10-Q/A 1 d10qa.txt AMENDMENT #1 TO 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q/A Amendment No. 1 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____ Commission File No. 0-27801 DATA RETURN CORPORATION (Exact name of registrant as specified in its charter) Texas 75-2725998 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 222 West Las Colinas Boulevard Suite 450 Irving, Texas 75039 (Address, including zip code, of principal executive offices) (972) 869-0770 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ------ ------ The registrant had 36,172,350 shares of Common Stock, par value $.001 per share, outstanding as of September 30, 2001. The following items of our Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2001 are hereby amended. Such items are set forth herein in their entirety, as amended. Item 1. Condensed Financial Statements Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 1. Condensed Financial Statements Data Return Corporation Condensed Balance Sheets (in thousands, except per share data) Unaudited

See accompanying notes to Condensed Financial Statements. Data Return Corporation Condensed Statements of Operations (in thousands, except per share data) Unaudited

See accompanying notes to Condensed Financial Statements. Data Return Corporation Condensed Statements of Cash Flows (in thousands, except per share data) Unaudited

See accompanying notes to Condensed Financial Statements. 1. Organization and Basis of Presentation Organization Data Return Corporation (the "Company") was incorporated in August 1997 under the laws of the State of Texas and commenced operations on September 22, 1997 (inception). The Company primarily provides advanced Microsoft Internet hosting services to businesses, web site developers, application service providers, and other organizations. The Company's advanced Microsoft hosting services enable its customers to establish and maintain e-commerce and other applications through which they can conduct transactions and manage information on a worldwide basis over the Internet. The Company's computer equipment, principally servers, is primarily located in separate facilities owned by one of its vendors. The vendor provides data center facilities and bandwidth connectivity to the Company on a contractual basis. The Company closed its initial public offering of common stock on November 4, 1999. The Company sold 7,187,500 shares of common stock to the public, including the underwriters' overallotment, and received net proceeds of $85.9 million. During the quarter ended September 30, 2001, the Company began to implement a cost savings plan with an objective of becoming substantially cash flow breakeven at current revenue levels by reducing cash outflows. As part of this plan, the Company reduced its real estate lease expenses by $193,000 per month, personnel expenses by $961,000 per month and discretionary expenses by $296,000 per month. The Company expects to begin to realize the full effect of these costs savings during the quarter ending December 31, 2001. The Company expected to negotiate a reduction of its other fixed operating expenses (including capital leases). As a result, the Company was not making its lease payments, or were making partial lease payments, under these leases and was in default under these leases at September 30, 2001. Because the restructuring of these leases would likely have impacted its capital structure, it did not negotiate the restructuring while it was engaged in the negotiations that resulted in the execution of the merger agreement described below in "Subsequent Events." In connection with the execution of the merger agreement (see note 9), the Company entered into a credit agreement with divine, inc. on November 1, 2001 pursuant to which divine has agreed to make available to the Company interim financing of up to a maximum of $12.8 million. Outstanding balances bear interest at 10%. The facility is secured by all of the Company's assets other than certain assets that are already encumbered or cannot be pledged. The credit facility contains standard events of default and other covenants. The Company received its first advance, in the amount of $4.3 million, on November 5, 2001, and plans to use a substantial portion of such amount to make past-due payments to its capital lease vendors. The Company currently expects that its cash and investment balances available at September 30, 2001 and the amounts available to it under the credit agreement should be sufficient to meet its working capital and capital expenditure requirements at least through the end of its current fiscal year (March 31, 2002). However, the Company's ability to access the remaining amounts is subject to its meeting certain financial covenants and other conditions. In addition, under certain circumstances, divine would be entitled to either restrict the Company's borrowing ability or declare the entire unpaid balance due, or both. The Company expects the merger agreement to close in January 2002, subject to regulatory and shareholder approval. If the merger agreement is terminated, in addition to funding its ongoing expenses, the Company could be required to repay outstanding amounts under the credit agreement and, under certain circumstances, termination fees and expenses totaling $2.2 million. If divine terminates the merger agreement because the Company has breached a covenant or agreement or representation or warranty or the Company's board of directors withdraws its recommendation of the merger or takes certain actions with respect to another acquisition proposal, the Company would be required to repay all outstanding amounts within 90 days after the termination date. If the Company terminates the merger agreement because divine's stock price closes for 10 consecutive trading days below $0.329, the Company would be required to repay all outstanding amounts within 180 days after the termination date. If the Company terminates the merger agreement because divine has breached a covenant or agreement or representation or warranty or divine's board of directors withdraws its recommendation of the merger, all outstanding amounts convert to shares of the Company's common stock at $0.94 per share. If the Company is required to repay outstanding loans from divine and some or all of the other expenses as a result of the termination of the merger agreement, the Company would be required to raise a significant amount of capital and the covenants in the credit agreement with divine prohibit the Company from raising additional capital or incurring additional debt without repaying divine in full. As a result, it is likely that, if the merger agreement is terminated and the outstanding loans did not convert to equity, the Company would not be able to continue as a going concern unless the Company is able raise this additional capital quickly. In any event, the Company would be required to significantly curtail its operations to allow the Company to continue to operate while the Company attempted to secure additional sources of capital. If the Company requires additional financing for any reason, there can be no assurance that such additional financing will be available to the Company on acceptable terms, or at all. If the Company requires additional capital and is unable to raise it, the Company may be required to substantially reduce or curtail its operations. Basis of Presentation The accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary to present fairly the information set forth therein have been included. Operating results for the three- and six-month periods ended September 30, 2001 are not necessarily an indication of the results that may be expected for the year ending March 31, 2002. The balance sheet at March 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying condensed financial statements should be read in conjunction with the audited financial statements and footnotes included in the Company's Annual Report on Form 10-K for the Year Ended March 31, 2001. 2. Net Loss Per Share Basic and diluted net loss per share is computed using the weighted average number of shares of common stock outstanding during each period. Common stock equivalents are not considered in the calculation of diluted net loss per share as the Company has incurred a loss for all periods presented and the effect of common stock equivalents would be anti-dilutive. Thus, 9,691,961 employee stock options and 345,910 warrants to acquire shares of common stock are not included in this calculation. 3. Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission (SEC) issued SAB 101, which summarizes some of the SEC staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. We adopted the new guidance as a change in accounting principle beginning January 1, 2001 but effective April 1, 2000. We changed our method of recognizing revenue on set up fees to defer the revenue and recognize it over the initial term of the contracts with our customers. The change in accounting method has been accounted for as a cumulative effect adjustment, which resulted in (a) the financial information for the quarters of fiscal 2001 prior to adoption of SAB 101 being restated and (b) the cumulative effect adjustment being reflected in the first quarter of the year of adoption of SAB 101. As a result of the cumulative effect adjustment on prior years, which totals approximately $1,626,000, revenue that has previously been recognized in our financial statements has been and will continue to be amortized to income in financial reporting periods subsequent to the period of adoption of SAB 101. In July 2001, the Financial Accounting Standard Board issued Statement of Financial Accounting Standards No. 141, Business Combinations ("SFAS 141"), and Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Under SFAS 141, the Company must recognize and report intangible assets acquired in a purchase method business combination apart from goodwill, if specific criteria are met. Purchase price previously allocated to an assembled workforce may no longer be accounted for separately; rather, it is subsumed into goodwill. Beginning January 1, 2002, SFAS 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The adoption of SFAS 141 and SFAS 142 will not have an impact on the Company. 4. Restricted Cash and Marketable Securities The Company has classified $2.0 million as restricted cash and marketable securities which is composed of $635,000 in cash and $1,365,000 in marketable securities. This secures a guarantee issued by the Company to a financial institution of up to $2.0 million of the margin debt of a Texas family limited partnership (an estate planning entity) owned by Sunny C. Vanderbeck, the Chairman of the Board and Chief Executive Officer of the Company. On November 6, 2001, the financial institution exercised its rights under the guarantee and took possession of the $2.0 million securing the guarantee. Pursuant to a letter agreement with the limited partnership and Mr. Vanderbeck, the limited partnership and Mr. Vanderbeck are required to repay the $2.0 million paid by the Company under the guarantee. Mr. Vanderbeck has also granted to the Company a security interest in certain properties. The Company has recorded an asset due from Mr. Vanderbeck and a corresponding liability related to fulfillment of the guarantee obligation of $2.0 million. Also see Note 9. Subsequent Events, and the Recent Developments section in Management's Discussion and Analysis. 5. Investment in Available for Sale Securities Available-for-sale securities are comprised of debt securities for which there is a determinable fair market value and for which there are no restrictions on the Company's ability to sell the security. In accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders' equity. Realized gains and losses and declines in value deemed to be other-than- temporary on available-for-sale securities are included in other income. The cost basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. At March 31, 2001, the realized gains on sales of available-for-sale securities totaled $55,000. The net adjustment of unrealized gains of $281,000 has been recorded as a separate component of shareholders' equity. There were no available-for-sale securities as of September 30, 2001. 6. Property and Equipment Property and equipment consists of the following (in thousands):

Property and equipment includes assets acquired under capital leases, principally computer equipment with a cost of $43,994,000 at September 30, 2001 and $40,918,000 at March 31, 2001, respectively. Related allowances for depreciation and amortization are $18,055,000 and $11,337,000 respectively. 7. Accrued Expenses Accrued expenses consist of the following (in thousands):

8. Restructuring Costs On May 10, 2001 the Company initiated a restructuring plan intended to reduce its workforce and eliminate excess office space and furniture and fixtures at its headquarters. In determining net loss during the June 30, 2001 quarter, the Company recorded restructuring costs of $2,191,000 related to that plan, which included $1,690,000 for costs associated with lease terminations and asset write offs and $501,000 for severance costs. During the September 30, 2001 quarter, the Company was able to execute terminations on one of its leases. The Company continues to maintain an accrued reserve of $455,000 at September 30, 2001 for anticipated costs of restructuring certain facilities and furniture leases. On August 11, 2001, the Company initiated a voluntary separation benefit program to reduce the Company's workforce. 108 employees were approved to participate in this program. Restructuring costs, consisting of severance and benefits, were $1,343,000 during the quarter ended September 30, 2001 and are included in restructuring costs in determining net loss. The remaining estimated restructuring accrual of $717,000 at September 30, 2001 relates to severance and benefits for those employees participating in the voluntary separation program. 9. Subsequent Events On November 1, 2001, the Company signed a merger agreement with divine, inc., a Delaware corporation, and TD Acquisition Corp., a Texas corporation and wholly owned subsidiary of divine. Under the terms of the merger agreement, except as provided in the following sentence, each of the approximately 36.3 million shares of the Company's common stock currently outstanding will be converted into the right to receive 1.9876 shares of divine class A common stock. If divine would be required to issue more than 72,250,000 shares of its class A common stock because warrants or options to purchase more than 167,934 shares of the Company's common stock are exercised prior to closing of the transaction, the exchange ratio of 1.9876 will be decreased so that the number of shares of divine common stock being issued will equal 72,250,000. The transaction is expected to be tax-free to the shareholders of both companies. Subject to the Company's shareholder approval, divine's stockholder approval, if necessary, and customary closing conditions, the transaction is expected to close in January 2002. The details of the transaction are discussed in the Company's Current Report on Form 8-K filed with the SEC on November 2, 2001. In January 2001, the Company entered into a guarantee with a financial institution pursuant to which the Company guaranteed up to $5.0 million of the margin debt of a Texas family limited partnership (an estate planning entity) owned by Sunny C. Vanderbeck, the Chairman of the Board and Chief Executive Officer of the Company. In June 2001, this guarantee was replaced with a new guarantee that reduced the amount to $2.0 million. On October 26, 2001, the financial institution sold the remaining shares of common stock securing the margin debt and, on November 6, 2001, exercised its rights under the guarantee and took possession of the $2.0 million securing the guarantee. Pursuant to a letter agreement with the limited partnership and Mr. Vanderbeck, the limited partnership and Mr. Vanderbeck are required to repay the $2.0 million paid by the Company under the guarantee. Mr. Vanderbeck has also granted to the Company a security interest in certain properties. The Company has recorded an asset due from Mr. Vanderbeck and a corresponding liability related to fulfillment of the guarantee obligation of $2.0 million. ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of the financial condition and results of operations of Data Return should be read in conjunction with the condensed financial statements and the related notes thereto included elsewhere in this Form 10-Q and the Data Return Annual Report on form 10-K for the year ended March 31, 2001. Forward-Looking Statements The statements contained in this report that are not historical facts are "forward-looking statements" (as such term is defined in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). Forward-looking statements are typically identified by the use of terms such as "plan", "may," "will," "expect," "intend," "anticipate," "estimate" and similar words, or by discussions of strategies and plans, although some forward-looking statements are expressed differently. You should be aware that our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, including without limitation, external competitive market factors, changes in our business strategy or an inability to execute our strategy or plans, changes in the hosting industry, the economy in general and changes in the use of the Internet and the viability of Internet- based businesses. We cannot guarantee future results, levels of activity, performance or achievements. Our actual results could differ materially from those anticipated in forward-looking statements as a result of certain factors, including those set forth in the section of this report entitled "Risk Factors." Readers are cautioned not to place undue reliance on any forward-looking statements contained in this report. All written and oral forward-looking statements made in connection with this report that are attributable to us or persons acting on our behalf are expressly qualified in their entirety by the "Risk Factors" and other cautionary statements included herein. We disclaim any obligation to update information contained in any forward-looking statement. We undertake no obligation to publish the results of any adjustments to these forward-looking statements that may be made to reflect events on or after the date of this report or to reflect the occurrence of unexpected events. Overview Data Return provides advanced Internet hosting services based on Microsoft technologies. We provide these services to businesses seeking to outsource the deployment, maintenance and support of their complex web sites. Our services include providing, configuring, operating and maintaining the hardware, software and network technologies necessary to implement and support these web sites. We derive substantially all of our revenue from hosting and managed services. This includes revenue from our dedicated server offerings, including clustered servers, and our shared server offering. With our dedicated server offerings, each server is dedicated to providing service to one customer. In a clustered configuration, we utilize two or more dedicated servers to distribute content and functionality across multiple servers or, in the case of multi-site clusters, across multiple data centers. Hosting and managed services revenue also includes shared hosting, in which more than one customer shares the same server. Historically, we have also derived a nominal amount of revenue from technical reviews and the resale of software and other products. Currently, most of our advanced hosting and managed services revenues are generated from recurring monthly fees. Substantially all of the remainder is derived from one- time set-up fees for installation and from sales of services, such as time and materials billing and certain lab or consulting services. Services are billed on a monthly basis and, except as described below, are recognized as the service is performed. As a result of our adoption of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB 101"), revenues from set-up, or installation, services are recognized over the longer of the length of the customer contract and the estimated life of the customer contract. See "Recent Accounting Pronouncements" for a description of our adoption and the effect of SAB 101. Our expenses are comprised of: . cost of revenue, which consists primarily of compensation and related expenses for technical operations, broadband services expenses, space in data centers and depreciation of equipment; . general and administrative, which consists primarily of compensation and related expenses and occupancy costs; . marketing and sales, which consists primarily of compensation and related expenses, advertising expenses and occupancy costs; . product research and development, which consists primarily of compensation and related expenses and occupancy costs; . stock-based compensation, which relates to employee stock options granted at prices less than fair value; and . restructuring costs, which consists primarily of severance compensation and related expenses, occupancy costs and restructuring costs on assets. We have incurred significant losses since our inception and, as of September 30, 2001, had an accumulated deficit of approximately $90.9 million. We expect to continue to incur substantial losses for the foreseeable future. We may not be able to successfully execute our plans. Pending Merger On November 1, 2001, we signed a merger agreement with divine, inc., a Delaware corporation, and TD Acquisition Corp., a Texas corporation and wholly owned subsidiary of divine. Under the terms of the merger agreement, except as provided in the following sentence, each of the approximately 36.3 million shares of our common stock currently outstanding will be converted into the right to receive 1.9876 shares of divine class A common stock. If divine would be required to issue more than 72,250,000 shares of its class A common stock because warrants or options to purchase more than 167,934 shares of our common stock are exercised prior to closing of the transaction, the exchange ratio of 1.9876 will be decreased so that the number of shares of divine common stock being issued will equal 72,250,000. The transaction is expected to be tax-free to the shareholders of both companies. Subject to our shareholder's approval, divine's stockholder approval, if necessary, and customary closing conditions, the transaction is expected to close before year end. The details of the transaction are discussed in our Current Report on Form 8-K filed with the SEC on November 2, 2001. Results of Operations Comparison of quarters ended September 30, 2001 and 2000 Revenues Our revenues decreased $196,000 to $12,160,000 for the quarter ended September 30, 2001 from $12,356,000 for the quarter ended September 30, 2000. The decrease is a result of our continued loss of customers. Dedicated hosting revenue and managed services fees increased $171,000 to $10,381,000, or 85.4% of revenue, for the quarter ended September 30, 2001 from $10,204,000, or 82.6% of revenue, for the quarter ended September 30, 2000. Shared hosting revenue decreased $133,000 to $613,000, or 5.0% of revenue, for the quarter ended September 30, 2001 from $746,000, or 6.0% of revenue, for the quarter ended September 30, 2000. The continued shift towards dedicated revenues reflects our focus on our dedicated hosting and managed services product offerings. Set-up fees decreased $226,000 to $714,000, or 5.9% of revenue, for the quarter ended September 30, 2001 from $940,000, or 7.6% of revenue, for the quarter ended September 30, 2000, due to a decline in new customer orders. Cost of revenue Our cost of revenue increased $314,000 to $11,839,000, or 97.4% of revenue, for the quarter ended September 30, 2001 from $11,525,000, or 93.3% of revenue, for the quarter ended September 30, 2000. The increase in cost of revenue was due primarily to increases in communication and bandwidth expenses, and increases in depreciation and amortization expenses, offset by decreases in personnel and related costs and facilities related expenses. Communication and bandwidth expenses increased $1,197,000 to approximately $3,181,000, or 26.2% of revenue, for the quarter ended September 30, 2001 from $1,984,000, or 16.1% or revenue, for the quarter ended September 30, 2000 due to increased usage by our customers. In particular, one customer accounted for a significant portion of the increase. Depreciation and amortization expenses increased approximately $1,041,000 to $3,990,000, or 32.8% of revenue, for the quarter ended September 30, 2001 from $2,949,000, or 23.9% of revenue, for the quarter ended September 30, 2000, as we added approximately $15.3 million in computer and related equipment since September 30, 2000. Personnel and related expenses decreased approximately $1,754,000 to $3,789,000, or 31.2% of revenue, for the quarter ended September 30, 2001 from $5,543,000, or 44.9% of revenue, for the quarter ended September 30, 2000, as we decreased our systems and customer support personnel to 158 at September 30, 2001 from 251 at September 30, 2000. Facilities expense decreased approximately $267,000 to $229,000 as we terminated leases on office space due to decreases in personnel. General and administrative General and administrative expense decreased $486,000 to $5,269,000, or 43.3% of revenue, during the quarter ended September 30, 2001 from $5,755,000, or 46.6% of revenue, during the quarter ended September 30, 2000. The decrease is primarily due to decreases in personnel and related expenses, professional services expense, and facilities expense offset by an increase in bad debt expense. Bad debt expense increased $581,000 to $1,150,000, or 9.5% of revenue, in the quarter ended September 30, 2001 as many of our customers ceased operations or reduced or eliminated the web site operations hosted by us. Personnel and related expenses decreased $1,168,000 to $1,783,000, or 14.7% of revenue, for the quarter ended September 30, 2001 from $2,951,000, or 23.9% of revenue, for the quarter ended September 30, 2000 due to a decrease in general and administrative personnel to 56 employees at September 30, 2001 from 138 employees at September 30, 2000. Professional service expense decreased $229,000 to $226,000 for the quarter ended September 30, 2001 from $455,000 due to the completion of various projects and the reduction of contract employees. Facilities expense decreased $180,000 to $430,000 as we terminated leases on office space as a result of decreases in personnel. Marketing and sales Marketing and sales expense decreased $2,379,000 to $4,671,000, or 38.4% of revenue, during the quarter ended September 30, 2001 from $7,050,000, or 57.1% of revenue, for the quarter ended September 30, 2000. The decrease was primarily due to a decrease in marketing and sales personnel to 76 at September 30, 2001 from 90 at September 30, 2000, decreases in sales commissions, and to decreases in advertising costs. Personnel and related expenses, including sales commissions, decreased $1,665,000 to $2,955,000, or 24.3% of revenue, for the quarter ended September 30, 2001 from $4,620,000, or 37.4% of revenue, for the quarter ended September 30, 2000. Advertising costs decreased $1,228,000 to $767,000 for the quarter ended September 30, 2001 from $1,995,000 for the quarter ended September 30, 2000. Product research and development Product research and development expense remained constant at $1,115,000, or 9.2% of revenue, during the quarter ended September 30, 2001 compared to $1,113,000, or 9.0% of revenue, during the quarter ended September 30, 2000. Stock-based compensation Deferred stock compensation was recorded in connection with the grant of employee stock options below fair value in 1998 and 1999. Amortization of stock- based compensation totaled $59,000 for the quarter ended September 30, 2001 and $25,000 for the quarter ended September 30, 2000. The amortization of stock- based compensation is based on the vesting schedule of stock options held by our employees. Restructuring costs On August 11, 2001, we initiated a voluntary separation benefit program to reduce the our workforce. 108 employees were approved for this program. Restructuring costs relating to this program, consisting of severance pay and benefits, were $1,343,000 during the quarter ended September 30, 2001. Other income (expense) Other income (expense) consists primarily of interest income on our cash balances and investments in marketable securities and interest expense on our outstanding notes payable and capital lease obligations. Interest earned on our cash and cash equivalents decreased $941,000 to $148,000 for the quarter ended September 30, 2001 from $1,089,000 for the quarter ended September 30, 2000. This decrease was due primarily to having lower cash balances for investments as cash has been used to fund operating losses. During the quarter ended September 30, 2001, interest expense increased $247,000 to $788,000 related primarily to equipment acquired under capital leases during the last four quarters. Income taxes No provision for federal income taxes has been recorded as we have incurred net operating losses since our inception. We have recorded a valuation allowance against all of our net deferred tax asset, which is primarily attributable to net operating loss carry forwards, due to uncertainty that we will generate sufficient taxable income during the carry forward period to realize the benefit of our net deferred tax asset. Cumulative effect of change in accounting principle Effective April 1, 2000, we changed our method of accounting for set-up fees in accordance with SAB 101. We recorded a cumulative effect adjustment of $1.6 million as of April 1, 2000 and amortized set-up fees into revenues during fiscal 2001. Set-up fees are now amortized over the longer of the length of the customer contract and the estimated life of the customer contract. Net loss Net loss increased $212,000 to $12,776,000 for the quarter ended September 30, 2001 from $12,564,000 for the quarter ended September 30, 2000. As more fully discussed above, the increased net loss is primarily attributable to the decrease in revenues. EBITDA EBITDA, as defined below, increased $2,669,000 to negative $6,693,000 for the quarter ended September 30, 2001 from negative $9,362,000 for the quarter ended September 30, 2000. The increase is primarily attributable to the cost reduction efforts described above. We expect to generate negative EBITDA for fiscal 2002. Costs associated with our personnel and our fixed commitments will continue to represent a large portion of our expenses. EBITDA for the quarters ended September 30, 2001 and 2000 consists of loss from operations of $12,136,000 and $13,112,000 plus depreciation and amortization of $5,384,000 and $3,725,000 and amortization of unearned stock- based compensation of $59,000 and $25,000, respectively. EBITDA does not represent funds available for management's discretionary use and is not intended to represent cash flow from operations as measured under generally accepted accounting principles. EBITDA should not be considered as an alternative to net loss or net cash used in operating activities, but may be useful to investors as an indication of operating performance. This caption excludes components that are significant in understanding and assessing the results of operations and cash flows. In addition, EBITDA is not a term defined by generally accepted accounting principles and, as a result, our calculations of EBITDA may not be consistent with calculations of EBITDA used by others. However, we believe that EBITDA is relevant and useful information that is often reported and widely used by analysts, investors and other interested parties in the advanced hosting industry. Accordingly, we are disclosing this information to permit a more comprehensive analysis of our operating performance, as an additional meaningful measure of performance and liquidity and to provide additional information with respect to our ability to meet future working capital requirements. Comparison of six-month periods ended September 30, 2001 and 2000 Revenues Our revenues increased $4,307,000 to $25,743,000 for the six-month period ended September 30, 2001 from $21,436,000 for the six-month period ended September 30, 2000. The increase is as a result of an increase in the number of customers and the growth in revenues from some existing customers. Dedicated hosting revenue and managed services fees increased $4,790,000 to $21,852,000, or 84.9% of revenue, for the six-month period ended September 30, 2001 from $17,062,000, or 79.6% of revenue, for the six-month period ended September 30, 2000. Shared hosting revenue decreased $264,000 to $1,274,000, or 4.9% of revenue, for the six-month period ended September 30, 2001 from $1,538,000, or 7.2% of revenue, for the six-month period ended September 30, 2000. These changes reflect our continued focus on our dedicated hosting and managed services product offerings. Set-up fees decreased $402,000 to $1,435,000, or 5.6% of revenue, for the six-month period ended September 30, 2001 from $1,837,000, or 8.6% of revenue, for the six-month period ended September 30, 2000, due to a decline in new customer orders. Cost of revenue Our cost of revenue increased $4,461,000 to $24,997,000, or 97.1% of revenue, for the six-month period ended September 30, 2001 from $20,536,000, or 95.8% of revenue, for the six-month period ended September 30, 2000. The increase in cost of revenue was due primarily to increases in communication and bandwidth expenses, and increases in depreciation and amortization expenses offset by decreases in personnel and related costs and facilities related expenses. Communication and bandwidth expenses increased $3,466,000 to approximately $6,724,000 for the six-month period ended September 30, 2001 from $3,258,000 for the six-month period ended September 30, 2000. This was due to the Company having purchased higher-performance bandwidth from more costly vendors to support our increased business activities and increased usage by our customers. Depreciation and amortization expenses increased approximately $2,841,000 to $7,850,000 for the six-month period ended September 30, 2001, as we added approximately $15.3 million in computer and related equipment since September 30, 2000. Personnel and related expenses decreased approximately $1,467,000 to $8,581,000, or 33.3% of revenue, for the six-month period ended September 30, 2001 from $10,049,000, or 46.9% of revenue, for the six-month period ended September 30, 2000, as we decreased our systems and customer support personnel to 158 at September 30, 2001 from 251 at September 30, 2000. Facilities expense decreased approximately $412,000 to $438,000 as we terminated leases on office space due to the decrease in personnel. General and administrative General and administrative expense increased $1,219,000 to $11,205,000, or 43.5% of revenue, during the six-month period ended September 30, 2001 from $9,986,000, or 46.6% of revenue, during the six-month period ended September 30, 2000. The increase is primarily due to increases in bad debt expense, other taxes expense, depreciation and amortization expense, and facilities expense, offset by decreases in personnel and related expenses, and professional services expense. Bad debt expense increased $1,074,000 to $1,864,000 in the six-month period ended September 30, 2001 as many of our customers ceased operations or reduced or eliminated the web site operations hosted by us. Other taxes, which include primarily property tax, were $677,000 for the six-month period ended September 30, 2001. Depreciation and amortization expense increased $508,000 to $1,218,000 in the six-month period ended September 30, 2001, due to increased computer and office equipment necessary to support the growth of our business. Facilities expense increased $330,000 to $1,212,000 as a result of our move into a larger facility and the growth in the average number of general and administrative employees during the first quarter of fiscal 2001. Personnel and related expenses decreased $1,179,000 to $4,290,000, or 16.7% of revenue, for the six-month period ended September 30, 2001 from $5,469,000, or 25.5% of revenue, for the six-month period ended September 30, 2000 due to a decrease in the number of general and administrative personnel to 56 employees at September 30, 2001 from 138 employees at September 30, 2000. Professional services expense decreased $557,000 to $456,000 for the six-month period ended September 30, 2001 due to the completion of various projects and the reduction of contract employees. Marketing and sales Marketing and sales expense decreased $90,000 to $11,557,000, or 44.9% of revenue, during the six-month period ended September 30, 2001 from $11,647,000, or 54.3% of revenue, during the six-month period ended September 30, 2000. The decrease was due primarily to a decrease in marketing and sales personnel and related expenses, a decrease in sales commissions due to lower sales, and an increase in depreciation expenses. Personnel and related expenses, including sales commissions, decreased $631,000 to $6,803,000, or 26.4% of revenue, for the six-month period ended September 30, 2001 from $7,434,000, or 34.7% of revenue, for the six-month period ended September 30, 2000. Depreciation and amortization expenses increased $494,000 to $655,000 for the six-month period ended September 30, 2001 due to our move into a larger facility. We decreased our marketing and sales personnel to 76 at September 30, 2001 from 90 at September 30, 2000. Product research and development Product research and development expense increased $449,000 to $2,334,000, or 9.1% of revenue, during the six-month period ended September 30, 2001 from $1,885,000, or 8.8% of revenue, during the six-month period ended September 30, 2000. The increase was due primarily to an increase in product research and development personnel and related expenses and depreciation and amortization expenses. Personnel and related expenses increased $292,000 to $1,865,000, or 7.2% of revenue, for the six-month period ended September 30, 2001 from $1,573,000, or 7.3% of revenue, for the six-month period ended September 30, 2000. Depreciation and amortization increased $64,000 to $136,000 for the six- month period ended September 30, 2001 from $72,000 for the six-month period ended September 30, 2000. Stock-based compensation Deferred stock compensation was recorded in connection with the grant of employee stock options below fair value in 1998 and 1999. Amortization of stock- based compensation totaled $74,000 for the six-month period ended September 30, 2001 and $125,000 for the six-month period ended September 30, 2000. The amortization of stock-based compensation is based on the vesting schedule of stock options held by our employees. Restructuring costs Restructuring costs totaled $3,534,000 during the six-month period ended September 30, 2001. The May 10, 2001 restructuring plan resulted in estimated costs associated with termination of leases and asset write offs of $1,690,000 and severance costs of $501,000. The August 11, 2001 restructuring plan resulted in severance and benefit costs of $1,343,000. On May 10, 2001, we initiated a restructuring plan intended to reduce our workforce and eliminate excess office space and furniture and fixtures at our headquarters. On May 11, 2001, we reduced our workforce by 94 employees. We renegotiated the lease for our headquarters facilities and anticipate that we will renegotiate certain excess furniture and fixtures leases. We have also recorded a charge for the net book value of leasehold improvements related to the excess office space at our headquarters facilities. The reduction in workforce was a result of slower than anticipated growth and increased process and other operational efficiencies. On August 11, 2001, we initiated a voluntary separation benefit program to reduce our workforce. 108 employees were approved for the program. Other income (expense) Other income (expense) consists primarily of interest income on our cash balances and investments in marketable securities and interest expense on our outstanding notes payable and capital lease obligations. Interest earned on our cash and cash equivalents decreased $1,760,000 to $555,000 for the six-month period ended September 30, 2001 from $2,315,000 for the six-month period ended September 30, 2000. This decrease was due primarily to having lower cash balances for investments as cash has been used to fund operating losses. During the six-month period ended September 30, 2001, interest expense increased $616,000 to $1,602,000 related primarily to equipment acquired under capital leases during the last four quarters. Income taxes No provision for federal income taxes has been recorded as we have incurred net operating losses since our inception. We have recorded a valuation allowance against all of our net deferred tax asset, which is primarily attributable to net operating loss carry forwards, due to uncertainty that we will generate sufficient taxable income during the carry forward period to realize the benefit of our net deferred tax asset. Cumulative effect of change in accounting principle Effective April 1, 2000, we changed our method of accounting for set-up fees in accordance with SAB 101. We recorded a cumulative effect adjustment of $1.6 million as of April 1, 2000 and amortized set-up fees into revenues during fiscal 2001. Set-up fees are now amortized over the longer of the length of the customer contract and the estimated life of the customer contract. Net loss Net loss increased $5,965,000 to $29,005,000 for the six-month period ended September 30, 2001 from $23,040,000 for the six-month period ended September 30, 2000. As more fully discussed above, the increased net loss is primarily attributable to increased expenses. EBITDA EBITDA, as defined above, decreased $936,000 to negative $17,322,000 for the six-month period ended September 30, 2001 from negative $16,386,000 for the six- month period ended September 30, 2000. The decrease is primarily attributable to costs associated with anticipated growth partially offset by cost reduction efforts. We expect to generate negative EBITDA for fiscal 2002. Costs associated with our personnel and our fixed commitments will continue to represent a large portion of our expenses during our anticipated expansion. EBITDA for the six-month periods ended September 30, 2001 and 2000 consists of loss from operations of $27,958,000 and $22,743,000 plus depreciation and amortization of $10,562,000 and $6,232,000 and amortization of unearned stock- based compensation of $74,000 and $125,000, respectively. Liquidity and Capital Resources We have historically financed our operations primarily through sales of equity securities and capital leases. Since our inception, we have raised $15.9 million through private placements of our common stock. In November 1999, we raised $85.9 million in net proceeds from our initial public offering. As of September 30, 2001, we had cash and cash equivalents of $8.6 million. Net cash used in our operating activities for the six-month period ended September 30, 2001 was $15.4 million. The net cash used in operations was comprised primarily of working capital requirements and our net loss, net of depreciation and amortization. Net cash provided by investing activities was $22.2 million for the six-month period ended September 30, 2001 and consisted of the sale of marketable debt securities of $25.4 million and purchases of property and equipment of approximately $2.6 million. Our purchases of property and equipment consisted primarily of equipment to provide services to our customers. We acquired $3.1 million in computer and related equipment under capital leases for the six-month period ended September 30, 2001. Net cash used in financing activities was approximately $4.7 million for the six-month period ended September 30, 2001 and consisted primarily of principal payments on our notes payable and capital leases. Total borrowings under our notes payable and capital lease obligations as of September 30, 2001 were approximately $29.4 million. In December 1999 we entered into a revolving credit facility with Bank One, Texas, N.A. This $2.0 million credit facility matured on July 31, 2001, and we did not renew it. We did not borrow any amounts under the facility. Under our agreement with Level 3, we are required to purchase at least an additional $7.6 million of bandwidth and colocation services over the next three years. Our quarterly commitment was $300,000 per quarter through July 2001, is $400,000 per quarter through July 2002 and is $600,000 per quarter during the next 12 months and $1.0 million per quarter during the final 12 months of the agreement. During the quarter ended September 30, 2001, we began to implement a cost savings plan with an objective of becoming substantially cash flow breakeven at current revenue levels by reducing cash outflows. As part of this plan, we reduced our real estate lease expenses by $193,000 per month, personnel expenses by $961,000 per month and discretionary expenses by $296,000 per month. We expect to begin to realize the full effect of these costs savings during the quarter ending December 31, 2001. We expected to negotiate a reduction of our other fixed operating expenses (including capital leases). As a result, we were not making our lease payments, or were making partial lease payments, under these leases and were in default under these leases at September 30, 2001. Because the restructuring of these leases would likely have impacted our capital structure, we did not negotiate the restructuring while we were engaged in the negotiations that resulted in the execution of the merger agreement described above in "Pending Merger." In connection with the execution of the merger agreement, we entered into a credit agreement with divine on November 1, 2001 pursuant to which divine has agreed to make available to us interim financing of up to a maximum of $12.8 million. Outstanding balances bear interest at 10%. The facility is secured by all of our assets other than certain assets that are already encumbered or cannot be pledged. The credit facility contains standard events of default and other covenants. We received our first advance, in the amount of $4.3 million, on November 5, 2001, and plan to use a substantial portion of such amount to make past-due payments to our capital lease vendors. We currently expect that our cash and investment balances available at September 30, 2001 and the amounts available to us under the credit agreement should be sufficient to meet our working capital and capital expenditure requirements at least through the end of our current fiscal year (March 31, 2002). However, our ability to access the remaining amounts is subject to our meeting certain financial covenants and other conditions. In addition, under certain circumstances, divine would be entitled to either restrict our borrowing ability or declare the entire unpaid balance due, or both. We expect the merger agreement to close in January 2002, subject to regulatory and shareholder approval. If the merger agreement is terminated, in addition to funding our ongoing expenses, we could be required to repay outstanding amounts under the credit agreement and, under certain circumstances, termination fees and expenses totaling $2.2 million. If divine terminates the merger agreement because we have breached a covenant or agreement or representation or warranty or our board of directors withdraws its recommendation of the merger or takes certain actions with respect to another acquisition proposal, we would be required to repay all outstanding amounts within 90 days after the termination date. If we terminate the merger agreement because divine's stock price closes for 10 consecutive trading days below $0.329, we would be required to repay all outstanding amounts within 180 days after the termination date. If we terminate the merger agreement because divine has breached a covenant or agreement or representation or warranty or divine's board of directors withdraws its recommendation of the merger, all outstanding amounts convert to shares of our common stock at $0.94 per share. If we are required to repay outstanding loans from divine and some or all of the other expenses as a result of the termination of the merger agreement, we would be required to raise a significant amount of capital and the covenants in the credit agreement with divine prohibit us from raising additional capital or incurring additional debt without repaying divine in full. As a result, it is likely that, if the merger agreement is terminated and the outstanding loans did not convert to equity, we would not be able to continue as a going concern unless we were able to raise this additional capital quickly. In any event, we would be required to significantly curtail our operations to allow us to continue to operate while we attempted to secure additional sources of capital. If we require additional financing for any reason, there can be no assurance that such additional financing will be available to us on acceptable terms, or at all. Further, if we raise additional funds through the issuance of additional equity securities, the percentage ownership of our shareholders would be substantially diluted. Any new equity securities may have rights, preferences or privileges senior to those of our common stock. Recent Developments In January 2001, we entered into a guarantee with a financial institution pursuant to which we guaranteed up to $5.0 million of the margin debt of a Texas family limited partnership (an estate planning entity) owned by Sunny C. Vanderbeck, our Chairman of the Board and Chief Executive Officer. In June 2001, this guarantee was replaced with a new guarantee that reduced the amount to $2.0 million. On October 26, 2001, the financial institution sold the remaining shares of common stock securing the margin debt and, on November 6, 2001, exercised its rights under the guarantee and took possession of the $2.0 million securing the guarantee. Pursuant to a letter agreement with the limited partnership and Mr. Vanderbeck, the limited partnership and Mr. Vanderbeck are required to repay the $2.0 million paid by us under the guarantee. Mr. Vanderbeck has also granted us a security interest in certain properties. Recent Accounting Pronouncements In December 1999, the Securities and Exchange Commission issued SAB 101, which summarizes some of the SEC staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. We adopted the new guidance as a change in accounting principle in January 2001 but effective April 1, 2000. We changed our method of recognizing revenue on set up fees to defer the revenue and recognize it over the initial term of the contracts with our customers. The change in accounting method has been accounted for as a cumulative effect adjustment, which resulted in (a) the financial information for the quarters of fiscal 2001 prior to adoption of SAB 101 being restated and (b) the cumulative effect adjustment being reflected in the first quarter of the year of adoption of SAB 101. As a result of the cumulative effect adjustment on prior years, which totals approximately $1,626,000, revenue that has previously been recognized in our financial statements has been and will continue to be amortized to income in financial reporting periods subsequent to the period of adoption of SAB 101. In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141, Business Combinations ("SFAS 141"), and Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. Under SFAS 141, the Company must recognize and report intangible assets acquired in a purchase method business combination apart from goodwill, if specific criteria are met. Purchase price previously allocated to an assembled workforce may no longer be accounted for separately; rather, it is subsumed into goodwill. Beginning January 1, 2002, SFAS 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The adoption of SFAS 141 and SFAS 142 will not have an impact on the Company. Risk Factors The risks and uncertainties described below are not the only risks we face. Additional risks and uncertainties not presently known to us, or that are currently deemed immaterial may also impair our business operations. If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected. Our business and stock price may be adversely affected if the merger with divine is not completed. On November 1, 2001, we entered into an agreement with divine, inc. pursuant to which divine would acquire all of the outstanding shares of our common stock. Consummation of the transaction is conditioned upon our shareholders' approval and, if required by Nasdaq rules, the approval of divine's stockholders, as well as the satisfaction of other customary conditions to closing. If the transaction is not completed, we could be subject to a number of risks that may adversely affect our business and stock price. First, we would not realize the strategic benefits or the enhanced financial and competitive position we expect to realize from being part of a combined company with divine. In addition, the diversion of our management's attention from the day to day business and the disruption to our employees and our relationships with customers as a result of efforts and uncertainties relating to the anticipated merger may detract from our ability to grow revenues and minimize costs. Also, under certain circumstances we could be required to pay divine a termination fee equal to $1,700,000 and up to $500,000 of its transaction related expenses, as well as our own transaction expenses and up to $12.8 million that we may, under certain circumstances, borrow from divine under our credit facility with divine. If the merger agreement is terminated and the outstanding loans under the credit agreement with divine become payable, we may not be able to raise enough capital to repay the loans, which could result in our inability to continue as a going concern. If the merger agreement is terminated, in addition to funding our ongoing expenses, we could be required to repay outstanding amounts under the credit agreement and, under certain circumstances, termination and other fees and expenses totaling $2.2 million. If divine terminates the merger agreement because we have breached a covenant or agreement or representation or warranty or our board of directors withdraws its recommendation of the merger or takes certain actions with respect to another acquisition proposal, we would be required to repay all outstanding amounts within 90 days after the termination date. If we terminate the merger agreement because divine's stock price closes for 10 consecutive trading days below $0.329, we would be required to repay all outstanding amounts within 180 days after the termination date. If we terminate the merger agreement because divine has breached a covenant or agreement or representation or warranty or divine's board of directors withdraws its recommendation of the merger, all outstanding amounts convert to shares of our common stock $0.94 per share. If we are required to repay outstanding loans from divine or some or all of the other expenses as a result of the termination of the merger agreement, we would be required to raise a significant amount of capital and the covenants in the credit agreement with divine prohibit us from raising additional capital or incurring additional debt without repaying divine in full. As a result, it is likely that, if the merger agreement is terminated and the outstanding loan balance is not converted into equity, we would not be able to continue as a going concern unless we were able to raise this additional capital quickly. In any event, we would be required to significantly curtail our operations to allow us to continue to operate while we attempted to secure additional sources of capital. If we require additional financing for any reason, there can be no assurance that such additional financing will be available to us on acceptable terms, or at all. Further, if we raise additional funds through the issuance of additional equity securities, the percentage ownership of our shareholders would be substantially diluted. Any new equity securities may have rights, preferences or privileges senior to those of our common stock. We have a history of substantial losses, and we anticipate continuing losses. We have experienced operating losses and negative cash flows from operations in each quarterly and annual period since incorporating in 1997. We experienced net losses of approximately $12.8 million, or negative 105% of revenues, for the quarter ended September 30, 2001. As of September 30, 2001, we had an accumulated deficit of approximately $90.9 million. We are required to purchase an additional $800,000 of colocation and bandwidth services from Level 3 during the remainder of fiscal 2002. We expect to incur operating losses for at least the next fiscal year. We cannot assure you that we will ever be profitable on a quarterly or annual basis or that, if we achieve profitability, it will be sustainable. Our business and prospects are difficult to evaluate because we have a limited operating history and our business model is still evolving. It is difficult to evaluate our business operations and our prospects because of our limited operating history and the pace of change in our business. We were incorporated in August 1997 and commenced operations in September of that year with a focus on hosting services, and our business model is still new and evolving. The revenue and income potential of our business is unproven. Our limited operating history and the relative newness of the industry in which we operate makes predicting future results difficult. We may not be able to successfully implement our business plan or adapt it to changes in the market. If we are not able to do so, our business, results of operations and financial condition will be adversely affected. Our quarterly and annual results may fluctuate, resulting in fluctuations in the price of our common stock. Our operating results may fluctuate significantly in the future on a quarterly and annual basis. Because of these fluctuations, comparisons of our operating results from period to period are not necessarily meaningful and should not be relied upon as an indicator of future performance. We expect to experience significant fluctuations as a result of a variety of factors, many of which are outside of our control. The following factors could affect our operating results: . demand for our services; . size and timing of customer installations and related payments; . reliable services and network availability; . ability and costs associated with increasing network and data center capacity; . fluctuations in data and voice communications costs; . fluctuations in hardware and software costs; . timing and magnitude of capital expenditures and other expenses; . costs relating to operations; . customer retention and satisfaction; . introduction by third parties, including our competitors, of new products and services; . termination or reduction of services by customers, including terminations by customers that do not have sufficient funding to continue their operations, either at all or at the level contemplated by our agreements with them; . customer discounts and credits; . timing and success of marketing efforts and service introductions by us; . changes in our pricing policies or those of our competitors; . retention of our key personnel; and . economic conditions specific to the hosting industry, as well as general economic conditions. A portion of our operating costs is fixed. If our revenues do not exceed our costs, our operating results will suffer. A portion of our operating costs are fixed at certain minimum levels, including our expenses for data center capacity, depreciation, interest, hardware lease payments, minimum bandwidth charges, real estate lease payments and personnel. Therefore, our results of operations are particularly sensitive to fluctuations in revenue. We will have to pay these fixed costs regardless of our revenues and our results of operations and financial condition would be adversely affected, if our revenues are not at the level we expect. Furthermore, many of our customers are relatively new business, or Internet- focused business initiatives of more established companies, and these businesses or initiatives may have negative cash flows or may not be successful, or both. As a result, we may not be able to collect revenues for the services we provide on a timely basis or at all. For these and other reasons, in future periods our operating results may fall below the expectations of securities analysts or investors, which could result in widely varying stock prices and negatively affect the market price of our common stock. Our customer base includes a significant number of businesses that currently face increasing difficulty in obtaining funding to support their operations. Many of our customers are businesses, including Internet-based businesses, that have traditionally been initially funded by venture capital firms and then through public securities offerings. Funding alternatives for these businesses have become more limited than in the past. The unproven business models of many of our customers and the uncertain economic climate make their continued viability uncertain. Many of these customers have ceased or reduced their operations, and it has become increasingly difficult for us to collect our accounts receivable from these businesses. If the market for technology and Internet-based businesses is not supported by the private and public investors who have funded these customers or if their business models prove to be unsuccessful, we face the risk that these customers may cease, curtail or limit web site operations hosted by us. If this continues to occur, we would likely experience a loss of revenue associated with these customers and will then have to increase sales to other businesses in order to preserve and grow our revenue. If we are successful in increasing sales to other businesses, we will incur the expenses associated with these new customers, such as sales and marketing expenses, including commissions, and implementation costs. As a result, to preserve and grow our revenue, we will have to increase sales by substantially more than the amount of lost revenue. Because we operate in a new and evolving market with uncertain prospects for growth, we may be unable to sustain growth in our customer base and our operating results may suffer. Our market is new and rapidly evolving. Growth in demand for and acceptance of advanced hosting services is highly uncertain. Businesses may not be aware of the potential benefits of outsourcing or may find it less expensive, more secure or otherwise preferable to host their web sites internally. Internet technologies, such as e-commerce applications, which require advanced hosting, may not grow as rapidly as we expect. We currently incur costs that are greater than our revenues. If we cannot grow and retain our customer base, we will not be able to offset our fixed and operating costs. Our future growth, if any, will depend on businesses outsourcing the management of their Internet and other applications and our ability to sell our services to these businesses in a cost- effective manner to a sufficient number of these businesses. If the market for advanced hosting services fails to grow or grows more slowly than anticipated or if we are unable to respond effectively to changes in this market, our business, operating results and financial condition will be adversely affected. Growth in the demand for our products and services may be inhibited, and we may be unable to sustain growth in our customer base for a number of reasons, including: . our inability to market our products and services in a cost-effective manner to new customers; . the inability of customers to differentiate the products and services we offer from those of our competitors; . our inability to strengthen awareness of our brand; and . reliability, quality or compatibility problems with our services. We rely on our strategic relationship with Level 3, and if this relationship is terminated or deteriorates our business may suffer. In July 1999, we entered into a strategic relationship with Level 3. Level 3 is a communications and information services company that is building an advanced facilities-based communications network through which it provides colocation, Internet connectivity and other services. As part of our relationship, we have committed to purchase a fixed amount of services from Level 3, including, among other things, bandwidth, colocation space, and installation and maintenance services, over the next three years. We will incur these expenses regardless of our revenues or, in some circumstances, if the agreement is terminated. We have also agreed that if Level 3 is capable of providing the services we request, and if those services are substantially similar to other services that we purchase, we will purchase 90% of these services from Level 3 through June 2004. We are required to purchase these services from Level 3 even if these services are available at lower prices from alternative vendors. We route the network traffic of our customers through multiple backbone providers to increase network performance. To enable us to do this, we obtain Internet connectivity through a number of providers, and Level 3 may not be able to provide all of the connectivity services that we require. As a result, we may purchase less than the applicable percentages of these services from Level 3. We also currently rely on Level 3 to provide substantially all of the data center capacity that we need to provide our hosting services, and in the future we may be required to purchase most of our data center capacity from Level 3. Further, Level 3 may provide personnel at these data centers to install equipment and assist with support as necessary for us to deliver service in these facilities. If Level 3 fails to provide this data center capacity or perform these services in a timely or effective manner, or at all, we would be required to make alternate arrangements. If demand for colocation space increases, Level 3 may not be able or willing to provide the data center capacity we require to deliver our services. If our relationship with Level 3 is terminated or if Level 3 does not provide the data center capacity that we need, or provide it on acceptable terms, we would be required to seek arrangements with other data center providers or construct our own data centers. We cannot be certain that alternate data center capacity will be available on commercially reasonable terms or at all. We currently rely, and for the foreseeable future will continue to rely, on Level 3 to provide a substantial part of our bandwidth and other networking services. If we were not able to obtain these services from Level 3, we would be required to seek arrangements with other providers of these services, and we cannot be certain that alternate services will be available on commercially reasonable terms or at all. Our success depends on Microsoft's continued success, and the loss or deterioration of our relationship with Microsoft could harm our business and have an adverse impact on our revenues. We focus on advanced hosting services for Microsoft-based Internet technologies. If these technologies are not widely used building blocks for advanced Internet sites in the future, the demand for our services would decrease and our business would be adversely affected. The final outcome of the antitrust case against Microsoft is uncertain, but the outcome could cause the acceptance of Microsoft products to decrease. Except for our relationship with Microsoft as a customer, and under the Development, License, and Co-Marketing Agreement, our relationship with Microsoft is generally informal. We believe this relationship provides us with access to developments in Microsoft products before they are generally available, which allows us to maintain and enhance our technical expertise. If our relationship with Microsoft deteriorates or if we lose some of the status or privileges we currently enjoy, our technical expertise could be adversely affected. Our ability to market our services as a provider of advanced hosting services for Microsoft-based Internet technologies would also be adversely affected if Microsoft does not continue to confer certifications and designations on us, or changes our current certifications and designations. We do not have a written agreement with Microsoft relating to all of these certifications or designations. Some of our competitors also have received these certifications and designations. Microsoft generally confers these certifications unilaterally and in its sole discretion and could change them at any time. We cannot be certain that we will continue to enjoy them. We operate in an extremely competitive market, and our business would suffer if we are unable to compete effectively. The market for hosting and Internet services is highly competitive. There are few substantial barriers to entry to keep new competitors from entering this market. We expect that we will face additional competition from existing competitors and new market entrants in the future. Many companies, including many large, established companies, have announced that they will begin to provide or plan to greatly expand their service offerings that are competitive with ours. These companies and many of our other competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. As a result, some of these competitors may be able to: . develop and expand their network infrastructures and service offerings more rapidly; . adapt to new or emerging technologies and changes in customer requirements more quickly; . take advantage of acquisition and other opportunities more readily; . devote greater resources to the marketing and sales of their services; and . adopt more aggressive pricing policies. In addition, some of our competitors have entered and will likely continue to enter into joint ventures or other arrangements to provide additional services competitive with those provided by us. The market in which we compete has experienced consolidation, and we believe that it is likely to continue to experience consolidation in the future, which could result in increased competition on price and other factors that could adversely affect our business. Some of our competitors may be able to provide their customers with additional benefits in connection with their Internet system and network management solutions, including reduced communications costs, which could reduce the overall costs of their services relative to ours. We may not be able to offset the effects of any price reductions. In addition, we believe our market is likely to experience further consolidation in the near future, which could result in increased competition, including price competition. In an effort to gain market share, some of our competitors have offered incentives not matched by us. In addition, some of our competitors may be able to provide customers with additional benefits that could reduce the overall costs of their services relative to ours. We may not be able to reduce the pricing of our services or offer incentives in response to the actions of our competitors without an adverse impact on our business. If we are unable to expand our network infrastructure when needed, we could lose customers and our operating results could suffer. We may have to expand and adapt our network infrastructure to accommodate our customers' requirements, the amount of information they wish to transmit and their changing requirements. We face risks related to our network's ability to be scaled to meet these requirements while maintaining acceptable performance levels. The continued expansion and adaptation of our networking and hosting infrastructure will continue to require substantial financial, operational and management resources as we negotiate bandwidth capacity with existing and other network infrastructure suppliers. If we are required to expand our network significantly and rapidly due to increased usage, additional stress will be placed upon our network hardware, traffic management systems and hosting facilities as well as our financial, operational and management resources. The ability of our network to support a substantially larger number of customers at high transmission speeds is unknown. Furthermore, it may be difficult for us to increase quickly our network capacity in light of current lead times to purchase circuits and other critical items. If the network providers upon which we rely fail to provide reliability, capacity and performance for our network, we could lose customers and our operating results could suffer. If the networks through which we deliver services do not have sufficient capacity, reliability or security, we could lose customers and our business would suffer. Our success partly depends upon the capacity, reliability and security of our network infrastructure, including the capacity leased from our network suppliers. Our network currently delivers service through Level 3, InterNap, AT&T, GTE, Netcom/Mindspring, PSINet, Qwest, Verio, MCI WorldCom, Inc., including UUNET Technologies, Inc., Sprint Corporation, Digex Incorporated, Cable & Wireless plc and SAVVIS Communications Enterprises, LLC. Some of these suppliers are also our competitors. In the future, we will be required to purchase most of our network capacity from Level 3 to the extent that it provides capacity that is substantially similar to the capacity of other providers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. If our customers' usage of telecommunications capacity increases, we will need to make additional investments in our infrastructure to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be significant. We monitor all network links to prevent their being utilized in excess of their recommended capacity. If our customers' usage increases and capacity is not available to us, our network may not be able to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along any increased costs to our customers. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business. Increased costs associated with our private transit Internet connections could result in the loss of customers or significant increases in operating costs. Our private transit Internet connections are more costly than other arrangements commonly utilized to move Internet traffic. If providers increase the pricing associated with utilizing their bandwidth, we may be required to identify alternative methods to distribute our customers' digital content. We cannot assure you that our customers will continue to be willing to pay the higher costs associated with direct private transit or that we could effectively move to another network approach. If we are unable to access alternative networks to distribute our customers' digital content on a cost-effective basis or to pass any additional costs on to our customers, our operating costs would increase significantly. We may not be able to deliver our services and our business may suffer if our third-party suppliers do not provide us with key components of our network infrastructure. We depend on other companies to supply key components of our network infrastructure. Any failure to obtain needed products or services in a timely fashion or at an acceptable cost could adversely affect our business. We buy servers, routers and switches on an as-needed basis and therefore do not carry significant inventories of them. We also have no guaranteed supply arrangements with our vendors. We currently only use servers from Compaq and rely on Compaq to provide us with access to Compaq technical personnel. In July 1999, we entered into an agreement with Compaq under which we agreed during the immediately following three years to purchase from Compaq the lesser of 2,000 servers or the number of servers reasonably necessary to adequately operate our business consistent with our business plan. Through September 30, 2001, we had purchased approximately 1,965 servers from Compaq under this agreement. Our requirement to purchase these servers is contingent upon Compaq providing financing for the servers on competitive terms, upon the price, performance and quality of the Compaq servers being reasonably satisfactory to us and upon Compaq's commitment to deliver these servers on the schedule we request. In addition, we rely on Cisco Systems, Inc. and others to supply equipment critical to our network, but we do not have a supply agreement with any of them. If this equipment were to become unavailable on terms acceptable to us, we would be forced to find alternative equipment. The inability to obtain equipment or technical services from Compaq, Cisco or others on terms acceptable to us would force us to spend time and money selecting and obtaining new equipment, training our personnel to use different equipment and deploying alternative components needed to integrate the new equipment, and as a result our business could be adversely affected. In addition, if our sole or limited source suppliers do not provide products or components that comply with evolving Internet and telecommunications standards or that interoperate with other products or components we use, our business would be harmed. For example, we have experienced performance problems, including previously unknown software and firmware bugs, with routers and switches that have caused disruptions in and impairment of network performance. We may not be able to adapt to evolving technologies and customer demands, which could cause our business to suffer. Our future success will depend on our ability to offer services that incorporate leading technology and address the increasingly sophisticated needs of our current and prospective customers. Our market is characterized by rapidly changing and unproven technology, evolving industry standards, changes in customer needs and frequent new product announcements. These characteristics are magnified by the growth of the Internet and the intense competition in our industry. We are also subject to risks from technological changes in the way hosting solutions are marketed and delivered. Future advances in technology may not be beneficial to or compatible with our business. To be successful, we must adapt to our rapidly changing market by continually improving the performance, features and reliability of our services and modifying our business strategies accordingly. We could also incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. In addition, our internal costs to provide service to our customers could be adversely affected. Our business would suffer if we fail to respond to these changes in a timely and cost-effective manner or at all. Our business will suffer if Internet usage does not continue to increase or if the Internet fails to perform reliably. Our ability to successfully market our services could be substantially impaired if we are unable to deploy new Internet technologies or service offerings or if new Internet technologies or service offerings deployed by us prove to be unreliable, defective or incompatible. We cannot assure you that we will not experience difficulties that could delay or prevent the successful development, introduction or marketing of Internet technologies in the future. If any newly introduced Internet technologies or our service offerings suffer from reliability, quality or compatibility problems, market acceptance of our services could be greatly hindered and our ability to attract new customers could be adversely affected. In addition, technological advances may have the effect of encouraging our customers or prospective customers to rely on in-house personnel and equipment to provide the services we provide. We cannot assure you that new applications or services deployed by us will be free from any reliability, quality or compatibility problems. If we incur increased costs or are unable, for technical or other reasons, to offer and deploy new Internet technologies or enhancements of existing technologies, our ability to successfully market our services could be substantially impaired. We believe that our ability to successfully compete is also dependent upon the continued compatibility of our services with products, services and architectures offered by various other companies. While we work with many vendors to test newly developed products, these products may not be compatible with our infrastructure or adequate to address changing customer needs. Any incompatibility could require us to make significant investments to achieve compatibility. If industry standards emerge, we may not be able to comply with them. Our failure to conform with any industry standards, or the failure of a common standard to emerge, could adversely affect our business. Our business will not grow unless Internet usage grows and Internet performance remains adequate. Use of the Internet for retrieving, sharing and transferring information among businesses, consumers, suppliers and partners has increased rapidly. Our success depends in large part on continued growth in the use of the Internet. In addition, our business plan anticipates significant growth in the web site hosting and application hosting markets. The growth of the Internet, including the web site hosting and application hosting markets, is subject to a high level of uncertainty and Internet usage and growth may be inhibited for a number of reasons, such as: . inadequate network infrastructure; . security concerns, including viruses and denial of service attacks; . uncertainty of legal and regulatory issues concerning the use of the Internet; . inconsistent quality of service; . the inability of Internet-based businesses to develop and maintain successful business models; . failure of Internet-based businesses; . lack of availability of cost-effective, reliable, high-speed service; and . failure of Internet use to expand internationally. If Internet usage grows, the Internet infrastructure may not be able to support the demands placed on it by this growth, or its performance and reliability may decline. For example, web sites have experienced interruptions in service as a result of outages and other delays occurring throughout the Internet network infrastructure. If these outages or delays occur frequently, use of the Internet as a commercial or business medium could in the future grow more slowly or decline, which would adversely affect our business. Any degradation in the performance of the web sites and other applications we host could undermine the benefits customers perceive in our services. Ultimately, the performance of the web sites and other applications we host relies upon the speed and reliability of networks operated by third parties. As a result, the growth of the market for our services and our ability to grow depends on the continued improvement of the entire Internet infrastructure. Many of the companies that have historically built new network capacity do not have access to the capital resources they did in the past. Consequently, they may not continue to invest in new network capacity at the same rates as they have in the past, or at all, which could adversely affect our business, operating results and financial condition. Failure of our operating and financial systems to keep pace with our business could result in customer dissatisfaction, operating inefficiencies and lost revenue opportunities. The rapid growth of our business and our service offerings in the past has placed a significant strain on our operating and financial resources. Our future performance will partly depend on our ability to manage our resources effectively, which will require that we further develop our operating and financial system capabilities and controls. If our information systems and other infrastructure, including customer service and support, are unable to support the demands placed on them in our business, we may be forced to implement new systems. If we fail to improve our operational systems or to expand our customer service capabilities to keep pace with the growth of our business, we could experience customer dissatisfaction, cost inefficiencies and lost revenue opportunities, which could harm our operating results. We may not be able to successfully implement these systems when needed or they may not perform reliably. We are currently developing internally a software application on which we intend to run our business. We expect that this application will provide the framework in which we provide services to our customers, including provisioning and service and support. We have expended, and will continue to expend, significant resources in developing this application. If we are unable to develop this system in a cost-effective and timely manner, or at all, or if the functionality we develop in this system does not support our business, our business, financial condition and operating results could be adversely affected. We may not be able to successfully sustain our business if we are unable to retain and attract highly skilled personnel. Our business requires individuals with significant levels of specific technical expertise. Competition for such personnel is intense, making it increasingly difficult to retain and attract the highly skilled employees necessary to provide the level of services that our customers expect. In light of the recent reduction in our work force and the decline in our stock price over the last 12 months, it may be difficult for us to retain and attract qualified personnel. We expect that we will gradually expand our sales and marketing staff to generate increased revenues. We may not be able to attract qualified personnel to fill new positions or to replace any of our current employees that we lose. We may be forced to provide higher compensation to such personnel than we currently anticipate, and the costs associated with training and integrating such new employees could be significant. If we are unable to effectively retain and attract qualified personnel on a cost-efficient basis, our operations and financial results could be adversely affected. We could experience system failures that could harm our business and reputation. To succeed, we must be able to operate our network management infrastructure without interruption. Our operations depend upon our ability to protect our network infrastructure, equipment and customer files against damage from human error, fire, earthquakes, hurricanes, floods, power loss, telecommunications failures, intrusion (including hackers), sabotage, intentional acts of vandalism and similar events. Our servers and network infrastructure are located primarily in the Dallas/Ft. Worth, Texas metropolitan area. The occurrence of a natural disaster or other unanticipated problems at any of the data centers from which we provide services could result in interruptions in the services we provide to our customers. Although we have attempted to build redundancy into our network and hosting infrastructure, we have experienced interruptions in service in the past. We have experienced partial system failures due to routing problems, hard drive failures, database corruption and other computer failures. Our network is subject to various points of failure, and a problem with our routers, switches or other equipment could cause an interruption in the services we provide to some or all of our customers. Any future interruptions could: . cause customers or end users to seek damages or service credits for losses incurred; . require us to replace existing equipment or add redundant facilities; . damage our reputation for reliable service; . cause existing customers to cancel their contracts; or . make it more difficult for us to attract new customers. Any of these results could damage our business. Our customer's satisfaction with our services is critical to our business. Our customers demand a high level of service. As customers outsource the hosting and management of business-critical applications to us, we are subject to liability claims and customer dissatisfaction if our systems fail or if we fail to maintain the availability of these applications. Our customer contracts generally provide some service level commitment that provides for remedies if their applications do not maintain a specified level of availability. If we incur significant service level commitment obligations in connection with downtime or system failures, we could be required to issue significant credits or pay significant damages, or both. Our liability insurance might not be adequate to cover such credits or damages. Any significant interruptions of service could result in claims and adversely affect our business, financial condition and results of operations. Disruption of our services caused by unknown software defects could harm our business and reputation. Our service offerings depend on complex software, including software licensed from third parties and our proprietary software tools. Complex software often contains defects, particularly when first introduced or when new versions are released. We may not discover software defects that affect our new or current services or enhancements until after they are deployed. These defects could cause service interruptions or performance issues, which could damage our reputation or increase our service costs, cause us to lose revenue, delay market acceptance or divert our development resources. Our business and reputation will suffer if we do not prevent security breaches. Unauthorized access, computer viruses, denial of service attacks, accidents, misconduct resulting in disruptions and other disruptions could occur. In addition, we may incur significant costs to prevent breaches in security or to alleviate problems caused by breaches. We work with Level 3 and other colocation vendors to protect our equipment and hardware against breaches in physical security and with other vendors of software and hardware to protect other breaches in security. We cannot be certain that they will provide adequate security. We have experienced and may in the future experience delays or interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees of Data Return or others. Furthermore, inappropriate use of the network by third parties could also jeopardize the security of confidential information, such as customer and Data Return passwords as well as credit card and bank account numbers, stored in our computer systems or those of our customers. As a result, we could become liable to others and lose existing or potential customers. The costs required to eliminate computer viruses and alleviate other security problems could be prohibitively expensive. In addition, the efforts to address these problems could result in interruptions, delays or cessation of service to our customers. Providing services to customers with mission-critical web sites and web-based applications could potentially expose us to lawsuits for customers' lost profits or other damages. Because our hosting services are critical to many of our customers' businesses, any significant interruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although many of our contracts disclaim our liability for any such damages, a customer could still bring a lawsuit against us claiming lost profits or other consequential damages as the result of a service interruption or other web site or application problems that the customer may ascribe to us. There can be no assurance a court would enforce any limitations on our liability, and the outcome of any lawsuit would depend on the specific facts of the case and legal and policy considerations. There can be no assurance we would prevail. In such cases, we could be liable for substantial damage awards. Such damage awards might exceed our liability insurance, which could seriously harm our business. Our limited ability or failure to protect our intellectual property may adversely affect our ability to compete. Third parties may infringe or misappropriate our technology or proprietary rights, which could have an adverse effect on our business, results of operations or financial condition. In addition, our competitors or potential competitors may independently develop technologies that are equivalent or superior to our technology. We rely on a combination of copyright, trademark, service mark and trade secret laws to protect our intellectual property. We have filed federal registrations for the mark "Data Return" and other marks. We also have internally developed software and other tools that are important to our business for which we rely on copyright protection. We have entered into contractual arrangements with some of our employees and contractors as well as suppliers, distributors and some of our customers in order to limit access to, and any disclosure of, our proprietary information. The steps we have taken to protect our intellectual property may be insufficient. We may need to take legal action to protect our intellectual property rights, which could be costly and divert the attention of our technical and management personnel. We may be accused of infringing the proprietary rights of others, which could subject us to costly and time-consuming litigation. In addition to the technologies we develop or have developed, we license certain technologies from third parties and may license additional technologies in the future. We could become subject to infringement actions based upon our internally developed technologies or technologies licensed from third parties. Any of these claims, with or without merit, could subject us to costly litigation and divert the attention of our technical and management personnel. In addition, third parties may change the terms of their license agreements in ways that would prevent us from using technologies licensed from them on commercially reasonable terms or that would prevent us from using them at all. We may not be able to replace those technologies with technologies that have the same features or functionality on commercially reasonable terms or at all. Regulatory and legal uncertainties could result in significant costs or otherwise harm our business. The success of our business depends on the growth of the Internet. Laws and regulations directly applicable to commerce or communications over the Internet are becoming increasingly prevalent. However, the law of the Internet remains largely unsettled. The adoption or modification of laws or regulations relating to the Internet could adversely affect our business if they impose a direct cost on us, or if they curtail the growth of the Internet. If liability for materials carried on or disseminated through their systems is imposed on service providers, we would make efforts to implement measures to reduce our exposure to such liability. Such measures could require us to expend substantial resources or discontinue certain product or service offerings. In addition, increased attention to liability issues, as a result of lawsuits, legislation and legislative proposals, could divert management attention, result in unanticipated expenses and harm our business. If legislation is adopted in the U.S. or internationally that makes transacting business over the Internet, such as e-commerce, less favorable or otherwise curtails the growth of the Internet, our business would suffer. We may be subject to legal claims in connection with the information disseminated through our network, which could have the effect of diverting management's attention and require us to expend significant financial resources. We may face potential direct and indirect liability for claims of defamation, negligence, copyright, patent or trademark infringement, violation of securities laws and other claims based on the nature and content of the materials disseminated through our network. For example, lawsuits may be brought against us claiming that content distributed by some of our current or future customers may be regulated or banned. In these and other instances, we may be required to engage in protracted and expensive litigation, which could have the effect of diverting management's attention and require us to expend significant financial resources. Our liability insurance may not cover any of these claims or may not be adequate to protect us against all liability that may be imposed or claimed. In addition, on a limited number of occasions in the past, businesses, organizations and individuals have sent unsolicited commercial e-mails from servers hosted at our facilities to massive numbers of people, typically to advertise products or services. This practice, known as "spamming," can lead to complaints against service providers that enable such activities, particularly where recipients view the materials received as offensive. We have in the past received, and may in the future receive, letters from recipients of information transmitted by our customers objecting to such transmission. Although we prohibit our customers by contract from spamming, we cannot assure you that our customers will not engage in this practice, which could subject us to claims for damages. The loss of key personnel including our Chairman and Chief Executive Officer, our President and our Chief Operating Officer could harm our business. We depend on the continued service of our key technical, sales and senior management personnel, including Sunny C. Vanderbeck, our Chairman and Chief Executive Officer, Michelle R. Chambers, our President, and Robert A. Prosen, our Chief Operating Officer. We have entered into employment agreements with Mr. Vanderbeck, Ms. Chambers and Mr. Prosen expiring in June 2002, but any of our officers or employees can quit at any time. Losing one or more of our key employees could harm our business. Difficulties presented by international economic, political, legal, accounting and business factors could harm our business in international markets. A component of our strategy is to expand into international markets. The rate of development and adoption of the Internet has been slower outside of the United States, and the cost of bandwidth has been higher, which may adversely affect our ability to expand operations and may increase our cost of operations internationally. The risks inherent in conducting business internationally include: . unexpected changes in regulatory requirements, export restrictions, tariffs and other trade barriers; . challenges in staffing and managing foreign operations; . differences in technology standards; . less protective intellectual property laws; . employment laws and practices in foreign countries; . longer payment cycles and problems in collecting accounts receivable; . political instability; . fluctuations in currency exchange rates and imposition of currency exchange controls; and . potentially adverse tax consequences. Our management will have significant flexibility in applying the proceeds from our initial public offering and our use of proceeds may not yield a favorable return. We have used and intend generally to continue to use the net proceeds from our November 1999 initial public offering to fund our capital expenditures and for working capital and other general corporate purposes. We may also acquire or make investments in other businesses, products, services or technologies and, if we do, we may not be able to make those acquisitions or investments on commercially acceptable terms or we could have difficulty assimilating and integrating any acquired businesses, technologies, services or products. We have not yet determined all expected expenditures and thus cannot estimate the amounts to be used for each specified purpose. Our management has significant flexibility in applying the net proceeds of our initial public offering. We cannot be certain that our use of the proceeds will yield a favorable return. Our principal shareholders, directors and executive officers currently own approximately 37.5% of our common stock, which may allow them to exert influence over us or to prevent a change of control. Our directors and executive officers and shareholders who currently own over 5% of our common stock collectively beneficially own approximately 37.5% of our outstanding common stock. These shareholders would be able to exercise significant influence over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership could also delay or prevent a change in control of Data Return even if beneficial to our shareholders. Some provisions of our articles, bylaws and rights plan and of Texas law could delay or prevent a change of control, which could adversely affect our stock price. Our articles of incorporation and bylaws contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. Some of these provisions: . authorize the issuance of preferred stock which can be created and issued by our board of directors without prior shareholder approval, commonly referred to as "blank check" preferred stock, with rights senior to those of common stock; . prohibit certain shareholder actions by written consent; . establish advance notice requirements for submitting nominations for election to our board of directors and for proposing matters that can be acted upon by shareholders at a meeting; and . provide for a board of directors with staggered three-year terms. We have also adopted a shareholders' rights plan that could delay, deter or prevent a change in control of us. In September 1999, we adopted a shareholder rights plan. This plan entitles our shareholders to rights to acquire additional shares of our common stock when a third party acquires 15% of our common stock or commences or announces its intent to commence a tender offer for at least 15% of our common stock. This plan could delay, deter or prevent a change in control of us. Future sales of our common stock could cause our stock price to decline. At September 30, 2001, 36,172,350 shares of our common stock were issued and outstanding. We cannot be sure what effect, if any, future sales of our common stock or the availability of shares for future sale will have on the market price of our common stock. The market price of our common stock could drop due to sales of a large number of shares of our common stock in the market or the perception that these sales could occur. These factors could also make it more difficult to raise funds through future offerings of our common stock. SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Data Return Corporation Dated: November 16, 2001 By: / s/ Stuart A. Walker ------------------------------------------- Stuart A. Walker, Vice President Chief Financial Officer (Principal Financial & Accounting Officer & Authorized Officer)

DATA RETURN CORP 10-Q/A