S-1/A 1 ds1a.htm AMENDMENT #2 TO FORM S-1 AMENDMENT #2 TO FORM S-1
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As filed with the Securities and Exchange Commission on July 15, 2008

Registration No. 333-150469

 

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

AMENDMENT NO. 2

TO

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

RACKSPACE HOSTING, INC.

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   7389   74-3016523

(State or Other Jurisdiction of

Incorporation or Organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(IRS Employer

Identification No.)

5000 Walzem Rd.

San Antonio, Texas 78218

(210) 312-4000

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

 

 

Alan Schoenbaum

Senior Vice President, General Counsel & Secretary

5000 Walzem Rd.

San Antonio, Texas 78218

(210) 312-4000

(Name, Address, Including Zip Code, and Telephone Number, Including Area Code, of Agent for Service)

 

 

Copies to:

 

Steven E. Bochner

Brian K. Beard

Derek L. Willis

Wilson Sonsini Goodrich & Rosati

Professional Corporation

900 South Capital of Texas Highway

Las Cimas IV, Fifth Floor

Austin, Texas 78746-5546

  

Paul E. Hurdlow

Philip W. Russell

DLA Piper US LLP

1221 South MoPac Expressway, Suite 400

Austin, Texas 78746

  

William H. Hinman, Jr.

Simpson Thacher & Bartlett LLP

2550 Hanover Street

Palo Alto, California 94304

 

 

Approximate date of commencement of proposed sale to the public:  As soon as practicable after this registration statement becomes effective.

If any of the securities being registered on this form are to be 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.  ¨

If this form is filed to register additional securities for an offering pursuant to Rule 462(b) 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.  ¨

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 statement number of the earlier effective registration statement for the same offering.  ¨

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.  ¨

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

Indicate by check mark whether registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one): ¨ Large accelerated filer, ¨ Accelerated filer, þ Non-accelerated filer (do not check if a smaller reporting company), or ¨ Smaller reporting company.

 

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to such Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted

 

Subject To Completion. Dated July 15, 2008

             Shares

LOGO

Rackspace Hosting, Inc.

Common Stock

 

 

This is an initial public offering of shares of common stock of Rackspace Hosting, Inc.

Rackspace Hosting is offering              of the shares to be sold in the offering. The selling stockholders identified in this prospectus are offering an additional              shares. Rackspace Hosting will not receive any of the proceeds from the sale of the shares being sold by the selling stockholders.

Prior to this offering, there has been no public market for the common stock. It is currently estimated that the initial public offering price per share will be between $             and $            . Application has been made for listing on the New York Stock Exchange under the symbol “RAX”.

 

 

See the section entitled “Risk Factors” on page 8 to read about factors you should consider before buying shares of the common stock.

 

 

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

     Per Share    Total

Initial public offering price

   $                 $             

Underwriting discount

   $                 $             

Proceeds, before expenses, to Rackspace Hosting

   $                 $             

Proceeds, before expenses, to the selling stockholders

   $                 $             

The price to the public and allocation of shares will be determined by an auction process. The minimum size for a bid in the auction will be 100 shares of our common stock. The method for submitting bids and a more detailed description of this auction process are included in the section entitled “Auction Process” on page 34.

To the extent that the underwriters sell more than              shares of common stock, the underwriters have the option to purchase up to an additional              shares from Rackspace Hosting at the initial public offering price less the underwriting discount.

 

 

The underwriters expect to deliver the shares against payment in New York, New York on                       , 2008.

 

Goldman, Sachs & Co.   Credit Suisse   Merrill Lynch & Co.

 

 

WR Hambrecht + Co

 

 

Prospectus dated                      , 2008.


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LOGO


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PROSPECTUS SUMMARY

This summary highlights certain information contained elsewhere in this prospectus. This summary does not contain all of the information you should consider before investing in our common stock. You should carefully read the entire prospectus, including the section entitled “Risk Factors” and our financial statements and related notes, before you decide whether to invest in our common stock. If you invest in our common stock, you are assuming a high degree of risk. See the section entitled “Risk Factors.” References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. Unless otherwise indicated, industry data are derived from publicly available sources, which we have not independently verified.

Rackspace Hosting

Overview

Rackspace Hosting is the world’s leader in hosting. We deliver websites, web-based IT systems, and computing as a service. Our rapid growth is the result of our commitment to serving our customers, known as Fanatical Support®, and our exclusive focus on hosting. Our financial success is the result of responsible financial management and our disciplined, just-in-time approach to capital investment. During 2007, we had net revenues of $362.0 million. As of March 31, 2008, we served over 31,000 business customers of all sizes with more than 39,000 servers, over 750,000 business email accounts, and more than 43,000 cloud hosting domains. To deliver on our Fanatical Support Promise to our customers, we have created a culture that encourages passionate, engaged employees who we call “Rackers.” In 2008, Fortune magazine ranked Rackspace Hosting #32 on its list of “100 Best Companies to Work For.”

Hosting providers offer services to support websites, web-based IT systems, and computing. The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver services is typically purchased and managed by the hosting provider. As a result, hosting providers reduce customers’ initial capital investment and ongoing operating costs. Hosting also reduces the complexity of deploying and managing IT systems and computing, and changes the way companies purchase these products and services. Rackspace Hosting offers a full suite of hosting services, including dedicated hosting, managed hosting, and email hosting, as well as emerging services such as platform hosting and cloud hosting.

Tier1Research estimates the worldwide hosting market to be $12.3 billion in 2007, with projected annual growth of 26% from 2007 to $24.4 billion in 2010. This revenue comes from three major categories – managed hosting, dedicated hosting, and shared hosting. In 2007, Rackspace Hosting was the world’s largest hosting provider by revenue, based on Tier1Research data for these categories.

Historically, our business has generated high revenue growth and has grown significantly faster than the overall hosting market. Over the past five years our net revenues have grown from $56.6 million in 2003 to $362.0 million in 2007, representing an annual growth rate of 59.0%. We have also been able to generate strong profitability. During that same five year period, our net income grew from $208,000 to $17.8 million. For the quarter ended March 31, 2008 our net revenues were $119.6 million and our net income was $5.4 million. See the sections entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of our results of operations.

 

 

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We are focused on two key principles. First, to be recognized as one of the world’s great service companies. Second, to generate economic returns that exceed our cost of capital. This approach has allowed us to profitably grow to our current size with only $39.6 million in equity capital raised to date, excluding proceeds from stock options exercised under our equity incentive plans. These key principles form the foundation of our business model, which includes the following elements:

 

  Ÿ  

Our Fanatical Support culture serves as a competitive advantage that has allowed us to establish our position as the world’s leading hosting company.

 

  Ÿ  

We are a hosting specialist providing standardized, highly scalable service offerings to our customers.

 

  Ÿ  

Our addressable market is not limited by geography. We manage large scale, centralized data centers and support operations that do not need to be located near our customers. This has allowed us to target hosting customers worldwide.

 

 

Ÿ

 

We are disciplined users of capital and are focused on profitable growth. Our goal is to produce long term economic profit.

Industry Background

The ability to operate online has become increasingly important to businesses. Advances in technology, network infrastructure, and availability of broadband access, have enabled more robust and frequent access to web-based computing capabilities. These capabilities have become the tools business users expect to be available to them anywhere, at any time. These trends have required business owners to invest more in their IT systems and the people who manage them in order to remain competitive. Businesses are also frustrated with the rising level of IT budgets and are searching for new ways to lower costs and support their users’ growing demands.

Hosting has emerged as the answer for businesses to address these factors. As the Internet has evolved, businesses have continued to migrate more and more of their IT systems and computing resources to hosting companies that support their growing needs.

Alternatives to Managing IT Systems and Computing

Businesses are rethinking how they manage their computing needs. In the past, the only alternative to managing IT systems internally was to outsource them. Hosting has emerged as an attractive alternative, one that is tailored to serve a much broader market at lower cost and without high initial capital investment.

Do-it-Yourself: Do-it-yourself is an approach to managing IT systems where a business retains complete ownership and responsibility for maintenance and support. Companies may choose to house their IT systems in their own facilities or may use a colocation vendor for data center space and network access.

Outsourcing: Businesses may also choose to outsource their IT systems and computing operations. Outsourcers typically provide an end-to-end, custom solution for their customers. The outsourcer also assumes responsibility for management of a customer’s IT systems, computing operations, and employees.

Hosting: Many businesses today are choosing hosting as an alternative to do-it-yourself and outsourcing. Hosting providers offer services to support IT systems and computing ranging from simple to very complex. The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver their services is typically purchased and managed by the hosting providers. This results in reduced upfront and ongoing capital expenditures and operating expenses, as well as reduced complexity of deploying and managing IT systems and computing.

 

 

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Benefits of Our Approach

Businesses typically buy our services because we provide them with a level of quality and flexibility that they could not achieve on their own. We believe our historic revenue growth and profitability demonstrate that we are delivering unique value to our customers, as detailed below:

 

  Ÿ  

Exceptional Service Experience.    Our culture is built around our brand of exceptional service, known as Fanatical Support. Rackers strive to deliver the highest level of support every day, and our customers have told us repeatedly that it is an invaluable element of our service.

 

 

Ÿ

 

Reliability and Performance.    We invest in infrastructure and technology. These investments, coupled with our commitment to Fanatical Support, deliver reliability and performance levels that exceed our customers’ ever-expanding needs.

 

  Ÿ  

Lower Cost.    Hosting reduces the capital investment in IT systems’ hardware and software. It also reduces operating costs associated with the IT staff required to manage these complex resources.

 

  Ÿ  

Simplicity and Focus.    Hosting reduces the complexities of managing IT systems, and allows companies to focus on their core business.

 

  Ÿ  

Rapid Deployment and Scalability.    Our organizational design, internal processes, and management tools allow us to rapidly deploy, upgrade, and scale IT systems and computing for our customers.

 

  Ÿ  

Access to the Latest Hosting Technology and Expertise.    Our services allow customers to benefit from our technology investments and expertise without assuming the cost and burden of deploying new technologies themselves or the risk of technology obsolescence.

Our Growth Strategy

Our vision is to be recognized as one of the world’s great service companies. Our goal is to expand our leadership position in hosting around the world, and our strategy for accomplishing this goal includes the following key elements:

 

  Ÿ  

Add New Customers.    We intend to continue our focus on aggressively acquiring profitable new customers.

 

  Ÿ  

Keep Existing Customers for Life and Sell Existing Customers More Services.    When we serve customers well, they generally stay with us and buy more services. This means each customer has the potential to generate significant lifetime economic value.

 

  Ÿ  

Add New Services.    Our goal is to add new services to meet our customers’ growing needs.

 

  Ÿ  

Expand Globally.    We intend to expand further into continental Europe and to Asia.

 

  Ÿ  

Continue to Invest in Our Culture and Hire the Best People.    We intend to continue our highly selective hiring process and maintain a work environment that encourages passionate, engaged Rackers.

The Auction Process

We plan to conduct this offering using an auction process to open participation in our initial public offering to all investors, both individual and institutional. We believe allowing open participation in this offering through a technology-enabled auction process aligns with our corporate culture and business mission. The auction process differs from methods that have been traditionally used in most other

 

 

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underwritten initial public offerings in the U.S. In particular, we and our underwriters plan to conduct an auction open to prospective purchasers to determine the initial public offering price and the allocation of shares in the offering. To participate in the auction, investors will submit bids to purchase shares of our common stock through one of our underwriters. An investor may submit bids that specify the number of shares the investor would be interested in purchasing and the price the investor would be willing to pay. We intend to use the auction to determine a clearing price for the offering, which is the highest price at which all of the shares offered (including shares subject to the underwriters’ over-allotment option) may be sold to potential investors. We may set the initial public offering price at the clearing price, though we and our underwriters have discretion to set the initial public offering price below the clearing price. All valid bids to purchase shares at or above the initial public offering price will receive an allocation of shares at the initial public offering price. If the number of shares represented by successful bids exceeds the number of shares we and the selling stockholders are offering, then we will allocate the shares among successful bids on a pro rata basis. See the section entitled “The Auction Process” for a description of how this process will work.

Risks Affecting Us

We are subject to a number of risks of which you should be aware before you decide to buy our common stock. These risks are discussed more fully in the section entitled “Risk Factors” found on page 8. Some of these risks are:

 

  Ÿ  

We may be unable to manage our growth effectively;

 

  Ÿ  

Our physical infrastructure is concentrated in very few facilities, and any failure in our physical infrastructure or services could lead to significant costs and disruptions;

 

  Ÿ  

We may be unable to hire and retain qualified employees to support our growth strategy;

 

  Ÿ  

Our business is affected by changes in the state of the general economy, and a slowdown or downturn in the general economy could disproportionately affect the demand for our services; and

 

  Ÿ  

We may not be able to compete successfully against current and future competitors.

Corporate Information

Rackspace Hosting, Inc. was incorporated in Delaware on March 7, 2000 under the name Rackspace.com, Inc. However, our operations began in 1998 as a limited partnership, which became our subsidiary through a corporate reorganization completed on August 21, 2001. The company’s name was changed to Rackspace Hosting, Inc. on June 5, 2008 through a merger with its wholly-owned subsidiary. Our principal executive offices are located at 5000 Walzem Rd., San Antonio, Texas 78218. Our telephone number is (210) 312-4000. Our website address is www.rackspace.com. The information contained in, or that can be accessed through, our website is not part of this prospectus.

Rackspace®, Fanatical Support®, Noteworthy® and MOSSO® are our registered service marks. Fanatical, Fanatiguy and Mailtrust are our unregistered service marks. Net Promoter® is a registered trademark of Bain & Company, Fred Reichheld and Satmetrix Systems, Inc.; NPS is a service mark of Bain & Company, Inc. EVA® is a registered trademark of Stern Stewart & Co. and EVAdimensions. Other trademarks and tradenames appearing in this prospectus are the property of their respective holders. We do not intend our use or display of other companies’ tradenames, trademarks, or service marks to imply a relationship with, or endorsement or sponsorship of us by, these other companies.

 

 

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The Offering

 

Common stock we are offering

            shares

 

Common stock offered by the selling stockholders

            shares

 

Common stock to be outstanding after this offering

            shares

 

Over-allotment option

            shares

 

Use of proceeds

We intend to use the net proceeds from this offering primarily to finance our growth plans, as well as for working capital and general corporate purposes. We may use a portion of the net proceeds to repay outstanding borrowings under our revolving line of credit or to acquire businesses, technologies or other assets. Currently, there are no commitments or agreements in place with respect to repayments of outstanding borrowings or acquisitions of businesses, technologies, or other assets. We will not receive any of the proceeds from the sale of shares by the selling stockholders. See the section entitled “Use of Proceeds.”

 

Proposed New York Stock Exchange symbol

RAX

The number of shares of our common stock to be outstanding immediately after this offering is based on 102,744,808 outstanding as of March 31, 2008, after giving effect to the conversion of our preferred stock into shares of common stock, and excludes:

 

  Ÿ  

21,554,832 shares issuable upon the exercise of options outstanding as of March 31, 2008, having a weighted average exercise price of $4.71 per share;

 

  Ÿ  

268,750 shares issuable upon the exercise of warrants outstanding as of March 31, 2008, having a weighted average exercise price of $1.03 per share;

 

  Ÿ  

936,275 additional shares available for future grant under our 2007 Long Term Incentive Plan and 500,000 additional shares to be available for future grant under our 2008 Employee Stock Purchase Plan, each as of March 31, 2008; and

 

  Ÿ  

5,400,000 additional shares that were authorized for future grant in May 2008 under our 2007 Long Term Incentive Plan.

Except as otherwise indicated, all information contained in this prospectus:

 

  Ÿ  

Assumes the underwriters do not exercise their over-allotment option;

 

  Ÿ  

Reflects a five-for-one forward split of our common stock effected on January 31, 2008 through a common stock dividend of four shares of our common stock for each share of our capital stock then outstanding; and

 

  Ÿ  

Assumes the automatic conversion of all outstanding shares of our preferred stock into 1,214,837 shares of common stock upon the completion of this offering.

 

 

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Summary Consolidated Financial Data

The following summary financial data for the fiscal years ended December 31, 2003, 2004, 2005, 2006, and 2007 are derived from our audited financial statements. The summary statements of income data for the three months ended March 31, 2007 and 2008, and the summary consolidated balance sheet data as of March 31, 2008, are derived from our unaudited consolidated financial statements and related notes included elsewhere in this prospectus. You should read this data together with our audited financial statements and related notes included elsewhere in this prospectus and the information under the sections entitled “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Unaudited Pro forma basic and diluted net income per common share has been calculated assuming the conversion of all of our outstanding shares of preferred stock into 1,214,837 shares of common stock.

 

    Years Ended December 31,     Three Months
Ended March 31,
 

Statements of Income Data:

  2003     2004     2005     2006     2007     2007     2008  
                                  (Unaudited)  
   

(in thousands, except per share data)

 

Net revenues

  $ 56,611     $ 86,763     $ 138,768     $ 223,966     $ 362,017     $ 75,225     $ 119,613  

Costs and expenses(1):

             

Cost of revenues

    19,405       28,934       40,987       64,889       118,225       23,593       39,223  

Sales and marketing

    10,258       14,999       21,837       35,667       53,930       11,661       17,568  

General and administrative

    16,998       22,725       38,968       59,832       102,777       20,946       33,633  

Depreciation and amortization

    8,871       12,471       20,193       32,335       56,476       11,835       19,051  
                                                       

Total costs and expenses

    55,532       79,129       121,985       192,723       331,408       68,035       109,475  
                                                       

Income from operations

    1,079       7,634       16,783       31,243       30,609       7,190       10,138  
                                                       

Other income (expense):

             

Interest expense

    (540 )     (612 )     (808 )     (1,095 )     (3,643 )     (525 )     (1,330 )

Interest and other income

    79       270       633       572       828       100       247  
                                                       

Total other income (expense)

    (461 )     (342 )     (175 )     (523 )     (2,815 )     (425 )     (1,083 )
                                                       

Income before income taxes

    618       7,292       16,608       30,720       27,794       6,765       9,055  

Income taxes

    (293 )     2,467       5,836       10,900       9,965       2,593       3,613  
                                                       

Net income from continuing operations

  $ 911     $ 4,825     $ 10,772     $ 19,820     $ 17,829     $ 4,172     $ 5,442  
                                                       

Net income (loss) from discontinued operations

  $ (703 )   $ 3,083     $ —       $ —       $ —       $ —       $ —    
                                                       

Net income

  $ 208     $ 7,908     $ 10,772     $ 19,820     $ 17,829     $ 4,172     $ 5,442  
                                                       

Net income per share:

             

Basic

  $ 0.00     $ 0.09     $ 0.12     $ 0.20     $ 0.18     $ 0.04     $ 0.05  
                                                       

Diluted

  $ 0.00     $ 0.08     $ 0.11     $ 0.19     $ 0.17     $ 0.04     $ 0.05  
                                                       

Weighted average number of shares:

             

Basic

    84,904       84,904       91,793       100,310       101,278       100,875       102,574  
                                                       

Diluted

    102,723       99,450       99,657       104,032       106,618       105,759       109,085  
                                                       

Pro forma net income per share:

             

Basic (unaudited)

          $ 0.18       $ 0.05  
                         

Diluted (unaudited)

          $ 0.17       $ 0.05  
                         

Pro forma weighted average number of shares:

             

Basic (unaudited)

            101,278         102,574  
                         

Diluted (unaudited)

            106,618         109,085  
                         

 

(1)Includes share-based compensation expense as follows:

 

       

Cost of revenue

  $ 212     $ 56     $ 4     $ 83     $ 433     $ 34     $ 365  

Sales and marketing

    223       125       93       156       598       72       401  

General and administrative

    949       177       175       851       3,221       485       1,986  
                                                       

Total share-based compensation expense

  $ 1,384     $ 358     $ 272     $ 1,090     $ 4,252     $ 591     $ 2,752  
                                                       

 

 

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The unaudited pro forma balance sheet data reflects the actual balance sheet data as of March 31, 2008, adjusted to give effect to the automatic conversion of our preferred stock into common stock upon completion of this offering. The pro forma as adjusted balance sheet data reflects the pro forma balance sheet data as of March 31, 2008, adjusted for the sale by us of          shares of our common stock in this offering 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, after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

     As of March 31, 2008

Balance Sheet Data:

   Actual    Pro Forma
(Unaudited)
   Pro Forma
as Adjusted
(Unaudited)
     (in thousands)

Cash and cash equivalents

   $ 27,497    $ 27,497   

Total assets

     355,320      355,320   

Current and non-current capital lease obligations

     60,235      60,235   

Current and non-current debt

     84,895      84,895   

Total stockholders’ equity

     105,770      105,770   

 

 

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RISK FACTORS

An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below, together with the financial and other information contained in this prospectus, including our consolidated financial statements and related notes, before deciding whether to purchase shares of our common stock. Our business, prospects, financial condition, and operating results could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment.

Risks Related to Our Business and Industry

If we are unable to manage our growth effectively our financial results could suffer and our stock price could decline.

We have increased our number of full-time employees from 730 as of December 31, 2005 to 2,021 as of December 31, 2007 and have increased our revenue from $138.8 million in 2005 to $362.0 million in 2007. The rapid growth of our business and our service offerings has strained our operating and financial resources. Further, we intend to continue to expand our overall business, customer base, headcount, and operations. We also intend to expand our data center capacity and have acquired a 1.2 million square foot facility in the San Antonio, Texas area to house our corporate operations and potentially additional data center facilities. Further, we intend to expand our operations internationally. Creating a global organization and managing a geographically dispersed workforce will require substantial management effort and significant additional investment in our operating and financial system capabilities and controls. If our information systems are unable to support the demands placed on them by our rapid growth, we may be forced to implement new systems which would be disruptive to our business. We may be unable to manage our expenses effectively in the future due to the expenses associated with these expansions, which may negatively impact our gross margins or operating expenses. If we fail to improve our operational systems or to expand our customer service capabilities to keep pace with the growth of our business, we could experience customer dissatisfaction, cost inefficiencies, and lost revenue opportunities, which may materially and adversely affect our operating results.

If we overestimate our data center capacity requirements, our operating margins and profitability could be adversely affected.

The costs of construction, leasing, and maintenance of our data centers constitute a significant portion of our capital and operating expenses. In order to manage growth and ensure adequate capacity for new and existing customers while minimizing unnecessary excess capacity costs, we continuously evaluate our short and long-term data center capacity requirements. Due to the lead time in expanding existing data centers or building new data centers, we are required to estimate demand for our services as far as two years into the future. We currently plan to substantially increase our infrastructure through the development of our new headquarters in the San Antonio, Texas area and the expansion of data centers in the U.S. and internationally. In contrast to our data centers that we have established to date, which were acquired relatively inexpensively as distressed assets of third parties, our current expansion plans may require us to pay full market rates for our new data center facilities. If we overestimate the demand for our services and therefore overbuild our data center capacity, our operating margins could be materially reduced, which would materially impair our profitability.

 

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If we underestimate our data center capacity requirements, our financial results and services could be impaired.

If we underestimate our data center capacity requirements, we may not be able to service any expanding needs of our existing customers, or we may be required to limit new customer acquisition while we work to increase data center capacity to satisfy demand, either of which may materially impair our revenue growth.

Our physical infrastructure is concentrated in very few facilities, and any failure in our physical infrastructure or services could lead to significant costs and disruptions and could reduce our revenues, harm our business reputation and have a material adverse effect on our financial results.

Our network and power supplies and data centers are subject to various points of failure, and a problem with our generators, UPS, or Uninterruptible Power Supply, routers, switches, or other equipment, whether or not within our control, could result in service interruptions for some or all of our customers or equipment damage. We currently manage seven data centers in the U.S. and the United Kingdom, or U.K., and plan to consolidate two of our three existing data centers in the U.K. into our new data center space in Slough, U.K. See the section entitled “Business—Facilities.” Because our hosting services do not require geographic proximity of our data centers to our customers, our hosting infrastructure is consolidated into a few large facilities. Accordingly, any failure or downtime in one of our data center facilities could affect a significant percentage of our customers. While data backup services are included in our hosting services, the majority of our customers do not elect to pay the additional fees required to store their backup data offsite in a separate facility. The total destruction or severe impairment of any of our data center facilities could result in significant downtime of our services and the loss of vast amounts of customer data. Since our ability to attract and retain customers depends on our ability to provide customers with highly reliable service, even minor interruptions in our service could harm our reputation. The services we provide are subject to failure resulting from numerous factors, including:

 

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Human error or accidents (such as an airplane crash into one of our facilities, some of which are located near major airports);

 

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Power loss;

 

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Equipment failure;

 

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Internet connectivity downtime;

 

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Improper building maintenance by the landlords of the buildings in which our facilities are located;

 

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Physical or electronic security breaches;

 

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Fire, earthquake, hurricane, tornado, flood, and other natural disasters;

 

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Water damage;

 

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Terrorism;

 

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Sabotage and vandalism; and

 

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Failure by us or our vendors to provide adequate service to our equipment.

Additionally, in connection with the expansion or consolidation of our existing data center facilities from time to time, there is an increased risk that service interruptions may occur as a result of server relocation or other unforeseen construction-related issues.

 

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We have experienced interruptions in service in the past, due to such things as power outages, power equipment failures, cooling equipment failures, routing problems, hard drive failures, database corruption, and other computer failures. During the fourth quarter of 2007, our data center operations in Grapevine, Texas were impaired for several hours due to separate incidents of simultaneous system failures. The system failures included the loss of our utility delivery systems which were damaged by two separate vehicle-related accidents as well as problems with certain redundant power and cooling systems in the data center. These system failures resulted in downtime for a substantial portion of the servers located in the facility. As a result of this downtime, we extended approximately $3.4 million in credits to our customers and may have suffered damage to our reputation with our customers. While we have not experienced larger than normal customer attrition following these events, the extent of any damage to our reputation is difficult to assess. Although we are taking certain steps to avoid this situation in the future through upgrades to our cooling equipment and other infrastructure, service interruptions due to equipment failures, a natural disaster, accident, or otherwise could still materially impact our business.

Any future interruptions could:

 

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Cause our customers to seek damages for losses incurred;

 

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Require us to replace existing equipment or add redundant facilities;

 

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Damage our reputation as a reliable provider of hosting services;

 

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Cause existing customers to cancel or elect to not renew their contracts; or

 

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Make it more difficult for us to attract new customers.

Any of these events could materially increase our expenses or reduce our revenues, which would have a material adverse effect on our operating results.

Customers with mission-critical applications could potentially expose us to lawsuits for their lost profits or damages, which could impair our financial condition.

Because our hosting services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we typically require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a service interruption or other Internet site or application problems that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and any legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may significantly exceed our liability insurance coverage by unknown but significant amounts, which could seriously impair our financial condition.

If we do not prevent security breaches, we may be exposed to lawsuits, lose customers, suffer harm to our reputation, and incur additional costs.

We rely on third-party suppliers to protect our equipment and hardware against breaches in security and cannot be certain that they will provide adequate security. The services we offer involve the transmission of large amounts of sensitive and proprietary information over public communications networks as well as the processing and storage of confidential customer information. Unauthorized access, computer viruses, accidents, employee error or malfeasance, fraudulent service plan orders, intentional misconduct by computer “hackers”, and other disruptions can occur that could compromise the security of our infrastructure, thereby exposing such information to unauthorized access by third parties and leading to interruptions, delays or cessation of service to our customers. Techniques used to obtain unauthorized access to, or to sabotage, systems change frequently and generally are not recognized until launched against a target, so we may be unable to implement security measures in a

 

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timely manner or, if and when implemented, these measures could be circumvented as a result of accidental or intentional actions by parties within or outside of our organization. Any breaches that may occur could expose us to increased risk of lawsuits, loss of existing or potential customers, harm to our reputation and increases in our security costs. Although we typically require our customers to sign agreements that contain provisions attempting to limit our liability for security breaches, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a security breach that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may significantly exceed our liability insurance coverage by unknown but significant amounts, which could seriously impair our financial condition.

Terrorist activity throughout the world and military action to counter terrorism could adversely impact our operating results.

Terrorist attacks and other acts of violence, as well as governments’ responses to such activities, may have an adverse effect on business, financial, and general economic conditions internationally. Terrorist activities may disrupt our ability to provide our services or may increase our costs due to the need to provide enhanced security, which would have a material adverse effect on our business and results of operations. These circumstances may also adversely affect our ability to attract and retain customers, our ability to raise capital, and the operation and maintenance of our facilities. We may not have adequate property and liability insurance to cover catastrophic events or attacks brought on by terrorist attacks and other acts of violence. In addition, we depend heavily on the physical infrastructure, particularly as it relates to power, that exists in the markets in which we operate. Any damage to such infrastructure in these markets where we operate may materially and adversely affect our operating results.

We rely on third-party hardware that may be difficult to replace or could cause errors or failures of our service, which could adversely affect our operating results or harm our reputation.

We rely on hardware acquired from third parties in order to offer our services. This hardware may not continue to be available on commercially reasonable terms in quantities sufficient to meet our business needs, which could adversely affect our ability to generate revenue. Any errors or defects in third-party hardware could result in errors or a failure of our service, which could harm our reputation and operating results. Indemnification from hardware providers, if any, would likely be insufficient to cover any damage to our business or our customers resulting from such hardware failure.

We rely on third-party software that may be difficult to replace or which could cause errors or failures of our service that could lead to lost customers or harm to our reputation.

We rely on software licensed from third parties to offer our services. This software may not continue to be available to us on commercially reasonable terms, or at all. Any loss of the right to use any of this software could result in delays in the provisioning of our services until equivalent technology is either developed by us, or, if available, is identified, obtained, and integrated, which could harm our business. Any errors or defects in third-party software could result in errors or a failure of our service which could harm our operating results by adversely affecting our revenues or operating costs.

We provide service level commitments to our customers, which could require us to issue credits for future services if the stated service levels are not met for a given period and could significantly harm our revenue and our reputation.

Our customer agreements provide that we maintain certain service level commitments to our customers relating primarily to network uptime, critical infrastructure availability, and hardware

 

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replacement. If we are unable to meet the stated service level commitments, we may be contractually obligated to provide these customers with credits for future services. As a result, a failure to deliver services for a relatively short duration could cause us to issue these credits to a large number of affected customers. In addition, we cannot assure you that our customers will accept these credits in lieu of other legal remedies that may be available to them. Our failure to meet our commitments could also result in substantial customer dissatisfaction or loss. Because of the loss of future revenues through these credits, potential customer loss and other potential liabilities, our revenue could be significantly impacted if we cannot meet our service level commitments to our customers.

If we are unable to maintain a high level of customer service, customer satisfaction and demand for our services could suffer.

We believe that our future revenue growth depends on our ability to provide customers with quality service that not only meets our stated commitments, but meets and then exceeds customer service expectations. If we are unable to provide customers with quality customer support in a variety of areas, we could face customer dissatisfaction, decreased overall demand for our services, and loss of revenue. In addition, our inability to meet customer service expectations may damage our reputation and could consequently limit our ability to retain existing customers and attract new customers, which would adversely affect our ability to generate revenue and negatively impact our operating results.

We may not be able to continue to add new customers and increase sales to our existing customers, which could adversely affect our operating results.

Our growth is dependent on our ability to continue to attract new customers while retaining and expanding our service offerings to existing customers. Growth in the demand for our services may be inhibited and we may be unable to sustain growth in our customer base, for a number of reasons, such as:

 

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Our inability to market our services in a cost-effective manner to new customers;

 

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The inability of our customers to differentiate our services from those of our competitors or our inability to effectively communicate such distinctions;

 

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Our inability to successfully communicate to businesses the benefits of outsourcing their hosting needs;

 

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The decision of businesses to host their Internet sites and web infrastructure internally or in colocation facilities as an alternative to the use of our hosting services;

 

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Our inability to penetrate international markets;

 

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Our inability to expand our sales to existing customers;

 

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Our inability to strengthen awareness of our brand; and

 

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Reliability, quality or compatibility problems with our services.

A substantial amount of our past revenue growth was derived from purchases of service upgrades by existing customers. Our costs associated with increasing revenue from existing customers are generally lower than costs associated with generating revenue from new customers. Therefore, a reduction in the rate of revenue increase from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins.

Any failure by us to continue attracting new customers or grow our revenue from existing customers could have a material adverse effect on our operating results.

 

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Our existing customers could elect to reduce or terminate the services they purchase from us because we do not have long-term contracts with our customers, which could adversely affect our operating results.

Our customer contracts for our services typically have initial terms of one to two years, which unless terminated, may be renewed or automatically extended on a month-to-month basis. Our customers have no obligation to renew their services after their initial contract periods expire. Moreover, our customers could cancel their service agreements before they expire. Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.

Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the innovation, creativity, and teamwork fostered by our culture, and our operating results may be harmed.

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity, and teamwork. If our organization grows, and we are required to implement more complex organizational management structures, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future operating results. In addition, this offering may create disparities in personal wealth among Rackspace Hosting employees, which may adversely impact relations among employees and our corporate culture.

If we fail to hire and retain qualified employees and management personnel, our growth strategy and our operating results could be harmed.

Our growth strategy depends on our ability to identify, hire, train, and retain IT professionals, technical engineers, operations employees, and sales and senior management personnel who maintain relationships with our customers and who can provide the technical, strategic, and marketing skills required for our company to grow. There is a shortage of qualified personnel in these fields, specifically in the San Antonio, Texas area, where we are headquartered and a majority of our employees are located, and we compete with other companies for this limited pool of potential employees. There is no assurance that we will be able to recruit or retain qualified personnel, and this failure could cause our operations and financial results to be negatively impacted.

Our success and future growth also depends to a significant degree on the skills and continued services of our management team, especially Graham Weston, our Chairman, and A. Lanham Napier, our President and Chief Executive Officer. We do not maintain key man insurance on any members of our management team, including Messrs. Weston and Napier.

Our business is affected by changes in the state of the general economy, and a slowdown or downturn in the general economy could disproportionately affect the demand for our services.

Our customers include a range of organizations whose success is intrinsically linked to the health of the economy generally. As a result, fluctuations, disruptions, instability or downturns in the general economy could disproportionately affect demand for our services. For example, such fluctuations, disruptions, instability or downturns may cause our customers to do the following:

 

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Cancel or reduce planned expenditures for our services;

 

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Seek to lower their costs by renegotiating their contracts with us;

 

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Move their hosting services in-house; or

 

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Switch to lower-priced solutions provided by our competitors.

If such conditions occur and persist, our business and financial results could be materially adversely affected.

Our operating results may fluctuate significantly, which could make our future results difficult to predict and could cause our operating results to fall below investor or analyst expectations.

Our operating results may fluctuate due to a variety of factors, including many of the risks described in this section, which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our operating results for any prior periods as an indication of our future operating performance. Fluctuations in our revenue can lead to even greater fluctuations in our operating results. Our budgeted expense levels depend in part on our expectations of long-term future revenue. Given relatively fixed operating costs related to our personnel and facilities, any substantial adjustment to our expenses to account for lower than expected levels of revenue will be difficult and take time. Consequently, if our revenue does not meet projected levels, our operating expenses would be high relative to our revenue, which would negatively affect our operating performance.

If our revenue or operating results do not meet or exceed the expectations of investors or securities analysts or fall below any guidance we may in the future provide to the market, the price of our common stock may decline.

Increased energy costs, power outages, and limited availability of electrical resources may adversely affect our operating results.

Our data centers are susceptible to increased regional, national or international costs of power and to electrical power outages. Our customer contracts do not allow us to pass on any increased costs of energy to our customers, which could harm our business. Further, power requirements at our data centers are increasing as a result of the increasing power demands of today’s servers. Increases in our power costs could harm our operating results and financial condition.

Since we rely on third parties to provide our data centers with power sufficient to meet our needs, our data centers could have a limited or inadequate amount of electrical resources necessary to meet our customer requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. Any system downtime resulting from insufficient power resources or power outages could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

Increased Internet bandwidth costs and network failures may adversely affect our operating results.

Our success depends in part upon the capacity, reliability, and performance of our network infrastructure, including the capacity leased from our Internet bandwidth suppliers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. Some of these providers are also our competitors. We exercise little control over these providers, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions or delays in network service. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business.

 

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As our customers’ usage of telecommunications capacity increases, we will need to make additional investments in our capacity to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be on terms unacceptable to us. If adequate capacity is not available to us as our customers’ usage increases, our network may be unable to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along the increased costs to our customers.

We may not be able to renew the leases on our existing facilities on terms acceptable to us, if at all, which could adversely affect our operating results.

We do not own the facilities occupied by our current data centers, but occupy them pursuant to commercial leasing arrangements. The initial terms of our existing data center leases expire over a period ranging from 2008 to 2015, with each having at least one renewal period of five years. Upon the expiration or termination of our data center facility leases, we may not be able to renew these leases on terms acceptable to us, if at all. If we fail to renew any data center lease and are required to move the data center to a new facility, we would face significant challenges due to the technical complexity, risk, and high costs of relocating the equipment. For example, if we are required to migrate customer servers to a new facility, such migration could result in significant downtime for our affected customers. This could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

Even if we are able to renew the leases on our existing data centers, we expect that rental rates, which will be determined based on then-prevailing market rates with respect to the renewal option periods and which will be determined by negotiation with the landlord after the renewal option periods, will be higher than rates we currently pay under our existing lease agreements. If we fail to increase revenue in our existing data centers by amounts sufficient to offset any increases in rental rates for these facilities, our operating results may be materially and adversely affected.

We could be required to repay substantial amounts of money to certain state and local governments if we lose tax exemptions or grants previously awarded to us, which could adversely affect our operating results.

On August 3, 2007, we entered into a lease for approximately 67 acres of land and a 1.2 million square foot facility in Windcrest, Texas, which is in the San Antonio, Texas area, to house our corporate headquarters and potentially a future data center operation. See the section entitled “Business—Facilities.”

In connection with this lease, we also entered into a Master Economic Incentives Agreement with the Cities of Windcrest and San Antonio, Texas; Bexar County; and certain other parties, pursuant to which we agreed to locate existing and future employees at the new facility location. The agreement requires that we meet certain employment levels each year, with an ultimate employee base requirement of 4,500 jobs by December 31, 2012. In addition, the agreement requires that the median compensation of those employees be no less than $51,000 per year. In exchange for meeting these employment obligations, the parties agreed to enter into the lease structure, pursuant to which, as a lessee of the Windcrest Economic Development Corporation, we will not be subject to most of the property taxes associated with the property for a 14 year period. If we fail to meet these job creation requirements, we could lose a portion or all of the tax benefit being provided during the 14-year period by having to pay “PILOT” payments to the City of Windcrest. The amount of the PILOT payment would be calculated based on the amount of taxes that would have been owed for that period if the property were not exempt, and then such amount would be adjusted pursuant to certain factors, such as the percentage of employment achieved compared to the stated requirements.

 

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In connection with this arrangement, the Cities of San Antonio and Windcrest entered into an agreement to move part of the boundary line between the two cities. This resulted in the land on which our new facility is located and additional contiguous property, which was formerly part of the City of San Antonio, becoming part of the City of Windcrest. After we entered into this arrangement, a neighboring property owner challenged the constitutionality of the boundary change. If such challenge is successful, our facility would revert back into the boundaries of San Antonio and we would be required to pay property taxes to San Antonio.

Further, we entered into an agreement with the State of Texas under which we could receive up to $22.0 million in state enterprise fund grants in four installments on the condition that we meet certain employment levels each year, with a requirement that we ultimately create at least 4,000 new jobs in the State of Texas paying an average compensation of at least $56,000 per year (subject to a 2% per year increase commencing in 2009) by December 31, 2012. We must sustain these jobs through December 31, 2018. To the extent we fail to meet these requirements, we would be required to repay all or a portion of the grants plus interest.

The loss of any anticipated tax benefits or grants described above or the repayment of the grant funds from the State of Texas could have a material adverse effect on our liquidity or results of operations.

We have significant debt obligations that include restrictive covenants limiting our flexibility to manage our business; failure to comply with these covenants could trigger an acceleration of our outstanding indebtedness and adversely affect our financial position and operating results.

As of March 31, 2008, outstanding indebtedness under our credit facility totaled approximately $77.3 million. Our credit facility requires that we maintain specific financial ratios and comply with covenants, including financial covenants, which contain numerous restrictions on our ability to incur additional debt, pay dividends or make other restricted payments, sell assets, enter into affiliate transactions and take other actions. See the section entitled “Description of Indebtedness.” Further, our existing credit facility is, and any future financing arrangements may be, secured by all of our assets. If we are unable to meet the terms of the financial covenants or if we breach any of these covenants, a default could result under one or more of these agreements, which may require us to repay all amounts owing under our credit facility. As of December 31, 2007, we were not in compliance with the fixed charge coverage ratio covenant. However, we received a waiver from the financial institution in April 2008, and, as of March 31, 2008, we are in compliance with the covenants.

If we are unable to generate sufficient cash available to repay our debt obligations when they become due and payable, either when they mature or in the event of a default, we may not be able to obtain additional debt or equity financing on favorable terms, if at all, which may negatively impact our ability to continue as a going concern.

We also have substantial equipment lease obligations, which totaled approximately $60.2 million as of March 31, 2008. The payment obligations under these equipment leases are secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

We may require additional capital and may not be able to secure additional financing on favorable terms to meet our future capital needs, which could adversely affect our financial position and result in stockholder dilution.

We may need to raise additional funds through equity or debt financings in the future in order to meet our operating and capital needs. We may not be able to secure additional debt or equity financing

 

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on favorable terms, or at all, at the time when we need such funding. If we are unable to raise additional funds, we may not be able to pursue our growth strategy and our business could suffer. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our common stock. In addition, any debt financing that we may obtain in the future could have restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions.

We are exposed to commodity and market price risks that have the potential to substantially influence our profitability and liquidity.

We are a large consumer of power. In 2007, we paid approximately $7.3 million to utility companies to power our data centers. We anticipate an increase in our consumption of power in the future as our sales grow. Power costs vary by locality and are subject to substantial seasonal fluctuations. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs have historically risen with general costs of energy, and continued increases in electricity costs may negatively impact our gross margins or operating expenses. Since power cost increases usually occur during the summer months, we annually evaluate the advisability of entering into fixed price utilities contracts for the summer months. If we choose not to enter into a fixed price contract, we expose our cost structure to this commodity price risk.

The majority of our customers are invoiced, and substantially all of our expenses are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. However, some of our customers are currently invoiced in currencies other than the applicable functional currency, such as the Euro. As a result, we may incur foreign currency losses based on changes in exchange rates between the date of the invoice and the date of collection. In addition, large changes in foreign exchange rates relative to our functional currencies could increase the costs of our services to non-U.S. customers relative to local competitors, thereby causing us to lose existing or potential customers to these local competitors. As a result, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Further, as we grow our international operations, our exposure to foreign currency risk could become more significant. To date, we have not entered into any hedging contracts, although we may do so in the future.

If we are unable to adapt to evolving technologies and customer demands in a timely and cost-effective manner, our ability to sustain and grow our business may suffer.

Our market is characterized by rapidly changing technology, evolving industry standards, and frequent new product announcements, all of which impact the way in which hosting services are marketed and delivered. These characteristics are magnified by the continued rapid growth of the Internet and the intense competition in our industry. To be successful, we must adapt to our rapidly changing market by continually improving the performance, features, and reliability of our services and modifying our business strategies accordingly. We could also incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. For example, our data center infrastructure could require improvements due to the development of new systems to deliver power to or eliminate heat from the servers we house or as a result of the development of new server technologies that require levels of critical load and heat removal that our facilities are not designed to provide. We may not be able to timely adapt to changing technologies, if at all. Our ability to sustain and grow our business would suffer if we fail to respond to these changes in a timely and cost-effective manner.

New technologies or industry standards have the potential to replace or provide lower cost alternatives to our hosting services. Additionally, the adoption of such new technologies or industry

 

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standards could render our services obsolete or unmarketable. We cannot guarantee that we will be able to identify the emergence of these new service alternatives successfully and modify our services accordingly, or develop and bring new products and services to market in a timely and cost-effective manner to address these changes.

Our failure to provide services to compete with new technologies or the obsolescence of our services could lead us to lose current and potential customers or could cause us to incur substantial costs, which would harm our operating results and financial condition.

We may not be able to compete successfully against current and future competitors.

The market for hosting services is highly competitive. We expect that we will face additional competition from our existing competitors as well as new market entrants in the future.

Our current and potential competitors vary by size and service offerings and by geographic region. These competitors may elect to partner with each other or with focused companies like us to grow their businesses. They include:

 

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Do-it-yourself solutions with a colocation partner such as AT&T, Equinix, SAVVIS, Switch & Data, and telecommunications companies;

 

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IT outsourcing providers such as CSC, EDS, and IBM; and

 

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Hosting providers such as AT&T, Pipex, SAVVIS, Terremark, The Planet, and Verio.

Further, we expect to face competition from new market entrants such as Microsoft, Google, and Amazon, which have already, or are expected to, offer hosting services.

The primary competitive factors in our market are: customer service and technical expertise; security reliability and functionality; reputation and brand recognition; financial strength; breadth of services offered; and price.

Many of our current and potential competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater brand recognition, and more established relationships in the industry than we do. As a result, some of these competitors may be able to:

 

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Develop superior products or services, gain greater market acceptance, and expand their service offerings more efficiently or more rapidly;

 

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Adapt to new or emerging technologies and changes in customer requirements more quickly;

 

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Bundle hosting services with other services they provide at reduced prices;

 

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Take advantage of acquisition and other opportunities more readily;

 

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Adopt more aggressive pricing policies and devote greater resources to the promotion, marketing, and sales of their services; and

 

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Devote greater resources to the research and development of their products and services.

We may be accused of infringing the proprietary rights of others, which could subject us to costly and time-consuming litigation and require us to discontinue services that infringe the rights of others.

There may be intellectual property rights held by others, including issued or pending patents, trademarks, and service marks, that cover significant aspects of our technologies, branding or

 

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business methods, including technologies and intellectual property we have licensed from third parties. Companies in the technology industry, and other patent and trademark holders seeking to profit from royalties in connection with grants of licenses, own large numbers of patents, copyrights, trademarks, service marks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. These or other parties could claim that we have misappropriated or misused intellectual property rights and any such intellectual property claim against us, regardless of merit, could be time consuming and expensive to settle or litigate and could divert the attention of our technical and management personnel. An adverse determination also could prevent us from offering our services to our customers and may require that we procure or develop substitute services that do not infringe. For any intellectual property rights claim against us or our customers, we may have to pay damages, indemnify our customers against damages or stop using technology or intellectual property found to be in violation of a third party’s rights. We may be unable to replace those technologies with technologies that have the same features or functionality and that are of equal quality and performance standards on commercially reasonable terms or at all. Licensing replacement technologies and intellectual property may significantly increase our operating expenses or may require us to restrict our business activities in one or more respects. We may also be required to develop alternative non-infringing technology and intellectual property, which could require significant effort, time, and expense.

Our use of open source software could impose limitations on our ability to provide our services, which could adversely affect our financial condition and operating results.

We utilize open source software, including Linux-based software, in providing a substantial portion of our services. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to offer our services. Additionally, the use and distribution of open source software can lead to greater risks than the use of third-party commercial software, as open source software does not come with warranties or other contractual protections regarding infringement claims or the quality of the code. From time to time parties have asserted claims against companies that distribute or use open source software in their products and services, asserting that open source software infringes their intellectual property rights. We could be subject to suits by parties claiming infringement of intellectual property rights with respect to what we believe to be open source software. In such event, we could be required to seek licenses from third parties in order to continue using such software or offering certain of our services or to discontinue the use of such software or the sale of our affected services in the event we could not obtain such licenses, any of which could adversely affect our business, operating results and financial condition. In addition, if we combine our proprietary software with open source software in a certain manner, we could, under some of the open source licenses, be required to release the source code of our proprietary software.

We may not be successful in protecting and enforcing our intellectual property rights, which could adversely affect our financial condition and operating results.

We primarily rely on copyright, trademark, service mark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights, all of which provide only limited protection. We rely on copyright laws to protect software and certain other elements of our proprietary technologies, although to date we have not registered for copyright protection. We cannot assure you that any future copyright, trademark or service mark registrations will be issued for pending or future applications or that any registered or unregistered copyrights, trademarks or service marks will be enforceable or provide adequate protection of our proprietary rights. We also currently have one patent issued and no patent applications pending in the U.S. Our patent may be contested, circumvented, found unenforceable or invalidated, and therefore, we cannot predict with certainty the effect of having this patent.

 

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We endeavor to enter into agreements with our employees and contractors and agreements with parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are substantially equivalent, superior to, or otherwise competitive to the technologies we employ in our services or that infringe our intellectual property. Moreover, we may be unable to prevent competitors from acquiring trademarks or service marks and other proprietary rights that are similar to, infringe upon, or diminish the value of our trademarks and service marks and our other proprietary rights. Enforcement of our intellectual property rights also depends on successful legal actions against infringers and parties who misappropriate our proprietary information and trade secrets, but these actions may not be successful, even when our rights have been infringed.

In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the U.S. Despite the measures taken by us, it may be possible for a third party to copy or otherwise obtain and use our technology and information without authorization. Policing unauthorized use of our proprietary technologies and other intellectual property and our services is difficult, and litigation could become necessary in the future to enforce our intellectual property rights. Any litigation could be time consuming and expensive to prosecute or resolve, result in substantial diversion of management attention and resources, and harm our business, financial condition, and results of operations.

We may be liable for the material that content providers distribute over our network and we may have to terminate customers that provide content that is determined to be illegal, which could adversely affect our operating results.

The law relating to the liability of private network operators for information carried on, stored on, or disseminated through their networks is still unsettled in many jurisdictions. We have been and expect to continue to be subject to legal claims relating to the content disseminated on our network, including claims under the Digital Millennium Copyright Act and other similar legislation. In addition, there are other potential customer activities, such as online gambling and pornography, where we, in our role as a hosting provider, may be held liable as an aidor or abettor of our customers. If we need to take costly measures to reduce our exposure to these risks, terminate customer relationships and the associated revenue or defend ourselves against such claims, our financial results could be negatively affected.

Government regulation of data networks is largely unsettled, and depending on its evolution, may adversely affect our operating results.

We are subject to varying degrees of regulation in each of the jurisdictions in which we provide services. Local laws and regulations, and their interpretation and enforcement, differ significantly among those jurisdictions. Future regulatory, judicial, and legislative changes may have a material adverse effect on our ability to deliver services within various jurisdictions. National regulatory frameworks that are consistent with the policies and requirements of the World Trade Organization have only recently been, or are still being, put in place in many countries. Accordingly, many countries are still in the early stages of providing for and adapting to a liberalized telecommunications market. As a result, in these markets we may encounter more protracted and difficult procedures to obtain any necessary licenses or negotiate interconnection agreements, which could negatively impact our ability to expand in these markets or increase our operating costs in these markets.

Our ability to operate and expand our business is susceptible to risks associated with international sales and operations.

We anticipate that, for the foreseeable future, a significant portion of our revenues will continue to be derived from sources outside of the U.S. A key element of our growth strategy is to further expand

 

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our customer base internationally and successfully operate data centers in foreign markets. We have limited experience operating in foreign jurisdictions and expect to rapidly grow our international operations. Managing a global organization is difficult, time consuming, and expensive. Our inexperience in operating our business globally increases the risk that international expansion efforts that we may undertake will not be successful. In addition, conducting international operations subjects us to new risks that we have not generally faced. These risks include:

 

  Ÿ  

Localization of our services, including translation into foreign languages and adaptation for local practices and regulatory requirements;

 

  Ÿ  

Lack of familiarity with and unexpected changes in foreign regulatory requirements;

 

  Ÿ  

Longer accounts receivable payment cycles and difficulties in collecting accounts receivable;

 

  Ÿ  

Difficulties in managing and staffing international operations;

 

  Ÿ  

Fluctuations in currency exchange rates;

 

  Ÿ  

Potentially adverse tax consequences, including the complexities of transfer pricing, foreign value added tax systems, and restrictions on the repatriation of earnings;

 

  Ÿ  

Dependence on certain third parties, including channel partners with whom we do not have extensive experience;

 

  Ÿ  

The burdens of complying with a wide variety of foreign laws and legal standards;

 

  Ÿ  

Increased financial accounting and reporting burdens and complexities;

 

  Ÿ  

Political, social, and economic instability abroad, terrorist attacks and security concerns in general; and

 

  Ÿ  

Reduced or varied protection for intellectual property rights in some countries.

Operating in international markets also requires significant management attention and financial resources. The investment and additional resources required to establish operations and manage growth in other countries may not produce desired levels of revenue or profitability.

We may make future acquisitions, which may divert our management’s attention, result in dilution to our stockholders and consume resources that are necessary to sustain our business.

Although we have no current agreements or commitments for any acquisitions, if appropriate opportunities present themselves, we may make acquisitions or investments or enter into joint ventures or strategic alliances with other companies. Risks commonly encountered in such transactions include:

 

  Ÿ  

The difficulty of assimilating the operations and personnel of the combined companies;

 

  Ÿ  

The risk that we may not be able to integrate the acquired services or technologies with our current services, products, and technologies;

 

  Ÿ  

The potential disruption of our ongoing business;

 

  Ÿ  

The diversion of management attention from our existing business;

 

  Ÿ  

The inability of management to maximize our financial and strategic position through the successful integration of the acquired businesses;

 

  Ÿ  

Difficulty in maintaining controls, procedures, and policies;

 

  Ÿ  

The impairment of relationships with employees, suppliers, and customers as a result of any integration;

 

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  Ÿ  

The loss of an acquired base of customers and accompanying revenue; and

 

  Ÿ  

The assumption of leased facilities, other long-term commitments or liabilities that could have a material adverse impact on our profitability and cash flow.

As a result of these potential problems and risks, businesses that we may acquire or invest in may not produce the revenue, earnings, or business synergies that we anticipated. In addition, there can be no assurance that any potential transaction will be successfully identified and completed or that, if completed, the acquired business or investment will generate sufficient revenue to offset the associated costs or other potential harmful effects on our business.

We may encounter difficulties in the implementation of our new billing system, which could adversely affect our operating results.

We intend to convert our billing system to a new third party billing software during 2008. The successful implementation of this new billing software will require the migration of large amounts of customer data and the implementation of new billing processes. This implementation may ultimately prove to be costly and time-consuming, which could harm our results of operations. Additionally, the migration of customer and billing data to a new billing system may result in the loss of, or inaccuracies in, customer data that could cause us to issue inaccurate invoices to our customers, which could harm our reputation. Unforeseen difficulties in the implementation of this billing system could hinder our ability to generate customer invoices, which could lead to longer customer payment cycles, which could materially affect our cash flows.

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 legal, accounting, and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, as well as rules subsequently implemented by the Securities and Exchange Commission, or the SEC, and the New York Stock Exchange have imposed various requirements on public companies, including requiring changes in corporate governance practices. Our management and other personnel will need to devote a substantial amount of time to these new 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 new 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 costs to maintain the same or similar coverage. These rules and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers.

In anticipation of becoming a public company and in order to respond to additional regulations applicable to public companies, such as Section 404 of the Sarbanes-Oxley Act, we have recently hired a number of finance and accounting personnel. We use independent contractors to fill certain positions and provide certain accounting functions. In the future, we may be required to hire additional full-time accounting employees to fill these and other related finance and accounting positions. Some of these positions require candidates with public company experience, and we may be unable to locate and hire such individuals as quickly as needed, if at all. In addition, new employees will require time and training to learn our business and operating processes and procedures. If our finance and accounting organization is unable for any reason to respond adequately to the increased demands that will result from being a public company, the quality and timeliness of our financial reporting may suffer and we could experience internal control weaknesses. Any consequences resulting from inaccuracies or delays in our reported financial statements could have an adverse effect on the trading price of our common stock as well as an adverse effect on our business, operating results, and financial condition.

 

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We are in the process of evaluating our system of internal controls and may not be able to demonstrate that we can accurately report our financial results or prevent fraud. As a result, our stockholders could lose confidence in our financial reporting, which could harm our business and the trading price of our common stock.

Ensuring 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 is a costly and time-consuming effort that needs to be re-evaluated frequently. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles, or GAAP. We are in the process of documenting, reviewing and improving our internal controls and procedures for compliance with Section 404 of the Sarbanes-Oxley Act, which requires an annual management assessment of the effectiveness of our internal controls over financial reporting and a report by our independent auditors assessing the effectiveness of such internal controls.

In January 2008, in connection with the audit of our consolidated financial statements, we determined that we had material weaknesses relating to communication of significant transactions to our accounting department and for proper accrual of expenditures (cutoff). A material weakness is defined as a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis by the company’s internal controls. The material weakness related to expenditure cutoffs resulted in the recording of audit adjustments for 2007. The remedial actions that we have taken will be subject to continued management review, supported by testing and validation, as well as audit committee oversight. While we believe we have appropriately remediated these material weaknesses, we cannot assure you that these or other material weaknesses or significant deficiencies will not exist or otherwise be discovered in the future, which could impair our ability to report our financial position, results of operations or cash flows in an accurate or timely manner.

Both we and our independent auditors will be testing our internal controls in connection with the audit of our financial statements for the year ending December 31, 2008, and as part of that documentation and testing, identifying areas for further attention and improvement. If we fail to demonstrate that we have effective internal controls, or if we fail to maintain proper and effective internal controls on a going forward basis, our ability to produce accurate and timely financial statements could be impaired, which could harm our operating results and our ability to operate our business, which could reduce the trading price of our stock.

Changes to financial accounting standards or practices may affect our reported financial results and cause us to change our business practices.

We prepare our financial statements to conform with GAAP. These accounting principles are subject to interpretation by the SEC and various other bodies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. Changes to those rules or the interpretation of our current practices may adversely affect our reported financial results or the way we conduct our business. For example, on December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 123 (revised 2004), Share-Based Payment, or SFAS 123(R). SFAS 123(R), which became effective for fiscal periods beginning after June 15, 2005 and requires that employee share-based compensation be measured based on its fair-value on the grant date and treated as an expense that is reflected in the financial statements over the related service period. As a result of SFAS 123(R), our operating results in 2006 and 2007 reflect share-based compensation expenses that are reflected in prior periods using a different methodology, making it more difficult for investors to evaluate our 2006 and 2007 operating results relative to prior periods.

 

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Risks Related to the Auction Process for Our Offering

Our stock price could decline rapidly and significantly following our initial public offering.

Our initial public offering price will be determined by an auction process conducted by us and our underwriters. We believe this auction process will provide information about the market demand for our common stock at the time of our initial public offering. However, this information may have no relation to market demand for our common stock once trading begins. We expect that the bidding process will reveal a clearing price for shares of our common stock offered in the auction. The auction clearing price is the highest price at which all of the shares offered, including shares subject to the underwriters’ over-allotment option, may be sold to potential investors. Although we and our underwriters may elect to set the initial public offering price below the auction clearing price, we may also set an initial public offering price that is equal to the clearing price. If there is little or no demand for our shares at or above the initial public offering price once trading begins, the price of our shares would likely decline following our initial public offering. In addition, the auction process may lead to more stock price volatility or a stock price decline after the initial sales of our stock in the offering, which could lead to class action or securities litigation that would be expensive, time-consuming, and distracting to our management team. If your objective is to make a short-term profit by selling the shares you purchase in the offering shortly after trading begins, you should not submit a bid in the auction.

The auction process for our public offering may result in a phenomenon known as the “winner’s curse,” and, as a result, investors may experience significant losses.

The auction process for our initial public offering may result in a phenomenon known as the “winner’s curse.” At the conclusion of the auction, bidders that receive allocations of shares in this offering (successful bidders) may infer that there is little incremental demand for our shares above or equal to the initial public offering price. As a result, successful bidders may conclude that they paid too much for our shares and could seek to immediately sell their shares to limit their losses should our stock price decline. In this situation, other investors that did not submit successful bids may wait for this selling to be completed, resulting in reduced demand for our common stock in the public market and a significant decline in our stock price. Therefore, we caution investors that submitting successful bids and receiving allocations may be followed by a significant decline in the value of their investment in our common stock shortly after our offering.

The auction process for our initial public offering may result in a situation in which less price sensitive investors play a larger role in the determination of our offering price and constitute a larger portion of the investors in our offering, and, therefore, the offering price may not be sustainable once trading of our common stock begins.

In a typical initial public offering, a majority of the shares sold to the public are purchased by professional investors that have significant experience in determining valuations for companies in connection with initial public offerings. These professional investors typically have access to, or conduct their own independent research and analysis regarding investments in initial public offerings. Other investors typically have less access to this level of research and analysis, and as a result, may be less sensitive to price when participating in our auction process. Because of our auction process, these less price sensitive investors may have a greater influence in setting our initial public offering price and may have a higher level of participation in our offering than is normal for initial public offerings. This, in turn, could cause our auction process to result in an initial public offering price that is higher than the price professional investors are willing to pay for our shares. As a result, our stock price may decrease once trading of our common stock begins. Also, because professional investors may have a substantial degree of influence on the trading price of our shares over time, the price of our common stock may decline and not recover after our offering. Furthermore, if our initial public offering

 

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price is above the level that investors determine is reasonable for our shares, some investors may attempt to short sell the stock after trading begins, which would create additional downward pressure on the trading price of our common stock.

Successful bidders may receive the full number of shares subject to their bids, so potential investors should not make bids for more shares than they are prepared to purchase.

We may set the initial public offering price near or equal to the auction clearing price. If we do this, the number of shares represented by successful bids will likely approximate the number of shares offered by this prospectus, and successful bidders may be allocated all or almost all of the shares that they bid for in the auction. Therefore, we caution investors against submitting a bid that does not accurately represent the number of shares of our common stock that they are willing and prepared to purchase.

Our initial public offering price may have little or no relationship to the price that would be established using traditional valuation methods, and therefore, the initial public offering price may not be sustainable once trading begins.

We may set the initial public offering price near or equal to the auction clearing price. The offering price of our shares may have little or no relationship to, and may be significantly higher than, the price that otherwise would be established using traditional indicators of value, such as our future prospects and those of our industry in general; our sales, earnings, and other financial and operating information; multiples of revenue, earnings, cash flows, and other operating metrics; market prices of securities and other financial and operating information of companies engaged in activities similar to ours; and the views of research analysts. As a result, our initial public offering price may not be sustainable once trading begins, and the price of our common stock may decline.

If research analysts publish or establish target prices for our common stock that are below the initial public offering price or the then current trading market price of our shares, the price of our shares of common stock may fall.

Although the initial public offering price of our shares may have little or no relationship to the price determined using traditional valuation methods, we believe that research analysts will rely upon these methods to establish target prices for our common stock. If research analysts, including research analysts affiliated with our underwriters, publish target prices for our common stock that are below our initial public offering price or the then current trading market price of our shares, our stock price may decline.

Submitting a bid does not guarantee an allocation of shares of our common stock, even if a bidder submits a bid at or above the initial public offering price.

Our underwriters may require that bidders confirm their bids before the auction for our initial public offering closes. If a bidder is requested to confirm a bid and fails to do so within the permitted time period, that bid will be deemed to have been withdrawn and will not receive an allocation of shares even if the bid is at or above the initial public offering price. In addition, the underwriters, in consultation with us, may determine that some bids that are at or above the initial public offering price are manipulative or disruptive to the bidding process, in which case all of the bids submitted by that investor may be rejected.

 

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Risks Related to the Offering and Ownership of Our Common Stock

There is no existing market for our common stock, and you cannot be certain that an active trading market or a specific share price will be established.

Prior to this offering, there has been no public market for shares of our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of a trading market or how liquid that market might become. The initial public offering price for the shares of our common stock will be determined by an auction process, and may not be indicative of the price that will prevail in the trading market following this offering. The market price for our common stock may decline below the initial public offering price, and our stock price is likely to be volatile.

If our stock price fluctuates after the offering, you could lose a significant part of your investment.

The market price of our common stock could be subject to wide fluctuations in response to, among other things, the risk factors described in this section of this prospectus, and other factors beyond our control, such as fluctuations in the valuation of companies perceived by investors to be comparable to us.

Furthermore, the stock markets have experienced price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political, and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock.

In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

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              shares of common stock outstanding. 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:

 

Number of shares and percentage
of total outstanding

  

Date available for sale into public market

shares, or     %

   Immediately after this offering.

shares, or     %

   Generally, 180 days after the date of this prospectus due to lock-up agreements between certain of the holders of these shares and the underwriters or to contractual arrangements between the other holders of these shares and us, subject to a potential extension under certain circumstances.

shares, or     %

   At various dates more than 180 days after the date of this prospectus.

 

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After this offering and the expiration of the lock-up period, the holders of an aggregate of              shares of our common stock 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, subject to lock-up restrictions, they can be freely sold in the public market upon issuance. Furthermore, Goldman, Sachs & Co. and Credit Suisse Securities (USA) LLC may, at their discretion and at any time without notice, release all or any portion of the securities subject to lock-up agreements with the underwriters. 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.

Investors in this offering will suffer immediate and substantial dilution.

The initial public offering price of our common stock is substantially higher than the net tangible book value per share of our outstanding common stock immediately after this offering. Therefore, if you purchase our common stock in this offering, you will incur an immediate dilution of $             in net tangible book value per share from the price you paid. In addition, following this offering, purchasers in the offering will have contributed     % of the total consideration paid by our stockholders to purchase shares of common stock. The exercise of outstanding options will result in further dilution. For a further description of the dilution that you will experience immediately after this offering, see the section entitled “Dilution.”

The issuance of additional stock in connection with acquisitions, our stock option plans, or otherwise will dilute all other stockholdings.

After this offering, we will have an aggregate of              shares of common stock authorized but unissued and not reserved for issuance under our stock option plans or otherwise. We may issue all of these shares without any action or approval by our stockholders. We intend to continue to actively pursue strategic acquisitions. We may pay for such acquisitions, partly or in full, through the issuance of additional equity. Any issuance of shares in connection with our acquisitions, the exercise of stock options or otherwise would dilute the percentage ownership held by the investors who purchase our shares in this offering.

Your ability to influence corporate matters may be limited because a small number of stockholders beneficially own a substantial amount of our common stock.

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. 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. Although our directors and executive officers are not currently party to any agreements or understandings to act together on matters submitted for stockholder approval following the completion of this offering, 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. For information regarding the ownership of our outstanding stock by our executive officers and directors and their affiliates, see the section entitled “Principal and Selling Stockholders.”

 

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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 our net proceeds from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management may not apply our net proceeds from this offering in ways that increase the value of your investment. We expect to use the net proceeds from this offering for primarily to finance our growth plans, as well as for working capital and general corporate purposes, which may in the future include investments in, or acquisitions of, complementary businesses, services or technologies. In addition, we may choose to use a portion of the net proceeds from this offering to repay outstanding borrowings under our revolving line of credit from time to time. 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 our net proceeds from this offering.

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change of control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.

Our restated certificate of incorporation and amended and restated bylaws contain provisions that could delay or prevent a change of control of our company or changes in our board of directors deemed undesirable by our board of directors that our stockholders might consider favorable. Some of these provisions:

 

  Ÿ  

Authorize the issuance of blank check preferred stock which can be created and issued by our board of directors without prior stockholder approval, with voting, liquidation, dividend, and other rights senior to those of our common stock;

 

  Ÿ  

Provide for a classified board of directors, with each director serving a staggered three-year term;

 

  Ÿ  

Prohibit our stockholders from filling board vacancies or increasing the size of our board, calling special stockholder meetings or taking action by written consent;

 

  Ÿ  

Provide for the removal of a director only with cause and by the affirmative vote of the holders of a majority of the shares then entitled to vote at an election of our directors; and

 

  Ÿ  

Require advance written notice of stockholder proposals and director nominations.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our restated certificate of incorporation, amended and restated bylaws and Delaware law could make it more difficult for stockholders or potential acquirors to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

 

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FORWARD-LOOKING STATEMENTS

This prospectus, including the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Business” contains forward-looking statements. Forward-looking statements convey our current expectations or forecasts of future events. All statements contained in this prospectus other than statements of historical fact, including statements regarding our future results of operations and financial position, business strategy and plans, use of the net proceeds of this offering, and our objectives for future operations, are forward-looking. You can identify forward-looking statements by terminology such as “anticipates,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will” or “would” or the negative of these terms or similar expressions.

We have based the forward-looking statements in this prospectus largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives, and financial needs. However, there are a number of important factors that could cause our actual results to differ materially from the results anticipated by these forward-looking statements. These important factors include those that we discuss in this prospectus under the section entitled “Risk Factors.” You should read these factors and the other cautionary statements made in this prospectus as being applicable to all related forward-looking statements wherever they appear in this prospectus. If one or more of these factors materialize, or if any underlying assumptions prove incorrect, our actual results, performance, or achievements may vary materially from any future results, performance, or achievements expressed or implied by these forward-looking statements. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make.

The forward-looking statements contained in this prospectus are excluded from the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act which does not extend to initial public offerings. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law.

This prospectus also contains statistical data and estimates, including those relating to market size and growth rates of the markets in which we participate, that we obtained from industry publications and reports generated by Tier1Research. These publications include forward-looking statements made by the authors of such reports. These forward-looking statements are subject to a number of risks, uncertainties, and assumptions. Actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

You should read this prospectus and the documents that we reference in this prospectus and have filed with the SEC as exhibits to the registration statement of which this prospectus is a part with the understanding that our actual future results, levels of activity, performance, and events, and circumstances may be materially different from what we expect.

 

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LOGO

2008 Racker Letter to Investors

Hosting is at the center of a multi-year shift in computing that is changing the way businesses buy IT services. Hosting delivers “computing as a service.” Today, low-cost, ubiquitous bandwidth, along with the emergence of new technologies such as virtualization and cloud computing, deliver meaningful cost savings, which make hosting even more compelling for a broader market.

As the world’s leader and specialist in hosting, Rackspace Hosting is well positioned to capitalize on this trend. We believe going public strengthens our ability to pursue this opportunity via expansion, acquisitions, and leveraging new technologies. This will support our goal of becoming one of the world’s great service companies.

At the heart of computing today is a disorganized IT closet housing a collection of aging servers surrounded by a tangle of cables and supported by a costly army of IT generalists. To the business leader, this represents a “black hole” of ongoing capital investment and operating cost with disappointing returns. To the IT leader, this represents a mountain of maintenance and low value activity that prevent him from delivering more value to the business.

Hosting makes the IT department more effective. We believe that the economies gained from centralized, standardized data centers and cloud computing platforms will make IT services and computing better, less costly and more available to the broader business market. Hosting changes how businesses buy computing. Additionally, our specialists are available 24x7 to provide their deep knowledge of numerous software applications and computing technologies. They become valuable partners for IT managers.

With similar strategies, Rackspace Hosting will change how businesses buy computing—making it more reliable and more affordable for businesses, large and small.

Today, Rackspace is the world’s leader in hosting. We have earned this position because we learned quickly what customers really wanted from us. Very simply, they wanted great service. In fact, the common definition of a “host” is “someone who receives and entertains guests.” Consistent with this definition, we built our company and our culture around that idea; we call it Fanatical Support.

Fanatical Support is the reason our growth has outpaced the hosting market. It’s the reason that during the past five years, we’ve grown net revenues more than 50% per year to $362.0 million in 2007, and serve more than 29,000 businesses located in over 100 countries.

What is Fanatical Support?

Fanatical Support can be hard to define, yet our customers and employees (we call them Rackers) know what it is. Fanatical Support means that we are invested in the success of our customers’ businesses, that we listen to them and will do what it takes to keep them up and running. We are accountable, responsive, transparent and easy to do business with; all the time. We work hard to earn our customers’ loyalty—and keep it.

At every level of our company, Rackers have a sense of urgency about serving customers. We work to earn their trust and we genuinely care about them, often making our customer relationships personal. It starts with having a real person answer every phone call. That’s Fanatical Support and it underpins our philosophy and transcends our entire business.

We believe that there are very few companies who have been able to build and consistently deliver a customer experience designed to maintain customers for life. That’s why we have embraced

 

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this philosophy and deliver what we call The Fanatical Support Promise—that our customers complete satisfaction is our sole ambition and anything less is unacceptable.

This commitment puts our customer relationships at a different level, one where we become a trusted partner, part of their team. Fanatical Support has helped us keep customers with us for years. We believe it will help keep them with us for life, as we meet their growing needs—and if we do our jobs right, they will refer their friends and colleagues to us.

Rackers are not perfect. They’re people, and people make mistakes. We know we will sometimes fall short of our Fanatical Support. When we do, we tell the truth, and we do our best to make it right for our customers. We learn from our mistakes, and often that improves the service experience for all customers.

Our Culture

To deliver on our promise, we have created a unique culture that encourages and enables Rackers to give their best every day. In 2008, Fortune magazine ranked Rackspace Hosting #32 on its 2008 list of “100 Best Companies to Work For.”

Each Racker is an individual and has unique strengths. We help them develop their strengths rather than ask them to change who they are. We encourage Rackers to talk about their strengths and to find positions in the company that leverage their inherent talents. This approach creates happier, more engaged Rackers who look forward to coming to work.

We spend a great amount of time selecting and training the best people to become Rackers. We’ve all been in situations where a roadblock has been cleared by a single person who handles the situation well. Those are the people and companies that earn our enduring loyalty, where we buy again and again—and tell our friends. We work hard to find people like these to become Rackers.

We empower Rackers with the tools to deliver Fanatical Support every day, but it’s up to each Racker to take responsibility for our customers. We can’t mandate that; they have to volunteer to make the extra effort. Rackers must instinctively know and actively want to do what it takes to build lasting trust with our customers. After all, there is no rulebook for winning customers’ hearts. The most coveted award in our company is the Straight Jacket award. The winners are our heroes; they are the people whose actions we celebrate and who exemplify Racker culture.

Some consider this an expensive way to do business. We respectfully disagree. Our investment in Rackers leads to greater Racker engagement and in turn, higher customer loyalty. One thing is for sure—as a public company, our philosophy of putting Rackers first will not change. Our commitment to Rackers is our commitment to our customers. Anything less will affect our reputation and our customers’ trust in us and, ultimately, our own success.

A Whole New Way of Doing IT

There have traditionally been two ways to manage IT systems—in-house and IT outsourcing. But over the past few years, companies of all sizes are discovering a third way—hosting.

Running IT in-house requires a large, highly technical staff, servers for every software application and often results in high costs. In-house IT departments spend much of their time tending to maintenance tasks, eating up the budget that would otherwise be allocated to their higher value activities.

The second option is IT outsourcing. Outsourcers often take control of every IT task from desktop support to server backups, and frequently hire their customers’ IT personnel.

 

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Neither solution works for most businesses because they need the greater flexibility of selecting which applications get hosted and which remain in-house. They need a partner who is flexible, and will address their needs without requiring an all-encompassing contract spanning five, seven, or ten years. These two drivers, along with the rise of new, disruptive technologies, including virtualization and cloud computing, have created a new wave of demand for hosting.

We believe that hosting will come in many forms. Just as businesses currently have diverse IT needs, they will also have diverse hosting needs. In the last year we’ve launched several new hosting services based on cloud technology, including Rackspace Email Hosting and Rackspace Cloud Hosting. Today, these services account for less than 5% of our overall revenue, but they are growing rapidly and have generated notable market interest.

We believe the opportunity in the hosting market is undeniable. Google, Amazon, and Microsoft all have recently introduced cloud hosting services to meet the growing demand. Firms such as Salesforce.com and SuccessFactors are blazing new trails in delivering cloud applications.

While the competitive landscape is changing dramatically, computing is changing even faster. With the emergence of virtualization, cloud computing, and low cost storage technologies, we have the opportunity to deliver hosting to our customers in an even more efficient manner. These technologies, coupled with centralized computing platforms, will allow customers to consume computing power more reliably and cheaply than was ever possible in the past. As computing costs go down, demand will rise. This is the transformation that IT is undergoing today.

Managing for the Long Term

To Rackspace, success means maximizing our long-term results. We define long-term results as sustainable growth of our economic profit—profit that deducts the cost of all capital, debt and equity. These results will come from our ability to strengthen our market leadership in hosting—the stronger our leadership, the greater our financial success—and our ability to deliver our services on a large scale.

We believe the opportunity ahead of us is substantial, and that we are uniquely positioned in the marketplace. Rackspace’s status as a public company and the resulting infusion of capital will allow us to pursue this market opportunity by investing in expansion, acquisitions, and new technologies. Investing to win in the broad hosting market will require that we invest more aggressively than ever before. Many of these investments will not produce a return in the short run. Some may not produce a return at all.

Being a public company will also pressure us to continuously perform on more short-term oriented metrics such as quarterly revenue and earnings targets. It will be our duty to subordinate these pressures in favor of our long-term objective of building a market-leading business that creates sustainable economic profit.

Core Values Guide Our Decision Making

Rackspace’s success has been guided by a set of core values, and they guide our decision-making—always. We’d like to share these values;

 

   

Fanatical Support in All We Do—Fanatical Support earns customer loyalty, but it also applies to all Rackers and everything they do at Rackspace. We’ve achieved our leadership position by relentlessly focusing on the quality of our service. Rackers also strive to make our company as efficient as possible—but we will not take short-cuts that will harm our customers.

 

   

Results First: Substance Over Flash—We value results over appearances. We are highly disciplined in the way we spend capital. We avoid frivolous spending, and look to maximize every investment that we make.

 

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Keep our Promises: Full Disclosure—We are transparent and honest with our customers and our fellow Rackers—even when times are rough. We also plan to give our stockholders the same level of honesty.

 

   

Embrace Change for Excellence—We must move at the speed of the Internet. We celebrate continuous improvement, and are never satisfied with the status quo.

 

   

Passion for Our Work—Passionate Rackers volunteer to do their best every day. This is not just a job for us—we are committed to building one of the world’s great service companies.

 

   

Treat Rackers like Friends and Family—The way Rackers treat each other matters. When we treat each other well, it creates a feeling of camaraderie and ultimately improves the company’s performance. As such, we continually invest in our culture.

Additional Investor Information

 

 

 

Our financial goal is to produce sustainable economic profits for our stockholders. We use an EVA® (Economic Value Added) management model to ensure that our decisions consider the cost of capital. This model is used to decentralize decision making.

 

   

We have always used our investors’ money wisely. We are proud to have grown to our current size having raised only $39.6 million in equity capital, excluding proceeds from stock options exercised under our equity incentive plans. We will continue to be disciplined users of capital as we aggressively pursue future opportunities.

 

   

If we are presented with the right long-term opportunities, we are prepared to incur losses or short-term reductions in profit to pursue them. Managing for the long term means that we will not “smooth our earnings.”

 

   

We do not plan to issue financial forecasts or guidance. We want the results to speak for themselves. We do not want to create short-term incentives to “make the numbers” that could encourage us to make decisions against the long-term interests of stockholders.

 

   

We will communicate honestly and openly and tell you the truth about our business. When we answer specific questions, we will make those answers available to all stockholders at the same time. Our intent is to keep you fully informed and to communicate in a way that treats everyone equally.

 

   

The reason for our auction-based IPO is that we believe it provides the best outcome for all our stockholders. It is important to us to have a fair process for our IPO that allows access for both large and small investors. As good stewards of capital, it is equally critical that we achieve a good outcome for Rackspace and its current stockholders.

Thank you for taking the time to learn a little more about us and for considering an investment in Rackspace Hosting. We’re more excited than ever about the future of our company, and we hope you are too.

Signing on behalf of all Rackers,

 

LOGO

 

LOGO

  LOGO   LOGO

Pat Condon

 

Dirk Elmendorf

  Lanham Napier   Graham Weston

Co-founder

 

Co-founder

  CEO and President   Chairman, former CEO

Racker since 1998

 

Racker since 1998

  Racker since 2000   Racker since 1998

 

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THE AUCTION PROCESS

The following describes the auction process being used for our initial public offering. We believe allowing open participation in this offering through a technology-enabled auction process aligns with our corporate culture and business mission. We are conducting this offering through an auction process to open participation in our initial public offering to all investors, both individual and institutional.

The auction process differs from methods that have been traditionally used in most other underwritten initial public offerings in the U.S. In particular, we and our underwriters will conduct an auction to determine the initial public offering price and the allocation of shares in the offering. We plan to conduct this auction in four stages—Bidding; Auction Closing; Pricing; and Allocation. Investors that do not submit bids through the auction process will not be eligible for an allocation of shares in our offering. See the section entitled “Risk Factors—Risks Related to the Auction Process for Our Offering.”

How to Participate in the Auction

We seek to enable all interested investors to have the opportunity to participate in the auction for our initial public offering. In order to participate in the auction, if you are an individual you must have an account with, and submit bids to purchase our shares through, Goldman, Sachs & Co., Credit Suisse Securities (USA) LLC (through its Private Banking USA business), Merrill Lynch, Pierce, Fenner & Smith Incorporated (through its Global Wealth Management business), W.R. Hambrecht + Co., LLC, or E*TRADE Securities LLC. Institutional investors must have an account with one of our underwriters listed in the table in the section entitled “Underwriting.” Institutional investors must submit bids electronically on an auction website by using a bidder ID. Institutional investors who have an account with Credit Suisse Securities (USA) LLC and have set up an “Auction ID” using the bidder ID previously obtained from Credit Suisse Securities (USA) LLC may continue to use such “Auction ID” to submit their bids on the auction website. Institutional investors who do not have a bidder ID may obtain a bidder ID from Goldman, Sachs & Co., Credit Suisse Securities (USA) LLC, or any of our other underwriters with which they have an account. Sales to an institutional investor will be settled through its account with the underwriter from which it obtained a bidder ID. In order to submit bids on the auction website, institutional investors will also have to agree to contractual terms related to the use of such website. Individual investors will not be required to obtain a bidder ID. The website at www.rackspaceipo.com will contain hyperlinks to the auction website and to the websites of W.R. Hambrecht + Co., LLC and E*TRADE Securities LLC.

Before you participate in our offering, you should:

 

  Ÿ  

Read this prospectus, including all the risk factors. We also recommend that you view the management road show presentation available at www.rackspaceipo.com.

 

  Ÿ  

Understand that our initial public offering price may be set at the auction clearing price, and, if there is little or no demand for our shares at or above the initial public offering price once trading begins, the price of our shares would decline.

 

  Ÿ  

Understand that we may modify the price range and the size of our offering multiple times in response to investor demand.

 

  Ÿ  

Understand that the underwriters, in consultation with us, will have the ability to reject bids that they believe have the potential to manipulate or disrupt the bidding process, and that if you submit such a bid, all of the bids you have submitted may be rejected, in which case you will not receive an allocation of shares in our initial public offering, even if your bid would otherwise have been successful.

 

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In addition, to bid in the auction, you will have to:

 

  Ÿ  

Have or establish an account with one of our underwriters.

 

  Ÿ  

If you are an institutional investor and have not previously obtained a bidder ID from Credit Suisse Securities (USA) LLC, obtain a bidder ID from Goldman, Sachs & Co. or Credit Suisse Securities (USA) LLC (if you have an account with Goldman, Sachs & Co. or Credit Suisse Securities (USA) LLC) or one of our other underwriters, and activate your bidder ID on the auction website.

 

  Ÿ  

Consent to electronic delivery of the preliminary prospectus and other communications related to this offering.

 

  Ÿ  

Acknowledge that you have received an electronic copy of the preliminary prospectus.

In order to facilitate participation in our initial public offering, the underwriters may require additional information, such as your tax identification number (usually your Social Security number) and a valid e-mail address and other contact information.

Goldman, Sachs & Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated require investors to have a pre-existing relationship with them prior to participating in this offering. Credit Suisse Securities (USA) LLC requires investors to have had an account with them for 60 days prior to participating in an initial public offering. As a result, in light of the expected timing of our offering, investors who do not yet have an account with Goldman, Sachs & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated, or Credit Suisse Securities (USA) LLC would, as a practical matter, have to participate in the offering through an account with another underwriter.

The minimum amount required to open an account at W.R. Hambrecht + Co., LLC is $2,000. Individual investors may also have purchases in the offering settled through accounts with E*TRADE Securities LLC, which does not have a minimum account opening amount.

We have not undertaken any efforts to register this offering in any jurisdiction outside the U.S. Except to the limited extent that this offering will be open to certain non-U.S. investors under private placement exemptions in certain countries other than the U.S., individual investors located outside the U.S. should not expect to be eligible to participate in this offering.

News About the Auction

Keep in contact with your brokerage firm, frequently monitor your relevant e-mail account and check www.rackspaceipo.com for notifications related to the offering, including:

 

  Ÿ  

Notice of Material Change / Request for Reconfirmation.    Notification that we have made material changes to the prospectus for this offering that require you to reconfirm your bid by contacting your brokerage firm.

 

  Ÿ  

Notice of Change in Price Range or Number of Shares Offered.    Notification that we have changed the price range or size of the offering.

 

  Ÿ  

Notice of Additional Information Conveyed by Free Writing Prospectus.    Notification that additional information about the offering is available in a free writing prospectus.

 

  Ÿ  

Notice of Intent to Go Effective.    Notification that we have asked the SEC to declare our registration statement effective.

 

  Ÿ  

Notice of Effectiveness.    Notification that the SEC has declared our registration statement effective.

 

  Ÿ  

Notice of Auction Closing.    Notification that the auction has closed.

 

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  Ÿ  

Notice of Acceptance.    Notification as to whether any of your bids are successful and have been accepted by the underwriters. This notification will include the final initial public offering price. Only bidders whose bids have been accepted will be informed about the results of the auction.

Please be careful only to trust e-mails relating to the auction that come from the underwriters or your brokerage firm. These e-mails will not ask for any personal information (such as a Social Security number or credit card numbers). If you are not sure whether to trust an e-mail, please contact your brokerage firm directly.

Potential investors may contact the underwriter or dealer through which they submitted their bid to discuss general auction trends, bidding and/or anticipated timing of the offering. Information with respect to such matters may also be available from time to time in the management road show presentation, available at www.rackspaceipo.com. The then current clearing price is at all times kept confidential and will not be disclosed during the auction to any bidder. Any general auction trend information that is provided orally by an underwriter or participating dealer or in a management road show presentation is necessarily accurate only as of the time that the auction trends were reviewed, does not reflect any advice or prediction with respect to the price at which our common stock may trade once we are a public company, may quickly become stale and may change significantly prior to the auction closing. Bidders should not assume that any particular bid will receive an allocation of shares in the auction based on any auction trend information provided to them orally by any underwriter or participating dealer or included in the management road show presentation.

The Bidding Process

Bidders who are individuals must submit bids through one of the following underwriters: Goldman, Sachs & Co., Credit Suisse Securities (USA) LLC (through its Private Banking USA business), Merrill Lynch, Pierce, Fenner & Smith Incorporated (through its Global Wealth Management business), W.R. Hambrecht + Co., LLC or E*TRADE Securities LLC. Sales to an individual will be settled through his or her account with the underwriter through which his or her bid was submitted. Institutional investors will submit bids via the auction website, to which a hyperlink is available at www.rackspaceipo.com. Sales to an institutional investor will be settled through its account with the underwriter from which it obtained a bidder ID.

In connection with submitting a bid, you must provide the following information:

 

  Ÿ  

The number of shares you are interested in purchasing; and

 

  Ÿ  

The price per share you are willing to pay.

Bids may be within, above or below the estimated price range for our initial public offering on the cover of this prospectus. Bid prices may be in any dollar or cent increment. The minimum size of any bid is 100 shares. Each bidder may submit multiple bids; however, the underwriters, in consultation with us, may reject any bid that has the potential to manipulate or disrupt the bidding process, as well as any other bids from any person or institution that the underwriters, in consultation with us, believe has submitted a manipulative or disruptive bid.

Each of your bids will be incremental to any other bids you have submitted, and you may be allocated up to the aggregate number of shares represented by all of your bids at or above the offering price. Therefore, do not submit bids that add up to more than the amount of money you want to invest in the offering. For example, if you place three bids—one for 100 shares at $12.00 (for a total value of $1,200), a second for an additional 200 shares at $10.00 (for a total value of $2,000), and a third for an additional 300 shares at $8.00 (for a total value of $2,400)—you would be legally obligated to purchase up to 600 shares for a total value of up to $4,800 (assuming an initial public offering price of $8.00 per

 

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share). The following table illustrates this example assuming that the initial public offering price is set at $10.00 and successful bids are not subject to pro rata allocation. See the section entitled “The Auction Process—The Allocation Process” for additional information on pro rata allocation.

 

Hypothetical Bid Information

   Hypothetical Auction Results

Bid

   Shares
Requested
   Bid
Price
   Hypothetical
Initial
Offering
Price
   Shares
Allocated
   Aggregate
Investment

1

   100    $ 12.00    $ 10.00    100    $ 1,000

2

   200      10.00      10.00        200      2,000

------------------------------------------------------------------------------------------------------------------------------

3

       300      8.00      10.00    0      0
                  

Total:

   600          300    $ 3,000

To participate in the auction for our initial public offering, you will be required to agree to accept electronic delivery of this prospectus, the final prospectus, any amendments to this prospectus, or the final prospectus, and other communications related to this offering. If you do not consent to electronic delivery, or subsequently revoke that consent prior to the time at which our underwriters accept your bid, you will not be able to submit a bid or participate in our offering and any previously submitted bids will be rejected. If you revoke your consent after the underwriters accept your bid, a copy of the final prospectus will be delivered to you via U.S. Mail at your request. Your consent to electronic delivery of these documents does not constitute consent by you to electronic delivery of other information about us not related to this offering, such as proxy statements and quarterly and annual reports, after completion of this offering, except to the extent that you have provided this consent in the context of a consent to electronic delivery given to your brokerage firm that is broader in scope than this offering.

For individual investors, we encourage you to discuss any questions regarding your bid and the suitability determinations that will be applied to your bid with the underwriter through which you expect to submit a bid. Each of our underwriters makes its own suitability determinations pursuant to rules and regulations of the Financial Industry Regulatory Authority to which the underwriters are subject. This could affect your ability to submit a bid. If an underwriter determines that a bid is not suitable for an investor, the underwriter will not submit that bid in the auction, and you might not be informed that your bid was not submitted in the auction.

Goldman, Sachs & Co. and Credit Suisse Securities (USA) LLC will manage the master order book, to which we will have concurrent access. The master order book will aggregate all bids collected by our underwriters. Our master order book will not be available for viewing by bidders. Only bidders whose bids are accepted will be informed about the result of those bids.

You should consider all the information in this prospectus in determining whether to submit a bid, the number of shares you seek to purchase, and the price per share you are willing to pay. The underwriters, in consultation with us, will have the ability to disqualify any bidder that submits a bid that they believe, in their sole discretion, has the potential to manipulate or disrupt the bidding process. These bids include bids that the underwriters, in consultation with us, believe do not reflect the number of shares that a bidder actually intends to purchase, or a series of bids that the underwriters, in consultation with us, consider disruptive to the auction process. The shares offered by this prospectus may not be sold, nor may offers to buy be accepted, prior to at least one hour following the time that the registration statement filed with the SEC becomes effective. A bid received by any underwriter involves no obligation or commitment of any kind by the bidder until our underwriters have notified you that your bid is successful by sending you a notice of acceptance. Therefore, you will be able to withdraw a bid at any time (except during any period in which the auction is temporarily closed pending the preparation of revised disclosure) until it has been accepted. You may withdraw your bid by contacting the underwriter through which you submitted your bid.

 

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During the bidding process, we, Goldman, Sachs & Co., and Credit Suisse Securities (USA) LLC will monitor the master order book to evaluate the demand that exists for our initial public offering. Based on this information and other factors, we and our underwriters may revise the public offering price range for our initial public offering set forth on the cover of this prospectus. In addition, we may decide to change the number of shares of common stock offered through this prospectus. It is possible that the number of shares offered will increase if the price range increases. You should be aware that we have the ability to make multiple such revisions. These increases in the public offering price range or the number of shares offered through this prospectus may result in little or no demand for our shares of common stock at or above the initial public offering price following this offering. Therefore, the price of our shares of common stock could decline following this offering, and investors should not expect to be able to sell their shares for a profit shortly after trading begins. You should consider whether to modify or withdraw your bid as a result of developments during the auction process, including changes in the price range or number of shares offered.

Reconfirmations of Bids

We will require that bidders reconfirm the bids that they have submitted in the offering if either of the following events shall occur:

 

  Ÿ  

More than 15 business days have elapsed since the bidder submitted his bid in the offering; or

 

  Ÿ  

We and the underwriters determine that there is a material change in the prospectus that requires that we or the underwriters convey the material change and file an amended registration statement.

If a reconfirmation of bids is required, an electronic notice will be sent to everyone who has an activated bidder ID or who has submitted a bid that has not been withdrawn, notifying them that they must reconfirm their bids by contacting the underwriter through which their bid was submitted (for individual investors) or on the auction website (for institutional investors). If bidders do not reconfirm their bids when requested, we and the underwriters will disregard their bids in the auction, and they will be deemed to have been withdrawn. We will give bidders at least until the earlier of (i) one hour following the effectiveness of the registration statement and (ii) 4:00 p.m., Eastern time, on the following business day from the time we send them notification that they must reconfirm, to reconfirm their bids.

If we and the underwriters determine that there is a material change in the prospectus that will require reconfirmation of bids, we may temporarily close the auction while we are preparing new disclosure or the new prospectus to be recirculated. If we do so, we will reopen the auction when we recirculate new disclosure or the prospectus. During any such temporary auction close, you will not be able to add, modify or withdraw a bid on the auction websites maintained by any of our underwriters. Once the auction is reopened, you will be required to reconfirm any existing bids (or else such bids will be deemed to have been withdrawn) and will have an opportunity to add, modify or withdraw a bid as described in the preceding paragraph. If we temporarily close the auction while preparing new disclosure or a new prospectus, electronic notice that the auction has been temporarily closed pending preparation of new disclosure will be sent to everyone who has an activated bidder ID or who has submitted a bid that has not been withdrawn.

Changes in the Price Range Prior to Effectiveness of the Registration Statement

If, prior to the time at which the SEC declares our registration statement effective, there is a change in the price range or the number of shares to be sold in our offering, we and the underwriters will:

 

  Ÿ  

Provide notice at www.rackspaceipo.com of the revised price range or number of shares to be sold in our offering, as the case may be; and

 

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  Ÿ  

Send an electronic notice to everyone who has an activated bidder ID or who has submitted a bid that has not been withdrawn, notifying them of the revised price range or number of shares to be sold in our offering, as the case may be.

The Auction Closing Process

We can close the auction at any time. You will have the ability to modify any bid until the auction is closed. You will have the ability to withdraw your bid until your bid is accepted by the underwriters, which would occur after the closing of the auction. If the underwriters accept your bid, they will do so following the closing of the auction by sending you a notice of acceptance. If you are requested to reconfirm a bid and fail to do so in a timely manner, your bid will be deemed to have been withdrawn.

When we submit our request that the SEC declare the registration statement effective, we and the underwriters will send an electronic notice to everyone who has an activated bidder ID or who has submitted a bid that has not been withdrawn, informing them of our request. Once the registration statement is effective, everyone who has an activated bidder ID or who has submitted a bid that has not been withdrawn will be sent another electronic notice informing them that the registration statement is effective. Prior to the time a bid is accepted, which cannot be less than one hour after the notice of effectiveness is sent to bidders, bidders may still withdraw their bids.

If we are unable to close the auction, determine a public offering price, and file a final prospectus with the SEC within 15 business days after the registration statement, of which this prospectus forms a part, is initially declared effective, we must file and have declared effective a post-effective amendment to the registration statement before the auction may be closed and any bids may be accepted.

Availability of Funds After Effectiveness of the Registration Statement

Your brokerage firm may require that you have funds or securities in your brokerage account with value sufficient to cover the aggregate dollar amount of your bid upon the effectiveness of our registration statement. If you do not provide the required funds or securities in your account by the required time, your bid may be rejected. We and our underwriters may elect to accept successful bids in as little as one hour after the SEC declares the registration statement effective regardless of whether bidders have deposited funds or securities in their brokerage accounts. In this case, as well as all other cases in which notices of acceptance have been sent, successful bidders would be obligated to purchase the shares allocated to them in the allocation process.

Sales to an individual will be settled through his or her account with the underwriter through which his or her bid was submitted. Sales to an institutional investor will be settled through its account with the underwriter from which it obtained a bidder ID.

The Pricing Process

The initial public offering price will be determined by us and our underwriters after the auction closes. We intend to use the auction to determine a clearing price for the initial public offering, and we may set the initial public offering price at the clearing price. The clearing price is the highest price at which all of the shares offered (including over-allotments) may be sold to potential investors, based on bids in the master order book that have not been rejected or withdrawn at the time we and our underwriters close the auction. However, we and our underwriters have discretion to set the initial public offering price below the auction clearing price. We may do this in an effort to achieve a broader distribution of our common stock (which would be expected to occur because at a lower offering price there would be a greater number of successful bids) or to potentially limit a decline in the trading price

 

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of our shares in the period shortly following our offering relative to what might be experienced if the initial public offering price were set at the auction clearing price. However, setting the initial public offering price below the auction clearing price may not achieve this result. Even if the initial public offering price is set below the auction clearing price, the trading price of our common stock could still decline significantly after the offering. In addition, although setting the initial public offering price below the clearing price may achieve a broader distribution of our shares, it may not result in allocations of shares in our offering to specific types of investors, such as professional or institutional investors. That is because there can be no assurance that investors of one type would submit bids at different prices than investors of other types, and so broadening the number of successful bids would not necessarily change the proportion of successful bids attributable to one type of investor or another.

We caution you that our initial public offering price may have little or no relationship to the price that would be established using traditional indicators of value, such as:

 

  Ÿ  

Our future prospects and those of our industry in general;

 

  Ÿ  

Our sales, earnings, and other financial and operating information;

 

  Ÿ  

Multiples of our revenue, earnings, cash flows, and other operating metrics;

 

  Ÿ  

Market prices of securities and other financial and operating information of companies engaged in activities similar to ours; and

 

  Ÿ  

The views of research analysts.

You should understand that the trading price of our common stock could vary significantly from the initial public offering price. Therefore, we caution you not to submit a bid in the auction process for our offering unless you are willing to take the risk that our stock price could decline significantly.

The pricing of our initial public offering will occur after we have closed the auction and after the registration statement has been declared effective. We will announce the initial public offering price on www.rackspaceipo.com. The price will also be included in the notice of acceptance, the confirmation of sale and the final prospectus that will be sent to the purchasers of common stock in our offering.

Acceptance of Bids

If the initial public offering price is between $             and $             per share, which is within 20% of either the high or low end of the price range on the cover of this prospectus, the underwriters can accept all bids at or above the initial public offering price, without seeking reconfirmation of bids, by sending electronic notices of acceptance to successful bidders. As a result of the varying delivery times involved in sending emails over the Internet, some bidders may receive these notices of acceptance before others.

If the initial public offering price is not between $             and $             per share, then we and the underwriters will:

 

  Ÿ  

Provide notice at www.rackspaceipo.com of the offering price; and

 

  Ÿ  

Send an electronic notice to everyone who has an activated bidder ID or who has submitted a bid that has not been withdrawn, notifying them of the offering price.

Under these circumstances, the underwriters will require bidders to reconfirm their bids. We may also decide as a result of the foregoing to circulate a revised prospectus and reopen the auction. In this event, bids submitted may be accepted immediately upon their being submitted by you, because more than an hour may have passed since the effectiveness of the Registration Statement.

 

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You should be aware that the underwriters will accept successful bids by sending an electronic notice of acceptance, and bidders who submitted successful bids will be obligated to purchase the shares allocated to them regardless of (i) whether such bidders are aware that the registration statement has been declared effective or (ii) whether they are aware that the electronic notice of acceptance of that bid has been sent. Once the underwriters have accepted a bid by sending out an electronic notice of acceptance, they will not cancel or reject any such bid. The issuer and the underwriters will rely on your bid in setting the public offering price and in sending notices of acceptance to successful bidders. As a result, you will be responsible for paying for all of the securities that are finally allocated to you, at the public offering price.

The Allocation Process

Once the initial public offering price has been determined, we and our underwriters will begin the allocation process. All investors who have bid at or above the initial public offering price, and whose bids were not rejected or withdrawn, will receive an allocation of shares in our offering at the initial public offering price.

If the initial public offering price is equal to the auction clearing price, all successful bidders will be offered share allocations that are equal or nearly equal to the number of shares subject to their successful bids. Therefore, we caution you against submitting a bid that does not accurately represent the number of shares of our common stock that you are willing and prepared to purchase, as bidders who submitted successful bids will be obligated to purchase the shares allocated to them. Furthermore, neither we nor our underwriters will be obligated to inform you that we have rejected your bids.

In the event that the number of shares represented by successful bids exceeds the number of shares offered, the offered shares will need to be allocated across the successful bidder group. We will allocate the shares among successful bids on a pro rata basis based on the following rules:

 

  Ÿ  

The pro rata allocation percentage will be determined by dividing the number of shares offered (including over-allotments) by the number of shares subject to successful bids; and

 

  Ÿ  

Each bidder who has a successful bid will be allocated a number of shares equal to the pro rata allocation percentage multiplied by the number of shares subject to the successful bid, rounded to the nearest whole number of shares, except that, to the extent possible, each allocation of 100,000 or more shares will be rounded to the nearest 100 shares.

The following hypothetical example illustrates how pro rata allocation might work in practice:

 

Assumptions

      

Shares Offered

   20,000  

Total Shares Subject to Successful Bids

   21,200  

Pro Rata Allocation Percentage

   94.3 %

 

Successful Bidder

   Shares
Subject to
Successful
Bid
   Pro Rata
Allocation

A

   100    94

B

   2,100    1,981

C

   4,000    3,774

D

   4,500    4,245

E

   5,000    4,717

F

   5,500    5,189
         

Totals

   21,200    20,000

 

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Following the allocation process, our underwriters will provide successful bidders with a final prospectus and confirmations that detail their purchases of shares of our common stock and the purchase price. The final prospectus will be delivered electronically, and confirmation will be delivered by regular mail, facsimile, email, or other electronic means. Successful bidders can expect to receive their allocated shares in their brokerage accounts three or four business days after the final offering price is established by us and the underwriters.

 

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USE OF PROCEEDS

We estimate that the net proceeds to us from this offering will be approximately $             , based upon an assumed initial public offering price of $             per share, the mid-point of the range set forth on the cover page of this prospectus, after deducting underwriting discounts and commissions and estimated offering expenses payable by us. If the underwriters exercise their over-allotment option in full, the net proceeds to us will be approximately $             . We will not receive any proceeds from the sale of shares of common stock by the selling stockholders. The selling stockholders include certain of our executive officers and members of our board of directors or entities affiliated with or controlled by them.

Currently our primary sources of capital are cash generated from operating activities, equipment financing arrangements with vendor-related leasing companies, and funds available under our revolving line of credit. We intend to use the net proceeds from this offering to supplement these existing sources of capital primarily to finance our growth plans, as well as for working capital and general corporate purposes. However, we have not allocated any portion of net proceeds from this offering for any specific purpose and have no agreements or commitments with respect to the use of such proceeds. We currently anticipate making aggregate capital expenditures of approximately $335 million in 2008, $160 million of which is expected to be allocated for construction contracts for our new corporate headquarters in the San Antonio, Texas area and expansion of data center facilities in the U.S. and the U.K., with the remaining $175 million expected to be allocated for purchases of IT equipment. However, we may accelerate or postpone those expenditures to align our asset base with the need to support our customers and to exploit opportunities to acquire assets. The timing and amount of our actual expenditures will be based on many factors, including cash flows from operations and the anticipated growth of our business.

Initially, we may choose to use a portion of the net proceeds from this offering to repay outstanding borrowings under our revolving line of credit. The borrowing costs of this revolving line of credit are determined by London Inter-bank Offered Rate, or LIBOR, plus an applicable margin spread. This spread starts at 0.675% and goes up to 1.550% based on our amount of leverage, which is defined as the ratio of funded debt to our EBITDA, as defined in the credit agreement. The initial term of the revolving line of credit expires in August 2012. Because we entered into an interest rate swap agreement with a notional amount of $50.0 million maturing on December 10, 2010, we do not currently expect to reduce our outstanding borrowings in the near future to an amount below $50.0 million. We have not identified any specific circumstances under which we will repay all or any portion of the line credit using the proceeds from this offering. As of March 31, 2008, outstanding indebtedness under our credit facility totaled approximately $77.3 million. See the section entitled “Description of Indebtedness.” Proceeds from our line of credit have been used, along with cash generated from operating activities and equipment financing arrangements with vendor-related leasing companies, to fund our capital expenditures. We intend to keep the credit facility in place after the offering to have access to sufficient liquidity to execute our growth plans.

We may also use a portion of the net proceeds to acquire businesses, technologies, or other assets. We do not, however, have agreements or commitments for any specific acquisitions at this time.

Pending the uses mentioned above, we intend to invest the net proceeds of this offering in short-term, interest bearing, investment grade securities.

DIVIDEND POLICY

We have never declared or paid any cash dividends on our capital stock. Neither Delaware law nor our restated certificate of incorporation requires our board of directors to declare dividends on our

 

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common stock. Any future determination to declare cash dividends will be made at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements, general business conditions, and other factors that our board of directors may deem relevant. We do not anticipate paying cash dividends for the foreseeable future.

On August 31, 2007, our wholly-owned subsidiary, Rackspace US, Inc., as borrower, entered into an amended and restated credit agreement with Comerica Bank, as administrative agent, swing-line lender and lender, JPMorgan Chase Bank, N.A., Wachovia Bank, N.A., the Frost National Bank, N.A., and Bank of America, N.A., as lenders. If there is a default under the credit agreement or the borrower cannot meet its financial covenants (see the section entitled “Description of Indebtedness” for a description of the defaults and financial covenants), then the credit agreement prohibits the borrower, us, and all subsidiary guarantors from declaring or making any dividends, distributions, or payments on account of any of our or their equity interests or purchasing, redeeming, or otherwise acquiring for value any of our or their equity interests. This restriction does not apply to dividends, distributions, and payments made by us or any of our subsidiaries (other than the borrower) to borrower, us or any subsidiary guarantor.

 

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CAPITALIZATION

The following table sets forth our capitalization as of March 31, 2008:

 

  Ÿ  

On an actual basis;

 

  Ÿ  

On a pro forma basis to give effect to the automatic conversion of all of our outstanding preferred stock into 1,214,837 shares of common stock upon the completion of this offering; and

 

  Ÿ  

On a pro forma as adjusted basis to give effect to the sale of             shares of common stock by us in this offering 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 estimated underwriting discounts and commissions and estimated offering expenses payable by us.

The pro forma as adjusted information set forth in the table below is illustrative only and will adjust based on the actual initial public offering price and other terms of this offering determined at pricing.

You should read the information in this table together with our financial statements and notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus.

 

     As of March 31, 2008
     Actual
(Unaudited)
    Pro Forma
(Unaudited)
    Pro Forma
Adjusted
(Unaudited)
     (In thousands, except share data)

Cash and cash equivalents

   $ 27,497     $ 27,497     $             

Current capital lease obligations

     27,703       27,703    

Current portion of debt

     3,276       3,276    

Non-current capital lease obligations

     32,532       32,532    

Non-current debt

     81,619       81,619    

Stockholders’ equity:

      

Series A Convertible Preferred stock, $0.001 par value; 50,000,000 shares authorized, 1,214,837 shares issued and outstanding, actual; no shares issued pro forma and pro forma as adjusted

     1       —      

Common stock, $0.001 par value; 300,000,000 shares authorized, 101,612,676 shares issued and 101,529,971 shares outstanding, actual; 102,827,513 shares issued and 102,744,808 shares outstanding, pro forma;                  shares issued and              outstanding, pro forma as adjusted

     102       103    

Additional paid-in capital

     44,623       44,623    

Treasury stock, at cost, 82,705 common shares held

     (126 )     (126 )  

Accumulated other comprehensive income (loss)

     (574 )     (574 )  

Retained earnings

     61,744       61,744    
                      

Total stockholders’ equity

     105,770       105,770    
                      

Total capitalization

   $ 278,397     $ 278,397     $             
                      

The number of shares of our common stock set forth in the table above excludes:

 

  Ÿ  

21,554,832 shares issuable upon the exercise of options outstanding as of March 31, 2008, having a weighted average exercise price of $4.71 per share;

 

  Ÿ  

268,750 shares issuable upon the exercise of warrants outstanding as of March 31, 2008, having a weighted average exercise price of $1.03 per share;

 

  Ÿ  

936,275 shares available for future grant under our 2007 Long Term Incentive Plan and 500,000 additional shares to be available for future grant under our 2008 Employee Stock Purchase Plan, each as of March 31, 2008; and

 

  Ÿ  

5,400,000 additional shares that were authorized for future grant in May 2008 under our 2007 Long Term Incentive Plan.

 

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DILUTION

Our pro forma net tangible book value as of March 31, 2008 was $96.7 million, or $0.94 per share of 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 upon the completion of this offering. Dilution in pro forma net tangible book value per share to new investors in this offering represents the difference between the amount per share paid by purchasers of shares of common stock in this offering and the pro forma 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 in this offering 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 March 31, 2008 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:

 

Assumed initial public offering price per share

      $             

Pro forma net tangible book value per share as of March 31, 2008, before giving effect to this offering

   $ 0.94   

Increase in pro forma net tangible book value per share attributable to new investors

     
         

Pro forma as adjusted net tangible book value per share after giving effect to this offering

     
         

Dilution per share to new investors in this offering

      $             
         

A $1.00 increase or decrease in the assumed initial public offering price of $             would increase or decrease 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, the pro forma as adjusted net tangible book value per share after this offering would be $             per share, and the dilution in pro forma net tangible book value per share to new investors in this offering would be $             per share.

The following table summarizes, on a pro forma as adjusted basis as of March 31, 2008 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.

 

     Shares Purchased     Total Consideration     Average Price
Per Share
     Number    Percent     Amount    Percent    

Existing stockholders

   102,744,808                 %   $ 51,258,450                 %   $ 0.50

New investors

             $         
                          

Total

      100.0 %   $                 100.0 %  
                          

 

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A $1.00 increase or decrease in the assumed initial public offering price of $             per share would increase or decrease, respectively, 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 foregoing discussion and tables are based upon the number of shares issued and outstanding on March 31, 2008, assumes the conversion of all outstanding shares of our preferred stock as of March 31, 2008 into common stock and assumes no exercise of options or warrants outstanding as of March 31, 2008. As of that date, there were:

 

  Ÿ  

21,554,832 shares of our common stock issuable upon exercise of options outstanding at a weighted average exercise price of $4.71 per share; and

 

  Ÿ  

268,750 shares of our common stock issuable upon exercise of warrants outstanding at a weighted average exercise price of $1.03 per share.

For a description of our equity plans, see the section entitled “Management—Benefit Plans.”

If all our outstanding options and warrants had been exercised, the pro forma net tangible book value as of March 31, 2008 would have been $198.5 million, or $1.59 per share, and the pro forma net tangible book value after this offering would have been $             million, or $             per share, causing dilution to new investors of $             per share.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with the financial statements and the notes to those statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this prospectus. The selected consolidated financial data in this section are not intended to replace the financial statements and is qualified in its entirety by the consolidated financial statements and related notes thereto included elsewhere in this prospectus.

The statements of income data for the fiscal years ended December 31, 2005, 2006, and 2007 and the balance sheet data as of December 31, 2006 and 2007 have been derived from our audited consolidated financial statements, which have been audited by KPMG, LLP, independent registered public accounting firm, and included elsewhere in this prospectus. The statements of income data for the years ended December 31, 2003 and 2004 and the balance sheet data as of December 31, 2003, 2004 and 2005 have been derived from our audited consolidated financial statements, which have been audited by KPMG, LLP, independent registered public accounting firm, but are not included in this prospectus. Historical results are not necessarily indicative of future results. The selected consolidated statements of income data for the three months ended March 31, 2007 and 2008, and the selected consolidated balance sheet data as of March 31, 2008, are derived from our unaudited consolidated financial statements and related notes included elsewhere in this prospectus. The unaudited selected consolidated financial data set forth below include, in the opinion of management, all adjustments, which are normal recurring in nature, that are necessary for a fair presentation of the information set forth therein. The results for any interim period are not necessarily indicative of the results that may be expected for a full year. See note 4 to the financial statements for an explanation of the method used to determine the number of shares used in computing basic and diluted net income per common share and pro forma basic and diluted net income per common share.

 

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    Years Ended December 31,     Three Months Ended
March 31,
 
     2003     2004     2005     2006     2007     2007     2008  
                                  (Unaudited)  
   

(In thousands, except per share data)

 

Statements of Income Data(1):

             

Net revenues

  $ 56,611     $ 86,763     $ 138,768     $ 223,966     $ 362,017     $ 75,225     $ 119,613  

Costs and expenses:

             

Cost of revenues

    19,405       28,934       40,987       64,889       118,225       23,593       39,223  

Sales and marketing

    10,258       14,999       21,837       35,667       53,930       11,661       17,568  

General and administrative

    16,998       22,725       38,968       59,832       102,777       20,946       33,633  

Depreciation and amortization

    8,871       12,471       20,193       32,335       56,476       11,835       19,051  
                                                       

Total costs and expenses

    55,532       79,129       121,985       192,723       331,408       68,035       `109,475  
                                                       

Income from operations

    1,079       7,634       16,783       31,243       30,609       7,190       10,138  
                                                       

Other income (expense):

             

Interest expense

    (540 )     (612 )     (808 )     (1,095 )     (3,643 )     (525 )     (1,330 )

Interest and other income

    79       270       633       572       828       100       247  
                                                       

Total other income (expense)

    (461 )     (342 )     (175 )     (523 )     (2,815 )     (425 )     (1,083 )
                                                       

Income before income taxes

    618       7,292       16,608       30,720       27,794       6,765       9,055  

Income taxes

    (293 )     2,467       5,836       10,900       9,965       2,593       3,613  
                                                       

Net income from continuing operations

  $ 911     $ 4,825     $ 10,772     $ 19,820     $ 17,829     $ 4,172     $ 5,442  
                                                       

Net income (loss) from discontinued operations

  $ (703 )   $ 3,083     $ —       $ —       $ —       $ —       $ —    
                                                       

Net income

  $ 208     $ 7,908     $ 10,772     $ 19,820     $ 17,829     $ 4,172     $ 5,442  
                                                       

Net income per share

             

Basic

  $ 0.00     $ 0.09     $ 0.12     $ 0.20     $ 0.18     $ 0.04     $ 0.05  
                                                       

Diluted

  $ 0.00     $ 0.08     $ 0.11     $ 0.19     $ 0.17     $ 0.04     $ 0.05  
                                                       

Weighted average number of shares outstanding

             

Basic

    84,904       84,904       91,793       100,310       101,278       100,875       102,574  
                                                       

Diluted

    102,723       99,450       99,657       104,032       106,618       105,759       109,085  
                                                       

Pro forma net income per share

             

Basic (unaudited)

          $ 0.18       $ 0.05  
                         

Diluted (unaudited)

          $ 0.17       $ 0.05  
                         

Pro forma weighted average number of shares outstanding

             

Basic (unaudited)

            101,278         102,574  
                         

Diluted (unaudited)

            106,618         109,085  
                         

Balance Sheet Data:

             

Cash and cash equivalents

  $ 10,012     $ 7,288     $ 8,022     $ 8,374     $ 24,937     $ 13,199     $ 27,497  

Total assets

    41,310       56,012       83,645       132,983       301,813       153,635       355,320  

Interest bearing debt(2)

    11,415       9,250       7,992       19,324       111,451       27,988       145,130  

Stockholders’ equity

    20,837       29,259       46,713       70,490       96,873       75,649       105,770  

Statements of Cash Flows Data:

             

Cash Flow provided by operations

  $ 12,445     $ 25,636     $ 34,705     $ 60,630     $ 104,935     $ 25,791     $ 36,158  

Cash Flow used in investing activities

    (9,549 )     (25,559 )     (35,127 )     (54,807 )     (140,721 )     (23,351 )     (47,248 )

Cash Flow provided by (used in) financing activities

    3,413       (7,730 )     1,265       (5,646 )     52,379    

 

2,357

 

   
13,661
 

Other Financial Data:

             

Cash Flow used in investing activities

  $ (9,549 )   $ (25,559 )   $ (35,127 )   $ (54,807 )   $ (140,721 )   $ (23,351 )   $ (47,248 )

Vendor financed equipment purchases(3)

    (3,949 )     (5,578 )     (6,365 )     (18,825 )     (44,149 )     (6,222 )     (21,619 )
                                                       

Adjusted cash flow used in investing activities

  $ (13,498 )   $ (31,137 )   $ (41,492 )   $ (73,632 )   $ (184,870 )   $ (29,573 )   $ (68,867 )

 

             

(1)       Includes share-based compensation expense as follows:

         

       

Cost of revenue

  $ 212     $ 56     $ 4     $ 83     $ 433     $ 34     $ 365  

Sales and marketing

    223       125       93       156       598       72       401  

General and administrative

    949       177       175       851       3,221       485       1,986  
                                                       

Total share-based compensation expense

  $ 1,384     $ 358     $ 272     $ 1,090     $ 4,252     $ 591     $ 2,752  
                                                       
(2) Includes the total amount of interest bearing debt outstanding, including indebtedness under our capitalized lease obligations.
(3) Includes non-cash purchases of property and equipment. Non-cash purchases consist of capital expenditures which are purchased and financed through a vendor financing facility.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read with “Selected Consolidated Financial Data” and our audited financial statements and related notes included elsewhere in this prospectus. The discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to these differences include those discussed in “Risk Factors,” “Forward-Looking Statements,” and elsewhere in this prospectus. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements.

Overview

Rackspace Hosting is the world’s leader in hosting. We deliver websites, web-based IT systems, and computing as a service. Our rapid growth is the result of our commitment to serving our customers, known as Fanatical Support, and our exclusive focus on hosting. We have been successful in attracting and retaining thousands of customers and in growing our business at high rates. We aspire to maintain our service-centric focus in the future and will follow our vision to be considered one of the world’s great service companies. As of December 31, 2007, we served over 29,000 customers running on over 36,000 servers within our data centers in the U.S. and the U.K. As of March 31, 2008, we served over 31,000 customers running on over 39,000 servers.

Our subscription-based business model generates almost all of our revenues on a recurring basis. Our customers pay us a recurring fee based on the size and complexity of the IT systems we manage and the level of service intensity we provide, pursuant to service agreements that typically provide for monthly payments. Recurring revenues include certain SLA and non-SLA credits (SLA stands for Service Level Agreements, which define our contractual commitments) and also include revenues related to customers who have cancelled their service. A minor portion of our revenues are non-recurring, which includes certain usage charges, set up fees, and professional services. Our net revenues grew from $138.8 million in 2005 to $362.0 million in 2007. Revenues for the quarter ended March 31, 2008 were $119.6 million.

We sell our services to small and medium-sized businesses as well as large enterprises. During 2007, 28.0% of our net revenues were generated by our operations outside of the U.S., mainly from the U.K. We intend to continue to target international customers and plan to expand our operational footprint in continental Europe and Asia. Since 2005, no individual customer has accounted for greater than 2% of our net revenues in any year.

Our growth is driven by both upgrades from existing customers and the addition of new customers. With respect to our existing customers, we experience upgrades, downgrades, and customer terminations. Many of our customers upgrade and downgrade their service contracts over time to meet the changing demands of their businesses. Other customers leave us altogether. We measure upgrades / downgrades at the time a customer signs a new contract with us and we measure customer terminations at the time when they tell us about their plans to leave us. As a result, the measurement of upgrades / downgrades and customer terminations happens prior to the corresponding recognition in revenue. Upgrades (downgrades / customer terminations) are expressed as percentage increases (decreases) in the contractual monthly recurring fee associated with a service agreement for a given customer. From a managerial standpoint, we carefully observe the growth in installed base, which is the percentage of upgrades minus the percentage of downgrades and customer terminations. This growth in installed base indicates how fast our existing customer base is growing before we add any new customers. For the years 2005, 2006, and 2007, the average monthly growth in installed base amounted to 1.4%, 1.5%, and 1.6%, respectively. For the quarter ended March 31, 2008, our average monthly growth in installed base was 0.9% per month.

 

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Our increases in net revenues are primarily due to increased volume of services provided, both due to an increasing number of customer accounts over time and due to incremental services rendered to existing customers. We do not typically increase unit prices of our services. Our customers have strong expectations of unit prices being constant or slightly falling over time, reflecting the general belief that technology solutions become more cost-effective over time. While pricing pressure is observable mainly on the low end of our service offerings, we believe that our growth rates are a reflection of our ability to sell our services at competitive and reasonable price levels. We also believe that our strong service focus has contributed to our ability to maintain relatively stable price levels over time. Our pricing strategy follows two main principles: to set a price that enables us to recover the full cost of doing business and also allows us to compete successfully. Both of these principles have allowed us to grow at rates higher than the industry average, while being profitable on an overall company basis. We continually strive to improve our cost of providing service, which will allow us to sell our services profitably at prices that are competitive.

As we grow our revenues and customer base, we incur incremental costs. When we acquire a new customer or increase our business with an existing customer, we generally acquire customer related hardware and software for deployment in our data centers, which typically also increases our power and bandwidth costs. As our customer base grows, we continue to expand our support organization to maintain our commitment to Fanatical Support. Our total headcount grew from 503 employees as of December 31, 2004, to 2,021 employees as of December 31, 2007, as a result of our growth. Our operating expenses increased from $122.0 million during 2005 to $331.4 million during 2007. As of March 31, 2008, our total headcount was 2,254 and our operating expenses for the quarter ended March 31, 2008 were $109.5 million. We expect to continue to add personnel in all functional areas and expect to increase most of our costs as long as we continue to generate revenue growth.

We also strive to align our investment in data center infrastructure with our revenue growth to keep utilization rates high. We pursue a modular build-out strategy within our data centers that expands the operational footprint when needed. From time to time, we will be required to make significant investments in new data centers to support expected growth beyond our ability to build out additional modules in existing facilities.

Generally, our recurring revenue model and our just-in-time approach to resource allocation lead to relatively stable margins over time, which can be seen in the years 2005 and 2006. However, funding needs may increase and margins will likely decrease in periods when we make large investments in our future. Such investments may be made in connection with data center and office expansion, as well as significant product and market development initiatives and the preparation for becoming a public company. We made such investments in 2007 and expect to make similar investments in 2008.

Although we accept lower margins and higher cash flow deficits during periods of investments, we focus on customer level profitability, which we measure and manage on an on-going basis. A key requirement for our growth strategy is that the incremental revenue that we acquire is profitable and adds to stockholder value. We price our service offerings for full cost recovery on every item and every bundle we sell to a customer, and our full cost includes an opportunity cost of the capital invested in each service bundle. We seek to avoid unprofitable contracts for the sake of growth, loss leader products, or retaining unprofitable customers with the hope of up-selling them later. Our disciplined go-to-market approach aims to engage in profitable customer relationships where we can observe returns on capital that are consistently above our internal hurdle rate and where our customers can expect to experience outstanding service at competitive and relatively stable price levels.

Our operations and financial results are exposed to certain risks and uncertainties that may impact our financial condition and results of operations.

 

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Expanding and maintaining our talent base: We rely heavily on knowledgeable and experienced employees to provide a high level of service on a continuous basis in a complex technology-driven environment. This requires us to hire and retain professionals, many of whom may have employment opportunities elsewhere. We may have to adjust salary levels in the future to remain competitive in the market for talent which may increase our cost structure and may depress our margins.

Exposure to increasing energy costs: We have been exposed to the recent increases in energy costs (see the section entitled “Quantitative and Qualitative Disclosures” about Market Risks). For the year 2007, we paid $7.3 million for electricity usage in our data centers. While most of our data centers operate in regulated energy markets, power cost increases are possible and we may not be able to impose those cost increases on our customers through higher unit prices, which could increase our operating costs and depress our margins.

Customer acquisition costs: Our installed base growth has reduced our need to spend marketing dollars to acquire new revenues. If installed base growth declines, or if downgrades and customer terminations exceed upgrades, our sales and marketing expenses would increase on a relative basis in order to overcome lost revenue from downgrading and customer terminations. This would in turn increase our operating costs and decrease our margins.

Aligning infrastructure needs with revenues: We build out infrastructure, such as data centers and office space to accommodate future revenue growth. While we try to minimize the amount of excess capacity, we do need to consider appropriate lead times for these build outs, which requires us to build capacity ahead of actual revenue growth. There is no guarantee as to if and when this future revenue growth will occur, which exposes us to costs related to excess capacity and associated margin reductions.

New markets and service offerings: We are expanding our geographic footprint and are in the process of developing new services. Those new ventures may not yield the returns that we expect and we may incur development costs beyond what we expect today. Delays or unexpected costs may depress margins temporarily or permanently.

 

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Key Metrics

We carefully track several financial and operational metrics to monitor and control our growth, financial performance, and capacity. Our key metrics are structured around growth, profitability and capital efficiency, and infrastructure capacity, and utilization. The following data should be read in conjunction with the financial statements and the notes to those statements and other financial information included elsewhere in this prospectus.

 

     Years Ended December 31,     Three Months Ended
March 31,
 
     2005     2006     2007     2007     2008  

Growth

          

Number of employees

     730       1,234       2,021       1,489       2,254  

Number of customers

     8,897       12,677       29,193       13,530      
31,662
 

Number of servers deployed

     17,887       26,258       36,692       28,439       39,755  

Growth in installed base (monthly average)

     1.4 %     1.5 %     1.6 %     1.3 %     0.9 %

Net revenues (in thousands)

   $ 138,768     $ 223,966     $ 362,017     $ 75,225     $ 119,613  

Net revenue growth

     59.9 %     61.4 %     61.6 %     64.4 %     59.0 %

Profitability and Capital Efficiency

          

Income from operations (in thousands)

   $ 16,783     $ 31,243     $ 30,609     $ 7,190     $ 10,138  

Effective tax rate

     35.1 %     35.5 %     35.9 %     38.3 %     39.9 %
                                        

Net operating profit after tax (NOPAT, in thousands)

   $ 10,892     $ 20,152     $ 19,620     $ 4,436     $ 6,093  

NOPAT margin

     7.8 %     9.0 %     5.4 %     5.9 %     5.1 %

Interest-bearing debt (in thousands)

   $ 7,992     $ 19,324     $ 111,451     $ 27,988     $ 145,130  

Stockholders’ equity (in thousands)

   $ 46,713     $ 70,490     $ 96,873     $ 75,649     $ 105,770  
                                        

Capital base (in thousands)

   $ 54,705     $ 89,814     $ 208,324     $ 103,637     $ 250,900  

Average capital base (in thousands)

   $ 46,607     $ 72,260     $ 149,069     $ 96,726     $ 229,612  

Capital turnover (annualized)

     2.98       3.10       2.43       3.11       2.08  

Return on capital (annualized)

     23.4 %     27.9 %     13.2 %     18.3 %     10.6 %

Infrastructure Capacity and Utilization

          

Technical square feet of data center space

     77,155       91,905       114,749       91,905       114,749  

Utilization rate

     41.8 %     56.7 %     60.9 %     61.8 %     67.3 %

Annual net revenues per average square foot

   $ 1,799     $ 2,650     $ 3,504     $ 3,274     $ 4,170  

 

  Ÿ  

Growth: Given our customer centric service orientation, the number of our employees grows with the general size of our business. From December 31, 2005, to December 31, 2007, we have increased our headcount by 1,291, from 730 to 2,021. Those employees serve our customers’ accounts, which grew from 8,897 to 29,193 over the same period, and manage their IT equipment. We managed 36,692 servers as of December 31, 2007, up from 17,887 as of December 31, 2005. As of March 31, 2008, we employed 2,254 employees who served 31,662 customer accounts and managed 39,755 servers.

We continuously monitor how existing customers upgrade and downgrade their service contracts with us and if and when they announce their intention to stop using our services. We track changes to the monthly recurring subscription fees and we summarize these activities in the metric growth in installed base.

Incremental revenues from new customers and revenues from the growth in the installed base leads to growth in net revenues, which increased from $138.8 million during 2005 to $362.0 million during 2007, representing an annual growth rate of approximately 61.5%. For

 

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the quarter ended March 31, 2008, net revenues were $119.6 million, representing a growth rate of 59.0% relative to the quarter ended March 31, 2007, and a growth rate of 12.1% relative to the quarter ended December 31, 2007.

 

  Ÿ  

Profitability and Capital Efficiency: While we observe all cost categories and margins on the income statement, we focus on income from operations. This includes non-cash charges for depreciation and amortization as well as share-based compensation. We also calculate our net operating profit after tax, or NOPAT, by multiplying income from operations by 1 minus the effective tax rate. NOPAT margin expresses NOPAT as a percent of net revenues. Our NOPAT margin increased from 7.8% in 2005, to 9.0% in 2006, and decreased to 5.4% in 2007 as we started to make significant investments in people, products, systems, and infrastructure. The NOPAT margin in 2007 was also affected by $3.4 million in service credits granted in relation with the outage in November at our data center in Grapevine, TX and a $2.1 million expense in the fourth quarter of 2007 related to an unresolved contractual issue with a vendor. For the quarter ended March 31, 2008, our NOPAT margin was 5.1%

We also focus on our balance sheet and the capital we raise from lenders and stockholders to make the necessary investments into our business. We define capital as the sum of interest-bearing debt and stockholders’ equity. Capital turnover, our measure for capital efficiency, is calculated as the ratio between net revenues for the period and the average capital base (beginning and ending balance for the period divided by two). Our capital turnover demonstrates our ability to generate dollars of revenues relative to dollars of capital investments. During 2005, we generated $2.98 of revenue per dollar of average capital. In 2006, this ratio increased to 3.10x as we further utilized our existing infrastructure. In 2007, we started to make significant investments in office and data center infrastructure, which are under construction and do not yet support revenue. As a result, capital turnover decreased to 2.43x for 2007. For the quarter ended March 31, 2008, our capital turnover was 2.08x on an annualized basis.

Combining profitability and capital efficiency gives us insight into our return on capital, which is defined as the product of NOPAT margin and capital turnover. We consider return on capital as a crucial performance metric, reflecting our ability to successfully deploy capital at returns that exceed our cost of capital. Our return on capital increased from 23.4% in 2005, to 27.9% in 2006, and decreased to 13.2% in 2007. For the quarter ended March 31, 2008, our return on capital was 10.6% on an annualized basis. Again, the reduction in return on capital in 2007 and 2008 is due to investments in people, products, systems, and infrastructure.

 

  Ÿ  

Infrastructure Capacity and Utilization: We require data center infrastructure as we serve more customers and deploy more IT equipment. The capacity of data centers can be measured both in square feet and in power that is available for IT equipment and cooling. We define technical floor space as space that can be utilized to support IT equipment. We continuously monitor our ability to handle growth and manage our footprint and power availability accordingly. We monitor a utilization rate measured relative to power, which in many cases is the limiting factor to the deployment of new equipment. We measure our annual net revenues per average square foot of data center space as an indicator of our ability to build and manage capacity when needed.

Return on Capital (ROC) (Non-GAAP financial measure)

We define Return on Capital (ROC) as follows:

ROC = Net Operating Profit After Tax (NOPAT)

Average Capital Base

Numerator = NOPAT = Income from operations x (1 – Effective tax rate)

Denominator = Average Capital Base = Average of (Interest bearing debt + stockholders’ equity) = Average of (Total assets – accounts payables and accrued expenses – deferred revenues – other non-current liabilities)

 

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We believe that Return on Capital (ROC) is an important metric for investors in evaluating a company’s performance. ROC relates after-tax operating profits with the capital that is put in place. It is therefore a performance metric that incorporates both the Statement of Income and the Balance Sheet. ROC measures how successfully capital is deployed within a company.

Note that ROC is not a measure of financial performance under accounting principles generally accepted in the United States (GAAP) and should not be considered a substitute for return on assets, which we consider to be the most directly comparable GAAP measure, and may not be comparable to similarly titled measures reported by other companies. See our ROC reconciliation to return on assets below.

ROC increased from 23.4% for the year ended December 31, 2005 to 27.9% for the year ended December 31, 2006. This increase was due to an increase in income from operations and a proportionately smaller increase in the average capital base over the same time period. ROC decreased from 27.9% for the year ended December 31, 2006 to 13.2% for the year ended December 31, 2007. This decrease was primarily due to capital investments during 2007 that support current and future revenue growth. Return on assets increased from 15.4% to 18.3% for the years ended December 31, 2005 and 2006, respectively and decreased from 18.3% to 8.2% for the years ended December 31, 2006 and 2007, respectively. For the quarter ended March 31, 2008, ROC was 10.6% and return on assets was 6.6%.

 

     Years Ended December 31,     Three Months Ended
March 31,
 
(In thousands except percent data)    2005     2006     2007     2007     2008  

Income from operations

   $ 16,783     $ 31,243     $ 30,609     $ 7,190     $ 10,138  

Effective tax rate

     35.1 %     35.5 %     35.9 %     38.3 %     39.9 %
                                        

Net operating profit after tax (NOPAT)

   $ 10,892     $ 20,152     $ 19,620     $ 4,434     $ 6,039  

Net income

   $ 10,772     $ 19,820     $ 17,829     $ 4,172     $ 5,442  

Average total assets

   $ 69,828     $ 108,314     $ 217,398     $ 143,309     $ 328,567  

Less: Average accounts payable and accrued expenses

     (16,297 )     (24,232 )     (47,922 )     (31,954 )     (71,071 )

Less: Average deferred revenues (current and non-current)

     (4,220 )     (7,600 )     (13,932 )     (10,390 )     (18,684 )

Less: Average other non-current liabilities

     (2,704 )     (4,222 )     (6,475 )     (4,239 )     (9,200 )
                                        

Average capital base

   $ 46,607     $ 72,260     $ 149,069     $ 96,726     $ 229,612  

Return on assets (Net income / Average total assets)

     15.4 %     18.3 %     8.2 %     11.6 %     6.6 %

Return on capital (NOPAT / Average capital base)

     23.4 %     27.9 %     13.2 %     18.3 %     10.6 %

Description of our Revenues and Operating Expenses

Revenues

We primarily derive our revenues from the sale of hosting services to our customers. Our service agreements provide for monthly payments, which are typically fixed, based upon the size and complexity of the IT systems we manage and the level of service intensity we provide. An important characteristic of our subscription-based business model is our large percentage of recurring revenues. Recurring revenues accounted for approximately 94.9%, 96.3%, and 96.4% of our net revenues for 2005, 2006, and 2007, respectively. For the quarter ended March 31, 2008, recurring revenues were 96.4% of total net revenues. Recurring revenues are net of credits to customers and include revenues related to customers who have cancelled their service. Our customer agreements provide for service

 

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level commitments and our recurring revenues reflect a reduction for the amount of any such credits. Credits to customers in 2007 included $3.4 million attributable to outages in our Grapevine, Texas facility in the fourth quarter of 2007. Revenues from our service agreements are recognized in the month that the services are provided. Payments received in advance of providing services are recorded as deferred revenue until the services are provided, at which time they are recognized as revenue.

A minor portion of our net revenues is non-recurring and accounts for approximately 5.1%, 3.7%, and 3.6% of our net revenues for 2005, 2006, and 2007, respectively. For the quarter ended March 31, 2008, non-recurring revenues were 3.6% of total net revenues. Non-recurring revenues include incremental usage charges for bandwidth and backup, set up fees, and fees for professional services (e.g. migration services, IT security advice, and reporting).

Net revenues are the sum of recurring and non-recurring revenues, net of credits granted in the corresponding period. Our net revenues were $138.8 million, $224.0 million, and $362.0 million for 2005, 2006, and 2007, respectively. For the quarter ended March 31, 2008, net revenues were $119.6 million. Our increase in net revenues is primarily due to increased volume of services provided both due to an increasing number of customers accounts over time and due to incremental services rendered to existing customers.

Our business is managed as a single segment, and we report our financial results on this basis.

Operating Expenses

Cost of Revenues (excluding depreciation and amortization)

Cost of revenues consists of costs related to data center facilities and operations to support our services. The majority of these costs vary with the volume of services sold, and include:

 

  Ÿ  

Salaries and benefits (including share-based compensation) for our support teams and data center employees;

 

  Ÿ  

Data center costs, including power, bandwidth, and rent;

 

  Ÿ  

Costs associated with licenses; and

 

  Ÿ  

Costs related to maintenance and the replacement of IT equipment components.

These costs, with the exception of data center rent, are largely variable, and increase as we increase revenues. To maintain our service focus, our support teams grow largely proportionally to the growth of our business. Our contracts with network operators for bandwidth capacity generally commit us to pay a monthly fee based on usage. Our data centers rely on local and regional utility companies as their primary source of power. We generally do not enter into long-term contracts with our power providers; however, we sometimes enter into fixed-price power arrangements over the summer months. We enter into contracts with software providers that allow us to provide licenses to our customers. Our arrangements with these software vendors are typically one to three years in length and we generally pay a fixed fee per license.

In total, we expect our costs of revenues to increase in absolute dollars, but remain relatively stable as a percentage of revenues, with periodic variability associated with investments in our data center capacity and other growth initiatives.

 

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Sales and Marketing

Sales and marketing expenses are mainly incurred in connection with the acquisition of new customers and upgrades to our existing customers. Therefore, these costs are largely variable and related to our revenue growth. They primarily consist of:

 

  Ÿ  

Salaries, benefits, and commissions for our sales and marketing personnel (including share-based compensation);

 

  Ÿ  

Marketing activities, including web-based paid and natural search, participation in technology trade shows and conferences, web-based and mail-based advertisements, advertisements in business and technology publications, and targeted regional public relations activity; and

 

  Ÿ  

Travel and entertainment related to customer and sales events, and visits.

Sales and marketing activities are directed toward both the acquisition of new customers and increasing our business within existing customers. We pay commissions to our sales representatives generally upon execution of a service agreement. Sales and marketing expense also includes compensation to our channel partners.

Marketing expenditures are intended to communicate the advantages of our services and to generate customer demand. The majority of our marketing expenditures relate to lead generation through pay-per-click placements on major Internet search engines.

Travel and entertainment expenses are related to marketing events in cities across the U.S., customer visits, and expenses related to our sales force visiting prospects and customers.

In general, our sales and marketing expenses are directly related to our growth. As we strive to achieve continued high growth rates, invest in expanding our sales infrastructure, and expand our service offerings, our sales and marketing expenses will grow in absolute terms and potentially as a percent of revenue.

General and Administrative

General and administrative expense consists primarily of the following:

 

  Ÿ  

Salaries and benefits (including share-based compensation);

 

  Ÿ  

Professional fees related to corporate governance and legal, audit, tax, and compliance fees; and

 

  Ÿ  

General corporate costs, including insurance, property taxes, office rent, supplies, professional development, and travel and entertainment.

We plan to invest in our administrative infrastructure and personnel to support our continued growth and will incur additional expenses related to being a publicly traded company, including increased audit and legal fees, costs of compliance with securities and other regulations, implementation costs for Sarbanes-Oxley certification and compliance with Section 404, investor relations expense, and higher insurance premiums.

In total, we believe our general and administrative expense will increase in absolute dollars.

Depreciation and Amortization

Depreciation and amortization expense includes amortization of leasehold improvements associated with our data centers and corporate facilities, as well as data center equipment.

 

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Amortization expense is comprised of the amortization of our customer based intangible assets related to the acquisition of Webmail.us, Inc., internally developed technology, and software licenses purchased from third-party vendors, which are amortized over their estimated useful lives.

In August 2007, we entered into a lease for approximately 67 acres of land and a 1.2 million square foot facility located in Windcrest, Texas, which is in the San Antonio, Texas area. This facility was a former shopping mall, the Windsor Park Mall, and we are in the process of remodeling it to be used as our corporate headquarters and potentially as a data center. We intend to begin relocating to the Windsor Park Mall in the second quarter of 2008. As a result of the new lease, we expect our depreciation and amortization expense to increase once we begin utilizing this space.

Other Income (Expense)

In 2005, we started to finance certain equipment purchases with capital leases. Since then, we have more formally instituted leasing programs with three of our major equipment vendors and are now leasing all purchases from them. We have also borrowed under our revolving line of credit to fund the gap between our cash flows from operations and cash flows from investments. The total amount of interest bearing debt outstanding, including indebtedness under our capitalized lease obligations, was $8.0 million, $19.3 million, and $111.5 million as of December 31, 2005, 2006, and 2007, respectively. Interest bearing debt outstanding was $145.1 million as of March 31, 2008.

Accordingly, our interest expense has increased over the last three years. Our interest expense was $0.8 million, $1.1 million, and $3.6 million for 2005, 2006, and 2007, respectively. For the quarter ended March 31, 2008, interest expense was $1.3 million. Our cash and cash equivalent balances earned interest of $0.2 million, $0.4 million, and $0.8 million for 2005, 2006, and 2007, respectively. Interest earned on cash and cash equivalent balances was $0.2 million for the quarter ended March 31, 2008.

Other income further includes insignificant amounts of income and expenses related to foreign exchange gains and losses and miscellaneous income.

Share-Based Compensation

We have historically granted options to our employees representing a material component of overall compensation. We believe that share-based compensation provides our employees an incentive to help build long-term value. Prior to January 1, 2006, we accounted for share-based awards under the recognition and measurement provisions of SFAS 123, Accounting for Stock-Based Compensation. During this time, we recognized compensation cost for share-based awards based on the minimum value taking into account the exercise price of the option and the fair market value of our common stock on the date of grant. Effective January 1, 2006, we adopted SFAS 123(R), using the prospective transition method. We did not make and have not made any significant changes to our share-based compensation programs in anticipation of, or in consideration of, the adoption of SFAS 123(R). Share-based compensation may fluctuate significantly based on changes in fair market value due to changes in stock prices, volatility, exercise patterns, and other factors.

During 2005, 2006, and 2007, we recorded expense of $0.3 million, $1.1 million, and $4.3 million, respectively, in connection with share-based payment awards. For the quarter ended March 31, 2008, share-based compensation expense was $2.8 million. Unrecognized share-based compensation expense as of March 31, 2008 for unvested employee options of $43.9 million is expected to be recognized using the straight-line method over a weighted average period of 2.9 years. For options outstanding as of March 31, 2008, we expect to recognize share-based compensation expense of $11.5 million, $14.6 million, $13.2 million, $4.2 million, and $0.4 million for 2008, 2009, 2010, 2011 and 2012, respectively.

 

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Income Tax Expense

We account for income taxes in accordance with SFAS 109, Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax provision in each of the jurisdictions in which we operate. This process involves estimating our current income tax provision together with assessing temporary differences resulting from differing treatment for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet using the enacted tax rates in effect for the year in which we expect the temporary differences to reverse. Historically, we have been primarily subject to taxation in the U.S. and the U.K. In the future, we intend to further expand our operations outside these jurisdictions, in which case we would become subject to taxation in additional foreign countries, and our effective tax rate could fluctuate accordingly.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with generally accepted accounting principles in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. We review our estimates and judgments on an ongoing basis, including those related to revenue recognition, service credits, allowance for doubtful accounts, property and equipment, goodwill and intangibles, contingencies, the fair valuation of stock related to share-based compensation, software development, and income taxes. We base our estimates on circumstances prevailing at the time, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

Because we provide our hosting services to our customers and do not sell individual hardware and software products, we follow the provisions of SEC Staff Accounting Bulletin No. 104, Revenue Recognition, and Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. We recognize revenue when all of the following conditions are met:

 

  Ÿ  

There is persuasive evidence that an arrangement exists;

 

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The service has been provided to the customer;

 

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The amount of fees to be paid by the customer is fixed or determinable; and

 

  Ÿ  

The collection of the fees is reasonably assured.

We recognize hosting revenues, including implementation and set-up fees on a monthly basis, beginning on the date the customer commences use of our services. Implementation fees are amortized over the estimated average customer life. If a customer terminates their relationship with us before the expiration of the estimated average customer life, any unamortized installation fees are recognized as revenue at that time. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenues or revenues, depending on whether the revenue recognition criteria have been met. Therefore, deferred revenue primarily consists of prepaid service fees and set-up fees. Professional services are recognized in the period services are provided.

Our customers generally have the right to cancel their contracts by providing prior written notice to us of their intent to cancel the remainder of the contract term. In the event that a customer cancels their contract, they are not entitled to a refund for services already rendered.

 

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Valuation of Accounts Receivable and Service Credits

Estimates that further impact revenue recognition relate primarily to allowance for doubtful accounts and customer service credits. Both estimates are relatively predictable based on historical experience.

We make judgments as to our ability to collect outstanding receivables and provide allowances when collection becomes doubtful. Judgment is required to assess the likelihood of ultimate realization of recorded accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of either their ability or willingness to make payments, an increase in the allowance for doubtful accounts would be required. Similarly, a change in the payment behavior of customers generally may require an adjustment in the calculation of the appropriate allowance. Each month, management reviews customer payment patterns, historical data and anticipated customer default rates of the various aging categories of accounts receivables in order to determine the appropriate allowance for doubtful accounts. We write off customer accounts receivable balances to the allowance for doubtful accounts when it becomes likely that we will not collect from the customer.

All of our customer agreements provide that we will achieve certain service levels. To the extent that such service levels are not achieved, we record service credits, which are a reduction to revenues, and a corresponding increase in the allowance for customer credits to provide for estimated adjustments to receivables. We base these provisions on historical experience and evaluate the estimate of service credits on a regular basis, and adjust the amount reserved accordingly.

Property, Equipment and Other Long Lived Assets

We utilize significant amounts of property and equipment in providing services to our customers. We use straight-line depreciation for property, equipment, and leasehold improvements over the estimated useful lives. We use estimated useful lives of three to five years for equipment and software. Changes in technology or changes in the intended use of property and equipment may cause the estimated useful life or the value of these assets to change. We periodically review the appropriateness of the estimated economic useful lives for each category of property and equipment.

Periodically we assess potential impairment of our property and equipment, in accordance with the provisions of SFAS 144, Accounting for the Impairment and Disposal of Long-Lived Assets. We perform an impairment review whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or our overall business strategy, and significant industry or economic trends. When we determine that the carrying value of a long-lived asset may not be recoverable based upon the existence of one or more of the above indicators, we determine the recoverability by comparing the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate. We recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair market value of the asset.

Goodwill and Intangible Assets

Goodwill, which consists of the excess of the purchase price over the fair value of identifiable net assets of businesses acquired, is evaluated for impairment on an annual basis, or whenever events or circumstances indicate that impairment may have occurred. We follow the provisions of FAS 142, Goodwill and Other Intangible Assets, when evaluating goodwill for impairment.

Intangible assets, including technology, contracts, customer relationships, license agreements, and non-compete agreements arising principally from acquisitions, are recorded at cost less

 

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accumulated amortization. Intangible assets deemed to have indefinite useful lives, such as certain tradenames, are not amortized and are subject to annual impairment tests or whenever events or circumstances indicate impairment may have occurred. An impairment exists if the carrying value of the indefinite-lived intangible asset exceeds its fair value. For other intangible assets subject to amortization, impairment is recognized if the carrying amount is not recoverable and the carrying amount exceeds the fair value of the intangible asset.

There are many assumptions and estimates used that directly impact the results of impairment testing, including an estimate of future expected revenues, earnings and cash flows, and discount rates applied to such expected cash flows in order to estimate fair value.

Contingencies

We accrue for contingent obligations, including estimated legal costs, when the obligation is probable and the amount is reasonably estimable. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include those related to tax, legal, and other regulatory matters, changes in the interpretation and enforcement of international laws, and the impact of local economic conditions and practices, which are all subject to change as events evolve and as additional information becomes available during the administrative and litigation process.

Share-Based Compensation

Prior to January 1, 2006, we accounted for share-based awards under the recognition and measurement provisions of SFAS 123. During this time, we recognized compensation cost for share-based awards based on the minimum value taking into account the exercise price of the option and the fair market value of our common stock on the date of grant. Effective January 1, 2006, we adopted SFAS 123(R), using the prospective transition method. In accordance with SFAS 123(R), measurement and recognition of compensation expense for all share-based payment awards made to employees and directors beginning January 1, 2006 is recognized based on estimated fair values. SFAS 123(R) requires nonpublic companies that used the minimum value method under SFAS 123 for either recognition or pro forma disclosures to apply SFAS 123(R) using the prospective-transition method. As such, we continue to apply SFAS 123 in future periods to unvested equity awards outstanding at the date of adoption of SFAS 123(R).

Information regarding our stock option grants for 2006, 2007, and the quarter ending March 31, 2008 is summarized as follows:

 

      Number of
Options
Granted
   Exercise
Price
   Fair
Value
 

January 1, 2006 to June 30, 2006

   15,000    $ 2.30    $ 2.30  
   1,215,000      2.50      2.30  

July 1, 2006 to September 30, 2006

   415,000      3.40      3.40  

October 1, 2006 to December 31, 2006

   502,500      4.52      4.52  

January 1, 2007 to March 31, 2007

   572,500      4.94      4.94  

April 1, 2007 to November 11, 2007(1)

   4,083,750      5.82      5.82  

November 12, 2007 to December 31, 2007

   362,500      7.48      7.48  

January 1, 2008 to January 30, 2008

   653,000      7.48      8.87 (2)

January 31, 2008 to March 4, 2008(3)

   1,331,000      9.14      10.86 (2)

March 5, 2008 to March 31, 2008

   3,222,940      10.30      12.85 (2)

 

(1) The grants in the table above do not include the 104,440 options assumed in the business acquisition of Webmail.us, Inc.

 

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(2) This fair value reflects the reassessed fair value as discussed below.
(3) The grants exclude 4,058 options issued as a modification of an employee’s options.

Background of Valuations

In evaluating the fair value of our common stock, we followed procedures that are consistent with the recommendations of the American Institute of Certified Public Accountants Technical Practice Aid regarding “Valuation of Privately-Held Company Equity Securities Issued as Compensation,” or the AICPA Practice Aid, and the SEC staff commentary set forth in the Division of Corporation Finance, “Current Accounting and Disclosure Issues” dated August 31, 2001, Part II - “Other Current Accounting and Disclosure Issues,” and Paragraph I “Valuing Equity Instruments.”

Our board of directors made its determinations as to the fair value in connection with the grant of stock options exercising its best reasonable judgment at the time. In the absence of a public market for our common stock, numerous objective and subjective factors, referred to as the key valuation considerations, were analyzed to determine the fair value at each grant date, including the following:

Business Conditions and Results:

 

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Our actual financial condition and results of operations during the relevant period;

 

  Ÿ  

The status of strategic initiatives to increase the target market for our services;

 

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The competitive environment that existed at the time of the valuation;

 

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All important developments for us including the growth of our customer base, the progress of our business model, the introduction of new services, and international expansion;

 

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The status of our efforts to build our management team and to retain and recruit the talent and size organization required to support our anticipated growth;

Market Conditions:

 

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The market conditions affecting the technology industry;

 

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The general economic outlook in the U.S. and the rest of the world;

 

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The market prices of various publicly-held technology companies operating in our industry and other marketplaces similar to our business;

Liquidity and Valuation:

 

  Ÿ  

The fact that the option grants involved illiquid securities in a private company;

 

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The likelihood of achieving a liquidity event for the shares of our common stock underlying the options, such as an initial public offering or sale of our company, given prevailing market conditions and our relative financial condition at the time of grant; and

 

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A series of valuations conducted by independent third party valuation firms.

Our board of directors also considered third party sales of our common stock during this period to corroborate the valuation estimates. For example, on April 5, 2007 and July 23, 2007, there were third-party sales of our common stock at $4.94 and $5.82 per share, respectively, which provide support for the reasonableness of the valuations at or near those transaction dates. The April purchase was made by a group of investors, including three entities affiliated with Sequoia Capital, a venture capital firm,

 

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and the July purchase was made by an entity affiliated with Norwest Venture Partners, a venture capital firm.

The major drivers and assumptions used in calculating the fair value of our shares include:

 

  Ÿ  

Company Performance and Projections. Management prepared financial forecasts for a five-year period from the date of valuation, which were used, along with historical financials and information received from management in regard to any material events and trends, as a basis for the valuations.

 

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Comparable companies. Several companies in the hosting or IT services industry publicly traded on securities markets were selected in all valuations for reference as our comparable companies in order to derive discount rates and/or market multiples.

 

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Capital market valuation multiples. Updated capital market data of selected comparable companies was obtained and assessed, and multiples of enterprise value to revenue and enterprise value to earnings before interest, taxes, depreciation, and amortization were used for market approach valuations.

 

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Weighting between income approach and market approach. The income approach differs from the market approach in that the income approach is based on entity-specific assumptions, whereas the market approach is based on observable valuation ratios of comparable companies. The valuations prior to September 30, 2006 did not use a market approach and therefore allocated 100% of the valuation weight to the income approach. The valuation for the valuation period beginning in September 2006 had a weight allocation of 25% to the income approach and 75% to the market approach and the valuation for the valuation period beginning in January 2008 had a weight allocation of 10% to the income approach and 90% to the market approach. As stated above, the income approach allows for more of our company-specific factors to be reflected in the projection and therefore the resulting valuations reflect a consideration of our projected performance in the coming few years. However, the heavy reliance on the terminal year cash flow assumptions, which cumulatively reflect substantial growth over the prior five years, as well as the availability of reasonably comparable public companies, called for an increased weight allocation to the market approach. As we moved closer to a potential initial public offering, the higher weight allocation to the market approach was applied in order for the valuations to more closely follow the valuation criteria that are used for public companies.

 

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Discount for lack of marketability, or DLOM. The DLOM for our valuation has ranged from 5.0% to 27.5% for the periods set forth in the table, generally decreasing over time due to the steady and continuing improvements in our financial performance, which improves the likelihood of a liquidity event and reduces the time likely to accomplish such an event. The anticipated timing of the liquidity events utilized in these valuations was based on our then-current plans and estimates.

 

  Ÿ  

Discount Rate. Based on the assessments of our associated risks with achieving our forecasts, a discount rate range of 22.5% to 30.0% was used in the income approach.

All of our valuations were contemporaneous in that all or nearly all of the option grants made in any of the valuation periods were made at or near the valuation date and there were no material changes to our business or value drivers between the valuation date and the grant dates.

Although our board of directors carefully considered the key valuation considerations, the main driver in the increases for every valuation was the steady and continued improvements in our financial performance primarily in revenue growth. The improvements affected various aspects of the valuation, such as improved financial forecasts, which were utilized as key financial measurement points in the

 

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valuations, favorable comparisons to our public company comparable set, which improved multiples used in the valuations, and improved likelihood and reduced timing of a liquidity event, which reduced the DLOM.

Grants Made From January 1, 2006 to June 30, 2006

For the equity awards granted in the period from January 1, 2006 to June 30, 2006, our board of directors considered the key valuation considerations, including an independent valuation report dated December 19, 2005, which provided a fair value of our stock as of December 19, 2005. The determination of the fair value of our common stock relied on the income approach, with a cost of capital of 30.0%. Our board of directors also considered, among other things, the private placement of common stock that we had concluded in October 2005, pursuant to which we sold shares of common stock to investors at $2.10 per share. Based on the relevant factors, our board of directors concluded that the fair value of our common stock was $2.30 per share at the time of each grant during the period.

Grants Made From July 1, 2006 to September 30, 2006

For the equity awards granted in the period from July 1, 2006 to September 30, 2006, our board of directors considered the key valuation considerations, including an independent valuation report dated August 31, 2006, which provided a fair value of our common stock as of June 30, 2006. The determination of the fair value of our common stock again relied on the income approach, with a cost of capital of 30.0%. Based on the relevant factors, our board of directors concluded that the fair value of our common stock was $3.40 per share at the time of each grant during the period. The main factor in the increase in valuation from the prior period was an improvement in our operating performance and outlook, which resulted in improvements in the key financial measurement points that were used in the valuation.

Grants Made From October 1, 2006 to December 31, 2006

For the equity awards granted in the period from October 1, 2006 to December 31, 2006, our board of directors considered the key valuation considerations, including an independent valuation report dated December 11, 2006, which provided a fair value of our stock as of September 30, 2006. The determination of the fair value of our common stock relied on a 25% weight to the income approach and a 75% weight to the market approach. This allocation was determined by an assessment of our significant future growth reflected in our projections, the sensitivity of the value under the income approach to the terminal year assumptions, and the availability and comparability of public companies and comparable acquisitions from which pricing could be determined. The cost of capital used for the valuation was determined to be 22.5%. The discount for lack of marketability was determined to be 27.5% based on analysis of various studies while implementing our specific circumstances. Based on the relevant factors, which included a review of our product roadmap that indicated compelling product launches on the horizon, competitive analysis reports which showed favorable market positioning and indications of favorable available options from our initial search for data center space in both the U.S. and U.K., our board of directors concluded that the fair value of our common stock was $4.52 per share at the time of each grant during the period. The main factor in the increase in the valuation was our more favorable financial forecast based on our performance improvements and updated market outlook, which resulted in improvements in the key financial measurement points that were used in the valuation.

Grants Made From January 1, 2007 to March 31, 2007

For the equity awards granted in the period from January 1, 2007 to March 31, 2007, our board of directors considered the key valuation considerations, including an independent valuation report dated

 

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February 27, 2007, which provided a fair value of our stock as of December 31, 2006. The determination of the fair value of our common stock relied on a 25% weight to the income approach and a 75% weight to the market approach, a cost of capital of 22.5%, and a discount for lack of marketability of 27.5%, all of which were the same as used in the prior valuation. Based on the relevant factors, which included (i) the progress of (a) our planned expansion of our Grapevine data center facility, which was projected to provide an additional 22,000 square feet of raised floor for our operations, (b) the new Slough U.K. data center facility, which was projected to provide approximately 50,000 square feet of gross floor space, and (c) our new future headquarters, which was believed to be a potential real estate value opportunity and which could provide us with other benefits such as potential additional data center space and a facility that could accommodate and foster our unique culture and (ii) our progress in strengthening our Fanatical Support commitment, which management believed would help solidify our operations, and the favorable outlook of our future market potential, our board of directors concluded that the fair value of our common stock was $4.94 per share at the time of each grant during the period. The increase in the valuation was due to a higher market approach valuation resulting primarily from an increase in our financial measurements, which were increased due to our operating results as of December 31, 2006, and an increase in the multiples used in the valuation calculations, due mainly to our favorable performance comparison to comparable public companies in our industry.

From April 5, 2007 through April 10, 2007, 146,875 shares of our common stock were sold by stockholders in four separate transactions to accredited investors for $4.94 per share, or an aggregate of $725,563. Among the purchasers in two of these transactions were third party investment companies, including three entities affiliated with Sequoia Capital.

Grants Made From April 1, 2007 to November 11, 2007

For the equity awards granted in the period from April 1, 2007 to November 11, 2007, our board of directors considered the key valuation considerations, including an independent valuation report dated July 6, 2007, which provided a fair value of our stock as of July 3, 2007. The determination of the fair value of our common stock relied on a 25% weight to the income approach and a 75% weight to the market approach, which was the same allocation as used in the prior valuation. The cost of capital was increased to 23.5%, based mainly on a perceived increased risk related to our substantial anticipated capital expenditures for the completion of our new corporate headquarters’ facility and the expansion of data center capacity, a substantial portion of which was being funded with debt incurred under our line of credit arrangement. The discount for lack of marketability decreased to 25.0% based on the assumption that we were getting closer to a liquidity event. This assumption was based on management’s discussions with our board of directors regarding preliminary plans to initiate an initial public offering and the potential timing and completion of an offering. Based on the relevant factors, which included (i) the continuing progress being made in the U.S. and U.K. data center expansion plans and (ii) the progress being made in the plans relating to our new corporate headquarters, where real estate due diligence, negotiation of key terms, and identification of financing sources were completed or nearing completion, our board of directors concluded that the fair value of our common stock was $5.82 per share at the time of each grant during the period. Aside from the reduction in the discount for lack of marketability and other affects of our liquidity timing, our positive financial performance as of the valuation date, which resulted in improvements in the key financial measurement points that were used in the valuation, drove the increase in the valuation, although the increases were somewhat offset due to the significant changes in our risk profile due to our increased capital expenditures and heightened debt levels, which drove the multiples down. Further, we had favorable performance comparisons to many of the comparable public companies. However, the impact of these market increases and favorable comparisons on the valuation were minimized because we continued to operate as a private company.

On June 12, 2007, a stockholder sold 20,000 shares of our common stock in a private transaction to two employee accredited investors at a purchase price of $5.60 per share, and from July 16, 2007 to

 

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November 1, 2007, 65,560 shares of our common stock were sold by stockholders in eight separate transactions for $5.82 per share, or an aggregate of $381,559, to four employee accredited investors and an affiliate of Norwest Venture Partners.

Grants Made From November 12, 2007 to December 31, 2007

For the equity awards granted in the period from November 12, 2007 to January 30, 2008, the Board considered the key valuation considerations, including an independent valuation report dated November 12, 2007, which provided a fair value of our stock as of November 12, 2007. The determination of the fair value of our common stock relied on a 25% weight to the income approach and a 75% weight to the market approach, which was the same allocation as used in the prior valuation. The cost of capital was determined to be 23.0% and the discount for lack of marketability decreased to 20.0%, based on the assumption that we were getting closer to a liquidity event. Based on the relevant factors, which included (i) the status of our updated timing projections in preparation of an initial public offering, including information from informal discussions with various investment bankers, (ii) the status of updated plans relating to our new corporate headquarters, where agreements had now been completed and construction had begun, and (iii) the potential effect of the acquisition of Webmail.us, Inc., which had provided us with a significant footprint into the email hosting space, access to a new customer base and a business with a significant projected growth rate, our board of directors concluded that the fair value of our common stock was $7.48 per share at the time of each grant during the period. Aside from the reduction in the discount for lack of marketability, our positive financial performance, which resulted in improvements in the key financial measurement points that were used in the valuation, and an increase in the multiples used in the valuation calculations, attributable to changes in overall market performance and our favorable performance comparison to comparable public companies, drove the increase in the valuation as well. However, the impact of these market increases and favorable comparisons on the valuation were minimized because we continued to operate as a private company.

There were six separate transactions involving the purchase and sale of our common stock that occurred from November 23, 2007 to December 26, 2007, in which 88,565 shares of our common stock were sold by stockholders to employee accredited investors for $7.48 per share, or an aggregate of $662,466.

Valuations for 2008

Originally, our valuation from November 12, 2007 of $7.48 was effective until January 31, 2008, when we set the new valuation at $9.14. The January 31, 2008 valuation was effective until March 5, 2008, when we set the new valuation at $10.30. The March 5, 2008 valuation was effective through March 31, 2008. All of the key valuation considerations, including an independent valuation report were considered in each of these valuations. However, in connection with the preparation of the financial statements for the fiscal quarter ended March 31, 2008, we reassessed the estimated accounting fair value of our common stock in light of the potential completion of our initial public offering and preliminary discussions relating to our potential pricing range. We reassessed each of the key valuation considerations, including each independent valuation report delivered during 2008, and the discount taken in each case for lack of marketability. Based upon the reassessment, we determined that a discount for lack of marketability of 5.0% was more appropriate with respect to the determination of fair value for all grants during 2008, rather than the prior discounts which ranged from 20.0% to 15.0%. This determination was made because, in retrospect, we now consider the formal discussions with investment bankers in December 2007 to be a key event that has proven to have provided additional certainty that we could achieve an initial public offering. We also determined that, with respect to the fair value of our common stock during the period from March 5, 2008 to April 1, 2008, it was appropriate to increase our projected earnings before income, depreciation, taxes, and

 

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amortization multiple, or EBITDA multiple, in light of increases in comparable public company EBITDA multiples in early 2008 and due to the closer proximity to the target liquidity date.

We also reassessed the estimated accounting fair value of our common stock during 2007, considering key valuation considerations, including each independent valuation report delivered during 2007. Throughout 2007, our management and board of directors talked with advisors with respect to the potential acceptance of our business plan in the market. We believed that, during most of 2007, there was significant uncertainty as to whether we could achieve market acceptance and therefore uncertainty that a liquidity event would occur. Based upon these considerations and the third party transactions involving our common stock described above that occurred on April 5, 2007 and July 23, 2007, we determined that no adjustment to the fair value of our common stock was necessary prior to November 11, 2007. Additionally, due to the substantial uncertainty in our future results of operations created by our data center outages that occurred during the fourth quarter of 2007, we determined that no adjustment to the fair value during the period from November 11, 2007 to December 31, 2007 was necessary.

Grants Made From January 1, 2008 to January 30, 2008

Equity awards granted in the period from January 1, 2008 to January 30, 2008 were originally granted at a fair value of $7.48 pursuant to the valuation on November 12, 2007. As discussed above, upon the reassessment, we have applied a 5.0% discount for marketability to that valuation rather than the 20.0% discount that was previously used, making the fair value for equity grants during this period $8.87 per share.

Grants Made From January 31, 2008 to March 4, 2008

For the equity awards granted in the period from January 31, 2008 to March 4, 2008, our board of directors considered the key valuation considerations, including an independent valuation report dated January 30, 2008, which provided a fair value of our stock as of January 30, 2008. The determination of the fair value of our common stock relied on a reduction in the weight attributable to the income approach to 10% and an increase to the weight attributable to the market approach to 90% due to fact that we had engaged investment bankers to begin the process of preparing for our initial public offering. Since this was a significant step towards becoming a public company, the pricing in the marketplace was increasingly relied upon as a valuation factor. The determination of the fair value of our common stock also relied on a market multiple method using only a projected earnings before income, depreciation, taxes, and amortization, or EBITDA, calculation (as opposed to projected EBITDA and projected revenue), because a more reliable and smaller range of projected EBITDA from the comparable public company set became available. The discounting of the market multiple used in the valuation was also minimized due to actions taken that indicated we had made significant progress in becoming a public company, including the engagement of the investment bankers. The cost of capital was determined to be 23.0% and the discount for lack of marketability originally remained at 20.0%. As discussed above, upon the reassessment, we have applied a 5.0% discount for marketability to that valuation rather than the 20.0% discount that was previously used. Based on the relevant factors, which included (i) the repercussions of the significant downtime that occurred in the Grapevine data center during the fourth quarter of 2007, (ii) the status of adjustments and improvements being made to mitigate future data center risks, and (iii) the progress made in the integration of the Webmail.us, Inc. business into ours, which included integration of resources, systems, and personnel, our board of directors originally concluded that the fair value of our common stock was $9.14 per share at the time of each grant during the period. The main factor in the increase in the valuation was our more favorable financial forecast based on our performance improvements and updated market outlook, which resulted in improvements in the key financial measurement points that were used in the valuation. As reassessed with the reduced discount for marketability, the fair value has been adjusted to $10.86.

 

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Grants Made From March 5, 2008 to March 31, 2008

For the equity awards granted in the period from March 5, 2008 to March 31, 2008, our board of directors considered the key valuation considerations, including an independent valuation report dated March 5, 2008, which provided a fair value of our stock as of March 5, 2008. The determination of the fair value of our common stock again relied on a 10% weight to the income approach and 90% to the market approach. The cost of capital was determined to be 22.5% and the discount for lack of marketability was originally reduced to 17.5%, based on the assumption that we were getting closer to a liquidation event. As discussed above, upon the reassessment, we have applied a 5.0% discount for marketability to that valuation rather than the 17.5% discount that was previously used. Based on the relevant factors, which included (i) our significant progress towards filing our registration statement, (ii) the continued progress of the data center expansion plans, which were meeting time and budget expectations, (iii) progress with our international expansion plans, specifically our plans in Asia where we had formed an operating entity and begun searching for local data center space, (iv) the initial operational success of the Webmail.us business, which was now re-branded as Mailtrust, and (v) the positive outlook and increased growth of the business of Mosso, our cloud hosting division, our board of directors originally concluded that the fair value of our common stock was $10.30 per share at the time of each grant during the period. The main factor in the increase in the fair value was due to the use of a higher multiple, based on our strong performance, outlook and favorable comparison to the market. As reassessed with the reduced discount for marketability and an increased multiple, the fair value has been adjusted to $12.85.

As a result of the reassessed fair value of our common stock, the aggregate fair value of our stock options increased $9.6 million and $416 thousand was recognized as additional share-based compensation expense for the first quarter of 2008.

Board Experience

Our board of directors includes individuals with significant business, finance and/or venture capital experience. During the periods set forth in the table, our board of directors was comprised of several individuals with experience in valuing technology companies and pricing stock options. These board members are familiar with the valuations of technology companies entering into initial public offerings, as well as with the market for the acquisition of technology companies similar to our stage of development.

Consideration of Independent Valuation Firm Qualifications

Our consideration of the valuations from the independent third party valuation firms at the time of the determination of fair value is consistent with the guidance set forth in the AICPA Practice Aid because:

 

  Ÿ  

The independent third party valuation firms are independent;

 

  Ÿ  

The independent third party valuation firms considered the cost, income and market methods of valuation and determined the method to use based on our stage of life, revenues and outlook;

 

  Ÿ  

The independent third party valuation firm’s valuations were finalized before the Company established fair value, not after the fact; and

 

  Ÿ  

The independent third party valuation firms documented their assumptions and methods in their reports and those assumptions and methods were considered to be a consistent and reasonable basis for that assessment.

Consistent with the AICPA Practice Aid and the Staff Commentary, the independent third party valuation firm’s valuations utilized historical and prospective discussions of our performance. The

 

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prospective analysis was based on financial plans provided to the independent third party valuation firms by management.

The independent third party valuation firms also selected companies for the market valuation when utilized that we and the independent third party valuation firm agreed were comparable peers due to the nature of their products and services, size and current market positions. In the analyses, factors that distinguished us from the peer companies were noted and taken into account.

Information regarding the third party valuations of our common stock during the period beginning January 1, 2006 and ending on March 31, 2008 is summarized as follows:

 

Date of Valuation Report

  

Effective Date of Valuation

(as stated in the Valuation Report)

   Value of
Common Stock

August 31, 2006

   June 30, 2006    $ 3.40

December 11, 2006

   September 30, 2006      4.52

February 27, 2007

   December 31, 2006      4.94

July 6, 2007

   July 3, 2007      5.82

November 12, 2007

   November 12, 2007      7.48

January 30, 2008

   January 31, 2008      9.14

March 5, 2008

   March 5, 2008      10.30

Based upon an assumed initial public offering price of $         per share, which is the midpoint of the range listed on the cover page of this prospectus, the aggregate intrinsic value of options outstanding as of March 31, 2008 was $         million, of which $         million related to vested options and $         million to unvested options.

In accordance with SFAS 123(R), we use the Black-Scholes pricing model to determine the fair value of the stock options on the grant dates for share awards made on or after January 1, 2006. The Black-Scholes option valuation model requires the use of highly subjective and complex assumptions to determine the fair value of share-based awards, including the deemed fair value of the underlying common stock on the date of grant and the expected volatility of the stock over the expected term of the related grants. The value of the award is recognized as expense over the requisite service periods on a straight-line basis in our consolidated statements of income, and reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Software Development

We capitalize the salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects. If a project constitutes an enhancement to previously developed software, we assess whether the enhancement is significant and creates additional functionality to the software, thus resulting in capitalization. All other software development costs are expensed as incurred. We amortize capitalized software development costs over periods ranging from 12 to 36 months, which represents the estimated useful lives of the software.

Income Taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes and interest will be due. These reserves

 

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are established when we believe that certain positions are likely to be challenged and may not be sustained on review by tax authorities. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.

Our effective tax rates have differed from the statutory rate primarily due to the tax impact of foreign operations, research and development tax credits, state taxes, and certain benefits realized related to stock option activity. Our effective tax rate was 35.5% and 35.9% for 2006 and 2007, respectively. For the quarter ended March 31, 2008, our effective tax rate was 39.9%. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

Results of Operations

The following tables set forth our results of operations for the specified periods and as a percentage of our revenues for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

Condensed Consolidated Statements of Income:

 

     Years Ended December 31,     Three Months Ended
March 31,
 
     2005     2006     2007     2007     2008  
                       (Unaudited)  
     (In thousands)  

Net revenues

   $ 138,768     $ 223,966     $ 362,017     $ 75,225     $ 119,613  

Costs and expenses:

          

Cost of revenues

     40,987       64,889       118,225       23,593       39,223  

Sales and marketing

     21,837       35,667       53,930       11,661       17,568  

General and administrative

     38,968       59,832       102,777       20,946       33,633  

Depreciation and amortization

     20,193       32,335       56,476       11,835       19,051  
                                        

Total costs and expenses

     121,985       192,723       331,408       68,035       109,475  
                                        

Income from operations

     16,783       31,243       30,609       7,190       10,138  
                                        

Other income (expense):

          

Interest expense

     (808 )     (1,095 )     (3,643 )     (525 )     (1,330 )

Interest and other income

     633       572       828       100       247  
                                        

Total other income (expense)

     (175 )     (523 )     (2,815 )     (425 )     (1,083 )
                                        

Income before income taxes

     16,608       30,720       27,794       6,765       9,055  

Income taxes

     5,836       10,900       9,965       2,593       3,613  
                                        

Net Income

   $ 10,772     $ 19,820     $ 17,829     $ 4,172     $ 5,442  
                                        

 

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Condensed Consolidated Statements of Income, as a Percentage of Revenues:

 

     Years Ended December 31,     Three Months Ended
March 31,
 
         2005             2006             2007             2007             2008      
                       (Unaudited)  
     (Percent of net revenues)  

Net revenues

   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %

Costs and expenses

          

Cost of revenues

   29.5 %   29.0 %   32.7 %   31.4 %   32.8 %

Sales and marketing

   15.7 %   15.9 %   14.9 %   15.5 %   14.7 %

General and administrative

   28.1 %   26.7 %   28.4 %   27.8 %   28.1 %

Depreciation and amortization

   14.6 %   14.4 %   15.6 %   15.7 %   15.9 %
                              

Total costs and expenses

   87.9 %   86.1 %   91.5 %   90.4 %   91.5 %
                              

Income from operations

   12.1 %   13.9 %   8.5 %   9.6 %   8.5 %
                              

Other income (expense)

          

Interest expense

   (0.6 %)   (0.5 %)   (1.0 %)   (0.7 %)   (1.1 %)

Interest and other income

   0.5 %   0.3 %   0.2 %   0.1 %   0.2 %
                              

Total other income (expense)

   (0.1 %)   (0.2 %)   (0.8 %)   (0.6 %)   (0.9 %)
                              

Income before income taxes

   12.0 %   13.7 %   7.7 %   9.0 %   7.6 %

Income taxes

   4.2 %   4.9 %   2.8 %   3.4 %   3.0 %
                              

Net Income

   7.8 %   8.8 %   4.9 %   5.5 %   4.5 %
                              

Due to rounding, totals may not equal the sum of the line items in the table above.

Quarter ended March 31, 2008 and 2007

Net Revenues

Our net revenues were $75.2 million for the quarter ended March 31, 2007 and $119.6 million for the quarter ended March 31, 2008, an increase of $44.4 million, or 59.0%. Our increase in net revenues is primarily due to increased volume of services provided, both due to an increasing number of customer accounts over time and due to incremental services rendered to existing customers.

Recurring revenues

Our recurring revenue was $72.4 million for the quarter ended March 31, 2007 and $115.3 million for the quarter ended March 31, 2008, an increase of $42.9 million, or 59.3%. This increase was driven in part by revenue growth from our existing customers, and in part by the addition of new customers. For the quarter ended March 31, 2008, our average monthly growth in installed base was 0.9% per month. The number of customer accounts grew from 13,530 on March 31, 2007 to 31,662 on March 31, 2008, an increase of 134.0%. This increase in customers also includes our expansion into email hosting with our acquisition of Webmail.us, Inc. The revenue contribution of this acquisition on the quarter ended March 31, 2008 was $1.8 million.

Non-recurring revenues

Our non-recurring revenue increased from $2.8 million for the quarter ended March 31, 2007 to $4.3 million for the quarter ended March 31, 2008, primarily as a result of usage charges and set-up fees associated with the increase in our customers.

Cost of Revenues

Our cost of revenues was $23.6 million for the quarter ended March 31, 2007 and $39.2 million for the quarter ended March 31, 2008, an increase of $15.6 million, or 66.1%. Of this increase,

 

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$7.6 million was attributable to an increase in salaries, benefits, and share-based compensation expense. Employees hired to maintain our data center infrastructure and to provide Fanatical Support to our customers increased from 711 as of March 31, 2007 to 1,076 as of March 31, 2008. The cost increase was further attributable to an increase in license costs of approximately $3.4 million, an increase in data center costs of $2.2 million related to bandwidth, power, and rent, as well as maintenance and the replacement of IT equipment parts in the amount of $2.4 million.

Sales and Marketing Expenses

Our sales and marketing expenses were $11.7 million for the quarter ended March 31, 2007 and $17.6 million for the quarter ended March 31, 2008, an increase of $5.9 million, or 50.4%. Of this increase, $3.7 million was primarily attributable to an increase in salaries, commissions, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. We expanded our sales and marketing departments from 245 employees as of March 31, 2007 to 384 as of March 31, 2008. An additional $2.0 million of this increase was primarily attributable to an increase in public relations costs to promote our brand, and advertising and Internet-related marketing expenditures to support revenue growth for new and existing customer accounts.

General and Administrative Expenses

Our general and administrative expenses were $20.9 million for the quarter ended March 31, 2007 and $33.6 million for the quarter ended March 31, 2008, an increase of $12.7 million, or 60.8%. Of this increase, $10.6 million was attributable to an increase in salaries, benefits, and share-based compensation expense. General and administrative employees increased from 533 as of March 31, 2007 to 794 as of March 31, 2008. We incurred increased general overhead expenses in the amount of $2.0 million.

Depreciation and Amortization Expenses

Our depreciation and amortization expense was $11.8 million for the quarter ended March 31, 2007 and $19.1 million for the quarter ended March 31, 2008, an increase of $7.3 million, or 61.9%. This increase in depreciation expense was a direct result of an increase in property and equipment related to depreciable assets.

Other Income (Expense)

Our total other income (expense) was ($0.4) million for the quarter ended March 31, 2007 and ($1.1) million for the quarter ended March 31, 2008, an expense increase of $0.7 million.

Our interest expense was $0.5 million for the quarter ended March 31, 2007 and $1.3 million for the quarter ended March 31, 2008, an increase of $0.8 million. This relative increase was primarily due to the increased level of indebtedness. Interest expense was partially offset by interest income on our operating cash balances and other income. Interest and other income was $0.1 million for the quarter ended March 31, 2007 and $0.2 million for the quarter ended March 31, 2008.

Income Taxes

Our provision for income taxes was $2.6 million for the quarter ended March 31, 2007 and $3.6 million for the quarter ended March 31, 2008, an increase of $1.0 million, or 38.5%. The dollar increase in our provision for income taxes was due to both an increase in income before income taxes from $6.8 million to $9.1 million, as well as an increase in our effective tax rate from 38.3% for the

 

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quarter ended March 31, 2007 to 39.9% for the quarter ended March 31, 2008. In comparing the first quarter of 2007 with the first quarter of 2008, the 1.6% increase in our effective tax rate was due solely to the new Texas Margins Tax.

Year Ended December 31, 2006 and 2007

Net Revenues

Our net revenues were $224.0 million during 2006 and $362.0 million during 2007, an increase of $138.0 million, or 61.6%. Our increase in net revenues is primarily due to increased volume of services provided, both due to an increasing number of customer accounts over time and due to incremental services rendered to existing customers.

Recurring revenues

Our recurring revenue was $215.8 million during 2006 and $349.0 million during 2007, an increase of $133.2 million, or 61.7%. This increase was driven in part by revenue growth from our existing customers, and in part by the addition of new customers. During 2007, our average monthly growth in installed base was 1.6% per month. In addition, during the same period, our customers increased from 12,677 to 29,193, an increase of 130.3%. This increase in customers reflects our expansion into email hosting with our acquisition of Webmail.us, Inc. The revenue contribution of this acquisition on the year ended December 31, 2007 was $2.0 million. In addition, recurring revenue decreased by $3.4 million related to credits to our customers made in the fourth quarter of 2007 as a result of disruptions at our data center in Grapevine, Texas.

Non-recurring revenues

Our non-recurring revenue increased from $8.2 million during 2006 to $13.0 million during 2007, primarily as a result of set-up fees associated with the increase in our customers.

Cost of Revenues

Our cost of revenues was $64.9 million during 2006 and $118.2 million during 2007, an increase of $53.3 million, or 82.1%. Of this increase, $25.6 million is attributable to an increase in salaries, benefits, and share-based compensation expense. Employees hired to maintain our data center infrastructure and to provide Fanatical Support to our customers increased from 576 as of December 31, 2006 to 994 as of December 31, 2007. This increase is also attributable to an increase in license costs of approximately $11.9 million, an increase in data center costs of $6.9 million related to bandwidth, power, and rent, as well as maintenance and the replacement of IT equipment parts in the amount of $6.2 million. During 2007, we also recognized a $2.1 million charge for a loss contingency liability related to an unresolved contractual issue with a vendor.

Sales and Marketing Expenses

Our sales and marketing expenses were $35.7 million during 2006 and $53.9 million during 2007, an increase of $18.2 million, or 51.0%. Of this increase, $14.1 million is primarily attributable to an increase in salaries, commissions, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. We expanded our sales and marketing departments from 224 employees as of December 31, 2006 to 353 as of December 31, 2007. An additional $4.0 million of this increase was primarily attributable to an increase in public relations costs to promote our brand, and advertising and Internet-related marketing expenditures to support revenue

 

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growth for new and existing customer accounts. The remaining increase of $0.1 million was related to an increase of $0.6 million due to travel and entertainment expenses, partially offset by a decrease of $0.5 million in professional and consulting fees.

General and Administrative Expenses

Our general and administrative expenses were $59.8 million during 2006 and $102.8 million during 2007, an increase of $43.0 million, or 71.9%. Of this increase, $26.8 million is attributable to an increase in salaries, benefits, and share-based compensation expense. General and administrative employees increased from 434 as of December 31, 2006 to 674 as of December 31, 2007. During 2007, we added several key senior level management positions in human resources, marketing, information systems, talent management, and operations to support our growth. Additionally, we added headcount in legal, finance, and accounting to prepare us to operate as a publicly-traded company. The increase in headcount resulted in increased expenses of $6.2 million for travel and entertainment, supplies, and other overhead. Of the remaining increase, $4.7 million is primarily attributable to professional fees, including legal and accounting fees, and expenses associated with our Sarbanes-Oxley readiness program, domestic and global tax strategies, and implementation of an Enterprise Resource Planning system. Rent, property taxes, and other contributed $5.3 million to the increase in general and administrative expenses.

Depreciation and Amortization Expenses

Our depreciation and amortization expense was $32.3 million during 2006 and $56.5 million during 2007, an increase of $24.2 million, or 74.9%. This increase in depreciation expense is a direct result of an increase in property and equipment related to depreciable assets.

Other Income (Expense)

Our total other income (expense) was $(0.5) million during 2006 and $(2.8) million during 2007, an increase of $2.3 million.

Our interest expense was $1.1 million during 2006 and $3.6 million during 2007, an increase of $2.5 million. This increase was primarily due to the increased level of indebtedness in 2007. Interest expense was partially offset by interest income on our operating cash balances and other income. Interest and other income was $0.6 million during 2006 and $0.8 million during 2007.

Income Taxes

Our provision for income taxes was $10.9 million during 2006 and $10.0 million during 2007, a decrease of $0.9 million, or 8.3%. The dollar decrease in our provision for income taxes was primarily due to a decrease in income before income taxes. Our effective tax rate was 35.5% for 2006 and 35.9% for 2007. Our effective tax rate increased 2.0% as a result of the Texas legislature enacting a new reformed tax system called the Texas Margins Tax. The tax is based on taxable margin which is determined by revenue and apportioned to business conducted in Texas. The rate increase was partially offset due to proportionately more of our earnings being recognized by our subsidiaries outside of the U.S., where earnings are taxed at lower statutory rates.

We expect our effective tax rate in 2008 to be at or below 40%. The increase in the effective tax rate from 2007 is primarily due to the Texas Margins Tax being applied for the full 2008 calendar year, whereas it was only applied during the last six months of 2007. However, it could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by

 

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changes in tax laws, regulations, accounting principles, or interpretations thereof. We are implementing certain tax strategies that may cause a near-term increase in the effective tax rate with expected tax savings in future years. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

Year Ended December 31, 2005 and 2006

Net Revenues

Our net revenues were $138.8 million during 2005 and $224.0 million during 2006, an increase of $85.2 million, or 61.4%. Our increase in net revenues is primarily due to increased volume of services provided, both due to an increasing number of customer accounts over time and due to incremental services rendered to existing customers.

Recurring revenues

Our recurring revenue was $131.7 million during 2005 and $215.8 million during 2006, an increase of $84.1 million, or 63.9%. This increase was driven in part by revenue growth from our existing customers, and in part by the addition of new customers. During 2006, our average monthly growth in installed base was 1.5% per month. In addition, during the same period, our customer accounts increased from 8,897 to 12,677, an increase of 42.5%.

Non-recurring revenues

Our non-recurring revenue increased from $7.1 million during 2005 to $8.2 million during 2006, primarily as a result of set-up fees associated with the increase in our customers.

Cost of Revenues

Our cost of revenues was $41.0 million during 2005 and $64.9 million during 2006, an increase of $23.9 million, or 58.3%. Of this increase, $10.7 million is attributable to an increase in salaries, benefits, and share-based compensation expense. Employees hired to maintain our data center infrastructure and to provide Fanatical Support to our customers increased from 342 as of December 31, 2005 to 576 as of December 31, 2006. This increase is also attributable to an increase in license costs of approximately $6.5 million, an increase in data center costs of $4.4 million related to bandwidth, power, and rent, as well as maintenance and the replacement of IT equipment parts in the amount of $2.1 million.

Sales and Marketing Expenses

Our sales and marketing expenses were $21.8 million during 2005 and $35.7 million during 2006, an increase of $13.9 million, or 63.8%. Of this increase, $8.5 million is attributable to an increase in salaries, commissions, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. We expanded our sales and marketing departments from 156 employees as of December 31, 2005, to 224 as of December 31, 2006, including 60 sales employees that were added to continue our investment in our world-wide sales and global services organizations. Of the remaining increase, $4.1 million was attributable to an increase in advertising and Internet-related marketing expenditures to support revenue growth. The remaining increase was primarily due to professional fees and travel expenses.

 

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General and Administrative Expenses

Our general and administrative expenses were $39.0 million during 2005 and $59.8 million during 2006, an increase of $20.8 million, or 53.3%. Of this increase, $12.8 million is attributable to an increase in salaries, benefits, and share-based compensation expense as a result of the addition of employees in our executive management team, accounting, human resources, and legal departments. During 2006, we added several executive management positions including a Senior Vice President and General Counsel and Secretary; Senior Vice President, chief financial officer, and Treasurer; and Vice President of Operations, to support both current and anticipated growth. Overall, general and administrative employees increased from 232 as of December 31, 2005, to 434 as of December 31, 2006. The increase in headcount resulted in increased overhead of $3.0 million for travel and entertainment, recruiting fees, office rent, supplies, and other. Of the remaining increase, $1.8 million is primarily attributable to additional professional fees, including legal and accounting fees and expenses associated with our Sarbanes-Oxley readiness program, and $1.4 million was associated with insurance and property tax.

Depreciation and Amortization Expenses

Our depreciation and amortization expenses were $20.2 million during 2005 and $32.3 million during 2006, an increase of $12.1 million, or 59.9%. This increase in depreciation expense is a direct result of an increase in property and equipment related to depreciable assets.

Other Income (Expense)

Our other income (expense) was $(0.2) million during 2005 and $(0.5) million during 2006, an increase of $0.3 million.

Our interest expense was $0.8 million during 2005 and $1.1 million during 2006, an increase of $0.3 million, or 37.5%. Interest expense was partially offset by interest income on our operating cash balances and other income. Interest and other income was $0.6 million during each of 2006 and 2007.

Income Taxes

Our provision for income taxes was $5.8 million during 2005 and $10.9 million during 2006, an increase of $5.1 million, or 87.9%. The increase of $5.1 million in our provision for income taxes was primarily due to higher income before income taxes. Our effective tax rate was 35.1% for 2005 and 35.5% for 2006.

 

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Quarterly Results of Operations

The following table sets forth our unaudited quarterly condensed consolidated statement of operations data in absolute dollars and as a percentage of revenues for each of our last eight quarters in the period ended March 31, 2008. The quarterly data presented below have been prepared on a basis consistent with the audited consolidated financial statements included elsewhere in this prospectus, and in the opinion of management reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this information. You should read this information together with our consolidated financial statements and related notes included elsewhere in this prospectus. Our quarterly results of operations may fluctuate in the future due to a variety of factors. As a result, comparing our operating results on a period-to-period basis may not be meaningful. Our results for these quarterly periods are not necessarily indicative of the results of operations for a full year or any period.

 

    For the Quarter Ended (unaudited)  
    Jun 30,
2006
    Sep 30,
2006
    Dec 31,
2006
    Mar 31,
2007
    Jun 30,
2007
    Sep 30,
2007
    Dec 31,
2007
    March 31,
2008
 
    (In thousands)  

Net revenues

  $ 52,004     $ 59,015     $ 67,199     $ 75,225     $ 84,012     $ 96,097     $ 106,683     $ 119,613  

Costs and expenses

               

Cost of revenues

    14,127       17,164       20,793       23,593       26,148       30,555       37,929       39,223  

Sales and marketing

    8,834       9,636       10,360       11,661       12,609       14,222       15,438       17,568  

General and administrative

    13,784       15,359       17,582       20,946       24,279       26,277       31,275       33,633  

Depreciation and amortization

    7,526       8,673       9,680       11,835       13,133       14,047       17,461       19,051  
                                                               

Total costs and expenses

    44,271       50,832       58,415       68,035       76,169       85,101       102,103       109,475  
                                                               

Income from operations

    7,733       8,183       8,784       7,190       7,843       10,996       4,580       10,138  
                                                               

Other income (expense):

               

Interest expense

    (287 )     (274 )     (336 )     (525 )     (663 )     (1,000 )     (1,455 )     (1,330 )

Interest and other income

    130       163       148       100       127       273       328       247  
                                                               

Total other income (expense)

    (157 )     (111 )     (188 )     (425 )     (536 )     (727 )     (1,127 )     (1,083 )
                                                               

Income before income taxes

    7,576       8,072       8,596       6,765       7,307       10,269       3,453       9,055  

Income taxes

    2,588       2,979       2,914       2,593       2,495       3,978       899       3,613  
                                                               

Net Income

  $ 4,988     $ 5,093     $ 5,682     $ 4,172     $ 4,812     $ 6,291     $ 2,554     $ 5,442  
                                                               

 

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     Jun 30,
2006
    Sept 30,
2006
    Dec 31,
2006
    Mar 31,
2007
    Jun 30,
2007
    Sept 30,
2007
    Dec 31,
2007
    March 31,
2008
 
     (Percent of net revenues)  

Net revenues

   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %

Costs and expenses:

                

Cost of revenues

   27.2 %   29.1 %   30.9 %   31.4 %   31.1 %   31.8 %   35.6 %   32.8 %

Sales and marketing

   17.0 %   16.3 %   15.4 %   15.5 %   15.0 %   14.8 %   14.5 %   14.7 %

General and administrative

   26.5 %   26.0 %   26.2 %   27.8 %   28.9 %   27.3 %   29.3 %   28.1 %

Depreciation and amortization

   14.5 %   14.7 %   14.4 %   15.7 %   15.6 %   14.6 %   16.4 %   15.9 %
                                                

Total costs and expenses

   85.1 %   86.1 %   86.9 %   90.4 %   90.7 %   88.6 %   95.7 %   91.5 %
                                                

Income from operations

   14.9 %   13.9 %   13.1 %   9.6 %   9.3 %   11.4 %   4.3 %   8.5 %
                                                

Other income (expense):

                

Interest expense

   (0.6 %)   (0.5 %)   (0.5 %)   (0.7 %)   (0.8 %)   (1.0 %)   (1.4 %)   (1.1 %)

Interest and other income

   0.2 %   0.3 %   0.2 %   0.1 %   0.2 %   0.3 %   0.3 %   0.2 %
                                                

Total other income (expense)

   (0.3 %)   (0.2 %)   (0.3 %)   (0.6 %)   (0.6 %)   (0.8 %)   (1.1 %)   (0.9 %)
                                                

Income before income taxes

   14.6 %   13.7 %   12.8 %   9.0 %   8.7 %   10.7 %   3.3 %   7.6 %

Income taxes

   5.0 %   5.0 %   4.3 %   3.4 %   3.0 %   4.1 %   0.8 %   3.0 %
                                                

Net Income

   9.6 %   8.6 %   8.5 %   5.5 %   5.7 %   6.5 %   2.4 %   4.5 %
                                                

Due to rounding, totals may not equal the sum of the line items in the table above.

Revenues have increased sequentially in each of the quarters primarily due to increased volume of services provided, both due to an increasing number of customer accounts over time and due to incremental services rendered to existing customers. Net revenues increased from $52.0 million for the quarter ended on June 30, 2006 to $119.6 million for the quarter ended on March 31, 2008, which represents an average growth rate of approximately 12.6% per quarter. During the same period, our average monthly growth in installed base was 1.4% per month, and our customers increased from 10,358 at the end of the second quarter of 2006 to 31,662 at the end of the first quarter 2008. The net revenues for the fourth quarter of 2007 include a service credit in the amount of $3.4 million related to an outage in our data center in Grapevine, Texas. Net revenues grew from $106.7 million for the quarter ended December 31, 2007 to $119.6 million for the quarter ended March 31, 2008, an increase of $12.9 million or 12.1%. The increase in revenue came both from existing and new customers. The growth in installed base averaged 0.9% per month and we acquired an additional 2,469 customers.

Because of the rapid growth of our revenues, operating expenses increased sequentially in each of the quarters presented, primarily as we continue to add personnel and related costs to accommodate our growth. During the first half of 2006, we fell behind in our hiring efforts and we caught up during the second half of 2006 and the first half of 2007. This largely explains the increase in cost of revenue as a percent of revenue from 27.2% in the second quarter of 2006 to 31.4% in the first quarter of 2007 and the increase in general and administrative expenses as a percent of revenue from 26.5% in the second quarter of 2006 to 28.9% in the second quarter of 2007. We also decided to discontinue the use of certain software that was placed into service in August 2005, resulting in accelerated depreciation in the amount of $1.2 million in the first quarter of 2007 and $0.8 million in the second quarter of 2007. This increased our depreciation and amortization expense for those two quarters to 15.7% and 15.6%, respectively.

 

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The results of the fourth quarter of 2007 reflect large investments in our infrastructure and systems. Cost of revenue grew mainly in line with our overall revenue growth, with the exception of a $2.1 million charge for a loss contingency liability related to an unresolved contractual issue with a vendor, which we expect to resolve in 2008. In that same quarter, general and administrative costs increased by a total of $5.0 million compared to third quarter 2007, of which $2.9 million was related to increased salaries, benefits, and associated overhead, and $1.0 million was related to professional fees and consulting services for the implementation of an ERP system, development of internal provisioning systems, and audit fees. Depreciation and amortization increased by $3.4 million, of which $1.9 million was for incremental IT equipment to support new revenue, $0.4 million was for build-outs and leasehold improvements in our data center facility in Grapevine, Texas, $0.3 million was for other leasehold improvements, $0.7 million was for the amortization of capitalized software (ERP and monitoring systems), and $0.2 million was for amortization related to the acquisition of Webmail.us, Inc. As a result of the service credit and the investments mentioned above, our net income margin for the fourth quarter of 2007 decreased to 2.4%.

All of our major cost categories continued to increase in the first quarter of 2008 as we further expanded our business. Income from operations increased from $4.6 million to $10.1 million due to revenue growth and certain charges during the fourth quarter 2007, including an outage in our data center in Grapevine, Texas. Other income (expense) was lower mainly due to lower interest expense given the market-wide reductions in floating interest rates. Our provision for income taxes increased by $2.7 million, from $0.9 million in the fourth quarter of 2007 to $3.6 million in the first quarter of 2008. This increase was due to both an increase in income before taxes and an increase in our effective tax rate. Net income for the first quarter of 2008 was $5.4 million, an increase of $2.9 million over the previous quarter. Our net income margin increased from 2.4% to 4.5%.

Liquidity and Capital Resources

As of March 31, 2008, our cash and cash equivalents balance totaled $27.5 million. This cash balance is maintained primarily for operating reasons and for short-term access to liquidity. The cash balance earns interest through a sweep account, which invests the balances overnight in time deposits, denominated in U.S. dollars. Operating liquidity that is held in the U.K. earns interest directly on depository account balances.

Since 2001, we have funded our operations and met our capital expenditure requirements primarily out of cash flow from operations and capital leases, and to a lesser extent venture capital funding, and more recently through draws on our credit facility.

In 2005, we began to use capital leases to finance IT equipment. We have global master lease agreements with three of our primary vendors and, currently, we finance all purchases from these three vendors of dedicated customer servers and networking equipment through their respective finance companies. All obligations related to those leases are shown on our balance sheet. The outstanding lease obligations recorded as of March 31, 2008, were $60.2 million compared with $20.4 million as of March 31, 2007. We received favorable financing terms from our vendors and as a result have utilized these financing arrangements to acquire IT equipment.

In 2007, our cash outflows from investment activities exceeded our cash inflows from operating activities, mainly due to the start of infrastructure construction projects. To address these funding needs, we secured a $200.0 million credit facility with a commercial banking syndicate. As of December 31, 2007, we had $141.8 million available under this credit facility. On February 25, 2008, we amended the credit facility and increased the committed amount from $200.0 million to $245.0 million. As of March 31, 2008, we had $77.3 million of revolving loans outstanding and a $0.9 million letter of credit outstanding under the credit facility, and $166.8 million available.

 

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Future Needs

We currently anticipate making aggregate capital expenditures of approximately $335 million in 2008. Of these capital expenditures, approximately $160 million is related to construction contracts on our new headquarters facility and data center build-out of domestic and international locations. Our sources to fund those capital expenditures will be our cash and cash equivalents, cash flow from operations, capital leases, and existing amounts available under our revolving credit facility, together with the net proceeds from this offering.

We believe that our existing cash and cash equivalents, cash flow from operations and existing amounts available under our revolving credit facility, together with the net proceeds from this offering, will be more than sufficient to meet our anticipated cash needs for at least the next 12 months. Our long-term future capital requirements will depend on many factors, most importantly our growth of revenue, the expansion of sales and marketing activities, the acquisition of additional data centers, and the continuing acceptance of our services in the markets we serve. Our ability to generate cash depends on our financial performance, general economic conditions, technology trends and developments, and other factors. We could be required, or could elect, to seek additional funding in the form of debt or equity. These additional funds may not be available on terms acceptable to us, or at all.

The following table sets forth a summary of our cash flows for the periods indicated:

 

     Years Ended December 31,     Three Months Ended
March 31,
 
     2005     2006     2007     2007     2008  
                       (Unaudited)  
     (in thousands)  

Net cash provided by operating activities

   $ 34,705     $ 60,630     $ 104,935     $ 25,791     $ 36,158  

Net cash flows used in investing activities

   $ (35,127 )   $ (54,807 )   $ (140,721 )   $ (23,351 )   $ (47,248 )

Net cash provided by (used in) financing activities

   $ 1,265     $ (5,646 )   $ 52,379     $ 2,357     $ 13,661  

Acquisition of property and equipment by capital and finance method leases and notes payable

   $ 6,365     $ 18,825     $ 44,149     $ 6,222     $ 21,619  

Operating Activities

Net cash provided by operating activities is primarily a function of our profitability, the extent to which we incur non-cash charges, and our working capital management.

Net cash provided by operating activities was $25.8 million for the quarter ended March 31, 2007, compared to $36.2 million for the quarter ended March 31, 2008, an increase of $10.4 million, or 40.3%. Net revenues increased from $75.2 million for the quarter ended March 31, 2007 to $119.6 million for the quarter ended March 31, 2008, and net income increased from $4.2 million for the quarter ended March 31, 2007 to $5.4 million for the quarter ended March 31, 2008. The reduction in net income margin from 5.5% to 4.5% was related to the rapid cost increases due to the continued growth of our business, significant investments in people, systems, and infrastructure and due to increased interest expense related to higher levels of indebtedness. For the quarter ended March 31, 2007, we incurred depreciation and amortization charges in the amount of $11.8 million, compared to $19.1 million for the quarter ended March 31, 2008. The increase in depreciation and amortization was due to the acquisition of servers and networking gear and increased amounts for the amortization of computer software. We further incurred non-cash compensation expense in the amount of $0.7 million for the quarter ended March 31, 2007 and $2.8 million for the quarter ended March 31, 2008. The increase was mainly due to share-based compensation from stock option grants with respect to several key hires and increased fair values for granted stock options.

 

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With respect to certain assets and liabilities, changes in accounts receivables used $2.0 million in cash for the quarter ended March 31, 2007, compared to providing $0.4 million for the quarter ended March 31, 2008. While our accounts receivables balances are generally growing with our net revenues, the reduction from the end of 2007 to March 31, 2008 was due to improvements in our collection efforts. Changes in accounts payable and accrued expenses provided $10.4 million in cash for the quarter ended March 31, 2007, compared to providing $6.3 million for the quarter ended March 31, 2008. Increases in accounts payables and accrued expenses were due to increased operating expenses and favorable terms for services received and assets acquired.

Net cash provided by operating activities was $60.6 million during 2006 compared to $104.9 million during 2007, an increase of $44.3 million, or 73.1%. While revenues increased from $224.0 million during 2006 to $362.0 million during 2007, our net income fell from $19.8 million during 2006 to $17.8 million during 2007. The reduction in net income margin from 8.8% to 4.9% was related to the rapid cost increase due to the continued growth of our business, significant investments in people, systems and infrastructure and increased interest expense related to higher levels of indebtedness. A significant portion of those costs were non-cash charges. During 2006, we incurred depreciation and amortization expense in the amount of $32.3 million, compared to $56.5 million during 2007. The increase in depreciation and amortization was due to the acquisition of servers and networking gear and increased amounts for the amortization of computer software. We further incurred non-cash compensation expense in the amounts of $1.1 million during 2006 and $4.4 million during 2007. The increase was mainly due to share-based compensation with respect to several key hires and increased fair values for granted stock options. Accounts receivables grew from $16.1 million as of December 31, 2006 to $25.4 million as of December 31, 2007. The growth rate in accounts receivables was slightly below the rate of growth for our net revenues, reflecting a slight reduction in the time needed to collect our receivables. Other non-current assets grew from $1.3 million as of December 31, 2006 to $7.2 million as of December 31, 2007. The increase included deposits for leased office space and $5.0 million for a prepayment to the lessor of our new headquarters facility. Accounts payable and accrued expenses grew from $28.8 million as of December 31, 2006 to $67.1 million as of December 31, 2007, mainly due to our overall increase in costs, related to the growth in general business volume, headcount and increased activities on capital projects. Key initiatives related to the increase in accounts payables and accrued expenses are our build out of our new headquarters facility in San Antonio, TX, build out of our new data center facility in the U.K., services rendered related to the IPO and software development. We have attractive payment terms on many of those initiatives, which further contributed to the increase in accounts payables and accrued expenses.

Net cash provided by operating activities was $34.7 million during 2005 compared to $60.6 million during 2006, an increase of $25.9 million, or 74.6%. Net revenues increased from $138.8 million during 2005 to $224.0 million during 2006, and net income grew from $10.8 million during 2005 to $19.8 million during 2006. The increase in net income margin from 7.8% to 8.8% was mainly related to our ability to leverage fixed costs of infrastructure assets and general and administrative expenses. A significant portion of our costs were non-cash charges. During 2005, we incurred non-cash charges for depreciation and amortization, compensation expenses and other in the amount of $23.2 million, compared to $36.5 million during 2006. The majority of this increase was due to depreciation on servers and networking gear acquired during 2006. Accounts receivables grew from $8.3 million as of December 31, 2005 to $16.1 million as of December 31, 2006, primarily due to our growth in net revenues. Accounts payables and accrued expenses grew from $19.7 million as of December 31, 2005 to $28.8 million as of December 31, 2006, mainly related to our overall increase in costs, related to the growth in general business volume, headcount and purchases of fixed assets.

Net cash provided by operating activities was $34.7 million during 2005 compared to $60.6 million during 2006, an increase of $25.9 million, or 74.6%. This increase in net cash provided by operating activities comes from an increase in net income of $9.0 million, an increase in non-cash charges in the

 

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amount of $13.3 million, an increase of $0.1 million due to tax-related items, and an increase of $3.5 million due to changes in working capital compared to the year ended December 31, 2005.

Investing Activities

Net cash used in investing activities primarily relates to capital expenditures to support our growth. Our main investing activities have consisted of purchases of IT equipment for our data center infrastructure, furniture, and equipment and leasehold improvements to support our operations.

Our net cash used in investing activities was $23.4 million for the quarter ended March 31, 2007, compared to $47.2 million for the quarter ended March 31, 2008, an increase of $23.8 million, or 101.7%. Purchases of property and equipment to support our revenue growth increased from $23.4 million for the quarter ended March 31, 2007 to $38.4 million for the quarter ended March 31, 2008. Purchases related to the renovation and build out of our new headquarters facilities amounted to $8.9 million for the quarter ended March 31, 2008. We further acquired property and equipment by capital leases and notes payable in the amounts of $6.2 million for the quarter ended March 31, 2007 and $21.6 million for the quarter ended March 31, 2008.

Our net cash used in investing activities was $54.8 million during 2006 compared to $140.7 million during 2007, an increase of $85.9 million, or 156.8%. This increase in net cash used in investing activities comes from an increase in the purchase of property and equipment of $50.3 million and the purchase of our corporate facility and related improvements of $35.4 million. The remaining increase of $0.3 million was related to the acquisition of Webmail.us,Inc., net of $0.1 million increase in proceeds from disposal of property and equipment.

Our net cash used in investing activities was $35.1 million during 2005 compared to $54.8 million during 2006, an increase of $19.7 million, or 56.1%. This increase in net cash used in investing activities primarily comes from an increase in the purchase of property and equipment of $19.6 million.

We also acquired and financed equipment and software purchases through vendor-related financing companies. For the years 2005, 2006, and 2007, such acquisitions amounted to $6.4 million, $18.8 million, and $44.1 million, respectively.

Financing Activities

Net cash provided by (used in) financing activities was $2.4 million for the quarter ended March 31, 2007 compared to $13.7 million for the quarter ended March 31, 2008, an increase of $11.3 million. This increase was due primarily to advances from our revolving line of credit in the amounts of $5 million for the quarter ended March 31, 2007, compared to $20.0 million for the quarter ended March 31, 2008, partially offset by principal payments related to capital leases and notes payable in the amounts of $2.5 million for the quarter ended March 31, 2007, and $8.7 million for the quarter ended March 31, 2008. We also received $1.1 million in proceeds from the issuance of common stock and the exercise of stock options during the first quarter of 2008.

Net cash provided by (used in) financing activities was $(5.6) million during 2006 compared to $52.4 million during 2007, an increase of $58.0 million. This increase was due primarily to advances from our revolving line of credit and leasing related activities.

Net cash provided by (used in) financing activities was $1.3 million during 2005 compared to $(5.6) million during 2006, a decrease of $6.9 million. This decrease was due primarily to an increase in principal repayments of capital lease obligations in 2006 and a decrease in proceeds from issuance of common stock.

 

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Contractual Obligations, Commitments and Contingencies

The following table summarizes our contractual obligations as of December 31, 2007 (in thousands):

 

     Total    2008    2009-
2010
   2011-
2012
   2013 and
Beyond
     (In thousands)

Capital and finance method leases

   $ 51,890    $ 27,346    $ 23,064    $ 1,480    $ —  

Operating leases

     71,782      15,728      23,385      16,948      15,721

Purchase commitments

     6,904      3,425      3,479      —        —  

Revolving credit facility

     57,301      —        —        57,301      —  

Software and equipment notes

     5,640      2,902      1,972      766      —  
                                  

Total contractual obligations

   $ 193,517    $ 49,401    $ 51,900    $ 76,495    $ 15,721
                                  

The following table summarizes our contractual obligations as of March 31, 2008 (in thousands):

 

     Total    2008    2009-
2010
   2011-
2012
   2013 and
Beyond
    

(Unaudited)

     (In thousands)

Capital and finance method leases

   $ 64,606    $ 30,330    $ 31,470    $ 2,806    $ —  

Operating leases

     67,634      11,685      23,341      16,920      15,688

Purchase commitments

     6,080      2,624      3,456      —        —  

Revolving credit facility

     77,301      —        —        77,301      —  

Software and equipment notes

     7,594      2,776      4,049      769      —  
                                  

Total contractual obligations

   $ 223,215    $ 47,415    $ 62,316    $ 97,796    $ 15,688
                                  

Leases

Capital and finance method leases are primarily related to expenditures for IT equipment. Our operating leases are primarily for office space and data center facilities.

Purchase commitments

Our purchase commitments are primarily related to bandwidth for our data centers. Purchase commitments are defined as contractual obligations to purchase goods or services that are enforceable and legally binding on us, excluding contracts that may be cancelled without penalty. The minimum commitments for certain vendors are generally minimum purchase requirements through the term or the contract or penalties for early termination of the contract. Penalties are generally one time fees incurred at the date we terminate the contract early. Since termination penalties would not be paid every year, contracts with such penalties are excluded from the table; however, the minimum payments until the end of the term for these contracts are included. We have minimum purchase commitments of approximately $6.9 million as of December 31, 2007, and $6.1 million as of March 31, 2008, respectively.

Revolving Credit Facility

As of December 31, 2007, and March 31, 2008, we had $141.8 million and $166.8 million available under our senior secured revolving credit facility, respectively. We entered into the credit facility in March 2007. It was restructured in August 2007 to increase the commitment to a total of $200.0 million. On February 25, 2008, we amended the credit facility and increased the committed

 

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amount from $200.0 million to $245.0 million. As of that date, we had $67.3 million of revolving loans outstanding and a $0.9 million letter of credit outstanding under the credit facility, and $180.7 million available. We will use the revolving credit facility along with the net proceeds from this offering as our primary sources of liquidity.

The borrowing costs of the revolving credit facility are determined by 1-month LIBOR plus an applicable margin, or, at our election, a prime-based rate (equal to the greater of the Federal Funds effective rate plus 1.0% per annum and Comerica Bank’s prime rate) plus an applicable margin. In the case of LIBOR borrowings, the applicable margin ranges from 0.675% to 1.550% per annum based on our amount of leverage, which is defined as the ratio of funded debt to EBITDA, as defined in the credit agreement. In the case of prime-rate-based borrowings, the applicable margin ranges from zero to 0.5% per annum based on our amount of leverage. The credit agreement also requires us to pay an annual facility fee of 0.2% on the committed amount. The revolving credit line is secured by our assets and is governed by financial and non-financial covenants. Financial covenants include a minimum fixed charge coverage ratio of at least 1.25 to 1.00 from the effective date until the quarter ended December 31, 2009 and 1.50 to 1.00 for every quarter thereafter, and a maximum funded debt to EBITDA ratio of not greater than 3.00 to 1.00. Non-financial covenants include limitations on debt, liens, acquisitions, dispositions of assets, restricted payments, investments, and transactions with affiliates, among others. The non-financial covenants are subject to significant exceptions as set forth in the credit agreement. We have been and are in compliance with all material financial and non-financial covenants except the fixed charge coverage ratio as of December 31, 2007. We changed the definition of the fixed charge coverage ratio as part of our February 2008 credit facility amendment and in April 2008 received a waiver of the fixed charge coverage ratio solely for the period ending December 31, 2007. We would have been compliant with the fixed charge coverage ratio covenant if the February 2008 amendment had been in effect as of such date, and were in compliance with all covenants for the period ending March 31, 2008.

In December 2007, we entered into an interest rate swap agreement converting a portion of our interest rate exposure from a floating rate basis to a fixed rate of 4.135% per annum. The interest rate swap agreement has a notional amount of $50.0 million and matures in 2010.

Software and Equipment Notes

We finance certain software and equipment from third-party vendors. The terms of these arrangements are generally one to five years.

Off-Balance Sheet Arrangements

During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities or any other entity defined as such within Financial Accounting Standards Board Interpretation No. 46 (Revised 2003), Consolidation of Variable Interest Entities—An Interpretation of ARB No. 51. These entities are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury or the acts or omissions by us,

 

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our employees, agents or representatives. To date, there have been no claims against us or our customers pertaining to such indemnification provisions and no amounts have been recorded.

These indemnification obligations are considered off-balance sheet arrangements in accordance with FASB Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements. See Note 13 to our consolidated financial statements included in this prospectus for further discussion of these indemnification agreements.

Internal Control Over Financial Reporting

The SEC, as required by Section 404 of the Sarbanes-Oxley Act, adopted rules requiring every company that files reports with the SEC to include a management report on such company’s internal control over financial reporting in its annual report. In addition, our independent registered public accounting firm must attest to our internal control over financial reporting. Our first Annual Report on Form 10-K to be filed following the completion of the offering will not include a report of management’s assessment regarding internal control over financial reporting or an attestation report of our independent registered public accounting firm due to a transition period established by SEC rules applicable to newly public companies. Management will be required to provide an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2009.

In connection with the preparation of our consolidated financial statements for the year ended December 31, 2007, we identified certain matters involving our internal control over financial reporting that constitute material weaknesses. The Public Company Accounting Oversight Board defines a material weakness as a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.

The material weaknesses relate to communication of significant non-routine transactions to our accounting department and to proper cutoff of expenditures at period end. Specifically, we identified the following material weaknesses:

 

  Ÿ  

Our policies and procedures did not adequately address the financial reporting risks associated with accounting for significant non-routine transactions. Specifically, we did not have effective controls to ensure that the necessary information was provided to those responsible for determining the accounting for significant non-routine transactions.

 

  Ÿ  

We did not have effective controls to ensure that expenditures were properly accrued for at the end of each period (cutoff).

The material weakness related to expenditure cutoffs resulted in the recording of audit adjustments for 2007. We have taken steps intended to remediate both material weaknesses through:

 

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The establishment of policies and procedures that provide for complete and timely reporting of significant non-routine transactions;

 

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The establishment of a disclosure committee to ensure that all significant transactions are included in our financial results in a complete and timely manner; and

 

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The implementation of additional accounts payable controls (for cutoff considerations).

The remedial actions that we have taken will be subject to continued management review, supported by testing and validation, as well as audit committee oversight. While we believe we have

 

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appropriately implemented controls to remediate these material weaknesses, we cannot assure you that these or other material weaknesses or significant deficiencies will not exist or otherwise be discovered in the future, which could impair our ability to report our financial position, results of operations, or cash flows in an accurate or timely manner. We have not incurred and do not expect to incur significant costs to remediate these controls.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. We are required to adopt SFAS 157 effective the first quarter of 2008. FASB Staff Position No. FSP 157-2 delayed the effective date of SFAS 157 to periods beginning after November 15, 2008 for non-financial assets and liabilities. The adoption of SFAS 157 did not have a material adverse impact on our Consolidated Financial Statements. We do not expect FSP 157-2 will have a material impact on our consolidated financial statements.

In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS 159. SFAS 159 permits entities to choose, at specified election dates, to measure eligible items at fair value, or fair value option, and to report in earnings unrealized gains and losses on those items for which the fair value option has been elected. Under SFAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, and issued debt. SFAS 159 also requires entities to display the fair value of those assets and liabilities on the face of the balance sheet. SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 was effective for us as of the first quarter of 2008 and did not have a material impact on our financial statements.

In December 2007, the FASB issued SFAS 141(R), Business Combinations and SFAS 160, Noncontrolling Interests in Consolidated Financial Statementsan amendment to ARB No. 51. SFAS 141(R) and SFAS 160 require most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity, which changes the accounting for transactions with noncontrolling interest holders. Both SFAS 141(R) and SFAS 160 are effective for periods beginning on or after December 15, 2008, and earlier adoption is prohibited. SFAS 141(R) will be applied to business combinations occurring after the effective date. SFAS 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date. We are currently evaluating the impact of adopting SFAS 141(R) and SFAS 160 on our results of operations and financial position.

In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities– an amendment of FASB Statement No. 133. SFAS 161 expands disclosures for derivative instruments by requiring entities to disclose the fair value of derivative instruments and their gains or losses in tabular format. SFAS 161 also requires disclosure of information about credit risk-related contingent features in derivative agreements, counterparty credit risk, and strategies and objectives for using derivative instruments. SFAS 161 is effective for periods beginning on or after December 15, 2008. We do not expect this statement will have a material impact on our Consolidated Financial Statements.

 

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Quantitative and Qualitative Disclosures about Market Risk

Power Prices.    We are a large consumer of power. In 2007, we paid approximately $7.3 million to utility companies to power our data centers. Because we anticipate further revenue growth for the foreseeable future, we will consume even more power in the future. Power costs vary by geography and the source of power generation and they further exhibit substantial seasonal fluctuations. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs usually increase during the summer months and, as a result, we evaluate each year whether we want to enter into a fixed price contract for that period. Except for a fixed price contract covering the summer months of 2006, we have not entered into any such contracts.

Interest Rates.    Our main credit facility is a revolving line of credit with pricing determined by LIBOR. This market rate of interest is fluctuating and exposes our interest expense to risk. Our credit agreement obligates us to hedge part of that interest rate risk with appropriate instruments, such as interest rate swaps or interest rate options. On December 10, 2007, we entered into an at-the-market fixed-payer interest rate swap with a notional amount of $50.0 million at an annual rate of 4.135%. This swap essentially fixes the rate we pay on the first $50.0 million outstanding on our revolving line of credit. As we borrow more, we will enter into additional swaps to continuously control our interest rate risk. Generally, we do not hedge our complete exposure. As a result, we are exposed to interest rate risk on the un-hedged portion of our borrowings, which was $7.3 million and $27.3 million as of December 31, 2007 and March 31, 2008, respectively. For example, a 100 basis point increase in LIBOR would increase the interest expense on $10 million of borrowings that are not hedged by $0.1 million. We have chosen a structure to ensure that those hedges qualify for hedge accounting according to SFAS 133.

Foreign Currencies.    The majority of our customers are invoiced, and substantially all of our expenses are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. A relatively insignificant amount of customers are invoiced in currencies other than the applicable functional currency, such as the Euro. As a result, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. However, we believe that this exposure is immaterial at this time. To date, we have not entered into any hedging contracts, although we may do so in the future. As we grow our international operations, our exposure to foreign currency risk could become more significant.

 

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BUSINESS

Overview

Rackspace Hosting is the world’s leader in hosting. We deliver websites, web-based IT systems, and computing as a service. Our rapid growth is the result of our commitment to serving our customers, known as Fanatical Support, and our exclusive focus on hosting. Our financial success is the result of responsible financial management and our disciplined, just-in-time approach to capital investment. During 2007, we had net revenues of $362.0 million. During the quarter ended March 31, 2008, we had net revenues of $119.6 million. As of March 31, 2008, we served over 31,000 business customers of all sizes with more than 39,000 servers, over 750,000 business email accounts, and more than 43,000 cloud hosting domains. To deliver on our Fanatical Support Promise to our customers, we have created a culture that encourages passionate, engaged employees who we call “Rackers.” In 2008, Fortune magazine ranked Rackspace Hosting #32 on its list of “100 Best Companies to Work For.”

Hosting providers offer services to support websites, web-based IT systems, and computing. The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver services is typically purchased and managed by the hosting provider. As a result, hosting providers reduce customers’ initial capital investment and ongoing operating costs. Hosting also reduces the complexity of deploying and managing IT systems and computing, and changes the way companies purchase these products and services. Rackspace offers a full suite of hosting services, including dedicated hosting, managed hosting, and email hosting, as well as emerging services such as platform hosting and cloud hosting.

Tier1Research estimates the worldwide hosting market to be $12.3 billion in 2007, with projected annual growth of 26% from 2007 to $24.4 billion in 2010. This revenue comes from three major categories – managed hosting, dedicated hosting, and shared hosting. In 2007, Rackspace Hosting was the world’s largest hosting provider by revenue, based on Tier1Research data for these categories.

Historically, our business has generated high revenue growth and has grown significantly faster than the overall hosting market. Over the past five years our net revenues have grown from $56.6 million in 2003 to $362.0 million in 2007, representing an annual growth rate of 59.0%. We have also been able to generate strong profitability. During that same five year period, our net income grew from $208,000 to $17.8 million. See the sections entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of our results of operations.

We are focused on two key principles. First, to be recognized as one of the world’s great service companies. Second, to generate economic returns that exceed our cost of capital. This approach has allowed us to profitably grow to our current size with only $39.6 million in equity capital raised to date, excluding proceeds from stock options exercised under our equity incentive plans. These key principles form the foundation of our business model, which includes the following elements:

 

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Our Fanatical Support culture serves as a competitive advantage that has allowed us to establish our position as the world’s leading hosting company. Fanatical Support creates significant customer loyalty as we strive to maintain “customers for life.” This strengthens our business by gaining market share with low levels of customer terminations and increasing demand.

 

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We are a hosting specialist providing standardized services that are highly scalable for our customers. This service delivery platform and singular focus differentiates our proven business model and customer value proposition versus other hosting providers.

 

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Our addressable market is not limited by geography. We manage large scale, centralized data center and support operations that do not need to be located near our customers. This has allowed us to target hosting customers worldwide. Today, we serve customers located in over 100 countries from our facilities in only three countries. This element of our business model provides us with significant capital and operating cost efficiencies.

 

 

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We are disciplined users of capital and are focused on profitable growth. Our goal is to produce long term economic profit. We use an Economic Value Added, or EVA®, management model to ensure that our decisions at all levels consider the cost of capital.

Industry Background

The ability to operate online has become increasingly important to businesses. Advances in technology, network infrastructure, and availability of broadband access, have enabled more robust and frequent access to web-based computing capabilities. These capabilities have become the tools business users expect to be available to them anywhere, at any time. These trends have required business owners to invest more in their IT systems and the people who manage them in order to remain competitive. Businesses are also frustrated with the rising level of IT budgets and are searching for new ways to lower costs and support their users’ growing demands.

Hosting has emerged as the answer for businesses to address these factors. As the Internet has evolved, businesses have continued to migrate more and more of their IT systems and computing resources to hosting companies that support their growing needs.

 

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Simple Websites.    With the emergence of the Internet in the 1990s, companies began to use the Web as a global medium for communication. Initial websites were relatively simple and were generally not integrated with companies’ core IT systems and computing.

 

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Revenue Generating Websites.    As the Internet grew, companies moved more business transactions to the Web. Traditional “brick and mortar” companies began to launch eCommerce initiatives and web-based business models emerged. The demand for eCommerce services and resulting revenue growth moved websites from simple information delivery vehicles to high availability, mission critical systems. These changes heightened the need for reliability and performance as websites began generating revenue.

 

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Increasing Website Functionality.    Increased availability to all forms of broadband access, and continued gains in computing and processing capabilities drove the aggressive growth of new media such as streaming video, social networking, and online music. These advances in technology drove the need for complex IT talent and investment in facilities to maintain and deliver the highest quality, always available, online experience to customers.

 

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IT Systems and Computing Become Web-Enabled.    Continued Internet and computing technology gains have created opportunities far beyond traditional websites and eCommerce. Many aspects of IT systems and computing are becoming web-enabled, allowing companies to leverage the benefits of the Internet. Today, business users remotely manage and access software systems for sales management, human resource management, payroll, and accounting. In addition, companies have emerged that provide businesses with new options to address their increasingly complex and growing IT systems and computing needs. These companies provide colocation, hosting, and outsourcing services that allow businesses to move all or a portion of their mission-critical IT systems to a more stable, protected environment. As a result, web-enabled computing has become an integral approach to business operations today.

Alternatives to Managing IT Systems and Computing

Businesses are rethinking how they manage their computing needs. In the past, the only alternative to managing IT systems internally was to outsource them. Hosting has emerged as an

 

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attractive alternative, one that is tailored to serve a much broader market at lower cost and without high initial capital investment.

Do-it-Yourself:    Do-it-yourself is an approach to managing IT systems where a business retains complete ownership and responsibility for maintenance and support. Companies may choose to house their IT systems in their own facilities or may use a colocation vendor for data center space and network access.