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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington,WASHINGTON, D.C. 20549
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                                   FORM 10-K
(Mark One)
 
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)15(D) OF THE SECURITIES EXCHANGE ACT
    OF 1934
(No Fee Required)
                   For the Fiscal Year Ended DecemberFOR THE FISCAL YEAR ENDED DECEMBER 31, 19971998
 
                                       OR
 
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)15(D) OF THE SECURITIES EXCHANGE
    ACT OF 1934
(No Fee Required)

For the Transition Period from                      to
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Commission File NumberFOR THE TRANSITION PERIOD FROM ________ TO ________
 
                         COMMISSION FILE NUMBER 0-22967
 
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                            NETWORK SOLUTIONS, INC.
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             (Exact name of registrant as specified in its charter)
 
                                                  
                   DelawareDELAWARE                                            52-1146119
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         (StateState or other jurisdiction                      (I.R.S. Employer Identification No.)
       of incorporation or organization)organization
            505 Huntmar Park Drive, Herndon, VirginiaHUNTMAR PARK DRIVE                                       20170
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         (Address of principal executive offices)HERNDON, VIRGINIA                                        (Zip Code)
   (703) 742-0400
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         (Registrant's telephone number,
         including area code)(Address of principal executive offices)
(703) 742-0400 Registrant's telephone number, including area code Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Class A Common Stock, $.001 Par Value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ][X] The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $82,025,402.50$2,029,595,706 on March 13, 199812, 1999 based on the last sale price as reported by the Nasdaq National Market System. 1 2 The aggregate numberAs of outstandingMarch 12, 1999, the registrant had 18,384,634 shares of Class A Common Stock, $.001common stock, $0.001 par value per share, issued and outstanding, and 14,850,000 shares of the registrant was 3,813,063 shares as of March 13, 1998.Class B common stock, $0.001 par value per share, issued and outstanding which is not publicly traded. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's definitive Proxy Statement for the annual meeting of shareholders to be held on May 19, 1998,18, 1999, which will be filed with the Commission within 120 days after the end of the registrant's fiscal year ended December 31, 1997,1998, are incorporated by reference into Part III of this Form 10-K. 2- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 32 TABLE OF CONTENTS
PagePAGE ---- PART I ITEMItem 1. BUSINESS ................................................................................... 4 ITEMBusiness.................................................... 1 Item 2. PROPERTIES..................................................................................33 ITEMProperties.................................................. 20 Item 3. LEGAL PROCEEDINGS...........................................................................33 ITEMLegal Proceedings........................................... 20 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.........................................34Submission of Matters to a Vote of Security Holders......... 22 PART II ITEMItem 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.................................................................36 ITEMMarket for Registrant's Common Equity Stock and Related Stockholder Matters......................................... 24 Item 6. SELECTED FINANCIAL DATA.....................................................................38 ITEMSelected Financial Data..................................... 25 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS...............................................40 ITEMManagement's Discussion and Analysis of Financial Condition and Results of Operation.................................... 28 Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...........................................................................53 ITEMQuantitative and Qualitative Disclosures About Market Risk........................................................ 42 Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................................................53 ITEMFinancial Statements and Supplementary Data................. 42 Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE..................................................................................53Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.................................... 43 PART III ITEMItem 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT..........................................53 ITEMDirectors and Executive Officers of the Registrant.......... 43 Item 11. EXECUTIVE COMPENSATION......................................................................53 ITEMExecutive Compensation...................................... 43 Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT..............................54 ITEMSecurity Ownership of Certain Beneficial Owners and Management.................................................. 43 Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..............................................54Certain Relationships and Related Transactions.............. 43 PART IV ITEMItem 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K............................54 SIGNATURES....................................................................................................56Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................................................... 44 Signatures.................................................. 46
3 43 PART I THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS THAT HAVE BEEN MADE PURSUANT TO THE PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. SUCHTHESE FORWARD-LOOKING STATEMENTS ARE BASED ON MANAGEMENT'S CURRENT EXPECTATIONS, ESTIMATES AND PROJECTIONS, BELIEFS AND ASSUMPTIONS. WORDS SUCH AS "ANTICIPATES," "EXPECTS," "INTENDS," "PLANS," "BELIEVES," "SEEKS," "ESTIMATES," VARIATIONS OF SUCH WORDS AND SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY SUCH FORWARD-LOOKING STATEMENTS. THESE STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND ARE SUBJECT TO CERTAIN RISKS, UNCERTAINTIES AND ASSUMPTIONS THAT ARE DIFFICULT TO PREDICT; THEREFORE, ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE EXPRESSED OR FORECASTED IN ANY SUCH FORWARD-LOOKING STATEMENTS. SUCHTHESE RISKS AND UNCERTAINTIES INCLUDE THOSE SET FORTH HEREINDISCUSSED BELOW UNDER "BUSINESS-RISK"BUSINESS -- RISK FACTORS" ON PAGES 1911 THROUGH 3220 AND ELSEWHERE IN THIS FORM 10-K. UNLESS REQUIRED BY LAW, THE COMPANY UNDERTAKESWE UNDERTAKE NO OBLIGATION TO UPDATE PUBLICLY ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE. HOWEVER, READERS SHOULD CAREFULLY REVIEW THE FACTORS SET FORTHDISCUSSED IN OTHER REPORTS OR DOCUMENTS THE COMPANY FILESTHAT WE FILE FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE COMMISSION, PARTICULARLY THE QUARTERLY REPORTS ON FORM 10-Q AND ANY CURRENT REPORTS ON FORM 8-K. ITEM 1. BUSINESS.BUSINESS OVERVIEW Network Solutions, Inc. (the "Company" or "Network Solutions") isWe are the leading Internet domain name registration servicesservice provider worldwide. The CompanyWe currently actsact as the exclusive registry and registrar for second level domain names within the .com, .org, .net and .edu top-leveltop level domains ("TLDs") pursuant tounder a cooperative agreement (the "Cooperative Agreement") with the National Science Foundation (the "NSF"). The Cooperative Agreement became effective January 1, 1993. It includes a three-month phase-in period, a five-year operational period (commencing April 1, 1993 and ending March 31, 1998), and a six-month "flexibility period" through September 30, 1998.Department of Commerce. We also facilitate global registration of domain names in other existing top level domains including country code top level domains. By registering Internet domain names, the Company enableswe enable businesses, other organizations and individuals to establish a unique Internet identitypresence from which to communicate and conduct commerce. The Company also is responsible for maintaining the .com, .org, .net, and .edu TLD zone files, which contain the second-levelAn Internet domain name is made up of a top level domain and its corresponding Internet Protocol ("IP") numeric address. In this capacity,a second level domain. For example, in the Company enablesdomain name "companyX.com," "companyX" is the efficient operationsecond level domain and ".com" is the top level domain. As a registry, we maintain the master database of the Internet by supplying or making available to the Internet root servers located around the world an identical copy of the file for all second level domain names registered in these TLDs. On February 20, 1998,for our top level domains. As a registrar, we enter new second level domain names into the National Telecommunicationsmaster database maintained by us, as registry, and Information Administration ofprocess modifications, transfers, re-registrations and deletions for existing second level domain names. We have agreed with the Department of Commerce (the "NTIA") published for commentto transition to a shared, or competitive, registration system in the Federal Register a proposed rule which if issued, would provide, among other things, (i) that additional companies could act asmultiple registrars formay register second level domain names withinwith us, as registry, in the .com, .net and .org and .net TLDs and (ii) that additional TLDs would be permittedtop level domains. This transition will occur in a phased approach with limited competition scheduled to be added to the Internet's root zone 4 5 system. See "Relationship with the NSF; Recent Developments in Internet Governance" and "Competition." Through its Consulting Services Division, the Company provides enterprise network consulting services to large businesses that desire to establish or enhance their Internet presence or "re-engineer" legacy network infrastructures to accommodate the integration of both Internet connectivity and Intranet network technology into their information technology base. The Division's service offerings have evolved from the Company's Internet pioneering efforts that date back to 1979 and presently include: (i) network engineering; (ii) network and systems security; and (iii) network management.begin April 26, 1999. In addition, the Company intends to offer1998, we introduced a portfolio of Internet-based products and services. We also provide Internet technology consulting services that will draw upon its positionfocus on network engineering, network and systems security and network management. On December 31, 1998, our Board of Directors approved a two-for-one stock split of the shares of our Class A common stock and Class B common stock, that was effected in the registration businessform of a 100% 1 4 stock dividend distributed on March 23, 1999 on shares of our Class A common stock and make proper use ofClass B common stock outstanding on February 26, 1999. Except as noted otherwise, all share or per share information in this Annual Report on Form 10-K has been adjusted to reflect the customer data that the Company collects. The Company wastwo-for-one stock split. We were incorporated in Washington, D.C. in 1979 as Network Solutions Incorporated. The Company wasWe were acquired by Science Applications International Corporation, ("SAIC"),or SAIC, an employee-owned, diversified professional and technical services company that designs, develops and manufactures high-technology products, on March 10, 1995, and waswere reincorporated as Network Solutions, Inc. in Delaware in November 1996. The CompanyWe completed itsour initial public offering ("IPO") of 3,795,000 shares (pre-split) of itsour Class A common stock, $.001 par value, ("Class A Common Stock"), on October 1, 1997. As of March 13, 1998,12, 1999, SAIC owned 100% of the Company'sour Class B common stock, $.001 par value, ("Class B Common Stock"), representing approximately 75.8%45% of the Company'seconomic interest of our outstanding common stock, $.001 par value, ("Common Stock"), and 96.9%approximately 89% of the combined voting power of the Company'sour outstanding Class A and Class B Common Stock. The Company'scommon stock. Our principal executive offices are located at 505 Huntmar Park Drive, Herndon, Virginia 20170, itsour telephone number is (703)742-0400 and itsour Class A Common Stockcommon stock is traded on the Nasdaq National Market under the ticker symbol NSOL. INDUSTRY BACKGROUND The Internet is a global network of millions of interconnected computers and computer networks that allow businesses, other organizations and individuals to communicate. Historically,OUR BUSINESS We provide the Internet had been used by a limited number of academic institutions, defense contractors and government agencies to facilitate remote access to host computers and transmit electronic mail. However, use of the Internet has now become dominated by a broad range of commercial organizations and individuals who utilize the Internet to communicate electronically, to distribute and retrieve information and to conduct commerce. Advances in technology, low-cost Internet access and an increasing corporate reliance on distributed information environments have fueled the rapid growth of the Internet. The Company believes that in order to support the demands placed on this evolving and rapidly growing medium of commerce and information exchange, a wide range offollowing: - Domain name registration services, - Internet-based products and services, will need to be developed and enhanced, including: (i) domain name registration services; (ii) Internet-based products and services; and (iii) enterprise network consulting- Internet technology services. Domain Name Registration Services. All communication on the Internet requires a unique numerical electronic address called an IP address. However, since IP addresses are hard to remember, the Internet functions through the establishment of a unique Internet identity (a "domain name") that correlates to an IP address and the proliferation of such domain names in the global Internet root servers. Currently, there are 13 root servers, ten of which are located in 5 6 the United States, two of which are located in Europe and one of which is located in Asia. When communication with a particular domain name is required and the IP address of that domain name's host is not known locally, the root servers "point" to a direct or indirect source of the information. See "Risk Factors - Reliance on Third Parties." An Internet domain name is made up of a TLD, such as .com, .org, .net or .edu, and additional domain levels consisting of at least one additional domain level, referred to as a second level domain name. For example, in the domain name "companyX.com," "companyX" is the second level domain name. With the increased commercialization of the Internet, second level domain names are being utilized not only by large corporations but also increasingly by other users, including small businesses, organizations and individuals. Particularly within the .com TLD, users are also registering domain names to establish Internet identities for other purposes such as trademarks, products and events. The most common TLDs include .com, .org, .net, .edu and .gov, as well as country code TLDs represented by "." followed by two letter country codes (e.g., .us for the United States, .uk for the United Kingdom and .de for Germany). The Internet is not bound by geography or lines of business and coordination and administration services are required for the registration, allocation and use of TLDs and for the effective operation of the Internet. In 1992, the NSF entered into the Cooperative Agreement with the Company for the performance of these functions for the .com, .org, .net, .edu and .gov TLDs. Internet-Based Products and Services. The proliferation of Internet users provides businesses, other organizations and individuals with new means by which to conduct business. To facilitate business-to-business and business-to-consumer transactions, Internet users are seeking important Internet-based products and services, such as transaction security services, electronic payment mechanisms and directory, communications, data and research and identity promotion services. Consulting Services. Many businesses are developing enterprise networks that employ Internet data formats and communications protocols. Internal enterprise networks ("Intranets") enhance user productivity and connectivity allowing users controlled access to internal information while also accessing and exchanging information on the Internet. As more businesses, organizations and individuals establish an Internet presence and begin to deploy Intranets, the Company believes there will be an increasing demand for Intranet development and enterprise network consulting services. In addition, the Company believes that Intranets are becoming increasingly sophisticated and are allowing users increased capabilities and improved access to information. As a result, businesses are increasingly seeking experienced enterprise network consulting firms to enable all of these services. PRINCIPAL SERVICES A. Registration Services.Services Registration services are the Company'sour core business. The Company registersWe have been performing these services since 1993 under the Cooperative Agreement. We register second level domain names in the .com, .org, .net and .edu TLDs, enabling registrants to establish a unique identity on the Internet. The Company'stop level domains. Our customers apply to register second level domain names either directly through the Company'sour web sites and e-mail-based registration templates or indirectly through Internet access providers which are the largest source of customers for the Company. Prior to September 14, 1995, the Company was reimbursed under the Cooperative Agreement by the NSF for providingand others. Our InterNIC registration services on a cost reimbursement plus fixed-fee basis. Effective September 14, 1995, the NSF and the Company amended the Cooperative 6 7 Agreement to authorize the Company to begin charging customers a service fee of $50 per year for each second level domain name registered. Customers in the .com, .org and .net TLDs have paid a two-year services fee of $100 for initial registrations and $50 per year foris an e-mail based registration renewals. Under the terms of the amendment to the Cooperative Agreement, 30% of the services fees collected have been required to be set aside to be disbursed in a manner approved by the NSF for the enhancement of the intellectual infrastructure of the Internet. These funds have not been recognized as revenue by the Company. With regard to registrations on or after April 1, 1998, the NSF and the Company have further amended the Cooperative Agreement to provide that (i) the Company will no longer charge or set aside a portion of the services fee for the enhancement of the intellectual infrastructure of the Internet and (ii) the Company's fees will be reduced to a two-year services fee of $70 for initial registrations and $35 per year for renewals. Through the internic web site, Network Solutions provides a domain name registrationtemplate application process for the registration of second level domain names. The Company'sOur customers submit registration applications to the Company via e-mail through the Internet. The Company processesWe process the application and either registersregister the requested domain name in the requested TLDtop level domain or rejectsreject the application. Upon registration or rejection, the Company notifieswe notify the customer via e-mail. For domain names which are registered, the Company invoiceswe invoice the customers and permitspermit them to pay the registration services fee after the domain name is registered. The Company performsWe perform internally (i.e., it does not outsource) itsour core proprietary automated registration process and associated security functions. On December 1, 1997, Network Solutions announced its new WorldNIC(TM) Services brand,we began to offer a suite of enhanced domain name registration services geared toward businesses building their online identities.small businesses. On January 14, 1998, Network Solutions unveiled RegistrationPlus(TM),we introduced RegistrationPlus, the first such service. The RegistrationPlus service offering under the WorldNIC(TM) Services brand. RegistrationPlus(TM) is a serviceweb-based transaction process that provides a way for small businessesis intended to establish themselves onsimplify the Internet. RegistrationPlus(TM)'sregistration process. The RegistrationPlus five step registration process minimizes technical and procedural barriers for new users seeking to gain an entry point on the Internet. RegistrationPlus(TM) allows users to register or reserve a second level domain name, in real-time whether or not they have a computer,and activate it later by providing domain name record hosting, either through Network Solutions' WorldNIC(TM) Servicesour web site or by calling a toll-free number. As part of RegistrationPlus(TM),The RegistrationPlus service also validates and accepts credit card payments, providing a customer confirmation number, via our secure web-based online payment system. On March 20, 1999, we consolidated into a single web site our InterNIC informational web site and our RegistrationPlus web site. Now, through the Company offers the option of reservingnew web site, users can reserve a name and activating it later by providingsecond level 2 5 domain name record hosting. In addition tothrough our RegistrationPlus service or register a second level domain name through our InterNIC service using the Company'ssame processes that were available under the separate web sites. Our customers currently pay a two-year servicesservice fee for initial registrations, as of March 13, 1998, RegistrationPlus(TM) customers pay $10$119 for the Company's enhanced registration services or, if applicable, $49 forinitial reservation of a domain name. The RegistrationPlus(TM) service offering isname and $70 for the initial registration of a web based transaction process that is intended to make the registration process easier, more streamlined and more accessible. The Company believes that ease of use is becoming increasingly important as the Internet is being more widely adopted by users who are less technically sophisticated. To facilitate payment of registration and renewal fees, the Company, as part of its RegistrationPlus(TM) service, implemented an electronic payment mechanism through which a user pays for its domain name via credit or debit card through an Internet-based on-line payment system. The Company believes that a streamlined registration process and on-line payment system will make it easier$35 per year for customers to registerre-registrations of a domain name. As partThrough our 1998 acquisition of Internet Domain Names, Inc., or idNames, we now offer search and registration services for domain names in country code top level domains around the world. Internet-Based Products and Services We have introduced a portfolio of Internet-based products and services and intend to develop additional Internet-based products and services, which may include directory and other Internet identity services. In 1998, we introduced the following Internet-based products and services: - DOT COM MAIL. In August 1998, we launched dot com mail, a portable, personalized e-mail service designed primarily for small businesses. The dot com mail service is hosted by our outsourcing vendor, Critical Path, Inc., and enables a business to use its unique domain name for its e-mail address instead of the domain name of its registration services offering,Internet access provider. Currently, the Company provides the following services and support: 7 8 1. Customer Support Services. The Company believes that high quality customer supportdot com mail service is vitalavailable only to client satisfaction. The domain name registration services fee provides the customer access to the Company's customer support services, including a telephone help desk, an on-line processing facility for account information updates and other services. The Company's customer service representatives in its Herndon, Virginia facility provide such support services. As part of its WorldNIC(TM) Services launch, the Company recently outsourced toll free telephone help desk support for its RegistrationPlus(TM) services to a large, experienced call center support entity. The outsourcing contractor is providing 24 hour 7 days a week support with customer service representatives trained by the Company's training staff. The help desks and on-line processing facility are important to the success of the Company's registration business because they are the front line to the customer and provide initial and ongoing customer service and support. At the end of 1996, the Company entered into arrangements to outsource certain back office operations, including invoicing, check processing and credit card processing. In addition, in December 1997, the Company introduced a new Oracle-based billing and accounts receivable system (BARS), an Internet-based transaction billing system. BARS improves tracking capabilities for billing information and enhances the speed and accuracy with which the Company's customer service representatives handle payment inquiries. The outsourcing efforts, in conjunction with BARS, have improved customer service and account handling and expanded the Company's capacity to service larger volumes of registrants. 2. Domain Name Dispute Policy Administration. The Company's established domain name dispute policy is an integral part of the maintenance and administration of the Company's domain name registration business. This policy seeks to take a neutral position with regard to domain name disputes between trademark owners and domain name holders and is designed to address claims thatcustomers who reserve a domain name registeredwhich we host. - DOT COM TOOLKIT. In September 1998, we launched the dot com toolkit, a small business resource center that provides access to tools and services for setting up a web site and conducting business on the Internet. The dot com toolkit resource center is available on our web site and offers tools and services categorized into four areas: - starting a business on-line, - setting up an Internet presence, - managing a business online, and - promoting a business online. Within each category, the resource center visitor has the ability to purchase services from a select group of companies that have contracted with us to be included in the resource center. We receive referral fees from certain purchases made by our customers from links in the Company infringesdot com toolkit resource center. - DOT COM PROMOTIONS. In August 1998, we launched our dot com promotions service through a third party's federal trademark. As of March 13, 1998, the Company had receivedjoint marketing agreement with LinkExchange, Inc. Through dot com promotions, a domain name registrant can link to and subscribe to various LinkExchange services which include: - registering a web site with over 3,600 written objections400 Internet search engines by subscribing to the registrationSubmit It! Service, - monitoring its rank in the search engines through the PositionAgent service, - participating in a competitive advertising network that allows users to promote their web sites and use oftrack success through the Banner Network service, and - buying targeted advertising space on affordable web sites through the LinkExchange Express service. We receive referral fees from certain domain names. Of these, approximately 1,960 were disputes in which the Company's domain name dispute policy was involved. Although 42 out of these situations have resulted in litigation involving the Company, as of March 13, 1998, no payments have beenpurchases made by our customers from links from the Company to any plaintiff and only four of these cases are pending. The Company expends considerable management and legal resources in the development, refinement and administration of its domain name dispute policy. See "Itemdot com promotions service. 3 - Legal Proceedings." 3. Technical Infrastructure Support. The Company is investing significant technical and financial resources to improve and to operate its domain name registration business. A substantial portion of the Company's software is custom-developed and proprietary. The Company's internally developed and proprietary software includes an automated registration capability that currently processes in excess of 90% of all new registration requests without human intervention. The Company believes that significant engineering talent is required to create a registration services capability and that knowledge of 6 Internet domain name system ("DNS") structures,Technology Services We deliver Internet security, data routing and routing protocols is critical to creating and enhancing registration service capabilities. The Company developed RWhois, a standard open protocol, which is used in the registration services business. The Company's engineering staff has significant expertise in the RWhois protocol. The Company believes that engineers skilled in protocol development are difficult to identify, hire and retain and thus its staff of engineers represents a valuable resource. See "Operations." 8 9 The Company currently maintains in excess of one and one-half million unique second level domain name registrations. The Company has realized significant scale efficiencies throughout its registration process as a result of its large customer base and technical infrastructure. B. Consulting Services. The Company delivers enterprise networktechnology consulting services to some of the world's leading businesses that are utilizing Internet technologies for their internal enterprise networks, (i.e., Intranets), connecting securely with their key partners through Extranets and accessing the Internet. The Company's engineers have extensive knowledge and experience in network engineering, network security and network management. The engineers have a broad base of expertise in such areas as local area network ("LAN")/wide area network ("WAN") protocols; routing, switching and remote access technologies; virtual private networks; IP addressing; domain name architecture; and UNIX, NT and other network operating systems. By leveraging this knowledge and experience, the Company is able to provide solutions to clients' complex network needs. The Company sells and markets its consulting services primarily to large companies that utilize their enterprise networks for a strategic advantage. During 1997, the Company provided consulting services to more than 35 individual companies. Ten of the Consulting Services Division's clients accounted for approximately 80% of its revenues. Each of these clients was in either the financial services industry or the oil and gas industry. Companies within these two industry groups will continue to be a primary focus for future business opportunities. The Company provides requirements analysis, design and implementation services within the following service offerings: 1. Network Engineering. The Company offersintranets. - NETWORK ENGINEERING. We offer a line of services to help develop optimize, and integrate enterprise network solutions in a manner tailored to individual clients' needs. All of these services are focused on building a strong network foundation for the enterprise. This includes service level analysis of IP address space engineering; DNS and dynamic host configuration protocol ("DHCP") architecture engineering; routing and switching architecture engineering; Extranet architecture engineering; virtual private network architecture engineering; and electronic messaging architecture engineering. 2. Network Security. The Company provides- NETWORK AND SYSTEM SECURITY. We provide a range of security consulting services to allow clients to protect the integrity of their data and systems. The enterprise network's security architecture establishes theWe develop access and protection controls that will permit internal and remote users to access computer systems, databases and applications on the network, while protecting against unauthorized or inadvertent access to information or misuse of systems services. The Company's methods to secure the backbone, LAN-to-WAN access, remote access and facilities can supplement or replace existing systems security measures. The Company maintains resident expertise in emerging network protocols, encryption and key technologies, firewalls, packet filters, proxy services, secure remote access strategies and secure Intranet servers. 3. Network Management. The Company providessystems. - NETWORK MANAGEMENT. We provide a range of services tothat allow clients to monitor, control and improve their mission-critical network performance. Such services include developing network capacity plans and performance management tools, conducting baseline assessments, performing network optimization and tuning, integrating new technology, and implementing complex network management centers. The CompanyWe also providesprovide planning and analysis to implement disaster recovery and contingencies for network system failures. 9 10 The Company'sDuring 1998, we provided Internet technology consulting services to more than 20 large companies. Our Internet technology consulting services are generally provided to clients on a time and expense basis. The CompanyWe also performsperform a limited number of engagements on a fixed-price basis. Many of the Company's consulting services clients have been developed through direct contact or referrals from SAIC. The Company intends to continue to rely on its relationship with SAIC and its subsidiary, Bell Communications Research, Inc. ("Bellcore"), to attempt to access SAIC's and Bellcore's major customers and strategic partners. The Company's Consulting Services Division is establishing its own dedicated sales team with account executives assigned to key clients in regional territories. In January 1998, Network Solutions and Informatica, Negocios, y Technologia, S.A. ("INTESA"), a joint venture between Petroleos de Venezuela S.A. (PDVSA) and SAIC, headquartered in Caracas, Venezuela, entered into an agreement under which the Company will provide consulting services to INTESA. The Company will provide expertise in Internet connectivity, messaging services, network security and wide area network (WAN) re-engineering to INTESA under a broad umbrella contract. As part of SAIC's joint venture agreement with PDVSA, the Company is currently subject to a noncompetition arrangement pursuant to which the Company has agreed to provide, with certain limited exceptions, consulting services to other companies in the Latin American market solely through INTESA. C. Internet-Based and Other Services. The Company intends to offer a portfolio of Internet-based products and services that will draw upon the Company's position in the registration business and makes proper use of the customer data that it collects. These products and services could include directory, communications, data and research, identity promotion and other services. Some of these products and services could include distribution of third party offerings through on-line enrollment for such products and services from the Company's domain name registration web site. Some of these products and services are currently in the process of development. See "Risk Factors - Technological Change and Additional Technology, Products and Services and - Evolving Sales and Marketing Organization and Distribution Channels." D. Strategic Acquisitions. The Company will seek to identify and, where appropriate, pursue acquisition opportunities which would provide businesses, products, services or technology complementary to the Company's current business. See "Risk Factors - Uncertainty of Future Acquisitions." RELATIONSHIP WITH THE NSF; RECENT DEVELOPMENTS IN INTERNET GOVERNANCE The Internet is not bound by geography or lines of business and coordination and administrative services are required for the registration, allocation and use of TLDs and for the effective operation of the Internet. The Internet historically has been loosely administered by government agencies which were involved in the creation of its infrastructure, initially the Department of Defense's Advanced Research Projects Agency ("ARPA") and, more recently, the NSF. Since the original role of the Internet was to link computers at governmental and academic institutions to facilitate communication and research, the Internet was historically administered by entities which were involved in sponsoring research rather than by any of the traditional federal or state regulatory agencies. In 1992, the Company entered into the Cooperative Agreement with the NSF, which had been funding the Defense Information Systems Agency ("DISA"), to perform registration services for second level domain names within the .com, .org, .net, .edu and .gov TLDs. Under the Cooperative Agreement, the Company was given the responsibility for ensuring the quality, timeliness and effective management of registration services to non-military Internet users and networks. The registration services provided by the Company under the Cooperative 10 11 Agreement included second level domain name registration, domain name server registration and network number assignment, as well as autonomous system number assignment and IP address mapping and allocation for North and South America, the Caribbean and parts of Africa. The Cooperative Agreement became effective January 1, 1993. It includes a three-month phase-in period, a five-year operational period (commencing April 1, 1993 and ending March 31, 1998), and a six-month "flexibility period" through September 30, 1998. The Cooperative Agreement is subject to review by the NSF and may be terminated by the NSF at any time at its discretion or by mutual agreement. The NSF has stated that it will not be re-awarding a cooperative agreement at the end of the flexibility period. On July 1, 1997, as part of the Clinton Administration's "Framework for Global Electronic Commerce," the President directed the Secretary of Commerce to privatize, increase competition in, and promote international participation in the DNS. Accordingly, on July 2, 1997, the NTIA issued a Request for Comments on administration of Internet domain names, on behalf of an inter-agency working group previously formed to explore the appropriate future role of the U.S. government in the DNS. This request appeared in the form of the Notice of Inquiry ("NOI") in the U.S. Federal Register. The NOI requested specific input in five broad areas: general principles, general/organizational framework issues, creation of new TLDs, policy issues for new registrars and trademark dispute issues. During the comment period, over 430 comments, including those of the Company, were received by the NTIA. On January 30, 1998, the NTIA issued a discussion draft, entitled "A Proposal to Improve Technical Management of Internet Names and Addresses" (the "Proposed Rule"). The following is a summary of the principal features of the Proposed Rule, and is not intended to be a complete description thereof. This summary is subject to and qualified in its entirety by reference to the Proposed Rule, which was published pursuant to the Administrative Procedures Act in the U.S. Federal Register on February 20, 1998. The Proposed Rule provides notice and seeks public comment on a proposal to transfer over time the administration of the DNS to a new private, not-for-profit corporation and increase competition in the administration of TLDs and the registration of second level domain names. The Proposed Rule states the view that the U.S. government should end its management role in the Internet number and name address systems in a responsible manner that ensures the stability of the Internet. The Proposed Rule covers generic TLDs and does not address country-code TLDs, which are administered by the corresponding governments or by private entities with the appropriate government's acquiescence. Under the new Proposed Rule, administration of the DNS would be transferred over time to a new private, not-for-profit corporation. After a transition period, the corporation would have authority: (i) to set policy for and direct the allocation of IP address number blocks to regional number registries for the assignment of Internet addresses; (ii) to oversee the operation of the root server system; (iii) to oversee policy for determining the circumstances under which new TLDs are added to the root system; and (iv) to coordinate the development of other technical protocol parameters to maintain universal connectivity on the Internet. The Proposed Rule provides that the new corporation would be headquartered in the United States and incorporated under U.S. law. The Proposed Rule states that the board of directors of the new corporation should represent membership associations of key stakeholders, including IP number registries, domain name registries, domain name registrars, the technical community 11 12 and Internet users (commercial, not-for-profit and individuals). The Proposed Rule provides that the corporation should hire a Chief Executive Officer with a background in the corporate sector. The new corporation would be funded by domain name registries and regional IP registries. The Proposed Rule provides that the transition would commence as soon as possible, with operational responsibility moved to the new corporation by September 30, 1998. The U.S. government would participate in policy oversight to assure stability until the new corporation is established and stable, phasing out as soon as possible, but in no event later than September 30, 2000. The Commerce Department would coordinate the U.S. government policy role. The Proposed Rule distinguishes between "registries" and "registrars". A "registry" is responsible for maintaining a TLD's zone files, which contain each second level domain name in that TLD and the corresponding IP addresses of its name servers. Each registry would establish minimum dispute resolution and other procedures relating to trademark considerations and would be required to indemnify the new corporation for costs incurred in connection with trademark disputes. A "registrar" acts as an interface between domain-name holders and the registry, providing registration and value-added services. The registrar submits zone file information for each of its customers in a single TLD to the registry. Currently, the Company acts as both the exclusive registry and as the exclusive registrar for the .com, .net, .org and .edu TLDs. During the transition to private administration of the DNS, the Proposed Rule provides for the addition of up to five new registries, each of which, at least initially, would be limited to a single TLD. During the transition, the first five entities to meet the technical, managerial and site criteria provided in the Proposed Rule would be allowed to establish a domain name registry. The Proposed Rule does not specify whether the pool of eligible applicants would be unlimited or limited, and, if limited, on what basis. Neutral accounting and technical consultancy firms would be engaged to evaluate a proposed registry under the criteria and certify an applicant as qualified. Qualified registries would, in the order of their qualification, select a TLD from a list of available TLDs or propose another TLD. The Proposed Rule states that such list of TLDs would be proposed based on input received and market data. The Proposed Rule provides that any entity would be permitted to provide registrar services within a TLD so long as it met certain specified minimum qualifications. Registries could set additional requirements for registrars with which they wished to do business. The Proposed Rule provides that if a registry wishes to act both as registry and registrar for the same TLD, it must do so through separate subsidiaries, and appropriate accounting and confidentiality safeguards shall be used to ensure that the registry subsidiary's business is not utilized in any manner to benefit the registrar subsidiary to the detriment of any other registrar. Each TLD database will be maintained by only one registry. The Internet Assigned Number Authority ("IANA"), which is headed by Dr. Jon Postel of the Information Sciences Institute at the University of Southern California and which currently provides IP address allocation, would be involved in many of the functions during the transition period to the new corporation. The Proposed Rule provides that during the transition period, the new corporation should evaluate the effects that the addition of new TLDs has on the operation of the Internet, on users and on trademark holders. After the transition, the new corporation would determine whether or when the introduction of additional TLDs was desirable and would have authority over the terms and conditions for the admission of new TLDs. The Proposed Rule provides that the U.S. government would phase out the Cooperative Agreement by the end of 12 13 September 1998. In addition, the Proposed Rule provides that, as the U.S. government is seeking to end its role in the DNS, the provision in the Cooperative Agreement requiring allocation of 30% of the registration fee to the Internet Intellectual Infrastructure Fund should terminate on April 1, 1998, the beginning of the flexibility period. The Proposed Rule provides that the Company and the U.S. government would negotiate an agreement that should contain the following terms designed to promote competition in domain name registration: (1) the Company would effectively separate and maintain a clear division between its current "registry" and "registrar" functions; (2) the Company would continue to operate the .com, .org and .net registries and to act as a registrar for those TLDs, but other companies would be permitted to act as registrar for those TLDs; (3) the .edu TLD would be transferred to a not-for-profit entity; (4) the Company's registry would treat all registrars on a nondiscriminatory basis and price registry services according to an agreed upon formula for a period of time; (5) as part of the transition, the Company would develop (or license) and implement the technical capability to share the registrar functions in the .com, .org, and .net TLDs with competing registrars as soon as possible, by an agreed upon date; (6) the Company would provide the U.S. government with "a copy and documentation of all the data, software, and appropriate licenses to other intellectual property generated under the Cooperative Agreement, for use by the new corporation for the benefit of the Internet"; (7) the Company would turn over control of the A-root server and the management of the root server system when instructed to do so by the U.S. government; and (8) the Company would be required to meet the requirements, set forth in the Proposed Rule, for registrars and registries. The Proposed Rule also provides that as part of the transition, an agreement would need to be reached between the U.S. government and IANA on the transfer of IANA functions to the new corporation. The formal comment period for the Proposed Rule ended on March 23, 1998. The NTIA expresses in the Proposed Rule its hope that a reasonable consensus can be found and that, after appropriate modifications, implementation of a final rule can begin in April 1998. Numerous comments have been received on the Proposed Rule, including comments from the Company. Some of the comments are critical of certain of the Proposed Rule's provisions. The Commerce Department has indicated that a final rule will be issued shortly after review of the comments received. It is impossible to predict at this time whether or when a final rule will be issued and, if issued, the timing of its implementation, the exact nature of its provisions or of any terms negotiated by the U.S. government and the Company or the precise effect of such provisions or terms on the Company. In addition, any final rule that is issued or any negotiated terms could be challenged by persons or entities who disagree therewith. See "Risk Factors - Uncertainty of Internet Governance and Regulation." 13 14 On October 1, 1997, the Company, pursuant to the NSF's directive, transferred its registration functions for the .gov TLD to the General Services Administration ("GSA"). The Company was released from all of its obligations under the Cooperative Agreement relating to the .gov TLD upon such transfer. On December 22, 1997, the Company, pursuant to the NSF's directive, transferred the allocation and administration of IP addresses for North and South America, the Caribbean and parts of Africa to a not-for-profit organization named the American Registry for Internet Numbers ( "ARIN"). The Company has agreed with the NSF to provide financial support to ARIN through the end of the first quarter of 1998. The Company believes that the amount of such support to the ARIN in the first quarter of 1998 will not be material. MARKETING AND DISTRIBUTION The Company has designed itsRELATIONSHIPS We are establishing and expanding marketing and distribution strategy to increase the use of the .com, .net and .org TLDs worldwide and to address the particular requirements of its diverse international customer base. The Company has begun and intends to continue to promote the use of the .com, .net and .org TLDs. The Company is working to expand its domain name registration business by: (i) building on relationships with Internet access providers; (ii) developing co-marketing programs with channel partners; (iii) working with major platform providers to provide the registration function; (iv) increasing its advertising and direct sales efforts; (v) establishing international alliances; (vi) working with server software application providers to develop an automated registration function; and (vii) establishing relationships with Internet-based product and service providers.companies worldwide. Strategic AgreementsPrograms with Internet Access Providers. The Company hasProviders and Others We have entered into agreements to provide specializedenhanced services to certain Internet access providers, including Internet service providers, ("ISPs"),or "ISPs," both in the United States and in other countries, who register a significant number of second-level domain names with the Companyus on behalf of such providers'their customers. This- PREMIER PROGRAM. Our Premier Domain Registration ServicesService Program ("Premier Program") provides suchparticipating Internet access providers with customized registration services, personalized account management, customized billing and financial reports, private e-mail boxes and other customized features and provides the Company with a multi-year registration stream from such providers.features. As of March 13, 1998, the Company12, 1999, we had entered into agreements with 49165 companies including: MCI, Inc., America Online, Incorporated (PrimeHost Division), TABNet, MindSpring Enterprises, Inc., BBN Corporation (a subsidiaryunder the Premier Program which include agreements with 71 companies located in the United States and 94 companies located in Canada, Australia, New Zealand and the European, South American and Asia-Pacific regions. - ALLIANCE PROGRAM. The Alliance Program is available to members of GTE Internetworking), Earthlink Network, Inc., NETCOM Interactive, UUNET Technologies, Inc., Sprint Communications Company L.P.the Premier Program who have participated in the program for a minimum of one year and Rapidsite, Inc. (Hiway).who have registered a significant number of second-level domain names with us. The Company intendsAlliance Program is designed to build upon its current relationships with certainenable us and our participating companies to provide reciprocal links and referrals to the other party's distribution channels for each other's complementary services. - AFFILIATE PROGRAM. In September 1998, we launched our Affiliate Program. This program provides a way for small Internet access providers that have agreedand other companies and individuals to participate in the Premierestablish a link to our RegistrationPlus domain name registration process. The Affiliate Program and intends to pursue relationships with additionalis designed for participation by Internet access providers. Through these relationships,providers, web hosting companies, and web site design companies that currently register their customers' domain names through us, as well as other companies and individuals who could benefit from providing this service to their customers. As of March 12, 1999, approximately 4,375 Affiliates were part of the Company seeks to deliver enhanced registration services and identify additional opportunities to expand its registration services business.program. 4 7 Distribution Channel Marketing Agreements with Channel Partners. The Company has developedWe are developing co-marketing programs with channel partners designed to take advantage of their complementary marketing capabilities.partners. DOMESTIC AGREEMENTS. In January 1998, the Companywe entered into strategic agreements with Dun & Bradstreet Corporation, ("D&B") and Inc. Online, ("Inc.")infoUSA and Centraal Corporation for the marketing and development of products and services to meet the future needs of the business marketplace. Theservices. - Our agreement with D&B makes it possible for businesses to register an Internet domain name and apply for a D&B D-U-N-S(R)D-U-N-S Number from either the D&B web site or the Company's WorldNIC(TM) Servicesour web site. As part of the agreement, Network Solutionswe and D&B placed a hyper linkhyperlink on each other's Internet 14 15 home pageweb site that will allow businesses and individuals registering for a domain name to complete that task and then apply for their D&B D-U-N-S(R)D-U-N-S Number or vice versa. The Company's- Under our agreement with Inc. is intended to help small businesses establish a unique identity and grow a brand on the Internet. Network Solutions is, we are sponsoring Inc.'s "Guide to the Internet" web site. In the "Guide to the Internet," Inc. helps small-to-midsize companies navigate through the information and decisions needed to choose systems, tie them together, get employees to embrace them and apply them to strategic goals. From Inc.'s web site, small businesses and individuals can hyper linkhyperlink to the Company's WorldNIC(TM) Servicesour web site where they can register or reserve a domain name within minutes using our RegistrationPlus services. - Under our agreement with infoUSA, we and infoUSA are providing reciprocal links and referrals to each other's products and services so that our customers can purchase infoUSA's sales leads and mailing lists services and receive information on businesses for marketing or credit purposes. InfoUSA's customers can register a domain name through our RegistrationPlus service from the Company's RegistrationPlus(TM)infoUSA home page or purchase any other service offered through our web site. - Under our agreement with Centraal, we market, sell and service Centraal's "RealName" subscription orders to domain name holders, directly and through our channels worldwide. The RealName service is a web navigation service that enables users to navigate to specific Web pages and is complementary to our domain name registration services. See "International Alliances.As part of the agreement, Centraal placed a hyperlink on its web site that allows Centraal customers to register a domain name with us. INTERNATIONAL AGREEMENTS. We have also established distribution channels in Beijing, China through the Computer Network Information Center, or "CNIC," Agreementsand in Japan through ASCII Corporation, or "ASCII". - Under our agreement with Major Platform Providers to Provide the Registration Function. The Company intends to seek to expand itsCNIC, CNIC is promoting in China our domain name registration services business through agreements with major platform providers (i.e., operating system manufacturers or hardware vendors who provide bundled operating system software) to provide an automated registration functionin the .com, .org and .net top level domains through a "point-and-click" interface directly intojoint marketing campaign with us in Chinese publications, web sites and other media, and by providing seminars in China on registering domain names with us. Under the software installation procedures. Advertising.agreement, we are promoting domain name registration in .cn, the China country code top-level domain, under which CNIC is the registry. - In October 1998, we launched a Japanese language version of our RegistrationPlus service, through a strategic agreement with ASCII. Through this relationship, we will make our RegistrationPlus service available to Japanese Internet users in the Japanese language, with a Japanese call center customer support help desk and through an advertising and marketing campaign in Japanese publications, Japanese web sites and through other media. Advertising In December 1997, the Companywe launched our first significant marketing campaign, a targeted print and on-line advertising campaign for itsour registration services with the announcement of its new corporate logo and its WorldNIC(TM) Services brand.services. This the Company's first significant marketing campaign iswas focused on small businesses5 8 businesses. We also launched several major multi-piece direct mail, print and their needweb site banner advertising campaigns announcing our new products and services, such as RegistrationPlus and dot com mail. In addition, we have run two national cable television ad campaigns. In December 1998, we entered into two separate global marketing agreements with Yahoo Inc. and Netscape Communications Corporation under which we purchased advertising to establish their own unique identity and to grow a brand on the Internet. The Company is currently developing additional campaigns in thispromote our domain name registration services and other services on certain Yahoo! and Netscape web sites during 1999. Direct Sales We market segments. Direct Sales. The Company'sand distribute our services are marketed and distributed directly through itsour Internet home pages. In addition, the Company iswe are continuing to develop itsour product management, marketing and sales force to target channel and distribution partners to offer the Company'sour registration services electronically through existing Internet web sites and through other direct channels, such as direct mail and telemarketing. ONGOING PRIVATIZATION OF INTERNET ADMINISTRATION The CompanyInternet is seekingnot bound by geography and neither the U.S. Government nor any organization or entity currently has formal authority over all aspects of the Internet. There is, however, a requirement for central policy decisions surrounding the coordination of the administrative services required for the registration, allocation and use of top level domains and Internet Protocol numbers, and for the effective global operation of the Internet. This role has been generally filled through mutual cooperation and interrelated informal agreements, historical leadership from an unincorporated entity called the Internet Assigned Numbers Authority and involvement from the U.S. Government. With the onset of increased commercial growth of the Internet, the U.S. Government initiated an activity directed at increased privatization of the policy making and central administration of the Internet. Without authoritative policy making, it has become more difficult to achieve consensus in the historical manner. Failure to achieve consensus among the various groups who now informally administer the Internet could disrupt Internet operations or delay infrastructure improvements or changes in operations needed to maintain and expand the numberInternet. Within the U.S. Government, leadership for the continued privatization of registrations in targeted customer segments both domesticallyInternet administration is currently provided by the Department of Commerce. After a series of draft proposals and internationally. The Company is targeting customer segments such as small business users, individuals, holderspublic comment periods, on June 10, 1998, the Department of trademarks, service marks and product marks and event sponsors. International Alliances. The Company intends to establish distribution alliances for registration services in selected international countries. These could include remarketing agreements with channel partners. In addition, the Company intends to offer "ease of use" solutions for entities worldwide for registrationCommerce published in the various TLDs, including country code TLDs. Agreements with Server Software Application Providers.Federal Register a plan referred to as the Statement of Policy or "White Paper," calling for the formation of a not-for-profit corporation to assume responsibilities relating to the domain name system, but not to perform actual registration of domain names either as a registrar or registry. The Company has entered into an agreement with Microsoft Corporation ("Microsoft")Statement of Policy invites private sector Internet stakeholders to providework together to form a "point-and-click" interfacenew private, not-for-profit corporation to oversee policy for an automated registration function. This interface is designedthe Internet name and address system and provides that: - the not-for-profit corporation should be headquartered and incorporated in the United States and have a board of directors from around the world; - in making a decision to facilitate the easedevolve U.S. government oversight of the registration processdomain name system to the not-for-profit corporation, the U.S. government will be guided by, and consider the entity's commitment to, the principles of stability, competition, private bottom-up coordination and representation; - to the extent that the not-for-profit corporation is established and operationally stable, transition to the private sector of domain name system administration will be phased in by September 30, 2000; and 6 9 - the not-for-profit corporation ultimately should have the authority to: - set policy for usersand direct allocation of Internet protocol number blocks to regional Internet number registries; - oversee operation of the authoritative Internet root server software andsystem; - oversee policy for determining the circumstances under which any new top level domains are added to allow for the Company to have a preferred provider position on the registration wizard screen that appears during the server initialization process. 15 16 Agreements with Internet-Based Product and Services Providers. The Company has entered into an agreement with VeriSign, Inc. ("VeriSign") pursuant to which the Company provides its customers with direct access to VeriSign's server security certificates through the Company's domain name registration process. The Company will receive a portionsystem; and - coordinate the assignment of VeriSign's subscription fees for providing such accessother Internet technical parameters as needed to VeriSign subscribers. The Company may enter into other agreements designed to allow the Company to build upon its strategy of becoming an Internet-based business center where a business or individual can have access to companies which provide the enabling products and services to conduct businessmaintain universal connectivity on the Internet. The Company sellsStatement of Policy distinguishes between the registry and marketsregistrar functions of the domain name system, both of which functions are currently performed exclusively by us in the .com, .org, .net and .edu top level domains, and calls for increased competition. The current technical structure of the Internet will permit only one registry for each top level domain. A registrar acts as the interface between the registry and the end-user domain name holders. Registrars submit to the registry information and other data for each of their customers that has a second level domain name in that top level domain. A registrar can provide value-added products and services in addition to its consultingbasic registration service. Numerous registrars will be able to operate within each top level domain. As part of the process initiated by the Statement of Policy, several proposals were put forward to the Department of Commerce on the establishment and governance of the not-for-profit corporation. The proposals differed in several respects including, among others, their approaches to the following issues: place and form of incorporation; method for selection of the interim and permanent board of directors; who should be eligible to become a member and on what questions should the members vote; what authority should be granted to the board of directors and what authority should be reserved to the members, if any; and whether there should be separate supporting organizations and, if so, what authority these organizations should have. A U.S. based private not-for-profit corporation with an international board of directors, denoted the Internet Corporation for Assigned Names and Numbers, or "ICANN," submitted various proposals which formed the basis of discussion at a number of public and private meetings. As a result of these and other meetings and private negotiations, the process initiated by the Statement of Policy has resulted in the entry by the U.S. Government into a Memorandum of Understanding, or "MOU," with ICANN. Under the MOU, the parties will jointly design, develop and test the mechanisms, methods and procedures that should be in place and the steps necessary to transition management responsibility for certain domain name system functions to a private-sector not-for-profit entity. The MOU provides that once testing is successfully completed, it is contemplated that management of certain domain name system functions will be transitioned to the mechanisms, methods and procedures designed and developed in this joint project. The U.S. Government has sent us a letter directing us to treat ICANN as the not-for-profit corporation identified in the October amendment to the Cooperative Agreement described below under "-- Status of Cooperative Agreement," in the performance of ICANN's obligations under the MOU and until such time as the MOU is terminated. We have not yet responded to that letter. ICANN's bylaws call for the creation of supporting organizations that will select some ICANN board members and provide policy recommendations in particular areas. ICANN called for submission by February 5, 1999 of applications from groups urging "recognition" of a domain name supporting organization that would be charged with developing recommendations for policies ICANN might apply when, and if, it begins exercising responsibility over certain domain name system matters. Those responsibilities could include entering into contracts with registries for all top level domains and eventually adding new top level domains. We submitted comments regarding the structure and function of such a domain name supporting organization. On March 4, 1999, the ICANN Board adopted a domain name supporting organization formation concept statement reflecting some, but not 7 10 all of our comments. On March 15, 1999, ICANN released a staff draft of amendments to its bylaws based on the formation concept statement to establish a domain name supporting organization that will first meet in May 1999. We cannot be sure that ICANN will take positions favorable to us in the adoption or implementation of the final bylaws or in its further policy development or contract formation. STATUS OF COOPERATIVE AGREEMENT On January 1, 1993, we initiated phase-in of a Cooperative Agreement with the National Science Foundation. The three-month phase-in was followed by a five-year operations period, commencing April 1, 1993 and ending March 31, 1998, and a six-month flexibility period through September 1998. Effective in September 1998, the responsibility for the Cooperative Agreement was transferred to the Department of Commerce. In October 1998, the Cooperative Agreement was amended to extend the flexibility period through September 30, 2000 and to transition to a shared registration system. In this transition, we will operationally separate our registry business from our registrar business. Additional, competing registrars will be able to market registrations in the .com, .net and .org top level domains through the registry that we maintain for each of those top level domains. Accordingly, persons registering second level domain names will be able to choose among a number of different registrars, including us. As the registry, we will have contracts with these competing registrars allowing them to register names in our registry database. Our registry services will be subject to large companiesa price cap, the details of which are currently under discussion with the Department of Commerce. Registrar services, once competitive, may be priced in different ways by us and competing registrars. On March 12, 1999, the Cooperative Agreement was amended to, among other things, delay the schedule for the development and deployment of the shared registration system, due to the fact that utilize their enterprise networkthe MOU was not signed until November 25, 1998, or 25 days later than had been assumed when the milestones were established. The following summarizes certain terms of the October 1998 amendment to the Cooperative Agreement, as amended by the March amendment: - We will develop a protocol and associated software to support a shared registration system which will permit multiple registrars to provide registration services within the top level domains for which we now act as exclusive registry and registrar. Implementation of the shared registration system will reflect an agreed-upon time line, which assumes that the U.S. Government does not request changes in the specifications, including the following dates: - By April 26, 1999, we will initially deploy the shared registration system by establishing a test bed supporting actual registrations in .com, .org and .net by five registrars accredited by the not-for-profit corporation; - By June 25, 1999, we will deploy the shared registration system and make it available to support multiple licensed and accredited registrars within the top level domains for which we act as registry; - By October 25, 1999, we will complete reengineering of our registry/registrar interface and back end systems so as to assure that we, acting as registry, will give all licensed and accredited registrars equivalent access to registry services through the shared registration system; - We and other accredited entities will function as domain name registrars through the shared registration system. The shared registration system will, among other things, permit second level domain name holders to change registrars within the same registry without changing domain names; 8 11 - We will also continue in our role as the registry of .com, .org and .net top level domains. Commencing upon the initial deployment of the shared registration system, our price for registry services in the top level domains for which we now act as registry will be no more than a dollar amount per registration, per year, agreed upon with the U.S. Government and reflecting our costs and a reasonable return on our investment; - Commencing upon the initial deployment of the shared registration system, for a strategic advantage, including financialperiod of 18 months, we will permit any customer with whom we have an exclusive contract as registrar to obtain registration services companies, banks, oilfrom other registrars; - From the date of the October 1998 amendment and gas companiesfor a period of 18 months after initial deployment of the shared registration system, we may not enter into any agreement that limits a party's ability to serve as a registrar or operate a registry; - We agreed to submit to the U.S. Government an electronic copy of all software and telecommunications companies.data, and a copy of documentation therefor, generated under the Cooperative Agreement through September 30, 1998. The Company believes that these organizations have a substantial installed base of enterprise networks and additional requirements for network engineering, networkU.S. Government agreed to take appropriate measures to protect the security and network management consulting services. In addition, the Company intendsconfidentiality of such data, software and documentation; and - We have agreed to continue to rely on its relationshipfunction as the administrator and operator for root zone servers A and J until such time as the U.S. Government instructs us to transfer either or both of those functions to the not-for-profit corporation or a specific alternate entity. As the U.S. Government transitions certain responsibilities for the domain name system to the not-for-profit corporation, corresponding obligations under the Cooperative Agreement may be terminated and, as appropriate, covered in a contract between the not-for-profit corporation and us. The U.S. Government has directed us to treat ICANN as the not-for-profit corporation for the purposes described above, but we have not yet reached agreement with SAICthe U.S. Government or ICANN with respect to the terms of such transition. We may not be able to reach agreement and Bellcore to attempt to access SAIC's and Bellcore's major customers and strategic partners. The Company's Consulting Services Division is also establishing a direct sales force with account executives assigned to key customers in regional territories. See "Competition." See "Risk Factors - Evolving Sales and Marketing Organization and Distribution Channels and - Technological Change and Additional Technology, Products and Services." OPERATIONS On June 16, 1997,either ICANN or the Company leased 31,247 square feetU.S. Government may take positions that adversely affect us. We have held two meetings of a 53,136 square foot facilityfocused technical advisory group to support itscomment on and participate in testing of our shared registration system. The group included members suggested by ICANN to the Department of Commerce and other individuals. ICANN has issued accreditation standards for competing registrars and methods for selection of the initial five registrars to participate in the test bed under the shared registration system. Under the ICANN approach each accredited registrar will enter into an accreditation contract with ICANN. The proposed accreditation contract would require payment of fees to ICANN and would impose special restrictions on a registrar also acting as the registry. We filed substantial comments with ICANN objecting to various aspects of the proposed accreditation approach. We are currently in discussions with ICANN and the U.S. Government regarding implementation of the shared registration system and a wide range of contractual issues. We cannot be sure that these discussions will result in agreements or outcomes that are favorable to us. OPERATIONS The functioning of the domain name registration business operations. Effective February 1, 1998,system depends on a hierarchy of specialized software programs resident in network computers called domain name servers. The top level of this hierarchy consists of 13 globally distributed domain name servers, called root zone servers. The root zone servers contain the Company leased an additional 9,059 square feetmaster directory of all top level domains in the same facility to expand its operations. This leased facility is designed to meetInternet. Below the root zone servers in the hierarchy are the top level domain zone servers. The top level domain zone servers contain the database of active second-level domain names and corresponding Internet protocol numbers registered in each top level domain. 9 12 The location and control of the root zone and top level domain zone servers historically has been determined by consensus of various members of the Internet community. We currently administer and operate two of the 13 root zone servers, specifically root zone servers A and J, and four top level domain zone servers. The other root zone and top level domain zone servers that we do not administer and operate are administered and operated by independent operators on a volunteer basis. Every night we update root zone server A with a file that contains the current registration services customer support needs as well as to provide expansion capability for future business. It includes: (i) a call center; (ii) a training center equipped for both computerlist of top level domains and telephone training, including a simulated operations environment; and (iii) a new computer room with expanded systems and telecommunications services.the Internet protocol numbers of the top level domain zone servers. The Company believesother top level domain zone servers then copy that this new facility with the accompanying system enhancements provides the environment and tools that are essential for quality customer support.file. To register a domain name within the .com, .org, .net and .edu TLDs, the Company'stop level domains, our customer or the customer's Internet access provider (i)on behalf of the customer, completes a registration application which is submitted to the Companyus via e-mail or (ii) submits a web-based registration application through the Company's WorldNIC(TM) Servicesour web site. Once the customer is registered, the Company loads the domain name intois included in the A-root zone server, which contains the Internet's definitive global listing of addresses and which Network Solutions manages under authority from the NSF. Ittop level domain master database that is from the A-root zone server that the Internet root server administrators obtain their nightly updates of the zone files maintained by the Company. In January 1998, the Company installed a back-up facility in Charlotte, North Carolina to provide redundancy and enhanced reliability for its Internet root zone administration. Seven T1 and one T3 (high-speedupdated nightly. Eleven high-speed data communications line)line links connected to five ISPseight Internet service providers support the Company'sour registration services. The aggregate capacity of the Company's T1 links is 10.5 megabits per second and the capacity of the T3 link is 45 megabits per second. Thus the aggregate capacity of the T1 and T3 links is 55.5 megabits per second. By connecting to fiveeight different ISPs, the Company seeksInternet service providers, we seek redundancy to ensuremaintain constant access to the Internet should 16 17 any given ISPInternet service provider or link develop complications. The Company believes itsWe believe our current network is adequate and that any additional capacity will be available in the future as needed. Substantial portionsPortions of the Company'sour internally developed registration software have been custom-developed and are proprietary. The Company'sOur internally developed registration software includes an automated registration capability that currently processes in excess of 90% of all new registration requests without human intervention. The Company has a capital lease/purchase process for its computer equipment that allows the Company to use the latest technology within itsWe have an operating infrastructure. The Company has over 300 NT workstations providing customer service and approximately 150 UNIX servers running a variety of applications to evenly distribute operational load. Additionally, the Company utilizes several large network file serversfacility to support its directoryour current registration operations and registrationcustomer support needs. The facility includes a call center, a training center equipped for both computer and telephone training and a new computer room with expanded systems and telecommunications services. These serversWe contract for a back-up facility at a third party's secure facility in California to provide a mirrored file system forredundancy and enhanced reliability for our Internet root zone administration. Recently, our systems have been subject to unusually large numbers of speculative and back-up coverage. The Company isrepetitive e-mail domain name registration and modification requests from domain name speculators and other abusers. Such abuses of our systems have resulted in processing delays. We have taken, and are continuing to take, actions to combat these delays and abusive e-mails by accelerating the processimplementation of implementing a state-of-the-art network management technology that will improve overall operational efficienciesplanned hardware upgrades to our systems and by taking other actions, including imposing certain restrictions on access to our customer quality.database, to minimize the impact of such system abuses. RESEARCH AND DEVELOPMENT All research and development expenses incurred in 1995 were reimbursed to the Company by direct charges to contracts, including the Cooperative Agreement. In 1996, our research and development expenses were $680,000 or 3.6% of net revenue. In 1997, our research and development expenses were $1,653,000 or 3.6% of net revenues. The Company believesIn 1998, our research and development expenses were $4,821,000 or 5.1% of net revenues. We expect that significantthe level of research and continuing investmentsdevelopment expenses will continue to increase in productsthe near future in terms of absolute dollars as we invest in developing new service offerings. COMPETITION COMPETITION IN THE REGISTRATION BUSINESS A principal objective expressed in the Statement of Policy is the introduction of competition and services developmentglobal participation in the management of Internet names and addresses including, among other things, competition among registrars within a single top level domain and competition among existing 10 13 and new top level domains. This objective is embodied, in part, in the October 1998 amendment to the Cooperative Agreement. Many aspects of how competition will be required to maintain its position as the leaderwork in the domain name registration businesssystem, however, remain unsettled and to achieve its strategycould be impacted by, among other things, actions of leveraging its registration services business to offer and distribute other enabling services. COMPETITION The Companythe not-for-profit corporation. We currently is the leading provider of domain name registration services. It currently is the exclusive registry and registrar for second level domain names within the .com, .org, .net, and .edu TLDs. The Company currently facesface competition in the domain name registration business from registries for country code TLDs,top level domains, third level domain name providers such as Internet access providers and registrars and registries of TLDstop level domains other than those TLDstop level domains that we currently being registered by the Company.administer. A number of entities have already begun to offer competing registration services using other TLDs. On July 1, 1997, President Clinton directedtop level domains. In developing and distributing future products and services for the Commerce DepartmentInternet-based services markets, we face intense competition and expect to privatize, increase competition in, and promote international participation inhave multiple competitors for each of the DNS. On February 20, 1998, the NTIA published the Proposed Rule in the Federal Register for comment. The Proposed Rule, if issued, would provide, among other things, (i) that additional companies could act as registrars for second level domain names within the .com, .org and .net TLDs and (ii) that additional TLDs would be permitted to be added to the Internet's root zone system. The Company believes that additional competition will be forthcoming in the domain name registration services business. The exact timing and nature of that competition is, at this time, however, uncertain. Additional competition could result through the emergence of competing 17 18 registrars in the .com, .org and .net TLDs and/or the emergence of additional registries with responsibility for new TLDs. In the event that a final rule is issued that results in additional competition in the DNS business or additional competition is introduced through some other means, there could be a material adverse effect on the Company's business, financial condition and results of operations. Future competition in the Company's domain name registration business could come from many different companies, including, but not limited to, major telecommunications firms, cable companies and Internet access providers. Such entities have core capabilities to deliver registration services, such as help desks, billing services and network management, along with strong name recognition and Internet industry experience. Other companies with some or all of these capabilities may also enter the registration business. Also emerging is a growing contingent of domain name resellers. In addition, the Company's revenue and registration fees could be reduced due to increased competition or pricing pressures. For example, other registrars may bundle domain name registrations with other products or services, effectively providing such registrationif any, which we develop or sell. Furthermore, the industry in which we intend to compete is characterized by rapid changes and frequent product and service introductions. If a competitor were to successfully introduce certain products or services for free. The Company believes that competition in the domain name registration servicesbefore us, it could cause our business is in the best interests of the Internet community. The Company believes that it is well positioned to be successful in a competitive environment by virtue of (i) its existing customer base; (ii) global recognition of the .com, .net and .org TLDs; (iii) its agreements with Internet access providers; (iv) its established technical infrastructure; (v) its experience in the administration of a domain name dispute policy; and (vi) its skilled technical personnel who are experienced in the domain name registration business. In addition, a substantial portion of the Company's registration software has been custom-developed and is proprietary. Additionally, the Company's internally-developed registration software includes an automated registration capability that currently processes in excess of 90% of all new registration requests without human intervention. See "Relationship With the NSF; Recent Developments in Internet Governance."suffer. COMPETITION IN THE INTERNET TECHNOLOGY SERVICES BUSINESS Companies with Internet expertise are current or potential competitors to the Company's consulting servicesour Internet Technology Services business. SuchThese companies include systems integrators and consulting firms, such as Andersen Consulting, IBM Global Services and International Network Services. The CompanyWe also competescompete with certain companies that have developed products that automate the management of IP addresses and name maps throughout enterprise-wide Intranets,intranets, and with companies with internally-developed systems integration efforts. An IP address allows a router, a computer which connects networks together, to determine the network to which the router should send the data it receives. A number of these competitors and potential competitors have longer operating histories and greater name recognition and significantly greater financial, technical, marketing, distribution and other resources than the Company. There can be no assurance that the Company willwe do. We may not be able to successfully compete in the consulting services business. Failure by the Company to successfully compete in the consulting services business could have a material adverse effect on the Company's business, financial condition and results of operations. In developing and distributing future products and services for the Internet-based services markets, the Company faces intense competition and expects to have multiple competitors for each of the products or services, if any, which it develops or sells. Many of the Company's 18 19 potential competitors have longer operating histories, greater name recognition and significantly greater financial, technical, marketing, distribution and other resources than the Company. Furthermore, the industry in which the Company intends to compete is characterized by rapid changes and frequent product and service introductions. To the extent a competitor introduces a competitive product or service prior to introduction of the same or similar product or service by the Company, market acceptance of the competitor's product or service may adversely affect the Company's competitive position. See "Risk Factors - Competition."Internet Technology Services area. INTELLECTUAL PROPERTY RIGHTS The Company'sOur principal intellectual property consists of, and itsour success is dependent upon, the Company'sour proprietary software utilizedused in itsour registration service business and certain methodologies and technical expertise it utilizeswe use in both the design and planned implementation of itsour current and future registration serviceservices and proposed Internet-enablingInternet-based products and services businesses. Some of the software and protocols used by the Companywe use in itsour registration service and proposed Internet-enabling businessesservices are in the public domain or are otherwise available to the Company'sour competitors. The CompanyWe also hashave compiled a database of information relating to customers in itsour registration business. While a portion of this database is available to the public in the Company believesform of a directory service, we believe that it haswe have certain ownership rights in this database and intendswe intend to protect such rights. The Company's engineersWe have in-depth technical knowledge and unique processes that are critical to the Company's consulting services business, in which a full range of consulting and systems integration services are offered in order to transition organizations from private, legacy networks to more scalable and efficient enterprise networks. The Company has no patents but itsour proprietary materials are protected by trade secret laws. The CompanyWe also has registeredown or have rights to various copyrights, trademarks and trade names in certain of its proprietary software and the Company owns several trademarks. See "Risk Factors - Intellectual Property Rights."our business. EMPLOYEES As of December 31, 1997, the Company1998, we had approximately 260385 full-time employees. None of the Company'sour employees are covered by collective bargaining agreements. The Company believesWe believe that itsour relations with itsour employees are good. RISK FACTORS IN ADDITION TO OTHER INFORMATION IN THIS FORM 10-K, THE FOLLOWING RISK FACTORS SHOULD BE CAREFULLY CONSIDERED IN EVALUATING THE COMPANYUS AND ITSOUR BUSINESS BECAUSE SUCH FACTORS CURRENTLY HAVE A SIGNIFICANT IMPACT OR MAY HAVE A SIGNIFICANT IMPACT ON THE COMPANY'SOUR BUSINESS, OPERATING 11 14 RESULTS OR FINANCIAL CONDITION. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS CONTAINED IN THIS FORM 10-K AS A RESULT OF THE FOLLOWING RISK FACTORS SET FORTHDISCUSSED BELOW AND ELSEWHERE IN THIS FORM 10-K. Limited Operating History. Prior to September 14, 1995,INDUSTRY RISKS Ongoing privatization of Internet administration could harm our registration business The Statement of Policy or "White Paper," calls for a phased transition of the Company was paid directly byDepartment of Commerce's responsibilities for the NSF for providing registration services on a cost reimbursement plus fixed fee basis. Accordingly, the Company has only a limited operating history under its current subscription-based pricing model for its domain name registration business upon which an evaluation of the Company and its prospects can be based. 19 20 The Company's prospects must be considered in light of the risks frequently encountered by companies in their early stages of development, particularly companies in new and rapidly evolving markets. To address these risks, the Company must, among other things, respond to competitive developments, increase its sales and marketing organization, continue to identify, attract, retain and motivate qualified persons and continue to upgrade its technologies and commercialize products and services incorporating such technologies. While the Company has been involved in network consulting services since its inception, due to the rapidly evolving nature of Internet technologies, the Company's consulting services business faces similar risks. There can be no assurance that the Company will be successful in addressing such risks or that the Company will continue to obtain new registrations at current rates or obtain renewals from a significant portion of its customers. The Company's expense levels are based in part on its expectations as to future revenue andsystem to a large extent are fixed. As a result, quarterly sales and operating results generally depend on the volume of and ability to fulfill registration requests, which are difficult to forecast. The Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfall of demand for the Company's services in relation to the Company's expectations would have an immediate adverse impact on the Company's business, financial condition and results of operations. In addition, the Company expects a significant increase in its operating expenses as it funds greater levels of product and services development, increases its sales and marketing operations, upgrades systems and infrastructure, opens new offices, develops new distribution channels and broadens its customer support capabilities. To the extent that such expenses precede or are not subsequently followednot-for-profit corporation by an increase in revenue, the Company's business, financial condition and results of operations will be materially and adversely affected. Uncertainty of Internet Governance and Regulation. The Internet historically has been loosely administered by government agencies which were involved in the creation of its infrastructure, initially ARPA and, more recently, the NSF. No single organization or entity (including the NSF) currently has formal authority over all aspects of the Internet and it currently operates under a system of mutual cooperation. Since the original role of the Internet was to link computers at governmental and academic institutions to facilitate communication and research, the Internet was historically administered by entities which were involved in sponsoring research rather than by any of the traditional federal or state regulatory agencies. With the commercialization and internationalization of the Internet, the role of these entities in Internet administration has become less clear and private parties have begun to assume a larger role in the enhancement and maintenance of the Internet's infrastructure. The Cooperative Agreement became effective January 1, 1993. It includes a three-month phase-in period, a five-year operational period (commencing April 1, 1993 and ending March 31, 1998), and a six-month "flexibility period" through September 30, 1998.2000. The Cooperative Agreementdomain name system is subject to reviewthe system by the NSFwhich Internet names and may be terminated by the NSF at any time at its discretion or by mutual agreement. The NSF has stated that it will not be re-awarding a cooperative agreement at the end of the flexibility period. The U.S. government has issued the Proposed Rule to provide noticeaddresses are registered, allocated and seek public comment on a proposal to transfer over time the administration of the DNS to a private, U.S. not-for-profit corporation and increase competition in the administration of TLDs and the registration of second level domain names. The Proposed Rule states that the "U.S. government seeks as much consensus as possible before acting." See "Relationship with the NSF; Recent Developments in Internet Governance." Comments on the Proposed Rule have revealed substantial differences regarding how the DNS should evolve and competing proposals concerning DNS management to those set forth in the Proposed Rule have been advancedused. We face risks from time to time. There is a risk thatthis transition, including: - failure to achieve consensus could, among other things, prevent or delay the issuance of a final rule. In addition, any rule that is issued could be challenged by persons or entities who disagree with its provisions. Any of such events could have a material adverse effect on the Company's business, financial condition and results of operations through continued uncertainty about 20 21 future Internet governance or a disruptionmany issues relating to the administration, effective operation or maintenancefunctioning and expansiongovernance of the Internet,not-for-profit corporation could result in general, orinstability in domain name system administration, - the DNS,not-for-profit corporation could fail to gain legitimacy resulting in particular. Additionally, any final rule could be different, perhaps substantially, from the Proposed Rule. Any final rule or any terms negotiated byinstability in domain name system administration, - the U.S. government and the CompanyGovernment could contain provisions which are not favorablerefuse to transfer certain responsibilities for domain name system administration to the Companynot-for-profit corporation due to security, stability or other reasons resulting in fragmentation or other instability in domain name system administration, and - the not-for-profit corporation could adopt or promote policies, procedures or programs that are unfavorable to our role in the registration of domain names or that are not consistent with the Company'sour current or future plans. ItAs the U.S. Government transitions certain responsibilities for domain name system administration to the not-for-profit corporation, corresponding obligations under our Cooperative Agreement with the Department of Commerce may be terminated and, as appropriate, covered in a contract between the not-for-profit corporation and us. We might not reach an acceptable contractual agreement with the not-for-profit corporation for our continuing role in the registration of domain names. The U.S. Government has sent us a letter directing us to treat ICANN as the not-for-profit corporation identified in the October amendment to the Cooperative Agreement described above, in the performance of its obligations under the MOU and until such time as the MOU is terminated. We have not yet responded to that letter. We are currently in discussions with ICANN and the U.S. Government regarding implementation of the shared registration system and a wide range of contractual issues. We cannot be sure that these discussions will result in agreements favorable to us. Despite the significant efforts undertaken to date, it is impossible to predict at this time whether or when a final rulethe process initiated by the Statement of Policy will be issuedresult in the full transition to the not-for-profit corporation of domain name system responsibilities as and to the extent contemplated in the White Paper and, if issued,it does, the timing of its implementation, the exact nature of its provisions or any terms negotiated by the U.S. government and the Company or the precise effect on us of such provisionstransition. See "-- Ongoing Privatization of Internet Administration." Changes to or disputes under the cooperative agreement could harm our business Termination, or a change in the terms, onof the Company. It is possible thatCooperative Agreement could harm our business. While the Cooperative Agreement by its terms expires in September 2000, it may be terminated earlier. The Department of Commerce's interpretation of certain provisions of any final rule or certain of such terms could have a material adverse effect on the Company's business, financial condition and results of operations. See "Competition." In the United States, apart from its obligations under the Cooperative Agreement the Company is not currently subject to direct regulation other than federal and state regulation applicable to businesses generally. However, changes in the regulatory environment could result in the Company being subject to direct regulation by other U.S. regulatory agencies, such as the Federal Communications Commission (the "FCC").differ from ours. For example, the Company is awareDepartment of Commerce has publicly expressed concerns about our consolidation into a single web site the web sites through which our InterNIC registration services and our RegistrationPlus services were offered. These differences in interpretation 12 15 could lead to disputes between us and the Department of Commerce or the not-for-profit corporation, which may or may not be resolved in our favor. Certain aspects of implementation of the Cooperative Agreement also remain to be fully negotiated, including the maximum price we will charge for registry services in the top level domains for which we now act as registry. If we are unsuccessful in negotiating acceptable terms of implementation, the costs of implementation of the Cooperative Agreement, our relationship with the not-for-profit corporation and other matters affecting our position in a more competitive domain name system environment could be harmed. See "-- Status of Cooperative Agreement." Challenges to authority over domain name administration could harm our business Withdrawal of or challenges to the U.S. Government's sponsorship or authorization of certain industry requestsfunctions that we perform could create a public perception or result in a legal finding that we lack authority to the FCC to review the impact of Internet usage on the U.S. telecommunications service providers,continue in particular, the generally lower cost structure for data transmission versus voice. In addition,our current role as Internet usage becomes more widespread internationally, there is an increased likelihood of international regulation. The Company cannot predict whetherregistry or to what extent any such new regulation will occur; however, such regulation could have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, the applicability to the Company of existing laws governing issues such as intellectual property ownership is uncertain. Courts have indicated that, under certain circumstances, ISPs could be held responsible for the failure to prevent the distribution of material that infringes on others' copyrights and other intellectual property. The future interpretation by the courts of the obligation of domain name registrars to prevent trademark infringement and other legal issues is uncertain. See "Item 3 - Legal Proceedings." Costs incurred or decisions rendered as a result of government actions, including enactment of new laws or adoption of new regulations, investigations or lawsuits relating to any of the foregoing, could have a material adverse effect on the Company's business, financial condition and results of operations. Competition. The Company currently is the exclusive registrar for second level domain names inwithin the .com, .org.,.org, .net and .edu TLDs. Multiple registrars dotop level domains. The legal authority underlying the roles of the Department of Commerce and the not-for-profit corporation with regard to the domain name system also could be challenged. The impact, if any, of any such public perception or finding is unknown, but it could be harmful to our business. We may not currently register namesbe able to compete effectively due to increased competition in the same TLD, but this may changedomain name registration business The introduction of additional competition into the domain name registration business could be harmful to our business. This includes, in the future. The Companyparticular, competition among registrars within a single top level domain, like .com, and competition among registrars and registries of existing and potential new top level domains. In addition, we currently facesface competition in the domain name registration business from registries for country codes,code top level domains, third level domain name providers such as Internet access providers and registrars and registries of TLDstop level domains other than those TLDstop level domains which we currently being registered by the Company.register. A number of entities have already begun to offer competing registration services using other TLDs.top level domains and when the shared registration system takes effect we will no longer be the exclusive registrar in the .com, .org and .net top level domains. Future competition in the Company's domain name registration business as a registry or registrar could come from many different companies, including, but not limited to,including: - domain name registration resellers, - country code registries, - Internet access providers, and - major telecommunications firms, cable companies and Internet access providers. Suchfirms. Many of these entities have core capabilities to deliver registrationregistry and/or registrar services, such as help desks, billing services and network management, along with strong name recognition and Internet industry experience. Other companies with some or all of these capabilities may also enter the registration business. Also emerging is a growing contingent of domain name resellers. The Company's position as the leading registrar of domain names could be materially and adversely affected by the emergence of any of the foregoing competitors and potential 21 22 competitors, many of which have longer operating histories and significantly greater name recognition and greater financial, technical, marketing, distribution and other resources than the Company. In addition, the Company'sOur revenue and registration fees could be reduced due to increased competition, pricing pressures or pricing pressures.a modification of billing practices. For example, other entities may bundle domain name registrations with other products or services, effectively providing such registration services for free. Various governmental technical and Internet groups have been discussing for some time ways of introducing more competition into the domain name registration business. On February 20, 1998, the NTIA published the Proposed Ruleservices. See "-- Competition in the Federal Register to provide notice and seek public commentRegistration Business." 13 16 We depend on a proposal to increase competition in the administration of TLDs and the registration of domain names. Under the Proposed Rule, the Company would continue to operate the .com, .org, and .net registries and to act as a registrar for those TLDs, but other companies would be permitted to act as registrar for those TLDs. The Proposed Rule also provides for additional new TLDs. The Company believes that it is well positioned to succeed in a more competitive environment. However, the adoption of the Proposed Rule or a similar rule or the introduction of additional competition into the domain name registration business in some other manner could have a material adverse effect on the Company's business, financial condition and results of operations. See "Relationship with the NSF; Recent Developments in Internet Governance" and "Competition." In addition, the Company faces substantial competition in its consulting services business and in the development and distribution of future products and services for the Internet-based services markets. See "Competition." Reliance on Third Parties. Reliable communications over the Internet are dependent upon the Internet root servers, which serve as the authoritative source of Internet locations and which allow the resolution of IP addresses from domain names on the Internet. Currently, there are 13 root servers, ten of which are located in the United States, two of which are located in Europe and one of which is located in Asia. Nine of the root servers currently are populated with the domain names registered by the Company, while these nine and the other four also contain information with respect to other TLDs, including country TLDs. When communication with a particular domain name is required and the IP address of that domain name's host is not known locally, the root servers "point" to a direct or indirect source of the information. Multiple root servers are required for purposes of load balancing and redundancy. The location and control of these root servers has been determined by consensus of various membersgrowth of the Internet community. The Companyand Internet infrastructure Our future success substantially depends on the continued growth in the use of the Internet. If the use of and interest in the Internet does not continue to grow, our business would be harmed. Continued growth of the Internet could be slowed by: - inadequate infrastructure, - lack of availability of cost-effective, high speed systems and service, - delays in developing or adopting new standards and protocols to handle increased levels of Internet activity, or - government regulation. We rely on third parties who maintain and control root zone and top level domain zone servers We currently controlsadminister and operate only onetwo of thesethe 13 root zone servers and temporarily administers one other root server.four top level domain zone servers. The other eleven root serversothers are maintainedadministered and controlledoperated by independent operators on a volunteer basis. TheseBecause of the importance to the functioning of the Internet of these root zone servers and top level domain zone servers, our registration business could be harmed if these volunteer operators may at any time, for any reason, fail to properly maintain such servers or abandon such servers. The occurrenceFurther, our registration business could be harmed if any of any such events could have a material adverse effect on the Company's business, financial condition and results of operations. Further, no single organization or entity currently has formal authority over all aspects of the root zone system. Somethese volunteer root server operators have questioned which organization or entity has the legal authority to direct where the root servers are to be pointed. The operators of the root servers have historically taken guidance from the IANA. Therefore, it is possible that IANA could direct the root servers not to accept information updates from the Company or that the operators of the root servers could choose to no longer carry the Company's information. In the event that the root servers were changed to exclude the information maintained by the Company, all domain names registered by the Company in 22 23 TLDs for which the Company acts as the registry would no longer be accessible by other users of the Internet. This could cause widespread disruption of the Internet. If some, but not all, of the root servers were changed to exclude the Company's data, the multiple root servers would contain inconsistent information. The failure by any or all of the root serversfail to include or provide accessibility to the Company's data would materially and adversely affectthat we maintain in the Internetroot zone servers and the Company'stop level domain zone servers that we control. See "-- Operations." We rely on Internet service providers Our registration business financial condition and results of operations. The Proposed Rule provides that a new corporation wouldcould be established to oversee the operation of an authoritative root server system. Under the Proposed Rule, IANA and the U.S. government, in cooperation with the Company, theharmed if enough Internet Architecture Board and other relevant organizations, would undertake a review of the root server system to recommend means to increase the security and professional management of the system. However, no assurance can be given that this provision will be part of any final rule or that, if this provision is adopted, it would eliminate the risks in this area. The Company's success and ability to compete also are dependent upon the relationships between the Company and ISPs worldwide. Thus, if ISPs were to electservice providers decided not to route Internet communications to or from domain names registered by the Companyus or if enough ISPs were to electInternet service providers decided to provide routing to a set of accepted rootdomain name servers which did not point to the Company's TLD servers, the Company'sour top level domain zone servers. System failure or interruption, security breaches or our failure to meet increasing demands on our systems could harm our business financial condition and results ofAny significant problem with our systems or operations would be materially and adversely affected. Year 2000. Network Solutions, like many other companies, iscould result in the process of assessing its computer software applications and systems to ensure their functionality with respect to the "Year 2000" millenium change. At this time, the Company believes that the remediation costs, if any, needed to make all of its internal applications and systems Year 2000 compliant are not material. Although the Company believes that its internal mission critical systems are Year 2000 compliant, thelost revenue, customer dissatisfaction or lawsuits against us. A failure of the software applications or internal systems of other companies on which the Company's systems rely or to which they are connected or of other Internet-related companies, including Internet web hosting companies, Internet access providers, or Internet root server operators, none of which the Company controls, to be Year 2000 compliant upon January 1, 2000 could have a material adverse effect onin the operation of our registration system could result in deletion of one or more domain names from the Internet and/for a period of time. A failure in the operation or a material adverse effect on the Company's business, financial condition and results of operations. Litigation. The Company is involved in several legal proceedings as described in "Item 3 - Legal Proceedings." As of March 13, 1998, the Company was a defendant in 6 lawsuits involving domain name disputes between trademark owners and domain name holders in which 23 24 the Company has been named as a defendant. On March 20, 1997, PG Media, Inc., a New York-based corporation, filed a lawsuit (the "PG Media suit"), alleging that the Company had restricted access to the Internet by not adding PG Media's requested TLDs in violationupdate of the Sherman Act. On October 17, 1997, a groupmaster database that we maintain could result in deletion of six plaintiffs filed a lawsuit (the "Thomas suit") against the Company and the NSF challenging the legality of fees defendants charge for the registration and renewal of domain names onone or more top level domains from the Internet and seeking restitutionthe discontinuation of fees collected fromsecond level domain names in those top level domains for a period of time. The inability of our registration system and telecommunications systems to meet the demands of the increasing number of domain name registrants in an amount in excess of $100 million, damages,registration requests and injunctivecorresponding customer e-mails and other relief. The plaintiffs allege violations of the Administrative Procedures Act, the Independent Offices Appropriations Act, the Sherman Act and the U.S. Constitution. In each of these cases, the Company believes it has meritorious defenses and intends to defend itself vigorously. While the Company cannot reasonably estimate the potential impact of the claims advanced in the PG Media or Thomas suits, a successful claim against the Company in either of these proceedingstelephone calls could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, on June 27, 1997, SAIC received a Civil Investigative Demand from the U.S. Department of Justice issued in connection with an investigation to determine whether there is, has been, or may be an antitrust violation under the Sherman Act relating to Internet registration products and services. The Company cannot reasonably estimate the potential impact of the investigation nor can it predict whether a civil action will ultimately be filed by the Department of Justice. The Company is unable to predict the form of relief that might be sought in such an action or that might be awarded by a court or imposed as a result of any settlement. Any such relief could have a material adverse effect on the Company's business, financial condition and results of operations. Litigation in which the Company is involved has resulted and likely will result in, and any future litigation can be expected to result in substantial legaldegradation in our customer support service and other expensesour ability to the Company andprocess registration requests in a diversion of the efforts of the Company's personnel. System Interruption and Security Risks. The Company'stimely manner. Our operations are dependent upon itsdepend on our ability to maintain itsour computer and telecommunications equipment in effective working order and to reasonably protect itsour systems against interruption frominterruption. The root zone servers and top level domain zone servers that we operate are critical hardware to our operations. Interruptions could result from: - fire, natural disaster, sabotage, power loss, telecommunication failure, human error or similar events. The vast majority of the Company's computer and telecommunications equipment is located in a single facility. Although the Company has established back-up facilities at its Charlotte, North Carolina site, this measure will not eliminate the significant risk to the Company's operations from a natural disaster or system failure at its principal site. Despite the implementation of security measures and standard operating procedures, the Company's infrastructure may also be vulnerable toevents, - computer viruses, hackers human error or similar disruptive problems caused by its employees, customers or other Internet users. Computer break-insusers, and other disruptions may jeopardize14 17 - systems strain caused by the security of information stored in and transmitted through the computer systems of the Company and may deter potential customers from utilizing the Company's services. In addition, growth of the Company'sour customer base may put strain on the capacity of its computers and telecommunications systems and the Company'sour inability to sufficiently maintain or upgrade its systems could lead to degradation in performanceour systems. See "-- Operations." We may lose revenue or system failure. Any damage,incur significant costs if Year 2000 compliance issues are not properly addressed Our failure, or delaythe failure of third parties on which we rely, to adequately address Year 2000 compliance issues may cause us to lose revenue or to incur significant costs. The primary risks that causes significant interruptions in the Company's systems would have a material adverse effect on the Company's business, financial condition and results of operations. On July 17, 1997, during a routine update of the root serverwe face with regard to Year 2000 failures are those which impact our domain name files,registration business. These risks include: - significant and protracted interruption of electrical power to data and call-center operations in our engineering facility, - significant and protracted interruption of telecommunications and data network services in either of our headquarters or engineering facilities, - the Company inadvertently released corrupted database files forfailure of components of our current back office and domain name registration related systems, and - the .comoccurrence of a Year 2000 problem with respect to third-party suppliers', vendors' and .net TLDs, causing disruption throughout the Internet. The originaloutsourcing service providers' products and services. If we fail to solve a Year 2000 compliance problem which was caused by a database error, was compounded when the normal quality control mechanisms used to validate the .comwith our mission critical business systems and 24 25 .net TLD files were incorrectly overridden by Company personnel and the corrupted files were released. As a result, certain Internet users were unable to access certain web sites. The database error was subsequently fixed and the corrected files were regenerated and re-released by the Company within four hours, although the length of time during which certain Internet users experienced disruption in accessing the Internet varied. The Company has taken several steps to avoid any future occurrences of this or similar problems,processes, including but not limited to, adding software code to make it more difficult to transmit a problematic file and additional quality checks by a senior level person prior to each file transmission. There can be no assurance, however, that the Company's standard operating procedure or the additional measures implemented by the Company will prevent or mitigate a similar occurrence in the future. Separately, in July 1997, an entity which offers competing registration services using other TLDs exploited a security vulnerability in the Berkeley Internet Name Domain ("BIND") software, a third-party Internet name server software used by Internet companies' Unix systems, to redirect traffic intended for the Company's web site. The Company's systems were not impacted by the exploitation. However, Internet users that were relying on systems that had not upgraded to a more current version of BIND were redirected from the Company's web site which impacted the Company's business. If any of these or similar problems should recur or occur in the future, it could result in, among other things, damage to the Company's reputation and credibility, increased intervention by governmental entities or reduced customer confidence, which could in turn materially and adversely affect the Company's business, financial condition and results of operations. Uncollectible Receivables; Modifications to Billing Practices. Currently, the Company invoices a majority of its customers and permits them to pay the services fee after the domain name servers under our control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by our employees, the result could be a failure of or interruption to normal business operations. Furthermore, our business depends on the continued operation of, and widespread access to, the Internet. This, in turn, depends to a large extent on the software and systems of third parties on which our systems rely or to which they are connected. These third parties include, among others, Internet-related companies, including Internet web hosting companies, Internet access providers and Internet domain name server operators. We have no responsibility for, nor control over, other Internet domain name server operators that are critical to the efficient operation of the Internet. We do not know whether such domain name server operators have hardware, software or firmware that is registered.Year 2000 compliant. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Year 2000 Compliance." COMPANY RISKS Our search for a new chief executive officer presents risks and uncertainties On November 16, 1998, we announced the resignation of Gabriel A. Battista from his positions as Chief Executive Officer and director. We cannot reasonably estimate at this time the potential impact on us of the hiring of a new Chief Executive Officer. While we conduct a search for a new Chief Executive Officer, Michael A. Daniels, our Chairman of the Board, is acting as the Chief Executive Officer and assuming the executive responsibilities previously performed by Mr. Battista. In addition, Robert J. Korzeniewski, our Chief Financial Officer, is also acting as our Chief Operating Officer, assuming responsibility for day-to-day operations. We cannot be certain of the timing of our hiring of a new Chief Executive Officer or the effect of any delays in our hiring of a new Chief Executive Officer on the development or implementation of our strategic plan. 15 18 We must attract, integrate, train and retain key personnel knowledgeable about our business Given the relative "newness" and rapid growth of the Internet, there is intense competition for the limited supply of people qualified to work for us. Our future success depends on the continued service of key engineering, sales, marketing, executive and administrative personnel, and our ability to attract, hire, integrate, train and retain such personnel. Competition for engineering, sales, marketing and executive personnel is intense, particularly in the technology and Internet sectors and in the regions where our facilities are located. We cannot be certain that we will be able to retain existing personnel or attract, hire or retain additional qualified personnel. The Company believes it hasloss of the services of any of our senior management team or other key employees or our failure to attract, integrate, train and retain additional key employees could harm our business. Our near term success depends on the growth of our domain name registration business We may not be able to sustain the revenue growth we have experienced in recent periods. In addition, past revenue growth may not be indicative of future operating results. If we do not successfully maintain our current position as a leading provider of domain name registration services or develop or market additional services, our business could be harmed. Our domain name registration services business generates over 90% of our revenue and is expected to continue to account for a very significant portion of our revenue in at least the near term. Our future success will depend largely on: - the continued increase in domain name registrations, - re-registration rates of our customers, - our ability to maintain our current position as a leading registrar of domain names, and - the successful development, introduction and market acceptance of new services that address the demands of Internet users. We must effectively manage our marketing organization and establish and maintain distribution channels We will need to effectively manage our growing sales and marketing organization if we want to achieve future revenue growth. We do not know if we will be able to identify, attract and retain experienced sales and marketing personnel with relevant experience. Further, our sales and marketing organization may not be able to successfully compete against the significantly more extensive and well-funded sales and marketing operations of our current or potential competitors for registration or consulting services. Our ability to achieve future revenue growth will also depend on our ability to continue to establish direct sales channels and to develop multiple distribution channels. To do this we must maintain relationships with Internet access providers and other third parties. We have a high level of uncollectible receivables Because of our high level of uncollectible receivables, we continually review our billing practices. Any modifications that we implement as a result of these reviews could have unanticipated harmful consequences to our business. We believe we have experienced a high level of uncollectible receivables due to, among other factors, the large number of individuals and corporations that have registered multiple domain names with the apparent intention of resellingtransferring such registrationsnames at a profit. The Company'sOur experience has been that such resellers have a greater tendency than other customers to default on their services fees. The Company hasWe have established a provision for uncollectible accounts that it believeswhich we believe to be adequate to cover anticipated uncollectible receivables; however, actual results could differ from the Company's estimate and could have a material adverse effect on the Company's business, financial condition and results of operations.16 19 our estimates. See "Item 7 -- Management's"Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 43 of Notes to Financial Statements. The Company continually reviews its billing practices for modificationWe are party to respond to market conditions and to implement operational improvements. Any such modificationseveral legal proceedings which could have unanticipated consequencesa negative financial impact on us We are involved in several legal proceedings. We cannot reasonably estimate the potential impact of any of these proceedings. An adverse determination in any of these proceedings, however, could harm our business. Legal proceedings in which could result in a material adverse effect on the Company's business, financial conditionwe are involved are expensive and results of operations. Limited Service Offerings to Date; Reliance on Domain Name Registration Services and Consulting Services for Substantially All Revenue. The Company's domain name registration services and consulting services businesses have in the past generated substantially all of the Company's revenue from continuing operations and are expected to continue to account for substantially all of the Company's revenue from continuing operations in the near term. The Company's future success will be highly dependent upon the continued increase in domain name registrations with the Company, renewal rates of its customers, the ability of the Company to maintain its current position both as a registrar of domain names and as the leading 25 26 registrar of domain names within the .com TLD and the successful development, introduction and market acceptance of new services that address the demands of Internet users. Although the Company has experienced revenue growth in recent periods, such growthdivert our personnel. See "Item 3 -- Legal Proceedings." We may not be sustainable and may not be indicative of future operating results. There can be no assurance that the Company will be able to successfully retain its current leading position in providing domain name registration services or develop or market additional services. Failure to do so would materially and adversely affect the Company's business, financial condition and results of operations. The Company's future success will also be dependent on its ability to maintain and expand its consulting services business. In 1997, ten clients of the Company's Consulting Services Division accounted for 80% of the division's revenues. There is no guarantee that the Company will be able to maintain or expand its consulting services business. Technological Change and Additional Technology, Products and Services. The development of RWhois, a Company-developed, standard open protocol, and the associated technology, allows remote registration by others. The Company's efforts to standardize and proliferate RWhois as the registration standard may result in a material adverse effect on the Company's future competitive position by enabling others to become competing registrars more easily. RWhois is also the protocol that the Company may utilize for any global directory services that the Company might offer. The successful introduction of such directory services may blur the distinction between directory services and domain name registration. Should this or another global directory service become widely proliferated, domain name registration may be subsumed into such a service. In that case, should the Company fail to secure a leadership position in providing such a global directory service or establish a system for charging for such service, the Company's business, financial condition and results of operations would be materially and adversely affected. The Company's future financial success will be highly dependent upon its ability to develop and commercialize in a timely manner new technology, products and services that can be offered in conjunction with the Company's current domain name registration and consulting services and that can meet the changing requirements of its current and future customers. The market for such technology, products and services is characterized by rapidly changing technology, evolving industry standards and frequent introductions of new Intranet and Internet-related products and services. Generally, the successful development and commercialization of new technology, products and services involves many risks, including the identification of new Intranet and Internet-related product and service opportunities, the successful completion of the development process, and the identification, retention and hiring of appropriate research, development and technical personnel. There can be no assurance that the Company can successfully identify new products and service opportunities and develop and bring to market in a timely manner new technologies, products or services, or that technologies, products or services developed by others will not render those of the Company noncompetitive or obsolete. Failure by the Company to develop new technologies, products or services and bring them to market in a timely manner could have a material adverse effect on the Company's business, financial condition and results of operations. Dependence on Future Growth of the Internet and Internet Infrastructure. The Company's future success is substantially dependent upon continued growth in the use of the Internet. Rapid growth in the use of and interest in the Internet is a relatively recent phenomenon and there can be no assurance that use of the Internet will continue to grow at its current pace. Even if the Internet continues to experience significant growth in the number of users and level of use, there can be no assurance that the Internet infrastructure will continue to be able to support the demands placed upon it by such growth. The Company's success and the viability of the 26 27 Internet as an information medium and commercial marketplace will depend in large part upon the development of a robust infrastructure for providing Internet access and carrying Internet traffic. Failure to develop a reliable network system, or timely development of complementary products, such as high speed modems, could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Internet could lose its viability due to delays in the development or adoption of new standards and protocols required to handle increased levels of Internet activity or due to changes in government regulation. The lack of Internet governance or changes in governance or regulation could adversely affect the growth of the use of the Internet and have a material adverse effect on the Company's business, financial condition and results of operations. Because global commerce and on-line exchange of information on the Internet are new and evolving, it is difficult to predict with any assurance that the infrastructure or complementary products will be developed, or, if developed, that the Internet will become a viable information medium or commercial marketplace. If the use of the Internet does not continue to grow, if the necessary infrastructure or complementary products are not developed or do not effectively support growth that may occur, or if the Internet does not become a viable information medium or commercial marketplace, the Company's business, financial condition and results of operations would be materially and adversely affected. Intellectual Property Rights. If it were determined that the Company does not have ownership rights in its database of information relating to customers in its registration business or if the Company is unable to protect such rights in this database or is required to share the database with potential competitors, there could be a material adverse effect on the Company's business, financial condition and results of operations. The Proposed Rule would require the Company to provide the U.S. government with "a copy and documentation of all the data, software, and appropriate licenses to otherour intellectual property generated under the [C]ooperative [A]greement, for use by the new corporation for the benefit of the Internet." If certain of the Company's softwarerights and data generated which is proprietary to the Company were to be provided to the new corporation under the Proposed Rule and in turn provided to competing registries or registrars, the Company's business, financial condition and results of operations could be materially and adversely affected. The Company relies uponinformation We rely on a combination of nondisclosure and other contractual arrangements with itsthe U.S. Government, our employees and third parties, and privacy and trade secret laws to protect its proprietary rights and limit the distribution of itsour proprietary information. There cancustomer data, software, documentation and processes we have developed in connection with our domain name registration business. If we fail to adequately protect our intellectual property rights and proprietary information or if we become involved in litigation relating to our intellectual property rights, proprietary information or access to our customer data, our business could be no assurance that the steps taken by the Company in this regard willharmed. Any actions we take may not be adequate to deter misappropriation ofprotect our proprietary information or that the Company will be able to detect unauthorized use of its proprietary informationrights and take appropriate steps to enforce its intellectual property rights. Furthermore, even if these steps are successful, there can be no assurance that others will notother companies may develop technologies that are similar or superior to the Company'sour proprietary technology. The U.S. Government or ICANN could take positions adverse to our claims regarding proprietary rights or could attempt to require us to enter into agreements limiting such claims. Although the Company believeswe believe that itsour services do not infringe on the intellectual property rights of others and that it haswe have all rights necessaryneeded to utilizeuse the intellectual property employed in itsour business, the Companyit is possible that we could become subject to the risk of claims alleging infringement of third party intellectual property rights. Any such claims could subject us to costly litigation, and may require the Companyus to spend significant sums in litigation, pay damages and develop non-infringing intellectual property or acquire licenses to the intellectual property that is the subject of assertedthe alleged infringement. Failure by the Company to adequately protect its proprietary rightsUnsuccessful future acquisitions and investments could decrease operating income, cause operational problems or litigation relating to intellectual property rights could have a material adverse effectotherwise disrupt our business We evaluate potential acquisitions and investments on the Company's business, financial condition and resultsan ongoing basis for various reasons including, among others, diversification of operations. 27 28 Potential Fluctuations in Quarterly Results. The Company believes that future operating results will be subject to quarterly fluctuations due to a variety of factors, many of which are beyond the Company's control. Such factors may include, but are not limited to, developments in Internet governance, the announcement of additional competing registries, registrars or TLDs, variations in the number of requests for domain name registrations or demand for the Company's services, introduction or enhancements of services by the Company or its competitors, market acceptance of new service offerings, increased competition, costs associated with developing or providingour domain name registration or other services, litigation costs, results of litigation, patterns of growth in the use of and interest in the Internetconsulting businesses. Our acquisition and general economic conditions. The Company is continuing to increase its operating expenses for personnel, facilities and new services development and, if its revenues doinvestment strategy poses many risks, including: - we may not correspondingly increase, the Company's business, financial condition and results of operations would be materially and adversely affected. Since the Company recognizes consulting services revenue only when engineers are engaged on client projects, the relative utilization of engineers directly affects the Company's operating results. In addition, a majority of the Company's consulting services operating expenses, particularly personnel and related costs, depreciation and rent, are substantially fixed in advance of any particular quarter. As a result, any under-utilization of engineers may cause significant variations in operating results in any particular quarter and could result in losses for such quarter. Termination or completion of contracts in the Company's consulting services business or failure to obtain additional contracts in its consulting services business could have a material adverse effect on the Company's business, financial condition and results of operation. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations." Uncertainty of Future Acquisitions. The Company evalutes potential acquisitions on an ongoing basis. No assurance can be given as to the Company's abilityable to compete successfully for available acquisition candidates, or to complete future acquisitions and investments or as toaccurately estimate the financial effect on the Companyour company of any acquired businesses. Futurebusinesses we acquire or investments we make, - future acquisitions by the Companyand investments may involverequire us to spend significant cash expenditures andamounts or may result in decreaseddecrease our operating income, either- we may have trouble integrating the acquired business and retaining personnel, - acquisitions or investments may disrupt our business and distract our management from other responsibilities, and - to the extent that any of the companies which could have a material adverse effect on the Company'swe acquire or in which we invest fail, our business financial condition and results of operations. Should the Company be unable to implement successfully its acquisition strategy, its business, financial condition and results of operations could be materially and adversely affected. Managementharmed. Whether or when pooling of Growth; Dependenceinterests accounting for acquisitions might become available to us depends on Key Personnel. The Company has recently experienced growth in the number of its employees and in the scope of its operating and financial systems. This growth has resulted in an increase in responsibilities for both existing and new management personnel. The Company's ability to manage growth effectively will require it to successfully integrate its management team, continue to implement and improve its operational, financial and management information systems and to train, motivate, manage and retain its employees. There can be no assurance that the Company will be able to manage its expansion effectively and a failure to do so could have a material adverse effect on the Company'smany factors beyond our control. 17 20 We face increasing risks associated with our international business financial condition and results of operations. In addition, growth of the Company's customer base may strain the capacity of its computers and telecommunications systems, and the Company's inability to sufficiently maintain or upgrade its systems could lead to degradation in performance or system failure. The Company's future success depends in part on the continued service of its key engineering, sales, marketing, executive and administrative personnel, and its ability to identify, hire and retain additional personnel. In addition, the future success of the Company's consulting services will depend in large part on its ability to hire, train and retain engineers who have expertise in a wide array of network and computer systems and a broad understanding of the industries the Company serves. An inability of the Company to identify, hire, train and retain a sufficient number of qualified engineers could impair the Company's ability to adequately manage and complete its existing projects or to obtain new projects, which, in turn, could have a material adverse effect on the Company's business, financial condition and results of operations and could impair the Company's expansion of its business. Competition for engineering, sales, marketing and executive personnel is intense and there can be no assurance that the Company can retain existing personnel or identify, hire or retain additional qualified 28 29 personnel. Evolving Sales and Marketing Organization and Distribution Channels. The Company has had limited experience in marketing and selling its services under its current subscription-based pricing model. The Company's ability to achieve revenue growth in the future will depend in large part on its ability to manage and grow its new sales and marketing organization. There can be no assurance that the Company will be able to successfully manage this organization or identify, attract and retain experienced sales and marketing personnel with relevant experience, that the cost of such personnel will not exceed the revenue generated or that the Company's sales and marketing organization will be able to successfully compete against the significantly more extensive and well-funded sales and marketing operations of the Company's current or potential competitors. In addition to establishing its direct sales channels, the Company's distribution strategy is to develop multiple distribution channels. Accordingly, the Company's ability to achieve revenue growth in the future will also depend in large part on establishing and maintaining relationships with Internet access providers and other third parties and on effectively using the Internet as a medium of distribution. There can be no assurance that the Company will be able to successfully develop third party distribution channels, develop its own capabilities to distribute services using the Internet or that any such development will result in an increase in revenue. Any failure by the Company to manage and grow its new sales and marketing organization, develop and expand its distribution channels or use the Internet as a medium of distribution could materially and adversely affect the Company's business, financial condition and results of operations. Control by SAIC. As of March 13, 1998, SAIC owned 100% of the Company's outstanding Class B Common Stock, representing approximately 75.8% of the outstanding Common Stock of the Company and approximately 96.9% of the combined voting power of the Company's outstanding Common Stock. The Class B Common Stock is convertible into Class A Common Stock, subject to certain limitations set forth in the Company's Second Amended and Restated Certificate of Incorporation (the "Certificate of Incorporation"). As a result, SAIC effectively controls all matters requiring approval by the stockholders of the Company, including the election of members of the Company's Board of Directors, changes in the size and composition of the Board of Directors and a change in control of the Company. SAIC does not have an agreement with the Company restricting its rights to convert, distribute or sell its shares of the Company's Common Stock and there can be no assurance that SAIC will maintain its ownership of the Company's Class B Common Stock. The Internal Revenue Code of 1986, as amended (the "Code"), requires beneficial ownership by SAIC of at least 80% of the total voting power and 80% of each class of nonvoting capital stock of the Company in order for SAIC to be able to effect a tax-free spin-off of the Company under the Code. As of March 13, 1998, SAIC owned approximately 96.9% of the total voting power of the Company. Because SAIC may seek to maintain its beneficial ownership of the Company for tax planning purposes or otherwise and may not desire to acquire additional shares of Common Stock in connection with a future issuance of shares by the Company, the Company may be constrained in its ability to raise equity capital in the future or to issue Common Stock or other equity securities in connection with acquisitions. Reliance on SAIC for Certain Corporate Services. SAIC and the Company have entered into certain intercompany agreements, including an agreement pursuant to which SAIC will 29 30 provide various corporate services to the Company that may be material to the conduct of the Company's business (the "Corporate Services Agreement"). These services include certain routine and ordinary corporate services, including business insurance, accounting systems, employee benefits, payroll, tax and legal services as well as assistance in government relations and corporate quality assurance services as described in the Corporate Services Agreement. With respect to matters covered by the Corporate Services Agreement, the relationship between SAIC and the Company is intended to continue in a manner generally consistent with past practices. If SAIC's ownership of the Company's Common Stock drops below 50% of the Company's issued and outstanding Common Stock, the Corporate Services Agreement will be terminable by either party upon 180 days' prior written notice. Certain individual services are also terminable by either party upon 180 days' prior written notice, regardless of SAIC's stock holdings. In the event that SAIC elects to terminate the Corporate Services Agreement, there can be no assurance that the Company would be able to secure alternative sources for such services within 180 days or that such services could be obtained for costs comparable to costs to be charged by SAIC. Control of Tax Matters; Tax and ERISA Liability. By virtue of its controlling ownership and the terms of a tax sharing agreement (the "Tax Sharing Agreement") entered into between the Company and SAIC, SAIC will effectively controlWhile substantially all of our operations, facilities, and personnel are located within the Company's tax decisions for taxable periods during which SAIC and the Company file, for federal purposes, a consolidated income tax return or, for state and local purposes, a consolidated, combined or unitary tax return. Under the Tax Sharing Agreement, SAIC has sole authority to respond to and conduct all tax proceedings (including tax audits) relating to the Company, to file federal, state and local returns on behalf of the Company and to calculate the amount of the Company's liability to SAIC under the Tax Sharing Agreement. Upon completion of the IPO, the Company is no longer part of SAIC's consolidated group for federal income tax purposes. Given the Company's past participation in SAIC's consolidated group for tax purposes and pursuant to the terms of the Tax Sharing Agreement, upon such deconsolidation, the Company's ability to recognize a benefit for future tax losses it may incur is subject to SAIC's approval. SAIC may also choose to contest, compromise or settle any adjustment or deficiency proposed by taxing authorities in a manner that may be beneficial to SAIC and detrimental to the Company. Each member of a consolidated group for federal income tax purposes is jointly and severally liable for the federal income tax liability of each other member of the consolidated group. In addition, under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and federal income tax law, each member of the controlled group is jointly and severally liable for funding and termination liabilities of tax qualified defined benefit retirement plans as well as certain plan taxes. Accordingly, during the period in which the Company was included in SAIC's consolidated or controlled group, the Company could be liable if such liability or tax is incurred, and not discharged, by any other member of SAIC's consolidated or controlled group. Potential Conflicts of Interest. Various conflicts of interest between the Company and SAIC could arise and persons serving as directors, officers and employees of both the Company and SAIC may have conflicting duties to each. Currently, Michael A. Daniels, the Company's Chairman of the Board, also serves as a Sector Vice President and Sector Manager of SAIC, and Donald N. Telage, the Company's Senior Vice President, Internet Relations and one of the Company's directors, also serves as a Group Senior Vice President of SAIC. Further, J. Robert Beyster, a director of the Company, is also the Chief Executive Officer and Chairman of the Board of SAIC, John E. Glancy, a director of the Company, is also a Corporate Executive Vice President and a director of SAIC, J. Dennis Heipt, a director of the Company, is also the Senior Vice President - Administration of SAIC and William A. Roper, Jr., a director of the Company, is also Senior Vice President and Chief Financial Officer of 30 31 SAIC. Ownership interests of directors or officers of the Company in the common stock of SAIC could also create or appear to create potential conflicts of interest when directors and officers are faced with decisions that could have different implications for the Company and SAIC. In addition, for financial reporting purposes, the Company's financial results will be included in SAIC's consolidated financial statements. The members of the Board of Directors of the Company and the executive officer of the Company who are affiliated with SAIC will consider not only the short-term and long-term impact of financial and operating decisions on the Company, but also the impact of such decisions on SAIC's consolidated financial results. In some instances, the impact of such decisions could be disadvantageous to the Company while advantageous to SAIC. Certain Charter Provisions and Limitations on Liability. The Company's Certificate of Incorporation includes provisions relating to competition by SAIC with the Company, allocations of corporate opportunities, transactions with interested parties and intercompany agreements and provisions limiting the liability of certain persons. The enforceability under Delaware corporate law of such provisions which eliminate certain rights that might have been available to stockholders under Delaware law had such provisions not been included has not been established. The Company's Certificate of Incorporation provides that any person purchasing or acquiring an interest in shares of capital stock of the Company shall be deemed to have consented to the provisions in the Certificate of Incorporation relating to competition by SAIC with the Company, conflicts of interest, corporate opportunities and intercompany agreements, and such consent may restrict such person's ability to challenge transactions carried out in compliance with such provisions. The corporate charter of SAIC does not include comparable provisions and, as a result, persons who are directors and/or officers of the Company and who are also directors and/or officers of SAIC may choose to take action in reliance on such provisions rather than act in a manner that might be favorable to the Company but adverse to SAIC. Under the Company's Certificate of Incorporation, the personal monetary liability of the directors of the Company for breach of their fiduciary duty of care, including actions involving gross negligence, is eliminated to the fullest extent permitted under Delaware law. International Operations. The Company'sUnited States, our revenues from sources outside the U.S. have increased significantly and may continue to increase in the future. As a result, the Company will increasingly bewe are subject to the risks of conducting business internationally, including unexpected changes in regulatory requirements, fluctuations in the U.S. dollar, tariffs and other barriers and restrictions and the burdens of complying with a variety of foreign laws. In addition,We do not know what the Company will increasingly be subject to general geo-political risks, such as political and economic instability and changes in diplomatic and trade relationships, in connection with its international operations. There can be no assurance thatimpact of such regulatory, geopolitical and other factors will not adversely impact the Company's operationsbe on our business in the future or require the Companyif we will have to modify itsour business practice. In addition, the laws of certain foreign countries may not protect the Company'sour proprietary rights to the same extent as do the laws of the United States. Shares Eligible for Future Sale. SAIC owns 100% of the Company's outstanding Class B Common Stock, which, as of March 13, 1998, represented approximately 75.8% of the outstanding Common Stock of the Company. A decision by SAIC to sell such shares could materiallyOur quarterly operating results may fluctuate; our future revenue and adversely affect the market price of the Class A Common Stock. The Company and SAIC have entered into a registration rights agreement (the "Registration Rights Agreement") which requires the Company to effect a registration statement covering some or all of the shares of Class A Common Stock to be owned by SAIC upon conversion of the Class 31 32 B Common Stock owned by SAIC and any other shares of Class A Common Stock otherwise acquired by SAIC, subject to certain terms and conditions. The Company has agreed to indemnify SAIC in connection with any such registration. In certain circumstances, including without limitation, a public offering or distribution of Class B Common Stock by SAIC, the Class B Common Stock would trade separately from the Class A Common Stockprofitability are uncertain Our quarterly operating results may fluctuate significantly in the public market. Separate tradingfuture due to a variety of the Class B Common Stockfactors, some of which are beyond our control. Factors that may affect our revenue include: - variations in the publicnumber of requests for domain name registrations or demand for our services, - termination or completion of contracts in our Internet Technology Services business or failure to obtain additional contracts in that business, and - market acceptance of new service offerings. In addition, we expect a significant increase in our operating expenses as we: - increase our sales and marketing operations and activities, and - continue to update our systems and infrastructure. If the increase in our expenses is not followed by an increase in our revenue, our operating results will be harmed. The fact that in the past our revenues have increased and we have been profitable on a quarterly and annual basis is not indicative of whether our revenues will increase or whether we will be profitable on a quarterly or annual basis in the perceptionfuture. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations." INVESTMENT RISKS Our stock price, like that such trading could occur, could materially and adversely affect the market price of the Class A Common Stock. Possible Volatility of Stock Price.many Internet companies, is highly volatile The market price of the shares ofour Class A Common Stock at timescommon stock has been and is likely to continue to be highly volatile and may be significantly affected by factors such asas: - general market conditions and market conditions affecting technology and Internet stocks generally, - actual or anticipated fluctuations in the Company'sour quarterly or annual registrations or operating results, of operations,- announcements of technological innovations, acquisitions or investments, developments in Internet governance announcement of additional competing registries, registrars or TLDs, litigation costs, results of litigation, introduction of new products or services by the Company or its competitors, developments with respect to patents, copyrights or proprietary rights,corporate actions such as stock splits, and - industry conditions and trends in the networking and other technology industries, changes in or failure by the Company to meet securities analysts' expectations, general market conditions and other factors. In addition, thetrends. The stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market prices forof the common stocks of technology companies, especially Internet-related companies. These broad market or technology or Internet sector fluctuations may adversely affect the market price of the Company'sour Class A Common Stock.common stock. Recently, the market price of our Class A common stock, like that of many Internet-related companies, has experienced significant fluctuations. For instance, from January 1, 1999 through March 12, 1999, the reported sales price for our Class A 18 21 common stock ranged from $128.0625 per share to $260.375 per share on a pre-split basis. On March 12, 1999, the reported last sale price of our Class A common stock was $222 per share on a pre-split basis. The market price of our Class A common stock also has been and is likely to continue to be significantly affected by expectations of analysts and investors. Reports and statements of analysts do not necessarily reflect our views. The fact that we have in the past met or exceeded analyst or investor expectations does not necessarily mean that we will do so in the future. In the past, following periods of volatility in the market price of a particular company's securities, securities class action litigation has often been brought against that company. There can be no assurance that such litigation will not occur in the future with respect to the Company.brought. Such litigation could result in substantial costs and a diversion of our management's attention and resources, whichresources. See "Item 5 -- Market for Registrant's Common Equity and Related Stockholder Matters." Future sales of common stock could have a material adverse effect uponaffect our stock price SAIC owns 14,850,000 of the Company's business, financial condition and resultsoutstanding shares of operations. Effectour common stock. A decision by SAIC to sell such stock could depress the market price of Certain Charter Provisions; Anti-takeover Effects of Certificate of Incorporation and Delaware Law. The holders ofthe Class A Common Stock are entitled to one votecommon stock. SAIC may maintain significant influence over us Because it holds a significant number of shares of our Class B common stock, which have ten votes per share, SAIC controls 89% of the combined voting power of the Class A and holdersClass B common stock and, therefore, effectively controls all matters requiring approval by our stockholders including the election of members of our board of directors, changes in the size and composition of the board of directors and a change in control. We do not have an agreement with SAIC which restricts its rights to convert, distribute or sell its shares of our common stock. If SAIC converts all of its remaining shares of Class B Common Stock are entitled to ten votes per share. Holders of Class A Common Stock and Class B Common Stock generally vote together as a single class. The Class B Common Stock held by SAIC is convertiblecommon stock into Class A Common Stock under certain conditions set forth in the Company's Certificate of Incorporation. The Company's Board of Directorscommon stock its economic interest and voting power will have the authority to issue up to 10,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights of such shares, without any further vote or action by the Company's stockholders. Such charter provisions could have the effect of delaying or preventing a change of controlbe below 50% of the Company. The rightstotal economic interest and voting power of the holders of Common Stockour common stock after such conversion. Nonetheless, SAIC will be subject to,remain our largest stockholder and may be adversely affectedable to exercise significant influence over us. Certain directors may have conflicts of interest Certain of our directors currently serve as directors, officers and employees of SAIC. Therefore, there may be various conflicts of interest or conflicting duties for these individuals. Since our directors and officers may also own stock of SAIC, there may be conflicts of interest when directors and officers are faced with decisions that could have different implications for us and SAIC. We rely on SAIC for certain corporate services and employee benefits We currently receive corporate services under an agreement with SAIC. Were SAIC to terminate these services, we may not be able to secure alternative sources for such services or such services may only be available to us at prices higher than those charged by the rightsSAIC. Our employees are currently eligible to participate in certain SAIC employee benefit plans. If SAIC converts its remaining shares of the holdersClass B common stock to Class A common stock, we will 19 22 have to establish certain employee benefit plans of any preferred stockour own which could result in incremental costs to us. Our certificate of incorporation contains provisions relating to SAIC that may adversely affect us or our stockholders Our certificate of incorporation includes provisions relating to competition by SAIC with us, allocations of corporate opportunities, transactions with interested parties and intercompany agreements and provisions limiting the liability of certain people. It is unclear whether such provisions are enforceable under Delaware corporate law. Our certificate of incorporation provides that any person purchasing or acquiring an interest in shares of our capital stock shall be issueddeemed to have consented to the provisions in the future.certificate of incorporation relating to competition with SAIC, conflicts of interest, corporate opportunities and intercompany agreements, and such consent may restrict such person's ability to challenge transactions carried out in compliance with such provisions. The issuancecorporate charter of preferred stock, while providing desirable flexibilitySAIC does not include similar provisions. Therefore, persons who are directors and/or officers of ours and who are also directors and/or officers of SAIC may choose to take action in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult forreliance on such provisions rather than act in a third partymanner that might be favorable to acquire a majority of the outstanding voting stock of the Company. The Company has no current plansus but adverse to issue shares of preferred stock. Further, certain provisions of the Company's Certificate of Incorporation and of Delaware law could delay or make more difficult a merger, tender offer or proxy contest involving the Company. 32 33SAIC. ITEM 2. PROPERTIES. The Company'sPROPERTIES Our principal executive office is located in 45,000 square feet of a facility in Herndon, Virginia, under a space usage arrangement with SAIC. SAIC's lease for this facility expires in November 2002. The CompanyWe also leaseslease an additional 40,30640,000 square feet in a facility in Herndon, Virginia under a lease expiring in July 2002. The CompanyWe also hashave offices located in a 10,000 square foot facility, also in Herndon, under a space usage arrangement with SAIC. SAIC's lease for this facility expires in October 1999. Additionally, the Companyour Internet Technology Services division has offices located inin: approximately 9,3002,900 square feet in a facility in Charlotte, North Carolina, under twoa space usage arrangementsarrangement with SAIC.SAIC; approximately 3,700 square feet in a facility in Duluth, Georgia, under a sublease; approximately 220 square feet in a facility in Thousand Oaks, California, under a space usage arrangement with SAIC; and, approximately 5,000 square feet in a facility located in New York, New York. SAIC's two leases with respect to this facilitythe Charlotte and Thousand Oaks facilities expire in August 1998July 2002 and July 2002. The Company believesMay 1999, respectively. Our sublease in Duluth and our lease in New York expire in January 2000 and December 2002, respectively. We recently entered into a lease to rent an additional 60,000 square foot facility in Herndon, Virginia commencing April 1, 1999 and ending March 31, 2004. We believe that itsour current facilities will be adequate for the next 12 months and that any additional facilities will be available in the future as needed on commercially reasonable terms. ITEM 3. LEGAL PROCEEDINGS As of March 13, 1998, the Company was12, 1999, we were a defendant in 6two active lawsuits involving domain name disputes between trademark owners and domain name holders. The Company isWe are drawn into such disputes, in part, as a result of claims by trademark owners that the Company iswe are legally required, upon request by a trademark owner, to terminate the right the Companywe granted to an alleged trademark infringera domain name holder to register thea domain name in question. Further, trademark owners have alsowhich is alleged that the Company shouldto be required to monitor future domain name registrations and reject registrations of domain names which are identical or similar to their federally registered trademark.the trademark in question. The holders of the domain name registrations in dispute have, in turn, questioned the Company'sour right, absent a court order, to take any action which suspends their registration or use of the domain names in question. Although 4248 out of approximately 3,6006,000 of these situations have resulted in litigation involving the Company,suits actually naming us as a defendant, as of March 13, 1998,12, 1999, no payments haveadverse judgment has been rendered and no award of damages has ever been made by the Company to any plaintiff and only four of these cases are pending. The Company believesagainst us. We believe that it haswe have meritorious defenses and intends to vigorously defend itselfourselves against these claims. On June 27, 1997, SAIC received a Civil Investigative Demand ("CID") from the U.S. Department of Justice ("DOJ") issued in connection with an investigation to determine whether there is, has been, or may be an antitrust violation under the Sherman Act relating to Internet registration products and services. The CID seeks documents and information from SAIC and the Company relating to their Internet registration business. The Company cannot reasonably estimate the potential impact of the investigation nor can it predict whether a civil action will ultimately be filed by the DOJ. The Company is unable to predict the form of relief that might be sought in such an action or that might be awarded by a court or imposed as a result of any settlement. Any such relief could have a material adverse effect on the Company's business, financial condition and results of operations. On March 20, 1997, PG Media, Inc., a New York-based corporation ("PG Media"), filed a lawsuit against the Companyus in the United States District Court, Southern District of New York alleging that the Companywe had restricted 20 23 access to the Internet by not adding PG Media's requested TLDstop level domains to the Internet root zone system in violation of the Sherman Act. In its complaint, PG Media, has, in addition to requesting damages, asked that the Companywe be ordered to include reference to PG Media's TLDstop level domains and name servers in the root zone file administered by the Companyus under the Cooperative Agreement. The Company has answered the complaint, but no motions are pending. In addition, in June 1997, the Companywe received written direction from the NSFNational Science Foundation not to take any action towhich would create additional TLDstop level domains or to add any new TLDstop level domains to the Internet root zone until the NSFNational Science Foundation provides further guidance. On September 17, 1997, PG Media filed a Second Amended Complaint adding the NSFNational Science Foundation as a defendant. The Company believes that it has 33 34 meritorious defenses and intendsOn May 14, 1998, PG Media served us with a motion for a preliminary injunction against both defendants to vigorously defend itselfcompel both defendants to add PG Media's top level domains to the Internet root zone within 30 days. In response, both defendants filed cross-motions for summary judgment against the claims of PG Media. AlthoughOn July 20, 1998, a hearing on all parties' motions occurred. The basic issue before the Company cannot reasonably estimatecourt is the potential impactNational Science Foundation's authority to control the Internet's root zone system. On March 16, 1999, the court granted both our and the National Science Foundation's motions for summary judgment, holding that the National Science Foundation does have authority over the root zone system and that the federal instrumentality immunity doctrine immunizes us against liability under both sections 1 and 2 of such claims, a successful claim under the plaintiff's theory could have a material adverse effect on the Company's business, financial condition and results of operations.Sherman Act. On October 17, 1997, a group of six plaintiffs filed a lawsuit (the "Thomas suit")the Thomas suit against the Companyus and the NSFNational Science Foundation in the United States District Court, District of Columbia, challenging the legality of fees defendants charge for the registration and renewal of domain names on the Internet and seeking restitution of fees collected from domain name registrants in an amount in excess of $100 million, damages, and injunctive and other relief. Plaintiffs originally alleged violations of the Competition in Contracting Act ("CICA"), the Sherman Act, and the U.S. Constitution. Following the filing of motions to dismiss by the defendants, the plaintiffs filed an amended complaint on January 30, 1998, dropping the cause of action based upon CICA, but adding alleged violations ofConstitution, the Administrative Procedures Act and the Independent Offices Appropriations Act. The plaintiffs also filed a motion for preliminary injunctive relief against the NSF concerning the "Intellectual Infrastructure Fund." On February 2, 1998, the United States District Court, District of Columbia, issued an order granting the plaintiffs' motion for a preliminary injunction, enjoining the NSF from spending any of the money collected by the Company for the Intellectual Infrastructure Fund. On February 10, 1998, the plaintiffs filed a motion for preliminary injunction against the Companyus seeking several items of relief. On February 24,April 6, 1998, the Company and the NSF filed motions to dismiss the amended complaint. Also on February 24,Court issued its opinion granting summary judgment in favor of the plaintiffs filed a motion for partial summary judgment concerningon the Intellectual Infrastructure Fund.Fund, ruling it an "unlawful tax." The plaintiffs'court also granted our motion forto dismiss all other counts (II through X) and simultaneously denied the plaintiffs' preliminary injunction motion against us. On April 30, 1998, Congress passed H.R. 3579 which was signed into law by the CompanyPresident on May 1, 1998. Section 8003 of H.R. 3579 legalized, ratified and partial summaryconfirmed the entire Intellectual Infrastructure Fund and authorized and directed the National Science Foundation to deposit the entire fund into the U.S. Treasury. On August 28, 1998, the District Court dismissed the entire case, issuing a final judgment againstin the NSF,matter. In October 1998, the plaintiffs appealed the court's dismissal of their claims, and both motions to dismiss were heard beforeoral argument occurred on February 25, 1999. We are awaiting the decision of the Court on March 17,of Appeals. On October 20, 1998, we were included as a defendant in a suit brought by the Pennsylvania Attorney General's office against a domain name holder who was alleged to have used his domain name in connection with a web site promoting white supremacy and threatening certain state employees. The Pennsylvania Attorney General named all of the Court has takencommunications companies in any way connected with the matters under advisement.domain name or web site. The Company believes that it has meritorious defenses and intendsPennsylvania Attorney General seeks to vigorously defend itself against the claimspermanently enjoin these entities, including us, from providing services to this domain name holder in the Thomas suit.event that the domain name holder fails to comply with the order of the court. We have answered the complaint denying any knowledge or participation in the actions of the primary defendant. No motions are pending and we expect to be dismissed from the matter. While the Companywe cannot reasonably estimate the potential impact of suchthe claims advanced in the PG Media, Thomas or Pennsylvania Attorney General suits, a successful claim against us in any of these proceedings could harm our business. On June 27, 1997, SAIC received a Civil Investigative Demand, or "CID," from the U.S. Department of Justice issued in connection with an investigation to determine whether there is, 21 24 has been, or may be any antitrust violation under the plaintiffs' theoriesSherman Act relating to Internet registration products and services. The CID seeks documents and information from SAIC and us relating to our Internet registration business. We cannot reasonably estimate the potential impact of the investigation nor can we predict whether a civil action may ultimately be filed by the Department of Justice or the form of relief that might be sought. Any such relief from such a suit could have a material adverseharmful effect on our business. On August 17, 1998, we received notice from the Commission of the European Communities, or "EC," of an investigation concerning the Company's business, financial conditionPremier Program agreements in Europe. The EC requested production of these agreements and resultsrelated materials for review and we complied. We cannot reasonably estimate the potential impact of operations. The Company isthe investigation nor can we predict whether an action will ultimately be brought by the EC or the form of relief that might be sought. Any such relief could harm our business. We are involved in various other investigations, claims and lawsuits arising in the normal conduct of itsour business, none of which, in theour opinion of the Company's management, will have a material adverse effect on its financial position, results of operations, cash flows or its ability to conductharm our business. LitigationLegal proceedings in which the Company iswe are involved hashave resulted and likely will result in, and any future litigationlegal proceedings can be expected to result in, substantial legal and other expenses to the Company and a diversion of the efforts of the Company'sour personnel. See "Item 1 --- Business --- Risk Factors - Litigation.-- We are Party to Several Legal Proceedings Which Could Have a Negative Financial Impact on Us." ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1997.1998. EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of the General Instructions to Form 10-K, the following information is included as an unnumbered Item in Part I of this Form 10-K. Set forth below is a list of the names and ages (as of March 30, 1998)12, 1999) of all executive officers of Network Solutions, all positions and offices with the Company held by each such person and 34 35 each such person's principal occupation or employment during at least the past five years. All such persons have been appointed to serve until their successors are appointed or until their earlier resignation or retirement.
Name Age Position -NAME AGE POSITION ---- --- -------- GabrielMichael A. BattistaDaniels................ 53 Chairman of the Board and Acting Chief Executive Officer Robert J. Korzeniewski............ 42 Chief Financial Officer and DirectorActing Chief Operating Officer Bruce L. Chovnick 38Chovnick................. 39 Senior Vice President and General Manager, ConsultingInternet Technology Services Jonathan W. Emery................. 47 Senior Vice President, General Counsel and Secretary David H. Holtzman 41Holtzman................. 42 Senior Vice President, Engineering Robert J. Korzeniewski 41 Chief Financial Officer Donald N. Telage 53Telage.................. 54 Senior Vice President, Internet Relations and Special Programs and Director Douglas L. Wolford 36Wolford................ 37 Senior Vice President, Marketing and Sales Charles A. Gomes.................. 52 Vice President, MarketingCustomer Programs Michael G. Voslow................. 39 Vice President, Finance and Treasurer
Gabriel22 25 MICHAEL A. BattistaDANIELS has served as Chairman of the Board of Network Solutions since 1995 and as Acting Chief Executive Officer of Network Solutions since November 1998. Since 1986, Mr. Daniels has served in various positions with SAIC and has served as a directorSector Vice President and Sector Manager for the Technology Applications Sector of SAIC since 1993. Prior thereto, Mr. Daniels served as a Group Senior Vice President of SAIC from 1991 to 1993. Mr. Daniels received a B.S. and an M.A. from Northwestern University and received a J.D. from the CompanyUniversity of Missouri School of Law. ROBERT J. KORZENIEWSKI has served as Chief Financial Officer of Network Solutions since NovemberMarch 1996 and as Chief Executive Officer of the Company since October 1996. From September 1995 to October 1996, Mr. Battista served as President and Chief Executive Officer of Cable & Wireless, Inc., a telecommunications company and U.S. subsidiary of Cable & Wireless, P.L.C. From 1991 to 1995, Mr. Battista served as President andActing Chief Operating Officer of Cable & Wireless, Inc.Network Solutions since November 1998. From 1987 until October 1997, Mr. Korzeniewski held a variety of senior financial positions with SAIC and from 1987 to 1991, he served as the Chief Operating Officera Corporate Vice President for Administration of National Telephone Services,SAIC from 1989 until 1997. Mr. Korzeniewski is a long distance operator service company. Mr. Battista also serves as a director of Axent Technologies, Inc.Certified Public Accountant and Systems & Computer Technology Corporation. Mr. Battista received a B.S.E.E.B.S. in Business Administration from Villanova University, a M.S.E.E. from Drexel University and an M.B.A. from Temple University. BruceSalem State College. BRUCE L. ChovnickCHOVNICK has served as Senior Vice President and General Manager, ConsultingInternet Technology Services of the CompanyNetwork Solutions since OctoberSeptember 1997. From October 1993 until September 1997, heMr. Chovnick served as Vice President of Global Internet Solutions forin various executive leadership roles with General Electric Information Services, Inc., an electronic commerce company.company, and, most recently, he served as Vice President of its Global Internet Solutions business. Prior to that he was a Senior Manager of IBM Corporation, a computer systems, software, networking systems and storage devices manufacturer, from January 1984 to September 1993. Mr. Chovnick received a B.S. in Computer Science from the University of Florida. DavidJONATHAN W. EMERY has served as Senior Vice President, General Counsel and Secretary of Network Solutions since December 1997. From 1986 until 1997, Mr. Emery held a variety of positions with Tambrands Inc., a consumer products company, most recently as Vice President, Senior Counsel and Assistant Secretary. Prior thereto, from 1977 until 1986, Mr. Emery was an Associate with the law firm of Brown & Wood. Mr. Emery received a B.A. from Trinity College, Hartford, Connecticut, and a J.D. from Boston University School of Law. DAVID H. HoltzmanHOLTZMAN has served as Senior Vice President, Engineering of the CompanyNetwork Solutions since February 1997. From September 1995 until January 1997, he served as Business Development Manager, Development Manager and Chief Scientist, IBM Internet Information Technology (InfoMarket) group of IBM Corporation, a computer systems, software, networking systems and storage devices manufacturer. Prior thereto, from May 1992 to 1994, he served as a Senior Associate at Booz-Allen & Hamilton, a management consulting firm. Mr. Holtzman received a B.A. in Philosophy from the University of Pittsburgh and a B.S. in Computer Science from the University of Maryland. Robert J. Korzeniewski has served as Chief Financial Officer of the Company since March 1996. From 1987 until October 1997, Mr. Korzeniewski held a variety of senior financial positions with SAIC and served as a Corporate Vice President for Administration of SAIC from 1989 until 1997. Mr. Korzeniewski is a Certified Public Accountant and received a B.S. in Business Administration from Salem State College. 35 36 DonaldDONALD N. TelageTELAGE has served as a director of the CompanyNetwork Solutions since May 1995 and as Senior Vice President, Internet Relations and Special Programs of the CompanyNetwork Solutions since February 1997. Dr. Telage also served as President and Chief Operating Officer of the CompanyNetwork Solutions from May 1995 to February 1997. Since 1986, Dr. Telage has served in various positions with SAIC and has served as a Group Senior Vice President of SAIC since 1993. Prior thereto, Dr. Telage served as a Corporate Vice President of SAIC from 1992 to 1993. Dr. Telage received his B.A. in Psychology from the University of Connecticut and received an M.A. and a Ph.D. in Mathematics from Clark University. DouglasDOUGLAS L. WolfordWOLFORD has served as Senior Vice President, Marketing and Sales of the CompanyNetwork Solutions since December 1997. From December 1994 to November 1997, Mr. Wolford was General Manager, Marketing foremployed by General Electric Information Services, Inc., an electronic commerce company.company, during which tenure he progressed to the position of General Manager -- Marketing (Americas). Prior thereto, he servedwas employed from March 1989 to December 1994 by the National Academy of 23 26 Engineering, most recently as Director, Development and Public Affairs for the National Academy of Engineering, from March 1989 to December 1994.Affairs. Mr. Wolford received a B.S. in Mechanical Engineering from North Carolina State University, a Certificat de Langue Francaise from Sorbonne University and an M.B.A. in Marketing from the University of Maryland. CHARLES A. GOMES has served as Vice President, Customer Programs of Network Solutions since March 1998. Mr. Gomes has been part of Network Solutions' management team since 1984. From October 1995 to March 1998, Mr. Gomes served as Director of Customer Programs. Prior to assuming his current responsibilities, Mr. Gomes managed various programs and projects at Network Solutions involving delivery of technical services to various federal and state government agencies. Mr. Gomes received a B.A. in Mathematics from the University of California, Davis, and a Master's of Education from Boston University. MICHAEL G. VOSLOW has served as Vice President, Finance and Treasurer since March 1998 and as Treasurer of Network Solutions since January 1997. From January 1995 to January 1997, Mr. Voslow was Vice President and Corporate Controller for MAXM Systems Corporation, a worldwide provider of computer software and professional services. Prior to joining MAXM, Mr. Voslow was a Senior Manager at Price Waterhouse where he served from August 1983 to January 1995. Mr. Voslow is a Certified Public Accountant and received a B.S. in Business Administration from Miami University (Ohio) and an M.B.A. in Finance from Duke University. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCKEQUITY AND RELATED STOCKHOLDER MATTERS The Company'sOur Registration Statement on Form S-1 (Registration No. 333-30705) was declared effective on September 25, 1997 by the Securities and Exchange Commission. TheOur Class A Common Stock of the Companycommon stock began trading publicly on the Nasdaq National Market on September 26, 1997 under the symbol NSOL. Prior to that date, there was no public market for the Class A Common Stock.common stock. The Companymanaging underwriters of the Class A common stock offering commencing September 26, 1997 were Hambrecht & Quist, J.P. Morgan & Co. and PaineWebber Incorporated. We registered and sold 3,220,000 shares on a pre-split basis for itsour own account at an aggregate price of $57,960,000 and the selling stockholder (SAIC)SAIC registered and sold 575,000 shares on a pre-split basis for its account at an aggregate price of $10,350,000, for a combined total of 3,795,000 shares on a pre-split basis at an aggregate price of $68,310,000. The offering is now completed. After subtractinghas since terminated. The total amount of expenses incurred for the Company'sour account in connection with the offering the Company'swas $5,555,200, which was comprised of $4,057,200 for underwriting discounts and commissions and $1,498,000 of other expenses. No expenses were paid to directors, officers or persons owning more than ten percent of any class of our equity securities. Our resultant net offering proceeds were $52,405,000.$52,404,800. The net proceeds to SAIC for its account were $9,625,500 after deducting the associated underwriting discounts and commissions of $724,500. On October 1, 1997, the Companywe received the offering proceeds from which a $10,000,000 dividend was paid to SAIC. SAIC owns ten percent or more of a class of our equity securities and is an affiliate of ours. The remaining proceeds have been invested in short-term investment grade government discount notes, commercial paper and commercial paper.corporate bonds. On December 31, 1998, our Board of Directors approved a 2-for-1 stock split of the shares of our Class A common stock and Class B common stock, that was effected in the form of a 100% stock dividend on March 23, 1999 on shares of our Class A common stock and Class B common stock outstanding on February 26, 1999. The following table sets forth the range of high and low last reported last sales prices of the Class A common stock on the Nasdaq National Market, adjusted to 24 27 retroactively reflect the stock split, for the period from September 26, 1997 through December 31, 1998.
HIGH LOW ---- --- Year Ended December 31, 1997: Fourth Quarter from September 26, 1997.................... $13 3/8 $ 5 7/8 Year Ended December 31, 1998: First Quarter............................................. 18 9/16 6 15/32 Second Quarter............................................ 27 1/2 16 1/4 Third Quarter............................................. 23 5/32 12 7/8 Fourth Quarter............................................ 82 23/64 14 3/16
As of March 19, 1999, there were 105 holders of record of Network Solutions Class A common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of beneficial stockholders, we are unable to determine the exact number of beneficial stockholders represented by these record holders. With the exception of the $10,000,000 dividend paid to SAIC on October 1, 1997, the Company haswe have neither declared nor paid cash dividends on its Common Stock. The Companyour common stock. We currently intendsintend to retain itsour earnings, if any, for future growth and doesdo not anticipate paying any dividends in the foreseeable future. ItsOur Board of Directors will determine the Company'sour future dividend policy on the basis of various factors, including the Company'sour results of operations, financial condition, capital requirements and investment opportunities. The following table provides the high and low sale prices of the Class A Common Stock on the Nasdaq National Market for the period from September 26, 1997 through December 31, 1997. High Low ---- --- $26.75 $11.75 As of March 20, 1998, there were 47 holders of record of Network Solutions Class A Common Stock. Because many of the Company's shares of Common Stock are held by brokers and other institutions on behalf of beneficial stockholders, the Company is unable to determine the exact number of beneficial stockholders represented by these record holders. 36 37 Since January 1, 1995, the Company has issued and sold (without payment of any selling commission to any person) the unregistered securities described below: 1. From October 14, 1996 to December 31, 1997, the Company granted incentive stock options to purchase an aggregate of 100,900 shares of the Company's Class A Common Stock to employees, officers and directors of the Company under its 1996 Stock Incentive Plan at exercise prices ranging from $11.25 to $14.00 per share. All of these options vest over a period of time following their respective dates of grant pursuant to the Company's 1996 Stock Incentive Plan. 2. From October 14, 1996 to December 31, 1997, the Company granted nonstatutory stock options to purchase an aggregate of 1,725,325 shares of the Company's Class A Common Stock to employees, officers and directors of the Company under its 1996 Stock Incentive Plan at exercise prices ranging form $11.25 to $14.875 per share. All of these options vest over a period of time following their respective dates of grant pursuant to the Company's 1996 Stock Incentive Plan. The sales of the above securities were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act, or Regulation D promulgated thereunder, or Rule 701 promulgated under Section 3(b) of the Securities Act, as transactions by an issuer not involving a public offering or transactions pursuant to compensatory benefit plans and contracts relating to compensation as provided under such Rule 701. The recipients of securities in each such transaction represented their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the share certificates and instruments issued in such transactions. All recipients had access, through their relationship with the Company, to information about the Company. 37 38 ITEM 6. SELECTED FINANCIAL DATA.
YEAR ENDED DECEMBER 31, ---------------------------------------------------------------- 1993 1994 1995 (1) 1996 1997 -------- -------- -------- -------- -------- (in thousands, except per share data) STATEMENT OF OPERATIONS DATA: Net revenue $ 4,369 $ 5,029 $ 6,486 $ 18,862 $ 45,326 Cost of revenue 2,924 3,073 5,704 14,666 25,798 -------- -------- -------- -------- -------- Gross profit 1,445 1,956 782 4,196 19,528 Research and development expenses - - - 680 1,653 Selling, general and administrative expenses 1,401 1,544 2,394 6,280 12,268 Interest expense (income), net 120 109 61 (496) (2,095) -------- -------- -------- -------- -------- Income (loss) from continuing operations before income taxes and cumulative effect of a change in accounting principle (76) 303 (1,673) (2,268) 7,702 Provision (benefit) for income taxes 34 114 (239) (643) 3,471 -------- -------- -------- -------- -------- Income (loss) from continuing operations (110) 189 (1,434) (1,625) 4,231 Loss from discontinued operations, net of income taxes (2) (936) (1,169) (1,403) - - Cumulative effect of change in accounting for income taxes 660 - - - - -------- -------- -------- -------- -------- Net income (loss) $ (386) $ (980) $ (2,837) $ (1,625) $ 4,231 ======== ======== ======== ======== ======== Basic earnings per share: - ------------------------- Income (loss) from continuing operations $ (0.10) $ 0.18 $ (0.14) $ (0.13) $ 0.32 Loss from discontinued operations (0.90) (1.12) (0.13) - - Cumulative effect of accounting change 0.63 - - - - -------- -------- -------- -------- -------- Net income (loss) $ (0.37) $ (0.94) $ (0.27) $ (0.13) $ 0.32 ======== ======== ======== ======== ======== Weighted average shares 1,048 1,042 10,335 12,500 13,305 Diluted earnings per share: - --------------------------- Income (loss) from continuing operations $ (0.10) $ 0.18 $ (0.14) $ (0.13) $ 0.31 Loss from discontinued operations (0.90) (1.12) (0.13) - - Cumulative effect of accounting change 0.63 - - - - -------- -------- -------- -------- -------- Net income (loss) $ (0.37) $ (0.94) $ (0.27) $ (0.13) $ 0.31 ======== ======== ======== ======== ======== Weighted average shares 1,048 1,047 10,335 12,500 13,483
38 39
Year Ended December 31, ---------------------------------------------------- 1993 1994 1995 1996 1997 ------ ------ ------ ------ ------ OTHER OPERATING DATA (3): Net new registrations 13 24 141 489 960 Less: Registrations not renewed - - (1) (39) (46) ------ ------ ------ ------ ------ Net registrations as of year end 13 37 177 627 1,541 ====== ====== ====== ====== ======
Year Ended December 31, ---------------------------------------------------- 1993 1994 1995 1996 1997 ------ ------ ------ ------ ------ BALANCE SHEET DATA: Cash and cash equivalents $ - $ 136 $ 5 $15,540 $ 41,146 Working capital (4) (179) (1,340) (559) 1,362 50,947 Total assets (5) 3,124 2,448 11,748 66,118 149,620 Deferred revenue, net 73 137 3,346 29,352 61,451 Long-term obligations, excluding current portion 344 81 1,353 9,440 18,743 Total stockholders' equity 1,221 252 3,062 1,437 47,655
- -------------------------- (1) The Selectedfollowing table sets forth selected financial and operating data of Network Solutions for the periods indicated and should be read in conjunction with "Management's Discussion and Analysis of Financial DataCondition and Results of Operations," the Financial Statements and the Notes related thereto included elsewhere and incorporated by reference in this Form 10-K. The selected financial data for the years ended December 31, 1996, 1997 and 1998 were derived from Network Solutions' audited financial statements included elsewhere in this Form 10-K. The information for the year ended December 31, 1994 is derived from Network Solutions' unaudited financial statements which, in the opinion of management, reflect all adjustments (consisting only of normal recurring items) necessary to present fairly the financial position and results of operations for the periods then ended. The selected financial data for the year ended December 31, 1995 waswere derived by combining the Company's resultsNetwork Solutions' Results of operationsOperations for the period January 1, 1995 through March 10, 1995 and the period March 11, 1995 through December 31, 1995, which, respectively, areboth as derived from Network Solutions' audited financial statements. Comparability of pre-acquisition periods before and afterto post-acquisition periods is 25 28 limited because the date of the SAIC acquisition. The data for these two periods werefinancial statements have been prepared on differing bases of accounting and, accordingly, the comparability of such data with other periods is limited, primarily as a result of goodwill amortization, new corporate services agreementsthe acquisition by SAIC.
YEAR ENDED DECEMBER 31, ----------------------------------------------- 1994 1995 1996 1997 1998 ------- ------- ------- ------- ------- IN THOUSANDS, EXCEPT PER SHARE DATA STATEMENT OF OPERATIONS DATA: Net revenue................................. $ 5,029 $ 6,486 $18,862 $45,326 $93,652 Cost of revenue............................. 3,073 5,704 14,666 25,798 38,530 ------- ------- ------- ------- ------- Gross profit................................ 1,956 782 4,196 19,528 55,122 Research and development expenses........... -- -- 680 1,653 4,821 Selling, general and administrative expenses.................................. 1,544 2,394 6,280 12,268 37,144 Interest income............................. -- -- (496) (2,211) (6,303) Other expenses.............................. 109 61 -- 116 116 ------- ------- ------- ------- ------- Income (loss) from continuing operations before income taxes....................... 303 (1,673) (2,268) 7,702 19,344 Provision (benefit) for income taxes........ 114 (239) (643) 3,471 8,109 ------- ------- ------- ------- ------- Income (loss) from continuing operations.... 189 (1,434) (1,625) 4,231 11,235 Loss from discontinued operations, net of income taxes.............................. (1,169) (1,403) -- -- -- ------- ------- ------- ------- ------- Net income (loss)........................... $ (980) $(2,837) $(1,625) $ 4,231 $11,235 ======= ======= ======= ======= ======= Basic earnings per share(1): Income (loss) from continuing operations............................. $ 0.09 $ (0.07) $ (0.07) $ 0.16 $ 0.35 Loss from discontinued operations......... (0.56) (0.07) -- -- -- ------- ------- ------- ------- ------- Net income (loss)......................... $ (0.47) $ (0.14) $ (0.07) $ 0.16 $ 0.35 ======= ======= ======= ======= ======= Weighted average shares..................... 2,084 20,670 25,000 26,610 31,957 Diluted earnings per share(1): Income (loss) from continuing operations............................. $ 0.09 $ (0.07) $ (0.07) $ 0.16 $ 0.34 Loss from discontinued operations......... (.56) (0.07) -- -- -- ------- ------- ------- ------- ------- Net income (loss)......................... $ (0.47) $ (0.14) $ (0.07) $ 0.16 $ 0.34 ======= ======= ======= ======= ======= Weighted average shares..................... 2,084 20,670 25,000 26,966 33,397
YEAR ENDED DECEMBER 31, ---------------------------------- 1994 1995 1996 1997 1998 ---- ---- ---- ----- ----- IN THOUSANDS OTHER OPERATING DATA (2): Net new registrations.............................. 24 141 489 960 1,911 Registrations not renewed.......................... -- 1 39 46 90 Net registrations as of period end................. 37 177 627 1,541 3,362
26 29
YEAR ENDED DECEMBER 31, ------------------------------------------------ 1994 1995 1996 1997 1998 ------ ------- ------- -------- -------- IN THOUSANDS BALANCE SHEET DATA: Cash and cash equivalents.......................... $ 136 $ 5 $15,540 $ 41,146 $ 12,862 Total marketable securities........................ -- -- -- 40,200 128,098 Working capital.................................... 1,340 (559) 1,362 50,947 65,791 Total assets....................................... 2,448 11,748 66,118 149,620 243,867 Restricted assets included in total assets......... -- 1,408 17,453 25,873 -0- Deferred revenue, net.............................. 137 3,346 29,352 61,451 129,194 Long-term obligations, excluding current portion... 81 1,353 9,440 18,743 35,721 Total stockholders' equity......................... 252 3,062 1,437 47,655 75,130
- --------------- (1) All share and per share data reflect the repayment of outstanding debt balances. See Notes 1 and 11 of Notes to Financial Statements for a discussion of the presentation for each of these periods.two-for-one stock split in March 1999. (2) See Note 13 of Notes to Financial Statements for a discussion of discontinued operations. (3) Net new registrations for each period include gross new registrations less an estimate of registrations that are uncollectible. Net registrations include net new registrations less an estimate of registrations not renewed. Prior to September 14, 1995, net registrations equaled gross registrations because the CompanyNetwork Solutions was reimbursed by the NSFNational Science Foundation for all registrations under a cost plus fixed-fee contract. (4) Working capital calculation includes $73, $137, $1,993, $19,912 and $43,789 of current deferred revenue as of December 31, 1993, 1994, 1995, 1996 and 1997, respectively. (5) Total assets include $0, $0, $1,408, $17,453 and $25,873 of restricted assets as of December 31, 1993, 1994, 1995, 1996 and 1997, respectively. 3927 4030 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.OPERATION The following discussion and analysis should be read in conjunction with "Item 6 -- Selected Financial Data" and Network Solutions' Financial Statements and Notes thereto included elsewhere and incorporated by reference in this Form 10-K. Except for the Company's accompanying financial statementshistorical information contained herein and notes thereto. Certain informationincorporated herein by reference, the discussion in this Form 10-K contains certain forward-looking statements. For this purpose, any statements contained herein that are notinvolve risks and uncertainties, such as statements of historical fact mayNetwork Solutions' plans, objectives, expectations and intentions. The cautionary statements made in this Form 10-K should be deemedread as being applicable to be forward-looking statements. Statements regarding the intent, belief or current expectations of the Company are intended to beall related forward-looking statements which may involve risk and uncertainty. There are a number of factors that could cause the Company'swherever they appear in this Form 10-K. Network Solutions' actual results tomay differ materially from those indicated by suchthe results discussed in the forward-looking statements as a result of certain factors, including, but not limited to, those discussed in "Factors Affecting Operating Results" as well as those discussed"Item 1 -- Business -- Risk Factors" and elsewhere in this Form 10-K and the Company's subsequent SEC filings.from time to time in Network Solutions' periodic reports. OVERVIEW The Company. The CompanyNetwork Solutions currently acts as the exclusive registry and registrar of Internet domain names within the .com, .org, .net and .edu TLDstop level domains pursuant to athe Cooperative Agreement with the NSF.Department of Commerce. Domain names are used to identify a unique site or presence on the Internet. As registry and registrar tofor these TLDs, the Companytop level domains, Network Solutions registers new domain names and is responsible for the maintenance and dissemination of the master file of domain names through daily updates to the Internet. The CompanyNetwork Solutions also provides enterprise network consulting services,Internet Technology Services, focusing on network engineering, network and systems security and network management solutions for commercial customers.solutions. Cumulative net registrations (gross registrations less management's estimate of uncollectible registrations and of non-renewals)non-re-registrations) within the TLDs maintainedtop level domains administered by the CompanyNetwork Solutions increased by 146%118%, from 627,000 domain names registered at December 31, 1996 to 1,541,000 domain names registered at December 31, 1997.1997 to 3,362,000 domain names registered at December 31, 1998. Net registrations in the .com TLDtop level domain represent 87%84% of the Company'sNetwork Solutions' total net registrations at December 31, 1997. Out of1998. Of the 1,541,0003,362,000 cumulative net registrations at December 31, 1997, 598,0001998, 1,453,000 registrations will be up for annual renewalre-registration during 1998the next twelve months based upon their respective anniversaries of initial registration. International registrations continued to increase as a percentageaccounted for 28% of net new registrations averaging 27% during 1997 with fourth quarter 1997 international registrations at 34%1998 and 26% of net new registrations as compared to 18% in the same quarter of 1996.during 1997. Net revenue from registration services accounted for 85.6%91.5% of the Company'sNetwork Solutions' net revenue for the year ended December 31, 1997. The Company's consulting services division1998. Network Solutions delivers full life cycleInternet Technology Services to large companies that desire to establish or enhance their Internet presence or re-engineer legacy network engineeringinfrastructures to accommodate the integration of both Internet connectivity and consulting for a broad range of companies including multinational oil and gas corporations and major financial institutions. A pioneer ininternal enterprise network, or intranet, technology into their information technology base. Our Internet technology since 1979, the Company has built an international reputation in enterpriseTechnology Services include network engineering, network and systems security and network operations center deployment.management. During the year ended December 31, 1998, Network Solutions provided Internet Technology Services to more than 20 companies. Net revenue from consulting servicesInternet Technology Services accounted for 14.4%8.5% of the Company'sNetwork Solutions' net revenue for the year ended December 31, 1997.1998. Registration Services.Services In December 1992, the CompanyNetwork Solutions entered into the Cooperative Agreement with the NSFNational Science Foundation under which the CompanyNetwork Solutions was to provide Internet domain name registration services for five TLDs:top level domains: .com, .org, .net, .edu and .gov. These "registration 40 41 services"registration services include the initial two year domain name registration and renewal,annual re-registration, and throughout the registration term, maintenance of and unlimited modifications to individual domain name records and dissemination of records through updates to the Internet.master file of domain names. The Cooperative Agreement became 28 31 effective January 1, 1993. It includesincluded a three-month phase-in period, a five-year operational period, (commencingcommencing April 1, 1993 and ending March 31, 1998),1998, and a six-month "flexibility period"flexibility period through September 30, 1998. TheEffective September 9, 1998, the Department of Commerce took over the administration of the Cooperative Agreement is subjectfrom the National Science Foundation. In October 1998, the Cooperative Agreement was amended to review by the NSF and may be terminated by the NSF at any time at its discretion or by mutual agreement. The NSF has stated that it will not be re-awarding a cooperative agreement at the end ofextend the flexibility period.period until September 30, 2000. The original terms of the Cooperative Agreement provided for a cost reimbursement plus fixed-fee contract (with aan initial fee of 8%). Effective September 14, 1995, the NSFNational Science Foundation and the CompanyNetwork Solutions amended the Cooperative Agreement to require the CompanyNetwork Solutions to begin charging end users a services fee of $50 per year for each domain name in the .com, .org and .net TLDs. Registrants paytop level domains. Until April 1, 1998, registrants paid a services fee of $100 for two years of domain name services upon each initial registration and an annual renewalre-registration fee of $50 per year thereafter (collectively "registration fees").thereafter. The NSFNational Science Foundation paid the registration fees for domain names within the .edu and .gov TLDstop level domains through March 31, 1997. Commencing April 1, 1997, the CompanyNetwork Solutions agreed with the NSFNational Science Foundation to provide domain name services within the .edu and .gov TLDstop level domains free of charge. As of October 1, 1997, the CompanyNetwork Solutions no longer registers or administers domain names in the .gov TLD. Historical registrations in the .edu and .gov TLDs represent less than 0.1% of cumulative net registrations at December 31, 1997 and less than 0.1% of net new registrations during the period from April 1, 1997 to December 31, 1997, and did not have a significant impact on the Company's net revenues or costs of services.top level domain. Under the terms of the September 14, 1995 amendment to the Cooperative Agreement, 30% of the registration fees collected by the Company isNetwork Solutions was required to be set aside for the enhancement of the intellectual infrastructure of the Internet (set aside funds) and, as such, iswas not recognized as revenue by the Company. The CompanyNetwork Solutions has reflected these set aside funds, along with the appropriate percentage of net accounts receivable, as restricted assets and has recorded an equivalent, related current liability. The Company maintainsNetwork Solutions maintained the cash received relating to the set aside funds in a separate interest bearing account. This restricted cash at December 31, 1996 and 1997 was approximately $13,049,000 and $23,512,000, respectively. The set aside funds, plus any interest earned, are intended to bewere disbursed at the direction of the NSF. In November 1997,National Science Foundation. As of December 31, 1998, the Company had cumulatively disbursed $23 million out of the fund to the NSF at its direction. Future collection or disbursement of theseall set aside funds will have no significant effect oncollected and associated interest earned for a total of $62.3 million to the Company's business, net financial position or results of operations.National Science Foundation at their direction. The restricted cash at December 31, 1997 and 1998 was approximately $23,512,000 and $0, respectively. On March 12, 1998, the NSFNational Science Foundation and the CompanyNetwork Solutions amended the Cooperative Agreement to eliminate the 30% set aside requirement effective April 1, 1998 and to reduce the registration fees by a corresponding amount. Initial registrations on and after April 1, 1998 will beare charged $70 for two years of registration services and an annual renewalre-registration fee of $35 per year thereafter. This amendment will havehad no effect on the revenue currently recognized on each registration, ($70$70 for initial registrations and $35 for renewals),re-registrations, since the CompanyNetwork Solutions previously did not recognize revenue on the 30% set aside funds. Accordingly, while the revenue to the CompanyNetwork Solutions on a per registration basis does not change, the amount charged to customers will decline. The impact of this price change on new registrations during the first quarter of 1998 is not expected to be material and the potential increase in demand for domain names for the remainder of 1998 due to the lower price point is uncertain.declined. In order to provide prompt access to new domain names on the Internet, the CompanyNetwork Solutions generally invoices customers and permits them to pay their registration fees after their domain names are registered. The Company'sNetwork Solutions' experience has been that, for the period from September 1995 to 41 42through December 1997,1998, approximately 30%31% of new registrations have ultimately been deactivated for non-payment. The CompanyNetwork Solutions believes that this level of uncollectible receivables is due to, among other factors, the large number of individuals and corporations that have registered multiple domain names with the apparent intention of resellingtransferring registration for such names at a profit. Such resellers have a greater tendency than other customers to default on their registration fees. As a consequence, the CompanyNetwork Solutions has recorded a comparable provision for uncollectible accounts in determining net registration revenue. This provision averaged 30% provision has been consistently applied for the period from September 1995 to Decemberin 1996 and 1997 and 32% in 1998 and is considered adequate by the Company.Network Solutions. 29 32 Registration fees charged to end userscustomers for registration services net of the 30% set aside funds, are recognized as revenue evenly over the registration term. Accordingly, the CompanyFor example, Network Solutions recognizes $70 ($100 fee less $30 set aside) on a straight-line basis over the two-year servicesservice period for each $70 initial domain name registration, equivalent to $35 per year. RenewalsAnnual re-registrations of domain name registrationsnames are recorded as revenue based upon $35 ($50 fee less $15 set aside) recognized on a straight-line basis over the one-year servicesservice period. This "subscription-based"subscription-based model defers revenue recognition until the CompanyNetwork Solutions provides the registration services, including daily updates to the Internet and maintenance of and unlimited modifications to individual domain name records, over the respective registration terms. At December 31, 1997, the Company1998, Network Solutions had net deferred revenue of $61.5 million,$129.2 million. Expenses for Network Solutions increased each quarter during 1996, 1997 and 1998 as a result of which $43.8 millionincreased business activities, primarily attributable to subscriber growth for Network Solutions' registration services business. Network Solutions believes continued investments in its back office infrastructure as well as significant expansion of its sales and marketing and product development activities are critical to the achievement of its goals and anticipates that costs and expenses will be recognized as revenuecontinue to increase in 1998. Consulting Services.each quarter for the foreseeable future. Internet Technology Services Substantially all of the Company's consulting servicesNetwork Solutions' Internet Technology Services revenue is derived from professional services which are generally provided to clients on a "timetime and expense"expense basis and is recognized as services are performed. The majority of Network Solutions' Internet Technology Services are provided to customers in the financial services industry. Bank of America, formerly NationsBanc, is currently Network Solutions' largest Internet Technology Services Inc. ("NationsBanc") is the Company's largest consulting services customerclient, accounting for 40% of Network Solutions' Internet Technology Services business net revenue and accounted for 29%3% of the Company's consulting servicesNetwork Solutions' total net revenue for the year ended December 31, 1997.1998. NationsBanc originally contracted with the CompanyNetwork Solutions in 1993 to provide ongoing analysis, design, implementation and support engineering for its enterprise network. The CompanyNetwork Solutions currently provides network design and engineering services as well as a variety of project specific services for NationsBanc. The Company's current contract with NationsBanc is a three-year contract which commenced January 1, 1997 and is a requirements contract under which the Company's services are ordered by task orders issued by NationsBanc. The NationsBanc contract may be terminated by NationsBanc at any time upon 30-days' prior written notice to the Company. During 1997, task orders for a number of services the Company had historically performed for NationsBanc were not renewed. The Company believes this reflects NationsBanc's focus on increasing its internal information technology staff as well as its continued efforts to integrate information technology staff from recent acquisitions. There can be no assurance that the Company will obtain any additional task orders under the NationsBanc contract. Financial Presentation. The accompanying historical financial statements for all periods presented reflect the results of continuing operations related to the commercial activities of the Company only. The operating results of both the minority-based government contracts business, which was transferred into a separate entity prior to the acquisition of the Company by SAIC, and the remaining government-based business, which was transferred to SAIC effective February 1996, are reflected as discontinued operations in the Company's financial statements. See Notes 1 and 9 to the Company's Financial Statements for a discussion of transactions with SAIC. 42 43 RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the percentage relationship to net revenue of certain items in the Company'sNetwork Solutions' Statements of Operations. The percentage relationships
YEAR ENDED DECEMBER 31, ------------------------------------ 1996 1997 1998 -------- -------- -------- PERCENTAGE OF NET REVENUE: Net revenue............................................. 100.0% 100.0% 100.0% Cost of revenue......................................... 77.8 56.9 41.1 ----- ----- ----- Gross profit............................................ 22.2 43.1 58.9 Research and development expenses....................... 3.6 3.6 5.1 Selling, general and administrative expenses............ 33.3 27.1 39.7 Interest and other expense (income)..................... (2.7) (4.6) (6.6) ----- ----- ----- Income (loss) before income taxes....................... (12.0) 17.0 20.7 Provision (benefit) for income taxes.................... (3.4) 7.7 8.7 ----- ----- ----- NET INCOME (LOSS)....................................... (8.6)% 9.3% 12.0% ===== ===== =====
30 33 COMPARISON OF YEARS ENDED DECEMBER 31, 1997 AND 1998 Net Revenue Net revenue increased 107% from $45.3 million for the year ended December 31, 1995 were derived by combining the Company's results of operations1997 to $93.7 million for the period January 1, 1995 through March 10, 1995year ended December 31,1998. This increase in net revenue was primarily attributable to the increase in the number of domain name registrations, principally in the .com top level domain. Net revenue from registration services increased 121% from $38.8 million for the year ended December 31, 1997 to $85.7 million for the year ended December 31, 1998. Net new registrations increased 99% from 960,000 for the year ended December 31, 1997 to 1,911,000 for the year ended December 31, 1998. Growth in net registrations continues to be driven by the widespread use and adoption by businesses of the Internet and intranets on a global basis. Cumulative net registrations as of December 31, 1997 were 1,541,000 as compared to 3,362,000 as of December 31, 1998 for a 118% increase. Additionally, net new registrations increased 137% from 262,000 for the three months ended December 31, 1997 to 621,000 for the three months ended December 31, 1998. This also represents a 23% increase over the 507,000 net new registrations for the three months ended September 30, 1998. The growth in cumulative net registrations was a 21% increase in Network Solutions' entire customer base since September 30, 1998. Net revenue from Internet Technology Services increased 22% from $6.5 million for the year ended December 31, 1997 to $8.0 million for the year ended December 31, 1998. Further, the fourth quarter reflected an increase of 117% over the same quarter last year and a 47% increase over the third quarter of 1998. NationsBanc accounted for $1.9 million or 4% of Network Solutions' total net revenue for the year ended December 31, 1997 and $3.2 million or 3% for the year ended December 31, 1998. During the year ended December 31, 1998, the Internet Technology Services division added new leadership in sales and operations and hired additional technical consultants. In addition, the division continued to emphasize its efforts targeted at lead generation and regional sales and marketing programs by opening offices in New York City and Atlanta, Georgia. Cost of Revenue Cost of revenue consists primarily of salaries and employee benefits, fees paid to subcontractors for work performed in connection with revenue producing projects, depreciation and equipment costs, lease costs of the operations infrastructure and the period March 11, 1995 throughassociated operating overhead. Cost of revenue increased from $25.8 million for the year ended December 31, 1997 to $38.5 million for the year ended December 31, 1998. This 49% increase was driven by a $3.0 million increase in labor, a $6.4 million increase in outsourcing costs and $2.7 million in additional depreciation charges and equipment expenditures primarily associated with supporting the growth of Network Solutions' registration services business. In the near term, the continued investment in the back office infrastructure and provision of customer service is expected to partially offset future margin improvements arising from economies of scale. As a percentage of net revenue, cost of revenue decreased from 56.9% for the year ended December 31, 1997 to 41.1% for the year ended December 31, 1998 principally reflecting economies of scale and other operational efficiencies achieved in Network Solutions' registration business. Research and Development Expenses Research and development expenses consist primarily of compensation and consultant expenses to support the creation, development and enhancement of Network Solutions' products, services and technologies. Research and development expenses increased 192% from $1.7 million for the year 31 34 ended December 31, 1997 to $4.8 million for the year ended December 31, 1998. As a percentage of net revenue, research and development expenses increased from 3.6% for the year ended December 31, 1997 to 5.1% for the year ended December 31, 1998. All significant research and development costs have been expensed as incurred. Network Solutions expects that the level of research and development expenses will continue to increase in the near future in terms of absolute dollars as Network Solutions invests in developing new service offerings. Selling, General and Administrative Expenses Selling, general and administrative expenses consist primarily of salaries of business development, general management, administrative and financial personnel, marketing expenses, corporate services from SAIC, legal and other professional costs and amortization of goodwill associated with Network Solutions' 1995 which, respectively, are periods beforeacquisition by SAIC. Selling, general and afteradministrative expenses increased 203% from $12.3 million for the dateyear ended December 31, 1997 to $37.1 million for the year ended December 31, 1998. The increase was attributable to a $16.9 million increase in marketing and business development expenses including television, Internet banner advertising and targeted direct mail campaigns, increased staffing expenses of $1.8 million and an increase in legal and other professional costs of $2.6 million. As a percentage of net revenue, selling, general and administrative expenses increased from 27.1% for the year ended December 31, 1997 to 39.7% for the year ended December 31, 1998. Network Solutions expects that the level of selling, general and administrative expenses will continue to increase significantly in the near future in terms of absolute dollars as operations continue to expand. In particular, sales, marketing and business development expenses will increase as Network Solutions continues to promote the value of a .com web address and other new Internet-based value-added services. Network Solutions also plans to continue to develop its distribution channels, both domestically and internationally. Interest Income Network Solutions had net interest income of $2.2 million for the year ended December 31, 1997 as compared to $6.3 million for the year ended December 31, 1998. The increase is attributable to the investment of the SAIC acquisition. Accordingly, the data for these two periodspositive cash flow resulting primarily from increasing domain name registrations and the net proceeds of Network Solutions' initial public offering. Income Taxes The provision for income taxes was 45% of pretax earnings, or $3.5 million for the year ended December 31, 1997, and 42%, or $8.1 million for the year ended December 31, 1998. The difference between the effective rates for both periods precedingpresented is principally attributable to the relative impact that non-deductible goodwill had on pretax operating income. Goodwill is being amortized by Network Solutions over five years and followingis associated with the acquisition were prepared on differing bases of accounting and, as a result, the comparability of such percentage relations with other periods is limited primarily as a result of the goodwill amortization, corporate services agreements and interest expense related to outstanding debt balances.
Percentage of Net Revenue ------------------------------- Fiscal Year Ended December 31, ------------------------------- 1995 1996 1997 ------- ------- ------ Net revenue 100.0% 100.0% 100.0% Cost of revenue 87.9 77.8 56.9 ------- ------- ------ Gross profit 12.1 22.2 43.1 Research and development expenses - 3.6 3.6 Selling, general and administrative expenses 36.9 33.3 27.1 Interest expense (income), net 0.9 (2.7) (4.6) ------- ------- ------ Income (loss) from continuing operations (25.7) (12.0) 17.0 Provision (benefit) for income taxes (3.6) (3.4) 7.7 ------- ------- ------ Income (loss) from continuing operations, net of income taxes (22.1%) (8.6%) 9.3% ======= ======= ======
43 44Network Solutions by SAIC in 1995. COMPARISON OF YEARS ENDED DECEMBER 31, 1996 AND 1997 Net Revenue.Revenue Net revenue increased 140% from $18.9 million in 1996 to $45.3 million in 1997. This increase in net revenue was primarily attributable to the increase in the number of domain name registrations, principally in the .com TLD.top level domain. Net revenue from registration services increased 246% from $11.2 million in 1996 to $38.8 million in 1997. Net new registrations increased 96% from 489,000 during 1996 to 960,000 during 1997. Growth in registrations has beenwas driven by the widespread use and adoption by businesses of the Internet and Intranetsintranets on a global basis. Cumulative net registrations as 32 35 of December 31, 1996 were 627,000 as compared to 1,541,000 as of December 31, 1997, for a 146% increase. Net revenue from consulting servicesInternet Technology Services decreased 16% from $7.7 million in 1996 to $6.5 million in 1997. This decrease was primarily attributable to a decrease in business from NationsBanc. NationsBanc, the Company'sNetwork Solutions' largest consulting servicesInternet Technology Services client, accounted for $3.7 million or 20% of the Company'sNetwork Solutions' total net revenue in 1996 and $1.9 million or 4% of the Company'sNetwork Solutions' total net revenue in 1997. The Company believes NationsBanc will continue to be a significant customer of its consulting services business, but to a lesser extent than in previous years, both in terms of dollars and as a percentage of the Company's total net revenue. Cost of Revenue. Cost of revenue consists primarily of salaries and employee benefits, fees paid to subcontractors for work performed in connection with revenue producing projects, depreciation, lease costs of the operations infrastructure and the associated operating overhead.Revenue Cost of revenue increased 76% from $14.7 million in 1996 to $25.8 million in 1997. The increase was primarily driven by the growth of the Company'sNetwork Solutions' registration business which experienced additional labor costs of $4.2 million and additional outsourcing costs of $1.6 million in support of the Company'sNetwork Solutions' invoicing, collection and processing activities. In June 1997, the CompanyNetwork Solutions opened a 31,200 square foot facility to support its Internet business operations and in January 1998, the CompanyNetwork Solutions signed an agreement to lease an additional 9,100 square feet at the same location. This leased facility is designed to meet current registration services customer support needs as well as to provide expansion capability for future business. The Company continues to invest in improvements to the back office component of its domain name registration business including investments in additional hardware, software, staffing and facilities and currently anticipates that it will continue to make significant investments in its back office for the foreseeable future. As a percentage of net revenue, cost of revenue decreased from 77.8% in 1996 to 56.9% in 1997. This decrease primarily reflects economies of scale that the Company has begun to achieveNetwork Solutions achieved due to the growth of its subscription-based domain name registration business. In the near term, the continued need for back office investments is expected to partially offset future margin improvements arising from economies of scale. Research and Development Expenses. Research and development expenses consist primarily of compensation expenses to support the development and enhancement of the Company's technologies.Expenses Research and development expenses increased 150% from $680,000 in 1996 to $1.7 million in 1997. To date, allAll of the Company'sNetwork Solutions' research and development costs have been expensed as incurred. The Company expects that the level of research and development expenses will increase significantly in the near future in absolute dollars as the Company invests in developing new product and service offerings. As a percentage of net revenue, research and development expenses were 3.6% for both 1996 and 1997. Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of salaries of business development, general management, 44 45 administrative and financial personnel, corporate services from SAIC, legal costs and amortization of goodwill associated with the Company's acquisition by SAIC.Expenses Selling, general and administrative expenses increased 95% from $6.3 million in 1996 to $12.3 million in 1997. The increase is primarily attributable to increased management and administrative labor expenses of $1.8 million, business development expenses of $1.3 million and an increase in legal costs of $1.0 million. As a percentage of net revenue, selling, general and administrative expenses decreased from 33.3% in 1996 to 27.1 %27.1% in 1997. The decrease in percentage of net revenue reflects economies the Company has begun to achieveof scale Network Solutions achieved due primarily to the growth of its domain name registration business. The Company expects that the level of selling, general and administrative expenses will increase significantly in the near future in terms of absolute dollars as operations continue to expand. In particular, sales, marketing and business development expenses will increase as the Company introduces new enhanced registration and other services and begins to actively promote the use of the .com TLD. Interest Income Net. The CompanyNetwork Solutions had net interest income of $496,000 in 1996 as compared to $2.1 million in 1997. The increase is attributable to the investment of the net proceeds of the Company'sNetwork Solutions' stock offering as well as improved cash flow resulting from the increase in domain name registrations. Income Taxes (Benefit). The income tax benefit was $643,000 in 1996 as compared to an income tax expense of $3.5 million in 1997. The effective tax rate changed from 28% in 1996 to 45% in 1997. The difference between the effective rates is principally attributable to the relative impact that non-deductible goodwill had on pretax operating income or loss for the year. Goodwill is being amortized by the CompanyNetwork Solutions over five years and is associated with the acquisition of the CompanyNetwork Solutions by SAIC in 1995. COMPARISON OF YEARS ENDED DECEMBER 31, 1995 AND 1996 Net Revenue. Net revenue increased 191%33 36 FACTORS AFFECTING OPERATING RESULTS The Department of Commerce has adopted a plan, referred to as the Statement of Policy or "White Paper," calling for a phased transition of the Department's responsibilities for the domain name system to a not-for-profit corporation by September 30, 2000. The domain name system is the system by which Internet names and addresses are registered, allocated and used. We face risks from $6.5 million in 1995 to $18.9 million in 1996. This increase in net revenue was primarily attributablethis transition. As the U.S. Government transitions certain responsibilities for domain name system administration to the increasenot-for-profit corporation, corresponding obligations under our Cooperative Agreement with the Department of Commerce may be terminated and, as appropriate, covered in a contract between the not-for-profit corporation and us. We might not reach an acceptable contractual agreement with the not-for-profit corporation for our continuing role in the numberregistration of domain name registrations, principallynames. The U.S. Government has sent us a letter directing us to treat ICANN as the not-for-profit corporation identified in the .com TLD, as well as the Company's shift to a subscription-based pricing model. Net revenue from registration services increased 600% from $1.6 million in 1995 to $11.2 million in 1996. Net revenue in 1995 primarily reflects the cost reimbursement plus fixed-fee contract with the NSF whereas net revenue for 1996 reflects the Company's subscription-based pricing model. Net new registrations increased 247% from 141,000 during the year ended December 31, 1995 to 489,000 during the year ended December 31, 1996. Cumulative net registrations increased 254% from 177,000 at December 31, 1995 to 627,000 at December 31, 1996. Net revenue from consulting services increased 57% from $4.9 million in 1995 to $7.7 million in 1996, including an increase in net revenue from NationsBanc, the Company's largest consulting services customer, which increased 42% from $2.6 million in 1995 to $3.7 million in 1996. This growth was primarily attributable to increased funding within NationsBanc to support internal network integration and expansion. The Company also experienced growth from a number of new consulting services customers, many of which were obtained through subcontracting with and utilizing leads from SAIC. NationsBanc accounted for 19.6% of total net revenue in 1996. NationsBanc accounted for 40.0% of total net revenue and the NSF (under the cost reimbursement plus fixed-fee contract) accounted for 20.8% of total net revenue in 1995. No other source of revenue accounted for 45 46 more than 7.1% of total net revenue in either year. Cost of Revenue. Cost of revenue increased 157% from $5.7 million in 1995 to $14.7 million in 1996. The increase in cost was related primarily to an increase in the cost of labor of $3.7 million as a result of the Company's rapid growth. Effective with the September 14, 1995October amendment to the Cooperative Agreement which implementeddescribed above, in the subscription-based pricing model, the Company established and continued to develop its back office capability. This required the Company to make significant investments in hardware and software as well as to utilize a number of third-party vendors in support of back office requirements. In particular, the Company began to outsource portionsperformance of its back office operations duringobligations under the fourth quarterMOU and until such time as the MOU is terminated. We have not yet responded to that letter. We are currently in discussions with ICANN and the U.S. Government regarding implementation of 1996. A principal benefit of outsourcing was to increase the capacity and efficiency of its back office operations; however, such action alone did not significantly impact operating margins. As a percentage of net revenue, cost of revenue decreased from 87.9% in 1995 to 77.8% in 1996. This decrease reflects economies of scale that the Company has begun to achieve due to the growth of its domain name registration business. Research and Development Expenses. There were no research and development expenses in 1995, in large part becauseshared registration system enhancements were reimbursable under the Cooperative Agreement. In 1996, research and development expenses were $680,000 or 3.6%a wide range of net revenue. Through December 31, 1996, all of the Company's research and development costs have been expensed as incurred. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased 162% from $2.4 million in 1995 to $6.3 million in 1996. This increase was primarily attributable to increases in management, administrative and business development staff, as well as increased legal costs associated with the administration of the Company's domain name dispute policy. Selling, general and administrative expenses include $237,000 in 1995 and $822,000 in 1996 of expenses allocated from SAIC in accordance with the then current intercompany agreement. If the expenses were based on the fee of 2.5% of net revenue under the intercompany agreement in effect during 1997, such expenses would have been $133,000 and $472,000, respectively. As a percentage of net revenue, selling, general and administrative expenses decreased from 36.9% in 1995 to 33.3% in 1996, reflecting the generally fixed nature of certain general and administrative expenses as well as management's control of such costs. Interest Expense (Income). The Company had net interest expense of $61,000 in 1995 as compared to interest income of $496,000 in 1996. The change is primarily attributable to positive cash flow in 1996 associated with the Company's domain name registration business. Income Taxes (Benefit). The income tax benefit was $239,000 in 1995 as compared to $643,000 in 1996. The effective tax rate increased from 14.3% in 1995 to 28.4% in 1996. The difference between the effective tax rates was primarily attributable to non-deductible goodwill comprising a higher percentage of the Company's net loss in 1995. Discontinued Operations. Immediately prior to the acquisition of the Company by SAIC, the portion of the Company's business relating to the minority-based government business had been transferred into a separately-owned entity. In November 1995, SAIC adopted a plan to transfer the Company's remaining government-based business to SAIC in order to enable the Company to focus on the growth of its commercial business, which includes registration and consulting services. This transfer was effective as of February 1996. November 1995 was the 46 47 measurement date for discontinued operations for accounting purposes. The activities of both the minority-based government business and the remaining government-based business are reflected as discontinued operations. Net income (loss) from discontinued operations excludes general corporate overhead of the Company. No gain or loss was incurred as a consequence of the transfer of these businesses. In 1995, discontinued operations incurred a net loss of $1.4 million. The loss was primarily attributable to the Company's remaining government business, which increased the Company's provision for uncollectible accounts associated with the bankruptcy of a prime contractor, high interest costs associated with payment issues from other prime contractors and over-runs of fixed-price and fixed-rate contracts. As mentioned above, this business was transferred to SAIC effective as of February 1996. FACTORS AFFECTING OPERATING RESULTS The Company's expense levels are based in part on its expectations as to future revenue and to a large extent are fixed. As a result, quarterly sales and operating results generally depend on the volume of and ability to fulfill registration requests and consulting services contract awards, which are difficult to forecast. The Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfall of demand for the Company's services in relation to the Company's expectations would have an immediate adverse impact on the Company's business, operating results and financial condition. In addition, the Company expects a significant increase in its operating expenses as it funds greater levels of product and services development, increases its sales and marketing operations, updates systems and infrastructure, expands its facilities, develops new distribution channels and broadens its customer support capabilities. While no individual expenditure is anticipated to have a material impact on the Company's operating results, the combined effect could be significant andcontractual issues. We cannot be reasonably estimated at this time. To the extentsure that such expenses precede or are not subsequently followed by an increasethese discussions will result in revenue, the Company's business, financial condition and results of operations will be materially and adversely affected. The Company believes that future operating results will be subject to quarterly fluctuations due to a variety of factors, many of which are beyond the Company's control. Such factors may include, but are not limited to, developments in Internet governance, increased competition, through the introduction of competing TLDs or competing registrars in .com, .org or .net or otherwise, variations in the number of requests for domain name registrations, demand for the Company's services, introduction or enhancements of services by the Company or its competitors, market acceptance of new service offerings, costs associated with providing domain name registration services, litigation costs, adverse results of litigation, termination or completion of contracts in the Company's consulting services business or failure to obtain additional contracts in its consulting services business, patterns of growth in the use of and interest in the Internet and general economic conditions. Operating results would be adversely affected by a downturn in the market for domain name registrations or a failure to maintain existing or obtain anticipated contracts in its consulting services business. Because the Company expects an increase in its operating expenses for personnel and new services development, the Company would be materially and adversely affected if its revenues did not correspondingly increase. See "Item 1 - Business - Risk Factors - Potential Fluctuations in Quarterly Results." 47 48 On February 20, 1998, the U.S. government published in the Federal Register the Proposed Rule to provide notice and seek public comment on a proposal to transfer over time the administration of the Internet domain name system from the U.S. government and the NSF to a new private, not-for-profit corporation and to increase competition in the administration of TLDs and the registration of second level domain names. Comments on the Proposed Rule have revealed substantial differences regarding how the DNS should evolve and competing proposals concerning DNS management to those set forth in the Proposed Rule have been advanced from time to time. There is a risk that failure to achieve consensus could, among other things, prevent or delay the issuance of a final rule. In addition, any rule that is issued could be challenged by persons or entities who disagree with its provisions. Any of such events could have a material adverse effect on the Company's business, financial condition and results of operation through continued uncertainty about future Internet governance or a disruption to the administration, effective operation or maintenance and expansion of the Internet, in general, or the domain name registration system, in particular. Additionally, any final rule could be different, perhaps substantially, from the Proposed Rule. Any final rule or any terms negotiated thereunder by the U.S. government and the Company could contain provisions which are notagreements favorable to us. Despite the Company or not consistent with the Company's current or future plans. Itsignificant efforts undertaken to date, it is impossible to predict at this time whether or when a final rulethe process initiated by the Statement of Policy will be issuedresult in the full transition to the not-for-profit corporation of domain name system responsibilities as and to the extent contemplated in the White Paper and, if issued,it does, the exact nature of its provisions or of any such terms, the timing of implementation or the precise effect on us of such provisionstransition. See "Business -- Ongoing Privatization of Internet Administration." Termination, or a change in the terms, onof the Company. It is possible thatCooperative Agreement could harm our business. While the Cooperative Agreement by its terms expires in September 2000, it may be terminated earlier. The Department of Commerce's interpretation of certain provisions of any final rulethe Cooperative Agreement could differ from ours. For example, the Department of Commerce has publicly expressed concerns about our consolidation into a single web site the web sites through which our InterNIC registration services and our RegistrationPlus services were offered. These differences in interpretation could lead to disputes between us and the Department of Commerce or certainthe not-for-profit corporation, which may or may not be resolved in our favor. Certain aspects of suchimplementation of the Cooperative Agreement also remain to be fully negotiated, including the maximum price we will charge for registry services in the top level domains for which we now act as registry. If we are unsuccessful in negotiating acceptable terms could have a material adverse effect onof implementation, the Company's business, financial condition and resultscosts of operations. See "Item 1-Business-Relationshipimplementation of the Cooperative Agreement, our relationship with the NSF; Recent Developments in Internet Governancenot-for-profit corporation and -Risk Factors-Uncertainty of Internet Governance and Regulation." Under the Proposed Rule, the Company would continue to operate the .com, .org and .net registries and to act as a registrar for those TLDs, but other companies would be permitted to act as registrar for those TLDs. The Proposed Rule also provides for additional new TLDs. The Company believes that it is well positioned to succeedmatters affecting our position in a more competitive environment. However,domain name system environment could be harmed. See "Business -- Status of Cooperative Agreement." Withdrawal of or challenges to the adoptionU.S. Government's sponsorship or authorization of certain functions that we perform could create a public perception or result in a legal finding that we lack authority to continue in our current role as registry or registrar within the .com, .org, .net and .edu top level domains. The legal authority underlying the roles of the Proposed RuleDepartment of Commerce and the not-for-profit corporation with regard to the domain name system also could be challenged. The impact, if any, of any such public perception or a similar rule or thefinding is unknown, but it could be harmful to our business. The introduction of additional competition into the domain name registration business could be harmful to our business. This includes, in someparticular, competition among registrars within a single top level domain, like .com, and competition among registrars and registries of existing and potential new top level domains. In addition, we currently face competition in the domain name registration business from registries for country code top level domains, third level domain name providers such as Internet access providers and registrars and registries of top level domains other mannerthan those top level domains which we currently register. A number of entities have already begun to offer 34 37 competing registration services using other top level domains and when the shared registration system takes effect we will no longer be the exclusive registrar in the .com, .org and .net top level domains. Our revenue could havebe reduced due to increased competition, pricing pressures or a material adverse effectmodification of billing practices. For example, other entities may bundle domain name registrations with other products or services. See "Business -- Competition in the Registration Business." Our future success substantially depends on the Company'scontinued growth in the use of the Internet. If the use of and interest in the Internet does not continue to grow, our business financial conditionwould be harmed. Any significant problem with our systems or operations could result in lost revenue, customer dissatisfaction or lawsuits against us. A failure in the operation of our registration system could result in deletion of one or more domain names from the Internet for a period of time. A failure in the operation or update of the master database that we maintain could result in deletion of one or more top level domains from the Internet and resultsthe discontinuation of operations. See "Item 1-Business-Competitionsecond level domain names in those top level domains for a period of time. The inability of our registration system and -Risk Factors-Competition." The Company'stelecommunications systems to meet the demands of the increasing number of domain name registration requests and corresponding customer e-mails and telephone calls could result in substantial degradation in our customer support service and our ability to process registration requests in a timely manner. Our operations are dependent upon itsdepend on our ability to maintain itsour computer and telecommunications equipment in effective working order and to reasonably protect itsour systems against damageinterruption. The root zone servers and top level domain zone servers that we operate are critical hardware to our operations. Our failure, or the failure of third parties on which we rely, to adequately address Year 2000 compliance issues may cause us to lose revenue or to incur significant costs. The primary risks that we face with regard to Year 2000 failures are those which impact our domain name registration business. If we fail to solve a Year 2000 compliance problem with our mission critical business systems and processes, including the domain name servers under our control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by our employees, the result could be a failure of or interruption to normal business operations. On November 16, 1998, we announced the resignation of Gabriel A. Battista from fire, natural disaster, sabotage, power loss, telecommunication failure, human errorhis positions as Chief Executive Officer and Director. We cannot reasonably estimate at this time the potential impact on us of the hiring of a new Chief Executive Officer. We cannot be certain of the timing of our hiring of a new Chief Executive Officer or similar events. In addition,the effect of any delays in our hiring of a new Chief Executive Officer on the development or implementation of our strategic plan. Given the relative "newness" and rapid growth of the Company's customer base may put strainInternet, there is intense competition for the limited supply of people qualified to work for us. Our future success depends on the capacitycontinued service of its computerskey engineering, sales, marketing, executive and telecommunications systemsadministrative personnel, and our ability to attract, hire, integrate, train and retain such personnel. The loss of the Company's inabilityservices of any of our senior management team or other key employees or our failure to sufficientlyattract, integrate, train and retain additional key employees could harm our business. We may not be able to sustain the revenue growth we have experienced in recent periods. In addition, past revenue growth may not be indicative of future operating results. If we do not successfully maintain our current position as a leading provider of domain name registration services or upgrade its systemsdevelop or market additional services, our business could leadbe harmed. Our domain name registration services business generates over 90% of our revenue and is expected to degradationcontinue to account for a very significant portion of our revenue in performance or system failure.at least the near term. Our ability to achieve future revenue growth will also depend on our ability to continue to establish direct sales channels and to develop multiple distribution channels. To do this we must maintain relationships with Internet access providers and other third parties. 35 38 Because of our high level of uncollectible receivables, we continually review our billing practices. Any damage, failure or delaymodifications that causes significant interruptionswe implement as a result of these reviews could have unanticipated harmful consequences to our business. We have established a provision for uncollectible accounts which we believe to be adequate to cover anticipated uncollectible receivables; however, actual results could differ from our estimates. We are involved in the Company's systems would have a material adverse effect on the Company's business, financial condition and results of operations. The Company is a party in a number ofseveral legal proceedings. While the CompanyWe cannot reasonably estimate the potential impact of the claims advancedany of these proceedings. An adverse determination in the PG Media or Thomas suits, a successful claim against the Company in eitherany of these proceedings, however, could have a material adverse effect on the Company's business, financial condition and results of operation. In addition, while the Company cannot predict what relief, if any, might be sought, awarded or imposed as a result of any civil action filed by the Department of Justice arising from its investigation regarding Internet registration products and services, any such relief could have a material adverse effect on the Company's business, 48 49 financial condition and results of operation. Moreover, litigationharm our business. Legal proceedings in which the Company iswe are involved has resultedare expensive and likely will result in, and any future litigation can be expected to result in, substantial legal and other expenses to the Company and a diversion of the Company'sdivert our personnel. See "Item 3 --- Legal Proceedings." The Company isOur quarterly operating results may fluctuate significantly in the processfuture due to a variety of assessing its computer software applications and systems to ensure their functionality with respect to the "Year 2000" millenium change. At this time, the Company believes that the remediation costs, if any, needed to make all of its internal applications and systems Year 2000 compliant are not material. Although the Company believes that its internal mission critical systems are Year 2000 compliant, the failure of the software applications or internal systems of other companies on which the Company's systems rely or to which they are connected or of other Internet-related companies, including Internet web hosting companies, Internet access providers, or Internet root server operators, nonefactors, some of which are beyond our control. In addition, we expect a significant increase in our operating expenses. If the Company controls, toincrease in our expenses is not followed by an increase in our revenue, our operating results will be Year 2000 compliant upon January 1, 2000 couldharmed. The fact that in the past our revenues have increased and we have been profitable on a material adverse effectquarterly and annual basis is not indicative of whether our revenues will increase or whether we will be profitable on a quarterly or annual basis in the operation of the Internet and/or a material adverse effect on the Company's business, financial condition and results of operation. See "Item 1-Business-Risk Factors - Year 2000."future. SELECTED QUARTERLY RESULTS OF OPERATIONS The following tables set forth certain unaudited quarterly financial information for 1996each of the eight quarters in the years ended December 31, 1997 and 1997.1998. In the opinion of management, this information has been presented on the same basis as the audited financial statements referenced in this Form 10-K, and all necessary adjustments (consisting only of normal recurring adjustments) have been included in the amounts stated below to present fairly the selected unaudited quarterly results when read in conjunction with the audited financial statements of the CompanyNetwork Solutions and notes thereto. The operating results of operations for any quarter are not necessarily indicative of results for any future periods. 49 50period.
Quarter Ended -------------------------------------------------------------------------------------------- Mar.QUARTER ENDED --------------------------------------------------------------------------------------- MAR. 31, Jun.JUNE 30, Sep.SEPT. 30, Dec.DEC. 31, Mar.MAR. 31, Jun.JUNE 30, Sep.SEPT. 30, Dec.DEC. 31, 1996 1996 1996 1996 1997 1997 1997 1997 1998 1998 1998 1998 -------- -------- --------- -------- -------- -------- --------- -------- -------- -------- -------- -------- (in thousands, except per share data)(IN THOUSANDS, EXCEPT PER SHARE DATA) Net revenue $ 2,333 $ 4,496 $ 5,180 $ 6,853 $ 8,655 $ 10,069 $ 12,172 $ 14,430revenue................. $8,655 $10,069 $12,172 $14,430 $16,492 $20,476 $25,427 $31,257 Cost of revenue 2,950 3,571 3,719 4,426revenue............. 5,294 6,141 7,033 7,330 -------- -------- -------- -------- -------- -------- -------- --------7,348 8,791 10,312 12,079 ------ ------- ------- ------- ------- ------- ------- ------- Gross profit (617) 925 1,461 2,427profit................ 3,361 3,928 5,139 7,100 9,144 11,685 15,115 19,178 Research and development expenses - 58 226 396expenses.................. 311 407 377 558 725 815 1,353 1,928 Selling, general and administrative expenses 921 1,449 1,932 1,978expenses... 2,301 2,487 3,105 4,375 6,182 8,008 10,248 12,706 Interest expense (income), net - (86) (288) (122)income............. (149) (335) (570) (1,041) -------- -------- -------- -------- -------- -------- -------- --------(1,292) (1,384) (1,654) (1,857) ------ ------- ------- ------- ------- ------- ------- ------- Income (loss) before income taxes (1,538) (496) (409) 175taxes..................... 898 1,369 2,227 3,208 3,529 4,246 5,168 6,401 Provision (benefit) for income (436) (140) (116) 49taxes..................... 382 629 995 1,465 taxes -------- -------- -------- -------- -------- -------- -------- --------1,480 1,783 2,163 2,683 ------ ------- ------- ------- ------- ------- ------- ------- Net income (loss) $ (1,102) $ (356) $ (293) $ 126income.................. $ 516 $ 740 $ 1,232 $ 1,743 ======== ======== ======== ======== ======== ======== ======== ========$ 2,049 $ 2,463 $ 3,005 $ 3,718 ====== ======= ======= ======= ======= ======= ======= ======= Basic and diluted EPS(1)EPS (1)............... $ (0.09)0.02 $ (0.03)0.03 $ (0.02) $ 0.01 $ 0.040.05 $ 0.06 $ 0.100.07 $ 0.08 $ 0.09 $ 0.11 ======== ======== ======== ======== ======== ======== ======== ============== ======= ======= ======= ======= ======= ======= ======= Diluted EPS (1)............. $ 0.02 $ 0.03 $ 0.05 $ 0.05 $ 0.06 $ 0.07 $ 0.09 $ 0.11 ====== ======= ======= ======= ======= ======= ======= =======
- --------------- (1) All per share data reflect the two-for-one stock split in March, 1999. Since there are changes in the weighted average number of shares outstanding each quarter, the sum of the quarterly basic and diluted EPS amounts may not equal the basic and diluted EPS for calendar years 19961997 and 1997. 501998. 36 5139
Quarter Ended ----------------------------------------------------------------------------- Mar.QUARTER ENDED --------------------------------------------------------------------------------------- MAR. 31, Jun.JUNE 30, Sep.SEPT. 30, Dec.DEC. 31, Mar.MAR. 31, Jun.JUNE 30, Sep.SEPT. 30, Dec.DEC. 31, 1996 1996 1996 1996 1997 1997 1997 1997 1998 1998 1998 1998 -------- -------- --------- -------- -------- -------- --------- -------- -------- -------- -------- -------- (as a percentage of revenue)(AS A PERCENTAGE OF NET REVENUE) Net revenuerevenue.................. 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Cost of revenue 126.4 79.4 71.8 64.6revenue.............. 61.2 61.0 57.8 50.8 44.6 42.9 40.6 38.6 ----- ----- ----- ----- ----- ----- ----- ----- Gross profit (26.4) 20.6 28.2 35.4profit................. 38.8 39.0 42.2 49.2 55.4 57.1 59.4 61.4 Research and development expenses - 1.3 4.4 5.8expenses................... 3.5 4.0 3.1 3.9 4.4 4.0 5.3 6.1 Selling, general and administrative expenses 39.5 32.2 37.3 28.9expenses.... 26.6 24.7 25.5 30.3 37.4 39.1 40.3 40.7 Interest expense (income), net - (1.9) (5.6) (1.8)income.............. (1.7) (3.2) (4.7) (7.2) (7.8) (6.7) (6.5) (5.9) ----- ----- ----- ----- ----- ----- ----- ----- Income (loss) before income taxes (65.9) (11.0) (7.9) 2.5taxes... 10.4 13.5 18.3 22.2 21.4 20.7 20.3 20.5 Provision (benefit) for income taxes (18.7) (3.1) (2.2) 0.7taxes... 4.4 6.2 8.2 10.1 9.0 8.7 8.5 8.6 ----- ----- ----- ----- ----- ----- ----- ----- Net income (loss) (47.2)% (7.9)% (5.7)% 1.8%income................... 6.0% 7.3% 10.1% 12.1% 12.4% 12.0% 11.8% 11.9% ===== ===== ===== ===== ===== ===== ===== =====
The CompanyNetwork Solutions has experienced quarterly fluctuations in operating results and anticipates that such fluctuations will continue. These fluctuations may be caused by, among other things, increases in legal and marketing expenses, market acceptance of new products, competitive pricing pressures and general economic conditions. As a result of the foregoing and other factors, the CompanyNetwork Solutions believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied on as indications of future performance. See "Factors Affecting Operating Results" and "Item 1 --- Business --- Risk Factors - Potential Fluctuations in-- Our Quarterly Results.Operating Results May Fluctuate; Our Future Revenue and Profitability are Uncertain." The Company'sNetwork Solutions' net revenue increased each quarter presented primarily due to an increase in the number of cumulative net registrations in each of those quarters. The CompanyNetwork Solutions currently expects registration services revenue for the first quarter of 19981999 to show continued growth based upon its existing registration base and net new registrations during the quarter. However, there can be no assurance that net registration revenue will continue to increase at historical rates, or at all, or not decrease in the future, especially when the Cooperative Agreement is terminated or if there is a change in the Company'sNetwork Solutions' status as the exclusive registry and registrar for domain names in the .com, TLD,.net and .org top level domains, particularly as a significant portion of the Company'sNetwork Solutions' net revenue is attributable to registrations in the .com TLD.top level domains. Notwithstanding the $61.5$129.2 million of deferred revenue at December 31, 1997,1998, of which $43.8$93.7 million will be recognized as revenue in 1998, the Company's1999, Network Solutions' revenue is dependent in large part on the continued growth of the Internet, the Company'sNetwork Solutions' ability to maintain its position as the leading Internet domain name registration service provider worldwide and the evolving nature of the Company'sNetwork Solutions' services, products and other factors. Operating expenses have generally increased in absolute dollars in each quarter shown as the CompanyNetwork Solutions has increased staffing and related infrastructure costs in its back office, selling and marketing, and administrative functions. Quarter-to-quarter growth in cost of revenue was primarily attributable to increased staffing levels and increased outsourcing costs which are a function of the number of registrants. Quarter-to-quarter growth in selling, general and administrative expenses are attributable to increased staffing at the management level, continuing legal expenses and marketing costs associated with the introduction of new services and products. 51 52 LIQUIDITY AND CAPITAL RESOURCES From the time of its acquisition by SAIC in March 1995 until December 1996, the CompanyNetwork Solutions participated in SAIC's centralized cash management system whereby cash received from operations was transferred to SAIC's centralized cash accounts and cash disbursements were funded 37 40 from such centralized cash accounts. Accordingly, cash requirements for operating purposes and for capital expenditures were met from this source. Beginning in 1997, the CompanyNetwork Solutions implemented its own cash management system. At December 31, 1998, Network Solutions' principal source of liquidity was its cash and cash equivalents of $12.9 million and its short-term investments of $118.8 million, which when combined represent an increase of $50.3 million from the December 31, 1997 the Company'sbalance in those accounts. Network Solutions also has $9.4 million of marketable securities held as long term investments as of December 31, 1998. At December 31, 1998, Network Solutions' cumulative net obligation to SAIC for intercompany activity was $1.3$4.8 million, a decreasenet increase of $14.0$3.5 million for the year then ended.from December 31, 1997. Intercompany activity is primarily comprised of corporate income tax payments made by SAIC on behalf of the Company in accordance with the companies' tax sharing arrangement and salaries and benefits paid by SAIC on behalf of the Company. Effective with the second quarter of 1997, corporate taxes were paid toNetwork Solutions. Network Solutions currently reimburses SAIC on a quarterly basis, with all otherfor intercompany balances between SAIC and the Company paidactivity on a monthly basis. Pursuant to the Tax Sharing Agreementa tax sharing agreement with SAIC dated September 26, 1997, the Company willNetwork Solutions now generally remitremits income tax payments directly to tax authorities as it no longer is part of SAIC's consolidated group for federal income tax purposes. The Company completed its initial public offering on October 1, 1997, raising $52.4 million for the Company. From these net proceeds, the Company paid a $10 million dividend to SAIC on October 1, 1997. Cash provided by operations was $41.1$63.4 million in 1997.for the year ended December 31, 1998. This amount is principally attributed to net income plus the increase in deferred revenue reflecting cash collected in advance of registration services revenue recognition which occurs ratably over the two- andtwo-and one-year registration terms. Partially offsetting this amount is an increase in deferred tax assets resulting from accelerated revenue recognition for tax purposes and the subsequentassociated tax liabilities. The net repayment of $14.0 million to SAIC during 1997 effectively reduces the cash provided by operations to $27.1 million. Investing activities used $43.4totaled $104.7 million in 1997,for the year ended December 31, 1998, of which $40.2$78.0 million was net purchases of short-term investments and $13.6 million of long-term investments. These investments are primarily comprised of commercial short-term investment grade securities. Purchases of furniture and equipment ofCapital expenditures were $3.2 million and $13.1 million for the years ended December 31, 1997 represents an increaseand December 31, 1998, respectively. These expenditures were primarily for computer equipment. Network Solutions will continue to invest in the back office infrastructure in advance of $1.3 million from 1996. In addition, the Company acquired $2.4 million of equipment through a capital lease transaction. The majority of current and anticipated future capital acquisitions are to supportcontinued growth in the domain name registrations and as Network Solutions designs and builds the shared registration business and are expected to be acquired through capital purchases as well as financed under various operating and capital lease agreements ranging from 24 to 36 months. The Companysystem in accordance with the Cooperative Agreement. Network Solutions believes that the net proceeds from its IPO, combined with its existing cash balance, short-term investments and cash flows expected from future operations will be sufficient to meet the Company'sNetwork Solutions' capital requirements for at least the next 12 months. YEAR 2000 COMPLIANCE Network Solutions is continually assessing the potential effects of the "Year 2000" millennium change on Network Solutions' business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees and its outsourcing vendors. Network Solutions' Year 2000 project is proceeding on schedule. The project goal is to 18 months. 52ensure that Network Solutions' business is not impacted by the date transitions associated with the Year 2000. Network Solutions' Year 2000 project plan is coordinated by a team that reports directly to senior management. The project team is evaluating the Year 2000 compliance of Network Solutions' business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees and its outsourcing vendors whom 38 5341 provide services relating to Network Solutions' domain name registration business. Network Solutions' Year 2000 project is comprised of the following parallel phases: - Phase 1 -- Inventory all of Network Solutions' business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees in order to assign priorities to potentially impacted systems and services. This phase has been completed; - Phase 2 -- Assess the Year 2000 compliance of all inventoried business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees and determine whether to renovate or replace any non-Year 2000 compliant systems and services. The assessment of mission critical systems has been completed however, assessment continues as a life cycle development activity; - Phase 3 -- Complete remediation of any non-Year 2000 compliant business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees. Conduct procurements to replace any other non-Year 2000 compliant business systems and processes, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees that won't be remediated. All remediation efforts are expected to be completed by June 30, 1999; - Phase 4 -- Test and validate remediated and replacement systems, if any such remediation or replacement is required, to ensure inter-system compliance and mission critical system functionality. The testing and validation efforts, if any are required, are expected to be completed by August 31, 1999; - Phase 5 -- Deploy and implement remediated and replacement systems after the completion of successful testing and validation. The deployment and implementation of the remediated or replacement systems are expected to be completed by October 30, 1999; and - Phase 6 -- Design contingency and business continuation plans in the event of the failure of business systems and processes, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by Network Solutions' employees due to the Year 2000 millennium change. The initial contingency and business continuation plan has been developed. The final contingency plan will be completed during the second quarter of 1999 and it will be updated throughout the year as appropriate. Based on its inventory and assessment, Network Solutions has found that less than one-half of one percent of the software code of its mission critical systems needs to be remediated to be made Year 2000 compliant. However, Network Solutions, in its normal course of business, anticipates replacing or upgrading, prior to the millennium change, portions of these systems with new systems which will also be Year 2000 compliant. Currently, Network Solutions is enhancing its "back-office" and registration-related systems and the software relating to its core domain name registration services business. When complete in 1999, this enhancement effort will result in replacing portions of the existing registration-related systems which will be procured from vendors as Year 2000 compliant and will be subjected to both component and end-to-end testing and validation to determine the Year 2000 compliance of such systems prior to acceptance and deployment in Network Solutions' business. This enhancement effort is a function of Network Solutions' business growth and not a Year 2000 remediation effort. 39 42 Based on its inventory and assessment, Network Solutions has found no material Year 2000 problems with its facilities and telecommunications systems. Network Solutions has conducted detailed assessments of the components of its telecommunications infrastructure and is working to identify appropriate system testing guidelines. In addition, Network Solutions is seeking assurances from its facilities' landlords and telecommunications equipment vendors and data circuit providers regarding the Year 2000 compliance of their facilities and equipment. In the event of electrical power interruption outside of Network Solutions' control, Network Solutions has deployed back-up power systems capable of operating its core business indefinitely. Network Solutions is now in the remediation and testing phases of its project cycle. At this time, Network Solutions believes that its incremental remediation costs needed to make its current business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees Year 2000 compliant are not material. While Network Solutions is incurring some incremental costs directly relating to staff augmentation for the Year 2000 program management and technical assessment, the costs expended by Network Solutions through December 31, 1998 are less than $250,000. Network Solutions' expected total costs, including remediation and replacement costs, are estimated to be between $1,000,000 and $1,500,000 over the life of the Year 2000 project. Since portions of the mission critical "back office" and domain name registration-related systems will generally be replaced as a function of business growth, the labor and capital costs associated with such replacement systems are not directly attributed to achieving Year 2000 compliance. Network Solutions will also incur costs for extending its software testing architecture which, in addition to testing remediated systems, will be used as a normal component of Network Solutions quality assurance infrastructure. As such these costs are not directly categorized as Year 2000 project costs but as normal business development and engineering costs. Network Solutions is contacting its hardware and software vendors, significant suppliers, outsourcing service providers and contracting parties to determine the extent to which Network Solutions is vulnerable to any such third party's failure to achieve Year 2000 compliance for their own systems. At the present time, Network Solutions does not expect Year 2000 issues of any such third parties to materially affect Network Solutions' business. Furthermore, Network Solutions' business depends on the continued operation of, and widespread access to, the Internet. This, in turn, depends to a large extent on the software and systems of third parties on which Network Solutions' systems rely or to which they are connected. These third parties include, among others, Internet-related companies, including Internet web hosting companies, Internet access providers and Internet domain name server operators. Network Solutions can give no assurances that the software or systems of such third parties will be Year 2000 compliant or that the failure of such third parties to achieve Year 2000 compliance will not have a material adverse effect on Network Solutions. To the extent that the normal operation of the Internet is disrupted by the Year 2000 millennium change, Network Solutions' business, financial condition or results of operations could be materially and adversely affected. Should Network Solutions fail to solve a Year 2000 compliance problem to its mission critical business systems and processes, including the Internet domain name servers under Network Solutions' control, telecommunications systems, facilities, data-networking infrastructure, commercial-off-the-shelf hardware, software and components used by its employees, the result could be a failure or interruption to normal business operations. Network Solutions believes that, with the deployment of the new "back office" and domain name registration related systems in 1999, the potential for significant interruptions to normal operations should be minimized. Network Solutions' primary risks 40 43 with regard to Year 2000 failures are those which impact its domain name registration business. The reasonably likely worst case risks inherent in Network Solutions' business are as follows: - Significant and protracted interruption of electrical power to data and call-center operations in Network Solutions' engineering facility could materially and negatively impact Network Solutions' ability to provide data and call-center operations. To mitigate this risk, Network Solutions has deployed back-up power systems capable of operating indefinitely. However, electrical power interruptions that impact Internet connectivity providers could adversely impact Network Solutions because of Network Solutions' reliance upon Internet-based operations for its day to day business. - Significant and protracted interruption of telecommunications and data network services in either of Network Solutions' headquarters or engineering facilities could materially and negatively impact Network Solutions' ability to provide data and call-center operations. Network Solutions has conducted detailed assessments of the components of its telecommunications infrastructure and is working to identify appropriate system testing guidelines. As part of its technical assessment, Network Solutions identified the compliance status of its data networking infrastructure and developed plans for remediation. Finally, Network Solutions has plans to seek additional assurances and a better understanding of the compliance programs of its telecommunications and data circuit providers. - The failure of components of Network Solutions' current "back office" and domain name registration related systems could materially and negatively impact Network Solutions' business. However, as a function of business growth, these systems are planned to be retired before the end of 1999. As a contingency planning measure, Network Solutions has conducted a technical assessment of the current systems and their software applications in the event that the deployment of the new systems is delayed beyond December 1999. - Despite the assurances of Network Solutions' third-party suppliers, hardware and software vendors, and outsourcing service providers regarding the Year 2000 compliance of their products and services, the potential exists that a Year 2000 problem relating to such third-party suppliers, vendors and outsourcing service providers products and services could have a material impact on Network Solutions' business. Network Solutions is conducting monthly discussions with its mission critical outsourcing service providers to determine the progress of their Year 2000 compliance programs. Although Network Solutions has found that it only has to remediate a small portion of its software code in its internal mission critical systems and despite Network Solutions' expectation that its enhancement effort will result in Year 2000 compliant "back-office" and registration-related systems and software relating to its core domain name registration services business, Network Solutions is currently developing a business continuation contingency plan and is performing a test on the existing core registration-related systems that are being replaced. Network Solutions finalized its initial contingency plan and completed testing of all existing systems. The final business continuation plan will be completed during the second quarter of 1999 and will be updated as appropriate throughout the year. Although Network Solutions is taking appropriate steps so that Network Solutions' business is not impacted by the date transitions associated with the Year 2000, Network Solutions has no responsibility for, nor control over other Internet domain name server operators or tens of thousands of lower level domain name system server operators that are critical to the efficient operation of the Internet. Network Solutions has not determined whether such domain name server operators or other server operators have hardware, software or firmware that is Year 2000 compliant. Network Solutions has notified the Department of Commerce of this issue. 41 44 Forward-Looking Statements The foregoing Year 2000 discussion and the information contained herein is provided as a "Year 2000 Readiness Disclosure" as defined in the Year 2000 Information and Readiness Disclosure Act of 1998 (Public Law 105-271, 112 Stat. 2386) enacted on October 19, 1998 and contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements, including without limitation, anticipated costs and the dates by which Network Solutions expects to complete certain actions, are based on management's best current estimates, which were derived utilizing numerous assumptions about future events, including the continued availability of certain resources, representations received from third parties and other factors. However, there can be no guarantee that these estimates will be achieved, and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the ability to identify and remediate all relevant systems, results of Year 2000 testing, adequate resolution of Year 2000 issues by governmental agencies, businesses and other third parties who are outsourcing service providers, suppliers, and vendors of Network Solutions, unanticipated system costs, the adequacy of and ability to implement contingency plans and similar uncertainties. The "forward-looking statements" made in the foregoing Year 2000 discussion speak only as of the date on which such statements are made, and Network Solutions undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Network Solutions is exposed to the impact of interest rate changes and change in the market values of its investments. INTEREST RATE RISK. Not applicable.Network Solutions' exposure to market rate risk for changes in interest rates relates primarily to the Company's investment portfolio. Network Solutions has not used derivative financial instruments in its investment portfolio. Network Solutions invests its excess cash in debt instruments of the U.S. Government and its agencies, and in high-quality corporate issuers and, by policy, limits the amount of credit exposure to any one issuer. The Company protects and preserves its invested funds by limiting default, market and reinvestment risk. Investments in both fixed rate and floating rate interest earning instruments carries a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, the Company's future investment income may fall short of expectations due to changes in interest rates or the Company may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. INVESTMENT RISK. The Company has invested in the equity instruments of a privately-held, information technology company for business and strategic purposes. This investment is included in other long-term assets and is accounted for under the cost method which approximates fair value. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.DATA The financial statements required by this item are set forth in a separate section of this Annual Report on Form 10-K as indicated in the "Index to Financial Information" appearing on page F-1 and is incorporated herein by reference. The supplementary data required by this item are set forth under the "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations" beginning on page 4028 hereof and are incorporated herein by reference. 42 45 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.REGISTRANT As permitted by General Instruction G(3) to Form 10-K, the information relating to nominees for election as directors of Network Solutions set forth under the caption "Election of Directors" in Network Solutions' definitive Proxy Statement for the annual meeting of stockholders to be held on May 19, 1998,18, 1999, which Proxy Statement will be filed with the Commission within 120 days after the end of the Company's fiscal year ended December 31, 1997,1998, is incorporated by reference. The information on executive officers set forth under the caption "Executive Officers of the Registrant" beginning on page 3422 hereof is incorporated herein by reference. The information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, set forth under the caption "Security Ownership of Certain Beneficial Owners and Management --- Section 16(a) Beneficial Ownership Reporting Compliance" in Network Solutions' definitive Proxy Statement for the annual meeting of stockholders to be held on May 19, 1998,18, 1999, which Proxy Statement will be filed with the Commission within 120 days after the end of the Company's fiscal yearYear ended December 31, 1997,1998, is incorporated by reference. ITEM 11. EXECUTIVE COMPENSATION.COMPENSATION As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference from the Sections entitled "Proposal Number 1 --- Election of Directors --- Compensation of Directors," "Executive Compensation" and "Compensation Committee Interlocks and Insider Participation" in Network Solutions' definitive Proxy Statement for the annual meeting of stockholders to be held on May 19, 1998,18, 1999, which Proxy Statement will be filed with the Commission within 120 days after the end of the Company's fiscal year ended December 31, 1997. 53 541998. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.MANAGEMENT As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference from the Section entitled "Security Ownership of Certain Beneficial Owners and Management" in Network Solutions' definitive Proxy Statement for the annual meeting of stockholders to be held on May 19, 1998,18, 1999, which Proxy Statement will be filed with the Commission within 120 days after the end of the Company's fiscal year ended December 31, 1997.1998. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.TRANSACTIONS As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference from the Section entitled "Relationship with SAIC and Certain Transactions" in the Company's definitive Proxy Statement for the annual meeting of stockholders to be held on May 19, 1998,18, 1999, which Proxy Statement will be filed with the Commission with 120 days after the end of the Company's fiscal year ended December 31, 1997.1998. 43 46 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.8-K (a) Documents filed as part of this report 1. Financial Statements. The list of financial statements set forth under the caption "Index to Financial Information" on page F-1 is incorporated herein by reference. 2. Financial Statement Schedules. The list of financial statement schedules set forth under the caption "Index to Financial Information" on page F-1 is incorporated herein by reference. All other schedules have been omitted, as the required information is inapplicable or the information is presented in the financial statements or related notes. 3. Exhibits
Exhibit Number Description of DocumentEXHIBIT NUMBER DESCRIPTION OF DOCUMENT - ----------------- ----------------------- 3(i)**3(i) Second Amended and Restated Certificate of Incorporation. **3(ii) Second Amended and Restated Bylaws of Network Solutions, Inc., as amended February 9,May 1, 1998. 4.1**4.1 Form of Common Stock Certificate. 4.2**4.2 Reference is made to Exhibits 3(i) and 3(ii). 10.1**10.1 Cooperative Agreement between the National Science Foundation and Network Solutions, Inc., as amended by Amendments Nos. 1, 2, 3 and 5. 10.2**10.2 Amendment No. 4 to the Cooperative Agreement dated September 13, 1995. 10.3**10.3 Master Services Agreement for System Management Services dated January 21, 1997 by and between NationsBanc Services, Inc. and Network Solutions, Inc. 10.4*+ 1996 Stock Incentive Plan and forms of agreements thereunder.
54 55 10.5**+10.4 1996 Stock Incentive Plan and forms of agreements thereunder. *10.5 Corporate Services Agreement between Network Solutions, Inc. and Science Applications International Corporation. 10.6**10.6 Tax Sharing Agreement between Network Solutions, Inc. and Science Applications International Corporation. 10.7**10.7 Registration Rights Agreement between Network Solutions, Inc. and Science Applications International Corporation. 10.8**10.8 Noncompetition and Corporate Opportunities Agreement between Network Solutions, Inc. and Science Applications International Corporation. 10.9*+*+10.9 Letter Agreement dated September 16, 1996 between the Company and Gabriel A. Battista, as amended as of September 23, 1996. 10.10**10.10 Science Applications International Corporation Employee Stock Ownership Plan and amendments thereto. 10.11**10.11 Science Applications International Corporation 1995 Stock Option Plan. 10.12**10.12 Letter dated September 13, 1995 regarding Amendment No. 4 to the Cooperative Agreement. 10.13**10.13 Asset Transfer Agreement between Network Solutions, Inc. and Science Applications International Corporation. 10.14**10.14 Amendment No. 6 to the Cooperative Agreement dated June 23, 1997. 10.15****+10.15 1997 Employee Stock Purchase Plan. ******10.16 Amendment No. 7 to the Cooperative Agreement dated December 3, 1997.
44 47
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT - ----------- ----------------------- ******10.17 Amendment No. 8 to the Cooperative Agreement dated February 20, 1998. ******10.18 Amendment No. 9 to the Cooperative Agreement dated March 12, 1998. 10.19++10.19 Form of Indemnification Agreement entered into by the Company and each of its directors and officers at the Vice President level or above. ******10.20 Deed of Lease By and Between Sugarland Business Park Limited Partnership and Network Solutions, Inc. dated May 30, 1997 ("Lease Agreement"). ******10.21 Amendment No. 1 to Lease Agreement dated January 31, 1998. ****10.22 Amendment No. 10 to the Cooperative Agreement dated September 29, 1998. *****10.23 Amendment No. 11 to the Cooperative Agreement dated October 6, 1998. 10.24 Amendment No. 12 to the Cooperative Agreement dated March 12, 1999. 23.1 Consent of Price WaterhousePricewaterhouseCoopers LLP. 27.1 Financial Data Schedule (in electronic format only). 27.2 Restated Financial Data Schedule (in electronic format only). 27.3 Restated Financial Data Schedule (in electronic format only).
- --------------- * Incorporated by reference from Network Solutions, Inc.'s Registration Statement on Form S-1 (Registration No. 333-30705). ** Incorporated by reference from Network Solutions, Inc.'s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1998. *** Incorporated by reference from Network Solutions, Inc.'s Registration Statement on Form S-8 (Registration No. 333-43821). **** Incorporated by reference from Network Solutions, Inc.'s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998. ***** Incorporated by reference from Network Solutions, Inc.'s Report on Form 8-K dated October 9, 1998. ****** Incorporated by reference from Network Solutions, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1997. + Executive Compensation Plans and Arrangements. We own or have rights to various copyrights, trademarks and trade names used in our business. These include Network Solutions, Inc.(R), WorldNIC(TM), RegistrationPlus(TM), dot com mail(TM), dot com toolkit(TM), dot com promotions(TM), dot com people(TM) and RegistrationPlus(TM) aredot com family(TM). This Annual Report on Form 10-K also includes trademarks, service marks and trade names of the Company.other companies. (b)Reports on Form 8-K NoThe following reports on Form 8-K were filed during the last quarter ended December 31, 1998: On October 9, 1998, we filed a report on Form 8-K, pursuant to Item 5 on such form, to report our entering into Amendment 11 to our Cooperative Agreement with the United States Department of fiscal year 1997. 55 56 SIGNATURES Pursuant toCommerce. Amendment 11, among other things, extends the requirements of Section 13 or 15(d)flexibility period of the Securities Exchange ActCooperative Agreement through September 30, 2000. On November 20, 1998, we filed a report on Form 8-K, pursuant to Item 5 on such form, to report the resignation of our Chief Executive Officer and Director, Gabriel A. Battista. 45 48 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 31, 1998THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. NETWORK SOLUTIONS, INC. By: /s/ GABRIELMICHAEL A. BATTISTA ---------------------------- GabrielDANIELS ------------------------------------ MICHAEL A. Battista Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act ofDANIELS CHAIRMAN OF THE BOARD AND ACTING CHIEF EXECUTIVE OFFICER Dated: March 30, 1999 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, as amended, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the dates set forth below.THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES INDICATED ON THE DATES INDICATED.
Name Title DateNAME TITLE DATE ---- ----- ---- /s/ GABRIELMICHAEL A. BATTISTADANIELS Chairman of the Board and Acting Chief March 30, 1999 - -------------------------- Chief---------------------------------- Executive Officer and Director March 31, 1998 GabrielMICHAEL A. BattistaDANIELS /s/ ROBERT J. KORZENIEWSKI - -------------------------- Chief Financial Officer (Principal Financial March 31, 1998 Robert30, 1999 - ---------------------------------- Officer) and Acting Chief Operating Officer ROBERT J. Korzeniewski Financial Officer)KORZENIEWSKI /s/ MICHAEL G. VOSLOW - -------------------------- Vice President, Finance and Treasurer March 31, 1998 Michael G. Voslow30, 1999 - ---------------------------------- (Principal Accounting Officer) /s/ MICHAEL A. DANIELS - -------------------------- Chairman of the Board March 31, 1998 Michael A. DanielsG. VOSLOW /s/ J. ROBERT BEYSTER - -------------------------- Director March 31, 199830, 1999 - ---------------------------------- J. Robert BeysterROBERT BEYSTER /s/ CRAIG I. FIELDS - -------------------------- Director March 31, 1998 Craig30, 1999 - ---------------------------------- CRAIG I. FieldsFIELDS /s/ JOHN E. GLANCY - -------------------------- Director March 31, 1998 John30, 1999 - ---------------------------------- JOHN E. GlancyGLANCY /s/ J. D. HEIPT Director March 30, 1999 - ---------------------------------- J. DENNIS HEIPT - --------------------------/s/ W. A. ROPER, JR. Director March 31, 1998 J. Dennis Heipt /s/30, 1999 - ---------------------------------- WILLIAM A. ROPER, JR. - -------------------------- Director March 31, 1998 William A. Roper, Jr. /s/ STRATTON D. SCLAVOS - -------------------------- Director March 31, 1998 Stratton30, 1999 - ---------------------------------- STRATTON D. Sclavos
56 57
Name Title Date ---- ----- ---- SCLAVOS /s/ DonaldDONALD N. Telage - --------------------------TELAGE Director March 31, 1998 Donald30, 1999 - ---------------------------------- DONALD N. TelageTELAGE
5746 5849 INDEX TO FINANCIAL INFORMATION
Page ReferencePAGE REFERENCE --------- Report of Independent Accountants......................................................... F-2, F-3Accountants........................... F- 2 1. Financial Statements: Statements of Financial Position as of December 31, 19961997 and 1997................ F-41998............................................... F- 3 Statements of Operations for the Periods from January 1, 1995 to March 10, 1995 and March 11, 1995 to December 31, 1995, and for the Years Ended December 31, 1996, 1997 and 1997................................................. F-51998.................................... F- 4 Statements of Changes in Stockholders' Equity for the Periods from January 1, 1995 to March 10, 1995 and March 11, 1995 toYears Ended December 31, 1995,1996, 1997 and 1998........... F- 5 Statements of Cash Flows for the Years Ended December 31, 1996, 1997 and 1997......................... F-6 Statements of Cash Flows for the Periods from January 1, 1995 to March 10, 1995 and March 11, 1995 to December 31, 1995, and for the Years Ended December 31, 1996 and 1997................................................. F-71998.................................... F- 6 Notes to Financial Statements.................................................... F-8Statements............................ F- 7 2. Financial Statement Schedule: Valuation and Qualifying Accounts and Reserves................................... F-24Reserves........... F-23
F-1 59 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Network Solutions, Inc. In our opinion, the financial statements listed in the index appearing on page F-1 present fairly, in all material respects, the results of operations and cash flows for Network Solutions, Inc. ("Predecessor") for the period from January 1, 1995 to March 10, 1995 in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. As discussed in Note 1 to the financial statements, on March 10, 1995 Science Applications International Corporation acquired the outstanding stock of the Company. The financial statements for the periods subsequent to March 10, 1995 have been prepared on the basis of accounting arising from this acquisition. The financial statements for the period from January 1, 1995 to March 10, 1995 are presented on the Company's previous basis of accounting. /s/ PRICE WATERHOUSE LLP PRICE WATERHOUSE LLP Falls Church, VA February 6, 1998 F-2 6050 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Network Solutions, Inc. In our opinion, the financial statements listed in the index appearing on page F-1 present fairly, in all material respects, the financial position of Network Solutions, Inc. (a majority-owned subsidiary of Science Applications International Corporation) at December 31, 19971998 and 1996,1997 and the results of its operations and its cash flows for each of the yearthree years in the period ended December 31, 1997 and 1996 and for the period from March 11, 1995 to December 31, 19951998 in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 1 to the financial statements, on March 10, 1995 Science Applications International Corporation acquired the outstanding stock of the Company. The financial statements for the periods subsequent to March 10, 1995 have been prepared on the basis of accounting arising from this acquisition. The financial statements for the period from January 1, 1995 to March 10, 1995 are presented on the Company's previous basis of accounting. /s/ PRICE WATERHOUSEPRICEWATERHOUSECOOPERS LLP PRICE WATERHOUSEPRICEWATERHOUSECOOPERS LLP Falls Church,McLean, VA February 6, 1998 F-35, 1999 F-2 6151 NETWORK SOLUTIONS, INC. STATEMENTS OF FINANCIAL POSITION
DECEMBER 31, DECEMBER 31, 1996 1997 ------------- ------------- ASSETS1998 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 15,540,000equivalents................................. $ 41,146,000 $ 12,862,000 Short-term investments -investments.................................... 40,200,000 118,808,000 Accounts receivable, net 12,587,000net.................................. 5,792,000 22,628,000 Prepaids and other assets 936,000assets................................. 1,005,000 4,001,000 Deferred tax asset 10,087,000asset........................................ 20,153,000 40,508,000 Restricted assets 17,453,000assets......................................... 25,873,000 ------------- --------------- ------------ ------------ Total current assets 56,603,000assets.............................. 134,169,000 198,807,000 Furniture and equipment, net 2,266,000net................................ 6,146,000 16,005,000 Long-term investments....................................... -- 13,590,000 Deferred tax asset 4,968,000asset.......................................... 8,128,000 14,831,000 Goodwill, net 2,281,000net............................................... 1,177,000 ------------- -------------634,000 ------------ ------------ Total Assets $ 66,118,000 $ 149,620,000 ============= ============= Assets...................................... $149,620,000 $243,867,000 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable and accrued liabilities $ 2,581,000liabilities.................. $ 6,426,000 $ 28,287,000 Due to parent 15,295,000parent............................................. 1,250,000 4,766,000 Income taxes payable -payable...................................... 5,042,000 5,409,000 Current portion of capital lease obligations -obligations.............. 842,000 834,000 Deferred revenue, net 19,912,000net..................................... 43,789,000 93,720,000 Internet fund liability 17,453,000liability................................... 25,873,000 ------------- --------------- ------------ ------------ Total current liabilities 55,241,000liabilities......................... 83,222,000 133,016,000 Capital lease obligations -obligations................................... 1,081,000 247,000 Long-term deferred revenue, net 9,440,000net............................. 17,662,000 ------------- -------------35,474,000 ------------ ------------ Total liabilities 64,681,000liabilities................................. 101,965,000 168,737,000 Commitments and contingencies Stockholders' equity: Preferred stock, $.001 par value, authorized 10,000,000 shares; none issued and outstanding in 19961997 and 19971998... -- -- Class A common stock, $.001 par value; authorized 100,000,000 shares; 3,795,0007,590,000 and 9,140,372 issued and outstanding in 1997 -and 1998........................... 4,000 9,000 Class B common stock, $.001 par value; authorized 30,000,000 shares; 12,500,000 and 11,925,00023,850,000 issued and outstanding in 19961997 and 19971998.......................................... 12,000 12,00024,000 Additional paid-in capital 4,468,000capital................................ 56,451,000 72,331,000 Retained earnings (accumulated deficit)................... (8,812,000) 2,407,000 Accumulated deficit (3,043,000) (8,812,000) ------------- -------------other comprehensive income.................... -- 359,000 ------------ ------------ Total stockholders' equity 1,437,000equity........................ 47,655,000 ------------- -------------75,130,000 ------------ ------------ Total Liabilities and Stockholders' Equity $ 66,118,000 $ 149,620,000 ============= =============
The accompanying notes are an integral part of these financial statements. F-4 62 NETWORK SOLUTIONS, INC. STATEMENTS OF OPERATIONS
PREDECESSOR COMPANY --------------- -------------------------------------------------- JANUARY 1, 1995 MARCH 11, 1995 YEAR ENDED YEAR ENDED TO MARCH 10, TO DECEMBER 31, DECEMBER 31, DECEMBER 31, 1995 1995 1996 1997 --------------- ---------------- ------------ ------------ Net revenue $ 1,177,000 $ 5,309,000 $ 18,862,000 $ 45,326,000 Cost of revenue 884,000 4,820,000 14,666,000 25,798,000 ------------ ------------ ------------ ------------ Gross profit 293,000 489,000 4,196,000 19,528,000 Research and development expenses - - 680,000 1,653,000 Selling, general and administrative expenses 280,000 2,114,000 6,280,000 12,268,000 Interest income - - (496,000) (2,211,000) Other expenses 9,000 52,000 - 116,000 ------------ ------------ ------------ ------------ Income (loss) before income taxes 4,000 (1,677,000) (2,268,000) 7,702,000 Provision (benefit) for income taxes 48,000 (287,000) (643,000) 3,471,000 ------------ ------------ ------------ ------------ Income (loss) from continuing operations (44,000) (1,390,000) (1,625,000) 4,231,000 Loss from discontinued operations, net of income taxes (1,375,000) (28,000) - - ------------ ------------ ------------ ------------ Net income (loss) $ (1,419,000) $ (1,418,000) $ (1,625,000) $ 4,231,000 ============ ============ ============ ============ BASIC EARNINGS PER SHARE: - ------------------------- Income (loss) from continuing operations $ (0.04) $ (0.11) $ (0.13) $ 0.32 Loss from discontinued operations (1.32) - - - ------------ ------------ ------------ ------------ Net income (loss) $ (1.36) $ (0.11) $ (0.13) $ 0.32 ============ ============ ============ ============ DILUTED EARNINGS PER SHARE: - --------------------------- Income (loss) from continuing operations $ (0.04) $ (0.11) $ (0.13) $ 0.31 Loss from discontinued operations (1.32) - - - ------------ ------------ ------------ ------------ Net income (loss) $ (1.36) $ (0.11) $ (0.13) $ 0.31 ============ ============Equity........ $149,620,000 $243,867,000 ============ ============
The accompanying notes are an integral part of these financial statements. F-5statements F-3 6352 NETWORK SOLUTIONS, INC. STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITYOPERATIONS
CLASS A CLASS B COMMON STOCK COMMON STOCK TREASURY STOCK --------------------------- -------------------------- --------------------------- SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT --------------------------- -------------------------- ---------------------------YEAR ENDED DECEMBER 31, --------------------------------------- 1996 1997 1998 ----------- ----------- ----------- PREDECESSOR Balance, December 31, 1994 1,159,000 $ 12,000 110,000 $ (628,000) PurchaseNet revenue....................................... $18,862,000 $45,326,000 $93,652,000 Cost of treasury stock - - 7,000 (30,000) Net loss for the period from January 1 to March 10, 1995 - - - - ---------- ----------- ---------- ----------- Balance, March 10, 1995 1,159,000 $ 12,000 117,000 $ (658,000) ========== =========== ========== =========== - ------------------------------------------------------------------------------------------------------------------------------------ COMPANY Purchase of outstanding common stock by SAIC on March 10, 1995 - - 12,500,000 $ 12,000 Net loss for the period from March 11 to December 31, 1995 - - - - ---------- ----------- ---------- ---------- Balance, December 31, 1995 - - 12,500,000 12,000 Net loss for the year ended December 31, 1996 - - - - ---------- ----------- ---------- ---------- Balance, December 31, 1996 - - 12,500,000 12,000 Declaration of Class B dividend - - - - Conversion of Class B Common Stock 575,000 - (575,000) - Issuance of Class A Common Stock 3,220,000 $ 4,000 - - Net income for the year ended December 31, 1997 - - - - ---------- ----------- ---------- ---------- Balance, December 31, 1997 3,795,000 $ 4,000 11,925,000 $ 12,000 ========== =========== ========== ==========
ADDITIONAL RETAINED TOTAL PAID-IN EARNINGS STOCKHOLDERS' CAPITAL (DEFICIT) EQUITY ----------- ----------- ------------- PREDECESSOR Balance, December 31, 1994 $ 1,241,000 $ (373,000) $ 252,000 Purchase of treasury stock - - (30,000) Net loss for the period from January 1 to March 10, 1995 - (1,419,000) (1,419,000)revenue................................... 14,666,000 25,798,000 38,530,000 ----------- ----------- ----------- Balance, March 10, 1995Gross profit...................................... 4,196,000 19,528,000 55,122,000 Research and development expenses................. 680,000 1,653,000 4,821,000 Selling, general and administrative expenses...... 6,280,000 12,268,000 37,144,000 Interest income................................... (496,000) (2,211,000) (6,303,000) Other expenses.................................... -- 116,000 116,000 ----------- ----------- ----------- Income (loss) before income taxes................. (2,268,000) 7,702,000 19,344,000 Provision (benefit) for income taxes.............. (643,000) 3,471,000 8,109,000 ----------- ----------- ----------- Net income (loss)................................. $(1,625,000) $ 1,241,000 $(1,792,000) $(1,197,000)4,231,000 $11,235,000 =========== =========== =========== - ---------------------------------------------------------------------------------------- COMPANY Purchase of outstandingEarnings (loss) per common stock by SAIC on March 10, 1995share: Basic........................................... $ 4,468,000 -(0.07) $ 4,480,000 Net loss for the period from March 11 to December 31, 1995 - $(1,418,000) (1,418,000) ----------- ----------- ----------- Balance, December 31, 1995 4,468,000 (1,418,000) 3,062,000 Net loss for the year ended December 31, 1996 - (1,625,000) (1,625,000) ----------- ----------- ----------- Balance, December 31, 1996 4,468,000 (3,043,000) 1,437,000 Declaration of Class B dividend - (10,000,000) (10,000,000) Conversion of Class B Common Stock - - - Issuance of Class A Common Stock 51,983,000 - 51,987,000 Net income for the year ended December 31, 1997 - 4,231,000 4,231,000 ----------- ----------- ----------- Balance, December 31, 1997 $56,451,000 $(8,812,000) $47,655,0000.16 $ 0.35 =========== =========== =========== Diluted......................................... $ (0.07) $ 0.16 $ 0.34 =========== =========== ===========
The accompanying notes are an integral part of these financial statements. F-6statements F-4 6453 NETWORK SOLUTIONS, INC. STATEMENTS OF CASH FLOWSCHANGES IN STOCKHOLDERS' EQUITY
PREDECESSOR COMPANY --------------- -------------------------------------------- JANUARY 1, 1995 MARCH 11, 1995 YEAR ENDED YEAR ENDED TO MARCH 10, TO DECEMBER 31 DECEMBER 31, DECEMBER 31, 1995 1995 1996 1997 --------------- --------------ACCUMULATED CLASS A CLASS B OTHER COMMON STOCK COMMON STOCK ADDITIONAL COMPRE- RETAINED ------------------ -------------------- PAID-IN HENSIVE EARNINGS SHARES AMOUNT SHARES AMOUNT CAPITAL INCOME (DEFICIT) --------- ------ ---------- ------- ----------- ----------- ------------ ------------- Cash flows from operating activities: Balance, December 31, 1995............... -- $ -- 12,500,000 $12,000 $ 4,468,000 $ -- $ (1,418,000) Net loss for the year ended December 31, 1996................................... -- -- -- -- -- -- (1,625,000) --------- ------ ---------- ------- ----------- -------- ------------ Balance, December 31, 1996............... -- -- 12,500,000 12,000 4,468,000 -- (3,043,000) Declaration of Class B dividend.......... -- -- -- -- -- -- (10,000,000) Conversion of Class B Common Stock....... 575,000 -- (575,000) -- -- -- -- Issuance of Class A Common Stock......... 3,220,000 4,000 -- -- 51,983,000 -- -- Net income (loss) $ (1,419,000) $ (1,418,000) $ (1,625,000) $for the year ended December 31, 1997............................... -- -- -- -- -- -- 4,231,000 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Net loss from discontinued operations 1,376,000 28,000 - - Depreciation and amortization 68,000 765,000 1,417,000 2,432,000 Provision for uncollectible accounts receivable - 124,000 3,597,000 8,082,000 Deferred income taxes - (2,221,000) (12,834,000) (13,226,000) Change in operating assets and liabilities: - - - - Increase in accounts receivable (161,000) (3,385,000) (12,144,000) (1,287,000) (Increase) decrease in prepaids and other assets (36,000) 45,000 (925,000) (69,000) (Increase) decrease in deposits (49,000) 1,053,000 - - Increase in accounts payable and accrued liabilities 233,000 282,000 1,226,000 3,845,000 Increase (decrease) in other liabilities 8,000 (89,000) - - Increase in income taxes payable - - - 5,042,000 Increase (decrease) in deferred revenue (30,000) 3,239,000 26,006,000 32,099,000--------- ------ ---------- ------- ----------- -------- ------------ ------------ ------------ ------------ Net cash provided by (used in) operating activities (10,000) (1,577,000) 4,718,000 41,149,000 ------------ ------------ ------------ ------------ Cash flows from investing activities: Purchase of furniture and equipment (134,000) (518,000) (1,901,000) (3,240,000) Purchase of short-term investments - - - (40,200,000) Net investment in net assets of discontinued operations 331,000 563,000 (208,000) - ------------ ------------ ------------ ------------ Net cash provided by (used in) investing activities 197,000 45,000 (2,109,000) (43,440,000) ------------ ------------ ------------ ------------ Cash flows from financing activities: Repayment of bank borrowings (293,000) (834,000) - - Dividend paid - - - (10,000,000) Capital lease obligations - - - (463,000) Proceeds from issuanceBalance, December 31, 1997............... 3,795,000 4,000 11,925,000 12,000 56,451,000 -- (8,812,000) Issuance of common stock - - - 52,405,000 Purchasepursuant to stock plans............................ 775,000 1,000 -- -- 10,273,000 -- -- Tax benefit associated with stock plans.................................. -- -- -- -- 5,607,000 -- -- Two-for-one common stock split effected in the form of treasurya 100% stock (30,000) - -dividend... 4,570,000 4,000 11,925,000 12,000 -- -- (16,000) Comprehensive Income: Net transactionsincome for the year ended December 31, 1998............................. -- -- -- -- -- -- 11,235,000 Other comprehensive income, net of tax; unrealized gains on securities....... -- -- -- -- -- 359,000 -- Comprehensive income..................... -- -- -- -- -- -- -- --------- ------ ---------- ------- ----------- -------- ------------ Balance, December 31, 1998............... 9,140,000 $9,000 23,850,000 $24,000 $72,331,000 $359,000 $ 2,407,000 ========= ====== ========== ======= =========== ======== ============ COMPRE- TOTAL HENSIVE STOCKHOLDERS' INCOME EQUITY ----------- ------------- Balance, December 31, 1995............... $ -- $ 3,062,000 Net loss for the year ended December 31, 1996................................... -- (1,625,000) ----------- ------------ Balance, December 31, 1996............... -- 1,437,000 Declaration of Class B dividend.......... -- (10,000,000) Conversion of Class B Common Stock....... -- -- Issuance of Class A Common Stock......... -- 51,987,000 Net income for the year ended December 31, 1997............................... -- 4,231,000 ----------- ------------ Balance, December 31, 1997............... -- 47,655,000 Issuance of common stock pursuant to stock plans............................ -- 10,274,000 Tax benefit associated with SAIC - 2,371,000 12,926,000 (14,045,000)stock plans.................................. -- 5,607,000 Two-for-one common stock split effected in the form of a 100% stock dividend... -- -- Comprehensive Income: Net income for the year ended December 31, 1998............................. 11,235,000 11,235,000 Other comprehensive income, net of tax; unrealized gains on securities....... 359,000 359,000 ----------- Comprehensive income..................... $11,594,000 -- =========== ------------ ------------ ------------ ------------ Net cash provided by (used in) financing activities (323,000) 1,537,000 12,926,000 27,897,000 ------------ ------------ ------------ ------------ Net increase (decrease) in cash and cash equivalents (136,000) 5,000 15,535,000 25,606,000 Cash and cash equivalents, beginning of period 136,000 - 5,000 15,540,000 ------------ ------------ ------------ ------------ Cash and cash equivalents, end of periodBalance, December 31, 1998............... $ - $ 5,000 $ 15,540,000 $ 41,146,000 ============ ============ ============75,130,000 ============
The accompanying notes are an integral part of these financial statements. F-7statements F-5 65 Network Solutions, Inc. Notes to Financial Statements54 NETWORK SOLUTIONS, INC. STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------------- 1996 1997 1998 ------------ ------------ ------------- Cash flows from operating activities: Net income (loss)........................... $ (1,625,000) $ 4,231,000 $ 11,235,000 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization............ 1,417,000 2,432,000 3,754,000 Provision for uncollectible accounts receivable............................. 3,597,000 8,082,000 2,247,000 Deferred income taxes.................... (12,834,000) (13,226,000) (27,317,000) Tax benefit associated with stock plans.................................. -- -- 5,607,000 Changes in operating assets and liabilities: Increase in accounts receivable........ (12,144,000) (1,287,000) (19,083,000) Increase in prepaids and other assets.............................. (925,000) (69,000) (2,996,000) Increase in accounts payable and accrued liabilities................. 1,226,000 3,845,000 21,861,000 Increase in income taxes payable....... -- 5,042,000 367,000 Increase in deferred revenue........... 26,006,000 32,099,000 67,743,000 ------------ ------------ ------------- Net cash provided by operating activities....................... 4,718,000 41,149,000 63,418,000 ------------ ------------ ------------- Cash flows from investing activities: Purchase of furniture and equipment......... (1,901,000) (3,240,000) (13,070,000) Purchase of short-term investments, net..... -- (40,200,000) (77,990,000) Purchase of long-term investments........... -- -- (13,590,000) Net investment in net assets of discontinued operations............................... (208,000) -- -- ------------ ------------ ------------- Net cash used in investing activities....................... (2,109,000) (43,440,000) (104,650,000) ------------ ------------ ------------- Cash flows from financing activities: Net transactions with SAIC.................. 12,926,000 (14,045,000) 3,516,000 Proceeds from issuance of common stock...... -- 52,405,000 -- Dividend paid............................... -- (10,000,000) -- Issuance of common stock pursuant to stock plans.................................... -- -- 10,274,000 Repayment of capital lease obligations...... -- (463,000) (842,000) ------------ ------------ ------------- Net cash provided by financing activities....................... 12,926,000 27,897,000 12,948,000 ------------ ------------ ------------- Net increase (decrease) in cash and cash equivalents................................. 15,535,000 25,606,000 (28,284,000) Cash and cash equivalents, beginning of year........................................ 5,000 15,540,000 41,146,000 ------------ ------------ ------------- Cash and cash equivalents, end of year........ $ 15,540,000 $ 41,146,000 $ 12,862,000 ============ ============ =============
The accompanying notes are an integral part of these financial statements F-6 55 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION-- COMPANY AND BASISSUMMARY OF PRESENTATIONSIGNIFICANT ACCOUNTING POLICIES Network Solutions Inc. ("the Company") currently acts as the exclusive registry and registrar of Internet domain names within the .com, .org, .net and .edu top level domains ("TLDs") pursuant to athe Cooperative Agreement with the National Science Foundation ("NSF") (Note 3).Department of Commerce. Domain names are used to identify a unique site or presence on the Internet. As registry and registrar tofor these TLDs, the Companytop level domains, Network Solutions registers new domain names and is responsible for the maintenance and dissemination of the master file of domain names through daily updates to the Internet. The CompanyNetwork Solutions also provides enterprise network consulting services,Internet Technology Services, focusing on network engineering, network and systems security and network management solutions for commercial customers. The Company was acquired by Science Applications International Corporation ("SAIC") on March 10, 1995 (the "acquisition"). Prior to the acquisition of the Company by SAIC, the Company's business included commercial and government contracts awarded to the Company on a competitive basis, including government contracts that were awarded to the Company partially upon the Company's then minority-owned status. The contracts which had been awarded to the Company based partially on the Company's then minority-owned status were transferred into a separately-owned entity prior to the acquisition of the Company by SAIC. In November 1995, SAIC adopted a plan to transfer the Company's remaining government-based business to SAIC in order to enable the Company to focus on the growth of its commercial business, which includes registration and consulting services. This transfer was effective as of February 1996. The operating results of both the minority-based government contract business and the remaining government-based business, are reflected as discontinued operations in the financial statements of the Company for all periods presented (Note 13). The commercial operations, as defined, are reflected as continuing operations in the financial statements of the Company for all periods presented. The financial statements for periods subsequent to March 10, 1995 are presented on the new basis of accounting arising from the acquisition (Note 9). The financial statements for the period from January 1, 1995 to March 10, 1995 are presented on the Company's previous basis of accounting. Subsequent to the acquisition, the results of continuing and discontinued operations include allocations by SAIC of: (i) costs for administrative functions and services performed on behalf of the continuing and discontinued operations of the Company by centralized staff groups within SAIC, (ii) SAIC's general corporate expenses, (iii) pension and other retirement benefit costs, and (iv) cost of capital (Notes 8, 9 and 12). Only costs directly attributable to the Company's government-based business that were not incurred by the Company subsequent to the transfer of this business to SAIC have been included in discontinued operations. F-8 66 NOTE 2 - RECAPITALIZATION AND INITIAL PUBLIC OFFERING On June 26, 1997, the Board of Directors amended the Certificate of Incorporation to provide for two classes of common stock, designated as Class A and Class B. The holders of Class A and Class B common stock generally have identical rights except that holders of Class A common stock are entitled to one vote per share while holders of Class B common stock are entitled to ten votes per share. Each share of Class B common stock is convertible at the holder's option into one share of Class A common stock. On October 1, 1997, the Company completed an initial public offering (the "IPO") of 3,795,000 shares of its $.001 par value Class A common stock, including 495,000 shares resulting from the exercise of certain overallotment provisions. The Company's net proceeds from the IPO, including overallotment, were $52.4 million based on the Company's direct sale of 3,220,000 shares of Class A common stock. Prior to the offering, the Company was a wholly-owned subsidiary of SAIC. In conjunction with the IPO, SAIC converted 575,000 shares (including 75,000 overallotment shares) of Class B common stock into 575,000 shares of Class A common stock and directly sold the shares as a selling stockholder. Upon completion of the offering, SAIC owned 100% of the outstanding Class B common stock representing 75.9% of the Company's equity and 96.9% of the combined voting power of the Company's outstanding Class B and Class A common stock. On August 21, 1997, the Company's Board of Directors declared a $10,000,000 dividend to be paid to SAIC upon consummation of the IPO. This dividend was paid to SAIC on October 1, 1997. NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NSFsolutions. Cooperative Agreement In December 1992, the CompanyNetwork Solutions entered into the Cooperative Agreement with the NSFNational Science Foundation under which the CompanyNetwork Solutions was to provide Internet domain name registration services for five TLDs:top level domains: .com, .org, .net, .edu and .gov. These "registration services"registration services include the initial two year domain name registration and renewal,annual re-registration, and throughout the registration term, maintenance of and unlimited modifications to individual domain name records and dissemination of records through updates to the Internet.master file of domain names. The Cooperative Agreement became effective January 1, 1993. It includesincluded a three-month phase-in period, a five-year operational period, (commencingcommencing April 1, 1993 and ending March 31, 1998),1998, and a six-month "flexibility period"flexibility period through September 30, 1998. TheEffective September 9, 1998, the Department of Commerce took over the administration of the Cooperative Agreement is subjectfrom the National Science Foundation. In October 1998, the Cooperative Agreement was amended to review by the NSF and may be terminated by the NSF at any time at its discretion or by mutual agreement. The NSF has stated that it will not be re-awarding a cooperative agreement at the end ofextend the flexibility period.period until September 30, 2000. The original terms of the Cooperative Agreement provided for a cost reimbursement plus fixed-fee contract (with aan initial fee of 8%). Effective September 14, 1995, the NSFNational Science Foundation and the CompanyNetwork Solutions amended the Cooperative Agreement to require the CompanyNetwork Solutions to begin charging end users a services fee of $50 per year for each domain name in the .com, .org and .net TLDs. Registrants paytop level domains. Until April 1, 1998, registrants paid a services fee of $100 for two years of domain name services upon each initial registration and an annual renewalre-registration fee of $50 per year thereafter (collectively "registration fees").thereafter. The NSFNational Science Foundation paid the registration fees to the Company for domain names within the .edu and .gov TLDstop level domains through March 31, 1997. Commencing April 1, 1997, the CompanyNetwork Solutions agreed with the NSFNational Science Foundation to provide domain name services within the .edu and .gov TLDstop level domains free of charge. As of October 1, 1997, the CompanyNetwork Solutions no longer registers or administers domain names in the .gov TLD. F-9 67top level domain. Under the terms of the September 14, 1995 amendment to the Cooperative Agreement, 30% of the registration fees collected by the Company isNetwork Solutions was required to be set aside for the enhancement of the intellectual infrastructure of the Internet ("set(set aside funds")funds) and, as such, iswas not recognized as revenue by the Company. The CompanyNetwork Solutions. Network Solutions has reflected these set aside funds, along with the appropriate percentage of net accounts receivable (Note 4)3), as restricted assets and has recorded an equivalent, related current liability. The Company maintainsNetwork Solutions maintained the cash received relating to the set aside funds in a separate interest bearing account. This restricted cash at December 31, 1996 and 1997 was approximately $13,049,000 and $23,512,000, respectively. The set aside funds, plus any interest earned, are intended to bewere disbursed at the direction of the NSF. In November 1997, the CompanyNational Science Foundation. As of December 31, 1998, Network Solutions had cumulatively disbursed $23 million out of this fund to the NSF at its direction. Future collection or disbursement of theseall set aside funds will havecollected and associated interest earned for a total of $62.3 million to the National Science Foundation at their direction. The restricted cash at December 31, 1997 and 1998 was approximately $23,512,000 and $0, respectively. F-7 56 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) On March 12, 1998, the National Science Foundation and Network Solutions amended the Cooperative Agreement to eliminate the 30% set aside requirement effective April 1, 1998 and to reduce the registration fees by a corresponding amount. Initial registrations on and after April 1, 1998 are charged $70 for two years of registration services and an annual re-registration fee of $35 per year thereafter. This amendment had no significant effect on the Company's business, net financial position, or results of operations (Note 15).revenue currently recognized on each registration, $70 for initial registrations and $35 for re-registrations, since Network Solutions previously did not recognize revenue on the 30% set aside funds. Accordingly, while the revenue to Network Solutions on a per registration basis does not change, the amount charged to customers declined. For purposes of the Company'sNetwork Solutions' statements of cash flows, amounts relating to these restricted assets and the Internet fund liability have been excluded in their entirety. Revenue Recognition Prior to September 14, 1995, net revenue was recognized under the Cooperative Agreement on the basis of direct cost plus allowable indirect costs and the earned portion of the fee. Since September 14, 1995, registrationRegistration fees charged to end users for registration services provided by the Company have beenNetwork Solutions are recognized on a straight-line basis over the life of the registration term, two years for initial registrations and one year for renewals. The Companyre-registrations. Network Solutions records revenue net of an estimated provision for uncollectible accounts receivable (Note 4)3). Substantially all of the Company's consulting servicesNetwork Solutions' Internet Technology Services revenue is derived from professional services which are generally provided to clients on a "timetime and expense"expense basis and is recognized as services are performed. NetOne Internet Technology Services' customer contributed approximately 20% of net revenue from two customers approximated 45% and 21% for the period from January 1, 1995 to March 10, 1995; 40% and 21% for the period from March 11, 1995 to December 31, 1995, and 20% and 0% for the year ended December 31, 1996. One of these customers was the NSF, whose impact on the above percentages of revenue was reflective of activity prior to the September 14, 1995 amendment of the Cooperative Agreement. During the yearyears ended December 31, 1997 and 1998, there were no customers which individually represented more than 5%4% of net revenues. Deferred Revenue Deferred revenue primarily represents the unearned portion of revenue related to the unexpired term of registration fees, net of an estimate for uncollectible accounts receivable (Note 4)3). Cash and Cash Equivalents The CompanyNetwork Solutions considers all highly liquid investments with an original maturitiesmaturity of ninety daysthree months or less to be cash equivalents. F-10Short and Long-Term Investments Short and long-term investments in marketable securities are classified as available-for-sale. All long-term investments in marketable securities mature within two years. At December 31, 1997 and 1998, the fair value of short and long-term investments approximated cost. Fair value is determined based upon the quoted market prices of the securities as of the balance sheet date. At December 31, 1998, Network Solutions also held equity interests in a privately-held, information technology company totaling $4,200,000. This investment is included in other long-term assets and is accounted for under the cost method which approximates fair value. F-8 6857 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Financial Instruments The recorded value of the Company'sNetwork Solutions' financial instruments, which include short-termshort and long-term investments, accounts receivable and accounts payable, approximates market value. Concentration of credit risks with respect to registration receivables is limited due to the wide variety and number of customers, as well as their dispersion across geographic areas. The CompanyNetwork Solutions has no derivative financial instruments. Furniture and Equipment Furniture and equipment are stated at cost. Depreciation on furniture, office and computer equipment is calculated principally using a declining-balance method over the useful lives of three to seven years. Equipment under capital leases is amortized using a declining-balance method over the shorter of the assets' useful lives or lease term, ranging from two to three years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the estimated useful lives of the assets, generally six years. Goodwill Goodwill represents the excess of the purchase cost over the fair value of net assets acquired in theNetwork Solutions' acquisition by Science Applications International Corporation, or SAIC, in 1995 and is amortized over five years using the straight-line method. Amortization expense of $580,000, $715,000, $686,000 and $686,000$543,000 for the period from March 11, 1995 to December 31, 1995, and the years ended December 31, 1996, 1997 and 1997,1998, respectively, was included in selling, general and administrative expenses. In connection with Network Solutions' initial public offering during 1997, SAIC sold a portion of its interest in Network Solutions resulting in a corresponding reduction of goodwill in the amount of $418,000 which was charged to additional paid-in capital. Stock Split On December 31, 1998, Network Solutions' board of directors approved a two-for-one stock split of the shares of Class A common stock and Class B common stock, to be effected in the form of a 100% stock dividend on shares of Class A common stock and Class B common stock outstanding on February 26, 1999. The stock dividend will be distributed on March 23, 1999. Share and per share information for all periods presented in the accompanying financial statements have been adjusted to reflect the two-for-one stock split. Software Development Costs Effective January 1, 1996, researchResearch and development costs are expensed as incurred. Research and development costs incurred for all periods presented prior to January 1, 1996 were reimbursed to the Company by direct charges to contracts and are included in cost of revenue for those periods. In accordance with Statement of Financial Accounting Standards ("SFAS")(SFAS) No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed", the CompanyNetwork Solutions has not capitalized any significant software development costs as of December 31, 1997.1998. Income Taxes Deferred taxes are accounted for under SFAS No. 109, "Accounting for Income Taxes," whereby deferred tax assets and liabilities are recognized for the expected future tax consequences of F-9 58 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) temporary differences between financial statement reporting and income tax purposes. A valuation allowance is recorded if it is "more likely than not" that some portion of or all of a deferred tax asset will not be realized. For the period from the acquisition until the IPO, the CompanyUntil Network Solutions' initial public offering, Network Solutions filed tax returns as part of SAIC's consolidated tax group. Tax expense during this period has been determined as if the CompanyNetwork Solutions was a separate taxpayer and was charged to the CompanyNetwork Solutions by SAIC. Effective October 1, 1997, the CompanyNetwork Solutions is no longer part of SAIC's consolidated tax group for federal income tax purposes and will prepareprepares its income tax returns as a separate entity. F-11 69 Stock Based Compensation The CompanyNetwork Solutions accounts for its stock option and employee stock purchase plans in accordance with the provisions of Accounting Principles Board Opinion ("APB")(APB) No. 25, "Accounting for Stock Issued to Employees". No compensation cost has been recognized by the CompanyNetwork Solutions for its employee stock plans. The SFAS No. 123, "Accounting for Stock-Based Compensation", provides an alternative accounting method to APB No. 25 and requires additional pro forma disclosures (Note 12)11). The CompanyNetwork Solutions expects to continue to account for its employee stock plans in accordance with the provisions of APB No. 25. Segment Data During 1998, Network Solutions adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". SFAS No. 131 supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise", replacing the "industry segment" approach with the "management" approach. The management approach designates internal reporting that is used by management for making operating decisions and assessing performance as the source of an entity's reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas and major customers. The adoption of SFAS No. 131 did not affect results of operations, financial position or segment information disclosures of Network Solutions due to the nature and relative magnitude of its business activities. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make reasonable estimates and assumptions, based upon all known facts and circumstances that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. Newly Issued Accounting Standards Effective December 31, 1997, the Company adopted SFAS No. 128, "Earnings per Share", which replaces the presentation of primary earnings per share ("EPS") with a presentation of basic EPS and necessitates the dual presentation of basic and diluted EPS on the face of the statement of operations. In addition, during FebruaryMarch 1998, the Company adopted Securities and Exchange Staff Accounting Bulletin ("SAB") No. 98,American Institute of Certified Public Accountants issued Statement of Position 98-1 (SOP 98-1), "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This standard requires companies to capitalize qualifying computer software costs which among other things, rescinded SAB No. 83 and thus eliminates the impact of common share equivalents granted by the Company at prices below the IPO offering priceare incurred during the twelve months precedingapplication development stage and amortize them over the initial IPO filing and through the filing's effective date. All prior period EPS data have been restated as required by SFAS No. 128 and SAB No. 98. See Note 11 for the reconciliation of the numerator and denominator used in the basic and diluted EPS computations. In June 1997, SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" was issued. SFAS No. 131 establishes standards for reporting information about operating segments in annual and interim financial statements issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131software's estimated useful life. SOP 98-1 is effective for fiscal years beginning after December 15, 1998. F-10 59 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 1 -- COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Network Solutions is currently evaluating the impact of SOP 98-1 on its financial statements and related disclosures. NOTE 2 -- RECAPITALIZATION AND INITIAL PUBLIC OFFERING On June 26, 1997, the Board of Directors amended the Certificate of Incorporation to provide for two classes of common stock, designated as Class A and willClass B. The holders of Class A and Class B common stock generally have no impactidentical rights except that holders of Class A common stock are entitled to one vote per share while holders of Class B common stock are entitled to ten votes per share. Each share of Class B common stock is convertible at the holder's option into one share of Class A common stock. On October 1, 1997, Network Solutions completed an initial public offering of 7,590,000 shares of its $.001 par value Class A common stock, including 990,000 shares resulting from the exercise of certain overallotment provisions. Network Solutions' net proceeds from the initial public offering, including overallotment, were $52.5 million based on Network Solutions' direct sale of 6,440,000 shares of Class A common stock. Prior to the Company's resultsoffering, Network Solutions was a wholly-owned subsidiary of operations, financial position or cash flows.SAIC. In conjunction with the initial public offering, SAIC converted 1,150,000 shares (including 150,000 overallotment shares) of Class B common stock into 1,150,000 shares of Class A common stock and directly sold the shares as a selling stockholder. Upon completion of the offering, SAIC owned 100% of the outstanding Class B common stock representing 75.9% of Network Solutions' equity and 96.9% of the combined voting power of Network Solutions' outstanding Class B and Class A common stock. On August 21, 1997, Network Solutions' Board of Directors declared a $10,000,000 dividend to be paid to SAIC upon consummation of the initial public offering. This dividend was paid to SAIC on October 1, 1997. NOTE 4 -3 -- ACCOUNTS RECEIVABLE Accounts receivable consist of the following amounts as of December 31:
1996 1997 ----------------- -----------------1998 ----------- ----------- Billed $ 27,430,000Billed................................................ $24,483,000 Unbilled 5,000,000$42,679,000 Unbilled.............................................. 1,526,000 ----------------- -----------------5,695,000 ----------- ----------- Total accounts receivable before allowances 32,430,000allowances............................... 26,009,000 48,374,000 Less --- Allowance for doubtful accounts (15,439,000)uncollectible accounts.......... (17,856,000) -(25,746,000) -- Accounts receivable allocable to 30% NSF set aside (Note 3) (4,404,000)1).............................. (2,361,000) ----------------- ------------------- ----------- ----------- Accounts receivable, net $ 12,587,000net.............................. $ 5,792,000 ================= =================$22,628,000 =========== ===========
F-12 70 Unbilled receivables consist of registration fees and time and material contract costs which have been incurred but which have not yet been billed. Under the Cooperative Agreement, 30% of collected registration fees will be set aside for disbursement at the direction of the NSF. In accounting for registration fees, the CompanyNetwork Solutions initially records the gross amount of the registration fee to accounts receivable and deferred revenue. The allowance for estimated uncollectible accounts is recorded against both accounts receivable and deferred revenue balances (see Note 1 for F-11 60 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 3 for-- ACCOUNTS RECEIVABLE -- (CONTINUED) treatment of the 30% NSFNational Science Foundation set aside). From the deferred revenue and allowance balances, Network Solutions records revenue and its provision for uncollectible accounts on a straight-line basis over the registration term. Effective April 1, 1998, Network Solutions consolidates and then amortizes only the net deferred revenue balance the Company recordsas net revenue on a straight-line basis over the registration term. The provision for uncollectible accounts receivable, which iswas separately recorded on a straight-line basis over the registration term and deducted from gross registration fees in determining net registration revenue, was $124,000 for the period from March 11, 1995 to December 31, 1995$3,597,000, $7,782,000 and $3,597,000 and $7,782,000,$2,168,000, respectively, for the years ended December 31, 1996, 1997 and 1997.1998. An additional $300,000 and $79,000 of bad debt expense was recorded in 1997 and 1998, respectively, for the write-off of consulting servicesInternet Technology Services receivables. The Company'sNetwork Solutions' allowance for uncollectible accounts receivable is associated solely with its registration services business. The Company believes it has been necessary to establish its provision for uncollectible accounts receivable is primarily due to the large number of individuals and corporations that have registered multiple domain names with the apparent intention of resellingtransferring registration for such names at a profit. The Company'sNetwork Solutions' experience has been that, in contrast to other registrants, such speculative resellers have a higher tendency ofto default on their registration fees.fees, returning the names into the available pool for subsequent registration. NOTE 5 -4 -- FURNITURE AND EQUIPMENT Furniture and equipment consist of the following amounts as of December 31:
1996 1997 1998 ----------- ----------- Furniture and office equipment $ 879,000equipment........................ $ 476,000 $ 833,000 Computer equipment 4,033,000equipment.................................... 8,619,000 19,400,000 Leasehold improvements 234,000improvements................................ 288,000 2,018,000 ----------- ----------- Furniture and equipment, at cost 5,146,000cost.................... 9,383,000 22,251,000 Less: Accumulated depreciation and amortization (2,880,000)amortization....... (3,237,000) (6,246,000) ----------- ----------- Furniture and equipment, netnet.......................... $ 2,266,000 $ 6,146,000 $16,005,000 =========== ===========
The above tableFurniture and equipment includes $2,386,000 of computer equipment acquired during 1997 under capital lease agreements. Amortization expense related to capital leases totaled $915,000 and $1,028,000 in 1997.1997 and 1998, respectively. Total depreciation and amortization expense for the periods from January 1, 1995 to March 10, 1995 and March 11, 1995 to December 31, 1995 and the years ended December 31, 1996, 1997 and 19971998 was $68,000, $185,000, $702,000, $1,746,000 and $1,746,000,$3,211,000, respectively. F-13 71 NOTE 6 -5 -- ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses consist of the following amounts as of December 31:
1996 1997 1998 ---------- --------------------- Accounts payable $1,054,000payable........................................ $1,896,000 $ 7,647,000 Accrued expenses 1,412,000expenses........................................ 2,384,000 16,717,000 Accrued payroll 115,000payroll......................................... 2,146,000 3,923,000 ---------- --------------------- Total accounts payable and accrued expenses $2,581,000expenses... $6,426,000 $28,287,000 ========== =====================
F-12 61 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 7 -6 -- LEASES Future minimum lease payments, including fixed escalation increases for office space and equipment under capital and operating leases with initial or remaining noncancelable lease terms in excess of one year as of December 31, 19971998 are:
Capital Operating Year Ending DecemberCAPITAL OPERATING YEAR ENDING DECEMBER 31: Leases Leases - ------------------------------------------------------------------------------------------------LEASES LEASES ------------------------ ---------- ----------- 19981999.................................................... $ 957,000885,000 $ 3,437,000 1999 885,000 3,438,000 20003,778,000 2000.................................................... 252,000 2,806,000 2001 - 1,818,000 2002 - 1,427,000 -----------3,099,000 2001.................................................... -- 1,935,000 2002.................................................... -- 1,452,000 ---------- ----------- Total minimum lease payments 2,094,000 $12,926,000payments.................. 1,137,000 $10,264,000 =========== Less: Amounts representing interest (171,000) -----------interest..................... (56,000) ---------- Present value of minimum lease payments 1,923,000payments................. 1,081,000 Less: Current portion (842,000) -----------portion................................... (834,000) ---------- Long-term portion of capital lease obligationsobligations.......... $ 1,081,000 ===========247,000 ==========
In December 1992, the CompanyNetwork Solutions entered into a lease agreement for the Company'sNetwork Solutions' headquarters in Herndon, Virginia. Subsequent to the acquisition, SAIC re-negotiated the lease with the landlord whereby SAIC posted a $1,000,000 letter of credit and then subleased the facilities to the CompanyNetwork Solutions under a lease expiring November 2002. During 1997, the CompanyNetwork Solutions leased a second facility in Herndon whose lease term expires in July 2002. LeaseOperating lease expense related to the continuing operations for the periods from January 1, 1995 to March 10, 1995 and March 11, 1995 to December 31, 1995, and for the years ended December 31,1996 and 1997 was $36,000, $342,000, $924,000 and $2,188,000, respectively. Lease expense incurred by the discontinued operations for the periods from January 1, 1995 to March 10, 1995 and March 11, 1995 to December 31, 1995 was $208,000 and $328,000, respectively. Subsequent to March 10, 1995, the Company generated rental income from subleases in 1995 of $135,000, and $187,000 and $291,000 for the years ended December 31, 1996, 1997 and 1998 was $924,000, $2,188,000 and $3,533,000, respectively. Network Solutions generated rental income from subleases of $187,000, $291,000 and $215,000 for the years ended December 31, 1996, 1997 and 1998, respectively. F-14 72 NOTE 8 -7 -- INTEREST EXPENSE AND INCOME Interest expense reflected in continuing operations and discontinued operations for the period January 1, 1995 to March 10, 1995 was $9,000 and $51,000, respectively. Interest charges prior to the acquisition have been reflected in continuing and discontinued operations based on the debt balances associated with each of the continuing and discontinued operations. In addition, interest expense of $52,000 and $164,000 for the period from March 11, 1995 to December 31, 1995 was allocated by SAIC to the Company's continuing operations and discontinued operations, respectively, based upon SAIC's cost of capital calculation. For the year ended December 31, 1996, interest income of $496,000 was allocated by SAIC based upon the cost of capital calculation. From its acquisition by SAIC in March 1995 until December 1996, the CompanyNetwork Solutions participated in SAIC's centralized cash management system whereby cash received from operations was transferred to SAIC's centralized cash accounts and cash disbursements were funded from such centralized cash accounts. Accordingly, the SAIC cost of capital formula provided for charges and credits to the CompanyNetwork Solutions based upon management of certain assets, including accounts receivable and fixed assets. Such amounts are not necessarily indicative of the cost that would have been incurred if the CompanyNetwork Solutions had been operated as a separate entity. Effective January 1, 1997, the CompanyNetwork Solutions was no longer subject to SAIC's cost of capital calculation in connection with the CompanyNetwork Solutions fulfilling its own treasury function. Interest paid for the periods from January 1, 1995 to March 10, 1995 and March 11, 1995 to December 31,1995 and for the years ended December 31, 1996, 1997 and 19971998 was $0, $103,000, $0$116,000 and $116,000, respectively. NOTE 9 -8 -- TRANSACTIONS WITH SAIC Under the terms of the acquisition agreement, the CompanyNetwork Solutions was acquired by SAIC on March 10, 1995 in a stock-for-stock transaction accounted for as a purchase. The fair market value of theF-13 62 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8 -- TRANSACTIONS WITH SAIC stock exchanged for the outstanding stock of the Company was approximately $3.9 million. The acquisition agreement provided for certain purchase adjustments and related additional stock issuance payments of approximately $600,000. After reflecting certain purchase accounting adjustments, the net assets included on the opening balance sheet were as follows: Current assets $ 929,000 Furniture and equipment 734,000 Goodwill 3,576,000 Other non-current assets 1,047,000 ---------- 6,286,000 Current liabilities 1,625,000 Net liabilities of discontinued operations 181,000 ---------- Net assets acquired at March 11, 1995 $4,480,000 ==========
-- (CONTINUED) The financial statements as of and for the period from March 11, 1995 to December 31, 1995 and for the years ended December 31, 1996, 1997 and 19971998 include significant transactions with other SAIC business units involving functions and services (such as cash management, tax administration, accounting, legal, data processing and employee benefit plans) that were provided to the CompanyNetwork Solutions by centralized SAIC organizations. The costs of these functions and services have been directly charged and/or allocated to the CompanyNetwork Solutions using methods that SAIC management believes are reasonable; primarily a percentage of budgeted administrative and overhead costs. Such charges and allocations are not necessarily indicative of the costs that would have been incurred if the CompanyNetwork Solutions had been a separate entity. Through August 9, 1996, the amounts allocated by SAIC to the CompanyNetwork Solutions included both administrative and overhead costs which are included in selling, general and F-15 73 administrative expenses and cost of revenue, respectively. Effective August 10, 1996, SAIC stopped allocating costs based generally upon pro rata labor and began assessing the CompanyNetwork Solutions for corporate services provided by SAIC at a fee equal to 2.5% of annual net revenue. The corporate services fee is negotiated annually and was 2.5% and 1.5% during 1997 and 1998, respectively. The agreement may be terminated by either party upon 180 daysdays' prior written notice. Amounts charged and allocated to the CompanyNetwork Solutions for these functions and services for the period from March 11, 1995 to December 31, 1995 and the years ended December 31, 1996, 1997 and 19971998 were $516,000, $1,196,000, $1,126,000 and $1,126,000,$1,447,000, respectively, and are principally included in selling, general and administrative expenses. Additionally, certain interest charges/credits were allocated by SAIC to the CompanyNetwork Solutions (Note 8)7). Sales as a subcontractor to SAIC for the period from March 11, 1995 to December 31, 1995 and the years ended December 31, 1996, 1997 and 19971998 were $509,000, $1,505,000, $2,445,000 and $2,445,000,$525,000, respectively. In addition, because the CompanyNetwork Solutions was included in SAIC's consolidated tax returns for periods from acquisition until the IPO, the Companyinitial public offering, Network Solutions was obligated to make payment for its tax liability to SAIC in accordance with the tax sharing arrangement (Note 10)9). The due to parent balance represents the cumulative net activity of all transactions between the CompanyNetwork Solutions and SAIC. The CompanyNetwork Solutions reflects this activity in the statementstatements of cash flows on a net basis because of the quick turnover, the large amounts and the short maturities of these related party cash transactions. NOTE 10 -9 -- PROVISION FOR INCOME TAXES The results of the CompanyNetwork Solutions since its acquisition by SAIC until its IPO are to beinitial public offering were included in SAIC's consolidated tax returns. The tax expense allocation is set forth in Note 3. Subsequent to the IPO, the Companyinitial public offering, Network Solutions is no longer part of SAIC's consolidated tax group for federal income tax purposes and will prepareprepares its income tax returns as a separate entity. F-14 63 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9 -- PROVISION FOR INCOME TAXES -- (CONTINUED) The provision for (benefit) from income taxes charged to continuing operations consists of the following:
For the Period 1995 ------------------------------ Year Ended Year Ended January 1 to March 11 to DecemberYEAR ENDED DECEMBER 31, December 31, March 10 December 31------------------------------------------ 1996 1997 ------------1998 ------------ ------------ ------------ Current: Federal $ 40,000 $ 1,521,000Federal.............................. $ 10,171,000 $ 13,931,000 State 8,000 311,000$ 29,559,000 State................................ 2,020,000 2,766,000 ------------5,867,000 ------------ ------------ ------------ Total current provision 48,000 1,832,000provision...... 12,191,000 16,697,000 ------------35,426,000 ------------ ------------ ------------ Deferred: Federal - (1,759,000)Federal.............................. (10,716,000) (11,035,000) State - (360,000)(22,792,000) State................................ (2,118,000) (2,191,000) ------------(4,525,000) ------------ ------------ ------------ Total deferred (benefit) - (2,119,000)..... (12,834,000) (13,226,000) ------------(27,317,000) ------------ ------------ ------------ Provision for (benefit) from income taxes $ 48,000 $ (287,000)taxes................................ $ (643,000) $ 3,471,000 ============$ 8,109,000 ============ ============ ============
F-16 74 Deferred tax assets are comprised of the following temporary differences as of December 31:
1996 1997 1998 ----------- ----------- Deferred Revenue $13,846,000revenue...................................... $26,295,000 $46,943,000 Provision for uncollectible accounts receivable 1,091,000receivable....... 1,841,000 Other 118,0008,409,000 Other................................................. 145,000 (13,000) ----------- ----------- Total deferred tax asset $15,055,000asset.................... $28,281,000 $55,339,000 =========== ===========
Tax valuation allowances were provided through March 10, 1995 against the net deferred tax assets of both continuing operations and discontinued operations. In connection with the acquisition purchase accounting, a determination was made that tax valuation allowances were no longer required. Although the Company hadNetwork Solutions has a past history of net losses, it has not established a current valuation allowance for its deferred tax assets since, in the opinion of management, it is more likely than not that all of the deferred tax assets will be realized. The deferred tax assets relate primarily to registration fees which are taxable upon initial registration but are recognized in the financial statements over the next 12 to 24 months, the registration term. A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate of 35% to income before income taxes is provided below. The statutory federal income tax rate used was 34% for the periods during 1995 and 35% for the years ended December 31, 1996 and 1997.below:
For the period 1995 ---------------------------- Year ended Year ended January 1 to March 11 to DecemberYEAR ENDED DECEMBER 31, December 31, March 10 December 31----------------------------------- 1996 1997 ----------- ----------- ------------ ------------1998 --------- ---------- ---------- Federal tax at statutory rate $ 1,000 $ (570,000) $ (794,000)rate................. $(794,000) $2,696,000 $6,771,000 State income taxes, net of Federalfederal tax benefit - (68,000)benefit..................................... (96,000) 374,000 1,015,000 Nondeductible goodwill amortization - 348,000amortization........... 281,000 240,000 Other 1,000 3,000213,000 Other......................................... (34,000) 161,000 Valuation allowance 46,000 - - - ---------- ----------110,000 --------- ---------- ---------- Provision for (benefit) from income taxes $ 48,000 $ (287,000) $ (643,000)taxes..... $(643,000) $3,471,000 ========== ==========$8,109,000 ========= ========== ==========
The CompanyNetwork Solutions paid income taxes of $119,000 for$31,235,000 during the period from January 1, to Marchyear ended December 31, 1998. F-15 64 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10 1995. F-17 75 NOTE 11 --- COMPUTATION OF EARNINGS (LOSS) PER SHARE The following is a reconciliation of the numerator and denominator used in the basic and diluted EPS computations for continuing operations:earnings per share computations:
Income (Loss) Shares Per Share (Numerator) (Denominator) AmountINCOME (LOSS) SHARES PER SHARE (NUMERATOR) (DENOMINATOR) AMOUNT ------------- ------------- ------------------- January 1, 1995 to March 10, 1995 - --------------------------------- Loss Per Share: - --------------- Basic $ (44,000) 1,046,000 $ (0.04) =========1996 LOSS PER SHARE: Basic..................................... $(1,625,000) 25,000,000 $(0.07) ====== Dilutive securities: Outstanding options - -options..................... -- ----------- ----------- Diluted---------- Diluted................................... $(1,625,000) 25,000,000 $(0.07) =========== ========== ====== 1997 EARNINGS PER SHARE: Basic..................................... $ (44,000) 1,046,0004,231,000 26,610,000 $ (0.04) =========== =========== ========= March 11, 1995 to December 31, 1995 - ----------------------------------- Loss Per Share: - --------------- Basic $(1,390,000) 12,500,000 $ (0.11) =========0.16 ====== Dilutive securities: Outstanding options - -options..................... 356,000 ----------- ----------- Diluted $(1,390,000) 12,500,000---------- Diluted................................... $ (0.11)4,231,000 26,966,000 $ 0.16 =========== =========== ========= 1996 Loss Per Share: - -------------------- Basic $(1,625,000) 12,500,000========== ====== 1998 EARNINGS PER SHARE: Basic..................................... $11,235,000 31,957,000 $ (0.13) =========0.35 ====== Dilutive securities: Outstanding options - -options..................... 1,440,000 ----------- ----------- Diluted $(1,625,000) 12,500,000---------- Diluted................................... $11,235,000 33,397,000 $ (0.13)0.34 =========== =========== ========= 1997 Earnings Per Share: - ------------------------ Basic $ 4,231,000 13,305,000 $ 0.32 ========= Dilutive securities: Outstanding options - 178,000 ----------- ----------- Diluted $ 4,231,000 13,483,000 $ .031 =========== =========== =================== ======
Common shares issued are weighted for the period the shares were outstanding and incremental shares assumed issued under the treasury stock method for dilutive EPSearnings per share are weighted for the period the underlying options were outstanding. Options outstanding in 1995 and 1996 are not reflected in the computation of diluted EPSearnings per share because the effects are antidilutiveanti-dilutive and would increase diluted EPS. F-18 76earnings per share. NOTE 12 -11 -- EMPLOYEE BENEFIT PLANS 1996 Stock Incentive Plan The 1996 Stock Incentive Plan, (the "Incentive Plan")or Incentive Plan, of the CompanyNetwork Solutions was adopted by the Board of Directors on September 18, 1996. The Incentive Plan provides for awards in the form of restricted shares, stock units, stock appreciation rights, and stock options (including incentive stock options ("ISOs") and nonstatutory stock options ("NSOs"))options). A total of 2,306,2504,612,500 shares of Class A Common Stock have been initially reserved for issuance under the Incentive Plan. The number of shares are increased by 2% of the total number of common shares of the CompanyNetwork Solutions outstanding at the end of the most recent calendar year, subject to a cumulative limit of 1,000,0002,000,000 shares. Through December 31, 1997,1998, an additional 564,4001,789,000 shares were eligible for issuance and have subsequently been reserved for a combined total of 2,870,6506,401,000 eligible shares under the Incentive Plan. F-16 65 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 -- EMPLOYEE BENEFIT PLANS -- (CONTINUED) Following is a summary of activity pursuant to the Company'sNetwork Solutions' Incentive Plan:
Weighted Average Shares Exercise PriceWEIGHTED AVERAGE SHARES EXERCISE PRICE ---------- ---------------- Balance at December 31, 1995 - - Granted 1,225,725 $12.97 Exercised - - Cancelled - -January 1, 1996........................... -- -- Granted.............................................. 2,451,000 $ 6.49 Exercised............................................ -- -- Cancelled............................................ -- -- ---------- Balance at December 31, 1996 1,225,725 $12.97 Granted 600,500 $14.21 Exercised - - Cancelled (36,500) $14.001996......................... 2,451,000 $ 6.49 Granted.............................................. 1,201,000 $ 7.11 Exercised............................................ -- -- Cancelled............................................ (73,000) $ 7.00 ---------- Balance at December 31, 1997 1,789,725 $13.361997......................... 3,579,000 $ 6.68 Granted.............................................. 1,359,000 $21.95 Exercised............................................ (1,520,000) $ 6.51 Cancelled............................................ (707,000) $ 9.26 ---------- Balance at December 31, 1998......................... 2,711,000 $13.74 ==========
Granted stock options generally become exercisable one year after the date of the grant, vest 30%, 30%, 20% and 20%, respectively, on each anniversary date of the grant and have a term of five years. The number of options exercisable at December 31, 1997 are 360,821 with an exercise price range of $11.25 to $14.00 and a weighted average exercise price of $12.95. The weighted average contractual life of all options outstanding at December 31, 1997 is 4.10 years. All options granted to date have been NSOsnonstatutory stock options except for 100,900 ISOs202,000 incentive stock options granted in 1996. No restricted shares, stock units or SARsstock appreciation rights have been granted to date. The following table summarizes the status of Network Solutions' stock options outstanding and exercisable at December 31, 1998:
STOCK OPTIONS STOCK OPTIONS OUTSTANDING EXERCISABLE ---------------------- ------------------ WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE AVERAGE RANGE OF CONTRACTUAL EXERCISE EXERCISE EXERCISE PRICES SHARES LIFE PRICE SHARES PRICE --------------- --------- ----------- -------- ------- -------- $ 7.00-$ 9.25.................. 1,712,000 3.31 $ 7.29 252,000 $7.16 $15.88-$34.25.................. 918,000 4.58 $21.20 -- -- $65.44-$69.50.................. 81,000 5.00 $65.59 -- -- --------- ---- ------ ------- ----- $ 7.00-$69.50.................. 2,711,000 3.79 $13.74 252,000 $7.16 ========= ==== ====== ======= =====
Employee Stock Purchase Plan Effective January 7, 1998, the CompanyNetwork Solutions adopted an Employee Stock Purchase Plan to provide substantially all full time employees an opportunity to purchase shares of its Class A common stock through payroll deductions of up to 10% of eligible compensation. Semiannually, on June 30 F-17 66 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 -- EMPLOYEE BENEFIT PLANS -- (CONTINUED) and December 31, participant account balances are used to purchase stock at the lesser of 85 percent of the fair market value on the trading day before the participation period starts or the trading day preceding the day on which the participation period ends. A total of 250,000500,000 shares are availablewere initially reserved for purchase under the plan. During the year ended December 31, 1998, a total of 30,000 shares were purchased under this plan. SAIC Benefit Plans Employees of the CompanyNetwork Solutions participate in various SAIC benefit plans, including stock, bonus and retirement plans, subject to the applicable eligibility requirements. SAIC charges the CompanyNetwork Solutions directly for the costs of such employee benefit plans. Charges related to the administration of the SAIC benefit plans in which employees of the CompanyNetwork Solutions participate are included within SAIC general corporate allocations (Notes 1 and 9)(Note 8). F-19 77 SAIC has one principal Cash or Deferred Arrangement ("CODA")plan which allows eligible participants to defer a portion of their income through payroll contributions. Such deferrals are fully vested, are not taxable to the participant until distributed from the CODACash or Deferred Arrangement plan upon termination, retirement, permanent disability or death and may be matched by SAIC. SAIC also has an SAIC Employee Stock Purchase Plan which allows eligible employees to purchase shares of SAIC's Class A common stock, with SAIC currently contributing 10% of the existing fair market value. SAIC has a Bonus Compensation Plan which provides for bonuses to reward outstanding performance. Bonuses are paid in the form of cash, fully vested shares of SAIC Class A common stock or vesting shares of SAIC Class A common stock. The CompanyNetwork Solutions participated in this plan during the period from acquisition until December 31, 1996. During the period from March 11, 1995 to December 31, 1995 and during the years ended December 31, 1996 and 1997, a total of 24,450, 53,04053,000 and 11,45011,000 SAIC options were granted to the Company'sNetwork Solutions' employees, respectively, with exercise prices ranging from $15.72 to $17.79, $19.33 to $22.83 and $25.96 to $34.78 per share, respectively, with a weighted average price of $16.17, $20.51 and $28.13, respectively. These options were granted under the SAIC 1995 Stock Option Plan to purchase SAIC Class A common stock and vest 20%, 20%, 20% and 40%, respectively, on each anniversary of the date of grant and have a term of five years. There were no SAIC options granted to Network Solutions' employees during 1998. Pro Forma Disclosures The weighted average fair value of the options granted during the period from March 11, 1995 to December 31,1995 and during the years ended December 31, 1996 and 1997 under the SAIC Bonus Compensation Plan were estimated at $3.66, $4.30 and $7.56, respectively, and $2.76$1.38, $2.34 and $4.68,$14.91, during 1996, 1997 and 1998, respectively, for the options granted during the years ended December 31, 1996 and 1997 under the Company'sNetwork F-18 67 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11 -- EMPLOYEE BENEFIT PLANS -- (CONTINUED) Solutions' Incentive Plan using the Black-Scholes model. The following weighted average assumptions were used in calculating the option fair values:values.
NETWORK SOLUTIONS SAIC Stock Options Company Stock Options ----------------------------------------------------- ---------------------------------- March 11, 1995 to Year ended Year ended Year ended Year ended DecemberSTOCK OPTIONS STOCK OPTIONS ---------------------------- ---------------------------- YEAR ENDED DECEMBER 31, DecemberYEAR ENDED DECEMBER 31, December 31, December 31, December 31, 1995---------------------------- ---------------------------- 1996 1997 1998 1996 1997 --------------- --------------- --------------- --------------- ---------------1998 ---- ---- ---- ---- ----- ----- Expected life (years)......... 4.0 5.0 -- 4.0 5.0 4.0 4.0 Risk-free interest rate 6.45%rate....... 5.91% 6.30% -- 5.98% 6.25% Volatility5.1% Volatility.................... 0.00% 0.00% -- 0.00% 20.79% 90.73% Dividend yield................ 0.00% 0.00% 20.79% Dividend yield 0.00% 0.00%-- 0.00% 0.00% 0.00%
F-20 78 Under the above models, the total value of SAIC stock options granted during 1995, 1996 and 1997 was approximately $89,000, $228,000 and $87,000, respectively, and $3,379,000, $2,809,000 and $2,809,000,$20,322,000, respectively, for the Company'sNetwork Solutions' employee stock purchase program and stock options granted in 1996, 1997 and 1997,1998, all of which would be amortized ratably on a pro forma basis over their respective option terms. Had the CompanyNetwork Solutions recorded compensation costs for these plans in accordance with SFAS No. 123, the Company'sNetwork Solutions' pro forma income (loss) would have been ($1,430,000) for the period March 11,1995 to December 31,19951,763,000), $3,510,000 and ($1,763,000) and $3,510,000,$9,236,000, respectively, for the years ended December 31,199631, 1996, 1997 and 1997.1998. Pro forma basic earnings (loss) per share on a diluted basis would have been ($0.14)0.07), $0.13 and $0.26,$0.28, respectively, for the years ended December 31,199631, 1996, 1997 and 1997.1998. NOTE 13 - DISCONTINUED OPERATIONS As discussed12 -- COMPREHENSIVE INCOME The changes in Note 1, in November 1995 SAIC adopted a plan to transfer the Company's government-based business to SAIC in ordercomponents of accumulated other comprehensive income are reported net of income taxes for the Company to focus on the growth of the commercial business. Such transfer was substantially completed as of February 1996. Prior to SAIC's acquisition of the Company, the portion of the Company's business relating to the minority-based government business had been transferred into a separately-owned entity. The activities of both the minority-based government business and the government-based business are reflected as discontinued operations in the financial statements of the Company for all periods presented. Net income (loss) from discontinued operations exclude general corporate overhead of the Company. No gain or loss was incurred as a consequence of the transfer of these businesses. Summary operating results of the discontinued operations wereyear ended December 31, 1998 as follows:
For the Period 1995 ---------------------------- January 1 to March 11 to March 10 December 31 ------------ -----------UNREALIZED GAINS ACCUMULATED OTHER ON SECURITIES COMPREHENSIVE INCOME ---------------- -------------------- Revenues $ 4,270,000 $ 7,882,000 Costs and expenses (5,478,000) (7,773,000) ----------- ----------- (Loss) income from discontinued operations before income taxes (1,208,000) 109,000 Provision for income taxes 167,000 137,000 =========== =========== Loss from discontinued operations, netPre-tax amount............................... $618,000 $618,000 Income tax................................... 259,000 259,000 -------- -------- Net of income taxes $(1,375,000) $ (28,000) =========== ===========tax amount............................ $359,000 $359,000 ======== ========
NOTE 14 -13 -- COMMITMENTS AND CONTINGENCIES As of December 31, 1997, the Company1998, Network Solutions was a defendant in 5two active lawsuits involving domain name disputes between trademark owners and domain name holders. The CompanyNetwork Solutions is drawn into such disputes, in part, as a result of claims by trademark owners that the CompanyNetwork Solutions is legally required, upon request by a trademark owner, to terminate the right the CompanyNetwork Solutions granted to an alleged trademark infringera domain name holder to register thea domain name in question. Further, trademark owners have alsowhich is alleged that the Company shouldto be required to monitor future domain name registrations and reject registrations of domain names which are identical or similar to their federally registered trademark.the trademark in question. The holders of the domain name registrations in dispute have, in turn, questioned the Company'sNetwork Solutions' right, absent a court order, to take any action which suspends their registration or use of the domain names in question. Although 4146 out of F-21 79approximately 4,500 of these objectionssituations have resulted in litigation involving the Company,suits actually naming us as a defendant, as of December 31, 1997,1998, no adverse judgment has been rendered and no award of damages have been awardedmade against the Company to any plaintiff in the 36 cases that have been resolved. The CompanyNetwork Solutions. F-19 68 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13 -- COMMITMENTS AND CONTINGENCIES -- (CONTINUED) Network Solutions believes that it has meritorious defenses and intends to vigorously defenddefends itself against these claims. On March 20, 1997, PG Media, Inc., a New York-based corporation (PG Media), filed a lawsuit against Network Solutions in the United States District Court, Southern District of New York alleging that Network Solutions had restricted access to the Internet by not adding PG Media's requested top level domains to the Internet root zone system in violation of the Sherman Act. In its complaint, PG Media, in addition to requesting damages, asked that Network Solutions be ordered to include reference to PG Media's top level domains and name servers in the root zone file administered by Network Solutions under the Cooperative Agreement. In June 1997, Network Solutions received written direction from the National Science Foundation not to take any action which would create additional top level domains or to add any new top level domains to the Internet root zone until the National Science Foundation provided further guidance. On September 17, 1997, PG Media filed a Second Amended Complaint adding the National Science Foundation as a defendant. On May 14, 1998, PG Media served Network Solutions with a motion for a preliminary injunction against both defendants to compel both defendants to add PG Media's top level domains to the Internet root zone within 30 days. In response, both defendants filed cross-motions for summary judgment against PG Media. On July 20, 1998, a hearing on all parties' motions occurred. The basic issue before the court is the National Science Foundation's authority to control the Internet's root zone system. The court has taken the issue under advisement and no date has been indicated for the issuance of a decision. With the transition of the Cooperative Agreement from the National Science Foundation to the Department of Commerce, Network Solutions is still required to request written direction from the U.S. Government before making or rejecting any modifications, additions or deletions to the root zone file, in accordance with the October 1998 amendment to the Cooperative Agreement. On October 17, 1997, a group of six plaintiffs filed a lawsuit (the "Thomas suit") against the CompanyNetwork Solutions and the NSFNational Science Foundation in the United States District Court, District of Columbia, challenging the legality of fees defendants charge for the registration and renewal of domain names on the Internet and seeking restitution of fees collected from domain name registrants in an amount in excess of $100 million, damages, and injunctive and other relief. Plaintiffs originally alleged violations of the Competition in Contracting Act ("CICA"), the Sherman Act, and the U.S. Constitution. Following the filing of motions to dismiss by the defendants, the plaintiffs filed an amended complaint on January 30, 1998, dropping the cause of action based upon CICA, but adding alleged violations ofConstitution, the Administrative Procedures Act and the Independent Offices Appropriations Act. TheOn February 10, 1998, the plaintiffs also filed a motion for preliminary injunctive reliefinjunction against the NSF concerning the "Intellectual Infrastructure Fund."Network Solutions seeking several items of relief. On February 2,April 6, 1998, the United States District Court District of Columbia, issued an orderits opinion granting the plaintiffs' motion for a preliminary injunction, enjoining the NSF from spending anysummary judgment in favor of the money collected by the Company forplaintiffs on the Intellectual Infrastructure Fund.Fund, ruling it an "unlawful tax." The Companycourt also granted Network Solutions' motion to dismiss all other counts (II through X) and simultaneously denied the plaintiffs' preliminary injunction motion against Network Solutions. On April 30, 1998, Congress passed H.R. 3579 which was signed into law by the President on May 1, 1998. Section 8003 of H.R. 3579 legalized, ratified and confirmed the entire Intellectual Infrastructure Fund and authorized and directed the National Science Foundation to deposit the entire fund into the U.S. Treasury. On August 28, 1998, the District Court dismissed the entire case, issuing a final judgment in the matter. In October 1998, the plaintiffs appealed the court's dismissal of their claims, with oral argument scheduled for February 25, 1999. On October 20, 1998, Network Solutions was included as a defendant in a suit brought by the Pennsylvania Attorney General's office against a domain name holder who has alleged to have used F-20 69 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13 -- COMMITMENTS AND CONTINGENCIES -- (CONTINUED) his domain name in connection with a web site promoting white supremacy and threatening certain state employees. The Pennsylvania Attorney General named all of the communications companies in any way connected with the domain name or web site. The Pennsylvania Attorney General seeks to permanently enjoin these entities, including Network Solutions, from providing services to this domain name holder in the event that the domain name holder fails to comply with the order of the court. Network Solutions has answered the complaint denying any knowledge or participation in the actions of the primary defendant. No motions are pending and Network Solutions expects to be dismissed from the matter. Network Solutions believes that it has meritorious defenses and intends to vigorously defenddefends itself against the claims advanced in the PG Media, Thomas suit.or Pennsylvania Attorney General suits. While the Companymanagement cannot reasonably estimate the potential impact of such claims, a successful claim under the plaintiffs' theoriesagainst Network Solutions in any of these proceedings could have a material adverse effect on the Company'sNetwork Solutions' business, financial condition and results of operations. See Note 15. On June 27, 1997, SAIC received a Civil Investigative Demand, ("CID")or "CID" from the U.S. Department of Justice ("DOJ") issued in connection with an investigation to determine whether there is, has been, or may be an antitrust violation under the Sherman Act relating to Internet registration products and services. The CID seeks documents and information from SAIC and the CompanyNetwork Solutions relating to their Internet registration business. The CompanyNetwork Solutions cannot reasonably estimate the potential impact of the investigation nor can it predict whether a civil action will ultimately be filed by the DOJ. The Company is unable to predictDepartment of Justice or the form of relief that might be sought in such an action or that might be awarded by a court or imposed as a result of any settlement.sought. Any such relief could have a material adverse effect on the Company'sNetwork Solutions' business, financial condition and results of operations. On March 20, 1997, PG Media, Inc., a New York-based corporation ("PG Media"), filed a lawsuit againstAugust 17, 1998, Network Solutions received notice from the Company in the United States District Court, Southern District of New York alleging that the Company had restricted access to the Internet by not adding PG Media's requested TLDs in violationCommission of the Sherman Act. In its complaint, PG Media has,European Communities, or "EC," of an investigation concerning Network Solutions' Premier Program agreements in addition to requesting damages, asked that the Company be ordered to include reference to PG Media's TLDsEurope. The EC requested production of these agreements and name servers in the root zone file administered by the Company under the Cooperative Agreement. The Company has answered the complaint. In addition, in June 1997, the Company received written direction from the NSF not to take any action to create additional TLDs or to add any new TLDs to the Internet root zone until the NSF provides further guidance. On September 17, 1997, PG Media filed a Second Amended Complaint adding the NSF as a defendant. No motions are pending as of December 31, 1997. The Company believes that it has meritorious defenses and intends to vigorously defend itself against the claims of PG Media. Although the Companyrelated materials for review. Network Solutions cannot reasonably estimate the potential impact of the investigation nor can Network Solutions predict whether an action will ultimately be brought by the EC or the form of relief that might be sought. Any such claims, a successful claim under the plaintiff's theoryrelief could have a material adverse effect on the Company's business, financial condition and results of operations. F-22 80 The Companyharm Network Solutions' business. Network Solutions is involved in various other investigations, claims and lawsuits arising in the normal conduct of its business, none of which, in themanagement's opinion will harm Network Solutions' business. Legal proceedings in which Network Solutions is involved have resulted and likely will result in, and any future legal proceedings can be expected to result in, substantial legal and other expenses and a diversion of the Company's management, will have a material adverse effect on its financial position, resultsefforts of operations, cash flows or its ability to conduct business.Network Solutions' personnel. NOTE 15 -14 -- SUBSEQUENT EVENTS (UNAUDITED) Proposed RuleSecondary Stock Offering On January 30, 1998,February 12, 1999, Network Solutions completed a secondary stock offering in which a total of 9,160,000 shares of Class A common stock were sold. Concurrent with the offering, SAIC converted 9,000,000 shares of Class B common stock into 9,000,000 shares of Class A common stock sold in the offering. The remaining 160,000 shares of Class A common stock were sold by other selling stockholders after they exercised the applicable stock options simultaneously with the closing of the offering. Network Solutions was not a selling stockholder, and, therefore, did not receive any F-21 70 NETWORK SOLUTIONS, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 14 -- SUBSEQUENT EVENTS (UNAUDITED) -- (CONTINUED) proceeds from the stock offering other than proceeds from options exercised as part of the offering. After the offering, SAIC owns approximately 89% of the combined voting power and approximately 45% of the economic interest of the outstanding common stock. By May 31, 1999, SAIC intends to convert all of the remaining Class B common stock into an identical number of shares of Class A common stock. After that conversion, Class A common stock will be the only class of common stock outstanding and SAIC will own approximately 45% of the voting power and economic interest of Network Solutions' outstanding common stock. Litigation On March 16, 1999, the United States District Court ruled in favor of Network Solutions' and the National Telecommunications and Information AdministrationScience Foundation's motions for summary judgment in the PG Media antitrust lawsuit. In the decision, Network Solutions was found to be immune to antitrust violations of the Department of Commerce issued a discussion draft, entitled "A Proposal to Improve Technical Management of Internet Names and Addresses" which was published in the U.S. Federal Register on February 20, 1998 (the "Proposed Rule"). The Proposed Rule provides notice and seeks public comment on a proposal to, among other things, increase competition in the administration of TLDs and the registration of domain names. The Company supports the transition of domain name services toward a self-regulatory commercial environment. It is impossible to predict at this time whether or when a final rule will be issued and, if issued, the exact nature ofSherman Act for its provisions or the precise effect of such provisions on the Company. Litigation On February 10, 1998, the plaintiffs in the Thomas suit filed a motion for preliminary injunction against the Company seeking several items of relief. On February 24, 1998, the Company and the NSF filed motions to dismiss the amended complaint. Also on February 24, the plaintiffs filed a motion for partial summary judgment concerning the set aside fund. The plaintiffs' motion for preliminary injunction against the Company and partial summary judgment against the NSF and both motions to dismiss were heard before the Court on March 17, 1998 and the Court hasactions taken the matters under advisement. NSF Cooperative Agreement Pursuant to an amendmentpursuant to the Cooperative Agreement, on March 12, 1998, the NSF directed the Company to begin charging end users $70 upon each initial registration for domain names registered April 1, 1998 or later and $35 for each renewal with an anniversary date of April 1, 1998 or later. In conjunction with this amendment to the Cooperative Agreement, the Company will no longer set aside 30% of the collected registration fees for the enhancement of the intellectual infrastructure of the Internet. This amendment does not alter the Company's existing revenue per net registration since the 30% set aside funds were previously not recognized as revenue. F-23Agreement. F-22 8171 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
================================================================================================================ COLUMN A COLUMN B COLUMN C ADDITIONS COLUMN D COLUMN E ADDITIONS --------------------------------- ----------- ------------------------ ------------ ----------- CHARGED TO BALANCE AT CHARGED TO OTHER BEGINNING COSTS AND ACCOUNTS-- DEDUCTIONS-- BALANCE AT DESCRIPTION OF YEAR EXPENSES DESCRIBE DESCRIBE END OF YEAR - --------------------------------------------------------------------------------------------------------------------------- ----------- ---------- ----------- ------------ ----------- For the period from January 1, 1995 to March 10, 1995Year ended December 31, 1996 Allowance for uncollectible accounts, continuing operations............ $ 2,118,000 $3,597,000 $19,270,000(1) $ 9,546,000(2) $15,439,000 Allowance for uncollectible accounts, included in net assets (liabilities) of discontinued operations...................... 809,000 344,000 -- -- 1,153,000 Deferred tax valuation allowance, continuing operations........... 56,000 46,000 -- -- 102,000(1) Deferred tax valuation allowance, discontinued operations......... 512,000 276,000 -- -- 788,000(1) - ---------------------------------------------------------------------------------------------------------------- For the period from March 11, 1995 to December 31, 1995 Allowance for uncollectible accounts, continuing operations...................... $ -- $ 124,000 $ 1,994,000(2) $ -- $ 2,118,000 Allowance for uncollectible accounts, included in net assets (liabilities) of discontinued operations...................... 1,153,000 465,000 -- -- 1,618,000 Year ended December 31, 1996 Allowance for uncollectible accounts, continuing operations...................... 2,118,000 3,597,000 19,270,000(2) 9,546,000(3) 15,439,000 Allowance for uncollectible accounts, included in net assets (liabilities) of discontinued operations......................operations............ 1,618,000 -- -- 1,618,000(4)1,618,000(3) -- Year ended December 31, 1997 Allowance for uncollectible accounts, continuing operations......................operations............ 15,439,000 8,082,000 35,368,000(2) 41,033,000(3)35,368,000(1) 41,033,000(2) 17,856,000 Year ended December 31, 1998 Allowance for uncollectible accounts, continuing operations............ $17,856,000 $2,247,000 $68,480,000(1) $62,837,000(2) $25,746,000
- --------------- (1) In connection with the acquisition purchase accounting, a determination was made that the tax valuation allowances were no longer required. (See Note 10 of Notes to Financial Statements.) (2) Charged to allowance for deferred revenue (See Notes 31 and 43 of Notes to Financial Statements). (3)(2) Amounts are write-offs of uncollectible accounts receivable. (4) Disposition associated with discontinued operations (See Note 13(3) In November 1995 SAIC adopted a plan to transfer Network Solutions' government-based business to SAIC in order for Network Solutions to focus on the growth of Notes to Financial Statements). F-24the commercial business. Such transfer was substantially completed as of February 1996. F-23 8272 INDEX TO EXHIBITS
Exhibit Number DescriptionEXHIBIT NUMBER DESCRIPTION - ------------- ----------- 3(ii) Bylaws of Network Solutions, Inc., as amended February 9, 1998. 10.1610.24 Amendment No. 7 to the Cooperative Agreement dated December 3, 1997. 10.17 Amendment No. 8 to the Cooperative Agreement dated February 20, 1998. 10.18 Amendment No. 912 to the Cooperative Agreement dated March 12, 1998. 10.19 Form of Indemnification Agreement entered into by the Company and each of its directors and officers at the Vice President level or above. 10.20 Deed of Lease By and Between Sugarland Business Park Limited Partnership and Network Solutions, Inc. dated May 30, 1997 ("Lease Agreement"). 10.21 Amendment No. 1 to Lease Agreement dated January 31, 1998.1999. 23.1 Consent of Price WaterhousePricewaterhouseCoopers LLP. 27.1 Financial Data Schedule (in electronic format only). 27.2 Restated Financial Data Schedule (in electronic format only). 27.3 Restated Financial Data Schedule (in electronic format only).