As filed with the Securities and Exchange Commission on March 22, 2007

Registration No. 333-      

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM S-1

REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933

 

 

 

 

 

 

 

 

2220 W. 14 ^th  Street

Tempe, AZ 85281

(602) 850-5000

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 

 

 

 

Jeffrey W. Lunsford

Chairman and Chief Executive Officer

Limelight Networks, Inc.

2220 W. 14 ^th  Street

Tempe, AZ 85281

(602) 850-5000

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

 

 

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

 

If any of the securities being registered on this Form are being offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended (the “Securities Act”), check the following box.  o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box.  o

 

 

 

 

 

 

PROSPECTUS SUMMARY

	•	Continuing to focus on customers with rich media content, a market which we believe represents a stable and growing business opportunity;
	•	Expanding content delivery network infrastructure to address significant growth opportunities and increase our market penetration in key international markets, including Europe and the Asia Pacific region;

	•	Continuing to innovate in order to enhance our content delivery capabilities;
	•	Expanding content delivery network capacity to further advantages associated with the scale of our network;
	•	Enhancing our sales and distribution channels to broaden our customer relationships and deepen our penetration of existing customer accounts; and
	•	Expanding our partner relationships to further complement our service offerings.

	•	the limited operating history in our market, which makes evaluating our business and future prospects difficult;
	•	the possibility that we might not manage our future growth effectively;
	•	the consequences of a potential adverse resolution of the lawsuit Akamai Technologies, Inc. and the Massachusetts Institute of Technology have filed against us;
	•	the highly competitive nature of the CDN market, and the adverse consequences if we are unable to compete effectively; and
	•	the possibility that rapidly evolving technologies or new business models could cause demand for our CDN services to decline or could cause these services to become obsolete.

THE OFFERING

 

Common stock offered by Limelight Networks		shares
Common stock offered by the selling stockholders		shares
Common stock to be outstanding after this offering		shares
Use of proceeds		We expect to use the net proceeds from this offering to fund capital expenditures for network and other equipment, as well as for working capital and other general corporate purposes. In addition, we intend to use approximately $23.8 million of the net proceeds to repay the outstanding balance under our credit facility. We also may use a portion of the net proceeds to acquire complementary businesses, products, services or technologies. We will not receive any proceeds from the sale of shares in this offering by the selling stockholders. See “Use of Proceeds.”
Proposed Nasdaq Global Market symbol		LLNW

	•	3,767,495 shares of common stock issuable upon exercise of options outstanding as of December 31, 2006 at a weighted average exercise price of $4.47 per share;
	•	65,390 shares of common stock issuable upon exercise of a warrant outstanding as of December 31, 2006 at an exercise price of $0.22 per share;
	•	602,836 shares of common stock reserved for future issuance under our Amended and Restated 2003 Incentive Compensation Plan as of December 31, 2006, plus an additional 950,000 shares that we reserved for issuance under this plan in March 2007; and
	•	shares of common stock reserved for future issuance under our 2007 Equity Incentive Plan adopted in          , subject to future adjustment as more fully described in “Management — Employee Benefit Plans.”

	•	no exercise by the underwriters of their option to purchase up to an additional           shares of our common stock to cover over-allotments;
	•	the conversion of each outstanding share of preferred stock into one share of common stock upon the closing of this offering; and
	•	the filing of our amended and restated certificate of incorporation prior to closing of this offering.

		Year Ended December 31,
		2004				2005				2006
		(in thousands,
		except per share data)
Consolidated Statement of Operations Data:
Revenue		$	11,192			$	21,303			$	64,343
Cost of revenue:
Cost of services(1)			4,834				9,037				25,662
Depreciation — network			775				2,851				10,316
Total cost of revenue			5,609				11,888				35,978
Gross profit			5,583				9,415				28,365
Operating expenses:
General and administrative(1)			2,147				4,107				18,274
Sales and marketing(1)			2,078				3,078				6,841
Research and development(1)			231				462				3,151
Depreciation and amortization			69				100				226
Total operating expenses			4,525				7,747				28,492
Operating income (loss)			1,058				1,668				(127	)
Other income (expense):
Interest expense			(189	)			(955	)			(1,782	)
Interest income			1				—				208
Other income (expense)			(48	)			(16	)			175
Total other income (expense)			(236	)			(971	)			(1,399	)
Income (loss) before income taxes			822				697				(1,526	)
Income tax expense(2)			306				300				2,187
Net income (loss)		$	516			$	397			$	(3,713	)
Net income (loss) allocable to common stockholders		$	317			$	185			$	(3,713	)
Net income (loss) per common share:
Net income (loss) per common share — basic		$	0.01			$	0.01			$	(0.22	)
Net income (loss) per common share — diluted		$	0.01			$	0.01			$	(0.22	)
Weighted average shares used in calculating net income (loss) per common share — basic			23,125				23,158				17,061
Weighted average shares used in calculating net income (loss) per common share — diluted			25,971				27,375				17,061
Other Operating Data:
Active customers at period end(3)			268				392				693
Annual revenue per customer (in thousands)(4)		$	42			$	54			$	93
Adjusted EBITDA (in thousands)(5)		$	1,869			$	4,697			$	21,284

(1)		Includes stock-based compensation as follows:

		Year Ended December 31,
		2004				2005				2006
		(in thousands)
Cost of services		$	—			$	—			$	459
General and administrative			14				94				6,686
Sales and marketing			—				—				329
Research and development			—				—				1,660
Total		$	14			$	94			$	9,134

(2)		In 2006, approximately $7.6 million in stock-based compensation expense was not deductible for tax purposes by us, which resulted in the incurrence of income tax expense despite our having generated a loss before income taxes in this period.
(3)		We define active customers as those that generated revenue for us within 30 days of the period end.
(4)		Annual revenue per customer equals revenue for the year divided by the number of active customers with respect to each period.
(5)		We calculate Adjusted EBITDA as follows:

		Year Ended December 31,
		2004				2005				2006
		(in thousands)
Net income		$	516			$	397			$	(3,713	)
Plus: depreciation and amortization			844				2,951				10,542
Plus: interest expense			189				955				1,782
Less: interest income			(1	)			—				(208	)
Plus: income tax expense			306				300				2,187
EBITDA		$	1,854			$	4,603			$	10,590
Plus: stock-based compensation			14				94				9,134
Plus: litigation expenses recoverable from escrow			—				—				1,560
Adjusted EBITDA		$	1,868			$	4,697			$	21,284

	•	on an actual basis;
	•	on a pro forma basis to give effect to the conversion of all outstanding shares of preferred stock into shares of common stock; and
	•	on a pro forma as adjusted basis to give effect to our receipt of net proceeds from our sale of           shares of common stock at an assumed initial public offering price of $      per share, the mid-point of the range on the cover of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

		As of December 31, 2006
										Pro Forma
		Actual				Pro Forma				As Adjusted(1)
		(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents		$	7,611			$	7,611			$	121,461
Working capital			14,033				14,033				127,883
Property and equipment, net			41,784				41,784				41,784
Total assets			73,928				73,928				187,778
Long-term debt, less current portion			20,415				20,415				20,415
Convertible preferred stock			30				—				—
Total stockholders’ equity			36,589				36,589				150,439

(1)		Each $1.00 increase or decrease in the assumed initial public offering price of $      per share would increase or decrease, as applicable, our cash and cash equivalents, working capital, total assets and total stockholders’ equity by approximately $      million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions payable by us.

 

Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below as well as the other information contained in this prospectus, including our consolidated financial statements and the related notes, before deciding to purchase any shares of our common stock. The occurrence of any of the following risks could harm our business, prospects, financial condition or operating results. In that case, the trading price of our common stock could decline and you may lose part or all of your investment.

 

Risks Related to Our Business

 

Our limited operating history makes evaluating our business and future prospects difficult, and may increase the risk of your investment.

 

Our company has only been in existence since 2001. A significant amount of our growth, in terms of employees, operations and revenue, has occurred since 2004. For example, our revenue has grown from $5.0 million in 2003 to $64.3 million in 2006. As a consequence, we have a limited operating history which makes it difficult to evaluate our business and our future prospects. We have encountered and will continue to encounter risks and difficulties frequently experienced by growing companies in rapidly changing industries, such as the risks described in this prospectus. If we do not address these risks successfully, our business will be harmed.

 

If we fail to manage future growth effectively, we may not be able to market and sell our services successfully.

 

We have recently expanded our operations significantly, increasing our total number of employees from 29 at December 31, 2004 to 158 at March 1, 2007, and we anticipate that further significant expansion will be required. Our future operating results depend to a large extent on our ability to manage this expansion and growth successfully. Risks that we face in undertaking this expansion include: training new sales personnel to become productive and generate revenue; forecasting revenue; controlling expenses and investments in anticipation of expanded operations; implementing and enhancing our CDN and administrative infrastructure, systems and processes; addressing new markets; and expanding international operations. A failure to manage our growth effectively could materially and adversely affect our ability to market and sell our products and services.

 

A lawsuit has been filed against us and an adverse resolution of this lawsuit could cause us to incur substantial costs and liability or force us to cease providing our CDN services altogether.

 

In June 2006, Akamai Technologies, Inc., or Akamai, and the Massachusetts Institute of Technology, or MIT, filed a lawsuit against us in the U.S. District Court for the District of Massachusetts alleging that we are infringing two patents assigned to MIT and exclusively licensed by MIT to Akamai. In September 2006, Akamai and MIT expanded their claims to assert infringement of a third, recently issued patent. These two matters have been consolidated by the Court. In addition to monetary relief, including treble damages, interest, fees and costs, the consolidated complaint seeks an order permanently enjoining us from conducting our business in a manner that infringes the relevant patents. A permanent injunction could prevent us from operating our CDN altogether. The Court has scheduled a claims construction hearing, known as a Markman hearing, for May 2007. Although the Court has not set a trial date, based on the schedule currently in place, we believe it is likely that the case will go to trial in 2008.

 

Akamai and MIT have asserted two of the patents at issue in the current litigation in two previous lawsuits against different defendants. Both cases were filed in the same district court as the current action, and assigned to the same judge currently presiding over the lawsuit filed against us. In one

case, a portion of one of these patents was upheld but neither lawsuit resulted in the defendant being able to obtain a license from Akamai or MIT, nor did the lawsuits result in a settlement. In addition, Akamai acquired the defendant prior to final resolution of the lawsuit in one of these cases.

 

While we believe that the claims of infringement asserted against us by Akamai and MIT in the present litigation are without merit and intend to vigorously defend the action, we cannot assure you that this lawsuit ultimately will be resolved in our favor. An adverse ruling could seriously impact our ability to conduct our business and to offer our products and services to our customers. This, in turn, would harm our revenue, market share, reputation, liquidity and overall financial position. Whether or not we prevail in our litigation, we expect that the litigation will continue to be expensive, time-consuming and a distraction to our management in operating our business.

 

We currently face competition from established competitors and may face competition from others in the future.

 

We compete in markets that are intensely competitive, rapidly changing and characterized by vendors offering a wide range of content delivery solutions. We have experienced and expect to continue to experience increased competition. Many of our current competitors, as well as a number of our potential competitors, have longer operating histories, greater name recognition, broader customer relationships and industry alliances and substantially greater financial, technical and marketing resources than we do. Our primary competitors include content delivery service providers such as Akamai, Level 3 Communications (which recently acquired Digital Island, SAVVIS Communications’ content delivery network services business) and Internap Network Services Corporation (which recently acquired VitalStream). Also, as a result of the growth of the content delivery market, a number of companies are currently attempting to enter our market, either directly or indirectly, some of which may become significant competitors in the future. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Some of our current or potential competitors may bundle their offerings with other services, software or hardware in a manner that may discourage content providers from purchasing the services that we offer. In addition, as we expand internationally, we face different market characteristics and competition with local content delivery service providers, many of which are very well positioned within their local markets. Increased competition could result in price reductions and revenue shortfalls, loss of customers, and loss of market share, which could harm our business, financial condition and results of operations.

 

We may lose customers if they elect to develop content delivery solutions internally.

 

Our customers and potential customers may decide to develop their own content delivery solutions rather than outsource these solutions to content delivery network, or CDN, services providers like us. This is particularly true as our customers increase their operations and begin expending greater resources on delivering their content using third-party solutions. For example, MusicMatch was our most significant customer in 2004 and one of our top 10 customers in 2005, but following its acquisition by Yahoo! Inc., MusicMatch’s content delivery requirements were in-sourced and it was not a customer of ours at all in 2006. If we fail to offer CDN services that are competitive to in-sourced solutions, we may lose additional customers or fail to attract customers that may consider pursuing this in-sourced approach, and our business and financial results would suffer.

 

Rapidly evolving technologies or new business models could cause demand for our CDN services to decline or could cause these services to become obsolete.

 

Customers or third parties may develop technological or business model innovations that address content delivery requirements in a manner that is, or is perceived to be, equivalent or superior to our CDN services. If competitors introduce new products or services that compete with or surpass the quality or the price/performance of our services, we may be unable to renew our agreements with existing customers or attract new customers at the prices and levels that allow us to generate

attractive rates of return on our investment. For example, one or more third parties might develop improvements to current peer-to-peer technology, which is a technology that relies upon the computing power and bandwidth of its participants, such that this technological approach is better able to deliver content in a way that is competitive to our CDN services, or even that makes CDN services obsolete. We may not anticipate such developments and may be unable to adequately compete with these potential solutions. In addition, our customers’ business models may change in ways that we do not anticipate and these changes could reduce or eliminate customers’ needs for CDN services. If this occurred, we could lose customers or potential customers, and our business and financial results would suffer. As a result of these or similar potential developments, in the future it is possible that competitive dynamics in our market may require us to reduce our prices, which could harm our revenue, gross margin and operating results.

 

If we are unable to sell our services at acceptable prices relative to our costs, our revenue and gross margins will decrease, and our business and financial results will suffer.

 

Prices for content delivery services have fallen in recent years and are likely to fall further in the future. Recently, we have invested significant amounts in purchasing capital equipment to increase the capacity of our content delivery services. For example, in 2006 we made $40.6 million in capital expenditures, primarily for computer equipment associated with the build-out and expansion of our content delivery network. Our investments in our infrastructure are based upon our assumptions regarding future demand and also prices that we will be able to charge for our services. These assumptions may prove to be wrong. If the price that we are able to charge customers to deliver their content falls to a greater extent than we anticipate, if we over-estimate future demand for our services or if our costs to deliver our services do not fall commensurate with any future price declines, we may not be able to achieve acceptable rates of return on our infrastructure investments and our gross profit and results of operations may suffer dramatically.

 

In addition, in 2007 and beyond, we expect to increase our expenses, in absolute dollars, in substantially all areas of our business, including sales and marketing, general and administrative, and research and development. In 2007 and 2008, as we further expand our content delivery network, we also expect our capital expenditures to be generally consistent with the high level of expenditures we made in this area in 2006. As a consequence, we are dependent on significant future growth in demand for our services to provide the necessary gross profit to pay these additional expenses. If we fail to generate significant additional demand for our services, our results of operations will suffer and we may fail to achieve planned or expected financial results. There are numerous factors that could, alone or in combination with other factors, impede our ability to increase revenue, moderate expenses or maintain gross margins, including:

 

 

If we are unable to develop new services and enhancements to existing services or fail to predict and respond to emerging technological trends and customers’ changing needs, our operating results may suffer.

 

The market for our CDN services is characterized by rapidly changing technology, evolving industry standards and new product and service introductions. Our operating results depend on our ability to develop and introduce new services into existing and emerging markets. The process of developing new technologies is complex and uncertain. We must commit significant resources to developing new services or enhancements to our existing services before knowing whether our investments will result in services the market will accept. For example, we recently introduced our Traffic Services Manager and Geo-Compliance paid service options, and we do not yet know whether our customers will adopt these offerings in sufficient numbers to justify our development costs. Furthermore, we may not execute successfully our technology initiatives because of errors in planning or timing, technical hurdles that we fail to overcome in a timely fashion, misunderstandings about market demand or a lack of appropriate resources. Failures in execution or market acceptance of new services we introduce could result in competitors providing those solutions before we do, which could lead to loss of market share, revenue and earnings.

 

We depend on a limited number of customers for a substantial portion of our revenue in any fiscal period, and the loss of, or a significant shortfall in demand from, these customers could significantly harm our results of operations.

 

During any given fiscal period, a relatively small number of customers typically accounts for a significant percentage of our revenue. For example, in 2006, revenue generated by sales to our top 10 customers, in terms of revenue, accounted for approximately 58% of our total revenue for the same period. One of these top 10 customers, CDN Consulting, which acted as a reseller of our services primarily to a single large content provider, represented in excess of 21% of our total revenue for that period. Prospectively, we do not expect sales to this reseller to continue at comparable levels. In the past, the customers that comprised our top 10 customers have continually changed, and we also have experienced significant fluctuations in our individual customers’ usage of our services. For example, one of our top 10 customers in 2005 was no longer a customer at all in 2006. In addition, our operating costs are relatively fixed in the near term. As a consequence, we may not be able to adjust our expenses in the short term to address the unanticipated loss of a large customer during any particular period. As such, we may experience significant, unanticipated fluctuations in our operating results which may cause us to not meet our expectations or those of stock market analysts, which could cause our stock price to decline.

 

If we are unable to attract new customers or to retain our existing customers, our revenue could be lower than expected and our operating results may suffer.

 

In addition to adding new customers, to increase our revenue, we must sell additional services to existing customers and encourage existing customers to increase their usage levels. If our existing and prospective customers do not perceive our services to be of sufficiently high value and quality, we may not be able to retain our current customers or attract new customers. We sell our services pursuant to service agreements that are generally one to three years in length. Our customers have no obligation to renew their contracts for our services after the expiration of their initial commitment period, and these service agreements may not be renewed at the same or higher level of service, if at all. Moreover, under some circumstances, some of our customers have the right to cancel their service agreements prior to the expiration of the terms of their agreements. Because of our limited operating history, we have limited historical data with respect to rates of customer service agreement renewals. This fact, in addition to the changing competitive landscape in our market, means that we cannot accurately predict future customer renewal rates. Our customers’ renewal rates may decline or fluctuate as a result of a number of factors, including:

 

 

 

If our customers do not renew their service agreements with us or if they renew on less favorable terms, our revenue may decline and our business will suffer. Similarly, our customer agreements often provide for minimum commitments that are often significantly below our customers’ historical usage levels. Consequently, even if we have agreements with our customers to use our services, these customers could significantly curtail their usage without incurring any penalties under our agreements. In this event, our revenue would be lower than expected and our operating results could suffer.

 

It also is an important component of our growth strategy to market our CDN services to industries, such as enterprise and the government. As an organization, we do not have significant experience in selling our services into these markets. We have only recently begun a number of these initiatives, and our ability to successfully sell our services into these markets to a meaningful extent remains unproven. If we are unsuccessful in such efforts, our business, financial condition and results of operations could suffer.

 

Our results of operations may fluctuate in the future. As a result, we may fail to meet or exceed the expectations of securities analysts or investors, which could cause our stock price to decline.

 

Our results of operations may fluctuate as a result of a variety of factors, many of which are outside of our control. If our results of operations fall below the expectations of securities analysts or investors, the price of our common stock could decline substantially. Fluctuations in our results of operations may be due to a number of factors, including:

 

 

 

We believe that our revenue and results of operations may vary significantly in the future and that period-to-period comparisons of our operating results may not be meaningful. You should not rely on the results of one period as an indication of future performance.

 

We generate our revenue almost entirely from the sale of CDN services, and the failure of the market for these services to expand as we expect or the reduction in spending on those services by our current or potential customers would seriously harm our business.

 

While we offer our customers a number of services associated with our content delivery network, we generated nearly 100% of our revenue in 2006 from charging our customers for the content delivered on their behalf through our CDN. As we do not currently have other meaningful sources of revenue, we are subject to an elevated risk of reduced demand for these services. Furthermore, if the market for delivery of rich media content in particular does not continue to grow as we expect or grows more slowly, then we may fail to achieve a return on the significant investment we are making to prepare for this growth. Our success, therefore, depends on the continued and increasing reliance on the Internet for delivery of media content and our ability to cost-effectively deliver these services. Factors that may have a general tendency to limit or reduce the number of users relying on the Internet for media content or the number of providers making this content available online include a general decline in Internet usage, litigation involving our customers and third-party restrictions on online content, including copyright restrictions, digital rights management and restrictions in certain geographic regions, as well as a significant increase in the quality or fidelity of offline media content beyond that available online to the point where users prefer the offline experience. The influence of any of these factors may cause our current or potential customers to reduce their spending on CDN services, which would seriously harm our operating results and financial condition.

 

Many of our significant current and potential customers are pursuing emerging or unproven business models which, if unsuccessful, could lead to a substantial decline in demand for our CDN services.

 

Because the proliferation of broadband Internet connections and the subsequent monetization of content libraries for distribution to Internet users are relatively recent phenomena, many of our customers’ business models that center on the delivery of rich media and other content to users remain unproven. For example, social media companies have been among our top recent customers and are pursuing emerging strategies for monetizing the user content and traffic on their web sites. Our customers will not continue to purchase our CDN services if their investment in providing access to the media stored on or deliverable through our CDN does not generate a sufficient return on their investment. A reduction in spending on CDN services by our current or potential customers would seriously harm our operating results and financial condition.

 

We may need to defend our intellectual property and processes against patent or copyright infringement claims, which would cause us to incur substantial costs.

 

Companies, organizations or individuals, including our competitors, may hold or obtain patents or other proprietary rights that would prevent, limit or interfere with our ability to make, use or sell our services or develop new services, which could make it more difficult for us to operate our business. From time to time, we may receive inquiries from holders of patents inquiring whether we infringe their proprietary rights. Companies holding Internet-related patents or other intellectual property rights are increasingly bringing suits alleging infringement of such rights or otherwise asserting their rights and seeking licenses. For example, in June 2006, we were sued by Akamai and MIT alleging we infringed patents licensed to Akamai. Any litigation or claims, whether or not valid, could result in substantial

costs and diversion of resources. In addition, if we are determined to have infringed upon a third party’s intellectual property rights, we may be required to do one or more of the following:

 

 

If we are forced to take any of these actions, our business may be seriously harmed. In the event of a successful claim of infringement against us and our failure or inability to obtain a license to the infringed technology, our business and operating results could be harmed.

 

Our business will be adversely affected if we are unable to protect our intellectual property rights from unauthorized use or infringement by third parties.

 

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. These legal protections afford only limited protection, and we have no currently issued patents. Monitoring infringement of our intellectual property rights is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our intellectual property rights. We have applied for patent protection in a number of foreign countries, but the laws in these jurisdictions may not protect our proprietary rights as fully as in the United States. Furthermore, we cannot be certain that any pending or future patent applications will be granted, that any future patent will not be challenged, invalidated or circumvented, or that rights granted under any patent that may be issued will provide competitive advantages to us.

 

Any unplanned interruption in the functioning of our network or services could lead to significant costs and disruptions that could reduce our revenue and harm our business, financial results and reputation.

 

Our business is dependent on providing our customers with fast, efficient and reliable distribution of application and content delivery services over the Internet. Many of our customers depend primarily or exclusively on our services to operate their businesses. Consequently, any disruption of our services could have a material impact on our customers’ businesses. Our network or services could be disrupted by numerous events, including natural disasters, failure or refusal of our third-party network providers to provide the necessary capacity, failure of our software or CDN delivery infrastructure and power losses. In addition, we deploy our servers in approximately 50 third-party co-location facilities, and these third-party co-location providers could experience system outages or other disruptions that could constrain our ability to deliver our services. We may also experience disruptions caused by software viruses or other attacks by unauthorized users. While we have not experienced any significant, unplanned disruption of our services to date, attacks by unauthorized users in the future may be successful, and our security measures may not be effective in preventing damages from such an attack. Despite our significant infrastructure investments, we may have insufficient communications and server capacity to address these or other disruptions, which could result in interruptions in our services.

 

Any widespread interruption of the functioning of our CDN and related services for any reason would reduce our revenue and could harm our business and financial results. If such a widespread interruption occurred or if we failed to deliver content to users as expected during a high-profile media event, game release or other well-publicized circumstance, our reputation could be damaged severely. Moreover, any disruptions could undermine confidence in our services and cause us to lose customers or make it more difficult to attract new ones, either of which could harm our business and results of operations.

 

We may have difficulty scaling and adapting our existing architecture to accommodate increased traffic and technology advances or changing business requirements, which could lead to the loss of customers and cause us to incur unexpected expenses to make network improvements.

 

Our CDN services are highly complex and are designed to be deployed in and across numerous large and complex networks. Our network infrastructure has to perform well and be reliable for us to be successful. The greater the user traffic and the greater the complexity of our products and services, the more resources we will need to invest in additional infrastructure and support. We have spent and expect to continue to spend substantial amounts on the purchase and lease of equipment and data centers and the upgrade of our technology and network infrastructure to handle increased traffic over our network and to roll out new products and services. This expansion is expensive and complex and could result in inefficiencies, operational failures or defects in our network and related software. If we do not expand successfully, or if we experience inefficiencies and operational failures, the quality of our products and services and users’ experience could decline. From time to time, we have needed to correct errors and defects in our software or in other aspects of our CDN. In the future, there may be additional errors and defects that may harm our ability to deliver our services, including errors and defects originating with third party networks or software on which we rely. These occurrences could damage our reputation and lead us to lose current and potential customers. We must continuously upgrade our infrastructure in order to keep pace with our customers’ evolving demands. Cost increases or the failure to accommodate increased traffic or these evolving business demands without disruption could harm our operating results and financial condition.

 

Our operations are dependent in part upon communications capacity provided by third-party telecommunications providers. A material disruption of the communications capacity we have leased could harm our results of operations, reputation and customer relations.

 

We lease private line capacity for our backbone from a third party provider, Global Crossing Ltd. Our contracts for private line capacity with Global Crossing generally have terms of three years. The communications capacity we have leased may become unavailable for a variety of reasons, such as physical interruption, technical difficulties, contractual disputes, or the financial health of our third party provider. As it would be time consuming and expensive to identify and obtain alternative third-party connectivity, we are dependent on Global Crossing in the near term. Additionally, as we grow, we anticipate requiring greater private line capacity than we currently have in place. If we are unable to obtain such capacity on terms commercially acceptable to us or at all, our business and financial results would suffer. We may not be able to deploy on a timely basis enough network capacity to meet the needs of our customer base or effectively manage demand for our services.

 

Our business depends on continued and unimpeded access to third-party controlled end-user access networks.

 

Our content delivery services depend on our ability to access certain end-user access networks in order to complete the delivery of rich media and other online content to end-users. Some operators of these networks may take measures, such as the deployment of a variety of filters, that could degrade, disrupt or increase the cost of our or our customers’ access to certain of these end-user access networks by restricting or prohibiting the use of their networks to support or facilitate our services, or by charging increased fees to us, our customers or end-users in connection with our services. This or other types of interference could result in a loss of existing customers, increased costs and impairment of our ability to attract new customers, thereby harming our revenue and growth.

 

In addition, the performance of our infrastructure depends in part on the direct connection of our CDN to a large number of end-user access networks, known as peering, which we achieve through mutually beneficial cooperation with these networks. If in the future a significant percentage of these

network operators elected to no longer peer with our CDN, the performance of our infrastructure could be diminished and our business could suffer.

 

If our ability to deliver media files in popular proprietary content formats was restricted or became cost-prohibitive, demand for our content delivery services could decline, we could lose customers and our financial results could suffer.

 

Our business depends on our ability to deliver media content in all major formats. If our legal right or technical ability to store and deliver content in one or more popular proprietary content formats, such as Adobe Flash or Windows Media, was limited, our ability to serve our customers in these formats would be impaired and the demand for our content delivery services would decline by customers using these formats. Owners of propriety content formats may be able to block, restrict or impose fees or other costs on our use of such formats, which could lead to additional expenses for us and for our customers, or which could prevent our delivery of this type of content altogether. Such interference could result in a loss of existing customers, increased costs and impairment of our ability to attract new customers, which would harm our revenue, operating results and growth.

 

If we are unable to retain our key employees and hire qualified sales and technical personnel, our ability to compete could be harmed.

 

Our future success depends upon the continued services of our executive officers and other key technology, sales, marketing and support personnel who have critical industry experience and relationships that they rely on in implementing our business plan. In particular, we are dependent on the services of our Chief Executive Officer, Jeffrey W. Lunsford and also our Chief Technical Officer, Nathan F. Raciborski. Neither of these officers nor any of our other key employees is bound by an employment agreement for any specific term. In addition, we do not have “key person” life insurance policies covering any of our officers or other key employees, and we therefore have no way of mitigating our financial loss were we to lose their services. There is increasing competition for talented individuals with the specialized knowledge to deliver content delivery services and this competition affects both our ability to retain key employees and hire new ones. The loss of the services of any of our key employees could disrupt our operations, delay the development and introduction of our services, and negatively impact our ability to sell our services.

 

Our senior management team has limited experience working together as a group, and may not be able to manage our business effectively.

 

Two members of our senior management team, our President and Chief Executive Officer, Jeffrey W. Lunsford, and our Chief Financial Officer, Matthew Hale, have been hired since November 2006. As a result, our senior management team has limited experience working together as a group. This lack of shared experience could harm our senior management team’s ability to quickly and efficiently respond to problems and effectively manage our business.

 

We face risks associated with international operations that could harm our business.

 

We have operations and personnel in Japan, the United Kingdom and Singapore, and we currently maintain network equipment in France, Germany, Hong Kong, Japan, the Netherlands and the United Kingdom. As part of our growth strategy, we intend to expand our sales and support organizations internationally, as well as to further expand our international network infrastructure. We have limited experience in providing our services internationally and such expansion could require us to make significant expenditures, including the hiring of local employees, in advance of generating any revenue. As a consequence, we may fail to achieve profitable operations that will compensate our investment in international locations. We are subject to a number of risks associated with international

business activities that may increase our costs, lengthen our sales cycle and require significant management attention. These risks include:

 

 

Internet-related and other laws relating to taxation issues, privacy and consumer protection and liability for content distributed over our network, could harm our business.

 

Laws and regulations that apply to communications and commerce conducted over the Internet are becoming more prevalent, both in the United States and internationally, and may impose additional burdens on companies conducting business online or providing Internet-related services such as ours. Increased regulation could negatively affect our business directly, as well as the businesses of our customers, which could reduce their demand for our services. For example, tax authorities abroad may impose taxes on the Internet-related revenue we generate based on where our internationally deployed servers are located. In addition, domestic and international taxation laws are subject to change. Our services, or the businesses of our customers, may become subject to increased taxation, which could harm our financial results either directly or by forcing our customers to scale back their operations and use of our services in order to maintain their operations. In addition, the laws relating to the liability of private network operators for information carried on or disseminated through their networks are unsettled, both in the United States and abroad. Network operators have been sued in the past, sometimes successfully, based on the content of material disseminated through their networks. We may become subject to legal claims such as defamation, invasion of privacy and copyright infringement in connection with content stored on or distributed through our network. In addition, our reputation could suffer as a result of our perceived association with the type of content that some of our customers deliver. If we need to take costly measures to reduce our exposure to these risks, or are required to defend ourselves against such claims, our financial results could be negatively affected.

 

If we are required to seek additional funding, such funding may not be available on acceptable terms or at all.

 

We may need to obtain additional funding due to a number of factors beyond our control, including a shortfall in revenue, increased expenses, increase investment in capital equipment or the acquisition of significant businesses or technologies. We believe that our cash, plus cash from operations and the proceeds from this offering will be sufficient to fund our operations and proposed capital expenditures for at least the next 12 months. However, we may need funding before such time. If we do need to obtain funding, it may not be available on commercially reasonable terms or at all. If we are unable to obtain sufficient funding, our business would be harmed. Even if we were able to find outside funding sources, we might be required to issue securities in a transaction that could be highly dilutive to our investors or we may be required to issue securities with greater rights than the

securities we have outstanding today. We might also be required to take other actions that could lessen the value of our common stock, including borrowing money on terms that are not favorable to us. If we are unable to generate or raise capital that is sufficient to fund our operations, we may be required to curtail operations, reduce our capabilities or cease operations in certain jurisdictions or completely.

 

Our business requires the continued development of effective business support systems to support our customer growth and related services.

 

The growth of our business depends on our ability to continue to develop effective business support systems. This is a complicated undertaking requiring significant resources and expertise. Business support systems are needed for:

 

 

Because our business plan provides for continued growth in the number of customers that we serve and services offered, there is a need to continue to develop our business support systems on a schedule sufficient to meet proposed service rollout dates. The failure to continue to develop effective business support systems could harm our ability to implement our business plans and meet our financial goals and objectives.

 

Changes in financial accounting standards or practices may cause adverse, unexpected financial reporting fluctuations and affect our reported results of operations.

 

A change in accounting standards or practices can have a significant effect on our operating results and may affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of existing accounting pronouncements have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, our recent adoption of SFAS 123R in 2006 has increased the amount of share-based compensation expense we record. This, in turn, has impacted our results of operations for the periods since this adoption and has made it more difficult to evaluate our recent financial results relative to prior periods. Under SFAS 123R, unrecognized stock-based compensation totaled $30.1 million at December 31, 2006.

 

We will incur significant increased costs as a result of operating as a public company, and our management will be required to devote substantial time to new compliance initiatives.

 

As a public company, we will incur significant accounting and other expenses that we did not incur as a private company. These expenses include increased accounting, legal and other professional fees, insurance premiums, investor relations costs, and costs associated with compensating our independent directors. In addition, the Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the Securities and Exchange Commission and the Nasdaq Global Market, impose additional requirements on public companies, including requiring changes in corporate governance practices. For example, the listing requirements of the Nasdaq Global Market require that we satisfy certain corporate governance requirements relating to independent directors, audit committees, distribution of annual and interim reports, stockholder meetings, stockholder approvals, solicitation of proxies, conflicts of interest, stockholder voting rights and codes of conduct. Our management and other personnel will need to devote a substantial amount of time to these compliance initiatives. Moreover, these rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly. For example, we expect these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability

insurance, and we may be required to accept reduced policy limits and coverage or incur substantial additional costs to maintain the same or similar coverage. These rules and regulations could also make it more difficult for us to identify and retain qualified persons to serve on our board of directors, our board committees or as executive officers.

 

If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our operating results, our ability to operate our business and investors’ views of us.

 

We must ensure that we have adequate internal financial and accounting controls and procedures in place so that we can produce accurate financial statements on a timely basis. We will be required to spend considerable effort on establishing and maintaining our internal controls, which will be costly and time-consuming and will need to be re-evaluated frequently. We have very limited experience in designing and testing our internal controls. We are in the process of documenting, reviewing and, if appropriate, improving our internal controls and procedures in anticipation of being a public company and eventually being subject to Section 404 of the Sarbanes-Oxley Act of 2002, which will require annual management assessments of the effectiveness of our internal control over financial reporting. In addition, we will be required to file a report by our independent registered public accounting firm addressing these assessments beginning with our Annual Report on Form 10-K for the year ended December 31, 2008. Both we and our independent auditors will be testing our internal controls in anticipation of being subject to Section 404 requirements and, as part of that documentation and testing, may identify areas for further attention and improvement. Implementing any appropriate changes to our internal controls may entail substantial costs to modify our existing financial and accounting systems, take a significant period of time to complete, and distract our officers, directors and employees from the operation of our business. These changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or a consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may seriously affect our stock price.

 

Failure to effectively expand our sales and marketing capabilities could harm our ability to increase our customer base and achieve broader market acceptance of our services.

 

Increasing our customer base and achieving broader market acceptance of our services will depend to a significant extent on our ability to expand our sales and marketing operations. Historically, we have concentrated our sales force at our headquarters in Tempe, Arizona. However, we have recently begun building a field sales force to augment our sales efforts and to bring our sales personnel closer to our current and potential customers. Developing such a field sales force will be expensive and we have limited knowledge in developing and operating a widely dispersed sales force. As a result, we may not be successful in developing an effective sales force, which could cause our results of operations to suffer.

 

We believe that there is significant competition for direct sales personnel with the sales skills and technical knowledge that we require. Our ability to achieve significant growth in revenue in the future will depend, in large part, on our success in recruiting, training and retaining sufficient numbers of direct sales personnel. We have expanded our sales and marketing personnel from a total of 13 at December 31, 2004 to 81 at March 1, 2007. New hires require significant training and, in most cases, take a significant period of time before they achieve full productivity. Our recent hires and planned hires may not become as productive as we would like, and we may be unable to hire or retain sufficient numbers of qualified individuals in the future in the markets where we do business. Our business will be seriously harmed if these expansion efforts do not generate a corresponding significant increase in revenue.

 

If the estimates we make, and the assumptions on which we rely, in preparing our financial statements prove inaccurate, our actual results may be adversely affected.

 

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments about, among other things, taxes, revenue recognition, share-based compensation costs, contingent obligations and doubtful accounts. These estimates and judgments affect the reported amounts of our assets, liabilities, revenue and expenses, the amounts of charges accrued by us, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances and at the time they are made. If our estimates or the assumptions underlying them are not correct, we may need to accrue additional charges that could adversely affect our results of operations, investors may lose confidence in our ability to manage our business and our stock price could decline.

 

As part of our business strategy, we may acquire businesses or technologies and may have difficulty integrating these operations.

 

We may seek to acquire businesses or technologies that are complementary to our business. Acquisitions involve a number of risks to our business, including the difficulty of integrating the operations and personnel of the acquired companies, the potential disruption of our ongoing business, the potential distraction of management, expenses related to the acquisition and potential unknown liabilities associated with acquired businesses. Any inability to integrate operations or personnel in an efficient and timely manner could harm our results of operations. We do not have prior experience as a company in this complex process of acquiring and integrating businesses. If we are not successful in completing acquisitions that we may pursue in the future, we may be required to reevaluate our business strategy, and we may incur substantial expenses and devote significant management time and resources without a productive result. In addition, future acquisitions will require the use of our available cash or dilutive issuances of securities. Future acquisitions or attempted acquisitions could also harm our ability to achieve profitability. We may also experience significant turnover from the acquired operations or from our current operations as we integrate businesses.

 

Risks Related to this Offering

 

The trading price of our common stock is likely to be volatile, and you might not be able to sell your shares at or above the initial public offering price.

 

The trading prices of the securities of technology companies have been highly volatile. Further, our common stock has no prior trading history. Factors affecting the trading price of our common stock will include:

 

 

 

In addition, if the market for technology stocks or the stock market in general experiences loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. The trading price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. Each of these factors, among others, could cause the value of your investment in our common stock to decline. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. If a suit were filed against us, regardless of its merits or outcome, it could result in substantial costs and divert management’s attention and resources. This could harm our business and cause our operating results and financial condition to suffer.

 

Our securities have no prior market and our stock price may decline after the offering.

 

Prior to this offering, there has been no public market for shares of our common stock. Although we have applied to have our common stock listed on the Nasdaq Global Market, an active public trading market for our common stock may not develop or, if it develops, may not be maintained after this offering. Our company, the representatives of the underwriters and our qualified independent underwriter will negotiate to determine the initial public offering price. The initial public offering price may be higher than the trading price of our common stock following this offering. As a result, you could lose all or part of your investment.

 

A significant portion of our total outstanding shares are restricted from immediate resale but may be sold into the market in the near future. If there are substantial sales of our common stock, the price of our common stock could decline.

 

The price of our common stock could decline if there are substantial sales of our common stock in the public stock market after this offering. After this offering, we will have          outstanding shares of common stock based on the number of shares outstanding as of December 31, 2006. This includes           shares being sold in this offering, all of which may be resold in the public market immediately following this offering. The remaining           shares, or approximately          % of our outstanding shares after this offering, are currently restricted as a result of securities laws or lock-up agreements but will be able to be sold in the near future as set forth below:

 

After this offering, the holders of an aggregate of 29,960,170 shares of our common stock as of December 31, 2006, including entities affiliated with one of our lead underwriters for this offering, will have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. We also intend to register the issuance of all shares of common stock that we have issued and may issue under our option plans. Once we register the issuance of these shares, they can be freely sold in the public market upon issuance, subject to lock-up agreements. Due to these factors, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock.

 

If securities or industry analysts do not actively follow our business or if they publish unfavorable research about our business, our stock price and trading volume could decline.

 

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. We do not currently have and may never obtain research coverage by securities and industry analysts. If no securities or industry analysts commence coverage of our company, the trading price for our stock may be negatively impacted. In the event we obtain securities or industry analyst coverage, if one or more of the analysts who covers us downgrades our stock or publishes unfavorable research about our business, our stock price would likely decline. If one or more of these analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.

 

Insiders will continue to have substantial control over us after this offering and will be able to influence corporate matters.

 

Upon completion of this offering, our directors and executive officers and their affiliates will beneficially own, in the aggregate, approximately          % of our outstanding common stock, including approximately          % beneficially owned by investment entities affiliated with Goldman Sachs & Co., our co-lead underwriter in this offering, in each case assuming no exercise of the underwriters’ option to purchase additional shares from us. These amounts compare to approximately          % of our outstanding common stock represented by the shares sold in this offering, also assuming no exercise of the underwriters’ option to purchase additional shares from us. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit your ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.

 

Because affiliates of the co-lead underwriter for this offering hold a substantial equity interest in us, the co-lead underwriter for this offering may have interests that conflict with yours as an investor in our common stock.

 

In July 2006, we completed the sale of our Series B preferred stock to certain investors, after which sale certain entities affiliated with Goldman Sachs & Co., the co-lead underwriter for this offering, held approximately 45% of the outstanding shares of our capital stock, and will hold     % after the completion of this offering. Because affiliates of Goldman Sachs & Co. own more than 10% of our outstanding capital stock, Goldman Sachs & Co. is deemed to be an affiliate of ours under Rule 2720(b)(1) of the NASD Conduct Rules and, therefore, the underwriters for this offering may also be deemed to have a conflict of interest under Rule 2720 of the NASD Conduct Rules. Accordingly, this offering will be made in compliance with the applicable NASD Conduct Rules, which require that the initial public offering price can be no higher than that recommended by a “qualified independent underwriter,” as defined by the NASD. Morgan Stanley & Co. Incorporated is serving in that capacity.

We cannot assure you that the use of a qualified independent underwriter will be sufficient to eliminate any actual or potential conflicts of interest. For more information regarding the role of the qualified independent underwriter in this offering and other relationships we and our affiliates have with the underwriters, we refer you to the disclosure under the heading, “Underwriting.”

 

As a new investor, you will experience substantial dilution as a result of this offering and future equity issuances.

 

The initial public offering price per share is substantially higher than the pro forma net tangible book value per share of our common stock outstanding prior to this offering. As a result, investors purchasing common stock in this offering will experience immediate substantial dilution of $      per share. In addition, we have issued options to acquire common stock at prices significantly below the initial public offering price. To the extent outstanding options are ultimately exercised, there will be further dilution to investors in this offering. This dilution is due in large part to the fact that our earlier investors paid substantially less than the initial public offering price when they purchased their shares of common stock. In addition, if the underwriters exercise their option to purchase additional shares from us or if we issue additional equity securities, you will experience additional dilution.

 

Anti-takeover provisions in our charter documents and Delaware law could discourage, delay or prevent a change in control of our company and may affect the trading price of our common stock.

 

We are a Delaware corporation and the anti-takeover provisions of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting us from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder, even if a change in control would be beneficial to our existing stockholders. In addition, our restated certificate of incorporation and amended and restated bylaws may discourage, delay or prevent a change in our management or control over us that stockholders may consider favorable. Our restated certificate of incorporation and amended and restated bylaws, which will be in effect as of the closing of this offering:

 

 

For more information regarding these and other provisions, see the section titled “Description of Capital Stock — Anti-Takeover Effects of Delaware Law and our Certificate of Incorporation and Bylaws.”

 

Our management will have broad discretion over the use of the proceeds we receive in this offering and might not apply the proceeds in ways that increase the value of your investment.

 

Our management will have broad discretion to use the net proceeds from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds of this offering in ways that increase the value of your investment. We expect to use the net proceeds from this offering for general corporate purposes, including working capital and capital expenditures, which may in the future include investments in, or acquisitions of, complementary businesses, services or technologies, or the repayment of all or a portion of our outstanding credit facility. We have not allocated these net proceeds for any specific purposes. Our management might not be able to yield a significant return, if any, on any investment of these net proceeds. You will not have the opportunity to influence our decisions on how to use the net proceeds from this offering.

 

We do not intend to pay dividends on our common stock.

 

We have never declared or paid any cash dividend on our common stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future.

 

This prospectus contains forward-looking statements that involve substantial risks and uncertainties. All statements, other than statements of historical facts, included in this prospectus regarding our strategy, future operations, future financial position, future revenue, projected costs, prospects and plans and objectives of management are forward-looking statements.

 

Forward-looking statements include, but are not limited to, statements about:

 

 

The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements that we make. We have included important factors in the cautionary statements included in this prospectus, particularly in the section entitled “Risk Factors,” that we believe could cause actual results or events to differ materially from the forward-looking statements that we make. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make. The forward-looking statements in this prospectus relate only to events as of the date on which the statements were made. We do not assume any obligation to update any forward-looking statements, except as required by law.

USE OF PROCEEDS

 

We estimate that we will receive net proceeds of approximately $113.9 million from the sale of the shares of common stock offered in this offering, based on an assumed initial public offering price of $      per share, the mid-point of the range set forth on the cover page of this prospectus, and after deducting the estimated underwriting discounts and estimated offering expenses payable by us. Each $1.00 increase or decrease in the assumed initial public offering price of $       per share would increase or decrease, as applicable, the net proceeds to us by approximately $        million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions payable by us. If the underwriters’ over-allotment option is exercised in full, we estimate that our net proceeds will be approximately $138.3 million. We will not receive any proceeds from the sale of shares of common stock in this offering by the selling stockholders, although we will bear the costs, other than underwriting discounts and commissions, associated with the sale of these sales.

 

The principal purposes for this offering are to fund our capital expenditures for network and other equipment, to increase our working capital, to create a public market for our common stock, to increase our ability to access the capital markets in the future, to provide liquidity for our existing stockholders and for general corporate purposes. In addition, we intend to repay the outstanding balance under our credit facility with Silicon Valley Bank, which carries a variable interest rate based on the prime or LIBOR rate ranging from 0% to 3.25% over the applicable rate, and maturation dates ranging from 2007 to 2011. At December 31, 2006, the outstanding balance under our credit facility with Silicon Valley Bank equalled approximately $23.8 million.

 

We may also use a portion of the net proceeds to acquire or invest in complementary businesses, products or services, or to obtain rights to such complementary technologies. We have no commitments with respect to any such acquisitions or investments. We may find it necessary or advisable to use the net proceeds for other purposes, and we will have broad discretion in the application of the net proceeds. Pending the uses described above, we intend to invest the net proceeds in short-term, interest-bearing, investment-grade securities.

DIVIDEND POLICY

 

We have never declared or paid any dividends on our capital stock. We currently expect to retain any future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends. Any further determination to pay dividends on our common stock will be at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements and other factors that our board of directors considers relevant.

 

The following table sets forth our unaudited cash, cash equivalents and capitalization as of December 31, 2006. Our cash, cash equivalents and capitalization is presented:

 

 

You should read this table together with the sections of this prospectus entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with our consolidated financial statements and related notes beginning on page F-1.

 

 

 

The number of pro forma as-adjusted shares of common stock shown as issued and outstanding is based on the number of shares of our common stock outstanding as of December 31, 2006 and excludes:

 

 

Our net tangible book value as of December 31, 2006 was $36.2 million, or $0.81 per share of pro forma common stock. Pro forma net tangible book value per share represents the amount of our total tangible assets reduced by the amount of our total liabilities and divided by the total number of shares of common stock outstanding including shares of common stock issued upon the conversion of all outstanding shares of our preferred stock. Dilution in pro forma as adjusted net tangible book value per share represents the difference between the amount per share paid by purchasers of shares of common stock in this offering and the pro forma as adjusted net tangible book value per share of common stock immediately after the completion of this offering. After giving effect to the sale of the shares of common stock offered by us at an assumed initial public offering price of $      per share, the mid-point of the range set forth on the cover page of this prospectus, and after deducting the estimated underwriting discounts and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of December 31, 2006 would have been $      million, or $      per share of common stock. This represents an immediate increase in pro forma net tangible book value of $      per share to existing stockholders and an immediate dilution of $      per share to new investors in our common stock. The following table illustrates this dilution on a per share basis:

 

 

A $1.00 increase or decrease in the assumed initial public offering price of $      would increase or decrease, as applicable, our pro forma as adjusted net tangible book value per share after this offering by $      per share and the dilution in pro forma as adjusted net tangible book value to new investors by $      per share, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

If the underwriters exercise their option to purchase additional shares of our common stock in full in this offering, the pro forma as adjusted net tangible book value per share after giving effect to this offering would be $      per share, and the dilution in pro forma net tangible book value per share to investors in this offering would be $      per share.

 

The following table summarizes, on a pro forma as adjusted basis as of December 31, 2006 and after giving effect to the offering, based on an assumed initial public offering price of $      per share, the differences between existing stockholders and new investors with respect to the number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid.

 

 

A $1.00 increase or decrease in the assumed initial public offering price of $      per share would increase or decrease, as applicable, total consideration paid by new investors and total

consideration paid by all stockholders by approximately $      million, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same.

 

If the underwriters exercise their over-allotment option in full, our existing stockholders would own     % and our new investors would own     % of the total number of shares of our common stock outstanding after this offering.

 

The above discussion and tables assume no exercise of 3,767,495 shares of common stock issuable upon the exercise of stock options outstanding as of December 31, 2006 with a weighted-average exercise price of approximately $4.47 per share and 65,390 shares of common stock issuable upon the exercise of a warrant outstanding as of the date of this prospectus with an exercise price of $0.22 per share. If all of these options and this warrant were exercised, then:

 

 

The following tables provide our selected consolidated financial data. The selected consolidated statement of operations data for each of the three years in the period ended December 31, 2006, and the selected consolidated balance sheet data as of December 31, 2005 and 2006 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. The selected consolidated balance sheet data as of December 31, 2004 was derived from our audited consolidated financial statements that are not included in this prospectus. The selected consolidated statement of operations data for the years ended December 31, 2002 and 2003 and the selected consolidated balance sheet data as of December 31, 2002 and 2003 have been derived from our unaudited consolidated financial statements that are not included in this prospectus. During the period from June 2001 through August 2003, we operated as a limited liability company. The full year pro forma 2003 financial data represents eight months of operations as a limited liability company and four months as a corporation. The share count and per share information for 2003 represents the end-of-year share count of the corporation. You should read this information together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus. Our historical results are not necessarily indicative of the results to be expected in any future period.

 

 

 

 

 

 

This management discussion of our financial condition and results of operations should be read together with the consolidated financial statements and related notes that are included elsewhere in this prospectus. This discussion contains forward-looking statements, which are based on current expectations that involve risks and uncertainties. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors, including those discussed in the section entitled “Risk Factors” and elsewhere in this prospectus.

 

Overview

 

We were founded in 2001 as a provider of content delivery network services to deliver rich media over the Internet. We began development of our infrastructure in 2001 and began generating meaningful revenue in 2002. Since inception, we have added more than 700 customers and have grown our revenue to $64.3 million in 2006. We achieved full-year profitability for the first time in 2004, and we were again profitable on a full-year basis in 2005. During 2006, we became unprofitable primarily due to an increase in our stock-based compensation expense, which increased from $0.1 million in 2005 to $9.1 million in 2006, and litigation expenses of $3.2 million.

 

We primarily derive revenue from the sale of content delivery network, or CDN, services to our customers. These services include delivery of digital media, including video, music, games, software and social media. We generate revenue by charging customers on a per-gigabyte basis, or on a variable basis based on peak delivery rate for a fixed period of time, as our services are used.

 

The following table sets forth our historical operating results, as a percentage of revenue for the periods indicated:

 

We have observed a number of trends in our business that are likely to have an impact on our financial condition and results of operations in the foreseeable future. Traffic on our network has grown dramatically in the last three years. This traffic growth is the result of growth in the number of new contracts, as well as growth in the traffic delivered to existing customers. Our near-exclusive focus is on providing content delivery network services, which we consider to be our sole industry segment.

 

Historically, we have derived a small portion of our revenue from outside of the United States. Our international revenue has grown recently, and we expect this trend to continue as we focus on our strategy of expanding our network and customer base internationally. For 2005 and 2006, 5% and 8%, respectively, of our revenue was derived outside of the United States, of which nearly all was derived from operations in Europe. We generated no revenue from outside the United Sates in 2004. We expect foreign revenue in 2007 will grow in absolute dollars and as a percentage of total revenue from what we have experienced historically. Our business is managed as a single geographic segment, and we report our financial results on this basis.

 

During any given fiscal period, a relatively small number of customers typically account for a significant percentage of our revenue. For example, in 2006, revenue generated from sales to our top 10 customers, in terms of revenue, accounted for approximately 58% of our total revenue. One of these top 10 customers, CDN Consulting, which acted as a reseller of our services primarily to a single large content provider, represented approximately 21% of our total revenue for that period. Prospectively, we do not expect sales to this reseller to continue at comparable levels. In 2005, no single customer accounted for more than 10% of our revenue, and in 2004, MusicMatch accounted for 13% of our revenue. We anticipate customer concentration levels will decline compared to prior years as our customer base continues to grow and diversify. In addition to selling to our direct customers, we maintain relationships with a number of resellers that purchase our services and charge a mark-up to their end customers. Revenue generated from sales to direct and reseller customers accounted for approximately 77% and 23% of our revenue in 2006, respectively.

 

In addition to these revenue-related business trends, our cost of revenue as a percentage of revenue has risen since 2004 primarily related to increased depreciation associated with increased investments to build out the capacity of our network. This increase, however, has been partially offset by a reduction in the cost of bandwidth as a percentage of revenue. Operating expense has increased in absolute dollars each period as revenue has increased. Beginning in the second half of 2006, these increases accelerated due to stock-based compensation and litigation-related expenses.

 

We make our capital investment decisions based upon careful evaluation of a number of variables, such as the amount of traffic we anticipate on our network, the cost of the physical infrastructure required to deliver that traffic, and the forecasted capacity utilization of our network. Our capital expenditures have increased substantially over time, in particular as we purchased servers and other computer equipment associated with our network build-out. For example, in 2004, 2005 and 2006, we made capital expenditures of $2.6 million, $10.9 million and $40.6 million, respectively. The substantial increase in capital expenditures in 2006, in particular, was related to a significant increase in our network capacity, reflecting our expectation for additional demand for our services. In the future, we expect these investments to be generally consistent in absolute dollars with our expenditures in 2006 and to decrease as a percentage of total revenue.

 

A significant portion of our historical capital expenditures involved related party transactions, in which we expended an aggregate of $2.1 million, $7.4 million and $29.9 million on server hardware in 2004, 2005 and 2006, respectively, from a supplier owned by one of our founders. This founder has recently divested himself of his ownership position in this supplier. In other transactions unrelated to this supplier relationship, we have also generated revenue from certain customers that are entities related to certain of our founders. The aggregate amounts of revenue derived from these related party transactions were $0.2 million, $0.2 million and $0.3 million in 2004, 2005 and 2006, respectively. We believe that all of our related-party transactions reflected arm’s length terms.

 

We are currently engaged in litigation with one of our principal competitors, Akamai Technologies, Inc., or Akamai, and its licensor, the Massachusetts Institute of Technology, or MIT, in which these parties have alleged that we are infringing three of their patents. Although no trial date has been set, based on the schedule currently in place, we believe this case will go to trial in 2008. Our legal and other expenses associated with this case have been significant to date, including aggregate expenditures of $3.1 million in 2006. We have reflected the full amount of these litigation expenses in our 2006 general and administrative expenses, as reported in our consolidated statement of operations. We expect that these expenses will continue to remain significant and may increase as a trial date approaches. We expect to offset one-half of the cash impact of these litigation expenses through the availability of an escrow fund established in connection with our Series B preferred stock financing. Any cash reimbursed from this escrow account will be recorded as additional paid-in capital. The cash offset from the litigation expense funded through the escrow account is recorded on our balance sheet in paid-in capital. For additional details on this escrow fund, see the related discussion under the caption “— Liquidity and Capital Resources.”

 

We were profitable in 2004 and 2005. During 2006, we became unprofitable primarily due to an increase in our stock-based compensation expense, which increased from $0.1 million in 2005 to $9.1 million in 2006, and litigation expenses of $3.2 million. The significant increase in stock-based compensation reflects an increase in the level of option and restricted stock grants coupled with a significant increase in the fair market value per share at the date of grant.

 

Our future results will be affected by many factors identified below and in the section of this prospectus entitled “Risk Factors,” including our ability to:

 

 

As a result, we cannot assure you that we will achieve our expected financial objectives, including positive net income.

 

Basis of Presentation

 

Revenue

 

We primarily derive revenue from the sale of content delivery network, or CDN, services to our customers. These services include delivery of digital media, including video, music, games, software and social media. We generate revenue by charging customers on a per-gigabyte basis, or on a variable basis based on peak delivery rate for a fixed period of time, as our services are used. Our customer agreements relating to these recurring services generally have a term of one to three years. However, some of our contracts with large customers operate on a month-to-month basis. The majority of our agreements generally commit the customer to a minimum monthly level of usage and provide the rate at which the customer must pay for actual usage above the monthly minimum. Our customer agreements typically automatically renew at the end of the initial term for an additional period unless the customer elects not to renew. Based on service usage experience, we and our customers often negotiate revised monthly minimum usage levels or other modified services or terms during a commitment period. For example, in exchange for increased minimum usage levels, we often agree to a reduced per-gigabyte pricing structure. Historically, we have derived substantially all of our revenue from these recurring service arrangements, which accounted for 94%, 98% and 99% of our revenue in 2004, 2005 and 2006, respectively.

 

Cost of Revenue

 

Cost of revenue consists of costs related to the delivery of services, as well as the depreciation costs associated with our network. Costs related to the delivery of our services include:

 

 

We enter into contracts with third-party network and data center providers, with terms typically ranging from several months to several years. Our contracts related to bandwidth provided by network operators generally commit us to pay either a fixed monthly fee or monthly fees plus additional fees for bandwidth usage above a contracted level. Our master contract with Global Crossing provides for the lease of private lines of varying capacity for our backbone, at fixed monthly fees with commitments ranging from 2 to 3 years. In addition to purchasing services from communications providers, we connect directly to many Internet service providers, or ISPs, generally without either party paying the other. This industry practice, known as peering, benefits us by allowing us to place content objects directly on user access networks, which helps us provide higher performance delivery for our customers. This practice also benefits the ISP and its customers by allowing them to receive improved content delivery through our local servers. We do not consider these relationships to represent the culmination of an earnings process. Accordingly, we do not recognize as revenue the value to the ISPs associated with the use of our servers nor do we recognize as expense the value of the bandwidth received at discounted or no cost.

 

During 2006, we continued to reduce our network bandwidth costs per gigabyte transferred by entering into new supplier contracts with lower pricing and amending existing contracts to take advantage of price reductions from our existing suppliers. However, due to increased traffic delivered over our network, our total bandwidth costs increased during 2006. We anticipate our overall bandwidth costs will continue to increase in absolute dollars as a result of expected higher traffic levels, partially offset by continued reductions in bandwidth costs per unit. We expect that our overall bandwidth costs as a percentage of revenue will remain relatively consistent with our historical results. If we do not experience lower per unit bandwidth pricing and we are unsuccessful at effectively routing traffic over our network through lower cost providers, network bandwidth costs could increase in excess of our expectations in future periods.

 

Depreciation expense related to our network equipment has increased over time due to additional equipment purchases, particularly those in 2006. We anticipate depreciation expense related to our network equipment will continue to increase in 2007 in absolute dollars and as a percentage of revenue due to full year depreciation on 2006 purchases and depreciation on additional purchases expected to be made in 2007. In 2007 and 2008, we expect that depreciation expense will increase in absolute dollars and decrease as a percentage of revenue.

 

In total, we believe our cost of revenue will increase in 2007 in both absolute dollars and as a percentage of revenue. Thereafter, we expect that the cost of revenue will increase in absolute dollars but could potentially decrease as a percentage of revenue. We expect to deliver more traffic on our network, which would result in higher expenses associated with the increased traffic; however, such costs are likely to be partially offset by lower bandwidth costs per unit. Additionally, we expect increases in depreciation expense related to our network equipment, as well as an increase in payroll and payroll-related costs, as we continue to make investments in our network to service our expanding customer base.

 

General and Administrative Expense

 

General and administrative expense consists primarily of the following components:

 

 

We expect our general and administrative expense to increase in 2007 in absolute dollars due to increased stock-based compensation expense on equity grants made in the later part of 2006, payroll and related costs attributable to increased hiring, continued costs associated with ongoing litigation, as well as increased accounting and legal and other costs associated with public reporting requirements and compliance with the requirements of the Sarbanes-Oxley Act of 2002. In 2007 and in the longer term, we expect our general and administrative expense to decrease as a percentage of revenue.

 

Sales and Marketing Expense

 

Sales and marketing expense consists primarily of payroll and related costs, including stock-based compensation expense and commissions for personnel engaged in marketing, sales and service support functions, as well as advertising, promotional and travel expenses.

 

We anticipate our sales and marketing expense will continue to increase in future periods in absolute dollars and as a percentage of revenue due to an expected increase in commissions on higher forecast sales, the expected increase in hiring of sales and marketing personnel, increases in stock-based compensation expense and additional expected increases in marketing costs such as advertising.

 

Research and Development Expense

 

Research and development expense consists primarily of payroll and related costs and stock-based compensation expense associated with the design, development, testing and certification of the software, hardware and network architecture of our content delivery network system. Research and development costs are expensed as incurred.

 

We anticipate our research and development expense will increase in future periods in absolute dollars and as a percentage of revenue due to increased stock-based compensation expense as well as increased payroll and related costs associated with continued hiring of development personnel and investments in our core technology and refinements to our other service offerings.

 

Non-Network Depreciation Expense

 

Non-network depreciation expense consists of depreciation on equipment and furnishing used by general administrative, sales and marketing and research and development personnel.

 

Interest Expense

 

Interest expense includes interest paid on our debt obligations as well as amortization of deferred financing costs.

 

Interest Income

 

Interest income includes interest earned on invested cash balances and cash equivalents. We anticipate interest income will increase in 2007 in absolute dollars due to an increase in the cash balances and cash equivalents resulting from proceeds of this offering and operating cash flow we expect to generate during the year.

 

Other Income (Expense), Net

 

Our other income consists primarily of gains or losses from the disposal of assets.

 

Income Tax Expense

 

Income tax expense depends on the statutory rate in the countries where we sell our services as well as the expenses in any year that are not deductible in those jurisdictions. Historically, we have primarily been subject to taxation in the United States because we have sold the majority of our services to customers in the United States. In the future, we intend to further expand our sales of services to customers located outside the United States, in which case we would become further subject to taxation based on the foreign statutory rates in the countries where these sales took place, and our effective tax rate could fluctuate accordingly.

 

In 2006, approximately $7.6 million of stock-based compensation expense was not deductible for tax purposes by us, as certain executives and other employees made tax elections which established tax bases in these awards granted at lower than the fair value recognized within the financial statements. This permanent difference was material to our pre-tax net loss for the year of $1.5 million. Future non-tax deductible expenses related to equity awards granted in 2006 are expected to be $9.4 million, $2.7 million, $2.7 million and $2.2 million for 2007, 2008, 2009 and 2010, respectively, based upon the unvested portion of the equity awards outstanding at December 31, 2006, and the anticipated vesting at that time.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, accounts receivable reserves, income and other taxes, stock-based compensation and equipment and contingent obligations. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.

 

We define our “critical accounting policies” as those U.S. generally accepted accounting principles that require us to make subjective estimates about matters that are uncertain and are likely to have a material impact on our financial condition and results of operations as well as the specific manner in which we apply those principles. Our estimates are based upon assumptions and judgments about matters that are highly uncertain at the time the accounting estimate is made and applied and require us to continually assess a range of potential outcomes.

 

Revenue Recognition

 

We recognize service revenue in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition,” and the Financial Accounting Standards Board’s, or FASB, Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed and collectibility of the resulting receivable is reasonably assured.

 

At the inception of a customer contract for service, we make an assessment of that customer’s ability to pay for the services provided. If we subsequently determine that collection from the customer is not reasonably assured, we record an allowance for doubtful accounts and bad debt expense for all of that customer’s unpaid invoices and cease recognizing revenue for continued services provided

until cash is received. Changes in our estimates and judgments about whether collection is reasonably assured would change the timing of revenue or amount of bad debt expense that we recognize.

 

We primarily derive income from the sale of CDN services to customers. For these services, we recognize the monthly minimum as revenue each month provided that an enforceable contract has been signed by both parties, the service has been delivered to the customer, the fee for the service is fixed or determinable and collection is reasonably assured. Should a customer’s usage of our service exceed the monthly minimum, we recognize revenue for such excess usage in the period of the usage. We typically charge the customer an installation fee when the services are first activated. The installation fees are recorded as deferred revenue and recognized as revenue ratably over the estimated life of the customer arrangement. We also derive income from services sold as discrete, non-recurring events or based solely on usage. For these services, we recognize revenue after an enforceable contract has been signed by both parties, the fee is fixed or determinable, the event or usage has occurred and collection is reasonably assured.

 

We periodically enter into multi-element arrangements. When we enter into such arrangements, each element is accounted for separately over its respective service or delivery period, provided that there is objective evidence of fair value for the separate elements. For example, objective evidence of fair value would include the price charged for the element when sold separately. If the fair value of each element cannot be objectively determined, the total value of the arrangement is recognized ratably over the entire service period to the extent that all services have begun to be provided at the outset of the period.

 

As of December 31, 2006 we had not licensed, but in the future we may license, software under perpetual and term license agreements. In such case, we would apply the provisions of Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modifications of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” As prescribed by this guidance, we would apply the residual method of accounting. The residual method requires that the portion of the total arrangement fee attributable to undelivered elements, as indicated by vendor specific objective evidence of fair value, be deferred and subsequently recognized when delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements would be recognized as revenue related to the delivered elements, if all other revenue recognition criteria of SOP 97-2 are met.

 

We also sell our services through a reseller channel. Assuming all other revenue recognition criteria are met, we recognize revenue from reseller arrangements over the term of the contract, based on the reseller’s contracted non-refundable minimum purchase commitments plus amounts sold by the reseller to its customers in excess of the minimum commitments. These excess commitments are recognized as revenue in the period in which the service is provided. We recognize revenue under these agreements on a net or gross basis, depending on the terms of the arrangement, in accordance with EITF 99-19 “Recording Revenue Gross as a Principal Versus Net as an Agent.”

 

From time to time, we enter into contracts to sell our services or license our technology to unrelated companies at or about the same time we enter into contracts to purchase products or services from the same companies. If we conclude that these contracts were negotiated concurrently, we record as revenue only the net cash received from the vendor, unless both the fair values of our services delivered to the customer and of the vendor’s product or service we receive can be established objectively and realization of such value is believed to be probable.

 

We may from time to time resell licenses or services of third parties. We record revenue for these transactions when we have risk of loss related to the amounts purchased from the third party and we add value to the license or service, such as by providing maintenance or support for such license or service. If these conditions are present, we recognize revenue when all other revenue recognition criteria are satisfied.

 

Deferred revenue includes amounts billed to customers for which revenue has not been recognized. Deferred revenue primarily consists of the unearned portion of monthly billed service fees, deferred installation and activation set-up fees and amounts billed under extended payment terms. Deferred revenue was not material to total liabilities or total revenues during prior years.

 

Accounts Receivable and Related Reserves

 

Trade accounts receivable are recorded at the invoiced amounts and do not bear interest. We record reserves as a reduction of our accounts receivable balance. Estimates are used in determining these reserves and are based upon our review of outstanding balances on a customer-specific, account-by-account basis. These estimates could change significantly if our customers’ financial condition changes or if the economy in general deteriorates. The allowance for doubtful accounts is based upon a review of customer receivables from prior sales with collection issues where we no longer believe that the customer has the ability to pay for prior services provided. We perform on-going credit evaluations of our customers. If such an evaluation indicates that payment is no longer reasonably assured for current services provided, any future services provided to that customer will result in the deferral of revenue until payment is made or we determine payment is reasonably assured. In addition, we recorded a reserve for service credits. Reserves for service credits are measured based on an analysis of credits to be issued after the month of billing related to management’s estimate of the resolution of customer disputes and billing adjustments. We do not have any off-balance sheet credit exposure related to our customers.

 

Stock-Based Compensation

 

Prior to January 1, 2006, we accounted for employee stock options pursuant to Statement of Financial Accounting Standards, or SFAS, No. 123, Accounting for Stock-Based Compensation , and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Under this method, compensation expense was recorded for stock options granted prior to January 1, 2006 using the minimum value method.

 

The fair value of the shares of common stock that underlie the stock options we have granted has historically been determined by our board of directors. Because there has been no public market for our common stock, our board has determined the fair value of our common stock at the time of grant of the option by considering a number of objective and subjective factors, including our sales of preferred stock to unrelated third parties, our operating and financial performance, the lack of liquidity of our capital stock, trends in the broader e-commerce market and other similar technology stocks. Beginning in July 2006, our board began receiving contemporaneous valuations performed by an unrelated valuation specialist.

 

In connection with the preparation of the financial statements necessary for a planned registration of shares with the Securities and Exchange Commission and based on the preliminary valuation information presented by the underwriters selected for the planned offering, we reassessed the estimated accounting fair value of common stock in light of the potential completion of this offering. The valuation methodology that most significantly impacted this reassessment of fair value was the market-based assessment of the valuation of existing comparable public companies. This methodology also de-emphasized the $260.0 million liquidation preference available to preferred shareholders in the event of a sale of our company. In determining the reassessed fair value of the common stock during 2006, we also determined it appropriate to reassess the estimate of accounting fair value for periods prior to December 31, 2006 based on operational achievements in executing against the operating plan and market trends. Because of the impact the achievement of unique milestones had on the valuation during the various points in time before the reassessment, certain additional adjustments for factors unique to us were considered in the reassessed values determined for the 12 months ended December 31, 2006, which impacted valuations throughout the twelve month period ended December 31, 2006. These included:

 

Based upon the reassessment, we determined the accounting fair value of the options granted to employees from February 1, 2006 to December 31, 2006 was greater than the exercise price for certain of those options.

 

Based upon the reassessment discussed above, we determined the reassessed accounting fair value of the options to purchase 5,385,542 shares of common stock granted to employees during the period from February 1, 2006 to December 31, 2006 ranged from $1.81 to $9.37 per share. Of these shares, 1,070,000 were issued at prices ranging from $9.80 to $19.80 for which the impact on the fair value was small given the grants were intended to be well above fair value.

 

Stock-based compensation expense for the year ended December 31, 2006 includes the difference between the reassessed accounting fair value per share of the common stock on the date of grant and the exercise price per share and is amortized over the vesting period of the underlying options using the straight-line method. There are significant judgments and estimates inherent in the determination of the reassessed accounting fair values. For this and other reasons, the reassessed accounting fair value used to compute the stock-based compensation expense may not be reflective of the fair market value that would result from the application of other valuation methods, including accepted valuation methods for tax purposes.

 

As of January 1, 2006, we have adopted SFAS No. 123 (revised 2004)  Share-Based Payment , or SFAS No. 123R. We are required to adopt SFAS No. 123R under the prospective method, in which nonpublic entities that previously applied SFAS No. 123 using the minimum-value method, whether for financial statement recognition or pro forma disclosure purposes, would continue to account for unvested stock options outstanding at the date of adoption of SFAS No. 123R in the same manner as they had been accounted for prior to the adoption of SFAS No. 123R. That is, since we have been accounting for stock options using the minimum-value method under SFAS No. 123, we will continue to apply SFAS No. 123 in future periods to stock options outstanding at January 1, 2006. SFAS No. 123R requires measurement of all employee stock-based compensation awards using a fair-value method. The grant date fair value was determined using the Black-Scholes-Merton pricing model. The Black-Scholes-Merton valuation calculation requires us to make key assumptions such as future stock price volatility, expected terms, risk-free rates and dividend yield. The weighted-average expected term for stock options granted was calculated using the simplified method in accordance with the provisions of Staff Accounting Bulletin No. 107, Share-Based Payment. The simplified method defines the expected term as the average of the contractual term and the vesting period of the stock option. We have estimated the volatility rates used as inputs to the model based on an analysis of the most similar public companies for which we have data. We have used judgment in selecting these companies, as well as in evaluating the available historical volatility data for these companies.

 

SFAS No. 123R requires us to develop an estimate of the number of stock-based awards which will be forfeited due to employee turnover. Quarterly changes in the estimated forfeiture rate may have a significant effect on stock-based compensation, as the effect of adjusting the rate for all expense amortization after January 1, 2006 is recognized in the period the forfeiture estimate is changed. If the actual forfeiture rate is higher than the estimated forfeiture rate, then an adjustment is made to increase the estimated forfeiture rate, which will result in a decrease to the expense recognized in the

financial statements. If the actual forfeiture rate is lower than the estimated forfeiture rate, then an adjustment is made to decrease the estimated forfeiture rate, which will result in an increase to the expense recognized in the financial statements. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. We have never paid cash dividends, and do not currently intend to pay cash dividends, and thus have assumed a 0% dividend yield.

 

We will continue to use judgment in evaluating the expected term, volatility and forfeiture rate related to our own stock-based awards on a prospective basis, and in incorporating these factors into the model. If our actual experience differs significantly from the assumptions used to compute our stock-based compensation cost, or if different assumptions had been used, we may have recorded too much or too little stock-based compensation cost.

 

We recognize expense using the straight-line attribution method. Unrecognized stock-based compensation totaled $30.1 million at December 31, 2006, of which we expect to amortize $15.2 million for 2007, and $7.7 million for 2008 and the remainder thereafter. We expect our stock-based compensation expense to increase as we grant additional options.

 

Contingencies

 

We record contingent liabilities resulting from asserted and unasserted claims against us, when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. We disclose contingent liabilities when there is a reasonable possibility that the ultimate loss will exceed the recorded liability. Estimating probable losses requires analysis of multiple factors, in some cases including judgments about the potential actions of third-party claimants and courts. Therefore, actual losses in any future period are inherently uncertain.

 

Deferred Taxes

 

When preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. We estimate our actual current tax liability together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood our deferred tax assets will be recovered from future taxable income within the relevant jurisdiction and to the extent we believe that recovery is not likely, we must establish a valuation allowance. The financial statements included in this report do not reflect a valuation allowance on our deferred tax assets, because we believe it is “more likely than not” that our deferred tax assets will be recovered from future taxable income. Should we determine we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to expense in the period such determination was made.

 

We conduct business in various foreign countries. During 2006, we established corporations in a portion of the foreign countries in which we conduct business. We have not provided U.S. tax for the profits of our foreign corporations, as we intend to permanently reinvest these profits outside the United States.

 

Taxing authorities in the United States and other countries in which we do business are increasing their scrutiny of how businesses are taxed. We believe we maintain adequate tax reserves to offset any potential tax liabilities that may arise upon audit. If such amounts ultimately prove to be unnecessary, the associated reserves would be reversed, resulting in our recording a tax benefit in the period the reserves were no longer deemed necessary. Conversely, if our estimates prove to be less than the ultimate assessment, a charge to expense would be recorded in the period in which the assessment is determined.

 

 

The increase in total revenue for 2006 as compared to 2005 was due to an increase in revenue from the sale of our recurring CDN services. The increase in CDN services revenue was primarily attributable to increases in the number of customers under recurring revenue contracts, as well as increases in traffic and additional services sold to new and existing customers.

 

 

The increase in cost of revenue for 2006 as compared to 2005 was primarily due to an increase in aggregate bandwidth and co-location fees of $13.1 million due to higher traffic levels, an increase in depreciation expense of network equipment of $7.4 million due to increased investment in our network, an increase of $1.6 million in royalty expenses, an increase in the payroll and related employee costs of $1.2 million associated with increased staff and an increase of stock-based compensation expense of $0.5 million and an increase of $0.3 million in other costs.

 

Cost of revenue in 2005 and 2006 was composed of the following: