stock have been or contemporaneously are declared and paid for all periods prior to and ending on the most recent Dividend Accrual Date, no dividend shall be declared or paid or set aside for payment or other distribution declared or made upon the Junior Securities (other than a dividend or distribution paid solely in shares of, or warrants, rights or options solely exercisable for or convertible into, Junior Securities), nor shall any Junior Securities be redeemed, purchased or otherwise acquired for any consideration, nor may any moneys be paid to or made available for a sinking fund for the redemption of any shares of any such securities, by the Corporation (other than redemptions and purchases pursuant to or in accordance with agreements between the Corporation and its or its subsidiaries' directors, officers and key employees), except by conversion into or exchange for 3 Junior Securities. 4. LIQUIDATION PREFERENCE. (a) In the event of any voluntary or involuntary liquidation, dissolution or winding up of the Corporation ("Liquidation Event"), the Holders of Series B Preferred Stock then outstanding shall be entitled to receive, prior and in preference to any distribution of any of the assets of the Corporation to the holders of Common Stock and other Junior Securities by reason of their ownership thereof, an amount per share equal to the sum of (i) the average of the Closing Price per share of Common Stock for the 30 Trading Days immediately preceding the Purchase Date (the "Average Stock Price") for each outstanding share of Series B Preferred Stock, (ii) the amount of all Liquidation Accretion Dividends that have been paid pursuant to Section 3(a)(i) (including an amount equal to a prorated dividend pursuant to Section 3(a)(i) for the period from the Dividend Accrual Date immediately preceding the date of the Liquidation Event through the date of the Liquidation Event), and (iii) all accumulations of accrued but unpaid dividends payable in cash pursuant to Section 3(a)(ii) on each share of Series B Preferred Stock (including an amount equal to a prorated dividend pursuant to Section 3(a)(ii) for the period from the Dividend Accrual Date immediately prior to the receipt of such sum to the date of receipt of such sum), with the sum of the amounts referred to in clauses (i), (ii) and (iii) referred to herein as the "Liquidation Value". The schedule of (i) the amount of the applicable Liquidation Accretion Dividend for each Share of Series B Preferred Stock for each Dividend Payment Date therefor, and (ii) the cumulative amount of the Liquidation Value for each Share of Series B Preferred Stock, as of each Dividend Payment Date, is as follows:
Amount of Applicable Quarterly Dividend Payment Liquidation Cumulative Liquidation Value for Date for Accretion Dividend for Each Share of Each Share of Series B Preferred Quarter Series B Preferred Stock Stock - ------------------ -------------------------------------- ---------------------------------- 1 $0.50 $67.31 2 0.50 67.82 3 0.51 68.32 4 0.51 68.84 5 0.52 69.35 6 0.52 69.87 7 0.52 70.40 8 0.53 70.93 9 0.53 71.46 10 0.54 71.99 11 0.54 72.53 12 0.54 73.08 13 0.55 73.63 14 0.55 74.18 15 0.56 74.73 16 0.56 75.29
4
Amount of Applicable Quarterly Dividend Payment Liquidation Cumulative Liquidation Value for Date for Accretion Dividend for Each Share of Each Share of Series B Preferred Quarter Series B Preferred Stock Stock - ------------------ -------------------------------------- ---------------------------------- 17 0.56 75.86 18 0.57 76.43 19 0.57 77.00 20 0.58 77.58
If upon the occurrence of such Liquidation Event, the assets and funds are not sufficient to pay in full the liquidation payments payable to the Holders of the Series B Preferred Stock, then the Holders of outstanding shares of Series B Preferred Stock shall share ratably in such distribution of assets. Except as provided in this Section 4(a), Holders of Series B Preferred Stock shall not be entitled to any additional distribution upon the occurrence of a Liquidation Event. (b) After the distribution described in Section 4(a) has been paid, the remaining assets of the Corporation available for distribution to shareholders shall be distributed among the holders of Junior Securities in accordance with their respective rights thereto. (c) Neither the consolidation, merger, Business Combination or any other form of business combination of the Corporation with or into any other person or entity, nor the sale, lease, exchange, conveyance or disposition of all or substantially all of the assets of the Corporation to persons or entities other than the holders of Junior Securities shall be deemed to be a Liquidation Event for purposes of this Section 4. 5. CONVERSION. The Holders of the Series B Preferred Stock shall have conversion rights as follows (the "Conversion Rights"): (a) OPTIONAL CONVERSION RIGHTS AND AUTOMATIC CONVERSION. (i) Each share of Series B Preferred Stock shall be convertible, at the option of the Holder thereof, at any time after June 5, 1999, at the office of the Corporation or any transfer agent for the Series B Preferred Stock, into such number of validly issued, fully paid and nonassessable shares of Common Stock, free and clear of all pledges, claims, liens, charges, encumbrances and security interests of any kind or nature whatsoever, as is determined by dividing the Liquidation Value by the Conversion Price at the time in effect for such share; provided, however, that, notwithstanding any other provision hereof to the contrary, conversion of all outstanding shares of Series B Preferred Stock shall be required in the event of consummation of a Business Combination. The Conversion Price per share for shares of Series B Preferred Stock shall be (i) for the period from the Purchase Date through the Dividend Accrual Date immediately after the fifth anniversary of the Purchase Date, the product of (A) the Average Stock Price, times (B) 116.118%, and (ii) thereafter, the Conversion Price then 5 in effect shall be increased at a rate per annum equal to six percent (6%) thereof, accruable quarterly, and in each case the Conversion Price shall be subject to adjustment, from time to time as set forth in Section 5(c). (ii) Upon conversion of any Series B Preferred Stock, payment shall be made for (A) dividends under Section 3(a)(i) on each converted share of Series B Preferred Stock in an amount equal to a prorated Liquidation Accretion Dividend for the period from the Dividend Accrual Date immediately prior to the date of conversion to such conversion date, and (B) unpaid dividends under Section 3(b) resulting from events described therein and occurring prior to the date of conversion. (b) MECHANICS OF CONVERSION. If the Holder of shares of Series B Preferred Stock desires to exercise such right of conversion, such Holder shall give written notice to the Corporation (the "Conversion Notice") of that Holder's election to convert a stated whole number of shares of Series B Preferred Stock (the "Conversion Shares") into shares of Common Stock, and surrender to the Corporation, at its principal office or at such other office or agency maintained by the Corporation for such purpose, such Holder's certificate or certificates evidencing such Conversion Shares. The Conversion Notice shall also contain a statement of the name or names (with addresses) in which the certificate or certificates for Common Stock shall be issued. Notwithstanding the foregoing, the Corporation shall not be required to issue any certificates to any person other than the Holder thereof unless the Corporation has obtained reasonable assurance that such transaction is exempt from the registration requirements of, or is covered by an effective registration statement under, the Securities Act of 1933, as amended (the "Act"), and all applicable state securities laws, including, if necessary in the reasonable judgment of the Corporation or its legal counsel, receipt of an opinion to such effect from counsel reasonably satisfactory to the Corporation. In no event would such opinion be required if the shares of Common Stock could, upon conversion, be resold pursuant to Rule 144 or Rule 144A under the Act. As promptly as practicable, and in any event within five business days, after the receipt of the Conversion Notice and the surrender of the certificate or certificates representing the Conversion Shares, the Corporation shall issue and deliver, or cause to be delivered, to the Holder of the Conversion Shares or his nominee or nominees, (i) a certificate or certificates for the number of shares of Common Stock issuable upon the conversion of such Conversion Shares and (ii) if less than the full number of shares of Series B Preferred Stock evidenced by the surrendered certificate or certificates are being converted, a new certificate or certificates, of like tenor, evidencing the number of shares evidenced by such surrendered certificate or certificates less the number of Conversion Shares. Such conversion shall be deemed to have been effected as of the close of business on the date the Corporation received the Conversion Notice and the certificate or certificates representing the Conversion Shares, and the person or persons entitled to receive the shares of Common Stock issuable upon conversion shall be treated for all purposes as the holder or holders of record of such shares of Common Stock as of the close of business on such date, provided, however, that if such conversion by a Holder of Series B Preferred Stock would give rise to the waiting period of the HSR Act, such conversion shall not be effective and shall be contingent upon (i) the expiration or termination of such waiting period, and (ii) the absence of any action taken or instituted by the Department of Justice, the Federal Trade Commission or any other governmental entity by the expiration or termination of such waiting period to delay, enjoin or place conditions on such conversion. 6 (c) CONVERSION PRICE ADJUSTMENTS OF PREFERRED STOCK. (i) If the Corporation should at any time or from time to time after the Purchase Date fix a record date for the effectuation of a split or subdivision of the outstanding shares of Common Stock or the determination of holders of Common Stock entitled to receive a dividend or other distribution payable in additional shares of Common Stock, then, as of such record date (or, if no record date is fixed, as of the close of business on the date on which the Board of Directors adopts the resolution relating to such dividend, distribution, split or subdivision), the Conversion Price shall be decreased to equal the product of the Conversion Price in effect immediately prior to such date multiplied by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior thereto and the denominator of which shall be the number of shares of Common Stock outstanding immediately thereafter. (ii) If the number of shares of Common Stock outstanding at any time or from time to time after the Purchase Date is decreased by a combination of the outstanding shares of Common Stock, then following such combination, the Conversion Price shall be increased to equal the product of the Conversion Price in effect immediately prior thereto multiplied by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior thereto and the denominator of which shall be the number of shares of Common Stock outstanding immediately thereafter. So long as any shares of Series B Preferred Stock are outstanding, the Corporation shall not combine any shares of Common Stock unless it likewise combines all shares of Common Stock. (iii) If the Corporation shall at any time and from time to time after the Purchase Date issue rights or warrants to all holders of the Common Stock entitling such holders to subscribe for or purchase Common Stock at a price per share less than the Current Market Price per share of the Common Stock on the record date for the determination of stockholders entitled to receive such rights or warrants, then, and in each such case, the number of shares of Common Stock into which each share of Series B Preferred Stock is convertible shall be adjusted so that the holder of each share thereof shall be entitled to receive, upon the conversion thereof, the number of shares of Common Stock determined by multiplying the number of shares of Common Stock into which such share was convertible on the day immediately prior to such record date by a fraction, (A) the numerator of which is the sum of (1) the number of shares of Common Stock outstanding on such record date and (2) the number of additional shares of Common Stock which such rights or warrants entitle holders of Common Stock to subscribe for or purchase ("Offered Shares"), and (B) the denominator of which is the sum of (1) the number of shares of Common Stock outstanding on the record date and (2) a fraction, (x) the numerator of which is the product of the number of Offered Shares multiplied by the subscription or purchase price of the Offered Shares and (y) the denominator of which is the Current Market Price per share of Common Stock on such record date. Such adjustment shall become effective immediately after such record date. (iv) If the Corporation shall be a party to any transaction, including any capital reorganization, reclassification or recapitalization involving the Common Stock of 7 the Corporation (other than (A) a transaction described in clauses (i) and (ii) of this Section 5(c) or in Section 3(b) or (B) a consummated Business Combination), or some other form of transaction (other than a consummated Business Combination) in which the previously outstanding shares of Common Stock shall be changed into or, pursuant to the operation of law or the terms of the transaction to which the Corporation is a party, exchanged, or would have been changed or exchanged as required by the Certificate of Incorporation if such Common Stock were outstanding, for different securities of the Corporation or common stock or other securities of another corporation or interests in a non-corporate entity (such other corporation or non-corporate entity is referred to herein as the "Surviving Entity") or other property (including cash) or any combination of the foregoing, then, as a condition to the consummation of such transaction, lawful and adequate provision shall be made whereby the Holders of the Series B Preferred Stock shall thereafter have the right to receive, in lieu of the shares of Common Stock of the Corporation immediately theretofore receivable with respect to the conversion of such shares of Series B Preferred Stock, such shares of stock or securities (such stock and securities are referred to herein as the "Surviving Entity Securities") or assets as would have been issued or payable with respect to or in exchange for the shares of Common Stock which such holders would have held had the shares of Series B Preferred Stock been converted immediately prior to such transaction. In any such case, appropriate provisions shall be made with respect to the rights and interests of the Holders of the Series B Preferred Stock to the end that such conversion rights (including, without limitation, provisions for adjustment of the Conversion Price) shall thereafter be applicable, as nearly as may be practicable in relation to any shares of Surviving Entity Securities or assets thereafter deliverable upon the exercise thereof. (d) STOCK TRANSFER TAXES. The issuance of stock certificates upon the conversion of the Series B Preferred Stock shall be made without charge to the converting Holder for any tax in respect of such issuance. The Corporation shall not, however, be required to pay any tax which may be payable in respect of any transfer involved in the issuance and delivery of shares in any name other than that of the Holder of such shares of Series B Preferred Stock converted, and the Corporation shall not be required to issue or deliver any such stock certificate unless and until the person or persons requesting the issuance thereof shall have paid to the Corporation the amount of such tax, if any. (e) NO FRACTIONAL SHARES: CERTIFICATE AS TO ADJUSTMENTS. (i) No fractional shares shall be issued upon conversion of the Series B Preferred Stock, and the number of shares of Common Stock to be issued shall be rounded to the nearest whole share. (ii) Upon the occurrence of each adjustment or readjustment of the Conversion Price of Series B Preferred Stock pursuant to this Section 5, the Corporation, at its expense, shall promptly compute such adjustment or readjustment in accordance with the terms hereof and prepare and furnish to each Holder of Series B Preferred Stock a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based. The Corporation shall, upon the written request at any time of any Holder of Series B Preferred Stock, furnish or cause to 8 be furnished to such Holder a like certificate setting forth (A) such adjustment and readjustment, (B) the Conversion Price at the time in effect, and (C) the number of shares of Common Stock and the amount, if any, of other property which at the time would be received upon the conversion of a share of Series B Preferred Stock. (f) NOTICES OF RECORD DATE. In the event of any taking by the Corporation of a record of the Holders of any class of securities for the purpose of determining the Holders thereof who are entitled to receive any dividend (other than a cash dividend or a Liquidation Accretion Dividend) or other distribution, any right or warrant to subscribe for, purchase or otherwise acquire any shares of stock or any class of any other securities or property, or to receive any other right (including, without limitation, making a dividend or other distribution of any rights under a stockholder rights plan (sometimes known as a "poison pill" plan), whether now existing or hereafter created), the Corporation shall mail to each Holder of Series B Preferred Stock, at least 20 days prior to the date specified therein, a notice specifying the date on which any such record is to be taken for the purpose of such dividend, distribution, right or warrant, and the amount and character of such dividend, distribution, right or warrant. The Corporation shall not issue such dividend, distribution, right or warrant described herein or in Section 5(c)(iii), or consummate any Business Combination, or any reorganization, reclassification or recapitalization described in Section 5(c)(iv), unless it provides the Holders of the Series B Preferred Stock at least 20 days advance written notice thereof. (g) RESERVATION OF SECURITIES ISSUABLE UPON CONVERSION. The Corporation shall at all times reserve and keep available out of its authorized but unissued shares of Common Stock, solely for the purpose of effecting the conversion of the shares of the Series B Preferred Stock, free from any preemptive right or other obligation, such number of its shares of Common Stock as shall from time to time be sufficient to effect the conversion of all outstanding shares of the Series B Preferred Stock; and if at any time the number of authorized but unissued shares of Common Stock shall not be sufficient to effect the conversion of all then outstanding shares of the Series B Preferred Stock, in addition to such other remedies as shall be available to the Holder of such Series B Preferred Stock, the Corporation will take such corporate action as may be necessary to increase its authorized but unissued shares of Common Stock to such number of shares as shall be sufficient for such purposes. The Corporation shall prepare and shall use commercially reasonable efforts to obtain and keep in force such governmental or regulatory permits or other authorizations as may be required by law, and shall comply with all requirements as to registration, qualification or listing of the Common Stock in order to enable the Corporation to lawfully issue and deliver to each Holder of record of Series B Preferred Stock such number of shares of its Common Stock as shall from time to time be sufficient to effect the conversion of all Series B Preferred Stock then outstanding and convertible into shares of Common Stock, including, without limitation, compliance with the filing and waiting period requirements of the HSR Act. (h) NOTICES. Any notice required by the provisions of this Section 5 to be given to the Holders of shares of Series B Preferred Stock shall only be effective upon receipt and may be given by personal delivery, U.S. certified mail, return receipt requested, or by a nationally recognized overnight delivery service (e.g., United Parcel Service or Federal Express), delivery or postage prepaid and addressed to each Holder of record at his address appearing on the books of this Corporation (and, in the case of any Holder that is a corporation ore other entity, to the 9 attention of the President). 6. REDEMPTION. (a) OPTIONAL REDEMPTION. The Series B Preferred Stock may be redeemed (subject to (i) the right of any or all shares of Series B Preferred Stock to be converted into Common Stock at any time prior to the Redemption Date (as defined in Section 6(b)), and (ii) subject to the restrictions described in this Section 6(a) and the legal availability of funds therefor) at any time after June 5, 2001, at the Corporation's option, in whole or in part, in the manner provided in Section 6(b), at a redemption price per share of Series B Preferred Stock (expressed as a percentage of the Liquidation Value, which includes the full accelerated amount of the Liquidation Accretion Dividends as prescribed by Section 3(a)(i)) set forth above), if redeemed during the 12-month period beginning on the anniversary date of the Purchase Date of each of the years set forth below:
Year Percentage ---------- 2001 103% 2002 102% 2003 101% Thereafter 100%
In the event a redemption of less than all of the outstanding shares of Series B Preferred Stock pursuant to this Section 6(a), the Corporation shall effect such redemption either pro rata according to the number of shares held by each Holder of shares of Series B Preferred Stock, or by lot, in each case, as may be determined by the Corporation in its sole discretion. (b) PROCEDURES FOR REDEMPTION. (i) At least 30 days and not more than 60 days prior to the date fixed for any redemption of the Series B Preferred Stock, written notice (the "Redemption Notice") shall be given by first-class mail, postage prepaid, to each Holder of record on the record date fixed for such redemption (the "Redemption Date") of the Series B Preferred Stock at such Holder's address as the same appears on the stock register of the Corporation, provided that no failure to give such notice nor any deficiency therein shall affect the validity of the procedure for the redemption of any shares of Series B Preferred Stock to be redeemed except as to the Holder or Holders to whom the Corporation has failed to give said notice or except as to the Holder or Holders whose notice was defective; provided, further, that the Corporation may withdraw such Redemption Notice and thereby have no obligation to consummate the redemption described therein at any time prior to the third day prior to the Redemption Date set forth therein by providing written notice of such withdrawal to each Holder who received such Redemption Notice. The Redemption Notice shall state: (1) the redemption price; (2) whether all or less than all the outstanding shares of the Series B 10 Preferred Stock are to be redeemed and the total number of shares of the Series B Preferred Stock being redeemed; (3) the number of shares of Series B Preferred stock held, as of the appropriate record date, by the Holder that the Corporation intends to redeem; (4) the Redemption Date; (5) that the Holder is to surrender to the Corporation, at the place or places where certificates for shares of Series B Preferred Stock are to be surrendered for redemption, in the manner and at the price designated, Holder's certificate or certificates representing the shares of Series B Preferred Stock to be redeemed; and (6) that cash dividends on the shares of the Series B Preferred Stock to be redeemed shall cease to accrue on such Redemption Date unless the Corporation defaults in the payment of the redemption price. (ii) Each Holder of Series B Preferred Stock shall surrender the certificate or certificates representing such shares of Series B Preferred Stock to the Corporation, duly endorsed, in the manner and at the place designated in the Redemption Notice and on the Redemption Date. The full redemption price for such shares of Series B Preferred Stock shall be payable in cash to the person whose name appears on such certificate or certificates as the owner thereof, and each surrendered certificate shall be canceled and retired. In the event that less than all of the shares represented by any such certificate are redeemed, a new certificate shall be issued representing the unredeemed shares. (iii) Unless the Corporation defaults in the payment in full of the applicable redemption price, cash dividends on the shares of Series B Preferred Stock called for redemption shall cease to accrue and accumulate on the Redemption Date, and the Holders of such redeemed shares shall cease to have any further rights with respect thereto from and after the Redemption Date, other than the right to receive the redemption price on the Redemption Date, without interest. 7. VOTING RIGHTS. The Holders of shares of Series B Preferred Stock shall not be entitled to any voting rights, except as hereinafter provided in Section 7(b) and Section 8 or as otherwise provided by law or by that certain Governance Agreement between the Corporation, Sprint, Sprint L.P. and the Corporation (formerly, Dolphin, Inc.), dated the Purchase Date (the "Governance Agreement"). Notwithstanding any other provision of this Section 7 or Section 8, the Holders of shares of Series B Preferred Stock shall not be entitled to any voting rights hereunder with respect to a Business Combination which is not a Discriminatory Transaction. 8. PROTECTIVE PROVISIONS. (a) CLASS VOTING. So long as shares of Series B Preferred Stock are outstanding, this Corporation shall not, without first obtaining the approval (by vote or written consent) of the Holders of sixty-six and two-thirds percent (66 2/3%) of the then outstanding shares of Series B 11 Preferred Stock (voting as a class): (i) alter or change the rights, preferences or privileges of the shares of Series B Preferred Stock so as to affect adversely the shares; (ii) increase the number of authorized shares of Series B Preferred Stock, or create any new series of stock or any other securities convertible into equity securities of the Corporation having a preference over, or being on a parity with, the Series B Preferred Stock (other than Alternative Securities) with respect to, dividends, distribution of assets upon liquidation, dissolution, winding up or otherwise or conversion rights; (iii) amend the Certificate of Incorporation, Bylaws or other organizational documents of the Corporation or take any action or enter into any other agreements which, prohibit or materially conflict with the Corporation's obligations hereunder with respect to the Holders of Series B Preferred Stock; or (iv) engage in a Liquidation Event. (b) NO IMPAIRMENT. The Corporation will not, by amendment of its Certificate of Incorporation, Bylaws or other organizational documents or through any reorganization, reclassification, recapitalization, Liquidation Event, issue or sale of securities or any other voluntary action by the Corporation, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Corporation but will at all times in good faith assist in the carrying out of all the provisions of this Certificate of Designation, and in the taking of all such action as may be necessary or appropriate in order to protect the conversion and other rights of the Holders of the Series B Preferred Stock against impairment; provided, however, that the protection provided by this Section 8(b) shall not apply to a Business Combination in which (i) neither the Liquidation Value nor the Conversion Price of the Series B Preferred Stock is changed, and (ii) the Holders of Series B Preferred Stock shall be entitled to receive consideration at the same time, and in the same amount and in the same form per share, as if each share of Series B Preferred Stock had been converted into Common Stock immediately prior to such Business Combination, after giving effect to the acceleration of the full amount of all of the Liquidation Accretion Dividends as contemplated by the last sentence of Section 3(a)(i). Without limiting the foregoing, but subject to the proviso in the immediately preceding sentence, the Corporation will not effect any transaction described in this Section 8(b), the result of which is to adversely affect any of the rights of holders of Common Stock relative to the rights of holders of any other securities other than the Series B Preferred Stock. (c) TOLLING OF AUTOMATIC CONVERSION AND OTHER TIME PERIODS FOR HSR COMPLIANCE. Notwithstanding any other provision of this Certificate of Designation, until such time as the filing and waiting period requirements of the HSR Act relating to the conversion of any of the shares of Series B Preferred Stock pursuant to Section 5 shall have been complied with, if any, and there shall be no action taken or instituted by the United States Department of Justice or the United States Federal Trade Commission to delay, enjoin or impose conditions on such conversion, and such waiting period applicable under the HSR Act shall have expired or received early termination: (i) there shall be no automatic conversion of the Series B Preferred Stock into Common Stock, (ii) the Redemption Date shall be automatically extended for a period of five 12 Business Days beyond the latest date contemplated by the first sentence of Section 6(b)(i) (as so extended, the "Extended Redemption Date") and each Holder of shares of Series B Preferred Stock shall be entitled to convert any or all of such shares into Common Stock prior to the Extended Redemption Date, and (iii) each other date or event that would otherwise impair any right to convert the Series B Preferred Stock into Common Stock or otherwise impair the rights of the Series B Preferred Stock shall be tolled until 10 days after the expiration or early termination of all waiting periods under the HSR Act; provided, however, that no cash dividends shall accrue during the period after the date originally set for redemption pursuant to Section 6. Any Holder who is required to comply with the filing and waiting period requirements of the HSR Act with respect to the conversion of any shares of Series B Preferred Stock shall use commercially reasonable efforts to cause such filing to be made as soon as practicable after such Holder has provided notice of its intention to convert such shares of Series B Preferred Stock and to diligently and in good faith pursue expiration or termination of the waiting period of the HRS Act. 9. STOCKHOLDER RIGHTS PLAN. Notwithstanding any other provision of this Certificate of Designation to the contrary, if the Corporation shall adopt a stockholders rights plan (sometimes known as a "poison pill" plan), and shall declare, order, pay or make a dividend or other distribution of rights thereunder with respect to the Common Stock (whether or not separate from the Common Stock), each Holder of shares of Series B Preferred Stock shall be entitled to receive from the Corporation, upon conversion of such shares of Series B Preferred Stock into Common Stock pursuant to Section 5, all of the rights distributed under such plan (but without any limitation or restriction or the exercise of such rights that are not also applicable to holders of Common Stock) fully and to the same extent as if immediately prior to the earlier of such distribution or any record date therefor (i) the Liquidation Value of such shares of Series B Preferred Stock had then increased by the full amount of all Liquidation Accretion Dividends payable as if such shares of Series B Preferred Stock had been held through and including the first Dividend Payment Date on or following the fifth anniversary of the Purchase Date, and (ii) such Holder had then converted all of such Holder's shares of Series B Preferred Stock into shares of Common Stock. The preceding sentence shall provide the exclusive protection under this Certificate of Designation to the Holders of the Series B Preferred Stock (including any adjustments that would otherwise be required by Section 5(c)) with respect to the subject matter of the immediately preceding sentence. 10. STATUS OF CONVERTED STOCK. In the event any shares of Series B Preferred Stock shall be converted pursuant to Section 5 hereof, the shares so converted shall be canceled and thereupon restored to the status of authorized but unissued Preferred Stock undesignated as to class or series. 11. CERTAIN DEFINITIONS. For purposes of this Certificate of Designation, Preferences and Rights of Series B Preferred Stock, unless the context otherwise requires: (i) "Acquisition Proposal" shall have the meaning set forth in the Governance Agreement. (ii) "Affiliate" and "Associate" shall have the respective meanings ascribed to such terms in Rule 12b-2 under the Exchange Act as such Rule is in effect on the Purchase Date. 13 (iii) "Alternative Securities" shall have the meaning set forth in the Governance Agreement. (iv) A Person shall be deemed to "beneficially own," any securities: (A) which such Person or any of such Person's Affiliates or Associates, directly or indirectly, has the right to acquire (whether such right is exercisable immediately or only after the passage of time) pursuant to any agreement, arrangement or understanding (whether or not in writing) or upon the exercise of conversion rights, exchange rights, rights, warrants or options, or otherwise; (B) which such Person or any of such Person's Affiliates or Associates, directly or indirectly, has the right to vote or dispose of or has "beneficial ownership" of (as determined pursuant to Rule 13d-3 under the Exchange Act as such Rule is in effect on the date of this Agreement), including pursuant to any agreement, arrangement or understanding, whether or not in writing; PROVIDED, HOWEVER, that a Person shall not be deemed the "Beneficial Owner" of, or to "beneficially own," any security under this subparagraph (B) as a result of an agreement, arrangement or understanding to vote such security if such agreement, arrangement or understanding arises solely from a revocable proxy given in response to a public proxy or consent solicitation made by the Corporation pursuant to, and in accordance with, the applicable provisions of the General Rules and Regulations under the Exchange Act; or (C) which are beneficially owned, directly or indirectly, by any other Person (or any Affiliate or Associate thereof) with which such Person (or any of such Person's Affiliates or Associates) has any agreement, arrangement or understanding (whether or not in writing), for the purpose of acquiring, holding, voting (except pursuant to a revocable proxy as described in the proviso to subparagraph (B)) or disposing of any voting securities of the Corporation; PROVIDED, HOWEVER, that nothing in this subparagraph (C) shall cause a person engaged in business as an underwriter of securities to be the "Beneficial Owner" of, or to "beneficially own," any securities acquired through such person's participation in good faith in a firm commitment underwriting under the Act until the expiration of 40 days after the date of such acquisition. (v) "Business Combination" shall have the meaning set forth in the Governance Agreement. (vi) "Business Day" means any day other than a Saturday, Sunday or a day on which banking institutions in the State of New York are authorized or obligated by law or executive order to close. (vii) "Closing Price" per share of Common Stock on any date shall be the last sale price, regular way, or, in case no such sale takes place on such day, the average of the closing bid and asked prices, regular way, in either case as reported in the principal 14 consolidated transaction reporting system with respect to securities listed or admitted to trading on the New York Stock Exchange or, if the Common Stock is not listed or admitted to trading on the New York Stock Exchange, as reported in the principal consolidated transaction reporting system with respect to securities listed on the principal national securities exchange on which the Common Stock is listed or admitted to trading or, if the Common Stock is not listed or admitted to trading on any national securities exchange, if such shares of Common Stock are not listed or admitted to trading on such exchange, as reported on the Nasdaq National Market, or if not quoted on the Nasdaq National Market, the last quoted sale price or, if not so quoted, the average of the high bid and low asked prices in the over-the-counter market, as reported by Nasdaq or such other system then in use, or, if on any such date the Common Stock is not quoted by any such organization, the average of the closing bid and asked prices as furnished by a professional market maker making a market in the Common Stock selected by the Board of Directors. If the Common Stock is not publicly held or so listed or publicly traded, "Closing Price" shall mean the Fair Market Value per share as determined in good faith by the Board of Directors of the Corporation. (viii) "Common Stock" shall mean the Corporation's authorized Common Stock, $.01 par value, as constituted on the Purchase Date, and any stock into which such Common Stock may thereafter be changed or reclassified, including, without limitation, any Surviving Entity Securities; provided, however, that if Common Stock is changed or reclassified into more than one class or series of equity securities, the term "Common Stock" shall refer to the class or series of such equity securities having the greatest general voting power in the election of directors of the Corporation as compared to the other classes or series of equity securities. (ix) "Corporation" means EarthLink Network, Inc., a Delaware corporation, together with any successors of the Corporation, whether by merger, consolidation or otherwise, including without limitation a Surviving Entity. (x) "Current Market Price" per share of Common Stock on any date shall be deemed to be the Closing Price per share of Common Stock on the Trading Day immediately prior to such date. (xi) "Discriminatory Transaction" shall have the meaning set forth in the Governance Agreement. (xii) "Dividend Accrual Date" shall mean each anniversary date of the Purchase Date and the dates three months, six months and nine months of each year thereafter, beginning with the date three months after the Purchase Date, or at such additional times and for such interim periods, if any, as determined by the Board of Directors. (xiii) "Dividend Payment Date" shall mean with respect to dividends under Section 3(a)(i), the Dividend Accrual Date, and with respect to dividends under Section 3(a)(ii), the date established by the Board of Directors for the payment of all or part of the accrued dividends on the Series B Preferred Stock. 15 (xiv) "Equity Security" means (i) any Common Stock, (ii) any debt or equity securities of the Corporation convertible into or exchangeable for Common Stock or other Equity Securities of the Corporation that grant the right to vote generally in the election of directors ("Voting Equity Securities"), (iii) any options, rights or warrants (or any other similar securities) issued by the Corporation to acquire Common Stock or other Voting Equity Securities or (iv) any security issuable in connection with any stock split, stock dividend, recapitalization or other similar transaction in which securities are issued on a proportionate basis to all holders of a class of Equity Securities. (xv) "Exchange Act" shall mean the Securities Exchange Act of 1934, as amended and in effect on the Purchase Date. (xvi) "Fair Market Value" means the amount which a willing buyer would pay a willing seller in an arm's-length transaction. (xvii) "Higher Threshold" shall have the meaning set forth in the Governance Agreement. (xviii) "HSR Act" means the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the regulations promulgated thereunder. (xix) "Lower Threshold" shall have the meaning set forth in the Governance Agreement. (xx) "Person" means any individual, firm, corporation, partnership, limited liability company or other entity, and shall include any successor (by merger or otherwise) of such entity. (xxi) "Purchase Date" means January 20, 1999. (xxii) "Qualified Offer" shall have the meaning set forth in the Governance Agreement. (xxiii) "Significant Subsidiary" shall have the meaning set forth in the Governance Agreement. (xxiv) "Sprint Offer" shall have the meaning set forth in the Governance Agreement. (xxv) "Sprint's Percentage Interest" shall have the meaning set forth in the Governance Agreement. (xxvi) "Subsidiary" of any person means any corporation or other entity of which a majority of the voting power of the voting equity securities or equity interest is owned, directly or indirectly, by such person. 16 (xxvii) "Trading Day" means a day on which the principal national securities exchange, Nasdaq or other securities market on which the Common Stock is listed or admitted to trading is open for the transaction of business or, if the Common Stock is not listed or admitted to trading on any national securities exchange, any day other than a Saturday, Sunday, or a day on which banking institutions in the State of New York are authorized or obligated by law or executive order to close. IN WITNESS WHEREOF, the Corporation has caused the foregoing certificate to be signed on January 20, 1999. EARTHLINK NETWORK, INC. By:/s/ Charles G. Betty -------------------- Name: Charles G. Betty ---------------- Title: President and Chief Executive Officer ------------------------------------- 17 EARTHLINK NETWORK, INC. CERTIFICATE OF AMENDMENT TO CERTIFICATE OF DESIGNATION, PREFERENCES AND RIGHTS OF SERIES B CONVERTIBLE PREFERRED STOCK EARTHLINK NETWORK, INC., a corporation organized and existing under and by virtue of the General Corporation Law of the State of Delaware, DOES HEREBY CERTIFY: FIRST: That the resolutions of the Board of Directors of EarthLink Network, Inc. (the "Company") were duly adopted February 16, 1999 setting forth a proposed amendment to the Certificate of Designation, Preferences and Rights of Series B Convertible Preferred Stock ("Certificate of Designation") of the Company, declaring said amendment to be advisable and recommending such change to the sole stockholder of the Series B Convertible Preferred Stock ("Series B Preferred Stock"). The resolution setting forth the proposed amendment is as follows: That the Certificate of Designation of EarthLink Network, Inc., filed January 20, 1999, be amended by changing the authorized number of shares of Series B Preferred Stock from 600,000 to 625,000. SECOND: That in lieu of a meeting and vote of the sole stockholder of the Series B Preferred Stock, such stockholder gave its unanimous written consent to said amendment to the Certificate of Designation in accordance with the provisions of Section 228 of the General Corporation Law of the State of Delaware. THIRD: That said amendment was duly adopted in accordance with the provisions of Section 242 of the General Corporation Law of the State of Delaware. IN WITNESS WHEREOF, said the Company has caused the foregoing certificate of amendment to be signed this 16th day of February, 1999. EARTHLINK NETWORK, INC. By:/s/ Charles G. Betty -------------------- Name: Charles G. Betty Title: President and Chief Executive Officer 18 EX-23.1 3 EXHIBIT 23.1 EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 333-22317, 333-48909, 333-66435 and 333-66437) of EarthLink Network, Inc. of our report dated February 16, 1999, except as to Note 14, which is as of February 24, 1999, appearing on page F-2 of EarthLink Network, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1998. PRICEWATERHOUSECOOPERS LLP Century City, California March 30, 1999 EX-27.1 4 EXHIBIT 27.1
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR YEAR YEAR DEC-31-1998 DEC-31-1997 DEC-31-1996 JAN-01-1998 JAN-01-1997 JAN-01-1996 DEC-31-1998 DEC-31-1997 DEC-31-1996 140,864 16,450 0 0 0 0 5,184 2,085 0 405 165 0 0 0 0 150,565 22,082 0 60,449 36,166 0 25,243 12,768 0 266,341 46,887 0 61,296 32,504 0 0 0 0 0 0 0 41 0 0 291 225 0 197,012 5,850 0 266,341 46,887 0 0 0 0 175,941 80,888 33,230 0 0 0 77,328 38,065 19,783 160,852 71,277 43,705 3,725 3,526 2,526 1,967 2,099 1,041 (59,782) (29,916) (31,149) 0 0 0 (62,239) (28,454) (30,258) 0 0 0 0 0 0 0 0 0 (67,383) (29,916) (31,149) (2.58) (1.50) (2.57) (2.58) (1.50) (2.57) Certain amounts in prior years are reclassified to conform to current year presentation.
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