-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, ESQuM8qEQpeMd/rY0JCNlxmu6HmUsRr2YKPDQ0ab+gxjHSLrJLVNm+/uMCjSBWJ8 kicWZg4jk09nF/ZckWemdQ== 0000940180-99-001456.txt : 19991123 0000940180-99-001456.hdr.sgml : 19991123 ACCESSION NUMBER: 0000940180-99-001456 CONFORMED SUBMISSION TYPE: S-1/A PUBLIC DOCUMENT COUNT: 6 FILED AS OF DATE: 19991122 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NET2PHONE INC CENTRAL INDEX KEY: 0001086472 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 223559037 STATE OF INCORPORATION: DE FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: S-1/A SEC ACT: SEC FILE NUMBER: 333-90317 FILM NUMBER: 99761764 BUSINESS ADDRESS: STREET 1: 17 MAIN STREET CITY: HACKENSACK STATE: NJ ZIP: 07601 BUSINESS PHONE: 2019282990 MAIL ADDRESS: STREET 1: 17 MAIN STREET CITY: HACKENSACK STATE: NJ ZIP: 07601 S-1/A 1 FORM S-1 AMENDMENT NO. 2 As filed with the Securities and Exchange Commission on November 22, 1999 Registration No. 333-90317 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- AMENDMENT NO. 2 TO FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 --------------- Net2Phone, Inc. (Exact name of registrant as specified in its charter) Delaware 4813 22-3559037 (State or other (Primary Standard Industrial (I.R.S. Employer jurisdiction of Classification Code Number) Identification No.) incorporation or organization) 171 Main Street Hackensack, New Jersey 07601 (201) 907-5304 (Address, including zip code, and telephone number, including area code, of registrant's principal executive offices) --------------- Howard S. Balter Chief Executive Officer Net2Phone, Inc. 171 Main Street Hackensack, New Jersey 07601 (201) 530-4000 (Name, address, including zip code, and telephone number, including area code, of agent for service) --------------- Copies to: Allen L. Weingarten, Esq. Alexander D. Lynch, Esq. Morrison & Foerster LLP Brobeck, Phleger & Harrison LLP 1290 Avenue of the Americas 1633 Broadway, 47th Floor New York, New York 10104 New York, New York 10019 (212) 468-8000 (212) 581-1600 --------------- Approximate date of commencement of the 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, 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, please 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, check the following box. [_] --------------- We hereby amend the registration statement on such date or dates as may be necessary to delay its effective date until we shall file a further amendment which specifically states that the registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ +The information in this prospectus is not complete and may be changed. We may + +not sell these securities until the registration statement filed with the + +Securities and Exchange Commission is effective. This prospectus is not an + +offer to sell these securities and it is not soliciting an offer to buy these + +securities in any state where the offer or sale is not permitted. + ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ SUBJECT TO COMPLETION, DATED NOVEMBER 22, 1999 PROSPECTUS - -------- 6,300,000 Shares [LOGO OF NET2PHONE] Common Stock This is an offering of common stock by Net2Phone, Inc. Of the 6,300,000 shares of common stock being sold in this offering, 3,400,000 shares are being sold by Net2Phone and 2,900,000 shares are being sold by selling stockholders. We will not receive any of the proceeds from the sale of shares by the selling stockholders. -------- Our common stock is traded on the Nasdaq National Market under the symbol NTOP. On November 18, 1999, the last reported sale price of our common stock on the Nasdaq National Market was $62.63 per share. --------
Per Share Total --------- ----- Public offering price........................................... $ $ Underwriting discounts and commissions.......................... $ $ Proceeds to Net2Phone, before expenses.......................... $ $ Proceeds to the selling stockholders, before expenses........... $ $
The underwriters have been granted an option for a period of 30 days to purchase up to 945,000 additional shares of common stock from other selling stockholders, including employees, officers and directors of Net2Phone and IDT Corporation. -------- Investing in the common stock involves a high degree of risk. See "Risk Factors" beginning on page 6. -------- Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. Hambrecht & Quist Donaldson, Lufkin & Jenrette Deutsche Banc Alex. Brown -------- Bear, Stearns & Co. Inc. Robertson Stephens , 1999 [Outside Front Gate] Graphic: Net2Phone Logo enlarged. [Inside Front Gate] Text: "Our service is available on many Web sites." Graphic: Screen shot of the Yahoo! People Search Web site, with an enlargement of Net2Phone banner. Text: "Click on the Net2Phone icon to go to Net2Phone's Web site to download and install our PC2Phone software." "Use any browser to search for a person's telephone number using the Yahoo! People Search online directory." "Use our PC2Phone software to place a call by clicking on the displayed telephone number." [Inside Front Cover] Text: "Our service will be available on the Netscape /TM/ browser. Graphic: Screen shot of a future version of the Netscape personal address Book Web site, with the Net2Phone icon enlarged. Text: "Place a voice call or send a fax from your PC to any telephone or fax in the world by clicking on the Net2Phone icon." "Call any number listed in your Netscape address book with Net2Phone one-click dialing function." "Net2Phone's easy-to-use software will be embedded in future versions of Netscape's browser. No separate downloading or installation is required." TABLE OF CONTENTS
Page ---- Prospectus Summary................................................... 1 Risk Factors......................................................... 6 Forward-Looking Statements........................................... 15 Use of Proceeds...................................................... 16 Dividend Policy...................................................... 16 Market Price of Our Common Stock..................................... 16 Capitalization....................................................... 17 Dilution............................................................. 18 Selected Financial Data.............................................. 19 Management's Discussion and Analysis of Financial Condition and Results of Operations............................................... 20 Business............................................................. 31 Management........................................................... 51 Principal and Selling Stockholders................................... 61 Certain Transactions................................................. 64 Description of Capital Stock......................................... 72 Shares Eligible for Future Sale...................................... 77 Underwriting......................................................... 78 Legal Matters........................................................ 80 Experts.............................................................. 80 Where You Can Find More Information.................................. 81 Index to Financial Statements........................................ F-1
We maintain Web sites at www.Net2Phone.com, www.Net2Phone.net, www.Click2Talk.com and www.EZSurf.com. Information contained on our Web sites does not constitute part of this prospectus. We own federal registrations of the marks "Net2Phone", "Net2Fax" and "N2P" issued by the United States Patent and Trademark Office. Applications to register 30 other service marks in the United States are pending, including applications to register the service marks "Phone2Phone", "Click2Talk", "Net2Phone Pro" and "Fax2Fax". PROSPECTUS SUMMARY This summary highlights selected information contained elsewhere in this prospectus. This summary may not contain all of the information that you should consider before investing in our common stock. You should read the entire prospectus carefully, including "Risk Factors" and the financial statements, before making an investment decision. Net2Phone Net2Phone is a leading provider of services enabling users to make high- quality, low-cost telephone calls over the Internet. These services are commonly referred to as Internet telephony. Our Internet telephony services enable our customers to call individuals and businesses worldwide using their personal computers or traditional telephones. According to International Data Corporation, a leading market research firm, we were the largest provider of Internet calls in the world in 1998 with a 39.4% market share in terms of minutes of use. In August 1996, we introduced our first service, "PC2Phone." We believe that PC2Phone was the first commercial telephone service to connect calls between personal computers and telephones over the Internet. In September 1997, we introduced "Phone2Phone," a service that enables international and domestic calls to be made over the Internet using traditional telephones. Our customers often pay substantially less for long-distance calls they make using our services than they would for calls made over traditional long distance networks, such as those owned by AT&T, Sprint and MCI WorldCom. We are using our expertise in Internet telephony to integrate live voice capabilities into the Web. We have developed simple, easy to use PC2Phone software that operates on a personal computer and allows individuals and businesses to: . speak with sales or customer service representatives of online retailers and other Web-based businesses while visiting their Web sites; . speak with individuals or businesses listed on various online directories, such as Yahoo! People Search; and . call almost any telephone number in the world. We promote our services through relationships with international resellers and leading Internet companies, including: . Netscape. Our PC2Phone software will be integrated on an exclusive basis into future versions of Netscape's Internet browser, including the Netscape Communicator products, for the term of our agreement. Netscape will also include a Net2Phone icon on the Netscape Navigator Personal Toolbar and has begun to integrate our services into the Netscape Netcenter site, which will allow Netcenter users to access our services from anywhere on the Web. . ICQ. We have entered into an agreement with ICQ, a subsidiary of America Online, Inc., to provide Internet telephony services to users of ICQ's instant messaging service. ICQ will integrate some of our Internet telephony services into ICQ's instant messaging software on an exclusive basis, allowing ICQ users to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls. We will also co-brand a prepaid phone-to- phone calling card with the ICQ service, allowing users to place calls from the United States and 19 other countries to virtually anywhere in the world. . Yahoo! and Excite. Our Web-based Internet telephony service is integrated into the Yahoo! People Search online telephone directory and Excite's Web sites in its International Network, which includes the United Kingdom, Germany, France, Japan, Italy, Australia, Sweden and the Netherlands. 1 Our strategy for building on our leadership position in our market and making live voice communication a common feature on the Internet includes the following key elements: . driving usage through resellers and strategic partners; . pursuing multiple sources of revenue; . enhancing worldwide brand recognition; . making our software readily available worldwide; and . expanding and enhancing our products and services. Upon the closing of this offering, IDT will own approximately 48.3% of our outstanding capital stock. IDT owns Class A stock that has twice the voting power of our common stock. As a result, IDT will control 58.2% of our vote. Our principal executive offices are located at 171 Main Street, Hackensack, New Jersey 07601, and our telephone number at that address is (201) 530-4000. Recent Developments We experienced substantial growth in revenue and customers in the fiscal year ended July 31, 1999. During this period, we generated revenue of $33.3 million and a loss from operations of $24.5 million, including a non-cash compensation charge of $17.9 million, as compared to revenue of $12.0 million and a loss from operations of $3.5 million in 1998. Over 90% of our revenue in fiscal 1999 was derived from prepaid per-minute charges from our PC2Phone and Phone2Phone services. In addition, as of the end of fiscal 1999, we served over 325,000 active customers who spent an average of approximately 60 minutes per month placing calls over the Internet, as compared to over 110,000 active customers who spent an average of approximately 45 minutes per month as of the end of fiscal 1998. We have also recently entered into arrangements with the following strategic partners: . America Online. We have entered into an agreement with America Online under which America Online will integrate our Internet telephony services into its instant messaging software, allowing its instant messaging users to make PC-to-phone and phone-to-PC calls and to use our PC-to-fax, fax-to-PC and conference calling services. We will also co- brand a prepaid phone-to-phone calling card with the America Online instant messaging service, allowing users to place calls and send faxes to virtually anywhere in the world, which America Online will distribute through the America Online instant messaging controlled properties. We will be the exclusive provider of these services for a period in excess of two years. . CompuServe. We have entered into a two-year marketing agreement (exclusive for the first year) with CompuServe, a subsidiary of America Online. Under this agreement, CompuServe has agreed to promote our phone-to-phone Internet telephony calling card services through the United States version of the CompuServe interactive service. . Priceline.com. We have entered into a memorandum of understanding and a co-marketing agreement with priceline.com, an Internet commerce service that allows users to name their own price to purchase goods and services over the Internet. Under the terms of our memorandum of understanding, we expect to offer our international and domestic Phone2Phone services as a premier provider through priceline.com, enabling priceline.com customers to name their own price to purchase blocks of minutes of our Phone2Phone services. We also expect to work with priceline.com to develop an offer-by-phone service that will enable consumers to make offers to purchase Phone2Phone services from us on a per-call basis. Under the terms of our co-marketing 2 agreement, we will participate in a co-marketing program with priceline.com through December 31, 1999. . Go2Net. We have entered into an exclusive three-year agreement with Go2Net, a network of branded, technology- and community-driven Web sites, to distribute and market our Internet telephony products and services throughout the Go2Net Network. Under the agreement, co-branded versions of our Internet telephony products and services will be integrated into the Go2Net Network. We will also create with Go2Net and CommTouch Software Ltd., a provider of email solutions, a unified communication and messaging platform on the Go2Net Network that will enable users to send and receive voice mail, faxes, email and telephone calls over the Internet. . InfoSpace.com. InfoSpace.com will place on its affiliate Web sites and, on an exclusive basis, on its own Web site, for a period of two years, advertisements, promotions, links, banners, logos and integrated access to our PC2Phone Service and, upon release, our new unified messaging service. . AT&T. We have entered into an agreement with AT&T to be the exclusive provider of PC-to-phone service on the AT&T WorldNet Beta Site for a period of 90 days through January 15, 2000. . Sprint. Sprint is testing our Internet telephony technology and international network for international consumer long distance calls to Asia through a service called Sprint Callternatives. As part of this test, we provide dedicated customer service, 24 hours a day, seven days a week, to assist customer inquiries in multiple languages, including Mandarin, Cantonese and Korean. In addition, our advanced billing technology allows users of this service to view their telephone accounts in real time from our Web site. We have recently strengthened our board of directors with the addition of four new members, Martin Yudkovitz, President of NBC Interactive Media, Daniel Schulman, President, Chief Operating Officer and a director of priceline.com, Michael Fischberger, Senior Vice President of Domestic Telecommunications and Internet services at IDT, and Harry C. McPherson, Jr., a partner in the law firm of Verner, Liipfert, Bernhard, McPherson and Hand, Chartered. We have enhanced our product and service offerings with the release of the next version of our PC2Phone software. This new version of our software incorporates advanced digital technologies for improved sound quality and a variety of new features, including Voice-Mailbox, a free voice-mail service that will store incoming messages as email attachments, free PC2PC calling and PC2Fax. In addition, we have developed a unified messaging service, which includes voice, fax and electronic messaging with multiple points of access. We anticipate releasing our unified messaging service in beta form in early 2000. 3 The Offering Common stock offered by Net2Phone....... 3,400,000 shares Common stock offered by the selling 2,900,000 shares stockholders............................. Total............................... 6,300,000 shares Capital stock to be outstanding after this offering: Common stock.......................... 17,672,616 shares Class A stock......................... 33,924,250 shares Total............................... 51,596,866 shares Use of proceeds......................... We expect to use the proceeds: for developing and maintaining strategic relationships; for advertising and promotion; for upgrading and expanding our network; for international expansion; for research and development; for potential acquisitions; and for general corporate purposes, including working capital. Nasdaq National Market symbol........... NTOP The share information set forth above excludes 7,364,150 shares of common stock issuable upon the exercise of stock options outstanding as of November 18, 1999. The outstanding stock options have a weighted average exercise price of $9.27 per share. Unless otherwise noted, the information in this prospectus: . assumes 11,672,616 shares of common stock outstanding as of November 18, 1999; and . assumes 36,524,250 shares of Class A stock outstanding as of November 18, 1999. Each share of Class A stock entitles the holder to two votes, while holders of our common stock are entitled to one vote. Each share of Class A stock is convertible into one share of common stock, and automatically converts into common stock upon transfer. ---------------- Our fiscal year ends on July 31 of each calendar year. All references to fiscal years in this prospectus refer to the fiscal years ending in the indicated calendar years. For example, "fiscal 1999" refers to the fiscal year ended July 31, 1999. 4 The table below sets forth summary financial information for the periods indicated. This information is not necessarily indicative of the results of operations or financial position which would have resulted had we operated as an independent entity during the periods indicated. It is important that you read this information together with the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our financial statements and the notes thereto included elsewhere in this prospectus. Summary Financial Information
Year Ended July 31, -------------------------------------- 1997 1998 1999 ----------- ----------- ------------ Statement of Operations: Revenue.............................. $ 2,652,303 $12,005,972 $ 33,256,457 Costs and expenses: Direct cost of revenue, excluding depreciation...................... 1,553,443 6,848,759 17,818,010 Selling and marketing.............. 76,724 2,887,766 8,828,167 General and administrative......... 2,599,283 5,087,628 10,836,072 Depreciation and amortization...... 120,500 726,508 2,316,545 Compensation charge from the issuance of stock options......... -- -- 17,919,541 ----------- ----------- ------------ Total costs and expenses......... 4,349,950 15,550,661 57,718,335 ----------- ----------- ------------ Loss from operations................. (1,697,647) (3,544,689) (24,461,878) Net interest......................... -- -- (243,314) ----------- ----------- ------------ Net loss............................. $(1,697,647) $(3,544,689) $(24,705,192) =========== =========== ============
The pro forma balance sheet data summarized below gives effect to: . the sale of 6,210,000 shares of common stock in our initial public offering; . the conversion of 3,140,000 shares of our Series A convertible preferred stock into 9,420,000 shares of our Class A stock at the closing of our initial public offering; . the exercise of options to purchase 75,000 shares of our common stock at a price of $3.33 per share and options to purchase 50,000 shares of our common stock at an exercise price of $15.00 prior to the closing of our initial public offering for proceeds of $999,750; and . the application of $7.0 million of the net proceeds from our initial public offering to pay a portion of the loan payable to IDT. The pro forma as adjusted balance sheet summarized below additionally reflects the sale of 3,400,000 shares of common stock by us in this offering.
July 31, 1999 ------------------------------------- Pro Forma Actual Pro Forma As Adjusted ----------- ----------- ------------ Balance Sheet Data: Cash and cash equivalents............... $20,379,048 $99,638,298 $302,231,673 Working capital......................... 6,303,452 92,562,702 295,156,077 Total assets............................ 50,816,891 130,076,141 332,669,516 Accounts payable to IDT................. 3,735,395 3,735,395 3,735,395 Loan payable to IDT..................... 14,000,000 7,000,000 7,000,000 Total stockholders' (deficit) equity.... (4,062,867) 110,125,383 312,718,758
5 RISK FACTORS You should carefully consider the risks described below before making an investment decision. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that event, the trading price of our shares could decline, and you may lose part or all of your investment. Risks Related to Our Financial Condition and Our Business Our limited operating history makes evaluating our business difficult. IDT formed us as a subsidiary in October 1997. Prior to that, we conducted business as a division of IDT. Therefore, we have only a limited operating history with which you may evaluate our business. You must consider the numerous risks and uncertainties an early stage company like ours faces in the new and rapidly evolving market for Internet-related services. These risks include our ability to: . increase awareness of our brand and continue to build user loyalty; . maintain our current, and develop new, strategic relationships; . respond effectively to competitive pressures; and . continue to develop and upgrade our network and technology. If we are unsuccessful in addressing these risks, sales of our products and services, as well as our ability to maintain or increase our customer base, will be substantially diminished. We have never been profitable and expect our losses to continue for the foreseeable future. We have never been profitable on an annual basis. We had an accumulated deficit of approximately $30.5 million as of July 31, 1999. We expect to continue to incur operating losses for the forseeable future. Our operating and marketing expenses have continuously increased since inception and we expect them to continue to increase significantly during the next several years. Accordingly, we will need to generate significant revenue to achieve profitability. We may not be able to do so. Even if we do achieve profitability, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or annual basis in the future. In addition, we expect to recognize significant additional charges relating to non-cash compensation in connection with options that we granted in May, July and October 1999. We recognized a charge of approximately $17.9 million in the fourth quarter of fiscal 1999 arising from these options, and will recognize charges of approximately $11.8 million during fiscal 2000, approximately $11.8 million during fiscal 2001 and approximately $8.3 million during fiscal 2002. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." We intend to pursue new streams of revenue, which we have not attempted to generate before and which may not be profitable. In the future, we intend to pursue revenue from new Web-based opportunities, such as banner and audio advertising, as well as from sponsorship opportunities on our user interface and our EZSurf.com Internet shopping directory. We also intend to explore the availability of revenue-sharing opportunities. We have not attempted to generate this type of revenue before. We intend to devote significant capital and resources to create these new revenue streams and we cannot ensure that these investments will be profitable. 6 We may have difficulties managing our expanding operations, which may reduce our chances of achieving profitability. Our future performance will depend, in part, on our ability to manage our growth effectively. To that end, we will have to undertake the following tasks, among others: . develop our operating, administrative, financial and accounting systems and controls; . improve coordination among our engineering, accounting, finance, marketing and operations personnel; . enhance our management information systems capabilities; and . hire and train additional qualified personnel. If we cannot accomplish these tasks, our chances of achieving profitability may be diminished. If we fail to establish and maintain strategic relationships our ability to meet analyst expectations and our sales would suffer. We currently have strategic relationships with Netscape, ICQ, Go2Net, InfoSpace.com, Yahoo!, Excite and others. We depend on these relationships to: . distribute our products to potential customers; . increase usage of our services; . build brand awareness; and . cooperatively market our products and services. We believe that our success depends, in part, on our ability to develop and maintain strategic relationships with leading Internet companies and computer hardware and software companies, as well as key marketing distribution partners. In cases where our products and services are integrated into our strategic partners' product and service offerings, our ability to meet analyst expectations and our sales depend upon a timely release of these offerings. If any of our strategic relationships are discontinued or if the release of these partners' offerings that integrate our products and services are delayed, sales of our products and services and our ability to maintain or increase our customer base may be substantially diminished. Further, our agreements with ICQ and Netscape do not provide for a date by which the next version of their respective products which incorporate our PC2Phone software will be released. Any delay by these or other strategic partners in releasing the next version of their respective products could delay the associated PC2Phone revenue we could expect to receive from these sources. If we hire a reseller who fails to market our products and services effectively or who provides poor customer service, our reputation will suffer and we could lose customers. If we hire a reseller who fails to market our products and services effectively, we could lose market share. Additionally, if a reseller provides poor customer service, we could lose brand equity. Therefore, we must maintain and hire additional resellers throughout the world that are capable of providing high-quality sales and service efforts. If we lose a reseller in a key market, or if a current or future reseller fails to adequately provide customer support, our reputation will suffer and sales of our products and services and our customer base will be substantially diminished. Competition could reduce our market share and decrease our revenue. The market for our services has been extremely competitive. Many companies offer products and services like ours, and many of these companies have a substantial presence in this market. In addition, many of these companies are larger than we are and have substantially greater financial, distribution and marketing resources than we do. We therefore may not be able to compete successfully in this market. If we do not succeed in competing with these companies, we will lose customers and our revenue will be substantially reduced. Our competitors include the following: . Internet Telephony Service Providers. Internet telephony service providers such as AT&T Jens (a Japanese affiliate of AT&T), deltathree.com (a subsidiary of RSL Communications), I-Link, iBasis 7 (formerly known as VIP Calling), ICG Communications, IPVoice.com, ITXC and OzEmail (which was acquired by MCI WorldCom) route voice traffic over the Internet. . Software/Hardware Providers. Companies such as VocalTec, Netspeak and e-Net produce software and other computer equipment that may be installed on a user's computer to permit voice communications over the Internet. . Telecommunications Companies. A number of telecommunications companies, including AT&T, Deutsche Telekom, MCI WorldCom and Qwest, currently maintain, or plan to maintain, packet-switched networks to route the voice traffic of other telecommunications companies. . Network Hardware Manufacturers. A number of large telecommunications providers and equipment manufacturers, including Alcatel, Cisco, Lucent, Northern Telecom and Dialogic (which was acquired by Intel), have announced that they intend to offer products similar to ours. We expect these products to allow live voice communications over the Internet between parties using a personal computer and a telephone and between two parties using telephones. Cisco Systems has also taken additional steps by recently acquiring companies that produce devices that help Internet service providers carry voice over the Internet while maintaining traditional phone usage and infrastructure. . Voice-Enabled Online Commerce Providers. Several companies, including USA Global Link and AT&T's Inter@active Communications, have begun to apply Internet telephony technologies in connection with online commerce transactions. These providers compete with services of ours such as Click2Talk by integrating voice communications into commercial Web sites. Pricing pressures may lessen our competitive pricing advantage. Our success is based on our ability to provide discounted domestic and international long distance services by taking advantage of cost savings achieved by carrying voice traffic over the Internet, as compared to carrying calls over long distance networks, such as those owned by AT&T, Sprint and MCI WorldCom. In recent years, the price of long distance calls has fallen. In response, we have lowered the price of our service offerings. For example, AT&T, Sprint and MCI WorldCom have adopted recent pricing plans in which the rates that they charge for U.S. domestic long distance calls are not always substantially higher than the rates that we charge for our U.S. domestic service. The price of long distance calls may decline to a point where we no longer have a price advantage over these traditional long distance services. Alternatively, other providers of long distance services may begin to offer unlimited or nearly unlimited use of some of their services for an attractive monthly rate. We would then have to rely on factors other than price to differentiate our product and service offerings, which we may not be able to do. We may not be able to compete with providers that can bundle long distance services with other offerings. Our competitors may be able to bundle services and products that we do not offer together with long distance or Internet telephony services. These services could include wireless communications, voice and data services, Internet access and cable television. This form of bundling would put us at a competitive disadvantage if these providers can combine a variety of service offerings at a single attractive price. In addition, some of the telecommunications and other companies that compete with us may be able to provide customers with lower communications costs or other incentives with their services, reducing the overall cost of their communications packages, and significantly increasing pricing pressures on our services. This form of competition could significantly reduce our revenues. We may not be able to hire and retain the personnel we need to sustain our business. We depend on the continued services of our executive officers and other key personnel. We have an employment agreement with only two of our executive officers, Clifford M. Sobel, our Chairman, and Jonathan Fram, our President. We need to attract and retain other highly-skilled technical and managerial personnel for whom there is intense competition. If we are unable to attract and retain qualified technical and managerial personnel, we may never achieve profitability. 8 If our customers do not perceive our service to be effective or of high quality, our brand and name recognition would suffer. We believe that establishing and maintaining a brand and name recognition is critical for attracting and expanding our targeted client base. We also believe that the importance of reputation and name recognition will increase as competition in our market increases. Promotion and enhancement of our name will depend on the effectiveness of our marketing and advertising efforts and on our success in continuing to provide high-quality products and services, neither of which can be assured. If our customers do not perceive our service to be effective or of high quality, our brand and name recognition would suffer. We depend on our international operations, which subject us to unpredictable regulatory and political situations. As of July 31, 1999, approximately 69% of our customers were based outside of the United States, generating approximately 62% of our revenue during fiscal 1999. A significant component of our strategy is to continue to expand internationally. We cannot assure you that we will be successful in expanding into additional international markets. In addition to the uncertainty regarding our ability to generate revenue from foreign operations and expand our international presence, there are certain risks inherent in doing business on an international basis, including: . changing regulatory requirements, which vary widely from country to country; . action by foreign governments or foreign telecommunications companies to limit access to our services; . increased bad debt and subscription fraud; . legal uncertainty regarding liability, tariffs and other trade barriers; . political instability; and . potentially adverse tax consequences. We cannot assure you that one or more of these factors will not materially adversely affect the growth of our business or our customer base. All of the telephone calls made by our customers are connected through local telephone companies and, at least in part, through leased networks that may become unavailable. We are not a local telephone company or a registered local exchange carrier. Our network covers only portions of the United States. Accordingly, we must route parts of some domestic and all international calls made by our customers over leased transmission facilities. In addition, because our network does not extend to homes or businesses, we must route calls through a local telephone company to reach our network and, ultimately, to reach their final destinations. In many of the foreign jurisdictions in which we conduct or plan to conduct business, the primary provider of significant intra-national transmission facilities is the national telephone company. Accordingly, we may have to lease transmission capacity at artificially high rates from a monopolistic provider and, consequently, we may not be able to generate a profit on those calls. In addition, national telephone companies may not be required by law to lease necessary transmission lines to us or, if applicable law requires national telephone companies to lease transmission facilities to us, we may encounter delays in negotiating leases and interconnection agreements and commencing operations. Additionally, disputes may result with respect to pricing terms and billing. In the United States, the providers of local telephone service are generally the incumbent local telephone companies, including the regional Bell operating companies. The permitted pricing of local transmission facilities that we lease in the United States is subject to uncertainties. The Federal Communications Commission has issued an order requiring incumbent local telephone companies to price those facilities at total element long-run incremental cost, and the United States Supreme Court recently upheld the FCC's jurisdiction to set a pricing standard for local transmission facilities provided to 9 competitors. However, the incumbent local telephone companies can be expected to bring additional legal challenges to the FCC's total element long-run incremental cost standard and, if they succeed, the result may be to increase the cost of incumbent local transmission facilities obtained by us. Our success depends on our ability to handle a large number of simultaneous calls, which our systems may not be able to accommodate. We expect the volume of simultaneous calls to increase significantly as we expand our operations. Our network hardware and software may not be able to accommodate this additional volume. If we fail to maintain an appropriate level of operating performance, or if our service is disrupted, our reputation could be hurt and we could lose customers. Because we are unable to predict the volume of usage and our capacity needs, we may be forced to enter into disadvantageous contracts that would reduce our operating margins. In order to ensure that we are able to handle additional usage, we have agreed to pay IDT a one-time fee of approximately $6.0 million for a 20-year right to use part of a new high capacity network that is under construction. This network has been pledged by IDT to its lenders under a credit facility. We may have to enter into additional long-term agreements for leased capacity. To the extent that we overestimate our call volume, we may be obligated to pay for more transmission capacity than we actually use, resulting in costs without corresponding revenue. Conversely, if we underestimate our capacity needs, we may be required to obtain additional transmission capacity through more expensive means that may not be available. We may not be able to obtain sufficient funds to grow our business. We intend to continue to grow our business. Due to our limited operating history and the nature of our industry, our future capital needs are difficult to predict. Therefore, we may require additional capital after this offering to fund any of the following: . unanticipated opportunities; . strategic alliances; . potential acquisitions; . changing business conditions; and . unanticipated competitive pressures. Obtaining additional financing will be subject to a number of factors, including market conditions, our operating performance and investor sentiment. These factors may make the timing, amount, terms and conditions of additional financings unattractive to us. If we are unable to raise additional capital, our growth could be impeded. Any damage to or failure of our systems or operations could result in reductions in, or terminations of, our services. Our success depends on our ability to provide efficient and uninterrupted, high-quality services. Our systems and operations are vulnerable to damage or interruption from natural disasters, power loss, telecommunications failures, physical or electronic break-ins, sabotage, intentional acts of vandalism and similar events that may be or may not be beyond our control. The occurrence of any or all of these events could hurt our reputation and cause us to lose customers. Unauthorized use of our intellectual property by third parties may damage our brand. We regard our copyrights, service marks, trademarks, trade secrets and other intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality 10 agreements with our employees, customers, partners and others to protect our intellectual property rights. Despite our precautions, it may be possible for third parties to obtain and use our intellectual property without authorization. Furthermore, the laws of some foreign countries may not protect intellectual property rights to the same extent as do the laws of the United States. It may be difficult for us to enforce certain of our intellectual property rights against third parties who may have acquired intellectual property rights by filing unauthorized applications in foreign countries to register the marks that we use because of their familiarity with our worldwide operations. Since Internet related industries such as ours are exposed to the intellectual property laws of numerous foreign countries and trademark rights are territorial, there is uncertainty in the enforceability and scope of protection of our intellectual property. The unauthorized use of our intellectual property by third parties may damage our brand. Defending against intellectual property infringement claims could be expensive and could disrupt our business. We cannot be certain that our products and services do not or will not infringe upon valid patents, trademarks, copyrights or other intellectual property rights held or claimed by third parties. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others in the ordinary course of our business. We may incur substantial expenses in defending against these third-party infringement claims, regardless of their merit. Successful infringement claims against us may result in substantial monetary liability or may materially disrupt the conduct of our business. See "Business--Intellectual Property." Year 2000 problems may disrupt our operations. Many computer systems and software products are coded to understand only dates that have two digits for the relevant year. These systems and products need upgrading to accept four digit entries in order to distinguish 21st century dates from 20th century dates. Without upgrading, many computer applications could fail or create erroneous results beginning in the year 2000. The "Year 2000" problems of companies on the Internet generally could affect our systems or operations. In addition, computer systems and software products in foreign countries may not be as prepared for the Year 2000 as computer systems and software products in the United States. Because a majority of our revenue is derived from customers located outside the United States, the failure of computer systems and software products in any foreign countries as a result of Year 2000 problems could block access to our services in those countries, which may adversely affect our customer base and revenue. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Year 2000 Systems Costs" for a more complete description of the Year 2000 risks that we face and the steps we have taken to reduce those risks. Risks Related to Our Relationship with IDT We have contracted with IDT for various services and for the use of its telecommunications network, which contracts we may not be able to renew when they expire. In May 1999, we entered into agreements with IDT under which IDT will continue to provide administrative and telecommunication services to us. These agreements have an initial term of one year, and at the end of the initial term and each year thereafter, will automatically renew for additional one year periods unless one party has given the other party prior termination notice. When these agreements expire, we will need to extend them, engage other entities to perform these services or perform these services ourselves. In addition, after the initial term, these agreements are terminable by either party upon prior written notice. We cannot assure you that IDT will not terminate these agreements or continue to provide these services after the initial term of the agreements. As a result, we may have to purchase these services from third parties or devote resources to handle these functions internally, which may cost us more than we paid IDT for the same services. In addition, IDT has provided us in the past with working capital to fund our operations, and IDT is not under any obligation, under these agreements or otherwise, to do so in the future. 11 We may experience conflicts of interest with IDT, which may not be resolved in our favor. Three members of our board of directors are officers and/or directors of IDT. One of these directors, Howard S. Jonas, is the Chairman and Chief Executive Officer of IDT and IDT's controlling shareholder. Additionally, one of our directors, James R. Mellor, was a director of IDT until June 1999. Clifford M. Sobel, our Chairman, has an option to transfer his interest in us to IDT in exchange for an option to purchase 875,000 shares of IDT common stock at a purchase price of $6.50 per share. See "Management--Employment Contracts." In addition, certain of our executive officers, directors and employees hold shares of IDT common stock and options to acquire shares of IDT common stock. These individuals may have conflicts of interest with respect to certain decisions involving business opportunities and similar matters that may arise in the ordinary course of our business or the business of IDT. If conflicts arise with IDT, we expect to resolve those conflicts on a case-by-case basis, and in the manner required by applicable law and customary business practices, subject to our agreement with IDT to resolve disputes involving $5.0 million or less through mandatory, binding arbitration. Conflicts, if any, could be resolved in a manner adverse to us and our stockholders, which could harm our business. Through its ownership of our stock, IDT effectively controls our company and may exert influence contrary to the interests of other stockholders. Immediately following this offering, IDT will own approximately 48.3% of our outstanding capital stock. Because IDT owns Class A stock, which entitles the holder to two votes per share, IDT will control 58.2% of our voting power. Therefore, IDT will have the power to determine the election of our directors, the appointment of new management and the approval of any other action requiring the approval of our stockholders, including any amendments to our certificate of incorporation and mergers or sales of our company or of all of our assets. In addition, without the consent of IDT, we could be prevented from entering into certain transactions that could be beneficial to us. Third parties could be discouraged from making a tender offer or bid to acquire us because of IDT's stockholdings and voting rights. IDT's ownership will increase if Clifford M. Sobel exercises his option to transfer his shares of our stock to IDT in exchange for an option to purchase shares of IDT. See "Principal and Selling Stockholders." IDT has pledged its shares of our stock to secure a credit facility, which shares may be transferred to a third party that would effectively control us if IDT defaults on its obligations. The shares owned by IDT are pledged as collateral to secure an IDT credit facility. The lenders under the credit facility have agreed to permit IDT to transfer our shares free and clear of any liens as and when IDT seeks to transfer shares of our stock. Such transferability will cease if IDT's ownership of our capital stock drops below 50% of the number of shares which it owned 72 hours after the consummation of our initial public offering. If IDT defaults in its obligations under the credit facility, then a third party could acquire the voting rights with respect to the pledged stock and become party to our intercompany agreements. We cannot assume that a third party would maintain good relations with us or maintain or renew our agreements with IDT. Risks Related to Our Industry If the Internet does not continue to grow as a medium for voice communications, our business will suffer. The technology that allows voice communications over the Internet is still in its early stages of development. Historically, the sound quality of Internet calls was poor. As the industry has grown, sound quality has improved, but the technology requires additional refinement. Additionally, the Internet's capacity constraints may impede the acceptance of Internet telephony. Callers could experience delays, errors in transmissions or other interruptions in service. Making telephone calls over the Internet must also be 12 accepted as an alternative to traditional telephone service. Because the Internet telephony market is new and evolving, predicting the size of this market and its growth rate is difficult. If our market fails to develop, then we will be unable to grow our customer base and our opportunity for profitability will be harmed. Our business will not grow without increased use of the Internet. The use of the Internet as a commercial marketplace is at an early stage of development. Demand and market acceptance for recently introduced products and services over the Internet are still uncertain. We cannot predict whether customers will be willing to shift their traditional activities online. The Internet may not prove to be a viable commercial marketplace for a number of reasons, including: . concerns about security; . Internet congestion; . inconsistent service; and . lack of cost-effective, high-speed access. If the use of the Internet as a commercial marketplace does not continue to grow, we may not be able to grow our customer base, which may prevent us from achieving profitability. Governmental regulations regarding the Internet may be passed, which could impede our business. The legal and regulatory environment that pertains to the Internet is uncertain and is changing rapidly as use of the Internet increases. For example, in the United States, the Federal Communications Commission is considering whether to impose surcharges or additional regulations upon certain providers of Internet telephony. In addition, regulatory treatment of Internet telephony outside the United States varies from country to country. For example, access to our PC2Phone services was recently blocked in certain countries in Asia and the Middle East by government-controlled telecommunications companies. These blockages have caused service interruptions that may cause us to earn as much as $250,000 less in PC2Phone revenue in the first quarter of fiscal 2000. There can be no assurance that there will not be future interruptions in these and other foreign countries or that we will be able to return to the level of service we had in each of these countries prior to any interruptions. In addition, one of our competitors, iBasis, recently disclosed that it had received a letter from the Israeli Minister of Communications requesting that it cease and desist terminating international calls over the Internet in Israel. These actions and other similar actions in foreign countries may adversely affect our continuing ability to offer services in these and other countries, causing us to lose customers and revenue. New regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet, which could adversely effect our customer base and our revenue. The growth of the Internet may also be significantly slowed. This could delay growth in demand for our products and services and limit the growth of our revenue. In addition to new regulations being adopted, existing laws may be applied to the Internet. See "Business--Regulation." New and existing laws may cover issues that include: . sales and other taxes; . access charges; . user privacy; . pricing controls; . characteristics and quality of products and services; 13 . consumer protection; . contributions to the universal service fund, an FCC-administered fund for the support of local telephone service in rural and high cost areas; . cross-border commerce; . copyright, trademark and patent infringement; and . other claims based on the nature and content of Internet materials. Our risk management practices may not be sufficient to protect us from unauthorized transactions or thefts of services. We may be the victim of fraud or theft of service. From time to time, callers have obtained our services without rendering payment by unlawfully using our access numbers and personal identification numbers. We attempt to manage these theft and fraud risks through our internal controls and our monitoring and blocking systems. If these efforts are not successful, the theft of our services may cause our revenue to decline significantly. Risks Related to this Offering Our stock price has been, and is likely to continue to be, highly volatile and could drop unexpectedly. Since trading commenced in July 1999, the trading price of our common stock has been highly volatile and may continue to be volatile in response to the following factors: . quarterly variations in our operating results; . announcements of technical innovations, new products or services by us or our competitors; . investor perception of us, the Internet telephony market or the Internet in general; . changes in financial estimates by securities analysts; and . general economic and market conditions. The stocks of many Internet-related companies have experienced significant fluctuations in trading price and volume. Often these fluctuations have been unrelated to operating performance. Declines in the market price of our common stock could also materially adversely affect employee morale and retention, our access to capital and other aspects of our business. If our stock price remains volatile, we may become subject to securities litigation, which is expensive and could divert our resources. In the past, following periods of market volatility in the price of a company's securities, security holders have instituted class action litigation. Many companies in our industry have been subject to this type of litigation. If the market value of our stock experiences adverse fluctuations, and we become involved in this type of litigation, regardless of the outcome, we could incur substantial legal costs and our management's attention could be diverted, causing our business to suffer. The sale of a substantial number of shares of our common stock after this offering may affect our stock price. The market price of our common stock could decline as a result of sales of substantial amounts of common stock in the public market after the closing of this offering or the perception that substantial sales could occur. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. 14 We may use the proceeds from this offering in ways with which you may not agree. We are not required to allocate the proceeds from this offering to any specific investment or transaction. Therefore, we have significant flexibility in applying these proceeds, and you cannot determine the value or propriety of our use of proceeds. If we do not apply the funds we receive effectively, our accumulated deficit will increase and we may lose significant business opportunities. See "Use of Proceeds" for a more detailed description of how we intend to apply the proceeds from this offering. Our certificate of incorporation, our bylaws and Delaware law make it difficult for a third party to acquire us, despite the possible benefit to our stockholders. Provisions of our certificate of incorporation, our bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. For example, our certificate of incorporation provides for a classified board of directors, meaning that only approximately one-third of our directors will be subject to re-election at each annual stockholder meeting. Moreover, our certificate of incorporation creates a class of stock with super-voting rights. The holders of Class A stock are entitled to two votes per share while the holders of common stock are entitled to one vote per share. Except as otherwise required by law or as described below, the holders of Class A stock and common stock will vote together as a single class on all matters presented to the stockholders for their vote or approval, including the election of directors. The holders of Class A stock may have the ability to elect all of our directors and to effect or prevent certain corporate transactions. These provisions could discourage takeover attempts and could materially adversely affect the price of our stock. FORWARD-LOOKING STATEMENTS This prospectus contains "forward-looking statements." These forward-looking statements include, without limitation, statements about our market opportunity, strategies, competition, expected activities and expenditures as we pursue our business plan, and the adequacy of our available cash resources. Our actual results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including the risk factors described above and elsewhere in this prospectus. 15 USE OF PROCEEDS We will receive net proceeds of approximately $202.6 million from the sale of 3,400,000 shares of our common stock at the assumed public offering price of $62.63 per share after deducting underwriting commissions and discounts of $9.6 million and estimated expenses of $750,000. As of the date of this prospectus, we have not made any specific allocations with respect to the net proceeds from this offering. Therefore, we cannot specify with certainty the particular uses for the net proceeds to be received upon consummation of this offering. Accordingly, our management will have significant flexibility in applying the net proceeds from this offering. We expect to use the net proceeds of this offering for: . developing and maintaining strategic relationships; . advertising and promotion; . upgrading and expanding our network; . international expansion; . research and development; . potential acquisitions; and . general corporate purposes, including working capital. Pending any use, the net proceeds of this offering will be invested in short-term, interest-bearing securities. DIVIDEND POLICY We have not paid any dividends in the past and do not intend to pay cash dividends on our capital stock for the foreseeable future. Instead, we intend to retain all earnings for use in the operation and expansion of our business. MARKET PRICE OF OUR COMMON STOCK Our common stock has traded on the Nasdaq National Market under the symbol NTOP since July 29, 1999. The following table sets forth the per share range of high and low closing sales prices of our common stock for the periods indicated:
Fiscal 1999 High Low - ----------- ------ ------ Fourth Quarter (July 29 and July 30 only)........................ $27.38 $26.56 Fiscal 2000 High Low - ----------- ------ ------ First Quarter.................................................... $84.94 $16.50 Second Quarter (November 1 through November 18 only)............. 62.63 47.75
On November 18, 1999, the last reported sale price for our common stock on the Nasdaq National Market was $62.63 per share. The market price for our stock is highly volatile and fluctuates in response to a wide variety of factors. See "Risk Factors--Our stock price is volatile." 16 CAPITALIZATION The following table sets forth: . our actual capitalization as of July 31, 1999; . our pro forma capitalization to give effect to: . the conversion of 3,140,000 shares of our Series A convertible preferred stock into 9,420,000 shares of our Class A common stock at the time that we closed our initial public offering, . the exercise of options to purchase 125,000 shares of our common stock prior to the closing of our initial public offering for proceeds of $999,750, . the sale of 6,210,000 shares of our common stock in our initial public offering, . the conversion of 517,839 shares of our Class A stock to common stock upon the transfer of those shares from IDT to Clifford M. Sobel at the closing of our initial public offering, and . the application of $7.0 million of the net proceeds of our initial public offering to pay a portion of the amounts due to IDT. . the pro forma as adjusted balance sheet summarized below further reflects: . the sale of 3,400,000 shares of common stock in this offering, and . the conversion of 2,600,000 shares of Class A stock to common stock upon the sale of those shares by the selling stockholders at the closing of this offering. This information also excludes an additional 7,364,150 shares of common stock issuable upon exercise of options to purchase our common stock as of November 18, 1999, at a weighted average exercise price of $9.27 per share. See "Management--1999 Stock Incentive Plan".
July 31, 1999 ---------------------------------------- Pro Forma As Actual Pro Forma Adjusted ------------ ------------ ------------ Accounts payable to IDT............. $ 3,735,395 $ 3,735,395 $ 3,735,395 ============ ============ ============ Loan payable to IDT................. $ 14,000,000 $ 7,000,000 $ 7,000,000 Redeemable convertible preferred stock, Series A, $.01 par value; 3,150,000 shares authorized, 3,140,000 shares issued and outstanding (actual) and no shares issued and outstanding (pro forma and pro forma as adjusted)......... 27,929,000 -- -- Stockholders' (deficit) equity: Preferred stock, $.01 par value; 6,850,000 shares authorized (actual), 10,000,000 shares authorized (pro forma and pro forma as adjusted), no shares issued and outstanding........................ -- -- -- Common stock, $.01 par value; 200,000,000 shares authorized; 4,819,777 (actual), 11,672,616 (pro forma) and 17,672,616 (pro forma as adjusted) shares issued and outstanding........................ 48,198 116,727 176,727 Class A stock, $.01 par value; 37,042,089 shares authorized; 27,622,089 (actual), 36,524,250 (pro forma) and 33,924,250 (pro forma as adjusted) shares issued and outstanding.................... 276,220 365,241 339,241 Additional paid-in capital.......... 61,126,266 175,156,966 377,716,341 Accumulated deficit................. (30,455,286) (30,455,286) (30,455,286) Deferred compensation--stock options............................ (31,908,275) (31,908,275) (31,908,275) Loans to stockholders............... (3,149,990) (3,149,990) (3,149,990) ------------ ------------ ------------ Total stockholders' (deficit) equity............................. (4,062,867) 110,125,383 312,718,758 ------------ ------------ ------------ Total capitalization................ $ 37,866,133 $117,125,383 $319,718,758 ============ ============ ============
17 DILUTION The net tangible book value of our common stock and Class A stock as of July 31, 1999, as adjusted to give effect to the issuance of 6,210,000 shares of common stock in our initial public offering, the issuance of 125,000 shares upon the exercise of stock options at the time of our initial public offering for an aggregate purchase price of $999,750 and the conversion of 3,140,000 shares of our Series A convertible preferred stock into 9,420,000 shares of our Class A stock at the closing of our initial public offering, was $105.1 million, or $2.18 per share of common stock and Class A stock. Net tangible book value per share represents the amount of our total tangible assets less our total liabilities, divided by the total number of shares of common stock and Class A stock outstanding. After giving effect to this offering, the receipt of $202.6 million of estimated net proceeds from this offering and the transactions described above, the pro forma net tangible book value of the common stock and Class A stock as of July 31, 1999 would have been $307.7 million, or $5.96 per share. This amount represents an immediate increase in net tangible book value of $3.78 per share to the existing stockholders and an immediate dilution in net tangible book value of $56.67 per share to purchasers of common stock in this offering. Dilution is determined by subtracting pro forma net tangible book value per share after this offering from the amount of cash paid by a new investor for a share of common stock. The following table illustrates such dilution: Public offering price per share................................ $ Net tangible book value per share at July 31, 1999........... $2.18 Increase per share attributable to new investors............. 3.78 ----- Pro forma net tangible book value per share after this offering 5.96 ------ Dilution per share to new investors............................ $56.67 ======
The following table sets forth, as of July 31, 1999, on the pro forma basis described above, the number of shares of capital stock purchased from us, the total consideration paid to us and the average price per share paid by existing stockholders and by new investors who purchase shares of common stock in this offering, before deducting the underwriting discounts and commissions and estimated offering expenses.
Shares Purchased Total Consideration ------------------ -------------------- Average Price Number Percent Amount Percent Per Share ---------- ------- ------------ ------- ------------- Existing stockholders... 48,196,866 93.4% $125,811,118 37.1% $2.61 New investors........... 3,400,000 6.6% 212,925,000 62.9% $ ---------- ----- ------------ ----- Total................. 51,596,866 100.0% $338,736,118 100.0% ========== ===== ============ =====
18 SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with our financial statements and related notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this prospectus. The statement of operations data for the period from January 2, 1996 (inception) to July 31, 1996, fiscal 1997, fiscal 1998 and fiscal 1999 and the balance sheet data as of July 31, 1998 and 1999 are derived from our financial statements that have been audited by Ernst & Young LLP, independent auditors, which are included elsewhere in this prospectus.
Period from January 2, 1996 Fiscal Year Ended July 31, (inception) to -------------------------------------- July 31, 1996 1997 1998 1999 --------------- ----------- ----------- ------------ Statement of Operations Data: Revenue: PC2Phone.............. $ -- $ 2,170,442 $ 7,962,821 $ 19,733,569 Phone2Phone........... -- 272 2,030,516 10,306,617 Other................. -- 481,589 2,012,635 3,216,271 ---------- ----------- ----------- ------------ Total revenue....... -- 2,652,303 12,005,972 33,256,457 ---------- ----------- ----------- ------------ Costs and expenses: Direct cost of revenue, excluding depreciation......... -- 1,553,443 6,848,759 17,818,010 Selling and marketing............ 34,468 76,724 2,887,766 8,828,167 General and administrative....... 465,015 2,599,283 5,087,628 10,836,072 Depreciation and amortization......... 8,275 120,500 726,508 2,316,545 Compensation charge from the issuance of stock options........ -- -- -- 17,919,541 ---------- ----------- ----------- ------------ Total costs and expenses........... 507,758 4,349,950 15,550,661 57,718,335 ---------- ----------- ----------- ------------ Loss from operations.... (507,758) (1,697,647) (3,544,689) (24,461,878) Interest expense--net... -- -- -- (243,314) ---------- ----------- ----------- ------------ Net loss................ (507,758) (1,697,647) (3,544,689) (24,705,192) Redeemable preferred stock dividends........ -- -- -- (29,219,362) ---------- ----------- ----------- ------------ Net loss available to common stockholders.... $ (507,758) $(1,697,647) $(3,544,689) $(53,924,554) ========== =========== =========== ============ Net loss per common share--basic and diluted................ $ (0.02) $ (0.06) $ (0.12) $ (1.73) ========== =========== =========== ============ Pro forma net loss per common share--basic and diluted................ $ (0.74) ============ Weighted average number of common shares used in calculation of basic and diluted net loss per common share....... 27,864,000 27,864,000 30,186,000 31,236,415 ========== =========== =========== ============ Pro forma weighted average number of common shares used in calculation of basic and diluted pro forma net loss per common share.................. 33,172,031 ============
July 31, -------------------------------------------------------------- 1996 1997 1998 1999 --------- ----------- ------------ ------------------------ Actual Pro Forma Balance Sheet Data: Cash and cash equivalents............ $ -- $ -- $ 10,074 $20,379,048 $99,638,298 Working capital......... (681,532) (3,104,830) (11,149,553) 6,303,452 92,562,702 Total assets............ 174,674 916,025 6,975,108 50,816,891 130,076,141 Accounts payable to IDT.................... 681,532 2,960,429 11,814,988 3,735,395 3,735,395 Loan payable to IDT..... -- -- -- 14,000,000 7,000,000 Total stockholders' (deficit) equity....... (507,758) (2,205,305) (5,649,994) (4,062,867) 110,125,383
19 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our financial statements and notes thereto. The historical financial information included in this prospectus does not necessarily reflect what our financial condition and results of operations would have been had we been operated as an independent entity during the periods presented. Overview We began our operations in January 1996, launched our first Net2Phone product in August 1996, and were established as a separate subsidiary of IDT in October 1997. We have incurred net operating losses since inception and expect to incur additional losses for the foreseeable future, primarily as a result of increased sales and marketing efforts. As of July 31, 1999, we had an accumulated deficit of approximately $30.5 million. We recognized significant charges relating to non-cash executive compensation expense in the fourth quarter of 1999 and will recognize additional significant charges on an ongoing basis, in connection with the grants of options to purchase shares of our common stock in May and July 1999. With respect to these options, we recognized a charge of approximately $17.9 million in the fourth quarter of fiscal 1999, and will recognize charges of approximately $11.8 million during fiscal 2000, approximately $11.8 million during fiscal 2001 and approximately $8.3 million during fiscal 2002. In May 1999, we issued 3,140,000 shares of Series A convertible preferred stock which were converted into 9,420,000 shares of Class A stock at $3.33 per share at the time of our initial public offering. The Series A convertible preferred stock contains beneficial conversion features. The total value of the beneficial conversion features is approximately $75 million. For accounting purposes, the value of the beneficial conversion features was limited to the amount of proceeds allocated to the Series A convertible preferred stock. We recorded a reduction in net income available to common stockholders in the quarter ended July 31, 1999 of approximately $29.2 million. In connection with the issuance of the Series A convertible preferred stock, we issued warrants to purchase up to 272,400 shares of common stock at an exercise price of $3.33 per share. The fair value of warrants on the date of issuance was $2.1 million. These warrants were exercised to purchase an aggregate of 136,648 shares of common stock at the time of our initial public offering. The fair value of the warrants was recorded as an increase to additional paid in capital and a decrease to the carrying value of the Series A convertible preferred stock. The decrease in the carrying value of the Series A convertible preferred stock will be accreted, with a corresponding reduction of additional paid-in capital, over the period to the initial redemption date in May 2006. At the closing of our initial public offering in August 1999, the balance of the unamortized discount was recorded as a reduction of the amount of income available for common shareholders. In connection with our distribution and marketing agreement with ICQ, we issued a warrant to America Online to purchase up to 3% of our outstanding capital stock on a fully-diluted basis. This warrant will vest in 1% increments upon the achievement of each of three incremental thresholds of revenue generated under the agreement during the first four years that the warrant is outstanding. The per share exercise price under the warrant will be equal to the lesser of $12.00 per share or $450 million divided by the number of our fully-diluted shares on the initial exercise date. If one or more of the revenue thresholds set forth in the warrant are achieved, we will recognize additional non-cash charges in an amount equal to the value of the warrant, as determined at the time that these thresholds are met. Sources of Revenue During fiscal 1999, approximately 59.3% of our revenue was derived from per- minute charges we billed to our customers on a prepaid basis to use our PC2Phone service, and approximately 31.0% of our revenue was derived from per- minute charges we billed to our customers and our international resellers on a prepaid 20 basis to use our Phone2Phone service. The remainder of our revenue was derived from the sale of Internet telephony gateways, technology licensing and for services we provide to IDT and other carriers. In the future, in order to diversify and enhance our revenue sources, we plan to introduce a variety of value-added services and Internet commerce solutions. In addition, we plan to sell Web-based advertising to leverage our customer reach. To date, these additional products and services have provided no revenue and we do not anticipate material revenue from these additional products and services through at least December 1999. Approximately 90.3% of our revenue in fiscal 1999 was generated from per- minute charges we charge our customers on a prepaid basis to use our PC2Phone and Phone2Phone services. During fiscal 1999, approximately 62% of our revenue was derived from customers based outside of the United States. As of July 31, 1999, we served over 325,000 active customers who spent an average of approximately 60 minutes per month placing calls over the Internet. We recognize revenue as our customers utilize the balances in their prepaid accounts by placing calls. As such, we have deferred revenue for all unutilized balances in our customers' accounts. The remaining 9.7% of our revenue, which is derived from the sale of Internet telephony gateways, technology licensing and from services provided to IDT and other carriers, is recognized upon installation of the equipment and performance of the services. Cost Structure Our costs and expenses include: . direct cost of revenue, excluding depreciation; . selling and marketing; . general and administrative; and . depreciation. Direct Cost of Revenue. Direct cost of revenue consists primarily of network costs associated with carrying our customers' traffic on our network and leased networks, and routing their calls through a local telephone company to reach their final destination. These costs exclude depreciation and include: . amounts paid to other carriers to terminate traffic on a per-minute basis; . the cost of leased routers and access servers; . telecommunications costs, including the cost of local telephone lines to carry subscriber calls to our network; . the costs associated with leased lines connecting our network directly to the Internet or to our operations centers and connecting our operations centers to the Internet; and . Internet backbone costs, which are the amounts we pay to Internet service providers for capacity. We expect our direct cost of revenue to increase in absolute terms over time to support our growing customer base. While some of these costs are fixed, other costs vary on a per minute basis. Therefore, there may be some volatility in our direct cost of revenue as a percentage of revenue, particularly as we expand our network. We try to terminate calls on our own network whenever possible. When we cannot terminate calls on our network, we terminate calls on the network of other suppliers, primarily IDT. We expect to continue to utilize this process. We also expect the percentage of our traffic that we terminate with IDT will decline in the future as we expand our own network. Selling and Marketing. Selling and marketing includes the expenses associated with acquiring customers, including commissions paid to our sales personnel, advertising costs, referral fees and amounts paid to our strategic partners in connection with revenue-sharing arrangements. We expect selling and marketing expenses to increase over time as we aggressively market our products and services. Historically, 21 selling and marketing expenses have been a relatively variable cost and are expected to increase both in terms of absolute dollars and as a percentage of revenue as our revenue grows. We expect to spend significant capital to build brand recognition. Most of our sales and marketing expenses will go toward securing significant and strategic relationships with a variety of Internet companies. We have strategic alliances with Netscape, ICQ, InfoSpace.com, Yahoo! and Excite and intend to continue to pursue relationships with other companies. General and Administrative. General and administrative expenses consist of the salaries of our employees and associated benefits, and the cost of insurance, travel, entertainment, rent and utilities. A large portion of our general and administrative expenses include operations and customer support. These include the expenses associated with customer service and technical support, and consist primarily of the salaries and employment costs of the employees responsible for those efforts. We expect operations and customer support expenses to increase over time to support new and existing customers. We expect general and administrative costs to increase to support our growth, particularly as we establish a larger organization to implement our business plan. We include our research and development costs, comprised primarily of payroll expenses for our technical team of engineers and developers, in general and administrative expenses. We plan to incur additional costs for research and development, though they are not expected to increase as a percentage of revenue. Over time, we expect these relatively fixed general and administrative expenses to decrease as a percentage of revenue. Depreciation and Amortization. Depreciation and amortization primarily relates to our hardware infrastructure. We depreciate our network equipment over its estimated five-year useful life using the straight-line method. We plan to acquire a domestic high capacity network to provide additional capacity to handle the expected increase in customer traffic as our business grows. In addition, we will be adding more network hardware as traffic volumes justify. We expect depreciation to increase in absolute terms as we expand our network to support new and acquired customers, but to decrease as a percentage of total revenue. We have also entered into a strategic agreement with Netscape, part of which includes the purchase of software and trademark licenses. We expect to amortize the costs relating to the software and trademark licenses acquired from Netscape over the two-year term of the agreement. Dependence on IDT. Historically, we have been dependent on IDT for working capital, its telecommunications network and for various services. In connection with establishing ourselves as an independent operating entity, we recently contracted with IDT for telecommunications services and administrative support. We believe that the terms of our agreements with IDT are no less favorable than those we would have obtained from unaffiliated third parties. 22 Results of Operations The following table sets forth certain items in our statement of operations as a percentage of total revenue for the periods indicated:
Fiscal Year Ended July 31, --------------------- 1997 1998 1999 ----- ----- ----- Revenue: PC2Phone............................................. 81.8% 66.3% 59.3% Phone2Phone.......................................... -- 16.9 31.0 Other................................................ 18.2 16.8 9.7 ----- ----- ----- Total revenue...................................... 100.0 100.0 100.0 ----- ----- ----- Costs and expenses: Direct cost of revenue, excluding depreciation and amortization........................................ 58.6 57.0 53.6 Selling and marketing................................ 2.9 24.1 26.5 General and administrative........................... 98.0 42.4 32.6 Depreciation and amortization........................ 4.5 6.1 7.0 Compensation charge from issuance of stock options... -- -- 53.9 ----- ----- ----- Total costs and expenses........................... 164.0 129.6 173.6 Loss from operations................................... (64.0) (29.6) (73.6) Net interest........................................... -- -- (0.7) ----- ----- ----- Net loss............................................... (64.0)% (29.6)% (74.3)% ===== ===== =====
Comparison of Fiscal Years Ended July 31, 1999 and 1998 Revenue. Revenue increased approximately 177% from approximately $12.0 million in fiscal 1998 to approximately $33.3 million for fiscal 1999. Of total revenue for fiscal 1999, PC2Phone generated approximately $19.7 million and Phone2Phone generated approximately $10.3 million. The increase in revenue was primarily due to an increase in minutes of use resulting from additional marketing of our products and services. Specifically, revenue from PC2Phone services increased approximately 148% from approximately $8.0 million for fiscal 1998 to approximately $19.7 million in revenue for fiscal 1999. Revenue from Phone2Phone increased approximately 408% from approximately $2.0 million for fiscal 1998 to approximately $10.3 million for fiscal 1999. We anticipate that revenue from PC2Phone and Phone2Phone will increase in absolute terms as our products become more widely distributed. However, as a percentage of revenue, we expect revenue from these products to decline over the next several years as we begin to market additional products and services and pursue additional sources of revenue. We also recognized revenue of approximately $2.0 million in fiscal 1998 and $3.2 million in fiscal 1999, from the sale of Internet telephone gateways, technology licensing and for services we provided to IDT and other carriers, which is included in "Other Revenue." Direct Cost of Revenue, Excluding Depreciation and Amortization. Total direct cost of revenue, excluding depreciation and amortization, increased by 160% from $6.8 million for fiscal 1998 to approximately $17.8 million for fiscal 1999. As a percentage of total revenue, these costs decreased from approximately 57.0% for fiscal 1998 to approximately 53.6% for fiscal 1999. This decrease is primarily attributable to improved efficiencies in terminating traffic and utilization of network assets. Over time, we expect direct cost of revenue to decline on a per-minute basis as international competition among carriers intensifies, resulting in lower prices from our suppliers, and as we leverage our position as a large provider of services and expand our own network. As a percentage of revenue, we expect direct cost of revenue to increase as a result of a decline in per-minute charges to customers. We expect to continue to utilize IDT's 23 international and domestic networks at the current fair market value rates for termination. We also expect to incur additional costs in connection with the growth of our business, especially in connection with increasing our own network capacity to handle increased traffic volumes. Selling and Marketing. Selling and marketing expenses increased approximately 206% from approximately $2.9 million for fiscal 1998 to approximately $8.8 million for fiscal 1999. As a percentage of total revenue, these costs increased from approximately 24.1% for fiscal 1998 to approximately 26.5% for fiscal 1999. This increase primarily reflects the increased marketing and advertising expenses associated with the agreements established with Netscape, ICQ, InfoSpace.com, Yahoo!, Excite and other strategic partners. We expect to continue to increase significantly our advertising and marketing expenditures to build additional brand recognition, and to enhance the distribution of our products and services. General and Administrative. General and administrative expenses increased approximately 113% from approximately $5.1 million for fiscal 1998 to approximately $10.8 million for fiscal 1999. As a percentage of total revenue, these costs decreased from approximately 42.4% for fiscal 1998 to approximately 32.6% for fiscal 1999. This decrease primarily reflects the efficiencies we have begun to realize from leveraging our sales and support infrastructure. We believe that general and administrative expenses will continue to decline as a percentage of total revenue as a result of greater economies of scale and additional efficiencies. In absolute terms, we expect these expenses to continue to increase as we incur additional costs in product development and costs associated with hiring additional personnel and adding new office space. Moreover, in absolute terms, our research and development expenses will increase as we hire the additional engineers necessary to continue the development of new products and services. However, these research and development expenses are not expected to significantly increase as a percentage of our total revenue. Depreciation and Amortization. Depreciation and amortization increased approximately 219% from approximately $727,000 for fiscal 1998 to approximately $2.3 million for fiscal 1999. As a percentage of total revenue, these costs remained constant in fiscal 1998 and fiscal 1999. This increase is primarily attributable to the increase in capital expenditures for the deployment of network equipment both domestically and internationally to manage increased call volumes. Depreciation will continue to increase as we build out our network and amortize intangibles such as our licenses and trademark rights acquired under agreements with strategic partners, including Netscape. Compensation Charge from the Issuance of Stock Options. We recognized $17.9 million of non-cash compensation expense in fiscal 1999 as a result of option grants made in May 1999 and July 1999. As a percentage of total revenue, the compensation charge from issuance of stock options was 53.9% in fiscal 1999. No compensation charge from the issuance of stock options was recognized in fiscal 1998. Loss from Operations. Loss from operations was approximately $3.5 million for fiscal 1998 as compared to loss from operations of approximately $24.5 million for fiscal 1999. Excluding the non-cash compensation charge described above, our loss from operations for fiscal 1999 would have been $6.5 million. This change is due to the substantial increase in both selling and marketing expenses as well as general and administrative expenses we incurred as we expanded our distribution relationships, corporate infrastructure and human resources. We anticipate continued and increasing losses as we pursue our growth strategy. Comparison of Fiscal Years Ended July 31, 1998 and 1997 Revenue. Revenue increased approximately 353% from approximately $2.7 million for fiscal 1997 to approximately $12.0 million for fiscal 1998. The increase in revenue was primarily due to an increase in minutes of use resulting from increased marketing of our Internet telephony products and services. Of total revenue for the year ended July 31, 1998, PC2Phone generated approximately $8.0 million in revenue and Phone2Phone generated approximately $2.0 million. The increase in revenue was primarily due to an increase in minutes of use due to the marketing of our Internet telephony products and services. 24 Specifically, revenue from PC2Phone services increased approximately 266% from approximately $2.2 million in revenue for fiscal 1997 to approximately $8.0 million in revenue for fiscal 1998. We realized significant revenue for the first time from our Phone2Phone services for fiscal 1998, as well as recorded revenue of approximately $1.5 million from the sale of equipment. In addition, we recognized revenue from amounts charged to IDT including monitoring the network operations center for IDT's Internet customers, of approximately $297,000 and $498,000, respectively, for fiscal 1997 and 1998. We do not expect to realize significant revenue from the sale of equipment in the future. Direct Cost of Revenue, Excluding Depreciation and Amortization. Total cost of revenue, excluding depreciation and amortization increased by approximately 341% from approximately $1.6 million for fiscal 1997 to approximately $6.8 million for fiscal 1998. As a percentage of total revenue, these costs decreased from approximately 58.6% for fiscal 1997 to approximately 57.0% for fiscal 1998. This decrease is primarily attributable to the impact of the higher margin equipment sold in the first half of fiscal 1998. Since we do not expect to realize significant revenue from the sale of equipment in the future, our direct costs will reflect our ability to terminate our traffic worldwide cost-effectively through our own network relationships or via those of IDT, our primary supplier. As a percentage of revenue we anticipate direct costs to remain approximately the same as our network expansion efforts mitigate potential pricing pressures. Selling and Marketing. Selling and marketing expenses increased by a factor of 37 from approximately $77,000 for fiscal 1997 to approximately $2.9 million for fiscal 1998. As a percentage of total revenue, these costs increased from approximately 2.9% for fiscal 1997 to approximately 24.1% for fiscal 1998. This increase primarily reflects the increased marketing and advertising expenses associated with the agreements established with Yahoo!, Excite and other strategic partners. We expect to continue to increase significantly our advertising and marketing expenditures to build additional brand recognition, and to enhance the distribution of our products and services. General and Administrative. General and administrative expenses increased approximately 96% from approximately $2.6 million for fiscal 1997 to approximately $5.1 million for fiscal 1998. As a percentage of total revenue, these costs decreased from approximately 98.0% for fiscal 1997 to approximately 42.4% for fiscal 1998. This decrease primarily reflects the efficiencies we have begun to realize from leveraging our sales and support infrastructure. We expect to continue to see further efficiencies and greater economies of scale, so that general and administrative expenses will continue to decline as a percentage of total revenue. In absolute terms, we expect these expenses to continue to increase as we incur additional costs associated with developing new products, hiring of additional personnel and adding new office space. Depreciation and Amortization. Depreciation and amortization increased from approximately $121,000 for fiscal 1997 to approximately $727,000 for fiscal 1998. As a percentage of total revenue, these costs increased from 4.5% in fiscal 1997 to 6.1% in fiscal 1998. This increase is primarily attributable to the increase in capital expenditures for the deployment of communications equipment both domestically and internationally to manage increased customer volume. Loss from Operations. Loss from operations was approximately $1.7 million for fiscal 1997 as compared to approximately $3.5 million for fiscal 1998. The increased losses reflect the substantial increase in marketing and general and administrative costs we incurred as we expanded our corporate infrastructure and resources to gain additional market share for our products and services. 25 Quarterly Results of Operations The following table sets forth certain quarterly financial data for the eight quarters ended July 31, 1999. This quarterly information is unaudited, has been prepared on the same basis as the annual financial statements, and, in our opinion, reflects all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the information for periods presented. Operating results for any quarter are not necessarily indicative of results for any future period.
Quarter Ended -------------------------------------------------------------------------------------------------------- Oct. 31, Jan. 31, April 30, July 31, Oct. 31, Jan. 31, April 30, July 31, 1997 1998 1998 1998 1998 1999 1999 1999 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Revenue: PC2Phone............. $1,371,598 $1,693,812 $ 2,019,766 $ 2,877,645 $ 3,776,777 $4,809,644 $5,188,416 $ 5,958,732 Phone2Phone.......... 70,939 148,572 799,324 1,011,681 1,287,415 2,280,366 2,935,916 3,802,920 Other................ 825,000 905,000 120,363 162,272 599,227 412,456 913,040 1,291,548 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Total revenue........ 2,267,537 2,747,384 2,939,453 4,051,598 5,663,419 7,502,466 9,037,372 11,053,200 Costs and expenses: Direct cost of revenue, excluding depreciation and amortization........ 602,389 1,070,051 1,916,861 3,259,458 3,353,247 3,970,504 4,524,338 5,969,921 Selling and marketing........... 133,963 316,141 912,956 1,524,706 1,299,903 1,691,810 1,754,603 4,081,851 General and administrative...... 730,893 1,073,165 1,450,229 1,833,341 1,900,234 2,286,770 3,111,102 3,537,966 Depreciation and amortization........ 68,169 123,844 229,635 304,860 338,469 400,584 477,659 1,099,833 Compensation charge from the issuance of stock options....... -- -- -- -- -- -- -- 17,919,541 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Total costs and expenses............ 1,535,414 2,583,201 4,509,681 6,922,365 6,891,853 8,349,668 9,867,702 32,609,112 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Income (loss) from operations........... 732,123 164,183 (1,570,228) (2,870,767) (1,228,434) (847,202) (830,330) (21,555,912) Net interest expense.. -- -- -- -- -- -- -- (243,314) ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Net income (loss)..... $ 732,123 $ 164,183 $(1,570,228) $(2,870,767) $(1,228,434) $ (847,202) $ (830,330) $(21,799,226) ========== ========== =========== =========== =========== ========== ========== ============ As a Percentage of Revenue -------------------------------------------------------------------------------------------------------- Revenue: PC2Phone............. 60.5% 61.7% 68.7% 71.0% 66.7% 64.1% 57.4% 53.9% Phone2Phone.......... 3.1 5.4 27.2 25.0 22.7 30.4 32.5 34.4 Other................ 36.4 32.9 4.1 4.0 10.6 5.5 10.1 11.7 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Total revenue........ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Costs and expenses: Direct cost of revenue, excluding depreciation and amortization........ 26.6 38.9 65.2 80.4 59.2 52.9 50.1 54.0 Selling and marketing........... 5.9 11.5 31.1 37.6 23.0 22.6 19.4 36.9 General and administrative...... 32.2 39.1 49.3 45.2 33.6 30.5 34.4 32.0 Depreciation and amortization........ 3.0 4.5 7.8 7.5 6.0 5.3 5.3 10.0 Compensation charge from the issuance of stock options....... -- -- -- -- -- -- -- 162.1 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Total costs and expenses............ 67.7 94.0 153.4 170.7 121.8 111.3 109.2 295.0 ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Income (loss) from operations........... 32.3 6.0 (53.4) (70.7) (21.8) (11.3) (9.2) (195.0) Net interest expense.. -- -- -- -- -- -- -- (2.2) ---------- ---------- ----------- ----------- ----------- ---------- ---------- ------------ Net income (loss)..... 32.3% 6.0% (53.4)% (70.7)% (21.8)% (11.3)% (9.2)% (197.2)% ========== ========== =========== =========== =========== ========== ========== ============
We have experienced growth in revenue in each quarter since inception, reflecting greater acceptance and usage of our products and services by our expanded customer base. We expect our revenue to grow over time as minutes of use increase. However, we may experience declines in average revenue per minute due to competitive pressures, promotions and marketing initiatives, increased commissions paid to our international resellers and increased amounts paid to our strategic partners under existing and future revenue-sharing arrangements. 26 We have experienced growth in total revenue in each quarter since inception. Our Phone2Phone revenue has increased in each quarter since inception and, over the last three quarters, has also increased as a percentage of our total revenue. This growth is primarily a result of expanding our network coverage to create an increased number of access points for our customers, enhanced service offerings, lower prices and increased selling and marketing efforts to promote our Phone2Phone service. Our PC2Phone revenue has also increased in each quarter since inception. Growth of PC2Phone revenue in future periods depends, in part, upon the additional distribution of our PC2Phone service through the integration of our PC2Phone software in the next versions of ICQ's instant messaging software and Netscape's Internet browser. We currently anticipate that the next version of ICQ's instant messaging software that incorporates our PC2Phone software will be released in mid-2000. The next version of Netscape's Internet browser that incorporates our PC2Phone software has not yet been released, and, similar to our agreement with ICQ, our agreement with Netscape does not provide for a date by which the next version will be released. Any PC2Phone revenue we would expect to receive as a result of our agreements with ICQ and Netscape would not actually be received by us until their respective products become generally available. Further, any delay by our strategic partners in releasing the next version of their respective products could delay the associated PC2Phone revenue we could expect to receive from these sources. In addition, other factors could delay our growth of PC2Phone revenue. These factors may include regulatory or other actions by foreign regulatory agencies or government-controlled telecommunications companies or Year 2000-related problems in foreign countries that would prevent our international customers from accessing our PC2Phone service. For example, access to our PC2Phone services was recently blocked in certain countries in Asia and the Middle East by government-controlled telecommunications companies. These blockages have caused service interruptions that may cause us to earn as much as $250,000 less in PC2Phone revenue in the first quarter of fiscal 2000. While we have resumed service in each of these countries, there can be no assurance that there will not be future interruptions in these and other foreign countries or that we will be able to return to the level of service we had in each of these countries prior to any interruptions. Because we derive revenue from more than one source, we have experienced volatility in our direct cost of revenue. Specifically, our direct cost of revenue in the first two quarters of fiscal 1998 was low as a percentage of total revenue due to sales of equipment in these quarters. Because these sales were on a non-recurring basis, we realized a significant, albeit temporary, reduced direct cost of revenue for these two quarters. In the second half of fiscal 1998, we increased our advertising expenditures as we began marketing our Phone2Phone service. Revenue from our Phone2Phone service grew from approximately 4.4% of total revenue in the first half of the year to approximately 26.0% of total revenue in the latter half. We experienced start-up costs for Phone2Phone that increased our direct cost of revenue for those two quarters. However, we have been able to reduce direct cost of revenue for our Phone2Phone product as we expanded our network in fiscal 1999, which resulted in lower direct cost of revenue. In the most recent quarter, direct cost of revenue as a percentage of revenue accounted for approximately 54.0% as compared to approximately 80.4% in the quarter ended July 31, 1998. Our increased selling and marketing expenses reflect the relationships we have with various online strategic partners with whom we advertise our PC2Phone and Phone2Phone services. We expect to continue to increase significantly our advertising and marketing expenditures to build additional recognition of our products and services. As a result of our limited operating history and the emerging nature of the markets in which we compete, we are unable to accurately forecast our revenue and direct cost of revenue as they may be impacted by a variety of factors. These factors include the level of use of the Internet as a communications medium, seasonal trends, capacity constraints, the amount and timing of our capital expenditures, introduction of new services by us or our competitors, price competition, technical difficulties or system downtime, and the development of regulatory restrictions. 27 Liquidity and Capital Resources Since inception in January 1996, we have financed our operations through advances from IDT. In May 1999, we received $29.9 million in net proceeds from the sale of our Series A convertible preferred stock and warrants. We applied a portion of the net proceeds from this sale to repay $8.0 million of the $22.0 million of advances from IDT that were outstanding as of April 30, 1999. The remaining $14.0 million due to IDT was converted into a promissory note in May 1999. Our operating activities generated negative cash flow of approximately $3.7 million in fiscal 1998 compared to negative cash flow of approximately $2.3 million in fiscal 1999. Cash used in investing activities was approximately $5.2 million in fiscal 1998 and approximately $19.5 million in fiscal 1999. Our use of cash in investing activities was principally for the purchase of telecommunications and Internet equipment and for the purchase of a trademark in fiscal 1999. In August 1999, we completed the initial public offering of 6,210,000 shares of our common stock, for which we received approximately $85.3 million in net proceeds. From these proceeds, we repaid $7.0 million of the principal amount of the $14.0 million note due to IDT. We had approximately $99.6 million in cash and cash equivalents, as of July 31, 1999, after giving effect to our initial public offering and the exercise of stock options at the time of the closing of the initial public offering. Our principal commitments following the closing of this offering are expected to consist of: . repayment of the remaining $7.0 million outstanding principal balance on the $14.0 million note to IDT, which is payable in 60 monthly installments of principal and interest at a rate of 9% per annum, commencing in June 1999; . $5,000,000 of the $15,000,000 due to Go2Net under our distribution and marketing agreement; . $600,000 per month to InfoSpace.com for a period of 24 months under the amendment to our agreement; . $6.0 million to IDT, payable in 60 monthly installments of principal and interest at a rate of 9% per annum, in connection with the acquisition of a new network; and . other costs relating to network equipment and expansion. Our future capital requirements will depend on numerous factors, including market acceptance of our services, brand promotions, the amount of resources we devote to the development of our current and future products, and the expansion of our sales force and marketing our services. We may experience a substantial increase in our capital expenditures and lease arrangements consistent with the growth in our operations and staffing. Additionally, we will evaluate possible investments in businesses, products and technologies. We believe that our current cash balances, expected cash flow from our operations and the proceeds of this offering will be sufficient to meet our working capital and capital expenditure needs for at least the next 24 months. However, there can be no assurance that we will have sufficient capital to finance potential acquisitions or other growth oriented activities, and may issue additional equity securities, incur debt or obtain other financing. Warrant Issued to America Online In connection with our distribution and marketing agreement with ICQ, an America Online subsidiary, we issued a warrant to America Online to purchase up to 3% of our outstanding capital stock on a fully diluted basis. In connection with the America Online agreement, we amended the warrant to include the right to purchase an additional .5% of our outstanding capital stock on a fully diluted basis. This warrant will vest in three 1% increments and then one .5% increment upon the achievement of four incremental thresholds of revenue generated under the both the ICQ and America Online agreements during the first four years that the warrant is outstanding. The per share exercise price under the warrant for the first three 1% increments will be equal to the lesser of $12.00 per share or $450 million divided by the number of our fully-diluted shares on the initial exercise date. The per share exercise price under the warrant for the additional .5% increment is $60.46 per share. The warrant may be exercised for a period of five years through November 19, 2004. 28 For example, if the first revenue threshold was reached immediately after the closing of this offering, AOL would be permitted to purchase 1% of 61,166,647 shares, calculated as the sum of: . 17,672,616 shares of our outstanding common stock; . 33,924,250 shares of our common stock issuable upon conversion of our Class A stock; and . 9,569,781 shares of our common stock reserved for issuance upon exercise of stock options that are outstanding or reserved for issuance under our 1999 Stock Option and Incentive Plan. Thus, AOL would be permitted to purchase a total of 1,834,999 shares of common stock. The per share exercise price of the AOL warrant would be $7.36 per share, which is $450 million divided by the 61,166,647 fully-diluted shares expected to be outstanding. Year 2000 Systems Costs Computer systems, software packages, and microprocessor-dependent equipment may cease to function or generate erroneous data on or after January 1, 2000. The problem affects those systems or products that are programmed to accept a two-digit code in date code fields. For example, computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. To correctly identify the Year 2000, and therefore be "Year 2000 compliant," a four-digit date code field is required. We have conducted a comprehensive review of the computer hardware and software that we use in order to ensure that our computer-related applications are Year 2000 compliant. This review commenced when we were operated as a division of IDT, at which time IDT provided services in connection with this review. Our cost of addressing the Year 2000 issue is not expected to be material to our operations or financial position. However, the consequences of an incomplete or untimely resolution of the Year 2000 issue could be expected to have a material adverse effect upon our financial results. In the absence of such a resolution, our ability to route traffic in a cost effective manner, to deliver our services, to properly obtain payment for these services, and/or to maintain accurate records of our business and operations, could be substantially impaired until this issue is remedied. We may become liable for substantial damages in the event that, as a result of the Year 2000 issue, we fail to deliver any services that we have contracted to provide. Also, our name and reputation may be harmed if our services are disrupted due to Year 2000 problems. Our plan to ensure Year 2000 compliance consists of the following phases: . conducting a comprehensive inventory of internal systems; . assessing and priortizing any required remediation; . repairing or, if appropriate, replacing any non-compliant systems; . testing all remediated systems for Year 2000 compliance; and . developing contingency plans that may be employed in the event that any systems used by us is unexpectedly affected by a previously unanticipated Year 2000 problem. We have substantially completed each of these phases, and believe that our internal systems are Year 2000 compliant. We are conducting an external review of our customers and suppliers, and any other third parties with whom we do business, to determine their vulnerability to Year 2000 problems and any potential impact on us. These parties include our equipment and systems providers. In particular, we may experience problems to the extent that telecommunications carriers whose networks connect with ours are not Year 2000 29 compliant. Our ability to determine the ability of these third parties to address issues relating to the Year 2000 problem is limited. To the extent that a limited number of carriers experience disruptions in service due to the Year 2000 issue, we believe that we will be able to obtain service from alternate carriers. However, our ability to provide certain services to customers in selected geographic locations may be limited. There can be no assurance that such problems will not have a material adverse effect on our business, reputation or operating results. In addition, computer systems and software products in foreign countries may not be as prepared for the Year 2000 problem as computer systems and software products in the United States. Because a majority of our revenue is derived from customers located outside the United States, the failure of computer systems and software products in any foreign country as a result of Year 2000 problems could block access to our services in those countries, which may adversely affect our customer base and revenue. We are also in the process of developing contingency plans with regard to potential or unforeseen Year 2000 problems. We believe that, in the event that one or more of our systems, or the systems of third parties with which we do business, is impaired due to unanticipated Year 2000 issues, our contingency plans will enable us to temporarily conduct operations on a temporarily modified basis until the impaired system or systems is remediated. There can be no assurances that our suppliers and customers will achieve full year 2000 compliance before the end of 1999 or that we will develop or implement effective contingency plans on a timely basis. A failure of our computer systems or the failure of our suppliers or customers to effectively upgrade their software and systems for transition to the Year 2000 could have a material adverse effect on our business, financial conditions and results of operations. Most of our internal systems were developed after developers became aware of Year 2000 problems. To date, we have not incurred material expenses in connection with the remediation of Year 2000 related issues. We do not expect to incur significant costs in connection with Year 2000 related issues. However, our actual costs may be significant if we discover that any major portion of our internal systems requires unforeseen remediation. We expense costs associated with Year 2000 remediation when they are incurred. Effects of Inflation Due to relatively low levels of inflation over the last several years, inflation has not had a material effect on our results of operations. 30 BUSINESS Overview Net2Phone is a leading provider of services enabling users to make high- quality, low-cost telephone calls over the Internet. This service is commonly referred to as Internet telephony. Our Internet telephony services enable our customers to call individuals and businesses worldwide using their personal computers or traditional telephones. We are leveraging our Internet telephony expertise to integrate real-time voice communication capabilities into the Web. We currently offer Web-based Internet telephony services, which enable customers to make calls and send faxes over the Internet using their personal computers, and basic Internet telephony services, which enable customers to make calls using traditional telephones and fax machines. We have developed a sophisticated PC2Phone software application that enables the use of our Web-based Internet telephony services. We distribute this software free of charge through the Internet and through agreements to include our software with products sold by our strategic partners. In January 1999, Netscape agreed to integrate our PC2Phone software on an exclusive basis into future versions of Netscape's Internet browser released during the term of our agreement, including the Netscape Communicator products. Netscape also agreed to include a Net2Phone icon on the Netscape Navigator Personal Toolbar. In addition, we have entered into an agreement with ICQ, a subsidiary of America Online, to provide Internet telephony services to users of ICQ's instant messaging service. ICQ will integrate some of our Internet telephony software into ICQ's Instant Messenger software on an exclusive basis, allowing ICQ users to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls. We will also co-brand a pre-paid phone-to-phone calling card with ICQ, allowing users to place calls from the United States and 19 other countries to virtually anywhere in the world. In addition, we have entered into strategic marketing and distribution relationships with leading Internet companies, including Yahoo!, Go2Net, InfoSpace.com, Snap.com, Excite, and ZDNet. We have also entered into arrangements with leading computer equipment and software companies, such as IBM, Compaq and Packard Bell-NEC Europe to include our software with their products. We promote our services through direct sales and marketing and through international resellers who buy minutes of use from us in bulk, and resell them to customers in their respective countries. Our software is currently available in ten languages (English, Spanish, Japanese, French, Dutch, Portuguese, Italian, German, Swedish and Chinese). We intend to make our software available in additional languages as we expand our international customer base and distribution channels. As of July 31, 1999, we served over 325,000 active customers who made an average of approximately 60 minutes of calls per month and handled over 20 million minutes of use per month. Our net loss increased from approximately $500,000 in fiscal 1996, $1.7 million in fiscal 1997 and $3.5 million in fiscal 1998 to $24.7 million in fiscal 1999. Our total assets increased from $916,000 at July 31, 1997 and $7.0 million at July 31, 1998 to $50.8 million at July 31, 1999. Our revenue has grown substantially, increasing from approximately $2.7 million in fiscal 1997 to approximately $12.0 million in fiscal 1998. Our revenue for fiscal 1999 was approximately $33.3 million. Industry Background The Internet is experiencing unprecedented growth as a global medium for communications and commerce. International Data Corporation estimates that the number of Internet users worldwide will grow from approximately 142 million at the end of 1998 to 399 million by the end of 2002. These users are increasingly using the Internet as a communications medium. A recent study by E-Marketer, a market research firm, estimated that 9.4 billion e-mail messages are delivered daily. Instant text communication through online "chat" rooms is also gaining widespread acceptance. 31 Online commerce is also becoming widely accepted as a means of doing business. According to International Data Corporation, Internet users worldwide purchased more than $50 billion of goods and services in 1998. International Data Corporation projects that commerce over the Internet will grow to approximately $1.3 trillion in 2003. Emergence of Internet Telephony TeleGeography, a market research firm, estimates that the international long distance market will grow to $79 billion in 2001, with consumers and businesses making an estimated 143 billion minutes of international long distance calls. Despite the large size of this market and the number of minutes of calls made, traditional international long distance calls are still relatively expensive for the consumer. The primary reason for this expense is tariffs set by foreign governments and carriers that are passed on to consumers in the form of higher long distance rates. Internet telephony has emerged as a low cost alternative to traditional long distance calls. International Data Corporation projects that the Internet telephony market will grow rapidly to over $19 billion in 2004, from approximately $480 million in 1999. Internet telephone calls are less expensive than traditional international long distance calls primarily because these calls are carried over the Internet or our network and therefore bypass a significant portion of international long distance tariffs. The technology by which Internet phone calls are made is also more cost-effective than the technology by which traditional long distance calls are made. We use a technology called "packet-switching" to break voice and fax calls into discrete data packets, route them over the Internet or our network and reassemble them into their original form for delivery to the recipient. Traditional international long distance calls, in contrast, are made using a technology called "circuit switching" which carries these calls over international voice telephone networks. These networks are typically owned by governments or carriers who charge a tariff for their use. Circuit switching requires a dedicated connection between the caller and the recipient that must remain open for the duration of the call. As a result, circuit-switching technology is inherently less efficient than packet-switching technology which allows data packets representing multiple conversations to be carried over the same line. This greater efficiency creates network cost savings that can be passed on to the consumer in the form of lower long distance rates. Integration of Voice into the Web We believe that Internet telephony offers significant benefits to consumers and businesses over and above international long distance cost savings. The technologies that enable Internet telephony can be applied to integrate live voice capabilities into the Web. We believe that this integration can enhance the potential for the Internet to become the preferred medium for both communications and commerce. For example, the integration of voice into the Web would supplement existing text-based modes of Internet communication such as e- mail and online chat by adding a live, secure, low-cost or free voice alternative. We believe that this will be attractive both to consumers and businesses. In addition, voice-enabling the Web would give Internet shoppers the ability to speak directly with customer service representatives of online retailers in order to ask questions and alleviate concerns about online security. This may increase the probability that a sale is made and may give online retailers a key competitive advantage by providing them with opportunities to sell higher margin and additional products to these customers. Voice-enabling a commercial Web site may also give online retailers the ability to provide more responsive customer support and service. Integrating live voice capabilities into the Web would also enable Internet companies to offer enhanced communications services, such as providing Internet users with a central source for retrieving voicemail, 32 e-mail, faxes and pages. We believe this would allow these companies to attract more users to their sites and to increase the amount of time these users spend on their sites. This increased usage will allow these Internet companies to attract advertisers and secure higher advertising rates, thereby increasing revenue. Limitations of Existing Internet Telephony Solutions The growth of Internet telephony has been limited to date due to poor sound quality attributable to technological issues such as delays in packet transmission and network capacity limitations. However, recent improvements in packet-switching technology, new software algorithms and improved hardware have substantially reduced delays in packet transmissions. In addition, the use of private networks to transmit calls as an alternative to the public Internet is helping to alleviate network capacity constraints. Finally, the emergence of new, lower cost Internet access technologies, such as high-speed modems, are addressing local Internet access issues. Several large long distance carriers, including AT&T and Sprint, have announced Internet telephony service offerings. However, many of these service offerings have not been deployed on a large scale. Many also require users to purchase other telecommunications services or allow only domestic calling. Smaller Internet telephony service providers also offer low-cost Internet telephony services from personal computers to telephones and from telephones to telephones. These services, however, are available only in limited geographic areas and require payment by credit card which may preclude many international customers from signing up for these services. We also believe that existing Internet telephony service providers rely upon technologies and systems that lack large-scale billing, network management and monitoring systems, and customer service capabilities required for the integration of voice communication into the Web. In addition, many companies currently provide Internet telephony software and services that allow Internet telephone calls to be made between personal computers. However, most of these companies require both the initiator and the recipient of the call to have the same software installed on their personal computers and to be online at the same time. The Net2Phone Solution We deliver high-quality Internet telephony services and voice-enabling Web applications to consumers and businesses. Our solution provides the following benefits to our customers: . Low Cost. Our PC2Phone software is distributed free of charge, and our services allow our customers to make telephone calls often at a fraction of the cost of traditional long distance service. Because international long distance calls routed over the Internet bypass the international settlement process, we are able to charge lower rates than traditional long distance carriers. . High Voice Quality. We offer high voice quality through our proprietary packet-switching technologies, which reduce packet loss and delay, route packets efficiently and perform quality enhancing functions, such as echo cancellation. We intend to continue to enhance the voice quality of our services as our customer base and business grow. . Ease of Use and Access. Our services are designed to be convenient and easy to access from anywhere in the world. To make a call using our Web- based services, a customer need only install our free software on a sound-enabled personal computer, register and be connected to the Internet. No additional telephone lines or special equipment are required. Our Phone2Phone service is also easy to use and requires a customer only to register and dial a toll-free or local access number from any telephone or fax machine. . Voice-Enabled Online Retailing. Our services enable users anywhere in the world to speak with sales or customer service representatives of online retailers and other Web-based businesses while visiting their Web sites. This provides customers an opportunity to ask questions of and to provide credit card information directly to a customer service representative if they are concerned about Internet security, thereby increasing the likelihood of consummating an online sale. In addition, 33 our services allow our customers outside of the United States and Canada to access telephone numbers that might otherwise be inaccessible to them through their local carriers. For example, users of our services in other countries may call United States or Canadian toll-free numbers (i.e., telephone numbers with 800, 877 or 888 prefixes), which are not otherwise available to them, at no charge. The ability to communicate with international customers in this manner provides United States and Canadian-based online retailers and other Web-based businesses with cost effective access to an expansive international customer base. . Reliable Service. Our network is reliable because of its technologically advanced design. This design allows us to expand our network and add capacity by adding switches to the existing network. Our system also provides seamless service and high-quality voice transmission through our ability to reroute packets if problems arise. We believe that our ability to provide reliable service is essential to voice-enable the Web. . Ease of Payment and Online Account Access. Once registered, our customers are able to make unlimited toll-free calls. In addition, they can make toll calls by opening a prepaid account using credit cards, wire transfers or checks payable in United States dollars. Acceptance of payment in multiple forms enables international customers who may not necessarily have credit cards to use our services. Our customers can access their accounts via the Internet in order to view their call history and account balances, and to increase their prepaid amounts. . Customer Support. We offer live customer support 24 hours a day, seven days a week in multiple languages. Our customer support center can be accessed from anywhere in the world at no charge either by calling our toll-free number, where available, or by using our Web-based Internet telephony service. Our integrated customer billing software and call management system provide our customer support staff with immediate access to user accounts, calling patterns and billing history to help us provide better, more responsive customer support. Strategy Our mission is to become the premier Web-based communications enabler. We intend to leverage our leadership position in the Internet telephony market to make our communications services readily available worldwide on the Internet and to develop and market online commerce and related products. Our strategy includes the following key elements: . Drive Usage through Resellers and Strategic Partners. We promote our services through direct sales and marketing and through relationships with international resellers and leading Internet hardware, software and content companies. We intend to build on these relationships and to add more partners and resellers to drive usage of our Internet telephony services. We also intend to partner with large telecommunications companies to enable them to offer our Internet telephony services under their brand. . Pursue Multiple Sources of Revenue. In addition to our minutes-based revenue, we intend to pursue new Web-based revenue opportunities from banner and audio advertising, as well as sponsorship opportunities on our PC2Phone software user interface and our EZSurf.com Web site. We also intend to explore the availability of revenue-sharing opportunities with online retailers. . Enhance Brand Recognition. We have established strong brand identity in the Internet telephony market in large part due to the high-quality of our services and our marketing efforts. We have entered into advertising relationships with leading Web companies such as Netscape, ICQ, Go2Net, InfoSpace.com, Yahoo! and Excite in order to promote our services. We intend to continue to implement aggressive advertising and sales campaigns to increase brand awareness. In addition, we intend to enhance our brand recognition by cooperatively marketing our Internet telephony services with leading computer hardware and software companies and Internet services providers. . Make Our Software Readily Available Worldwide. We have entered into strategic distribution relationships with leading computer equipment and software companies to expand the availability 34 of our software. For example, our software will be embedded into future versions of Netscape's Internet browser and a Net2Phone icon will be prominently positioned next to AOL's Instant Messenger icon on the Netscape Navigator Personal Tool Bar. In addition, customized versions of some of our Internet telephony services will be integrated into ICQ's instant messaging software and distributed by ICQ. Our software is included with IBM's Internet services and may be pre-loaded on computers sold by Compaq internationally. We intend to build upon these relationships and enter into new distribution relationships with other leading companies in order to enhance the distribution of our software worldwide. . Expand and Enhance Products and Services. We have committed significant resources to expand our network, enhance our existing product and service offerings and to develop and market additional products and services in order to continue to provide customers with high-quality Internet telephony services. For example, we plan to introduce new products and services, including: . PC2PC, which will allow high-quality Internet telephony from one personal computer to another; . Phone2PC, which will allow calls from a traditional telephone to a personal computer; . voice-enabled chat, which will allow two participants in an online chat room discussion to establish direct voice communication with each other while maintaining anonymity; . unified messaging services, which will include voice, fax and electronic messaging with multiple points of access, including the Web and conventional telephones; . online commerce applications, which will provide customer service representatives of online retailers with real-time access to a caller's profile and enable them to "push" specific content onto a caller's personal computer screen in order to better assist the caller in answering their inquiries; . customer payment applications, which will allow customers to pay for online commerce transactions by debiting their Net2Phone account; and . video conferencing between two or more personal computer users over the Internet. Strategic Relationships We have entered into strategic distribution, integration and advertising relationships with leading Internet and computer hardware and software companies. These relationships typically include arrangements under which we share with our strategic partners a portion of the revenue they bring to us. We believe that these relationships are important because they provide incentive to our partners and allow us to leverage the strong brand names and distribution channels of these companies to market our products and services. Our strategic partners include: Netscape Netscape has agreed to embed our PC2Phone software on an exclusive basis in future versions of Netscape's Internet browser released during the term of our agreement, including the Netscape Communicator products. Netscape also has agreed to: . place a Net2Phone icon on the Netscape Navigator Personal Toolbar immediately to the right of the AOL Instant Messenger icon, which will allow Netscape users to use our Web-based Internet telephony services from anywhere on the Web simply by clicking on our icon; . integrate our services into, and display our services on, the Netscape Netcenter site, including Netscape's Contacts section and Address Book section, which will allow Netscape users to make calls using our services simply by clicking on a displayed telephone number; and 35 . include the software for our Web-based Internet telephony services in Netscape's suite of online plug-in software and Netscape Smart Update programs (both domestically and when available internationally) for downloading by Netscape users from centralized locations on Netscape's Web site. We also have the right to place a specified number of banner and other advertisements on Web pages of our choice on Netscape's domestic and international Web sites. The two-year term of our exclusive agreement with Netscape commences with the beta release of the next version of Netscape's Internet browser. This next version of Netscape's Internet browser has not yet been released, and our agreement with Netscape does not provide for a date by which it will be released. Accordingly, we would not expect any potential PC2Phone revenue related to our agreement with Netscape until their product is released. ICQ In July 1999, we entered into an exclusive, four-year distribution and marketing agreement with ICQ, a subsidiary of America Online. Under this agreement, ICQ has agreed to: . co-brand and promote our phone-to-phone Internet telephony services in the United States and in 19 other countries; . integrate customized versions of some of our Internet telephony services on an exclusive basis into ICQ's instant messaging software to allow ICQ customers to make PC-to-phone and PC-to-PC calls and to receive phone- to-PC calls; . share revenue from some advertisements and sponsorships sold by ICQ within Internet-telephony-related areas within ICQ's instant messaging software; and . promote our services on some of ICQ's Web sites. All of our Internet telephony services that ICQ promotes under our agreement will be co-branded under both of our labels. Although our agreement with ICQ does not provide for definitive launch dates, we believe the phone-to-phone services will be launched in the United States later this year and internationally by early 2000. We also believe that the PC-based Internet telephony services will be launched in mid-2000. America Online In November 1999, we entered into a three-year integration, distribution and marketing agreement with America Online. Under this agreement, America Online will integrate customized versions of our core Internet telephony services, on an exclusive basis for a period in excess of two of the years, into the America Online instant messaging software, allowing members of America Online instant messaging to make PC-to-phone and phone-to-PC calls and to use our PC-to-fax, fax-to-PC and conference calling services. We will also co-brand phone-to-phone Internet telephony calling cards, which America Online will promote on the America Online instant messaging controlled properties. CompuServe In November 1999, we entered into a two-year marketing agreement (exclusive for the first year) with CompuServe, a subsidiary of America Online. Under this agreement, CompuServe has agreed to promote our phone-to-phone Internet telephony calling card services through the United States version of the CompuServe interactive service. 36 Go2Net In October 1999, we entered into an exclusive three-year distribution and marketing agreement with Go2Net, a network of branded, technology-and community-driven Web sites. Under this agreement, Go2Net has agreed to integrate co-branded versions of our Internet telephony products and services into the Go2Net Network. In addition, together with Go2Net and CommTouch Software Ltd., a provider of email solutions, we will create a unified communication and messaging platform on the Go2Net Network that will enable users to send and receive voice mail, faxes, email and telephone calls over the Internet. In addition, in the event Go2Net provides start pages or customized portal offerings for third parties distributed through set-top devices, cellular phones, personal digital assistants (also known as PDAs) and similar devices, we have the exclusive option to incorporate our services into such offerings to the extent Go2Net has the right to include Internet telephony services in such offerings. InfoSpace.com In March 1999, we entered into an agreement with InfoSpace.com, a leading Internet infrastructure company. Under this agreement, for a period of 30 months, one or more textual or graphical links to our www.net2phone.com Web site will be displayed on all then existing and future versions of InfoSpace.com's Web sites and its affiliate network sites, including Netscape's Netcenter Web site, the Microsoft Network, the GO Network and Xoom.com. In addition, our software is integrated into InfoSpace.com's network of white and yellow page directory services. In August 1999, we amended our agreement with InfoSpace.com under which InfoSpace.com will place on its affiliate network sites and, on an exclusive basis, on its own Web site, for a period of two years, advertisements, promotions, links, banners, logos and integrated access to our PC2Phone service and, upon release, our new unified messaging service. Priceline.com In November 1999, we entered into a memorandum of understanding and a co- marketing agreement with priceline.com, an Internet commerce service that allows users to name their own price to purchase goods and services over the Internet. Under the terms of our memorandum of understanding, we expect to offer our international and domestic Phone2Phone services as a premier provider through priceline.com, enabling priceline.com customers to name their own price to purchase blocks of minutes of our Phone2Phone services. It is expected that our Phone2Phone services will be offered for sale through priceline.com in the following manner: . domestic time blocks, where customers can name their own price for blocks of domestic long distance Phone2Phone minutes; . international time blocks, where customers can name their own price for blocks of international long distance Phone2Phone minutes to a specified country; and . priceline.com's "Call Anywhere" program, where customers can name their own price for blocks of Phone2Phone minutes that can be used to call multiple designated locations; the actual amount of time purchased will vary per location. We also expect to work with priceline.com to develop an offer-by-phone service which will enable consumers to make offers to purchase Phone2Phone services from us on a per-call basis. Under the terms of the co-marketing agreement, we will participate in a co-marketing program with priceline.com through December 31, 1999. 37 Yahoo! and Excite In 1998, we signed an agreement with Yahoo!, which was recently renewed through 2000. Our Web-based Internet telephony service is integrated into the Yahoo! People Search online telephone directory. As a result of this integration, an Internet user who performs a search on Yahoo! People Search can, after installing our software, simply click on a displayed telephone number to initiate a call to that number. Under this agreement, we also have the right to have our banner advertising appear when an Internet user performs a word- or category-search for "Internet Telephony" or related phrases on Yahoo! Additionally, our PC2Phone service is integrated into the Yahoo! Yellow Pages online directory. Our Web-based Internet telephony software is also integrated into Excite's Web sites in its International Network, which includes the United Kingdom, Germany, France, Japan, Italy, Australia, Sweden and the Netherlands. As a result, an Internet user in any of these countries will be able to click on any telephone number that appears on any page on these sites to initiate a call to that number using our PC2Phone service. In addition, our services will be prominently featured within the Excite International Network via advertising and promotion on various channels, including each member's homepage, business, technology/computer and travel channels, as well as the localized versions of My Excite, What's New/What's Cool and Mail Excite. We are negotiating with Excite to have our services integrated into Excite's United States Web sites as well. Other Strategic Relationships We also have entered into other important strategic relationships with other leading Internet and computer hardware and software companies, including: . Compaq. Our software is featured as a download from a special Compaq Web site accessible directly from the Compaq-branded keyboard, may be pre- installed on Compaq-branded computers distributed internationally and may be included with their other products. . Snap.com. Promotions for our services and a link to our Web site will be prominently displayed on the Snap.com Web site, and we are their preferred provider of PC-to-phone services. . ZDNet. We are the preferred provider of Internet telephony services for ZDNet and our Web-based Internet telephony service will be integrated throughout the ZDNet Web site. . WebHosting.com, 9Net Avenue, and Advanced Internet Technologies. Web hosting companies webhosting.com, 9Net Avenue, and Advanced Internet Technologies will resell our Click2Talk and Click2CallMe services to their clients. . AT&T. We have entered into an agreement with AT&T to be the exclusive provider of PC-to-phone service on the AT&T WorldNet Beta Site for a period of 90 days through January 15, 2000. Under the terms of the agreement, we will also provide 200 minutes of free calling time for calls that terminate in the United States to one AT&T WorldNet Beta Site member per household who has not previously used our PC-to-phone service. . Sprint. Sprint is testing our Internet telephony technology and international network for international consumer long distance calls to Asia through a service called Sprint Callternatives. As part of this test, we provide dedicated customer service, 24 hours a day, seven days a week to assist customer inquiries in multiple languages, including Mandarin, Cantonese and Korean. In addition, our advanced billing technology allows users of this service to view their telephone accounts in real time from our Web site. 38 Products and Services Our services enable our customers to make low-cost, high-quality phone calls over the Internet using their personal computers or traditional telephones. Our principal current product and service offerings are described in the table below. Product/Service Description Benefits - -------------------------------------------------------------------------------- Basic Internet Telephony Services: . Phone2Phone . Enables customers to . International long make calls over distance rates are . Fax2Fax traditional telephones typically 50% to and fax machines routed 70% lower than the . Net2Phone Pro over the Internet. rate charged by Customers must dial a traditional long local or domestic toll- distance carriers free access number to for calls access the Net2Phone originating in the network. United States, and up to 95% lower for . Customers are charged calls originating for toll and long outside the United distance calls on a States. per-minute basis. There . Users do not need is no charge for to purchase calling United States expensive hardware and Canadian toll-free or software. numbers. . Available in the United . High voice quality. States and in many . Faxes are international transmitted without locations. delay and users receive immediate . We market Phone2Phone delivery under the brand confirmations. "Net2Phone Direct." - -------------------------------------------------------------------------------- Web-based Internet Telephony Services: . PC2Phone . Enables customers to . Services are make calls and send available to any . Click2Talk faxes over the Internet Internet user with using their personal a sound-equipped . PC2Fax computers. Customers personal computer. must install our . Facilitates online software on their commerce by . Click2CallMe personal computers, providing live register with us and be voice contact online in order to make between online calls. retailers and Internet shoppers. . When browsing Web sites that have a Click2Talk . Customers do not icon, customers may require multiple initiate calls to a telephone lines and company whose site they need not log off are browsing simply by the Internet to clicking on the initiate a call. Click2Talk icon. . International long . Using Click2CallMe, distance rates are customers can request typically 50% to return telephone calls 70% lower than the at a specified time rates charged by from a company's Web traditional long site they are browsing distance carriers simply by clicking on for calls the Click2CallMe icon. originating in the United States, and . Customers are charged up to 95% lower for for toll and long calls originating distance calls on a outside the United per-minute basis. There States. is no charge for calling United States . United States and and Canadian toll-free Canadian toll-free numbers. numbers can be accessed from outside the United States and Canada. - -------------------------------------------------------------------------------- EZSurf.com . A Web-based shopping . Enables voice directory powered by communications with our Web-based Internet over 300 Web sites. telephony services from . Educates users by which Internet users providing them with can initiate calls to essential listed online retailers information by clicking on an icon required to buy on the Web site. products online. . Lists useful information for key online retailers, including payment and shipping options and return policies. 39 Sales, Marketing and Distribution We distribute our software through the Internet, strategic partnerships and international resellers. In addition, our software will be embedded into future versions of Netscape's browser, which, according to International Data Corporation, was used by 41.5% of all consumer Internet users in mid-1998. Additionally, our software will be distributed into future versions of ICQ's Instant Messenger software. Customers can also download our software at no charge from our Web site and through links on other Web sites, including Yahoo!'s People Search and Lands' End's home page. We also distribute our software through strategic relationships with leading Internet and computer hardware and software companies, including IBM, Compaq and Packard Bell-NEC Europe. Our software is included with our partners' products and services and distributed domestically and internationally. We expect to distribute over 20 million units of our software in 1999 as a result of these and other distribution arrangements. We have also entered into agreements with three Web hosting companies, WebHosting.com, 9Net Avenue and Advanced Internet Technologies, under which they will resell our Click2Talk and Click2CallMe services to their customers. We promote our services through online and Internet-based advertising venues and traditional print advertising in domestic and international publications. We will also be advertising our services on the NBC television network. Another way we sell our services internationally is by entering into exclusive agreements with resellers in other countries. We sell these resellers bulk amounts of minutes of use of our products and services to be resold in the resellers' respective countries. For example, in Asia, we have agreements with Daewoo and Naray Mobile Telecom in South Korea and Marubeni in Japan. In Europe and the Middle East, we have agreements with CAPCOM in Spain and Dot.LB in Lebanon, among others. To facilitate distribution and attract users in foreign countries, we have developed our software in ten languages (English, Spanish, Japanese, French, Dutch, Portuguese, Italian, German, Swedish and Chinese) and intend to increase the number of languages as our distribution broadens. Customer Service As part of our goal to attract and retain customers, we offer free live customer support in multiple languages. We employ approximately 101 customer service representatives, who offer customer support to our users 24 hours a day, seven days a week. These services can be reached from anywhere in the world at no cost using either our toll-free number, where available, or our Web-based Internet telephony services. The customer support staff provides technical assistance, as well as general service assistance, for all of our products and services. We also offer customer support via e-mail and fax. Our integrated customer billing software and call management system provide our customer support staff with immediate access to user accounts, calling patterns and billing history, thereby enhancing the quality of service provided to our customers. In addition, our international resellers typically provide their own front-line customer support. Technology PC2Phone Software Our PC2Phone software is simple to install and to use and has won various industry awards. The installation process is wrapped in the industry-standard "Install Shield" product. During installation, the Net2Phone "wizard" verifies that the user's microphone and speakers are properly set for Internet telephony. The installation also has a service registration process that allows the customer to quickly register for paid time with the product. Our software has several buttons and drop down headings to enable customization. These buttons allow the user to change specific properties, access and modify customer account information, program and use speed dialing and verify rates. 40 Our PC2Phone software has gone through fourteen releases, each improving upon our Internet telephony capabilities. The software is a Windows-compliant, 32-bit application written in a high-level PC language. The code is extendible allowing us to easily add new functionality, yet is relatively compact. The newest version of our software, can record and play sound files allowing us to deliver voice-mail services and can interface with third party PC mail software applications such as Eudora and Microsoft Outlook. We expect this to be released in beta form by November 30, 1999 and commercially by December 31, 1999. We also have developed a software development kit allowing other companies to quickly and easily integrate their products with our PC2Phone software. For example, our services have been successfully integrated with Quicknet's line of sound cards and telephone interface cards. This integration enables Internet telephony service to be deployed through inexpensive equipment currently used throughout the world. Call Management System To maintain our leadership position in the Internet telephony market, we believe that reliable and flexible billing, information management, monitoring and control systems are critical. Accordingly, we have invested substantial resources to develop and implement our sophisticated real-time call management information system. Key elements of this system include: . Customer Provisioning. The system provides automated online customer registration and customer registration through call centers and resellers. It also provides online credit card authorization and batch billing capabilities that streamline customer registration. A special remote access application program allows other people access to our database, enabling sophisticated partners to remotely service customers through our system, and to tie our system directly to their own business systems. This remote capability includes remote account management and continuous real-time call detail and billing information. Additionally, the system makes customer account records readily available to call center representatives in the event of customer billing problems. . Customer Access. Our system allows customers to independently access their billing records online without the need to contact customer service representatives. . Fraud Control. Fraud detection and prevention features include caller authentication, prevention of multiple simultaneous calls using the same account, pin code verification and call duration timers. We also generate reports on suspicious calling patterns to detect caller registration fraud. We routinely scan for fraudulent content before credit card purchases are allowed. . Network Security. Firewalls are employed to prevent attacks on our network. We use sophisticated techniques to safeguard sensitive database information. In addition, we encrypt call requests and portions of the call to prevent "network sniffers" from unauthorized access to data. . Call Routing. The network management system identifies and routes calls to the most efficiently priced carrier. The system also automatically routes calls around links or servers that are experiencing problems, have failed or have been manually taken out of service for maintenance or upgrades. This system provides remote administration facilities for maintaining routing tables and system monitoring. . Monitoring. The management system provides for real-time monitoring of all call information. We are able to track potential problems such as too many short calls on a server or a low percentage of call completions. The system also provides remote management that allows partners to monitor and manage their own accounts. . Reliability. We maintain two separate network operations centers in Hackensack and Lakewood, New Jersey. These facilities house redundant equipment and have the ability to track calls simultaneously. This redundant system gives our network a high degree of reliability, enabling each network operations center to serve as a back-up to the other. 41 . Detailed Call Records. The management software maintains detailed records for each call, including the account number of the caller, the caller's phone number, access number used, the point at which the call enters and exits our network, the account owner, the calling party, the server/service phone number, the number of the called party, a running account balance, and rate and billing information, including surcharges. The Net2Phone Network Through an agreement with IDT, we lease capacity on an Internet network comprised of leased high-speed fiber optic lines connecting eight major cities across the United States, and lease high-speed fiber optic lines connecting smaller cities to the network. We have a right to use network capacity leased by IDT. The network backbone uses state-of-the-art hardware including Cisco Series 7000 routers and Nortel Passport switches. Our high-speed backbone connects traffic at four major public Internet exchange points and is also facilitated by a growing number of private peering or exchange points with other networks. Through peering arrangements, we exchange Internet traffic with 25 other Internet backbone providers at these points. We operate IDT's network, one of the largest Internet access networks, providing local dial-up access through 36 locations. Our Internet network also includes more than 700 additional network access locations owned by local and regional Internet service providers. In addition, we entered into an agreement with AT&T Global Network Services, under which AT&T will provide us with managed IP networking services and collocation services, enabling us to extend the international reach of our Internet telephony services over AT&T's global network to 17 countries, with a dozen other countries under consideration for future expansion. AT&T will also provide collocation services for our servers at AT&T's Local Interface Gateway locations (or points of presence) in those countries. We are able to provide service in areas where we do not have dial-up equipment by utilizing call-forwarding technology to expand our coverage areas by increasing the total number of local access numbers. We have been closing down multiple network access points in a number of states in order to consolidate our equipment into central "Super Point of Presence" locations. For example, one Super Point of Presence in New Jersey can supply local access for the entire state of New Jersey. The diagram below illustrates the routing of an Internet telephony call initiated by a customer using a telephone, fax or a personal computer to a terminating telephone or fax machine over our network. [Call routing diagram] We seek to retain flexibility by utilizing dynamic call routing alternatives. This approach is intended to enable us to take advantage of the rapidly evolving Internet market in order to provide low-cost service to our customers. Accordingly, our network employs an "Open Shortest Path First" protocol that promotes 42 efficient routing of traffic. Additionally, we have placed redundant hardware for reliability in high traffic areas to minimize loss of data packets. Each network data exchange point employs hardware to direct network traffic and a minimum of two dedicated leased data lines to increase reliability. We manage our network hardware remotely. It is compatible with a variety of local network systems around the world. We believe our Internet telephony network can currently support approximately 5,000 simultaneous calls. We believe our systems are scalable to 10 times their current capacity through the purchase and installation of certain additional hardware. To date, the highest number of simultaneous calls serviced by our network was 1,975 simultaneous calls made on September 15, 1999. The Network Operations Center Our Network Operations Center, located in Hackensack, New Jersey, currently employs a staff of 34 people. There are two groups that work within the network operations center, the network analysis group and the Internet telephony monitoring group. Both groups have 24 hours a day, seven days a week coverage to quickly respond to any issues. The network analysis group works around-the-clock monitoring network issues, handling customer requests, repairing outages and solving security problems. Our monitoring group oversees a nationwide real-time network analysis map, which notifies our staff of network errors. They also use software we developed to monitor our hardware around the world. This group can dynamically turn on or turn off equipment and re-route Internet telephony traffic, as necessary. Customers We have a diverse, global customer base. As of July 31, 1999, approximately 69% of our customers were based outside of the United States. As of July 31, 1999, we served over 325,000 active customers who had used our services during the preceding three months. In addition, as of October 10, 1999, we had installed the Click2Talk service on approximately 176 commercial Web sites. Competition Long Distance Market The long distance telephony market and, in particular, the Internet telephony market, is highly competitive. There are several large and numerous small competitors, and we expect to face continuing competition based on price and service offerings from existing competitors and new market entrants in the future. The principal competitive factors in the market include price, quality of service, breadth of geographic presence, customer service, reliability, network capacity and the availability of enhanced communications services. Our competitors include AT&T, MCI WorldCom and Sprint in the United States and foreign telecommunications carriers. Many of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we have. As a result, certain of these competitors may be able to adopt more aggressive pricing policies, which could hinder our ability to market our Internet telephony services. One of our key competitive advantages is the ability to route calls through Internet service providers, which allows us to bypass the international settlement process and realize substantial savings compared to traditional telephone service. Any change in the regulation of an Internet service provider could force us to increase prices and offer rates that are comparable to traditional telephone call providers. 43 Web-Based Internet Telephony Services As consumers and telecommunications companies have grown to understand the benefits that may be obtained from transmitting voice over the Internet, a substantial number of companies have emerged to provide voice over the Internet. In addition, companies currently in related markets have begun to provide voice over the Internet services or adapt their products to enable voice over the Internet services. These related companies may potentially migrate into the Internet telephony market as direct competitors. . Internet Telephony Service Providers. During the past several years, a number of companies have introduced services that make Internet telephony services available to businesses and consumers. In addition to us, AT&T Jens (a Japanese affiliate of AT&T), deltathree.com (a subsidiary of RSL Communications), I-Link, iBasis (formerly known as VIP Calling), ICG Communications, IPVoice.com, ITXC and OzEmail (which was acquired by MCI WorldCom) provide a range of voice over the Internet services. These companies offer PC-to-phone or phone-to-phone services that are similar to the services we offer. Some, such as AT&T Jens and OzEmail, offer these services within limited geographic areas. Additionally, a number of companies have recently introduced Web-based voice-mail services and voice-chat services to Internet users. . Software/Hardware Providers. Many companies produce software and other computer equipment that may be installed on a user's computer to permit voice communications over the Internet. These products generally require each user to have compatible software and hardware equipment and rely on the public Internet for the transmission of traffic, which often results in reduced quality of communications. Representative companies include VocalTec, Netspeak and e-Net. We believe VocalTec's software and hardware are unable to handle large numbers of simultaneous calls. Netspeak focuses on delivering solutions targeted at traditional call centers that require significant customization. . Telecommunications Companies. A number of telecommunications companies, including AT&T, Deutsche Telekom, MCI WorldCom and Qwest, currently maintain, or plan to maintain, packet-switched networks to route the voice traffic of other telecommunications companies. These companies, which tend to be large entities with substantial resources, generally have large budgets available for research and development and therefore may enhance the quality and acceptance of the transmission of voice over the Internet. However, many of these companies are new to the Internet telephony market, and therefore may not build brand recognition among consumers for these services. These companies also may not have the range of product and service offerings that are necessary to independently provide a broad set of voice-enabled Web services. AT&T, for example, has attempted to enter the market but has focused its effort on the cable market and it is unclear if it will continue to pursue voice over the Web. Qwest has taken steps to enter the market by building a high capacity network in the United States. In addition, Qwest has also entered into a three-year strategic alliance with Netscape to provide one-stop access to Internet services including long distance calling, e-mail, voice mail, faxes, Internet access and conference calls. . Network Hardware Manufacturers. Several of the world's major providers of telecommunications equipment, such as Alcatel, Cisco, Lucent, Northern Telecom and Dialogic (which was acquired by Intel) have developed or plan to develop network equipment that may be used in connection with the provision of voice over the Web services, including routers, servers and related hardware and software. By developing this equipment, these manufacturers may exert substantial influence over the technology that is used in connection with transmission of voice over the Web and may develop products that facilitate the quality and timely roll-out of these networks. However, these companies are dependent upon the operators of Internet telephony networks to purchase and install their equipment into their networks. They are also dependent upon the developers of hardware and software to market their systems to end users. Cisco currently manufactures Internet telephony equipment for low to medium scale networking, but does not manufacture high-end Internet telephony equipment for large networks. However, Cisco recently acquired two companies that 44 produce devices to help Internet service providers transition voice and data traffic to packet networks while maintaining traditional phone usage and network equipment. Lucent has recently co-developed with VocalTec a set of industry standards that have been adopted by major competitors and is currently marketing Internet telephony hardware, including servers that allow the transmission of calls and faxes over the Internet. Lucent also offers related support products, such as billing centers and "Internet call centers," which allow Internet access and conversation with a customer support agent on a single line. . Voice-Enabled Online Commerce Providers. Several providers have begun to apply Internet telephony technologies in connection with e-commerce transactions. These providers compete with services of ours such as Click2Talk by integrating voice communications into commercial Web sites. These competitors include USA Global Link, which introduced its Instant Call service in 1998, a system that permits voice communications between a customer on the Web and customer service representatives. In addition, AT&T's Inter@active Communications is a group of services that integrates voice into the Web, including AT&T Chat 'N Talk, a voice- enabled chat service, and Click2Dial Conferencing Services, which initiates and manages conference calls. These services may emerge as significant competitors to our current and planned offerings. Research and Development Strategic Research and Development At our primary research and development center in Lakewood, New Jersey, we currently employ 17 engineers, whose specialties include software, hardware, switching, Internet security, voice compression, engineering real-time online transactions, billing, and network and call management. This staff is devoted to the improvement and enhancement of our existing product and service offerings, as well as to the development of new products and services. Current research and development activities include the following: . development of unified messaging services, PC2PC and Phone2PC products and voice-enabled chat; . enhancements to our customer billing software and call management system to increase the capacity of these systems; . improvements to our Internet telephony hardware to increase capacity; and . modifications to our PC2Phone software to increase functionality. Our future success will depend, in part, on our ability to improve existing technology and develop new products and services that incorporate leading technology. We incurred $473,000, $481,000 and $757,000 in product development expenses during fiscal 1997, fiscal 1998 and fiscal 1999, respectively. Management Information Systems Research and Development Our management information systems development team, located in Hackensack, New Jersey, has eleven programmers and a development manager dedicated to traditional management information systems development and upgrades. The group supports back-office accounting and reporting software, customer service support software and database support. The development schedule is primarily focused on a detailed list of upgrades that have been identified and prioritized by a team manager. The database architecture is managed by a senior developer in our Lakewood laboratory who was responsible for similar database functions at AT&T's WorldNet division. 45 Web Research and Development The majority of our Web research and development is done by a separate Web development group located in our headquarters in Hackensack. The group of nine consists of five developers, two programmers, one graphics designer and one development manager. The team is responsible for our multiple language Web site, the EZSurf.com Web site and specialized Web interfaces, including the integration of our PC2Phone client software into Netscape's Internet browser. Regulation Regulation of Internet Telephony The use of the Internet to provide telephone service is a recent market development. Currently, the Federal Communications Commission is considering whether to impose surcharges or additional regulations upon certain providers of Internet telephony. On April 10, 1998, the FCC issued its report to Congress concerning the implementation of the universal service provisions of the Telecommunications Act. In the report, the FCC indicated that it would examine the question of whether certain forms of phone-to-phone Internet telephony are information services or telecommunications services. The FCC noted that it did not have, as of the date of the report, an adequate record on which to make a definitive pronouncement, but that the record suggested that certain forms of phone-to-phone Internet telephony appear to have the same functionality as non- Internet telecommunications services and lack the characteristics that would render them information services. If the FCC were to determine that certain services are subject to FCC regulation as telecommunications services, the FCC may require providers of Internet telephony services to make universal service contributions, pay access charges or be subject to traditional common carrier regulation. It is also possible that PC-to-phone and phone-to-phone services may be regulated by the FCC differently. In addition, the FCC sets the access charges on traditional telephony traffic and if it reduces these access charges, the cost of traditional long distance telephone calls will probably be lowered, thereby decreasing our competitive pricing advantage. Changes in the legal and regulatory environment relating to the Internet connectivity market, including regulatory changes which affect telecommunications costs or that may increase the likelihood of competition from the regional Bell operating companies or other telecommunications companies, could increase our costs of providing service. For example, the FCC recently has determined that subscriber calls to Internet service providers should be classified for jurisdictional purposes as interstate calls. This determination could affect a telephone carrier's costs for provision of service to these providers by eliminating the payment of reciprocal compensation to carriers terminating calls to these providers. The FCC has pending a proceeding to encourage the development of cost-based compensation mechanisms for the termination of calls to Internet service providers. Meanwhile, state agencies will determine whether carriers receive reciprocal compensation for these calls. If new compensation mechanisms increase the costs to carriers of terminating calls to Internet service providers or if states eliminate reciprocal compensation payments, the affected carriers could increase the price of service to Internet service providers to compensate, which could raise the cost of Internet access to consumers. In addition, although the FCC to date has determined that providers of Internet services should not be required to pay interstate access charges, this decision may be reconsidered in the future. This decision could occur if the FCC determines that the services provided are basic interstate telecommunications services and no longer subject to the exemption from access charges that are currently enjoyed by providers of enhanced services. Access charges are assessed by local telephone companies to long-distance companies for the use of the local telephone network to originate and terminate long- distance calls, generally on a per minute basis. The FCC has stated publicly that it would be inclined to hold the provision of phone-to-phone Internet protocol telephony to be a basic telecommunications service and therefore subject to access charges and universal service contribution requirements. In a Notice of Inquiry released September 29, 1999, the FCC again asked for comment on the regulatory status of Internet telephony. Specifically, the FCC asks 46 commenters to address whether Internet telephony service generally, and phone- to-phone service in particular, may be regulated as a basic telecommunications service. If the Commission concludes that any or all Internet telephony should be regulated as basic communications service, it eventually could require that Internet telephony providers must contribute to universal service funds and pay access charges to local telephone companies. The imposition of access charges or universal service contributions would substantially increase our costs of serving dial-up customers. To our knowledge, there are currently no domestic and few foreign laws or regulations that prohibit voice communications over the Internet. State public utility commissions may retain jurisdiction to regulate the provision of intrastate Internet telephony services. A number of countries that currently prohibit competition in the provision of voice telephony have also prohibited Internet telephony. Other countries permit but regulate Internet telephony. If Congress, the FCC, state regulatory agencies or foreign governments begin to regulate Internet telephony, such regulation may materially adversely affect our business, financial condition or results of operations. In addition, access to our services may also be limited in foreign countries where laws and regulations otherwise do not prohibit voice communication over the Internet. For example, access to our PC2Phone service was recently blocked in certain countries in Asia and the Middle East by government-controlled telecommunications companies. These actions prevented our customers from originating PC2Phone calls in these countries. We have experienced similar actions in the past in other countries. In each case, we were able to negotiate agreements to continue to provide our services in these countries. We intend to do the same in these countries as well, but no assurances can be given that we will be successful in these negotiations. We have resumed service to our customers in these countries by providing alternative means of access to our service, which may also be blocked by these government-controlled telecommunications companies. Furthermore, one of our competitors, iBasis, recently disclosed that it has received a letter from the Israel Minister of Communications requesting that it cease and desist terminating international calls over the Internet in Israel. Regulation of the Internet Congress has recently adopted legislation that regulates certain aspects of the Internet, including online content, user privacy, taxation, access charges, liability for third-party activities and jurisdiction. In addition, a number of initiatives pending in Congress and state legislatures would prohibit or restrict advertising or sale of certain products and services on the Internet, which may have the effect of raising the cost of doing business on the Internet generally. The European Union has also enacted several directives relating to the Internet, one of which addresses online commerce. In addition, federal, state, local and foreign governmental organizations are considering other legislative and regulatory proposals that would regulate the Internet. Increased regulation of the Internet may decrease its growth, which may negatively impact the cost of doing business via the Internet or otherwise materially adversely affect our business, results of operations and financial condition. The Federal Trade Commission has proposed regulations regarding the collection and use of personal identifying information obtained from individuals when accessing Web sites, with particular emphasis on access by minors. These regulations may include requirements that companies establish certain procedures to disclose and notify users of privacy and security policies, obtain consent from users for certain collection and use of information and to provide users with the ability to access, correct and delete personal information stored by the company. These regulations may also include enforcement and redress provisions. There can be no assurance that we will adopt policies that conform with any regulations adopted by the FTC. Moreover, even in the absence of those regulations, the FTC has begun investigations into the privacy practices of companies that collect information on the Internet. One investigation resulted in a consent decree pursuant to which an Internet company agreed to establish programs to implement the principles noted above. We may become subject to a similar investigation, or the FTC's regulatory and enforcement efforts may adversely affect the ability to collect demographic and personal information from users, which 47 could have an adverse effect on our ability to provide highly targeted opportunities for advertisers and electronic commerce marketers. Any of these developments would materially adversely affect our business, results of operations and financial condition. The European Union has adopted a directive that imposes restrictions on the collection and use of personal data. Under the directive, citizens of the European Union are guaranteed rights to access their data, rights to know where the data originated, rights to have inaccurate data rectified, rights to recourse in the event of unlawful processing and rights to withhold permission to use their data for direct marketing. The directive could, among other things, affect United States companies that collect information over the Internet from individuals in European Union member countries, and may impose restrictions that are more stringent than current Internet privacy standards in the United States. In particular, companies with offices located in European Union countries will not be allowed to send personal information to countries that do not maintain adequate standards of privacy. The directive does not, however, define what standards of privacy are adequate. As a result, the directive may adversely affect the activities of entities such as us that engage in data collection from users in European Union member countries. Intellectual Property Our performance and ability to compete are dependent to a significant degree on our proprietary and licensed technology. We rely on a combination of patent, copyright, trademark and trade secret laws and contractual restrictions to establish and protect our technology. All key employees have signed confidentiality agreements and we intend to require each newly hired employee to execute a confidentiality agreement. These agreements provide that confidential information developed by or with an employee or consultant, or disclosed to such person during his or her relationship with us, may not be disclosed to any third party except in certain specified circumstances. These agreements also require our employees to assign their rights to any inventions to us. The steps taken by us may not, however, be adequate to prevent the misappropriation of our proprietary rights or technology. In addition, our competitors may independently develop technologies that are substantially equivalent or superior to our technology. We do not currently have any issued patents or registered copyrights. We own the registered service mark for three of the marks used in our business and have applications pending to register 30 other service marks used in our business. There can be no assurance that we will be able to secure significant protection for all our service marks. Competitors of ours or others could adopt product or service marks similar to our marks, or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customer confusion. We have not taken steps to file applications in foreign countries to obtain protection of our trademarks, except for our recent filing of a Community Trademark application for registration of the "Net2Phone" mark, which covers certain European countries, and an application for the "Net2Phone" mark in Australia and Ecuador. To the extent trademark rights are acquired through registration in countries outside the United States, we may not be able to protect our marks or assure that we are not infringing other parties' marks in those countries. We maintain Web sites at www.net2phone.com, www.net2phone.net, www.click2talk.com and www.ezsurf.com. Moreover, although we have taken some steps to commence the registration of "net2phone" as a domain name with the various international registries, we cannot assure you that this will be accomplished. We have been assigned the rights to patent applications claiming a number of the technologies underlying our products and services. Our two United States utility patent applications have been rejected, but we are continuing to pursue patent protection for the claimed subject material. There can be no assurance that the applications will result in the issuance of patents or that, if issued, such patents would adequately protect us against competitive technology or that they would be held valid and enforceable 48 against a challenge. In addition, it is possible that our competitors may be able to design around any such patents. Also, our competitors may obtain patents that we would need to license or circumvent in order to make, use, sell or offer for sale the technology. We have received correspondence from a company, NetPhone Inc., claiming that our use of the mark "Net2Phone" in connection with Internet telephony services infringes that company's "NetPhone" registered trademark and requesting that we cease and desist from using the "Net2Phone" mark. We responded by denying any infringement. No legal proceedings have been commenced against us with respect to this matter. This entity currently operates a Web site at www.netphone.com. There can be no assurance that the existence of this entity's claim, its business and Web site will not materially adversely affect our business. AT&T, who may have rights in the terms "Click2Dial," "Click2Whisper" and "Click2Interact," has filed with the United States Patent and Trademark Office a request to extend its time limit for opposing the registration of our "Click2Talk" mark. AT&T could oppose registration of our "Click2Talk" mark or take other action aimed at restricting us from using this mark. We have negotiated an agreement with AT&T by which AT&T will agree not to file the opposition if we consent to the registration of one of AT&T's marks. There can be no assurance that any agreement, or the exact terms thereof, will be signed until one is in place. We are also aware of several other parties that use marks that are the same or similar to marks that we use, though in some instances, to the best of our knowledge, these parties are not in the same business as we are. There can be no assurance that the companies that notified us or other companies with marks similar to our marks will not bring suit to prevent us from using the "Net2Phone" mark or other marks. Defending or losing any litigation relating to intellectual property rights could materially adversely affect our business, results of operations and financial condition. In addition, a company known as ITM, Inc. previously operated a Web site at www.net2phone.net without our permission or authorization, and in violation of the agency agreement ITM entered into with us for the distribution of the Net2Phone software with certain ITM software. ITM had also taken steps to secure registration and ownership of the "Net2Phone" mark in France. We have reached an agreement with ITM by which ITM assigned to us the French trademark application that it filed, as well as executed and delivered to us a Registrant Name Change Agreement to transfer the domain name net2phone.net to us. Network Solutions Inc. has processed the transfer and we now operate the Web site www.net2phone.net. We are taking steps to secure our rights in Ecuador and in Venezuela against two parties that are attempting to register the "Net2Phone" mark or a confusingly similar mark in these countries. We believe that we do not infringe upon the patent rights of any third party. The only third party that has asserted a patent infringement claim against us is TechSearch for what it alleges is a patent directed to Web sites. TechSearch has asked for a one time licensing fee. Our initial investigation has led us to believe that we do not infringe and /or the patent is invalid. If we do not accept the offer for a license and we are sued, we may incur substantial legal fees in defending the suit and may be enjoined from using our Web site if it is found to be infringing. If we do agree to the licensing fee, it may detract from our ability to support other projects. It is possible, however, that other patent infringement claims might be asserted successfully against us in the future. Our ability to make, use, sell or offer for sale our products and services depends on our freedom to operate. That is, we must ensure that we do not infringe upon the patents of others or have licensed all such rights. We have not requested or obtained an opinion from our outside counsel as to whether our products and services infringe upon the patent rights of any third parties. We are aware that patents have recently been granted to others based on fundamental technologies in the Internet telephony area. In addition, we are aware of at least one other patent application involving potentially similar technologies to our own which if issued could materially adversely affect our business. Because patent applications in the Unites States are not publicly disclosed until issued, other applications may have been filed which, if issued as patents, could relate to our services and products. However, foreign patent 49 applications do publish before issuance. We are aware of several such publications that relate to Internet telephony. One such published application claims as an inventor a previous consultant to IDT and has been assigned to another company. Issuance of a patent or patents from this application could materially adversely affect our ability to operate. A party making an infringement claim could secure a substantial monetary award or obtain injunctive relief which could effectively block our ability to provide services or products in the United States or abroad. If any of these risks materialize, we could be forced to suspend operations, to pay significant amounts to defend our rights, and a substantial amount of the attention of our management may be diverted from our ongoing business, each of which could materially adversely affect our ability to operate. We rely on a variety of technology, primarily software, that we license from third parties. Most of this technology was purchased or licensed on our behalf by IDT. Continued use of this technology by us may require that we purchase new or additional licenses from third parties or obtain consents from third parties to assign the applicable licenses from IDT. There can be no assurances that we can obtain those third party licenses needed for our business or that the third party technology licenses that we do have will continue to be available to us on commercially reasonable terms or at all. The loss or inability to maintain or obtain upgrades to any of these technology licenses could result in delays or breakdowns in our ability to continue developing and providing our products and services or to enhance and upgrade our products and services. Employees As of October 1, 1999, we had approximately 333 full-time employees, including approximately 146 in technical support and customer service, 84 in sales and marketing, 24 in management and finance, 30 in operations, and 49 in research and development. Our employees are not represented by any union, and we consider our employee relations to be good. We have never experienced a work stoppage. Properties Our primary facilities consist of approximately 15,445 square feet, which comprise our headquarters, executive offices and customer service and technical support centers, and are located in two buildings in Hackensack, New Jersey leased from corporations that are owned and controlled by Howard S. Jonas. Mr. Jonas is one of our directors, a director of IDT and the controlling stockholder of IDT. These leases expire at the end of February 2002 and require us to make annual rental payments of $186,144. We also sublease space for some of our computer equipment in Piscataway, New Jersey from IDT, which leases this space from a company also owned and controlled by Mr. Jonas. This lease runs for a three-year term, beginning in May 1999, with monthly rent of $8,400. In addition, we lease office space in Lakewood, New Jersey for our research and development center. Pursuant to this lease, which expires at the end of August 2001, we are required to make annual rental payments of $48,125. See "Certain Transactions--Facility Leases." Legal Proceedings We are not currently a party to any material legal proceedings. 50 MANAGEMENT Executive Officers and Directors The following persons are our executive officers and directors:
Name Age Position - ---- --- -------- Clifford M. Sobel....... 50 Chairman of the Board Howard S. Balter........ 38 Chief Executive Officer and Vice Chairman of the Board Jonathan Fram........... 42 President David Greenblatt........ 47 Chief Operating Officer Ilan M. Slasky.......... 29 Chief Financial Officer H. Jeff Goldberg........ 46 Chief Technology Officer Jonathan Reich.......... 33 Executive Vice President--Marketing and Corporate Development Martin Rothberg......... 30 Executive Vice President--Strategic Sales Jonathan Rand........... 36 Executive Vice President--International Sales and Treasurer Howard S. Jonas......... 43 Director James A. Courter........ 57 Director Gary E. Rieschel........ 43 Director James R. Mellor......... 69 Director Jesse P. King........... 44 Director Martin J. Yudkovitz..... 45 Director Daniel H. Schulman...... 41 Director Michael Fischberger..... 30 Director Harry C. McPherson, 70 Director Jr.....................
Clifford M. Sobel has been Chairman of the board of directors since May 1999, served as our President from October 1997 to July 1999 and served as our Chief Executive Officer from October 1997 to January 1999. Since 1994, Mr. Sobel has been Chairman and Chief Executive Officer of SJJ Investment Corp., which has invested in Internet, cable, real estate and cosmetics companies. Prior to this, Mr. Sobel founded several companies in the design and manufacturing of retail interiors and themed environments, including DVMI and its subsidiary, Bon-Art International, and Bauchet International. These companies were sold in 1994, in transactions in which Bear, Stearns & Co. Inc. served as financial advisor. Mr. Sobel has testified before Congress on foreign trade issues and, by Presidential appointment, served on the Holocaust Memorial Council in Washington, D.C. Howard S. Balter has been a director since October 1997, our Chief Executive Officer since January 1999, and our Vice Chairman of the board of directors since May 1999. Mr. Balter also served as our Treasurer from October 1997 to July 1999. Prior to his employment with us, Mr. Balter was IDT's Chief Operating Officer from 1993 to 1998 and Chief Financial Officer from 1993 to 1995. Mr. Balter was a director of IDT from December 1995 to January 1999 and Vice Chairman of IDT's board from 1996 to 1999. From 1985 to 1993, Mr. Balter operated his own real estate development firm. Jonathan Fram became our President in July 1999. Prior to his employment with us, Mr. Fram was General Manager of Bloomberg L.P.'s New Media Group from 1996 to 1999, where he was responsible for Bloomberg's Internet strategy. Mr. Fram was employed as General Manager of Bloomberg's Television and Radio Group from 1991 to 1996. From 1989 to 1991, Mr. Fram served as the Chief Executive Officer of FNN:PRO--Institutional Research Network, Inc. Mr. Fram was also employed by both Bear Stearns & Co. and Paine Webber, Inc. as a securities analyst, and worked for IBM as a computer design engineer. David Greenblatt has been our Chief Operating Officer since January 1999. Between January 1998 and January 1999, Mr. Greenblatt served as IDT's Vice President of Networks, during which time he was primarily responsible for the operations of Net2Phone. Prior to his employment with IDT in January 1998, Mr. Greenblatt was Senior Vice President of Research and Development for Nextwave Communications 51 from 1996 to 1997. From January 1984 to August 1996, Mr. Greenblatt was a principal of Financial Technologies, Inc., where he managed the process of software conversion for large and medium-sized businesses. From January 1980 to December 1984, Mr. Greenblatt was an information technologies consultant for various money center banks. From 1970 to 1980, Mr. Greenblatt has lectured in the areas of Computer Science and Mathematics at Queens College, New York University, Hunter College and Pace University. Ilan M. Slasky has been our Chief Financial Officer since January 1999. Prior to his employment with us, Mr. Slasky was IDT's Executive Vice President of Finance from December 1997 to January 1999, IDT's director of carrier services from November 1996 to July 1997 and IDT's Director of Finance from May 1996 to November 1996. From 1991 to 1996, Mr. Slasky worked for Merrill Lynch in various areas of finance, including risk management, fixed income trading and equity derivatives. H. Jeff Goldberg has been our Chief Technology Officer since January 1999. From January 1996 to January 1999, Mr. Goldberg was our Director of Technology and a consultant to IDT. Mr. Goldberg was an independent software consultant from 1985 to 1995, Vice President of Software and a member of the board of directors at Charles River Data Systems in Massachusetts from 1979 to 1985 and a developer of multimedia communications software at AT&T Bell Laboratories from 1977 to 1979. Mr. Goldberg is a founding member of the UNIX standards committee. Jonathan Reich has been our Executive Vice President--Marketing and Corporate Development since January 1999. Prior to his employment with us, Mr. Reich was IDT's Senior Vice President of Advertising, Marketing and Business Development in charge of strategic relationships for both us and IDT from June 1997 to December 1998 and IDT's director of advertising from January 1995 to November 1997. From 1992 to 1993, Mr. Reich worked for Sanford Bernstein & Co. as an associate analyst. Prior to this, Mr. Reich was an internal consultant for Morgan Stanley & Co. Martin Rothberg has been our Executive Vice President--Strategic Sales since January 1999 and a key employee since June 1997. Prior to his employment with us, Mr. Rothberg was IDT's Director of International Sales from September 1996 to June 1997 and IDT's Director of Domestic Sales from June 1995 to September 1996. Jonathan Rand has been our Executive Vice President--International Sales since January 1999, Treasurer since July 1999 and a key employee since January 1998. Prior to joining us, Mr. Rand was a member of IDT's senior management from 1992 to January 1999, including service as Senior Vice President-- International Sales and Senior Vice President--Finance. Additionally, Mr. Rand is a co-founder and director of the International Internet Association. Prior to joining IDT, Mr. Rand operated his own magazine publishing business from 1986 to 1992 and was employed by Procter & Gamble from 1985 to 1986 in Brand Management. Howard S. Jonas was appointed a director in October 1997. Mr. Jonas founded IDT in August 1990 and has served as Chairman of the Board and Treasurer since its inception and as Chief Executive Officer since December 1991. Additionally, he served as President of IDT from December 1991 through September 1996. Mr. Jonas is also the founder and has been President of Jonas Publishing Corp., a publisher of trade directories, since its inception in 1979. James A. Courter was appointed a director in May 1999. Mr. Courter has been President of IDT since October 1996 and a director of IDT since March 1996. Mr. Courter has been a senior partner in the New Jersey law firm of Courter, Kobert, Laufer & Cohen, P.C. since 1972. He was also a partner in the Washington, D.C. law firm of Verner, Liipfert, Bernhard, McPherson & Hand, Chartered from January 1994 to September 1996. From 1991 to 1994, Mr. Courter was chairman of the President's Defense Base Closure and Realignment Commission. Mr. Courter was a member of the United States House of Representatives for 12 years, retiring in January 1991. Mr. Courter also serves on the board of directors of Envirogen and The Berkeley School. 52 Gary E. Rieschel was appointed a director in June 1999. Mr. Rieschel is the Executive Managing Director of SOFTBANK Technology Ventures, which he joined in January 1996. Mr. Rieschel has extensive overseas experience, having spent over four years in Tokyo as General Manager of Sequent Computer Systems' Asian operations. He serves as a Director for several SOFTBANK Technology Ventures' portfolio companies and is a member of SOFTBANK Corporation's Global Executive Board. James R. Mellor was appointed a director in June 1999. Mr. Mellor served as a director of IDT between August 1997 and June 1999. Since 1981, Mr. Mellor worked for General Dynamics Corporation, a developer of nuclear submarines, surface combatant ships and combat systems. From 1994 until 1997, Mr. Mellor served as Chairman and Chief Executive Officer of General Dynamics, and from 1993 to 1994, he served as President and Chief Operating Officer of General Dynamics. Before joining General Dynamics, Mr. Mellor served as President and Chief Operating Officer of AM International, Inc. now Multigraphics, Inc. Before that time, Mr. Mellor spent 18 years with Litton Industries in a variety of engineering and management positions, including Executive Vice President in charge of Litton's Defense Group from 1973 to 1997. Jesse P. King was appointed a director in July 1999. Mr. King has served as the Operation Manager for the Rockefeller Foundation's Next Generation Leadership Program and the Philanthropy Workshop since January of 1996. Before joining The Rockefeller Foundation, Mr. King worked as the Senior Program Director and Human Resource Director for the Colorado Outward Bound School from 1990 to 1996. Additionally, Mr. King worked as a Project Director and Consultant for the Children's Defense Fund and the Black Community Crusade for Children from February 1994 to 1995. Martin J. Yudkovitz was appointed a director in September 1999. Mr. Yudkovitz has been President of NBC Interactive Media since December 1995. Mr. Yudkovitz is responsible for developing NBC's new media strategy and managing NBC's interactive operations. From December 1993 to December 1995, Mr. Yudkovitz served as Senior Vice President of NBC Multimedia, and in addition was appointed Senior Vice President of Strategic Development of NBC in March 1993. He has also served as General Counsel and Vice President for Business Affairs of CNBC. Mr. Yudkovitz joined NBC in 1984. Mr. Yudkovitz is a director of iVillage, Inc. and Talk City, Inc., as well as a member of the board of managers of Snap! LLC. Daniel H. Schulman was appointed a director in September 1999. Mr. Schulman has been the President, Chief Operating Officer and a director of priceline.com since July 1999. From December 1998 to July 1999, Mr. Schulman was President of the AT&T Consumer Markets Division of AT&T Corp., a telecommunications services company, and was appointed to the AT&T Operations Group, the company's most senior executive body. From March 1997 to November 1998, Mr. Schulman was President of AT&T WorldNet Service. From December 1995 to February 1997, he was Vice President, Business Services Marketing of the AT&T Business Markets Division, and from May 1994 to November 1995, Mr. Schulman was Small Business Marketing Vice President of the AT&T Business Markets Division. Mr. Schulman also serves as director of iVillage, the Global Internet Project and several charitable organizations, including INROADS and Teach for America. Michael Fischberger was appointed a director in September 1999. Mr. Fischberger has served as Senior Vice President of Domestic Telecommunications and Internet services at IDT since 1993. In this capacity, he helped build IDT's Internet business, guiding the development of IDT's sales, technical support, customer service and nationwide backbone. Mr. Fischberger currently supervises IDT's domestic products and services, which includes domestic long distance services, Internet access, calling cards and corporate services. Prior to July 1999, Mr. Fischberger managed our Phone2Phone sales, customer service and anti-fraud departments. Harry C. McPherson, Jr. was appointed a director in October 1999. Mr. McPherson has been a partner in the law firm of Verner, Liipfert, Bernhard, McPherson and Hand, Chartered since 1969. Mr. McPherson has been the President of the Economic Club of Washington since 1992. In 1993, Mr. McPherson was a 53 member of the Defense Base Closure and Realignment Commission. From 1988 to 1992, Mr. McPherson was the Vice Chairman of the United States International Cultural and Trade Center Commission. From 1983 to 1988, Mr. McPherson was President of the Federal City Council, Washington, D.C. In 1979, Mr. McPherson was a member of the President's Commission on the Accident at Three Mile Island. From 1965 to 1969, Mr. McPherson was Counsel and then Special Counsel to the President of the United States. From 1964 to 1965, Mr. McPherson was Assistant Secretary of State for Educational and Cultural Affairs. From 1963 to 1964, Mr. McPherson was Deputy Under Secretary of the Army for International Affairs. Board of Directors and Committees of the Board Our certificate of incorporation, as amended and restated, provides that the number of members of our board of directors shall be not less than five and not more than 11. The number of directors is currently 11. Our board of directors has been divided into three classes, and each class will be kept as nearly equal in number as possible. At each annual meeting of stockholders, the successors to the class of directors whose term expires at that time will be elected to hold office for a term of three years and until their respective successors are elected and qualified. All of the officers identified above serve at the discretion of our board of directors. IDT and Clifford M. Sobel, our Chairman, have agreed to vote all of their shares in favor of the election of a director nominated by SOFTBANK Technology Ventures IV and a director nominated by either GE Capital Equity Investments or NBC, in each case for as long as either entity holds a majority of the shares of Series A convertible preferred stock originally purchased by them or the shares into which they are convertible. Gary E. Rieschel was nominated to our board by SOFTBANK. Martin J. Yudkovitz was nominated to our board by GE and NBC. On October 29, 1999, Stephen A. Oxman resigned from our board of directors. On the same date, Mr. McPherson was appointed to our board of directors to replace him. We have established an audit committee, a compensation committee and a technology committee. The members of the compensation committee are Mr. Mellor, Mr. King and Mr. Rieschel. Mr. Mellor is currently the only member of the audit committee. Mr. Balter is the initial member of the technology committee. The audit committee oversees the retention, performance and compensation of the independent public accountants, and the establishment and oversight of such systems of internal accounting and auditing control as it deems appropriate. The compensation committee reviews and approves the compensation of our executive officers, including payment of salaries, bonuses and incentive compensation, determines our compensation policies and programs, and administers our stock option plans. The technology committee reviews and evaluates current technology as it relates to our business. 54 Executive Compensation The following table sets forth information relating to the compensation paid to our Chief Executive Officer and the four other individuals who served as our executive officers at the end of fiscal 1999 who earned the most cash compensation for services rendered on our behalf. The salary and bonus information in this table includes amounts paid by IDT for services rendered to us during fiscal 1999, in that all of these officers were compensated by IDT, and not by us directly, until January 1999. All of the named executive officers listed below were compensated by IDT until January 1999. Summary Compensation Table
Long-Term Annual Compensation Compensation Awards -------------------- --------------------- Securities Securities Underlying Underlying Net2Phone IDT Fiscal Options Options Name and Principal Position Year Salary ($) Bonus ($) (#) (#) - --------------------------- ------ ---------- --------- ---------- ---------- Howard S. Balter(1).......... 1999 90,067 -- 1,874,499 -- Chief Executive Officer H. Jeff Goldberg............. 1999 206,169 -- 460,000 -- Chief Technology Officer 1998 209,447 -- -- 50,000 David Greenblatt............. 1999 184,392 25,000 460,000 20,000 Chief Operating Officer 1998 104,238 -- -- 20,000 Martin Rothberg.............. 1999 122,059 -- 360,000 -- Executive Vice President-- 1998 78,762 -- -- 15,000 Strategic Sales Jonathan Rand(2)............. 1999 109,588 -- 120,000 6,000 Executive Vice President-- 1998 66,712 -- -- 10,000 International Sales and Treasurer
- -------- (1) Mr. Balter became our Chief Executive Officer in January 1999. Compensation information for fiscal 1999 excludes compensation paid during the period in which Mr. Balter served as IDT's Chief Operating Officer and Vice Chairman. (2) Mr. Rand joined Net2Phone in January 1998. Compensation information for fiscal 1998 excludes compensation paid during the period in which Mr. Rand rendered services primarily to IDT. 55 Option Grants During Fiscal 1999 The following table describes the options to acquire shares of our common stock that were granted to our executive officers in fiscal 1999:
% of Potential Total Realizable Value Options at Number of Granted Assumed Annual Securities to Rates of Stock Underlying Grantees Exercise Price Appreciation Net2Phone in or for Option Term(1) Options Fiscal Base Price Expiration --------------------- Name Granted (#) Year (%) ($/Sh) Date 5% ($) 10% ($) - ---- ----------- -------- ---------- ---------- ---------- ---------- Howard S. Balter........ 1,650,999 18.7 3.33 May 2009 34,836,079 58,742,544 Howard S. Balter........ 223,500 2.5 15.00 July 2009 2,107,605 5,343,885 Jonathan Fram........... 460,000 5.2 3.33 July 2009 9,706,000 16,366,800 Jonathan Fram........... 460,000 5.2 11.00 July 2009 6,177,800 12,838,600 Jonathan Fram........... 100,000 1.1 15.00 July 2009 943,000 2,391,000 David Greenblatt........ 360,000 4.1 3.33 May 2009 7,596,000 12,808,800 David Greenblatt........ 100,000 1.1 3.33 July 2009 2,110,000 3,558,000 H. Jeff Goldberg........ 360,000 4.1 3.33 May 2009 7,596,000 12,808,800 H. Jeff Goldberg........ 100,000 1.1 15.00 July 2009 943,000 2,391,000 Ilan M. Slasky.......... 360,000 4.1 3.33 May 2009 7,596,000 12,808,800 Jonathan Reich.......... 75,000 0.9 3.33 May 2009 1,582,500 2,668,500 Jonathan Reich.......... 200,000 2.3 15.00 July 2009 1,886,000 4,782,000 Martin Rothberg......... 360,000 4.1 3.33 May 2009 7,596,000 12,808,800 Jonathan Rand........... 45,000 0.5 3.33 May 2009 949,500 1,601,100 Jonathan Rand........... 75,000 0.9 15.00 July 2009 707,250 1,793,250
- -------- (1) Assumes that the fair market value of each grant on the date of each grant was equal to the initial public offering price of $15.00 per share. The following table describes the options to acquire shares of common stock of IDT granted to the individuals named in the summary compensation table during fiscal 1999:
Potential % of Realizable Value at Total Assumed Annual Number of Options Rates of Stock Securities Granted to Price Appreciation Underlying Employees Exercise or for Option Term IDT Options in Fiscal Base Price Expiration -------------------- Name Granted (#) Year (%) ($/Sh) Date 5% ($) 10% ($) - ---- ----------- ---------- ----------- ------------- --------- ---------- David Greenblatt........ 20,000 1.76 12.00 January 2009 150,935 382,498 Jonathan Rand........... 6,000 .53 12.625 February 2009 47,639 120,726
56 Value of Net2Phone Options at Year End The following table describes the value of Net2Phone options exercised in fiscal 1999 and the value of unexercised options held by the individuals named in the summary compensation table at July 31, 1999.
Number of Securities Value of Unexercised Number Underlying Unexercised in-the-Money of Shares Options at Fiscal Year-End Options at Fiscal Year-End Acquired on Value Exercisable/ Unexercisable Exercisable/ Unexercisable Names Exercise Realized(1) (#) ($)(2) - ----- ----------- ----------- -------------------------- -------------------------- Howard S. Balter........ 531,138 4,073,828 67,050/1,267,449 829,744/28,650,040 H. Jeff Goldberg........ 105,840 811,793 30,000/322,000 371,250/6,925,590 David Greenblatt........ 105,840 811,793 30,000/322,000 371,250/6,925,590 Martin Rothberg......... 105,840 811,793 0/252,000 0/6,059,340 Jonathan Rand........... 13,230 101,474 22,500/84,000 278,438/1,407,105
- -------- (1) All of the exercised options described in this table were exercised on May 17, 1999, before our initial public offering. The amounts in this table assume that the fair market value of our common stock on that date was $11.00 per share, the estimated mid-point of the offering price range of our common stock set forth in the amendment to the registration statement relating to our initial public offering, which was filed on June 28, 1999. (2) The closing price of Net2Phone's common stock on July 30, 1999, as reported on the Nasdaq National Market, was $27.375 per share. Value of IDT Options at Year End The following table describes the value of IDT options exercised in fiscal 1999 and the value of unexercised options held by the individuals named in the summary compensation table at July 31, 1999:
Number of Securities Value of Unexercised Number of Underlying Unexercised in-the-Money Shares Options at Fiscal Year-End Options at Fiscal Year-End Acquired on Exercisable/ Exercisable/ Unexercisable Names Exercise Value Realized Unexercisable (#) ($)(1) - ----- ----------- -------------- -------------------------- -------------------------- Howard S. Balter........ 157,920 2,447,863 75,000/0 862,500/0 H. Jeff Goldberg........ 15,000 324,375 207,500/37,500 2,431,455/0 David Greenblatt........ 20,000 213,175 22,500/0 99,375/0 Martin Rothberg......... 0 0 22,500/7,500 226,250/8,750 Jonathan Rand........... 0 0 31,800/11,000 581,252/100,256
- -------- (1) The closing price of IDT's common stock on July 30, 1999, as reported on the Nasdaq National Market, was $19.75 per share. Compensation of Directors Under our 1999 Stock Option and Incentive Plan, we granted options to purchase 10,000 shares of our common stock to each of our non-employee directors, other than to our non-employee directors who serve as officers or employees of IDT, at the time of our initial public offering, or at the time they joined the board. See "1999 Stock Incentive Plan." In May 1999, we granted options to purchase 120,000 shares of our common stock to each of James A. Courter and Michael Fischberger, who are currently members of our board, for $3.33 per share. We intend to reimburse the reasonable expenses incurred by our board members in attending board and committee meetings. 57 Employment Agreements Clifford M. Sobel, our Chairman, is employed pursuant to an employment agreement that was entered into in May 1997 and amended in May 1999. The agreement commenced in September 1997 and will expire in September 2000, and will automatically be extended though September 2001 unless either we or Mr. Sobel notifies the other that the extension will not take effect. Mr. Sobel receives an annual base salary of $100,000. In January 1998, in connection with an option set forth in his employment agreement, Mr. Sobel purchased 10% of our common stock for $100,000. Mr. Sobel's employment agreement provides him with an option to transfer his interest in us to IDT in exchange for an option from IDT to purchase 875,000 registered shares of IDT common stock at a purchase price of $6.50 per share. This option is exercisable at any time from September 15, 1999 through September 15, 2000, so long as he is employed by us as of September 15, 1999 and owns and holds all of the stock he received, other than shares that he transferred to a trust for the benefit of his offspring. Mr. Sobel is prohibited by an agreement with the underwriters from exercising this option until January 25, 2000. On July 2, 1999, we signed a three-year employment agreement with Jonathan Fram, our President. After its initial term, which ends on June 30, 2002, our agreement with Mr. Fram may be renewed annually. We will pay Mr. Fram an annual base salary of $350,000 and he is entitled to receive an annual bonus calculated on the basis of our gross revenue, which bonus could be up to $100,000. Additionally, we granted Mr. Fram options to purchase 920,000 shares of our common stock under our 1999 Stock Option and Incentive Plan. Of these options, 460,000 were granted at an exercise price of $3.33, 153,333 of which are vested and exercisable. The options to purchase the remaining 460,000 shares have an exercise price of $11.00. Other than those options already vested, the remaining 766,667 options will vest in three equal annual installments, commencing on July 20, 2000. An option to purchase an additional 100,000 shares of our common stock was granted to Mr. Fram on July 28, 1999. This option is immediately exercisable and has an exercise price equal to the initial public offering price of our common stock of $15.00 per share. These options will vest immediately if we terminate Mr. Fram's employment without cause, if Mr. Fram terminates his employment for good reason, or if the options of any other employee are accelerated upon a change of control of our company. At present, none of the other named executive officers or key employees is party to an employment agreement with us. 1999 Stock Incentive Plan Our 1999 Stock Option and Incentive Plan was adopted in April 1999. Under the plan, our officers, directors, key employees and consultants, together with those of IDT and its subsidiaries, are eligible to receive awards of stock options, stock appreciation rights, limited stock appreciation rights and restricted stock. Options granted under the plan may be incentive stock options or nonqualified stock options. Stock appreciation rights and limited stock appreciation rights may be granted simultaneously with the grant of an option or, in the case of nonqualified stock options, at any time during its term. Restricted stock may be granted in addition to or in lieu of any other award made under the plan. A total of 11,040,000 shares of common stock have been authorized to date for issuance under the plan, 5,040,000 of which were granted in May 1999, and 1,420,218 of which have been exercised. 1,321,500 of these options were granted to officers, directors and employees of IDT. These options have a weighted average exercise price of $3.33 per share. In connection with loans granted to several grantees under the plan to exercise a portion of these options, 23,382 outstanding options were cancelled. Additional options to purchase 7,000 shares were cancelled in connection with the termination of the employment of five grantees. In July 1999, we granted options to purchase an additional 920,000 shares of our common stock to Jonathan Fram, our President. See "--Employment Agreements." We granted options to purchase approximately 2,503,500 additional shares of our common stock on July 28, 1999 that have an exercise price equal to the initial public offering price of our common stock of $15.00. 307,000 of these options were granted to officers, directors and employees of IDT. In addition, we also granted on July 28, 1999 additional options to purchase 168,000 shares of our 58 common stock to employees that have an exercise price of $3.33 per share. None of these options were granted to officers, directors or employees of IDT. In October 1999, we granted options to purchase 183,250 shares of our common stock that have an exercise price of $55.25 per share. None of these options were granted to officers, directors or employees of IDT. The 1999 Stock Option and Incentive Plan is administered by the compensation committee of our board. Subject to the provisions of the plan, the board of directors or the compensation committee will determine the type of award, when and to whom awards will be granted, the number of shares covered by each award and the terms and kind of consideration payable with respect to awards. The board of directors or the compensation committee may interpret the plan and may at any time adopt the rules and regulations for the plan as it deems advisable. In determining the persons to whom awards shall be granted and the number of shares covered by each award, the board of directors or the compensation committee may take into account the duties of the respective persons, their present and potential contribution to our success and other relevant factors. Stock Options. An option may be granted on the terms and conditions as the board of directors or the compensation committee may approve, and generally may be exercised for a period of up to ten years from the date of grant. Generally, incentive stock options will be granted with an exercise price equal to the fair market value on the date of grant. Additional limitations will apply to incentive stock options granted to a grantee that beneficially holds 10% or more of our voting stock. The board of directors or compensation committee may authorize loans to individuals to finance their exercise of vested options. See "Certain Transactions--Officer Loans." Options granted under the 1999 Stock Option and Incentive Plan will become exercisable at those times and under the conditions determined by the board of directors or the compensation committee. To date, the options that have been granted to our executive officers will generally vest automatically in the event that there is a change of control of our company, if we are merged into another company or if any of these individuals are employed by a subsidiary of our company that is sold to another company. The 1999 Stock Option and Incentive Plan provides for automatic option grants to eligible non-employee directors. Options to purchase 10,000 shares of common stock have been granted to each eligible non-employee director and options to purchase 10,000 shares of common stock will be granted to each new eligible non-employee director upon the director's initial election to the board. In addition, options to purchase 10,000 shares of common stock are granted annually to each eligible non-employee director on the anniversary date of his or her election to the board. Each of these options will have an exercise price equal to the fair market value of a share of common stock on the date of grant. All options granted to non-employee directors will be immediately exercisable. All options held by non-employee directors, to the extent not exercised, expire on the earliest of: . the tenth anniversary of the date of grant; . one year following the optionee's termination of directorship other than for cause; and . three months following the optionee's termination of directorship for cause. Stock Appreciation Rights and Limited Stock Appreciation Rights. The 1999 Stock Option and Incentive Plan also permits the board of directors or the compensation committee to grant stock appreciation rights and/or limited stock appreciation rights with respect to all or any portion of the shares of common stock covered by options. Generally, stock appreciation rights and limited stock appreciation rights may be exercised only at that time as the related option is exercisable. Upon exercise of a stock appreciation right, a grantee will receive for each share for which an stock appreciation right is exercised, an amount in cash or common stock, as determined by the board of directors or the compensation committee, equal to the excess of the fair market value of a share of common stock on the date the stock appreciation right is exercised over the exercise price per share of the option to which the stock appreciation right relates. 59 Limited stock appreciation rights may be exercised only during the 90 days following a change in control, or a merger or similar transaction, involving Net2Phone. Upon exercise of a limited stock appreciation right, a grantee will receive, for each share for which a limited stock appreciation rights is exercised, an amount in cash equal to the excess of the highest fair market value of a share of our common stock during the 90-day period ending on the date of the limited stock appreciation rights is exercised, or an amount equal to the highest price per share paid for shares of our common stock in connection with a merger or a change of control of Net2Phone, whichever is greater, over the exercise price per share of the option to which the limited stock appreciation rights relates. In no event, however, may the holder of a limited stock appreciation right granted in connection with an incentive stock option receive an amount in excess of the maximum amount that will enable the option to continue to qualify as an incentive stock option. Restricted Stock. The 1999 Stock Option and Incentive Plan also provides for the granting of restricted stock awards, which are awards of common stock that may not be disposed of, except by will or the laws of descent and distribution, for a period of time determined by the compensation committee or the board of directors. The board or the compensation committee may also impose other conditions and restrictions on the shares as it deems appropriate, including the satisfaction of performance criteria. All restrictions affecting the awarded shares will lapse in the event of a merger or similar transaction involving Net2Phone. The board may amend or terminate the 1999 Stock Option and Incentive Plan. However, as required by any law, regulation or stock exchange rule, no change shall be effective without the approval of our stockholders. In addition, no change may adversely affect an award previously granted, except with the written consent of the grantee. No awards may be granted under the 1999 Stock Option and Incentive Plan after the tenth anniversary of its initial adoption. Options and Awards Under the 1999 Stock Option and Incentive Plan. We cannot now determine the number of options or awards to be granted in the future under the 1999 Stock Option and Incentive Plan to officers, directors and employees. Compensation Committee Interlocks and Insider Participation. Our compensation committee was established in June 1999. The committee's members are James R. Mellor, who served as a director of IDT and a member of its compensation committee before joining our board, and Jesse P. King. Prior to May 1999, compensation decisions relating to our executive officers, key employees and other senior personnel were generally made by IDT, which owned 90% of our outstanding capital stock until that time. Howard S. Jonas, James A. Courter, Hal Brecher and Joyce J. Mason, each of whom are executive officers of IDT, served as directors of Net2Phone during fiscal 1999. Howard S. Balter, our Chief Executive Officer and director, served as a Chief Operating Officer, Vice Chairman and as a director of IDT until January 1999. 401(k) Plan We established a plan in October 1999 under Section 401(k) of the Internal Revenue Code for the benefit of our employees. Our executive officers are permitted to participate on the same basis as our other employees. However, we do not intend to match the contributions that our executive officers make to the plan. 60 PRINCIPAL AND SELLING STOCKHOLDERS The following table sets forth information with respect to the beneficial ownership of our outstanding common stock as of November 2, 1999 and as adjusted to reflect this offering by: . each person who is the beneficial owner of more than 5% of our capital stock; . each of our directors; . each of our named executive officers in the summary compensation table; . each stockholder who is selling shares in this offering; and . all of our named executive officers and directors as a group. Except as otherwise indicated, all of the shares indicated in the table are shares of common stock. Other selling stockholders, including employees, officers and directors of Net2Phone and IDT, have granted the underwriters an option to purchase up to 945,000 shares of our common stock in this offering to cover over-allotments, if any.
Shares Beneficially Number of Shares Beneficially Owned Before the Offering Shares To Be Owned After the Offering -------------------------------- Sold in ------------------------ Holders Number Percentage(1) the Offering Number Percentage(1) - ------- --------------- ---------------------------- ---------- ------------- IDT Corporation(2)...... 27,104,250 56.2% 2,200,000 24,904,250 48.3% 190 Main Street Hackensack, New Jersey 07601 Howard S. Jonas(3)...... 27,104,250 56.2% 2,200,000 24,904,250 48.3% c/o IDT Corporation 190 Main Street Hackensack, New Jersey 07601 James A. Courter(4)..... 27,140,250 56.3% 2,200,000 24,940,250 48.3% c/o IDT Corporation 190 Main Street Hackensack, New Jersey 07601 SOFTBANK Technology Ventures IV, L.P.(5)... 4,500,000 9.3% 400,000 4,100,000 7.9% 333 West San Carlos Street, Suite 1225 San Jose, California 95110 Gary E. Rieschel(6)..... 4,510,000 9.4% 400,000 4,110,000 8.0% c/o SOFTBANK Technology Ventures IV, L.P. 333 West San Carlos Street, Suite 1225 San Jose, California 95110 Clifford M. Sobel(7).... 3,073,781 6.4% -- 3,073,781 6.0% c/o Net2Phone, Inc. 171 Main Street Hackensack, New Jersey 07601 America Online, Inc.(8)................ 2,750,000 5.7% -- 2,750,000 5.3% 22000 AOL Way Dulles, Virginia 20166 General Electric Company Group(9)(10)........... 2,637,581 5.5% -- 2,637,581 5.1% 120 Long Ridge Road Stamford, Connecticut 06927 Jewish Community Foundation of Metrowest.............. 300,000 * 300,000 -- -- Howard S. Balter(11).... 736,188 1.5% -- 736,188 1.4% David Greenblatt(12).... 135,840 * -- 135,840 * H. Jeff Goldberg(13).... 135,840 * -- 135,840 * Martin Rothberg(14)..... 105,840 * -- 105,840 * Jonathan Rand(15)....... 35,730 * -- 35,730 * James R. Mellor(16)(17)......... 10,000 * -- 10,000 * Jesse P. King(16)(18)... 10,000 * -- 10,000 * Martin J. Yudkovitz(10)(16)...... 10,000 * -- 10,000 * Daniel H. Schulman(16)(19)....... 10,000 * -- 10,000 * Michael Fischberger(20)........ 35,280 * -- 35,280 * Harry C. McPherson, Jr.(16)(21)............ 10,000 * -- 10,000 * Named Executive Officers and Directors as a Group (18 Persons)(22)....... 36,272,082 75.3% -- 33,672,082 65.3%
61 - -------- * Less than one percent. (1) Percentage of beneficial ownership prior to this offering is based on 11,672,616 shares of common stock and 36,524,250 shares of Class A stock outstanding at November 2, 1999. Percentage of beneficial ownership after this offering is based on 51,596,866 total shares outstanding, which includes all of the foregoing shares, plus 6,000,000 shares of common stock to be sold in this offering. All percentage calculations assume that all shares of Class A stock have been converted into shares of common stock. (2) All of the shares held by IDT are Class A stock. IDT has pledged its shares as collateral to secure a credit facility. The lenders under the credit facility have agreed to release IDT's shares from collateral to permit IDT to transfer our shares free and clear of any liens as and when IDT seeks to transfer our shares. Such transferability will cease if IDT's ownership of our capital stock drops below 50% of the capital stock owned by IDT 72 hours after the closing of our initial public offering. Unless IDT defaults in its obligations under the pledge agreement, it has the voting rights with respect to the pledged stock. (3) Howard S. Jonas, together with a number of entities formed for the benefit of charities and members of his family, owns shares of IDT's capital stock that enable him to vote more than 50% of IDT's capital stock. Mr. Jonas is also the Chairman and Chief Executive Officer of IDT. As a result, he may be deemed to be the beneficial owner of the shares of our capital stock owned by IDT. Mr. Jonas disclaims beneficial ownership of these shares. (4) James A. Courter, one of our directors, is the President, Vice Chairman and a director of IDT. As a result, in addition to the 36,000 shares of our common stock that he holds directly, he may be deemed to be the beneficial owner of the shares of our capital stock owned by IDT. Mr. Courter disclaims beneficial ownership of these additional shares. Mr. Courter has granted an option to the underwriters to purchase up to 12,000 shares to cover over-allotments, if any. (5) Includes 4,415,400 shares of Class A stock held by SOFTBANK Technology Ventures IV, L.P. and 84,600 shares of Class A stock held by SOFTBANK Technology Advisors Fund L.P. (6) Gary E. Rieschel is the Executive Managing Director of SOFTBANK Technology Ventures and, as a result, he may exercise the power to vote and to dispose of the shares held by SOFTBANK. Includes 10,000 shares issuable upon exercise of presently exercisable stock options. Mr. Rieschel has granted an option to the underwriters to purchase up to 1,000 shares to cover over-allotments, if any. (7) Mr. Sobel has granted an option to the underwriters to purchase up to 307,378 shares to cover over- allotments, if any. In addition, if one or more employees, officers or directors of Net2Phone or IDT who have granted an option to the underwriters' do not sell all of the shares subject to the option, then Mr. Sobel will sell additional shares to cover any such shortfall. (8) 2,250,000 of these shares are shares of Class A stock and 500,000 shares are shares of common stock. (9) Includes 1,950,000 and 300,000 shares of Class A stock held by GE Capital Equity Investments, Inc. and Snap! LLC, respectively. Also includes 155,833 and 216,500 shares of common stock held by GE Capital Equity Investments, Inc. and NBC, respectively, and 5,248 shares of common stock held by Snap. GE Capital Equity Investments, Inc. and NBC are subsidiaries of General Electric Company. Snap is primarily owned by NBC and CNET, Inc., and NBC appoints a majority of the Board of Managers of Snap. (10) Includes 10,000 shares of common stock issuable upon exercise of presently vested options held by Martin J. Yudkovitz, over which NBC has the power to direct the disposition pursuant to a nominee agreement. Mr. Yudkovitz disclaims beneficial ownership of these shares. (11) Includes 360,000 shares held of record by a trust for the benefit of Mr. Balter's family members, of which Mr. Balter and his spouse are the trustees. Also includes an aggregate of 138,000 shares held of record by trusts for the benefit of the family members of Messrs. Greenblatt, Slasky and Rothberg, for which Mr. Balter acts as trustee. Also includes 67,050 shares issuable upon exercise of presently exercisable stock options. Mr. Balter has granted an option to the underwriters to purchase up to 187,450 shares to cover over-allotments, if any. (12) Includes 54,000 shares held of record by a trust for the benefit of Mr. Greenblatt's family members, of which Mr. Balter is the trustee. Also includes 30,000 shares issuable upon exercise of presently 62 exercisable stock options. Mr. Greenblatt has granted an option to the underwriters to purchase up to 46,000 shares to cover over-allotments, if any. (13) Includes 72,000 shares held of record by a trust for the benefit of Mr. Goldberg's family members, of which Mr. Goldberg's spouse is the trustee. Also includes 30,000 shares issuable upon exercise of presently exercisable stock options. Mr. Goldberg has granted an option to the underwriters to purchase up to 46,000 shares to cover over-allotments, if any. (14) Includes 54,000 shares held of record by a trust for the benefit of Mr. Rothberg's family members, of which Mr. Balter serves as the trustee. Mr. Rothberg has granted an option to the underwriters to purchase up to 36,000 shares to cover over-allotments, if any. (15) Includes 22,500 shares held of record by a trust for the benefit of Mr. Rand's family members. Mr. Rand has granted an option to the underwriters to purchase up to 12,000 shares to cover over-allotments, if any. (16) All of these shares are shares of common stock issuable upon exercise of presently exercisable options. (17) Mr. Mellor has granted an option to the underwriters to purchase up to 1,000 shares to cover over-allotments, if any. (18) Mr. King has granted an option to the underwriters to purchase up to 1,000 shares to cover over-allotments, if any. (19) Mr. Schulman has granted an option to the underwriters to purchase up to 1,000 shares to cover over-allotments, if any. (20) All of these shares are shares of common stock. Mr. Fischberger has granted an option to the underwriters to purchase up to 12,000 shares to cover over-allotments, if any. (21) Mr. McPherson has granted an option to the underwriters to purchase up to 1,000 shares to cover over-allotments, if any. (22) Includes the shares of Class A stock held by IDT and SOFTBANK. Also includes an aggregate of 522,883 shares issuable upon exercise of presently exercisable stock options. Executive officers and directors as a group have granted an option to the underwriters to purchase up to 819,078 shares to cover over-allotments, if any. 63 CERTAIN TRANSACTIONS We believe that all of the transactions set forth below were made on an arms-length basis. All future transactions between us and our officers, directors, principal stockholders and affiliates will be approved by a majority of the board of directors, including a majority of the outside directors, and will continue to be on terms no less favorable to us than could be obtained from unaffiliated third parties. Relationship with IDT Upon the closing of this offering, IDT will own approximately 48.3% of our capital stock. IDT owns Class A stock that has twice the voting power of our common stock. Therefore, upon the closing of this offering, IDT will control 58.2% of our vote. Since inception, we have received various services from IDT, including administration (accounting, human resources, legal), customer support, telecommunications and joint marketing. IDT has also provided us with the services of a number of its executives and employees. In consideration for these services, IDT has historically allocated a portion of its overhead costs related to those services to us. We believe that the amounts allocated to us have been no greater than the expenses we would have incurred if we obtained those services on our own or from unaffiliated third parties. Prior to the execution of the agreements with IDT described below, none of these services had been provided to us pursuant to any written agreement. We entered into a suite of agreements with IDT in May 1999, including an assignment agreement, a separation agreement, an IDT services agreement, a Net2Phone services agreement, a tax sharing and indemnification agreement, a joint marketing agreement and an Internet/telecommunications agreement. Assignment Agreement In connection with this agreement, IDT assigned to us certain proprietary products, information, patent applications, trademarks and related intellectual property rights used in connection with our business. IDT also licensed to us certain proprietary business information that relates to our business. We licensed back to IDT certain software that IDT will use in connection with its business. IDT Services Agreement In connection with this agreement, IDT will continue to provide us with various administrative services, including general accounting services, payroll and benefits administration and customer support. . General Accounting Services. IDT will provide us with accounts payable services and general ledger services. IDT will charge us cost plus 20% for these services. This portion of the IDT services agreement may be cancelled by either party on 30-days prior written notice and may be renewed by mutual agreement of the parties. . Payroll and Benefits Administration. IDT will administer our payroll. Until we terminate this agreement or establish our own benefit plan for our employees, our employees will continue to be covered under IDT's health insurance policies. We will pay IDT for administering our payroll and benefits plans at IDT's cost plus 20%. Additionally, we will reimburse IDT for the employer's cost of health insurance attributable to each of our employees participating in IDT's group health insurance plan and for any other direct costs attributable to our employees' participation in IDT's benefit plans. . Customer Support. IDT has agreed to provide customer support services to our customers on a cost-plus 20% basis. In the event we request additional services from IDT and IDT agrees to provide those services, we will enter into an addendum to the IDT Services Agreement covering those services. We will negotiate in good faith any fees payable to IDT for those additional services. 64 Net2Phone Services Agreement In connection with this agreement, we will support IDT's prepaid calling card platform. Our services under this agreement include technical support for the platform, ordering lines to handle calls, managing the debit card database and monitoring the network, 24 hours per day, seven days per week. We will provide these services at the greater of cost-plus 20% and $.0025 per minute of IDT usage of the prepaid calling card platform. In addition, IDT will reimburse us for all of our direct costs in connection with the acquisition, maintenance or support of any and all additional or replacement equipment needed for the prepaid calling card platform. The Net2Phone services agreement has an initial term of one year, which automatically renews for subsequent one-year periods unless one party gives the other 30-days prior written notice. In addition, following the initial term, the Net2Phone services agreement may be terminated at any time at either party's option upon 30-days prior written notice. If IDT requests services in addition to those described in the Net2Phone services agreement and we agree to provide those services, we will enter into an addendum to the Net2Phone services agreement covering those services. We will negotiate in good faith any fees payable to us for those additional services. Tax Sharing and Indemnification Agreement In connection with this agreement, IDT and Net2Phone will share certain past tax liabilities and benefits, including: . the allocation and payment of taxes for periods during which we and our subsidiaries, if any, were included in the same consolidated group with IDT for federal income tax purposes, and are, or were, included in the same consolidated, combined or unitary returns for state, local or foreign tax purposes; . the allocation of responsibility for the filing of tax returns; . the conduct of tax audits and the handling of tax controversies; and . various related matters. For periods during which we and our subsidiaries, if any, were or are included in IDT's consolidated federal income tax returns or state, local or foreign consolidated, combined, or unitary tax returns, we are required to pay an amount of tax equal to the amount we would have paid had we and our subsidiaries, if any, had filed a tax return as a separate affiliated group of corporations filing a consolidated federal income tax return or state, local or foreign consolidated, combined, or unitary tax returns. We are responsible for our own separate tax liabilities that are not determined on a consolidated or combined basis with IDT. As a result of leaving the IDT consolidated group, certain tax attributes of the IDT group attributable to our operations, such as net operating loss carryforwards, may be allocated to us. The tax sharing and indemnification agreement obligates us, where permitted by law, to elect to carry any post- deconsolidation losses forward, rather than to carry back such losses to tax years when we were included in the IDT consolidated or combined returns. We were included in IDT's consolidated group for federal income tax purposes from our incorporation in October 1997 until May 1999 when we concluded the sale of our Series A convertible preferred stock. Each corporation that is a member of a consolidated group during any portion of the group's tax year is jointly and severally liable for the federal income tax liability of the group for that year. While the tax sharing and indemnification agreement allocates tax liabilities between us and IDT during the period on or prior to the closing date of this offering, in which we are included in IDT's consolidated group, we could be liable in the event federal tax liability allocated to IDT is incurred, but not paid, by IDT or any other member of IDT's consolidated group for IDT's tax years that include such periods. In such event, we would be entitled to seek indemnification from IDT pursuant to the tax sharing and indemnification agreement. 65 Joint Marketing Agreement In connection with this agreement, we agreed to: . continue to offer links to the other's Web site; . cross-sell one another's products, including through their promotional materials and customer services representatives; and . undertake additional promotions as to which the parties shall agree from time to time. IDT will pay to us a fee of $8.00 for each of our customers who becomes a new customer of IDT as a result of our referral. We will pay IDT a fee of $8.00 for each customer of IDT who becomes a new customer of ours as a result of an IDT referral. However, in either case, these fees will be payable only with respect to any new customer who incurs and pays $50.00 or more in charges. The joint marketing agreement has an initial term of one year, which automatically renews for subsequent one-year periods unless one party gives the other party 60-days prior written notice. In addition, following the initial term, the joint marketing agreement may be terminated at any time at either party's option upon 60-days prior written notice. Internet/Telecommunications Agreement IDT has granted us an indefeasible right to use portions of its current high-speed network. We have the right to terminate our right to use portions of the existing network to the extent that the existing network is replaced, the underlying leases expire or at anytime with IDT's consent. We are obligated to reimburse IDT for all termination or cancellation charges which it incurs. We have agreed to pay IDT $60,000 per month for the right to use those portions of its existing network. This amount will be reduced as IDT terminates its right to use portions of the existing network at our request. IDT also granted us an indefeasible right to use portions of a new DS3 Network, which it will have the right to use for 20 years. This grant will be effective as construction of this new network is completed and delivered to IDT. This network has been pledged by IDT to the lenders under a credit facility. We have agreed to pay IDT an installation fee of $600,000 for this network, which we will pay as each portion of the new network is delivered. We also will reimburse IDT for the one-time fee of approximately $6.0 million payable in monthly installments over a five-year period, with interest of 9% per annum. We will reimburse IDT for all of maintenance and upgrade costs incurred by IDT with respect to those portions of the network that we use. IDT has also granted us a right to use IDT's equipment and other assets at its backbone points of presence and its network operations center for a two- year period. We will pay IDT an aggregate of $1.2 million for this right over the two-year period. At the end of the two-year period, we have the right to purchase any of this equipment then owned by IDT at fair market value. We must pay for all repairs, maintenance and upgrades of equipment and other facilities we use pursuant to this agreement. IDT also has agreed to enter into transit relationship agreements with us giving us access substantially identical to IDT's at five different core locations for a period of one year commencing May 1999. Following the initial term, the transit relationship agreements may be terminated at any time at either party's option upon 60-days prior written notice. IDT retains primary control over the equipment covered by this agreement but may require assistance from us in gaining Internet access. We have agreed to assist in facilitating access for a one-year period commencing May 1999. For each month during the effectiveness of the agreement, IDT will pay us: . $1.00 for each of IDT's dial-up Internet customers; . for each dedicated-line Internet customer, the lesser of $100.00 or 20% of the fee IDT charges; and . 25% of all fees charged by IDT for installation of dedicated lines. Following the initial one year term, this agreement automatically renews for one-year periods unless one party gives the other 60-days prior written notice of termination. 66 Separation Agreement The separation agreement with IDT provides for the following: . Releases. This agreement provides for mutual general releases between us and IDT for alleged liability to the date of the agreement, with certain limited exceptions, including liability specifically excluded by any of the other agreements between us and IDT, and liability for unpaid amounts for products or services or refunds owing on products or services due on a value-received basis for work done by one party at the request or on behalf of the other. . Indemnification by Net2Phone. We have agreed to indemnify IDT and each of IDT's directors, officers and employees from all liabilities relating to, arising out of or resulting from our failure or the failure of any other person to pay, perform or otherwise promptly discharge any of our liabilities in accordance with their respective terms, and any breach by us of the agreements between us and IDT. . Indemnification by IDT. IDT has agreed to indemnify us and each of our directors, officers and employees from all liabilities relating to, arising out of or resulting from the failure of IDT or any other person to pay, perform or otherwise promptly discharge any liabilities of IDT other than our liabilities, and any breach by IDT of the agreements between us and IDT. . Dispute Resolution. We will attempt to resolve disputes by referring controversial matters to senior management (or other mutually agreed upon) representatives of the parties. If these efforts are not successful, either party may submit the dispute to mandatory, binding arbitration. This agreement contains procedures that are intended to expedite dispute resolution, including the selection of an arbitrator and certain limitations on discovery. In the event that any dispute may be in excess of $5.0 million, or in the event that an arbitration award in excess of $5.0 million is issued, either party may submit the dispute to a court of competent jurisdiction. If the parties disagree that the amount in controversy is in excess of $5.0 million, the parties are required to submit the disagreement to arbitration. . Noncompetition; Certain Business Transactions. For a period of 36 months commencing May 1999, IDT may not directly or indirectly, engage in the provision of or developmental efforts related to Internet telephony services and voice enabling Web applications anywhere in the world or become a stockholder, partner or owner of any entity that is engaged in such business anywhere in the world. However, subject to our approval, which may not be unreasonably withheld, IDT may acquire a passive interest of up to 20% in such entity so long as IDT does not assist that entity in developing an Internet telephony business or otherwise engaging in our business. Neither we nor IDT will have any duty to communicate or offer any corporate opportunity to the other party and may pursue or acquire any such opportunity for itself or direct such opportunity to any other person. Amounts Payable to IDT Since inception, IDT has provided the funds to finance our operations in the form of advances (approximately $22.0 million as of April 30, 1999, of which we repaid $8.0 million in May 1999 and $7.0 million in August 1999). These advances have been converted into a note that is payable in 60 monthly installments of principal and interest. The balance of the note is payable in 60 monthly installments of principal and interest at a rate of 9% per annum. In addition, as of July 31, 1999, we also owed IDT approximately $3.7 million under the suite of agreements we entered to in May 1999. 67 Relationship with Other Investors Series A Subscription Agreements Pursuant to Series A Subscription Agreements, dated as of May 13, 1999, SOFTBANK Technology Ventures IV, GE Capital Equity Investments, America Online, Access Technology Partners, Hambrecht & Quist and its affiliates and BT Alex. Brown and its affiliates, purchased from us, in the aggregate, 3,140,000 shares of Series A convertible preferred stock and warrants to purchase up to 180,000 shares of our common stock, of which warrants to purchase 44,248 shares of our common stock were exercised prior to the closing of our initial public offering. The remaining warrants to purchase 135,752 shares of our common stock terminated at the closing of our initial public offering. Additionally, a warrant to purchase 92,400 shares of our common stock was issued to Hambrecht & Quist as part of its fee as placement agent with respect to the sale of our Series A convertible preferred stock, which warrants were exercised prior to the closing of our initial public offering. In connection with the subscription agreements, we also entered into a registration rights agreement and a stockholders agreement, each of which is described below. Registration Rights Agreement The Series A investors acquired the following registration rights: . one demand for registration at any time after January 28, 1999. This demand registration right may be made by one or more holders of the Series A convertible preferred stock that own at least 50% of the shares of Class A stock into which the Series A convertible preferred stock converts. If our board of directors determines in good faith that the demand registration would be materially detrimental to us, we are entitled to postpone the filing of the registration statement otherwise required to be prepared and filed by us for a reasonable period of time, not to exceed 90 days; . piggyback registration rights if we propose to register any securities under the Securities Act in connection with any offering of our securities other than a registration statement on Form S-8 or Form S-4, subject to quantity limitations determined by underwriters if the offering involves an underwriting; and . two demand registrations at any time after we become eligible to register our securities on Form S-3 (or any successor form). Holders that beneficially own at least 20% of the shares of Class A stock into which the Series A convertible preferred stock converts may make these demands. We agreed to pay all reasonable expenses incurred in connection with any registration, filing or qualification pursuant to the Registration Rights Agreement. We also agreed, to the extent permitted by law, to indemnify the Series A investors against some liabilities in connection with the offering of the shares, including liabilities arising under the Securities Act. Stockholders Agreement IDT and Clifford M. Sobel, our Chairman, agreed to vote all of their shares in favor of the election of a director nominated by SOFTBANK Technology Ventures IV and a director nominated by GE Capital Equity Investments or NBC, in each case for as long as either entity holds a majority of the shares of Series A convertible preferred stock originally purchased by them or the shares into which they are convertible. In addition, each Series A convertible investor agreed to a lock up with respect to their shares until January 25, 2000. The Series A investors, IDT and Mr. Sobel also agreed not to transfer any of their shares to any of our competitors for a period of 36 months beginning in May 1999, and thereafter only subject to our right of first refusal. However, the stockholders agreement does permit transfers between Series A investors. 68 Agreements with America Online and Subsidiaries Netscape We signed a series of related agreements with Netscape, a subsidiary of America Online, on January 31, 1999, allowing us to embed our software and services in future versions of Netscape's Internet browsers. The two-year term of our exclusive arrangement with Netscape commences with the beta release of the next version of Netscape's Internet browser, which we believe will occur later this year. In addition, our services will be displayed on the Netscape Netcenter site and bundled with Netscape's suite of software and software updates. We also have a right to place advertisements on Netscape's Web site. In exchange, we will pay Netscape one-time licensing fees, a percentage of revenue generated by calls provided through our co-branded service and a percentage of advertising revenue generated by a co-branded Web page. Netscape's parent company, America Online, will beneficially own approximately 5.3% of our capital stock upon the closing of this offering. ICQ In July 1999, we entered into an exclusive, four-year distribution and marketing agreement with ICQ, a subsidiary of America Online. ICQ provides software that enables Internet users to contact other users on a real-time basis, and to determine whether other individuals are on-line. ICQ's software also enables Internet users to chat, send messages and files and to play Internet-based games with one another. We believe that this agreement will enable us to attract a substantial number of ICQ's users to utilize our services, which will enhance our revenue, customer base and market share. Under this agreement, ICQ has agreed to: . co-brand and promote our phone-to-phone Internet telephony services in the United States and in 19 other countries; . embed customized versions of our software on an exclusive basis to allow ICQ customers to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls; . share revenue from advertisements and sponsorships sold by ICQ on our software that is embedded in ICQ's instant messaging software; and . promote our services on some of ICQ's Web sites. We have agreed to: . pay ICQ a fee of $7.5 million, $4.0 million of which was paid at signing, and the remaining $3.5 million was paid in September 1999; . pay ICQ a share of minutes-based revenue generated through the ICQ service and award ICQ a performance bonus on the basis of the total revenue derived under the agreement; and . promote ICQ on our Web sites. ICQ has the right to terminate the exclusivity granted to us as to a particular service under the agreement under certain circumstances, including if: . the price for the service or the scope of the service offered by us to retail customers through any other distribution channel is more favorable than the corresponding service offered by Net2Phone through the ICQ service; . mutually agreed upon third party reviewers determine that the service offered by us is not competitive as to per minute rates and quality with similar services offered by a competitor of Net2Phone; or . our service is not prepared for launch in a particular country by the applicable cut-off date specified in the agreement. 69 In addition, ICQ has the right to terminate the entire agreement under certain circumstances, including if: . two or more of our services are not competitive with those of our competitors in terms of price, and the scope and quality of service; or . if more than one of our services is not fully prepared for launch by the specified cut-off dates. If at any time after July 14, 2001, ICQ or America Online enters into a strategic relationship with any major national or international telecommunications provider for the distribution of telecommunications services using America Online and its affiliates, and if ICQ terminates the agreement and the telecommunications provider does not agree to offer all of our services that are offered under the agreement on terms comparable to those in the agreement, then ICQ will be required to pay us a termination fee of up to $60.0 million. The amount of the termination fee, if any, will depend on whether the telecommunications provider offers any of our services and the aggregate transaction revenues represented by our services that will not be offered. America Online In November 1999, we entered into a three-year integration, distribution and marketing agreement with America Online. Under this agreement, America Online will integrate customized versions of our core Internet telephony services, on an exclusive basis for a period in excess of two of the years, into the America Online instant messaging software, allowing members of America Online instant messaging to make PC-to-phone and phone-to-PC and to use our PC-to-fax, fax-to- PC and conference calling services. We will also co-brand phone-to-phone Internet telephony calling cards, which America Online will promote on the America Online instant messaging controlled properties. In connection with our distribution and marketing agreement with ICQ, an America Online subsidiary, we issued a warrant to America Online to purchase up to 3% of our outstanding capital stock on a fully diluted basis. In connection with the America Online agreement, we amended the warrant to include the right to purchase an additional .5% of our outstanding capital stock on a fully diluted basis. This warrant will vest in three 1% increments and then one .5% increment upon the achievement of four incremental thresholds of revenue generated under the both the ICQ and America Online agreements during the first four years that the warrant is outstanding. The per share exercise price under the warrant for the first three 1% increments will be equal to the lesser of $12.00 per share or $450 million divided by the number of our fully-diluted shares on the initial exercise date. The per share exercise price under the warrant for the additional .5% increment is $60.46 per share. The warrant may be exercised for a period of five years through November 19, 2004. The warrant grants to America Online demand registration rights enabling America Online to cause us to effect two registrations and piggy-back registration rights that can be used in connection with future registrations. In addition, America Online will have the right to require us to file up to two additional registration statements relating to the shares issuable upon exercise of the warrant at such time as we shall become eligible to register these shares on Form S-3 under the Securities Act of 1933. CompuServe In November 1999, we entered into a two-year marketing agreement (exclusive for the first year) with CompuServe, a subsidiary of America Online. Under this agreement, CompuServe has agreed to promote our phone-to-phone Internet telephony calling card services through the United States version of the CompuServe interactive service. We have agreed to pay CompuServe a fee of $4.0 million (of which $2.0 million was paid at signing and the remaining $2.0 million will be paid over the first 21 months of the agreement), a share of minutes-based revenue generated through the phone-to-phone service, and a share of 70 certain other revenue generated from CompuServe customers. Both parties will share any revenue from advertisements and promotions sold on the Web pages supporting the services offered under the agreement. Agreements with NBC and Snap We signed an agreement with NBC on June 25, 1999 to purchase $1.5 million in television advertising time on the NBC television network. We also have the right to purchase additional spots to be telecast prior to June 30, 2000. Additionally, on May 18, 1999, we signed a non-binding letter of intent with NBC Multimedia, an affiliate of NBC. This letter of intent contemplates a one- year agreement whereby we will pay NBC Multimedia $280,000 in exchange for the integration of our services into the NBC.com and NBC Interactive Neighborhood Web sites. NBC is a wholly-owned indirect subsidiary of the General Electric Company Group, which will beneficially own approximately 5.1% of our capital stock upon the closing of this offering. On May 17, 1999, we entered into an agreement with Snap. Snap, an Internet portal service of NBC and CNET, will strategically display links to our Web site and services on its Snap.com Web site. In addition, we are their preferred provider of PC-to-phone services during the two-year term of this agreement. Snap also will deliver a preset minimum number of impressions on its site and has agreed to give us the right to a certain amount of online advertising, subject to certain conditions. In exchange, we agreed to pay Snap a one-time fee, a percentage of revenue generated through their site and bonus payments for customers delivered by Snap after meeting certain quotas. NBC, a wholly- owned indirect subsidiary of General Electric Company, together with CNET, is the primary owner of Snap. Agreements with Priceline.com In November 1999, we entered into a memorandum of understanding with priceline.com, an Internet commerce service that allows users to name their own price to purchase goods and services over the Internet. The term of our memorandum of understanding is for a period of three years. Daniel H. Schulman, the President, Chief Operating Officer and a director of priceline.com, is a member of our board of directors. Under the terms of our memorandum of understanding, we expect to offer our international and domestic Phone2Phone services as a premier provider through priceline.com, enabling priceline.com customers to name their own price to purchase blocks of minutes of our Phone2Phone services. It is expected that our Phone2Phone services will be offered for sale through priceline.com in the following manner: . domestic time blocks, where customers can name their own price for blocks of domestic long distance Phone2Phone minutes; . international time blocks, where customers can name their own price for blocks of international long distance Phone2Phone minutes to a specified country; and . priceline.com's "Call Anywhere" program, where customers can name their own price for blocks of Phone2Phone minutes that can be used to call multiple designated locations; the actual amount of time purchased will vary per location. We also expect to work with priceline.com to develop an offer-by-phone service which will enable consumers to make offers to purchase Phone2Phone services from us on a per-call basis. Under the terms of the co-marketing agreement, we will participate in a co-marketing program with priceline.com through December 31 , 1999. Under the terms of the memorandum of understanding, we expect to pay priceline.com the aggregate sum of $17,000,000 in increasing installment payments over a three year period. Under the terms of the co-marketing agreement, we will pay priceline.com the aggregate sum of at least $1,450,000. 71 Facility Leases We have entered into leases for the use of our Hackensack facilities with corporations that are owned and controlled by Howard S. Jonas, a member of our board of directors and a director of IDT. Additionally, Mr. Jonas, together with a number of entities formed for the benefit of charities and members of his family, owns shares of IDT's capital stock that enable him to vote more than 50% of IDT'S capital stock. As a result, he may be deemed to be the beneficial owner of the shares of Net2Phone capital stock owned by IDT. The two Hackensack leases run for three-year terms, beginning on March 1, 1999 with monthly rent of $5,600 for 294-298 State Street and $9,912 for 171-173 Main Street. We have also entered into a sublease with IDT for our Piscataway facility, which is leased by IDT from a corporation owned and controlled by Mr. Jonas. The Piscataway sublease runs for a three-year term, beginning in May 1999, with monthly rent of $8,400. Officer Loans In May 1999, Howard S. Balter, Ilan M. Slasky, David Greenblatt, Martin Rothberg, H. Jeff Goldberg, Jonathan Reich, and Jonathan Rand, each of whom is an executive officer, borrowed $1,447,240, $352,800, $352,800, $352,800, $352,800, $98,000 and $44,100, respectively, from us. All of the proceeds of these loans were used to purchase shares of our common stock upon the exercise of stock options. The loans bear interest at the rate of 7.0% per annum, and will mature in May 2001. As a condition to receiving these loans, these officers surrendered their right to exercise 8,862, 2,160, 2,160, 2,160, 2,160, 600 and 270 immediately exercisable options, respectively. 72 DESCRIPTION OF CAPITAL STOCK Authorized Capital Stock Our certificate of incorporation, as amended and restated, authorizes 247,042,089 shares of capital stock consisting of: . 10,000,000 shares of preferred stock, $0.01 par value; . 37,042,089 shares of Class A stock, $0.01 par value; and . 200,000,000 shares of common stock, $0.01 par value. Of the shares of common stock, 3,400,000 shares of our common stock are being offered through this prospectus. Immediately following the closing of the offering, 11,672,616 shares of common stock and 36,524,250 shares of Class A stock will be outstanding. We do not currently have any shares of preferred stock outstanding. Common Stock and Class A Stock General. The rights of holders of common stock and holders of Class A stock are identical, except for voting rights, conversion rights and restrictions on transferability. As of November 3, 1999, there were 11,672,616 shares of common stock outstanding and 36,524,250 shares of Class A stock outstanding. Voting Rights. The holders of Class A stock are entitled to two votes per share and the holders of common stock are entitled to one vote per share. Except as otherwise required by law or as described below, holders of Class A stock and common stock will vote together as a single class on all matters presented to the stockholders for their vote or approval, including the election of directors. Stockholders are not entitled to vote cumulatively for the election of directors, and no class of outstanding capital stock acting alone is entitled to elect any directors. Upon the closing of this offering, IDT will own approximately 48.3% of our outstanding capital stock. IDT owns Class A stock that has twice the voting power of our common stock. Accordingly, IDT will retain effective control of us through holding approximately 58.2% of the combined voting power of our outstanding capital stock. Therefore, IDT has the ability to elect all of our directors and to effect or prevent certain corporate transactions which require majority approval of the combined classes, including mergers and other business combinations. Transfer Restrictions. Class A stock is subject to certain limitations on transferability that do not apply to the common stock. Our certificate of incorporation provides that shares of Class A stock automatically convert into an equal number of shares of common stock if there is a transfer of shares of Class A stock to a person other than a permitted transferee. Thereafter, such shares of common stock may be freely transferred, subject to restrictions imposed under applicable securities laws. Shares of Class A stock acquired by us will be canceled and may not be reissued. Dividends and Liquidation. Holders of Class A stock and holders of common stock have an equal right to receive dividends when and if declared by the board of directors out of legally available funds. In the event of a liquidation, dissolution or winding up, holders of the shares of Class A stock and common stock are entitled to share equally, share-for-share, in the assets available for distribution after payment of all creditors and the liquidation preferences of our preferred stock. Optional Conversion Rights. Each share of Class A stock may, at any time and at the option of the holder, be converted into one fully paid and non- assessable share of common stock. Upon conversion, such shares of common stock would not be subject to restrictions on transfer that applied to the shares of Class A stock prior to conversion except to the extent such restrictions are imposed under applicable securities laws. The shares of common stock are not convertible into or exchangeable for shares of Class A stock or any other shares or securities. 73 Other Provisions. Holders of Class A stock and common stock have no preemptive rights to subscribe to any additional securities of any class which we may issue and there are no redemption provisions or sinking fund provisions applicable to either such class, nor is the Class A stock or the common stock subject to calls or assessments by us. The rights, preferences, and privileges of the holders of common stock and Class A stock are subject to and may be adversely affected by, the rights of the holders of any series of preferred stock. Preferred Stock Our certificate of incorporation provides that we may issue up to 10,000,000 shares of preferred stock in one or more series as may be determined by our board of directors who may establish the number of shares to be included in each such series, fix the designation, powers, preferences and relative rights of the shares of each such series and any qualifications, limitations, or restrictions thereof, and increase or decrease the number of shares of any such series without any vote or action by the stockholders. The board of directors may authorize, without stockholder approval, the issuance of preferred stock with voting and conversion rights that could adversely affect the voting power and other rights of holders of common stock or Class A stock. Preferred stock could be issued quickly with terms designated to delay or prevent a change in our control or to make the removal of management more difficult. This could have the effect of decreasing the market price of the common stock. In May 1999, we sold 3,140,000 shares of Series A convertible preferred stock pursuant to Series A Subscription Agreements. All shares of the Series A convertible preferred stock were automatically converted into 9,420,000 shares of our Class A stock at the closing of our initial public offering. We do not currently have any shares of preferred stock outstanding. We believe that the ability of the board to issue one or more series of preferred stock will provide us with flexibility in structuring possible future financings and acquisitions, and in meeting other corporate needs that might arise. The authorized shares of preferred stock, as well as shares of common stock, will be available for issuance without action by our stockholders, unless such action is required by applicable law or the rules of any stock exchange or automated quotation system on which our securities may be listed or traded. Although the board has no intention at the present time of doing so, it could issue a series of preferred stock that could, depending on the terms of such series, impede the completion of a merger, tender offer or other takeover attempt. The board will make any determination to issue such shares based on its judgment as to our best interests and the best interests of our stockholders. The board could issue preferred stock having terms that could discourage an acquisition attempt through which an acquirer may be able to change the composition of the board, including a tender offer or other transaction that some, or a majority, of our stockholders might believe to be in their best interests or in which stockholders might receive a premium for their stock over the then current market price. Certain Anti-Takeover Effects. Certain provisions of the certificate of incorporation and bylaws, summarized in the following paragraphs, may be considered to have an anti-takeover effect and may delay, deter or prevent a tender offer, proxy contest or other takeover attempt that a stockholder might consider to be in such stockholder's best interest, including such an attempt that might result in payment of a premium over the market price for shares held by stockholders. The certificate of incorporation and bylaws provide for the board of directors to be divided into three classes of directors serving staggered three-year terms upon the consummation of this offering. As a result, approximately one-third of the board of directors will be elected each year. Classification of the board of directors expands the time required to change the composition of a majority of directors and may tend to discourage a proxy contest or other takeover bid for us. Moreover, under the Delaware General Corporation Law, in the case of a corporation having a classified board of directors, the stockholders may remove a director only for cause. 74 The certificate of incorporation provides that a special meeting of stockholders may be called by any of the following: . the chairman of our board; . our president; . any of our vice presidents; or . our secretary. In addition, a special meeting of stockholders may be called by any such officer at the written request of a majority of the board of directors or at the written request of stockholders owning a majority of our capital stock issued and outstanding and entitled to vote. Section 203 of the Delaware General Corporation Law provides that, subject to certain exceptions specified therein, an "interested stockholder" of a Delaware corporation shall not engage in any business combinations, including mergers or consolidations or acquisitions of additional shares of the corporation, with the corporation for a three-year period following the date that such stockholder becomes an interested stockholder unless: . prior to such date, the board of directors of the corporation approved either the business combination or the transaction that resulted in the stockholder becoming an interested stockholder; . upon consummation of the transaction that resulted in the stockholder becoming an "interested stockholder," the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced (excluding certain shares); or . on or subsequent to such date, the business combination is approved by the board of directors of the corporation and authorized at an annual or special meeting of stockholders by the affirmative vote of at least 66.67% of the outstanding voting stock that is not owned by the interested stockholder. Except as otherwise specified in Section 203 of the Delaware General Corporation Law, an interested stockholder is defined to include (x) any person that owns (or, within the prior three years, did own) 15% or more of the outstanding voting stock of the corporation, or is an affiliate or associate of the corporation and was the owner of 15% or more of the outstanding voting stock of the corporation at any time within three years immediately prior to the date of determination and (y) the affiliates and associates of any such person. Under certain circumstances, Section 203 of the Delaware General Corporation Law makes it more difficult for a person who would be an interested stockholder to effect various business combinations with a corporation for a three-year period. We have not elected to be exempt from the restrictions imposed under Section 203 of the Delaware General Corporation Law. However, IDT and its affiliates are excluded from the definition of "interested stockholder" pursuant to the terms of Section 203 of the Delaware General Corporation Law. The provisions of Section 203 of the Delaware General Corporation Law may encourage persons interested in acquiring us to negotiate in advance with the board, since the stockholder approval requirement would be avoided if a majority of the directors then in office approves either the business combination or the transaction which results in any such person becoming an interested stockholder. Such provisions also may have the effect of preventing changes in our management. It is possible that such provisions could make it more difficult to accomplish transactions that our stockholders may otherwise deem to be in their best interests. 75 Liability of Directors; Indemnification The certificate of incorporation contains a provision that is designed to limit directors' liability to the extent permitted by the Delaware General Corporation Law. Specifically, directors will not be held liable to us or our stockholders for monetary damages for any breach of fiduciary duty as a director, except for liability as a result of: . any breach of the duty of loyalty to us or our stockholders; . actions or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; . payment of an improper dividend or improper repurchase of our stock under Section 174 of the Delaware General Corporation Law; or . actions or omissions pursuant to which the director received an improper personal benefit. The principal effect of the limitation of liability provision is that a stockholder is unable to prosecute an action for monetary damages against a director of ours unless the stockholder can demonstrate one of the specified bases for liability. The provision, however, does not eliminate or limit director liability arising in connection with causes of action brought under the federal securities laws. The certificate of incorporation does not eliminate a director's duty of care. The inclusion of this provision in the certificate of incorporation may discourage or deter stockholders or management from bringing a lawsuit against directors for a breach of their fiduciary duties, even though such an action, if successful, might otherwise have benefited us and our stockholders. This provision should not affect the availability of equitable remedies such as injunction or rescission based upon a director's breach of the duty of care. The bylaws also provide that we will indemnify our directors and officers, and may indemnify any of our employees and agents, to the fullest extent permitted by Delaware law. We are generally required to indemnify our directors and officers for all judgments, fines, penalties, settlements, legal fees and other expenses incurred in connection with pending, threatened or completed legal proceedings because of the director's or officer's position with us or another entity that the director or officer serves at our request, subject to certain conditions, and to advance funds to its directors and officers to enable them to defend against such proceedings. At present, there is no pending or threatened litigation or proceeding involving any director or officer, employee or agent of ours where such indemnification will be required or permitted. Transfer Agent and Registrar American Stock Transfer & Trust Company is the transfer agent and registrar for our common stock. 76 SHARES ELIGIBLE FOR FUTURE SALE Of the 17,672,616 shares of common stock and 33,924,250 shares of Class A stock to be outstanding upon the closing of this offering, the 6,300,000 shares of common stock sold in the offering (7,245,000 shares if the underwriters exercise their over-allotment option in full) will be freely tradable without restriction under the Securities Act of 1933, except for any such shares which may be acquired by an affiliate of ours, as that term is defined in Rule 144 promulgated under the Securities Act of 1933. Upon the closing of this offering, IDT will own 24,904,250 shares of Class A stock, which will constitute approximately 48.3% of our outstanding capital stock. Persons who are affiliates of ours will be permitted to sell the shares of common stock that are issued in the offering only pursuant to an effective registration statement under the Securities Act of 1933 or an exemption from the registration requirements of the Securities Act of 1933, including exemptions provided by Rule 144 of the Securities Act of 1933. In August 1999, we filed a registration statement for 9,569,782 of the shares of common stock that are authorized for issuance under our stock option plan. Shares issued pursuant to our stock option plan after the filing of this registration statement (other than shares issued to our affiliates) generally will be freely tradable without restriction or registration under the Securities Act of 1933. As of November 18, 1999, options to purchase 9,034,750 shares of common stock under our stock option plan have been granted, of which 1,470,218 have been exercised. See "Management--1999 Stock Incentive Plan." The shares of capital stock held by IDT are deemed "restricted securities" as defined in Rule 144 of the Securities Act of 1933, and may not be sold other than through registration under the Securities Act of 1933 or pursuant to an exemption from the regulations thereunder, including exceptions provided by Rule 144 of the Securities Act of 1933. Subject to applicable law and to the contractual restriction with the underwriters described below, IDT may sell any and all of the shares of capital stock it owns after completion of the offering. We, along with our directors and executive officers, IDT and the selling stockholders have agreed, for a period of 180 days after the date of the initial public offering prospectus, not to offer or sell any shares of Class A stock or common stock, subject to limited exceptions, without the prior written consent of Hambrecht & Quist LLC. IDT's shares of our capital stock are pledged as collateral to secure a credit facility. If IDT defaults in its obligations under the pledge agreement, then a third party could acquire the pledged stock and would not be subject to these agreements. See "Underwriting." 77 UNDERWRITING Hambrecht & Quist LLC, Donaldson, Lufkin & Jenrette Securities Corporation, Deutsche Bank Securities Inc., BancBoston Robertson Stephens, Inc. and Bear, Stearns & Co. Inc. are the representatives of the underwriters. Hambrecht & Quist LLC and Donaldson, Lufkin & Jenrette Securities Corporation are acting as joint book-running managers; Deutsche Bank Securities Inc. is acting as co-lead manager; and BancBoston Robertson Stephens Inc. and Bear, Stearns & Co. Inc. are acting as co-managers. Subject to the terms and conditions of the Underwriting Agreement, the underwriters named below, through their representatives, have severally agreed to purchase from Net2Phone and the selling stockholders the following respective number of shares of common stock:
Number of Name Shares ---- --------- Hambrecht & Quist LLC............................................ Donaldson, Lufkin & Jenrette Securities Corporation.............. Deutsche Bank Securities Inc..................................... BancBoston Robertson Stephens Inc................................ Bear, Stearns & Co. Inc.......................................... --------- Total.......................................................... 6,300,000 =========
The underwriting agreement provides that the obligations of the underwriters are subject to certain conditions precedent, including the absence of any material adverse change in our business and the receipt of certain certificates, opinions and letters from us, our counsel and the independent auditors. The underwriters are committed to purchase all of the shares of common stock offered by us if they purchase any shares. The following table shows the per share and total underwriting discounts and commissions we and the selling stockholders will pay to the underwriters. Such amounts are shown assuming both no exercise and full exercise of the underwriters' over-allotment option to purchase additional shares. Underwriting Discounts and Commissions
Without With Over-Allotment Over-Allotment Exercise Exercise -------------- -------------- Per Share...................................... $ $ Total.......................................... $ $
We estimate that the total expenses of this offering, excluding underwriting discounts and commissions, will be approximately $ million. The underwriters propose to offer the shares of common stock directly to the public at the public offering price set forth on the cover page of this prospectus and to certain dealers at that price less a concession not in excess of $ per share. The underwriters may allow and such dealers may reallow a concession not in excess of $ per share to certain other dealers. After this offering of the shares, the offering price and other selling terms may be changed by the underwriters. Other selling stockholders, including employees, officers and directors of Net2Phone and IDT, have granted to the underwriters an option, exercisable no later than 30 days after the date of this prospectus, to purchase up to 945,000 additional shares of common stock at the public offering price, less the underwriting discount set forth on the cover page of this prospectus. To the extent that the underwriters exercise this option, each of the underwriters will have a firm commitment to purchase approximately the same percentage thereof which the number of shares of common stock to be purchased by it shown in the above 78 table bears to the total number of shares of common stock offered hereby. Selling stockholders will be obligated, pursuant to the option, to sell shares to the underwriters to the extent the option is exercised. The underwriters may exercise this option only to cover over-allotments made in connection with the sale of shares of common stock in this offering. The offering of the shares is made for delivery when, as and if accepted by the underwriters and subject to prior sale and to withdrawal, cancellation or modification of the offering without notice. The underwriters reserve the right to reject an order for the purchase of shares in whole or in part. We, together with the selling stockholders, have agreed to indemnify the underwriters against certain liabilities, including liabilities under the Securities Act, and to contribute to payments the underwriters may be required to make in respect of these liabilities. Prior to the closing of our initial public offering, certain of our securityholders, including the Series A investors, IDT and our executive officers and directors, agreed that they will not, without the prior written consent of Hambrecht & Quist LLC, offer, sell or otherwise dispose of any shares of capital stock, options or warrants to acquire shares of capital stock or securities exchangeable for or convertible into shares of capital stock owned by them for a period of 180 days following our initial public offering. This period will terminate on January 25, 2000. We also agreed that we would not, without the prior written consent of Hambrecht & Quist LLC, offer, sell or otherwise dispose of any shares of capital stock, options or warrants to acquire shares of capital stock or securities exchangeable for or convertible into shares of capital stock until January 25, 2000, except that we may issue shares upon the exercise of options and warrants granted prior to the date hereof, and may grant additional options under our stock option plans. Without the prior written consent of Hambrecht & Quist LLC, any additional options granted shall not be exercisable until January 25, 2000. Certain persons participating in this offering may over-allot or effect transactions which stabilize, maintain or otherwise affect the market price of the common stock at levels above those which might otherwise prevail in the open market, including by entering stabilizing bids, effecting syndicate covering transactions or imposing penalty bids. A stabilizing bid means the placing of any bid or effecting of any purchase, for the purpose of pegging, fixing or maintaining the price of the common stock. A syndicate covering transaction means the placing of any bid on behalf of the underwriting syndicate or the effecting of any purchase to reduce a short position created in connection with the offering. A penalty bid means an arrangement that permits the underwriters to reclaim a selling concession from a syndicate member in connection with the offering when shares of common stock sold by the syndicate member are purchased in syndicate covering transactions. Such transactions may be effected on the Nasdaq National Market, in the over-the- counter market, or otherwise. Such stabilizing, if commenced, may be discontinued at any time. In connection with this offering, certain underwriters and selling group members (if any) who are qualified market makers on the Nasdaq National Market may engage in passive market making transactions in our common stock on the Nasdaq National Market in accordance with Rule 103 of Regulation M under the Securities Exchange Act of 1934, as amended. In general, a passive market maker must display its bid at a price not in excess of the highest independent bid of such security; if all independent bids are lowered below the passive market maker's bid, however, such bid must then be lowered when certain purchase limits are exceeded. Hambrecht & Quist LLC and persons associated with Hambrecht & Quist LLC beneficially own 60,000 shares of Class A stock and 92,400 shares of common stock. Additionally, Access Technology Partners, L.P., a fund of outside investors that is managed by a subsidiary of Hambrecht & Quist California, owns 240,000 shares of Class A stock. Deutsche Bank Securities Inc. and persons associated with Deutsche Bank Securities Inc. own 112,500 shares of Class A stock. 79 Denis Bovin, Vice Chairman-Investment Banking of Bear, Stearns & Co. Inc., owns 125,000 shares of common stock. Prior to the closing of the initial public offering, each of Hambrecht & Quist LLC and persons associated with it, SOFTBANK Technology Advisors Fund, L.P., The Charles Schwab Corporation, BT Alex. Brown Incorporated and persons associated with it, Denis Bovin and Stephen A. Oxman entered into written agreements with Net2Phone, whereby each of them agreed, for a period of one year from the date of the initial public offering prospectus with respect to 106,581 shares of capital stock, and three years from the date of the initial public offering prospectus with respect to 226,324 shares of capital stock, not to sell, transfer, assign, pledge or hypothecate any shares of capital stock owned by them that were deemed to be underwriting compensation in connection with the initial public offering. Hambrecht & Quist LLC and Deutsche Bank Securities Inc. have provided financial advisory services to Net2Phone and IDT in the past and have received compensation at market rates for these services. LEGAL MATTERS Certain legal matters with respect to the validity of the common stock offered hereby will be passed upon for us by Morrison & Foerster LLP, New York, New York. Morrison & Foerster LLP attorneys working on our matters beneficially own an aggregate of less than one percent of our common stock. Certain legal matters relating to this offering will be passed upon for the underwriters by Brobeck, Phleger & Harrison LLP, New York, New York. EXPERTS The financial statements of Net2Phone, Inc. and, for the periods prior to its incorporation, the Net2Phone division of IDT Corporation as of July 31, 1998 and 1999 and for the years ended July 31, 1997, 1998 and 1999 appearing in this prospectus and registration statement have been audited by Ernst & Young LLP, independent auditors, as set forth in their report thereon appearing elsewhere herein, and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. 80 WHERE YOU CAN FIND MORE INFORMATION We have filed with the Securities and Exchange Commission a registration statement on Form S-1 under the Securities Act of 1933 with respect to the common stock offered hereby. This prospectus does not contain all of the information set forth in the registration statement, certain portions of which are omitted as permitted by the rules and regulations of the Securities and Exchange Commission. For additional information pertaining to us and the common stock to be sold in this offering, reference is made to the registration statement, including the exhibits thereto and the financial statements, notes and schedules filed as a part thereof. Statements contained in this prospectus regarding the contents of any contract or other document referred to herein or therein are not necessarily complete, and in each instance reference is made to the copy of such contract or other document filed as an exhibit to the registration statement or such other document, each such statement being qualified in all respects by such reference. We are subject to the informational requirements of the Securities Exchange Act of 1934 and will file reports, proxy statements and other information with the Securities and Exchange Commission. Such reports, proxy statements and other information, as well as the registration statement and the exhibits and schedules thereto, may be inspected, without charge, at the public reference facility maintained by the Securities and Exchange Commission at Room 1024, Judiciary Plaza, 450 Fifth Street, NW, Washington, D.C. 20549, and at the Securities and Exchange Commission's regional offices located at Seven World Trade Center, New York, New York 10048 and Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661. Copies of such material may also be obtained from the Public Reference Section of the Securities and Exchange Commission at 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. Such materials can also be inspected on the Securities and Exchange Commission's Web site at www.sec.gov. 81 Net2Phone, Inc. INDEX TO FINANCIAL STATEMENTS Report of Independent Auditors............................................ F-2 Balance Sheets as of July 31, 1998 and 1999............................... F-3 Statements of Operations for the years ended July 31, 1997, 1998 and 1999..................................................................... F-4 Statements of Stockholders' Equity (Deficit) for the years ended July 31, 1997, 1998 and 1999...................................................... F-5 Statements of Cash Flows for the years ended July 31, 1997, 1998 and 1999..................................................................... F-6 Notes to Financial Statements............................................. F-7
F-1 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Net2Phone, Inc. We have audited the accompanying balance sheets of Net2Phone, Inc. (the "Company") as of July 31, 1999 and 1998, and the related statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended July 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company at July 31, 1999 and 1998 and the results of its operations and its cash flows for each of the three years in the period ended July 31, 1999, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP New York, New York September 22, 1999 F-2 Net2Phone, Inc. BALANCE SHEETS
July 31, ------------------------ July 31, 1998 1999 1999 ----------- ----------- ------------ (Pro Forma) (Unaudited) (Note 2) Assets Current assets: Cash and cash equivalents............ $ 10,074 $20,379,048 $ 99,638,298 Trade accounts receivable............ 1,465,475 531,536 531,536 Prepaid contract deposits............ -- 6,162,084 6,162,084 Other current assets................. -- 999,918 999,918 ----------- ----------- ------------ Total current assets............... 1,475,549 28,072,586 107,331,836 Property and equipment, net............ 5,409,061 17,844,901 17,844,901 Trademark, net......................... -- 4,791,667 4,791,667 Other assets........................... 90,498 107,737 107,737 ----------- ----------- ------------ Total assets....................... $ 6,975,108 $50,816,891 $130,076,141 =========== =========== ============ Liabilities and stockholders' equity (deficit) Current liabilities: Accounts payable..................... $ -- $ 2,151,778 $ 2,151,778 Accrued expenses..................... -- 4,692,953 4,692,953 Deferred revenue..................... 810,114 2,370,632 2,370,632 Due to IDT Corporation............... 11,814,988 12,553,771 5,553,771 ----------- ----------- ------------ Total current liabilities.......... 12,625,102 21,769,134 14,769,134 Due to IDT Corporation................. -- 5,181,624 5,181,624 ----------- ----------- ------------ Total liabilities.................. 12,625,102 26,950,758 19,950,758 Commitments and contingencies Redeemable convertible preferred stock, Series A, $.01 par value; 3,150,000 share authorized; no, 3,140,000 and no shares issued and outstanding......... -- 27,929,000 -- Stockholders' equity (deficit): Preferred stock, $.01 par value; 6,850,000 shares authorized; no shares issued and outstanding....... -- -- -- Common stock, $.01 par value; 200,000,000 shares authorized; 30,960,000, 4,819,777 and 11,672,616 shares issued and outstanding....... 100,100 48,198 116,727 Class A stock, $.01 par value; 37,042,089 shares authorized; no, 27,622,089 and 36,524,250 shares issued and outstanding.............. -- 276,220 365,241 Additional paid-in capital........... -- 61,126,266 175,156,966 Accumulated deficit.................. (5,750,094) (30,455,286) (30,455,286) Deferred compensation--stock options............................. -- (31,908,275) (31,908,275) Loans to stockholders................ -- (3,149,990) (3,149,990) ----------- ----------- ------------ Total stockholders' equity (deficit)......................... (5,649,994) (4,062,867) 110,125,383 ----------- ----------- ------------ Total liabilities and stockholders' equity (deficit).................. $ 6,975,108 $50,816,891 $130,076,141 =========== =========== ============
See accompanying notes. F-3 Net2Phone, Inc. STATEMENTS OF OPERATIONS
Year ended July 31 -------------------------------------- 1997 1998 1999 ----------- ----------- ------------ Revenue: Service revenue..................... $ 2,652,303 $10,490,972 $ 32,648,305 Product revenue..................... -- 1,515,000 608,152 ----------- ----------- ------------ Total revenue................... 2,652,303 12,005,972 33,256,457 Costs and expenses: Direct cost of revenue: Service cost of revenue*.......... 1,547,443 6,576,523 17,554,074 Product cost of revenue*.......... 6,000 272,236 263,936 ----------- ----------- ------------ Total direct cost of revenue*... 1,553,443 6,848,759 17,818,010 Selling and marketing............. 76,724 2,887,766 8,828,167 General and administrative........ 2,599,283 5,087,628 10,836,072 Depreciation and amortization..... 120,500 726,508 2,316,545 Compensation charge from the issuance of stock options........ -- -- 17,919,541 ----------- ----------- ------------ Total costs and expenses........ 4,349,950 15,550,661 57,718,335 ----------- ----------- ------------ Loss from operations.................. (1,697,647) (3,544,689) (24,461,878) Interest expense...................... -- -- (430,753) Interest income....................... -- -- 187,439 ----------- ----------- ------------ Net loss.............................. (1,697,647) (3,544,689) (24,705,192) Redeemable preferred stock dividends.. -- -- (29,219,362) ----------- ----------- ------------ Net loss available to common stockholders......................... $(1,697,647) $(3,544,689) $(53,924,554) =========== =========== ============ Net loss per common share--basic and diluted.............................. $ (0.06) $ (0.12) $ (1.73) =========== =========== ============ Weighted average number of common shares used in calculation of basic and diluted net loss per common share................................ 27,864,000 30,186,000 31,236,415 =========== =========== ============ Pro forma net loss per common share-- basic and diluted.................... $ (0.74) ============ Pro forma weighted average number of common shares used in calculation of basic and diluted net loss per common share................................ 33,172,031 ============
- -------- * Excludes depreciation and amortization. See accompanying notes. F-4 Net2Phone, Inc. Statements of Stockholders' Equity (Deficit) Years ended July 31, 1997, 1998 and 1999
Common Stock Class A Stock --------------------- -------------------- Additional Paid-in Accumulated Deferred Loans to Shares Amount Shares Amount Capital Deficit Compensation Stockholders ----------- -------- ---------- -------- ------------ ------------ ------------ ------------ Balance as of July 31, 1996... -- $ -- -- $ -- $ -- $ (507,758) $ -- $ -- Net loss for the year ended July 31, 1997....... -- -- -- -- -- (1,697,647) -- -- ----------- -------- ---------- -------- ------------ ------------ ------------ ----------- Balance at July 31, 1997........ -- -- -- -- -- (2,205,405) -- -- Issuance of Stock to IDT Corporation.... 27,864,000 100 -- -- -- -- -- -- Sale of Common Stock to offi- cer............ 3,096,000 100,000 -- -- -- -- -- -- Net loss for the year ended July 31, 1998....... -- -- -- -- -- (3,544,689) -- -- ----------- -------- ---------- -------- ------------ ------------ ------------ ----------- Balance at July 31, 1998........ 30,960,000 100,100 -- -- -- (5,750,094) -- -- Issuance of war- rants.......... -- -- -- -- 2,100,000 -- -- -- Exercise of stock options.. 1,345,218 13,452 -- -- 4,470,608 -- -- (3,149,990) Deferred compen- sation......... -- -- -- -- 49,827,816 -- (49,827,816) -- Capital contri- butions from IDT Corpora- tion........... -- 209,500 -- -- 4,420,338 -- -- -- Conversion of IDT Common stock to Class A stock........ (27,864,000) (278,640) 27,864,000 278,640 -- -- -- -- Conversion of Class A to Common Stock... 241,911 2,420 (241,911) (2,420) -- -- -- -- Exercise of war- rants.......... 136,648 1,366 -- -- 436,504 -- -- -- Accretion of discount on Se- ries A pre- ferred stock convertible to Class A stock.. -- -- -- -- (129,000) -- -- -- Net loss for the year ended July 31, 1999....... -- -- -- -- -- (24,705,192) -- -- Amortization of deferred com- pensation...... -- -- -- -- -- -- 17,919,541 -- ----------- -------- ---------- -------- ------------ ------------ ------------ ----------- Balance at July 31, 1999........ 4,819,777 48,198 27,622,089 276,220 61,126,266 (30,455,286) (31,908,275) (3,149,990) ----------- -------- ---------- -------- ------------ ------------ ------------ ----------- Issuance of Com- mon Stock...... 6,210,000 62,100 -- -- 85,197,400 -- -- -- Conversion of Class A Stock to Common Stock.......... 517,839 5,179 (517,839) (5,179) -- -- -- -- Conversion of Preferred Stock to Class A Stock.......... -- -- 9,420,000 94,200 27,834,800 -- -- -- Exercise of stock options.. 125,000 1,250 -- -- 998,500 -- -- -- ----------- -------- ---------- -------- ------------ ------------ ------------ ----------- Pro Forma balance at July 31, 1999 (unaudited)..... 11,672,616 $116,727 36,524,250 $365,241 $175,156,966 $(30,455,286) $(31,908,275) $(3,149,990) =========== ======== ========== ======== ============ ============ ============ =========== Total Stockholders' Equity (Deficit) -------------- Balance as of July 31, 1996... $ (507,758) Net loss for the year ended July 31, 1997....... (1,697,647) -------------- Balance at July 31, 1997........ (2,205,405) Issuance of Stock to IDT Corporation.... 100 Sale of Common Stock to offi- cer............ 100,000 Net loss for the year ended July 31, 1998....... (3,544,689) -------------- Balance at July 31, 1998........ (5,649,994) Issuance of war- rants.......... 2,100,000 Exercise of stock options.. 1,334,070 Deferred compen- sation......... -- Capital contri- butions from IDT Corpora- tion........... 4,629,838 Conversion of IDT Common stock to Class A stock........ -- Conversion of Class A to Common Stock... -- Exercise of war- rants.......... 437,870 Accretion of discount on Se- ries A pre- ferred stock convertible to Class A stock.. (129,000) Net loss for the year ended July 31, 1999....... (24,705,192) Amortization of deferred com- pensation...... 17,919,541 -------------- Balance at July 31, 1999........ (4,062,867) -------------- Issuance of Com- mon Stock...... 85,259,500 Conversion of Class A Stock to Common Stock.......... -- Conversion of Preferred Stock to Class A Stock.......... 27,929,000 Exercise of stock options.. 999,750 -------------- Pro Forma balance at July 31, 1999 (unaudited)..... $110,125,383 ==============
See accompanying notes. F-5 Net2Phone, Inc. Statements of Cash Flows
Year ended July 31 -------------------------------------- 1997 1998 1999 ----------- ----------- ------------ Operating activities: Net loss.............................. $(1,697,647) $(3,544,689) $(24,705,192) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization....... 120,500 726,508 2,316,545 Amortization of deferred compensation....................... -- -- 17,919,541 Changes in assets and liabilities: Accounts receivable.............. (16,500) (1,448,975) 933,939 Inventory......................... -- -- (540,000) Prepaid contract deposits......... -- -- (6,162,084) Other current assets.............. -- -- (459,918) Other assets...................... -- (90,498) (17,239) Accounts payable.................. -- -- 2,151,778 Accrued expenses.................. -- -- 4,692,953 Deferred revenue.................. 161,001 649,113 1,560,518 ----------- ----------- ------------ Net cash used in operating activities........................... (1,432,646) (3,708,541) (2,309,159) Investing activities: Purchases of trademark................ -- -- (5,000,000) Purchases of property and equipment... (845,351) (5,236,044) (14,544,052) ----------- ----------- ------------ Net cash used in investing activities........................... (845,351) (5,236,044) (19,544,052) Financing activities: Proceeds from issuance of Common Stock to IDT Corporation................... -- 100 -- Proceeds from issuance of Common Stock to officer........................... -- 100,000 -- Proceeds from issuance of Series A Preferred stock and warrants......... -- -- 29,900,000 Proceeds from exercise of stock options.............................. -- -- 1,334,070 Proceeds from exercise of warrants.... -- -- 437,870 Capital contributions from IDT Corporation.......................... -- -- 4,629,838 Net advances from IDT Corporation..... 2,277,997 8,854,559 5,920,407 ----------- ----------- ------------ Net cash provided by financing activities........................... 2,277,997 8,954,659 42,222,185 ----------- ----------- ------------ Net increase in cash and cash equivalents.......................... -- 10,074 20,368,974 Cash and cash equivalents at beginning of period............................ -- -- 10,074 ----------- ----------- ------------ Cash and cash equivalents at end of period............................... $ -- $ 10,074 $ 20,379,048 =========== =========== ============ Supplemental disclosure of cash flow information: Cash payments made for interest....... $ -- $ -- $ -- =========== =========== ============ Cash payments made for income taxes... $ -- $ -- $ -- =========== =========== ============
See accompanying notes. F-6 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS July 31, 1999 1. Description of Business and Basis of Presentation The accompanying financial statements reflect the historical financial information of Net2Phone, Inc. (the "Company"), a majority owned subsidiary of IDT Corporation ("IDT"), incorporated in October 1997, to operate and develop its Internet telephony business. Prior to such time, the Company's business was conducted as a division of IDT. The incorporation of Net2Phone, Inc. as a subsidiary of IDT was accounted for similar to a recapitalization. All earnings per share calculations assume that such shares were outstanding for all prior periods. The Company's statements of operations include allocations of certain costs and expenses from IDT (Note 6). Although such allocations are not necessarily indicative of the costs that would have been incurred if the Company operated as an unaffiliated entity, management believes that the allocation methods are reasonable. 2. Pro Forma Balance Sheet On August 3, 1999, the Company completed an initial public offering of 6,210,000 shares of common stock at an initial public offering price of $15.00 per share, resulting in net proceeds of approximately $85.3 million (the "IPO"). The accompanying Pro Forma balance sheet gives effect to the following as if they occurred on July 31, 1999: . the sale of 6,210,000 shares of common stock in the IPO; . the application of $7.0 million of the net proceeds from the IPO to pay a portion of the note payable to IDT; . the conversion of 517,839 shares of Class A stock to common stock; . the exercise of options to purchase 75,000 shares of common stock at a price of $3.33 per share and options to purchase 50,000 shares of common stock at $15.00 per share; and . the conversion of 3,140,000 shares of Series A convertible preferred stock into 9,420,000 shares of Class A stock. 3. Summary of Significant Accounting Policies Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results may differ from those estimates. Revenue Recognition Internet telephony service revenue is recognized as service is provided. Revenue derived from equipment sales and from services provided to IDT is recognized upon installation of the equipment and performance of the services, respectively (See Note 6). Pre-payments for communications services are deferred and recognized as revenue as the communications services are provided. F-7 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 3. Summary of Significant Accounting Policies (continued) The sale of equipment with software necessary to provide the Company's services is within the scope of the American Institute of Certified Public Accountants' Statement of Position 97-2, Software Revenue Recognition. Revenue on such sales is recognized when such products are delivered, collection of payments are assured and there are no significant future obligations. Direct Cost of Revenue Direct cost of revenue consists primarily of telecommunication costs, connectivity costs, and the cost of equipment sold to customers. Direct cost of revenue excludes depreciation and amortization. Property and Equipment Equipment and furniture and fixtures are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets of five years. Computer software is amortized using the straight-line method over the shorter of five years or the term of the related agreement. Advertising Costs The Company expenses the costs of advertising as incurred. Typically the Company purchases banner advertising on other companies' web sites pursuant to contracts which have one to three year terms and may include the guarantee of (i) a minimum number of impressions, (ii) the number of times that an advertisement appears in pages displayed to users of the web site, or (iii) a minimum amount of revenue that will be recognized by the Company from customers directed to the Company's Web site as a direct result of the advertisement. The Company recognizes expense with respect to such advertising ratably over the period in which the advertisement is displayed. In addition, some agreements require additional payments as additional impressions are delivered. Such payments are expensed when the impressions are delivered. In one case, the Company entered into an agreement with no specified term of years. In this case, the Company amortizes as expense the lessor of (i) the number of impressions to date/minimum guaranteed impressions, or (ii) revenue to date/minimum guaranteed revenue as a percentage of the total payments (See Note 9). For the years ended July 31, 1997, 1998, and 1999, advertising expense totaled approximately $6,000, $1,962,000, and $6,590,000, respectively. Software Development Costs Costs for the internal development of new software products and substantial enhancements to existing software products are expensed as incurred until technological feasibility has been established, at which time any additional costs would be capitalized. As the Company has completed its software development concurrently with the establishment of technological feasibility, it has commenced capitalizing these costs. Software development costs are the Company's only research and development expenditures. For the years ended July 31, 1997, 1998 and 1999, research and development costs totaled approximately $473,000, $481,000 and $757,000, respectively. F-8 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 3. Summary of Significant Accounting Policies (continued) Capitalized Internal Use Software Costs The Company capitalizes certain costs incurred in connection with developing or obtaining internal use software. These costs consist of payments made to third parties and the salaries of employees working on such software development. At July 31, 1998 and 1999, the Company has capitalized $2,198,000, and $4,065,000, respectively, of internal use software costs as computer software. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Cash and cash equivalents are carried at cost which approximates market value. Trademark Costs associated with obtaining the right to use trademarks owned by third parties are capitalized and amortized on a straight-line basis over the term of the trademark. Income Taxes The Company accounts for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities. Stock Based Compensation The Company accounts for stock options issued to employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"). Compensation expense for stock options issued to employees is measured as the excess of the quoted market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Stock options issued to employees of IDT are accounted for in accordance with Financial Accounting Standards Board Statement ("SFAS") No. 123, Accounting for Stock-Based Compensation. Compensation expense for stock options issued to employees of IDT is measured based on the fair value of the stock options on the grant date estimated using the Black-Scholes option pricing model. The Company applies the disclosure-only provisions of SFAS No. 123 with respect to stock options issued to the Company's employees. In March 1999, the Financial Accounting Standards Board issued an exposure draft of an interpretation on APB 25 containing proposed rules designed to clarify its application. The proposed rules included in the exposure draft are expected to be formally issued prior to December 31, 1999 and become effective at the time they are issued. The proposed rules would generally be applicable to events that occur after December 15, 1998. Consequently, if the exposure draft is enacted in the form currently proposed, the new rules would apply to all stock options granted by the Company in fiscal 1999. F-9 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 3. Summary of Significant Accounting Policies (continued) Earnings (Loss) Per Share Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to common shares by the weighted average of common shares outstanding during the period. Diluted earnings (loss) per share adjusts basic earnings (loss) per share for the effects of convertible securities, stock options and other potentially dilutive financial instruments, only in the periods in which such effect is dilutive. There were no dilutive securities in any of the periods presented herein. Current Vulnerability Due to Certain Concentrations Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, and trade receivables. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base. Management regularly monitors the creditworthiness of its domestic and international customers and believes that it has adequately provided for any exposure to potential credit losses. Long-Lived Assets In accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, the Company reviews the impairment of long-lived assets and certain identifiable intangibles whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The analysis of the recoverability utilizes undiscounted cash flows. The measurement of the loss, if any, will be calculated as the amount by which the carrying amount of the asset exceeds the fair value of the asset. Segment Disclosures SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, was issued in June 1997. This statement requires use of the "management approach" model for segment reporting. The management approach model is based on the way a company's management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregate a company. As the Company operates in one segment, the adoption of the statement in fiscal 1999 did not have any impact on its financial statements. F-10 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 4. Property and Equipment Property and equipment consists of the following:
July 31 ----------------------- 1998 1999 ---------- ----------- Equipment........................................... $3,631,140 $ 7,999,316 Computer software................................... 2,595,572 12,708,913 Furniture and fixtures.............................. 37,632 100,167 ---------- ----------- 6,264,344 20,808,396 Accumulated depreciation............................ (855,283) (2,963,495) ---------- ----------- Property and equipment, net......................... $5,409,061 $17,844,901 ========== ===========
5. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share:
Year ended July 31 -------------------------------------- 1997 1998 1999 ----------- ----------- ------------ Numerator: Net loss.......................... $(1,697,647) $(3,544,689) $(24,705,192) Redeemable preferred stock dividends........................ -- -- (29,219,362) ----------- ----------- ------------ Numerator for basic and diluted loss per common share-net loss available for common stockholders............ $(1,697,647) $(3,544,689) $(53,924,554) Denominator: Denominator for basic and dilutive loss per common share-weighted average shares................... 27,864,000 30,186,000 31,236,415 =========== =========== ============ Basic and diluted loss per share.... $ (.06) $ (.12) $ (1.73) =========== =========== ============
F-11 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 5. Earnings Per Share (continued) The following securities have been excluded from the dilutive per share computation as they are antidilutive:
Year ended July 31 ------------------- 1997 1998 1999 ---- ---- --------- Redeemable preferred stock............................... -- -- 9,420,000 Stock options............................................ -- -- 7,310,900
The following table sets forth the computation of pro forma basic and diluted loss per common share for the year ended July 31, 1999, assuming conversion of the redeemable preferred shares to shares of common stock on their date of issuance. Numerator: Net loss available to common stockholders................. $(53,924,554) Redeemable preferred stock dividends...................... 29,219,362 ------------ Numerator for pro forma loss available to common stockholders (24,705,192) ============ Denominator: Weighted average number of common shares.................. 31,236,415 Assumed conversion of preferred shares to common shares (if converted method).................................... 1,935,616 ------------ Denominator for pro forma basic and diluted loss per share.................................................... 33,172,031 ------------ Pro forma basic and diluted loss per share.................. $ (0.74) ============
6. Related Party Transactions In May 1999, the Company and IDT entered into a separation agreement whereby the transactions and agreements necessary to govern the relationship between the two companies necessary to effect their separation were determined. In accordance with such agreement, it was determined that amounts paid by IDT in excess of $22 million would be deemed to be capital contributions. In May 1999, the Company and IDT entered into an Internet/telecommunications agreement whereby the Company has agreed to pay IDT up to $110,000 per month for connectivity, the use of certain computer software and equipment owned or leased by IDT and to provide a platform for IDT's Internet services for a monthly per customer charge. In connection with such agreement, IDT has also granted the Company an indefeasible right, for a period of 20 years, to use a certain telecommunications network as it is completed and delivered for up to approximately $6.0 million. In May 1999, the Company and IDT entered into two one-year services agreements whereby the Company agreed to pay IDT for certain administrative, customer support and other services that IDT provides to it at the cost of such services plus 20%. Also, in conjunction with such agreements, the Company has agreed to provide IDT with certain support services for the cost of such services plus 20%. The agreement is effective for a period of two years. In May 1999, the Company and IDT entered into a joint marketing agreement whereby the companies have agreed to jointly advertise and market their products. The agreement continues for a term of one year and is automatically renewable for an additional one year unless terminated by either party. In conjunction with such agreement, a commission will be earned by each company for new customers generated by the other company as a result of such programs. F-12 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 6. Related Party Transactions (continued) In May 1999, the Company and IDT entered into an assignment agreement whereby IDT assigned all of its rights in certain trademarks, patents and proprietary products and information to the Company. These assets were contributed at IDT's historical cost which was $0. The accompanying financial statements for periods prior to the signing of the aforementioned agreements include charges by IDT to the Company for the aforementioned services. Such charges were based principally upon the Company's allocable portion of IDT's costs for such services. The ratios used to allocate these costs were the Company's total payroll and the Company's total revenue to IDT's total payroll and revenue, depending on the type of services provided. The allocated costs approximate the amounts that would have been charged under the inter-company agreements if they had been in effect during such periods. For the years ended July 31, 1997, 1998, and 1999, the Company recognized revenue for services provided to IDT of approximately $297,000, $498,000, and $2,578,000, respectively. At July 31, 1998 and 1999, the due to IDT balance represents the net amounts owed to IDT as a result of the aforementioned agreements and financing. No interest was charged on the Company's advances from IDT. The average balance owed to IDT during the years ended July 31, 1998 and 1999, were $7,388,000 and $14,775,000, respectively. On May 12, 1999, the Company converted a portion of its liability to IDT into a $14,000,000 promissory note. Such promissory note accrues interest at a rate of 9% per annum and is payable in 60 equal monthly installments of principal and interest. Notwithstanding the foregoing, $7,000,000 in principal was repaid in August 1999 with the proceeds of the IPO. 6. Related Party Transactions (continued) The activity in the intercompany account with IDT was as follows:
Year ended July 31 ------------------------------------- 1997 1998 1999 ---------- ----------- ------------ Opening Balance..................... $ 682,432 $ 2,960,429 $ 11,814,988 Expenses paid by IDT on behalf of the Company, net of cash received.. 1,225,771 7,000,725 18,550,915 Net charges to the Company for services provided by IDT........... 1,349,226 2,351,934 8,380,656 Revenue recognized by the Company for services provided to IDT....... (297,000) (498,000) (2,578,000) Capital contribution from IDT....... -- (100) (4,629,838) Repayments.......................... -- -- (13,803,326) ---------- ----------- ------------ Ending Balance...................... $2,960,429 $11,814,988 $ 17,735,395 ========== =========== ============
F-13 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 7. Income Taxes The Company will file a consolidated Federal income tax return with IDT through May 13, 1999 and has entered into a tax sharing agreement with IDT. Pursuant to such tax sharing agreement, the Company would, while included in the IDT consolidated tax return, be reimbursed for the use of its tax losses to the extent IDT realizes a tax reduction from the use of such tax losses. In May 1999 IDT's ownership interest in the Company fell below 80% and as a result the Company will no longer be a part of the IDT consolidated Federal tax group. Significant components of the Company's deferred tax assets and liabilities consists of the following:
July 31 ---------------------- 1998 1999 --------- ----------- Deferred tax asset: Net operating loss carryforward.................. $ 314,000 $ 3,921,205 Compensation charge from issuance of stock options......................................... -- 500,663 Deferred tax liabilities: Depreciation..................................... (300,000) (1,008,719) --------- ----------- Net deferred tax asset........................... 14,000 3,413,149 Valuation allowance.............................. (14,000) (3,413,149) --------- ----------- Total deferred tax assets.......................... $ -- $ -- ========= ===========
The net deferred tax assets have been fully offset by a valuation allowance due to the uncertainty of the realization of the assets. At July 31, 1999, the Company had net operating loss carryforwards for federal income tax purposes of approximately $8.0 million expiring in years through 2019 and for state income tax purposes of approximately $16 million expiring in years through 2006. These net operating loss carryforwards may be limited to future taxable earnings of the Company.
Year ended July 31 ---------------------------------- 1997 1998 1999 -------- ----------- ----------- Tax at effective rate.................. (577,000) $(1,205,000) $(8,646,817) Non-deductible expenses................ -- -- 4,597,338 Benefits used by IDT for which the Company received no compensation...... 577,000 1,205,000 1,017,088 Losses for which no benefit is provided.............................. -- -- 3,032,391 -------- ----------- ----------- Tax provision.......................... $ -- $ -- $ -- ======== =========== ===========
F-14 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 8. Stockholders' Equity (Deficit) Initial Public Offering On August 3, 1999, the Company completed an initial public offering of 6,210,000 shares of common stock at an initial public offering price of $15.00 per share, resulting in net proceeds of approximately $85.3 million. Series A Stock On May 13, 1999, the Company designated 3,150,000 shares of its preferred stock as Series A ("Series A Stock") and sold 3,140,000 of such shares to unrelated third parties in a private placement transaction for aggregate gross proceeds of $31,400,000. The Series A Stock entitled its holders to a non-cumulative dividend of 8% per annum on the original issue price. Each share of Series A Stock was convertible into three shares of Class A stock at the option of the holder, subject to certain adjustments, as defined. The Series A Stock was redeemable at the option of the holder, beginning May 2006, over a period of 3 years. The Series A Stock contained beneficial conversion features. The total value of the beneficial conversion feature approximated $75 million. For accounting purposes the value of the beneficial conversion features was limited to the amount of proceeds allocated to the Series A Stock. The Company recorded an increase in net loss available to common stockholders on the date of issuance of the Series A Stock in the amount of approximately $29.2 million. In connection with the sale of Series A Stock, the Company granted warrants to purchase 272,400 shares of common stock at an exercise price of $3.33 per share, subject to certain adjustments as defined, from the date of issuance through May 13, 2004 to the Series A Stock investors and placement agent. The warrants contained a provision whereby they were automatically terminated upon a merger or sale of the Company or an initial public offering of the Company's stock. In July 1999, 136,648 warrants were exercised. The unexercised warrants expired unexercised upon the Company's IPO in August 1999. The fair value of the warrants on the date of issuance was $2.1 million. This was computed using the Black Scholes model with the following assumptions: the fair value of the common stock equal to $11.00 per share, the risk free interest rate of 4.79%, volatility factor of 84%, an expected life of 6 months, and a dividend yield of 0%. The fair value of the warrants was recorded as an increase to additional paid-in capital and a decrease to the carrying value of the Series A Stock. The decrease in the carrying value of the Series A Stock was accreted with a reduction of additional paid-in capital over the period to the initial redemption date in May 2006. In connection with the Company's IPO, the Series A convertible preferred stock was converted into Class A stock. In August 1999 upon the consumation of the IPO the balance of the unamortized discount was recorded as a reduction of the amount of income available for common shareholders. Stock Options In April 1999, the Company adopted a stock option and incentive plan (the "Plan"). Pursuant to the Plan, the Company's officers, employees and non- employee directors, as well as those of IDT, are eligible to receive awards of incentives and non-qualified stock options, stock appreciation rights, limited stock appreciation rights and restricted stock. F-15 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 8. Stockholders' Equity (Deficit) (continued) In the fourth quarter of fiscal 1999, the Company granted options to purchase 8,821,500 shares of common stock at exercise prices ranging from $3.33 to $15.00 per share to employees of the Company and employees of IDT. The options generally vest over periods up to four years and expire ten years from the date of grant. In connection with the exercise of such options, the Company extended $3,149,900 of recourse loans to employees. In order to obtain the loans, optionees agreed to the cancellation of 23,382 outstanding options. Deferred compensation resulting from the issuance of the stock options of approximately $49.8 million is being charged to expense over the vesting period of the stock options as follows: fiscal 1999, $17.9 million; fiscal 2000, $11.8 million; fiscal 2001, $11.8 million; and fiscal 2002, $8.3 million. A summary of stock option activity under the Company's stock option plan is as follows:
Weighted Average Shares Exercise Price ---------- -------------- Outstanding at July 31, 1998...................... -- -- Granted........................................... 8,821,500 $7.18 Exercised......................................... (1,345,218) 3.33 Cancelled......................................... (23,382) 3.33 Forfeited......................................... (7,000) 3.33 ---------- ----- Outstanding at July 31, 1999...................... 7,445,900 $7.90 ========== =====
The following table summarizes the status of the stock options outstanding and exercisable at July 31, 1999:
Stock Options Outstanding ------------------------------------------------ Weighted- Number of Remaining Stock Exercise Number of Contractual Options Prices Options Life Exercisable -------- --------- ----------- ----------- $ 3.33 4,292,400 9.8 years 388,075 $10.00 180,000 10.0 years 54,000 $11.00 460,000 10.0 years -- $15.00 2,513,500 10.0 years 830,050 --------- --------- 7,445,900 1,272,125 ========= =========
The weighted average fair value of options granted was $9.99 for the year ended July 31, 1999. Pro forma information regarding net loss and loss per share has been determined as if the Company had accounted for employee stock options under the fair value method. The fair value of the stock options was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions for vested and non-vested options:
July 31, 1999 ------------- Assumptions Average risk-free interest rate.............................. 5.60% Dividend yield............................................... -- Volatility factor of the expected market price of the Company's common stock...................................... 84% Average life................................................. 5 years
F-16 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 8. Stockholders' Equity (Deficit) (continued) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics that are significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. For the year ended July 31, 1999, pro forma net loss available to common stockholders and pro forma net loss per common share amounted to approximately $66,050,383 and $2.11, respectively. Stock Split and Class A Stock On June 25, 1999, the Company effectuated a three-for-one stock split. The financial statements give retroactive effect to the stock split. In addition, the Company designated 15,000,000 shares of its capital stock as Class A stock. The holders of Class A stock are identical to those of common stock except for voting and conversion rights and restrictions on transferability. The Class A stock is entitled to two votes per share. 9. Commitments On February 8, 1998, the Company entered into an agreement with an Internet company to develop a link between its Internet site and that of the Company and advertise Company products on such site. The agreement is effective for fifteen months upon the completion of the link and automatically extends for an additional one year unless terminated by either party. Pursuant to such agreement, the Company has made payments of $3.3 million through July 31, 1999 for the design, development, installation and implementation of the link as well as the placement of Company advertisements on the Internet company's site, of which $750,000 attributable to the establishment of such link was deferred and is being amortized over the term of the agreement and $2.4 million attributable to monthly payments for advertising and the maintenance of the link was expensed monthly as incurred. As of July 31, 1999, the Company was required to make an additional payment of $150,000 in fiscal 2000 and pay certain future commissions, as defined, based upon revenue earned and usage of the link. On August 4, 1998, the Company entered into an agreement with an Internet company to advertise Company products on the Internet company's site. The agreement is effective as of October 1, 1998, the launch date of the link, and extends indefinitely until the Internet company fully provides all advertising impressions guaranteed under the agreement. Pursuant to such agreement, the Company has made payments of $646,000 through July 31, 1999 for Company advertisements on such site. The Company is required to make additional payments of $975,000 in fiscal 2000, and $167,000 in fiscal 2001 and pay certain future commissions, as defined, based upon revenue earned and usage of the link. Under this agreement the Company records expenses equal to the lesser of (i) the number of impressions to date/minimum guaranteed impressions, or (ii) revenue to date/minimum guaranteed revenue as a percentage of the total payments. On February 19, 1999, the Company entered into an agreement under which an international computer company is to provide connections to its global network. These connections will allow worldwide transport of the Company's IP traffic. The agreement is effective for 63 months upon availability of the connections. F-17 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1999 9. Commitments (continued) Pursuant to such agreement, the Company has made payments of $1 million through July 31, 1999 which have been reflected on the balance sheets as prepaid contract deposits. As of July 31, 1999, the Company is required to make an additional payment of $1 million when the connections are available and pay fees for additional connections and usage. The $2 million of prepayments will be amortized over the term of the agreement beginning at the time the connections are available for use. On January 31, 1999, the Company entered into a series of agreements with a third party. The agreements call for the bundling of the Company's Internet telephony products with the third party's Internet browser, the purchase of software from the third party and the use of the third party's trademark. The agreements require the Company to pay the third party (i) $5,000,000 for the use of the trademark, (ii) $8,000,000 for the purchase of software and (iii) commissions on revenues generated from customers that the Company obtains from the bundling of products. Through July 31, 1999, the Company had paid $1.5 million for the right to use the trademark and $8 million for certain software. The Company has capitalized the costs of the right to use the trademark and the software costs and will amortize them over the term of the bundling agreement, which expires two years after the release of the bundled product. The Company has distribution agreements under which it has agreed to pay its agents commissions for obtaining new Internet telephony customers. The agreements require commissions upon activation of the customers. In May 1997, the Company entered into a three year employment agreement with one of its officers. Under the terms of such agreement, which was amended in May 1999, the Company agreed to, among other things, provide such officer with an annual salary of $100,000 and the right to purchase a 10% interest in the Company for $100,000, which was the fair market value of the Company at that time. Such right, which includes an anti-dilutive provision mandating that the officer's ownership interest cannot be diluted below 8% of the total outstanding shares upon consummation of an initial public offering of the Company's common stock, was exercised during fiscal 1998. Such agreement is automatically renewable on an annual basis after its initial three year term unless terminated by either party. In March 1999, the Company entered into two lease agreements with companies which are owned by the Chairman, Chief Executive Officer and Treasurer of IDT. Pursuant to such lease agreements, the Company is required to make equal monthly rental payments aggregating $558,000 to such companies through February 2002. The Company entered into an agreement with Snap, an Internet portal service of NBC and CNET, on May 17, 1999. Snap will display links to the Company's Web site and services on its Snap.com Web site. In addition, the Company is Snap's preferred provider of PC-to-phone services during the two-year term of this agreement. Snap also will deliver a preset minimum number of impressions on its site and agreed to give the Company the right to advertise on its Snap.com Web site, subject to certain conditions. In exchange, the Company agreed to pay Snap a one-time fee, a percentage of revenue generated through their site and bonus payments for customers delivered by Snap of $2,000,000 after meeting certain quotas. The Company will amortize the up front payment over the term of the agreement. The Company signed an agreement with NBC on June 25, 1999 to purchase $1.5 million in television advertising on the NBC television network. The Company also has the right to purchase additional spots to be telecast prior to June 30, 2000. The cost of the advertising will be expensed as the spots are shown. F-18 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Concluded) July 31, 1999 9. Commitments (continued) On July 15, 1999, the Company entered into a four-year distribution and marketing agreement with ICQ, a subsidiary of America Online. Under this agreement, ICQ has agreed to co-brand and promote the Company's Internet telephony services in the U.S. and in 19 other countries, embed customized versions of the Company's software to allow ICQ customers to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls, share revenue from advertisements and sponsorships sold by ICQ on the Company's software that is embedded in ICQ's Instant Messenger software, and promote the Company's services on some of ICQ's Web sites. The Company agreed to pay ICQ a fee of $7.5 million, $4.0 million of which was paid at signing, and the remainder of which was paid in September 1999. The Company also agreed to pay ICQ a share of minutes-based revenue generated through ICQ and to award ICQ a performance bonus on the basis of the total revenue derived under the agreement, and to promote ICQ on the Company's Web sites. In connection with the Company's distribution and marketing agreement with ICQ, the Company issued a warrant to America Online to purchase up to 3% of the Company's outstanding capital stock on a fully-diluted basis. This warrant will vest in 1% increments upon the achievement of each of three incremental thresholds of revenue generated under the agreement during the first four years that the warrant is outstanding. The per share exercise price under the warrant will be equal to the lesser of 80% of the price per share in the Company's initial public offering, or $450 million dividend by the number of the Company's fully-diluted shares on the initial exercise date. The warrant may be exercised for a period of five years from the date of issuance. On July 2, 1999 the Company signed a three-year employment agreement with its new President. After the initial term, the agreement may be renewed annually. The Company will pay its President an annual base salary of $350,000 and he is entitled to receive an annual bonus calculated on the basis of the Company's gross revenue, which bonus could be up to $100,000. The Company granted its President options to purchase 920,000 shares of its common stock under its 1999 Stock Option and Incentive Plan. Of these options, 460,000 were granted at an exercise price of $3.33 per share, 153,333 of which are vested and exercisable. The options to purchase the remaining 460,000 shares were granted at $11.00 per share. Other than those options which are vested, the remaining 766,667 options will vest in three equal annual installments, commencing on July 20, 2000. The Company recorded compensation in connection with the issuance of the options with an exercise price less than the fair market value of the stock over the vesting period. 10. Customer and Geographical Area Revenues from customers outside the United States represented approximately 44%, 72%, and 62% of total revenues during the years ended July 31, 1997, 1998 and 1999, respectively. During the year ended July 31, 1998, revenues derived from equipment sales to a customer in Korea represented approximately 14% of total revenue. No single geographic area accounted for more than 10% of total revenue during the years ended July 31, 1999 and 1997. No customer accounted for more than 10% of revenue during the years ended July 31, 1999 and 1997. F-19 [Inside Back Cover] Text: "Here's how internet telephony works" Graphic: Picture of a man talking on a phone; Net2Phone Logo; Diagram explaining how Internet telephony works. Text: "Internet telephone calls are carried over a caller's local telephone network to an Internet or Net2Phone network access point where Net2Phone equipment is located." "The Net2Phone equipment translates the caller's voice (or fax) into a digital signal and routs this signal over the Internet or Net2Phone's network to Net2Phone equipment located as close to the recipient's local telephone network as possible." "To complete the call, Net2Phone equipment converts the digital signal back into the caller's voice (or fax) and transfers the call to the local telephone network for delivery to the recipient." Graphic: Net2Phone Logo enlarged. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 6,300,000 Shares [NET2PHONE LOGO] Common Stock ---------------- PROSPECTUS ---------------- Hambrecht & Quist Donaldson, Lufkin & Jenrette Deutsche Banc Alex. Brown ---------------- Bear, Stearns & Co. Inc. Robertson Stephens ---------------- , 1999 ---------------- You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock. No action is being taken in any jurisdiction outside the United States to permit a public offering of the common stock or possession or distribution of this prospectus in that jurisdiction. Persons who come into possession of this prospectus in jurisdictions outside the United States are required to inform themselves about and to observe any restrictions as to this offering and the distribution of this prospectus applicable to that jurisdiction. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART II INFORMATION NOT REQUIRED IN THE PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION Other expenses in connection with the issuance and distribution of the securities to be registered hereunder, all of which will be paid by us, will be substantially as follows (all amounts are estimated except the Securities and Exchange Commission registration fee, the National Association of Securities Dealers filing fee and the Nasdaq National Market listing fee):
Item Amount ---- ----------- Securities and Exchange Commission registration fee.......... $108,263.21 NASD filing fee.............................................. 30,500.00 Nasdaq National Market listing fee........................... 17,500.00 Blue Sky filing fees and expenses............................ 5,000.00 Accounting fees and expenses................................. 150,000.00 Legal fees and expenses...................................... 200,000.00 Transfer agent fees and expenses............................. 25,000.00 Printing and engraving expenses.............................. 200,000.00 Miscellaneous expenses....................................... 13,736.79 ----------- Total...................................................... $750,000.00 ===========
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS Reference is made to Section 145 of the Delaware General Corporation Law, which provides for indemnification of directors, officers and other employees in certain circumstances, and to Section 102(b)(7) of the Delaware General Corporation Law, which provides for the elimination or limitation of the personal liability for monetary damages of directors under certain circumstances. Article Sixth of our certificate of incorporation, as amended and restated, eliminates the personal liability for monetary damages of directors under certain circumstances. Our bylaws provide indemnification to our directors and officers to the fullest extent permitted by the Delaware General Corporation Law for, among other things, liabilities for judgments in and settlements of lawsuits and other proceedings and for the advance and payment of fees and expenses reasonably incurred by the director or officer in defense of any such lawsuit or proceeding. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES In October 1997, in connection with our initial organization, IDT Corporation purchased 27,864,000 shares of our common stock for nominal consideration. In January 1998, pursuant to the terms of his employment agreement with IDT Corporation, Mr. Clifford M. Sobel purchased 3,096,000 shares of our common stock for the purchase price of $100,000. This transaction was exempt from registration under Section 4(2) of the Securities Act of 1933, as amended. In May 1999, we issued and sold an aggregate of 3,140,000 shares of Series A convertible preferred stock at $10.00 per share, which were converted into 9,420,000 shares of our common stock in August 1999 at the time of our initial public offering. In connection with this transaction, we also issued warrants to purchase up to 180,000 shares of our class A stock (of which 44,248 were exercised in August 1999) to several investors for an aggregate of $31.4 million, pursuant to Series A Subscription Agreements, dated as of May 13, 1999. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. II-1 We also issued a warrant to purchase up to 92,400 shares of our common stock to the placement agent as partial consideration for its services. This warrant was exercised in its entirety in August 1999. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. In May 1999, we issued options to purchase 5,040,000 shares pursuant to our 1999 Stock Option and Incentive Plan, and issued 1,345,218 shares of common stock upon exercise of some of these options. In July 1999, we issued options to purchase an additional 920,000 shares under the Plan to our President. In July 1999, we issued options to purchase an additional 2,851,500 shares under the Plan, and issued 50,000 shares of common stock upon exercise of these options. Since July 1999, we have granted options to purchase an aggregate of 183,250 shares of our common stock. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. In July 1999, in connection with our distribution and marketing agreement with ICQ, we issued a warrant to America Online, enabling it to acquire shares of common stock representing up to 3.0% of our outstanding capital on a fully- diluted basis. This transaction was exempt from registration under Section 4(2) of the Securities Act of 1933. ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES Exhibits:
Exhibit Number Description of Exhibit ------- ---------------------- 1.1 Form of Underwriting Agreement. 3.1** Certificate of Incorporation, as amended. 3.2** Bylaws. 3.3** Certificate of Amendment to the Restated Certificate of Incorporation of the Registrant. 3.4** Certificate of Amendment to the Restated Certificate of Incorporation of the Registrant. 4.1** Specimen Common Stock Certificate of the Registrant. 5.1 Form of Opinion of Morrison & Foerster LLP. 10.1** Employment Agreement, dated May 1, 1997, by and between Clifford M. Sobel and IDT Corporation. 10.2** Amendment to Employment Agreement between IDT Corporation and Clifford M. Sobel, dated as of May 11, 1999, by and between Clifford M. Sobel, IDT Corporation and the Registrant. 10.3#** Bundling and Distribution Services Agreement, dated as of January 31, 1999, by and between Netscape Communications Corporation and the Registrant. 10.4** General License Terms & Conditions, dated as of January 31, 1999, by and between Netscape Communications Corporation and the Registrant. 10.5** Trademark License Agreement, dated as of January 31, 1999, by and between Netscape Communications Corporation and the Registrant Assignment. 10.6** Internet/Telecommunications Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.7** Joint Marketing Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.8** IDT Services Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant.
II-2
Exhibit Number Description of Exhibit ------- ---------------------- 10.9** Net2Phone Services Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.10** Assignment Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.11** Tax Sharing and Indemnification Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.12** Separation Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.13** Lease Agreement, dated as of March 1, 1999, by and between 171-173 Main Street Corporation and the Registrant. 10.14** Lease Agreement, dated as of March 1, 1999, by and between 294-298 State Street Corporation and the Registrant. 10.15** The Registrant's Amended and Restated 1999 Stock Option and Incentive Plan. 10.16** Series A Subscription Agreement, dated as of May 13, 1999, by and between the Investors listed therein and the Registrant. 10.17** Series A Preferred Shareholder Registration Rights Agreement, dated as of May 13, 1999, by and between the Investors listed therein and the Registrant. 10.18** Form of Warrant to Purchase Common Stock. 10.19** Promissory Note of Registrant to IDT Corporation, dated as of May 12, 1999. 10.20** Stockholders Agreement, dated as of May 13, 1999, by and among the Investors listed therein, IDT Corporation, Clifford M. Sobel, the trustee of the Scott Sobel Annual Gift Trust and the Registrant. 10.21** Letter agreement, dated as of May 12, 1999, by and among IDT Corporation, Clifford M. Sobel and the Registrant. 10.22** Letter agreement, dated as of May 17, 1999, by and among IDT Corporation, Clifford M. Sobel and the Registrant. 10.23** Co-Location and Facilities Management Services Agreement, dated as of May 20, 1999, by and between IDT Corporation and the Registrant. 10.24** Form of Loan Agreement between the Registrant and each of its executive officers. 10.25** Form of Stock Option Agreement for Executive Officers. 10.26#** Letter agreement, dated as of June 25, 1999, by and between National Broadcasting Company, Inc. and the Registrant. 10.27** Employment Agreement, dated July 2, 1999, by and between Jonathan Fram and the Registrant. 10.28#** IP Telephony Services Distribution and Interactive Marketing Agreement, dated as of July 15, 1999, by and between ICQ, Inc. and the Registrant. 10.29#** Stock Subscription Warrant, dated July 15, 1999, by and between America Online, Inc. and the Registrant. 10.30** Amendment No. 1 to Employment Agreement, dated July 16, 1999, by and between Jonathan Fram and the Registrant. 10.31 Amendment to Stock Subscription Warrant, dated November 19, 1999, by and between America Online, Inc. and the Registrant. 23.1 Consent of Ernst & Young LLP. 23.2 Consent of Morrison & Foerster llp (incorporated by reference into Exhibit 5.1).
II-3
Exhibit Number Description of Exhibit ------- ---------------------- 24.1*** Power of Attorney. 27.1 Financial Data Schedule.
- -------- ** Filed as an exhibit to the Registrant's Registration Statement on Form S-1, file number 333-78713. *** Included in the Registrant's Registration Statement on Form S-1, file number 333-90317, as filed with the Securities and Exchange Commission on November 4, 1999. # Confidential treatment has been obtained with respect to certain portions of the Exhibit. Omitted portions were filed separately with the Securities and Exchange Commission. Financial Statements and Schedule: Financial Statements: Financial Statements filed as a part of this registration statement are listed in the Index to Financial Statements of page F-1. Financial Statement Schedules: None. ITEM 17. UNDERTAKINGS The undersigned Registrant hereby undertakes to provide to the Underwriters at the closing of the offering specified in the Underwriting Agreement, certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act of 1933 and will be governed by the final adjudication of such issue. The undersigned registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act of 1933 shall be deemed to be part of this registration statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant has duly caused this Amendment No. 2 to the registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Hackensack, State of New Jersey, on November 22, 1999. Net2Phone, Inc. /s/ Howard S. Balter By: _________________________________ Howard S. Balter Chief Executive Officer Pursuant to the requirements of the Securities Act of 1933, this Amendment to the registration statement has been signed by the following persons in the capacities and on the dates indicated.
Name and Signatures Title Date ------------------- ----- ---- /s/ Clifford M. Sobel Chairman of the Board November 22, 1999 ___________________________________________ Clifford M. Sobel* /s/ Howard S. Balter Chief Executive Officer November 22, 1999 ___________________________________________ and Director (Principal Howard S. Balter Executive Officer) /s/ Ilan M. Slasky Chief Financial Officer November 22, 1999 ___________________________________________ (Chief Accounting Ilan M. Slasky* Officer) /s/ James R. Mellor Director November 22, 1999 ___________________________________________ James R. Mellor* /s/ Howard S. Jonas Director November 22, 1999 ___________________________________________ Howard S. Jonas* Director November 22, 1999 ___________________________________________ Gary E. Rieschel /s/ James A. Courter Director November 22, 1999 ___________________________________________ James A. Courter* /s/ Jesse P. King Director November 22, 1999 ___________________________________________ Jesse P. King* Director November 22, 1999 ___________________________________________ Martin J. Yudkovitz Director November 22, 1999 ___________________________________________ Daniel H. Schulman /s/ Michael Fischberger Director November 22, 1999 ___________________________________________ Michael Fischberger* Director November 22, 1999 ___________________________________________ Harry C. McPherson, Jr.
* Executed by attorney-in-fact Howard S. Balter. II-5 INDEX OF EXHIBITS
Exhibit Number Description of Exhibit ------- ---------------------- 1.1* Form of Underwriting Agreement. 3.1** Certificate of Incorporation, as amended. 3.2** Bylaws. 3.3** Certificate of Amendment to the Restated Certificate of Incorporation of the Registrant. 3.4** Certificate of Amendment to the Restated Certificate of Incorporation of the Registrant. 4.1** Specimen Common Stock Certificate of the Registrant. 5.1* Form of Opinion of Morrison & Foerster LLP. 10.1** Employment Agreement, dated May 1, 1997, by and between Clifford M. Sobel and IDT Corporation. 10.2** Amendment to Employment Agreement between IDT Corporation and Clifford M. Sobel, dated as of May 11, 1999, by and between Clifford M. Sobel, IDT Corporation and the Registrant. 10.3#** Bundling and Distribution Services Agreement, dated as of January 31, 1999, by and between Netscape Communications Corporation and the Registrant. 10.4** General License Terms & Conditions, dated as of January 31, 1999, by and between Netscape Communications Corporation and the Registrant. 10.5** Trademark License Agreement, dated as of January 31, 1999, by and between Netscape Communications Corporation and the Registrant Assignment. 10.6** Internet/Telecommunications Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.7** Joint Marketing Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.8** IDT Services Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.9** Net2Phone Services Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.10** Assignment Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.11** Tax Sharing and Indemnification Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.12** Separation Agreement, dated as of May 7, 1999, by and between IDT Corporation and the Registrant. 10.13** Lease Agreement, dated as of March 1, 1999, by and between 171-173 Main Street Corporation and the Registrant. 10.14** Lease Agreement, dated as of March 1, 1999, by and between 294-298 State Street Corporation and the Registrant. 10.15** The Registrant's Amended and Restated 1999 Stock Option and Incentive Plan. 10.16** Series A Subscription Agreement, dated as of May 13, 1999, by and between the Investors listed therein and the Registrant. 10.17** Series A Preferred Shareholder Registration Rights Agreement, dated as of May 13, 1999, by and between the Investors listed therein and the Registrant.
Exhibit Number Description of Exhibit -------- ---------------------- 10.18** Form of Warrant to Purchase Common Stock. 10.19** Promissory Note of Registrant to IDT Corporation, dated as of May 12, 1999. 10.20** Stockholders Agreement, dated as of May 13, 1999, by and among the Investors listed therein, IDT Corporation, Clifford M. Sobel, the trustee of the Scott Sobel Annual Gift Trust and the Registrant. 10.21** Letter agreement, dated as of May 12, 1999, by and among IDT Corporation, Clifford M. Sobel and the Registrant. 10.22** Letter agreement, dated as of May 17, 1999, by and among IDT Corporation, Clifford M. Sobel and the Registrant. 10.23** Co-Location and Facilities Management Services Agreement, dated as of May 20, 1999, by and between IDT Corporation and the Registrant. 10.24** Form of Loan Agreement between the Registrant and each of its executive officers. 10.25** Form of Stock Option Agreement for Executive Officers. 10.26#** Letter agreement, dated as of June 25, 1999, by and between National Broadcasting Company, Inc. and the Registrant. 10.27** Employment Agreement, dated July 2, 1999, by and between Jonathan Fram and the Registrant. 10.28#** IP Telephony Services Distribution and Interactive Marketing Agreement, dated as of July 15, 1999, by and between ICQ, Inc. and the Registrant. 10.29#** Stock Subscription Warrant, dated July 15, 1999, by and between America Online, Inc. and the Registrant. 10.30** Amendment No. 1 to Employment Agreement, dated July 16, 1999, by and between Jonathan Fram and the Registrant. 10.31 Amendment to Stock Subscription Warrant, dated November 19, 1999, by and between America Online, Inc. and the Registrant. 23.1 Consent of Ernst & Young LLP. 23.2 Consent of Morrison & Foerster llp (incorporated by reference into Exhibit 5.1). 24.1*** Power of Attorney. 27.1 Financial Data Schedule.
- -------- **Filed as an exhibit to the Registrant's Registration Statement on Form S-1, file number 333-78713. *** Included in the Registrant's Registration Statement on Form S-1, file number 333-90317, as filed with the Securities and Exchange Commission on November 4, 1999. # Confidential treatment has been obtained with respect to certain portions of the Exhibit. Omitted portions were filed separately with the Securities and Exchange Commission. EX-1.1 2 FORM OF UNDERWRITING AGREEMENT EXHIBIT 1.1 NET2PHONE, INC. 6,300,000 Shares/1/ Common Stock UNDERWRITING AGREEMENT ---------------------- November __, 1999 HAMBRECHT & QUIST LLC DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION DEUTSCHE BANK SECURITIES INC. BANCBOSTON ROBERTSON STEPHENS INC. BEAR, STEARNS & CO. INC. As Representatives of the Several Underwriters c/o Hambrecht & Quist LLC One Bush Street San Francisco, CA 94104 Ladies and Gentlemen: Net2Phone, Inc., a Delaware corporation (herein called the Company), proposes to issue and sell 3,400,000 shares of its authorized but unissued Common Stock, $.01 par value (herein called the Common Stock), and the stockholders of the Company named in Schedule II hereto (herein collectively called the Selling Primary Securityholders) propose to sell an aggregate of 2,900,000 shares of Common Stock (said 6,300,000 shares of Common Stock being herein called the Underwritten Stock). The stockholders of the Company named in Schedule III hereto (herein collectively called the Secondary Selling Securityholders and, together with the Primary Selling Securityholders, the Selling Securityholders) propose to grant to the Underwriters (as hereinafter defined) an option to purchase up to 945,000 additional shares of Common Stock (herein called the Option Stock and with the Underwritten Stock herein collectively called the Stock). The Common Stock is more fully described in the Registration Statement and the Prospectus hereinafter mentioned. The Company and the Selling Securityholders severally hereby confirm the agreements made with respect to the purchase of the Stock by the several underwriters, for whom you are acting, named in Schedule I hereto (herein collectively called the Underwriters, which term shall also include any underwriter purchasing Stock pursuant to Section 3(b) hereof). You represent and warrant that you have been authorized by each of the other Underwriters to enter into this Agreement on its behalf and to act for it in the manner herein provided. 1. Registration Statement. The Company has filed with the Securities and Exchange Commission (herein called the Commission) a registration statement on Form S-1 (No. 333- _________________ /1/ Plus an option to purchase from the Secondary Selling Securityholders up to 945,000 additional shares to cover over-allotments. 90317), including the related preliminary prospectus, for the registration under the Securities Act of 1933, as amended (herein called the Securities Act) of the Stock. Copies of such registration statement and of each amendment thereto, if any, including the related preliminary prospectus (meeting the requirements of Rule 430A of the rules and regulations of the Commission (herein called the Rules and Regulations)) heretofore filed by the Company with the Commission have been delivered to you. The term Registration Statement as used in this agreement shall mean such registration statement, including all documents incorporated by reference therein, all exhibits and financial statements, all information omitted therefrom in reliance upon Rule 430A and contained in the Prospectus referred to below, in the form in which it became effective, and any registration statement filed pursuant to Rule 462(b) of the Rules and Regulations with respect to the Stock (herein called a Rule 462(b) registration statement), and, in the event of any amendment thereto after the effective date of such registration statement (herein called the Effective Date), shall also mean (from and after the effectiveness of such amendment) such registration statement as so amended (including any Rule 462(b) registration statement). The term Prospectus as used in this Agreement shall mean the prospectus, including the documents incorporated by reference therein, relating to the Stock first filed with the Commission pursuant to Rule 424(b) and Rule 430A (or if no such filing is required, as included in the Registration Statement) and, in the event of any supplement or amendment to such prospectus after the Effective Date, shall also mean (from and after the filing with the Commission of such supplement or the effectiveness of such amendment) such prospectus as so supplemented or amended. The term Preliminary Prospectus as used in this Agreement shall mean each preliminary prospectus, including the documents incorporated by reference therein, included in such registration statement prior to the time it becomes effective. The Registration Statement has been declared effective under the Securities Act, and no post-effective amendment to the Registration Statement has been filed as of the date of this Agreement. The Company has caused to be delivered to you copies of each Preliminary Prospectus and has consented to the use of such copies for the purposes permitted by the Securities Act. 2. Representations and Warranties of the Company, the Parent and the Selling Securityholders. (a) Each of the Company and IDT Corporation, a Delaware corporation (herein call the Parent), and the Selling Securityholders named in Schedule IV hereto hereby represents and warrants as follows: (i) The Company has been duly organized and is validly existing as a corporation in good standing under the laws of the jurisdiction of its incorporation, has full corporate power and authority to own or lease its properties and conduct its business as described in the Registration Statement and the Prospectus and as being conducted, and is duly qualified as a foreign corporation and in good standing in all jurisdictions in which the character of the property owned or leased or the nature of the business transacted by it makes qualification necessary except where the failure to be so qualified 2 would not have a material adverse effect on the condition, results of operations or business of the Company (herein called a Material Adverse Effect). (ii) The outstanding shares of capital stock of the Company have been duly authorized and validly issued and are fully paid and non- assessable; the Stock is duly authorized, is (or in the case of shares of the Stock to be sold by the Company, will be, when issued and sold to the Underwriters as provided herein) duly and validly issued, fully paid and non-assessable; and no preemptive, co-sale, registration right, right of first refusal or other similar rights of stockholders exist with respect to any of the Stock or the issue and sale thereof, except as set forth in the Registration Statement. No further approval or authority of the stockholders or the Board of Directors of the Company will be required for the issuance and sale of the Stock. Neither the filing of the Registration Statement nor the offering or sale of the Stock as contemplated by this Agreement gives rise to any rights, other than those which have been waived or satisfied, for or relating to the registration of any shares of capital stock. Except as described in the Prospectus, there are no contracts, agreements or understandings between the Company and any person granting such person the right to require the Company to file a registration statement under the Securities Act with respect to any securities of the Company owned or to be owned by such person or to require the Company to include such securities in the securities registered pursuant to the Registration Statement or in any securities being registered pursuant to any other registration statement filed by the Company under the Securities Act. Except as described in the Prospectus, there are no outstanding subscriptions, rights, warrants, options, calls, convertible securities, commitments of sale or liens related to or entitling any person to purchase or otherwise to acquire any shares of the capital stock of, or other ownership interest in, the Company. (iii) The information set forth under the caption "Capitalization" in the Prospectus is true and correct in all material respects. All of the Stock conforms in all material respects to the description thereof contained in the Registration Statement. The form of certificates for the Stock conforms to the legal requirements of the state of Delaware. (iv) The Commission has not issued an order preventing or suspending the use of any Prospectus relating to the proposed offering of the Stock, nor, to the best knowledge of the Company, the Parent and the Selling Securityholders, instituted proceedings for that purpose. (v) The financial statements of the Company, together with related notes and schedules as set forth in the Registration Statement, present fairly, the financial position and the results of operations and cash flows of the Company at the indicated dates and for the indicated periods. Such financial statements and related schedules have, to the best of the Company's knowledge, been prepared in accordance with generally accepted principles of accounting, consistently applied throughout the periods involved, and all adjustments necessary for a fair presentation of results for such periods have been made. The summary and selected financial and statistical data included in the Registration Statement present fairly the information shown therein and such data has 3 been compiled on a basis consistent with the financial statements presented therein and the books and records of the Company. (vi) Ernst & Young LLP, who have certified certain of the financial statements filed with the Commission as part of the Registration Statement, are independent public accountants as required by the Securities Act and the Rules and Regulations. (vii) Except as disclosed in the Registration Statement, there is no action, suit, claim or proceeding pending, or, to the knowledge of the Company, the Parent and the Selling Securityholders, threatened against the Company or any of their respective officers or properties, before any court or administrative agency or otherwise, which if determined adversely to the Company could reasonably be expected to result in any Material Adverse Effect or prevent the consummation of the transactions contemplated hereby; and there are no agreements, contracts, leases or documents of the Company of a character required to be described or referred to in the Registration Statement or Prospectus or to be filed as an exhibit to the Registration Statement by the Securities Act or the Rules and Regulations which have not been accurately described in all material respects or referred to in the Registration Statement or Prospectus or filed as exhibits to the Registration Statement. The contracts so described in the Registration Statement and Prospectus are in full force and effect on the date hereof, and neither the Company nor, to the best of the Company's, the Parent's or the Selling Securityholder's knowledge, any other party, is in breach of or default under any of such contracts where such breach or default would have a Material Adverse Effect. (viii) The Company has good and marketable title to all of the properties and assets as described in the Registration Statement or as reflected in the financial statements filed with the Commission as part of the Registration Statement, free and clear of any lien, mortgage, pledge, charge or encumbrance of any kind except those reflected in such financial statements or as described in the Registration Statement. All leases to which the Company is a party are valid and binding obligations of the Company and no default by the Company has occurred or is continuing thereunder which could reasonably be expected to result in a Material Adverse Effect, and the Company enjoys peaceful and undisturbed possession under all such leases to which it is a party as lessee. (ix) The Company has timely filed all federal, state, local and foreign income tax returns which have been required to be filed and have paid all taxes indicted by said returns and all assessments received by them or any of them to the extent that such taxes have become due and are not being contested in good faith except where the failure to file such returns and pay such taxes would not have a Material Adverse Effect. All tax liabilities (including those being contested in good faith) for the periods covered by the financial statements of the Company that are included in the Registration Statement have been adequately provided for in such financial statements. (x) Since the respective dates as of which information is given in the Registration Statement and the Prospectus, there has not occurred any Material Adverse Effect or any development involving a prospective Material Adverse Effect whether or 4 not occurring in the ordinary course of business, and there has not been any material transaction entered into or any material transaction that is probable of being entered into by the Company, other than transactions in the ordinary course of business and changes and transactions described in the Registration Statement and the Prospectus, as each may be amended or supplemented. The Company has no material contingent obligations which are not disclosed or provided for in the Company's financial statements that are included in the Registration Statement. (xi) This Agreement has been duly authorized, executed and delivered by the Company, the Parent and the Selling Securityholders and is a valid and binding agreement of the Company, the Parent and the Selling Securityholders, enforceable in accordance with its terms except insofar as indemnification and contribution provisions may be limited by applicable law or equitable principles and except as enforceability may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws relating to or affecting creditors' rights generally or by general equitable principles. (xii) The Company is not, nor with the giving of notice or lapse of time or both will be, in violation of or in default under its Certificate of Incorporation or Bylaws or under any agreement, lease, contract, indenture or other instrument or obligation to which it is a party or by which it, or any of its properties, is bound and which default would have a Material Adverse Effect. The execution and delivery of this Agreement and the consummation of the transactions herein contemplated and the fulfillment of the terms hereof will not conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust or other agreement or instrument to which the Company, the Parent and the Selling Securityholders is a party, or of the respective Certificate of Incorporation or Bylaws of the Company or the Parent or, to the best knowledge of the Company, the Parent or the Selling Securityholders, any law, order, rule or regulation, injunction, judgment, or decree applicable to the Company, the Parent or the Selling Securityholders of any court or of any regulatory body or administrative agency or other governmental body having jurisdiction over the Company, the Parent or the Selling Securityholders which conflict, breach or default could have a Material Adverse Effect. (xiii) Each approval, consent, order, authorization, designation, declaration or filing by or with any regulatory, administrative or other governmental body necessary in connection with the execution and delivery by the Company, the Parent and the Selling Securityholders of this Agreement and the consummation of the transactions herein contemplated (except such additional steps as may be required by the National Association of Securities Dealers, Inc. (herein called the NASD) or such additional steps as may be necessary to qualify the Stock for public offering by the Underwriters under state securities or blue sky laws) has been obtained or made and is in full force and effect. (xiv) The Company is operating substantially in compliance with all statutes, laws, regulations, ordinances or court decrees applicable to its businesses and operations, except where any such non-compliance would not have a Material Adverse Effect. The Company has not violated any foreign, federal, state or local law or regulation relating to the protection of human health and safety, the environment or 5 hazardous or toxic substances or wastes, pollutants or contaminants or relating to discrimination in the hiring, promotion or pay of, or to the wages and hours of, employees, except for such violations as in the aggregate would not result in any Material Adverse Effect. To the best of Company's, Parent's and the Selling Securityholder's knowledge, no labor disturbance by the employees of the Company exists or is imminent, and the Company is not aware of any existing or imminent labor disturbance by the employees of any of its principal suppliers, value added resellers, authorized dealers or distributors that might be expected to result in a Material Adverse Effect. No collective bargaining agreement exists with any of the Company's employees and, to the best of the Company's, the Parent's and the Selling Securityholder's knowledge, no such agreement is imminent. (xv) The Company is in compliance in all material respects with all currently applicable provisions of the Employee Retirement Income Security Act of 1974, as amended, including the regulations and published interpretations thereunder (herein called ERISA); no "reportable event" (as defined in ERISA) has occurred with respect to any "pension plan" (as defined in ERISA) for which the Company would have any liability; the Company has not incurred and does not expect to incur liability under (i) Title IV of ERISA with respect to termination of, or withdrawal from, any "pension plan" or (ii) Sections 412 or 4971 of the Internal Revenue Code of 1986, as amended, including the regulations and published interpretation thereunder (herein called the Code); and each "pension plan" for which the Company would have any liability that is intended to be qualified under Section 401(a) of the Code is so qualified in all material respects and nothing has occurred, whether by action or by failure to act, that would cause the loss of such qualification. (xvi) The Company holds all material licenses, certificates and permits from governmental authorities that are necessary to the conduct of its businesses and as contemplated by the Prospectus. (xvii) Except as set forth in the Registration Statement, the Company owns or possesses adequate rights to use all inventions, designs, computer programs, computer code, communications protocols, security devices, trade secrets, know-how, trademarks, service marks, trade names, copyright works or other information (herein collectively called Intellectual Property) which are necessary to conduct its businesses as described in the Registration Statement and the Prospectus; Except as set forth in the Registration Statement, the Company has not received any notice of, and has no knowledge of, any infringement of or conflict with any rights of the Company by others with respect to any Intellectual Property which, singly or in the aggregate, if the subject of an unfavorable decision, ruling or finding, would have a Material Adverse Effect; Except as set forth in the Registration Statement, the Company and the Parent have not received any notice of, and have no knowledge of, any infringement of or conflict with any rights of others with respect to any Intellectual Property which, singly or in the aggregate, if the subject of an unfavorable decision, ruling or finding, would have a Material Adverse Effect; to the Company's and the Parent's best knowledge, none of the Intellectual Property licensed to or by the Company are unenforceable or invalid; and except as set forth in the Registration Statement, the Company is not aware of the 6 granting of any patent rights to third parties or the filing of any patent applications by third parties or any other rights of third parties to any Intellectual Property owned by the Company. (xviii) The Company has not taken, directly or indirectly, any action designed to cause or result in, or which has constituted or which might reasonably be expected to constitute, the stabilization or manipulation of the price of the shares of Common Stock to facilitate the sale or resale of the Stock. (xix) The Company is not an "investment company" or a company "controlled" by an "investment company" within the meaning of such terms under the Investment Company Act of 1940, as amended (herein called the Investment Company Act), and the rules and regulations of the Commission thereunder. (xx) The Company maintains a system of internal accounting controls sufficient to provide reasonable assurances that (i) transactions are executed in accordance with management's general or specific authorization; (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain accountability for assets; (iii) access to assets is permitted only in accordance with management's general or specific authorization; and (iv) the recorded accountability for assets is compared with existing assets at reasonable intervals and appropriate action is taken with respect to any differences. (xxi) The Company carries, or is covered by, insurance with insurers of nationally recognized reputability in such amounts and covering such risks as it believes is customary for companies engaged in similar industries. (xxii) The Stock to be sold by the Selling Securityholders and the Company has been authorized for listing by the Nasdaq National Market upon official notice of issuance. (xxiii) The Registration Statement and the Prospectus comply, and on the Closing Date and the Option Closing Date (as such dates are hereinafter defined) the Prospectus will comply, in all material respects, with the provisions of the Securities Act and the Rules and Regulations; on the Effective Date the Registration Statement did not, and on each of the Closing Date and the Option Closing Date, will not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein not misleading; and, on the Effective Date the Prospectus did not and, on each of the Closing Date and the Option Closing Date, will not contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading; provided, however, that none of the representations and warranties in this Section 2(a)(xxiii) shall apply to statements in, or omissions from, the Registration Statement or the Prospectus made in reliance upon and in conformity with information herein or otherwise furnished in writing to the Company by the Underwriters for use in the Registration Statement or the Prospectus. 7 (xxiv) The statements in the Prospectus under the heading "Certain Transactions" set forth all existing agreements, arrangements, understandings or transactions, or proposed agreements, arrangements, understandings or transactions, between or among the Company, on the one hand, and any officer, director or stockholder of the Company, or with any partner, affiliate or associate of any of the foregoing persons or entities, on the other hand, required to be set forth or described thereunder. (xxv) There are no issues related to the Company's preparedness for the Year 2000 that (i) are of a character required to be described or referred to in the Registration Statement or Prospectus by the Securities Act or the Rules and Regulations which have not been accurately described in the Registration Statement or Prospectus or (ii) might reasonably be expected to result in any Material Adverse Effect. Except as set forth in the Registration Statement, all internal computer systems and each Constituent Component (as defined below) of those systems and all computer-related products and each Constituent Component of those products of the Company fully comply with the Year 2000 Qualification Requirements. "Year 2000 Qualification Requirements" means that the internal computer systems and each Constituent Component of those systems and all computer- related products and each Constituent Component of those products of the Company (i) have been reviewed to confirm that they store, process (including sorting and performing mathematical operations, calculations and computations), input and output data containing date and information correctly regardless of whether the date contains dates and times before, on or after January 1, 2000, (ii) have been designated to ensure date and time entry recognition, calculations that accommodate same century and multi-century formulas and date values, leap year recognition and calculations, and date data interface values that reflect the century, (iii) accurately manage and manipulate data involving dates and times, including single century formulas and multi-century formulas, and will not cause an abnormal ending scenario within the application or generate incorrect values or invalid results involving such dates, (iv) accurately process any date rollover and (v) accept and respond to two-digit year date input in a manner that resolves any ambiguities as to the century. "Constituent Component" means all software (including operating systems, programs, packages and utilities), firmware, hardware, networking components, and peripherals provided as part of the configuration. (xxvi) The Company has not at any time since its inception (i) made any unlawful contribution to any candidate for foreign office or failed to disclose fully any contribution in violation of law, or (ii) made any payment to any U.S. federal or state governmental officer or official, or other person charged with similar public or quasi-public duties, other than payments required or permitted by the laws of the United States or any jurisdiction thereof. (xxvii) Neither the Company, the Parent nor the Selling Securityholders has distributed and neither will distribute prior to the later of (i) the Closing Date, or any date on which Option Stock is to be purchased, as the case may be, and (ii) completion of the distribution of the Stock, any offering material in connection with the offering and sale of the Stock other than any Preliminary Prospectuses, the Prospectus, the Registration Statement and other materials, if any, permitted by the Securities Act. 8 (xxviii) The Company has not incurred any liability for any finder's fees or similar payments in connection with the transactions contemplated hereby other than to the Underwriters. (xxix) The sale of Stock to be sold by the Selling Securityholders will not violate any provision of the Securities Act, the Rules and Regulations or any applicable state securities laws. (xxx) The minute books of the Company have been made available to the Representatives and contain a complete summary of all meetings and actions of the directors, stockholders, audit committee, compensation committee and any other committee of the Board of Directors of the Company, respectively, since the time of its incorporation, and reflect all transactions referred to in such minutes accurately. (xxxi) There are no agreements between the Company and its affiliates (other than Parent) and any former officer of the Company relating to the payment of severance or other compensation. (b) Each of the Selling Securityholders hereby represents and warrants as follows: (i) Such Selling Securityholder has good and marketable title to all the shares of Stock to be sold by such Selling Securityholder hereunder, free and clear of all liens, encumbrances, equities, security interests and claims whatsoever, with full right and authority to deliver the same hereunder, subject, in the case of each Selling Securityholder, to the rights of American Stock Transfer & Trust Company, as Custodian (herein called the Custodian), and that upon the delivery of and payment for such shares of the Stock hereunder, the several Underwriters will receive good and marketable title thereto, free and clear of all liens, encumbrances, equities, security interests and claims whatsoever. (ii) Certificates in negotiable form for the shares of the Stock to be sold by such Selling Securityholder have been placed in custody under a Custody Agreement for delivery under this Agreement with the Custodian; such Selling Securityholder specifically agrees that the shares of the Stock represented by the certificates so held in custody for such Selling Securityholder are subject to the interests of the several Underwriters and the Company, that the arrangements made by such Selling Securityholder for such custody, including the Power of Attorney provided for in such Custody Agreement, are to that extent irrevocable, and that the obligations of such Selling Securityholder shall not be terminated by any act of such Selling Securityholder or by operation of law, whether by the death or incapacity of such Selling Securityholder (or, in the case of a Selling Securityholder that is not an individual, the dissolution or liquidation of such Selling Securityholder) or the occurrence of any other event; if any such death, incapacity, dissolution, liquidation or other such event should occur before the delivery of such shares of the Stock hereunder, certificates for such shares of the Stock shall be delivered by the Custodian in accordance with the terms and conditions of this Agreement as if such death, incapacity, dissolution, liquidation or other event had not 9 occurred, regardless of whether the Custodian shall have received notice of such death, incapacity, dissolution, liquidation or other event. (iii) This Agreement has been duly authorized, executed and delivered by or on behalf of such Selling Securityholder and is a valid and binding agreement of such Selling Securityholder, enforceable in accordance with its terms except insofar as indemnification and contribution provisions may be limited by applicable law or equitable principles and except as enforceability may be limited by bankruptcy, insolvency, reorganization, moratorium or similar laws relating to or affecting creditors' rights generally or by general equitable principles. (iv) Such Selling Securityholder has not distributed and will not distribute prior to the later of (i) the Closing Date, or any date on which Option Stock is to be purchased, as the case may be, and (ii) completion of the distribution of the Stock, any offering material in connection with the offering and sale of the Stock other than any Preliminary Prospectuses, the Prospectus, the Registration Statement and other materials, if any, permitted by the Securities Act. (v) The sale of Stock to be sold by such Selling Securityholder will not violate any provision of the Securities Act, the Rules and Regulations or any applicable state securities laws. (vi) The information in the Registration Statement under the caption "Principal and Selling Stockholders" which specifically relates to such Selling Securityholder does not, and will not on the Closing Date, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading. 3. Purchase of the Stock by the Underwriters. (a) On the basis of the representations and warranties and subject to the terms and conditions herein set forth, the Company agrees to issue and sell 3,400,000 shares of the Underwritten Stock to the several Underwriters, each Selling Securityholder agrees to sell to the several underwriters the number of shares of the Underwritten Stock set forth in Schedule II and/or Schedule III opposite the name of such Selling Securityholder, and each of the Underwriters agrees to purchase from the Company and the Selling Securityholders the respective aggregate number of shares of Underwritten Stock set forth opposite its name in Schedule I. The price at which such shares of Underwritten Stock shall be sold by the Company and the Selling Securityholders and purchased by the several Underwriters shall be $_____ per share. The obligation of each Underwriter to the Company and each of the Selling Securityholders shall be to purchase from the Company and the Selling Securityholders that number of shares of the Underwritten Stock which represents the same proportion of the total number of shares of the Underwritten Stock to be sold by each of the Company and the Selling Securityholders pursuant to this Agreement as the number of shares of the Underwritten Stock set forth opposite the name of such Underwriter in Schedule I hereto represents of the total number of shares of the Underwritten Stock to be purchased by all Underwriters pursuant to this 10 Agreement, as adjusted by you in such manner as you deem advisable to avoid fractional shares. In making this Agreement, each Underwriter is contracting severally and not jointly; except as provided in paragraphs (b) and (c) of this Section 3, the agreement of each Underwriter is to purchase only the respective number of shares of the Underwritten Stock specified in Schedule I. (b) If for any reason one or more of the Underwriters shall fail or refuse (otherwise than for a reason sufficient to justify the termination of this Agreement under the provisions of Section 8 or 9 hereof) to purchase and pay for the number of shares of the Stock agreed to be purchased by such Underwriter or Underwriters, the Company or the Selling Securityholders shall immediately give notice thereof to you, and the non-defaulting Underwriters shall have the right within 24 hours after the receipt by you of such notice to purchase, or procure one or more other Underwriters to purchase, in such proportions as may be agreed upon between you and such purchasing Underwriter or Underwriters and upon the terms herein set forth, all or any part of the shares of the Stock which such defaulting Underwriter or Underwriters agreed to purchase. If the non-defaulting Underwriters fail so to make such arrangements with respect to all such shares and portion, the number of shares of the Stock which each non-defaulting Underwriter is otherwise obligated to purchase under this Agreement shall be automatically increased on a pro rata basis to absorb the remaining shares and portion which the defaulting Underwriter or Underwriters agreed to purchase; provided, however, that the non-defaulting Underwriters shall not be obligated to purchase the shares and portion which the defaulting Underwriter or Underwriters agreed to purchase if the aggregate number of such shares of the Stock exceeds 10% of the total number of shares of the Stock which all Underwriters agreed to purchase hereunder. If the total number of shares of the Stock which the defaulting Underwriter or Underwriters agreed to purchase shall not be purchased or absorbed in accordance with the two preceding sentences, the Company and the Selling Securityholders shall have the right, within the 24 hours next succeeding the 24-hour period above referred to, to make arrangements with other underwriters or purchasers satisfactory to you for purchase of such shares and portion on the terms herein set forth. In any such case, either you or the Company and the Selling Securityholders shall have the right to postpone the Closing Date determined as provided in Section 5 hereof for not more than seven business days after the date originally fixed as the Closing Date pursuant to said Section 5 in order that any necessary changes in the Registration Statement, the Prospectus or any other documents or arrangements may be made. If neither the non-defaulting Underwriters nor the Company and the Selling Securityholders shall make arrangements within the 24- hour periods stated above for the purchase of all the shares of the Stock which the defaulting Underwriter or Underwriters agreed to purchase hereunder, this Agreement shall be terminated without further act or deed and without any liability on the part of the Company or the Selling Securityholders to any non- defaulting Underwriter and without any liability on the part of any non- defaulting Underwriter to the Company or the Selling Securityholders. Nothing in this paragraph (b), and no action taken hereunder, shall relieve any defaulting Underwriter from liability in respect of any default of such Underwriter under this Agreement. (c) On the basis of the representations, warranties and covenants herein contained, and subject to the terms and conditions herein set forth, the Secondary Selling Securityholders grant an option to the several Underwriters to purchase, severally and not jointly, up to 945,000 shares in the aggregate of the Option Stock from the Secondary Selling Securityholders at the price of $_____ per share. Said option may be exercised only to cover 11 over-allotments in the sale of the Underwritten Stock by the Underwriters and may be exercised in whole or in part at any time (but not more than once) on or before the thirtieth day after the date of this Agreement upon written or telegraphic notice by you to the Company and the Custodian setting forth the aggregate number of shares of the Option Stock as to which the several Underwriters are exercising the option. Delivery of certificates for the shares of Option Stock, and payment therefor, shall be made as provided in Section 5 hereof. The number of shares of the Option Stock to be purchased by each Underwriter shall be the same percentage of the total number of shares of the Option Stock to be purchased by the several Underwriters as such Underwriter is purchasing of the Underwritten Stock, as adjusted by you in such manner as you deem advisable to avoid fractional shares. 4. Offering by Underwriters. (a) The terms of the public offering by the Underwriters of the Stock to be purchased by them shall be as set forth in the Prospectus. The Underwriters may from time to time change the public offering price after the closing of the public offering and increase or decrease the concessions and discounts to dealers as they may determine. (b) The information set forth under "Underwriting" in the Registration Statement, any Preliminary Prospectus and the Prospectus relating to the Stock filed by the Company (insofar as such information relates to the Underwriters and their affiliates) constitutes the only information furnished by the Underwriters to the Company for inclusion in the Registration Statement, any Preliminary Prospectus, and the Prospectus, and you on behalf of the respective Underwriters represent and warrant to the Company that the statements made therein are correct. 5. Delivery of and Payment for the Stock. (a) Delivery of certificates for the shares of the Underwritten Stock and the Option Stock (if the option granted by Section 3(c) hereof shall have been exercised not later than 10:00 a.m., New York time, on the date two business days preceding the Closing Date), and payment therefor, shall be made at the offices of Brobeck, Phleger & Harrison LLP, 1633 Broadway, 47th Floor, New York, New York, at 10:00 a.m., New York time, on the fourth business day after the date of this Agreement, or at such time on such other day, not later than seven full business days after such fourth business day, as shall be agreed upon in writing by the Company and you. The date and hour of such delivery and payment (which may be postponed as provided in Section 3(b) hereof) are herein called the Closing Date. (b) If the option granted by Section 3(c) hereof shall be exercised after 10:00 a.m., New York time, on the date two business days preceding the Closing Date, delivery of certificates for the shares of Option Stock, and payment therefor, shall be made at the offices of Brobeck, Phleger & Harrison LLP, 1633 Broadway, New York, New York, at 10:00 a.m., New York time, on the third business day after the exercise of such option. The date and hour of such delivery and payment (which may be postponed as provided in Section 3(b) hereof) are herein called the Option Closing Date. (c) Payment for the Stock purchased from the Company shall be made to the Company or its order, and payment for the Stock purchased from the Selling Securityholders 12 shall be made to the Custodian, for the account of the Selling Securityholders, in each case by wire or one or more certified or official bank check or checks in same day funds. Such payment shall be made upon delivery of certificates for the Stock to you for the respective accounts of the several Underwriters against receipt therefor signed by you. Certificates for the Stock to be delivered to you shall be registered in such name or names and shall be in such denominations as you may request at least one business day before the Closing Date, in the case of Underwritten Stock, and at least one business day prior to the purchase thereof, in the case of the Option Stock. Such certificates will be made available to the Underwriters for inspection, checking and packaging at the offices of Lewco Securities Corporation, 2 Broadway, New York, New York 10004 on the business day prior to the Closing Date or, in the case of the Option Stock, by 3:00 p.m., New York time, on the business day preceding the date of purchase. It is understood that you, individually and not on behalf of the Underwriters, may (but shall not be obligated to) make payment to the Company and the Selling Securityholders for shares to be purchased by any Underwriter whose check shall not have been received by you on the Closing Date or any later date on which Option Stock is purchased for the account of such Underwriter. Any such payment by you shall not relieve such Underwriter from any of its obligations hereunder. 6. Further Agreements of the Company and the Selling Securityholders. Each of the Company and the Selling Securityholders covenants and agrees as follows: (a) The Company will (i) prepare and timely file with the Commission under Rule 424(b) a Prospectus containing information previously omitted at the time of effectiveness of the Registration Statement in reliance on Rule 430A and (ii) not file any amendment to the Registration Statement or supplement to the Prospectus of which you shall not previously have been advised and furnished with a copy or to which you shall have reasonably objected in writing or which is not in compliance with the Securities Act or the Rules and Regulations. (b) The Company will promptly notify each Underwriter in the event of (i) the request by the Commission for amendment of the Registration Statement or for supplement to the Prospectus or for any additional information, (ii) the issuance by the Commission of any stop order suspending the effectiveness of the Registration Statement, (iii) the institution or notice of intended institution of any action or proceeding for that purpose, (iv) the receipt by the Company of any notification with respect to the suspension of the qualification of the Stock for sale in any jurisdiction, or (v) the receipt by it of notice of the initiation or threatening of any proceeding for such purpose. The Company will make every reasonable effort to prevent the issuance of such a stop order and, if such an order shall at any time be issued, to obtain the withdrawal thereof at the earliest possible moment. (c) The Company will (i) on or before the Closing Date, deliver to you a signed copy of the Registration Statement as originally filed and of each amendment thereto filed prior to the time the Registration Statement becomes effective and, promptly upon the filing thereof, a signed copy of each post- effective amendment, if any, to the Registration Statement (together with, in each case, all exhibits thereto unless previously furnished to you) and will also deliver to you, for distribution to the Underwriters, a sufficient number of additional conformed copies of each of the foregoing (but without exhibits) so that one copy of each may be distributed to each 13 Underwriter, (ii) as promptly as possible deliver to you and send to the several Underwriters, at such office or offices as you may designate, as many copies of the Prospectus as you may reasonably request, and (iii) thereafter from time to time during the period in which a prospectus is required by law to be delivered by an Underwriter or dealer, likewise send to the Underwriters as many additional copies of the Prospectus and as many copies of any supplement to the Prospectus and of any amended prospectus, filed by the Company with the Commission, as you may reasonably request for the purposes contemplated by the Securities Act. (d) If at any time during the period in which a prospectus is required by law to be delivered by an Underwriter or dealer, any event relating to or affecting the Company, or of which the Company shall be advised in writing by you, shall occur as a result of which it is necessary, in the opinion of counsel for the Company or of counsel for the Underwriters, to supplement or amend the Prospectus in order to make the Prospectus not misleading in the light of the circumstances existing at the time it is delivered to a purchaser of the Stock, the Company will forthwith prepare and file with the Commission a supplement to the Prospectus or an amended prospectus so that the Prospectus as so supplemented or amended will not contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements therein, in the light of the circumstances existing at the time such Prospectus is delivered to such purchaser, not misleading. If, after the initial public offering of the Stock by the Underwriters and during such period, the Underwriters shall propose to vary the terms of offering thereof by reason of changes in general market conditions or otherwise, you will advise the Company in writing of the proposed variation, and, if in the opinion either of counsel for the Company or of counsel for the Underwriters such proposed variation requires that the Prospectus be supplemented or amended, the Company will forthwith prepare and file with the Commission a supplement to the Prospectus or an amended prospectus setting forth such variation. The Company authorizes the Underwriters and all dealers to whom any of the Stock may be sold by the several Underwriters to use the Prospectus, as from time to time amended or supplemented, in connection with the sale of the Stock in accordance with the applicable provisions of the Securities Act and the Rules and Regulations for such period. (e) Prior to the filing thereof with the Commission, the Company will submit to you, for your information, a copy of any post-effective amendment to the Registration Statement and any supplement to the Prospectus or any amended prospectus proposed to be filed. (f) The Company will cooperate, when and as requested by you, in the qualification of the Stock for offer and sale under the securities or blue sky laws of such jurisdictions as you may designate and, during the period in which a prospectus is required by law to be delivered by an Underwriter or dealer, in keeping such qualifications in good standing under said securities or blue sky laws; provided, however, that the Company shall not be obligated to file any general consent to service of process or to qualify as a foreign corporation in any jurisdiction in which it is not so qualified. The Company will, from time to time, prepare and file such statements, reports, and other documents as are or may be required to continue such qualifications in effect for so long a period as you may reasonably request for distribution of the Stock. (g) During a period of five years commencing with the date hereof, the Company will furnish to you, and to each Underwriter who may so request in writing, copies of all periodic 14 and special reports furnished to stockholders of the Company and of all information, documents and reports filed with the Commission. (h) Not later than the 45th day following the end of the fiscal quarter first occurring after the first anniversary of the Effective Date, the Company will make generally available to its security holders an earnings statement in accordance with Section 11(a) of the Securities Act and Rule 158 thereunder. (i) The Company and the Selling Securityholders named in Schedule IV hereto jointly and severally agree to pay all costs and expenses incident to the performance of their obligations under this Agreement, including all costs and expenses incident to (i) the preparation, printing and filing with the Commission and the NASD of the Registration Statement, any Preliminary Prospectus and the Prospectus, (ii) the furnishing to the Underwriters of copies of any Preliminary Prospectus and of the several documents required by paragraph (c) of this Section 6 to be so furnished, (iii) the printing of this Agreement and related documents delivered to the Underwriters, (iv) the preparation, printing and filing of all supplements and amendments to the Prospectus referred to in paragraph (d) of this Section 6, (v) the furnishing to you and the Underwriters of the reports and information referred to in paragraph (g) of this Section 6 and (vi) the printing and issuance of stock certificates, including the transfer agent's fees. The Selling Securityholders will pay any transfer taxes incident to the transfer to the Underwriters of the shares of Stock being sold by the Selling Securityholders. (j) The Company and the Selling Securityholders named in Schedule IV hereto jointly and severally agree to reimburse you, for the account of the several Underwriters, for blue sky fees and related disbursements (including counsel fees and disbursements and cost of printing memoranda for the Underwriters) paid by or for the account of the Underwriters or their counsel in qualifying the Stock under state securities or blue sky laws and in the review of the offering by the NASD. (k) The provisions of paragraphs (i) and (j) of this Section are intended to relieve the Underwriters from the payment of the expenses and costs which the Company and the Selling Securityholders hereby agree to pay and shall not affect any agreement which the Company and the Selling Securityholders may make, or may have made, for the sharing of any such expenses and costs. (l) If at any time during the 25-day period after the Registration Statement becomes effective any rumor, publication or event relating to or affecting the Company shall occur as a result of which in your opinion the market price for the Stock has been or is likely to be materially affected (regardless of whether such rumor, publication or event necessitates a supplement to or amendment of the Prospectus), the Company will, after written notice from you advising the Company to the effect set forth above, forthwith prepare, consult with you concerning the substance of, and disseminate a press release or other public statement, reasonably satisfactory to you, responding to or commenting on such rumor, publication or event. (m) The Company is familiar with the Investment Company Act and has in the past conducted its affairs, and will in the future conduct its affairs, in such a manner to ensure 15 that the Company was not and will not be an "investment company" or a company "controlled" by an "investment company" within the meaning of the Investment Company Act and the rules and regulations thereunder. (n) The Company will comply with the Securities Act and the Rules and Regulations, and the Securities Exchange Act of 1934 (herein called the Exchange Act) and the Rules and Regulations, so as to permit the completion of the distribution of the Stock as contemplated in this Agreement and the Prospectus. (o) The Company shall apply the net proceeds of its sale of the Stock as set forth in the Prospectus under the heading "Use of Proceeds." (p) The Company will not take, directly or indirectly, any action designed to cause or result in, or that has constituted or might reasonably be expected to constitute, the stabilization or manipulation of the price of the Common Stock of the Company. (q) The Company will maintain a transfer agent and, if necessary under the jurisdiction of incorporation of the Company, a registrar (which may be the same entity as the transfer agent) for its Common Stock. 7. Indemnification and Contribution. (a) Subject to the provisions of paragraph (f) of this Section 7, the Company, the Parent and the Selling Securityholders jointly and severally agree to indemnify and hold harmless each Underwriter and each person (including each partner or officer thereof) who controls any Underwriter within the meaning of Section 15 of the Securities Act from and against any and all losses, claims, damages or liabilities, joint or several, to which such indemnified parties or any of them may become subject under the Securities Act, the Exchange Act, or the common law or otherwise, and the Company and the Selling Securityholders jointly and severally agree to reimburse each such Underwriter and controlling person for any legal or other expenses (including, except as otherwise hereinafter provided, reasonable fees and disbursements of counsel) incurred by the respective indemnified parties in connection with any investigation or inquiry of, or other proceeding which may be brought against, the respective indemnified parties, in each case arising out of or based upon (i) any untrue statement or alleged untrue statement of a material fact contained in the Registration Statement (including the Prospectus as part thereof and any Rule 462(b) registration statement) or any post-effective amendment thereto (including any Rule 462(b) registration statement), or the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, or (ii) any untrue statement or alleged untrue statement of a material fact contained in any Preliminary Prospectus or the Prospectus (as amended or as supplemented if the Company shall have filed with the Commission any amendment thereof or supplement thereto) or the omission or alleged omission to state therein a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading; provided, however, that (1) the indemnity agreements of the Company, the Parent, and the Selling Securityholders contained in this paragraph (a) shall not apply to any such losses, claims, damages, liabilities or expenses if such statement or omission was made in reliance upon and in conformity with information furnished as herein stated or otherwise 16 furnished in writing to the Company by or on behalf of any Underwriter for use in any Preliminary Prospectus or the Registration Statement or the Prospectus or any such amendment thereof or supplement thereto, (2) the indemnity agreement contained in this paragraph (a) with respect to any Preliminary Prospectus shall not inure to the benefit of any Underwriter from whom the person asserting any such losses, claims, damages, liabilities or expenses purchased the Stock which is the subject thereof (or to the benefit of any person controlling such Underwriter) if at or prior to the written confirmation of the sale of such Stock a copy of the Prospectus (or the Prospectus as amended or supplemented) was not sent or delivered to such person (excluding the documents incorporated therein by reference) and the untrue statement or omission of a material fact contained in such Preliminary Prospectus was corrected in the Prospectus (or the Prospectus as amended or supplemented) unless the failure is the result of noncompliance by the Company with paragraph (c) of Section 6 hereof and (3) each Selling Securityholder (other than the Parent and any Selling Securityholder named in Schedule IV hereto) shall only be liable under this paragraph with respect to (a) information pertaining to such Selling Securityholder furnished by or on behalf of such Selling Securityholder expressly for use in any Preliminary Prospectus or the Registration Statement or the Prospectus or any such amendment thereof or supplement thereto, or (B) facts that would constitute a breach of any representation or warranty of such Selling Securityholder set forth in Section 2(b) hereof. The indemnity agreements of the Company, the Parent, and the Selling Securityholders contained in this paragraph (a) and the representations and warranties of the Company, the Parent, and the Selling Securityholders contained in Section 2 hereof shall remain operative and in full force and effect regardless of any investigation made by or on behalf of any indemnified party and shall survive the delivery of and payment for the Stock. (b) Each Underwriter severally agrees to indemnify and hold harmless the Company, each of its officers who signs the Registration Statement on his own behalf or pursuant to a power of attorney, each of its directors, each other Underwriter and each person (including each partner or officer thereof) who controls the Company or any such other Underwriter within the meaning of Section 15 of the Securities Act, and the Selling Securityholders from and against any and all losses, claims, damages or liabilities, joint or several, to which such indemnified parties or any of them may become subject under the Securities Act, the Exchange Act, or the common law or otherwise and to reimburse each of them for any legal or other expenses (including, except as otherwise hereinafter provided, reasonable fees and disbursements of counsel) incurred by the respective indemnified parties in connection with any investigation or inquiry of, or other proceeding which may be brought against, the respective indemnified parties, in each case arising out of or based upon (i) any untrue statement or alleged untrue statement of a material fact contained in the Registration Statement (including the Prospectus as part thereof and any Rule 462(b) registration statement) or any post-effective amendment thereto (including any Rule 462(b) registration statement) or the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading or (ii) any untrue statement or alleged untrue statement of a material fact contained in the Prospectus (as amended or as supplemented if the Company shall have filed with the Commission any amendment thereof or supplement thereto) or the omission or alleged omission to state therein a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading, if such statement or omission was made in reliance upon and in conformity with information furnished as herein stated or otherwise furnished in writing to the Company by such 17 indemnifying Underwriter for use in the Registration Statement or the Prospectus or any such amendment thereof or supplement thereto. The indemnity agreement of each Underwriter contained in this paragraph (b) shall remain operative and in full force and effect regardless of any investigation made by or on behalf of any indemnified party and shall survive the delivery of and payment for the Stock. (c) Each party indemnified under the provision of paragraphs (a) and (b) of this Section 7 agrees that, upon the service of a summons or other initial legal process upon it in any action or suit instituted against it or upon its receipt of written notification of the commencement of any investigation or inquiry of, or proceeding against, it in respect of which indemnity may be sought on account of any indemnity agreement contained in such paragraphs, it will promptly give written notice (herein called the Notice) of such service or notification to the party or parties from whom indemnification may be sought hereunder. No indemnification provided for in such paragraphs shall be available to any party who shall fail so to give the Notice if the party to whom such Notice was not given was unaware of the action, suit, investigation, inquiry or proceeding to which the Notice would have related and was prejudiced by the failure to give the Notice, but the omission so to notify such indemnifying party or parties of any such service or notification shall not relieve such indemnifying party or parties from any liability which it or they may have to the indemnified party for contribution or otherwise on account of such indemnity agreement. Any indemnifying party shall be entitled at its own expense to participate in the defense of any action, suit or proceeding against, or investigation or inquiry of, an indemnified party. Any indemnifying party shall be entitled, if it so elects within a reasonable time after receipt of the Notice by giving written notice (herein called the Notice of Defense) to the indemnified party, to assume (alone or in conjunction with any other indemnifying party or parties) the entire defense of such action, suit, investigation, inquiry or proceeding, in which event such defense shall be conducted, at the expense of the indemnifying party or parties, by counsel chosen by such indemnifying party or parties and reasonably satisfactory to the indemnified party or parties; provided, however, that (i) if the indemnified party or parties reasonably determine that there may be a conflict between the positions of the indemnifying party or parties and of the indemnified party or parties in conducting the defense of such action, suit, investigation, inquiry or proceeding or that there may be legal defenses available to such indemnified party or parties different from or in addition to those available to the indemnifying party or parties, then counsel for the indemnified party or parties shall be entitled to conduct the defense to the extent reasonably determined by such counsel to be necessary to protect the interests of the indemnified party or parties and (ii) in any event, the indemnified party or parties shall be entitled to have counsel chosen by such indemnified party or parties to participate in, but not conduct, the defense. If, within a reasonable time after receipt of the Notice, an indemnifying party gives a Notice of Defense and the counsel chosen by the indemnifying party or parties is reasonably satisfactory to the indemnified party or parties, the indemnifying party or parties will not be liable under paragraphs (a) through (c) of this Section 7 for any legal or other expenses subsequently incurred by the indemnified party or parties in connection with the defense of the action, suit, investigation, inquiry or proceeding, except that (A) the indemnifying party or parties shall bear the legal and other expenses incurred in connection with the conduct of the defense as referred to in clause (i) of the proviso to the preceding sentence and (B) the indemnifying party or parties shall bear such other expenses as it or they have authorized to be incurred by the indemnified party or parties. If, within a reasonable time after receipt of the Notice, no Notice of Defense has been given, the indemnifying party or parties shall be 18 responsible for any legal or other expenses incurred by the indemnified party or parties in connection with the defense of the action, suit, investigation, inquiry or proceeding. (d) If the indemnification provided for in this Section 7 is unavailable or insufficient to hold harmless an indemnified party under paragraph (a) or (b) of this Section 7, then each indemnifying party, in lieu of indemnifying such indemnified party, shall contribute to the amount paid or payable by such indemnified party as a result of the losses, claims, damages or liabilities referred to in paragraph (a) or (b) of this Section 7 (i) in such proportion as is appropriate to reflect the relative benefits received by each indemnifying party from the offering of the Stock or (ii) if the allocation provided by clause (i) above is not permitted by applicable law, in such proportion as is appropriate to reflect not only the relative benefits referred to in clause (i) above but also the relative fault of each indemnifying party in connection with the statements or omissions that resulted in such losses, claims, damages or liabilities, or actions in respect thereof, as well as any other relevant equitable considerations. The relative benefits received by the Company, the Parent and the Selling Securityholders on the one hand and the Underwriters on the other shall be deemed to be in the same respective proportions as the total net proceeds from the offering of the Stock received by the Company, the Parent, and the Selling Securityholders and the total underwriting discount received by the Underwriters, as set forth in the table on the cover page of the Prospectus, bear to the aggregate public offering price of the Stock. Relative fault shall be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or the omission or alleged omission to state a material fact relates to information supplied by each indemnifying party and the parties' relative intent, knowledge, access to information and opportunity to correct or prevent such untrue statement or omission. The parties agree that it would not be just and equitable if contributions pursuant to this paragraph (d) were to be determined by pro rata allocation (even if the Underwriters were treated as one entity for such purpose) or by any other method of allocation which does not take into account the equitable considerations referred to in the first sentence of this paragraph (d). The amount paid by an indemnified party as a result of the losses, claims, damages or liabilities, or actions in respect thereof, referred to in the first sentence of this paragraph (d) shall be deemed to include any legal or other expenses reasonably incurred by such indemnified party in connection with investigation, preparing to defend or defending against any action or claim which is the subject of this paragraph (d). Notwithstanding the provisions of this paragraph (d), no Underwriter shall be required to contribute any amount in excess of the underwriting discount applicable to the Stock purchased by such Underwriter. No person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the Securities Act) shall be entitled to contribution from any person who was not guilty of such fraudulent misrepresentation. The Underwriters' obligations in this paragraph (d) to contribute are several in proportion to their respective underwriting obligations and not joint. Each party entitled to contribution agrees that upon the service of a summons or other initial legal process upon it in any action instituted against it in respect of which contribution may be sought, it will promptly give written notice of such service to the party or parties from whom contribution may be sought, but the omission so to notify such party or parties of any such service shall not relieve the party from whom contribution may be sought from any obligation it 19 may have hereunder or otherwise (except as specifically provided in paragraph (c) of this Section 7). (e) Neither the Company, the Parent nor the Selling Securityholders will, without the prior written consent of each Underwriter, settle or compromise or consent to the entry of any judgment in any pending or threatened claim, action, suit or proceeding in respect of which indemnification may be sought hereunder (whether or not such Underwriter or any person who controls such Underwriter within the meaning of Section 15 of the Securities Act or Section 20 of the Exchange Act is a party to such claim, action, suit or proceeding) unless such settlement, compromise or consent includes an unconditional release of such Underwriter and each such controlling person from all liability arising out of such claim, action, suit or proceeding. (f) The liability of each Selling Securityholder (other than Parent) under such Selling Securityholder's representations and warranties contained in paragraphs (a) and (b) of Section 2 hereof and under the indemnity and reimbursement agreements contained in the provisions of this Section 7 and Section 11 hereof shall be limited to an amount equal to the public offering price of the stock sold by such Selling Securityholder to the Underwriters. The Company and the Selling Securityholders may agree, as among themselves and without limiting the rights of the Underwriters under this Agreement, as to the respective amounts of such liability for which they each shall be responsible. 8. Termination. This Agreement may be terminated by you at any time prior to the Closing Date by giving written notice to the Company and the Selling Securityholders if after the date of this Agreement trading in the Common Stock shall have been suspended, or if there shall have occurred (i) the engagement in hostilities or an escalation of major hostilities by the United States or the declaration of war or a national emergency by the United States on or after the date hereof, (ii) any outbreak of hostilities or other national or international calamity or crisis or change in economic or political conditions if the effect of such outbreak, calamity, crisis or change in economic or political conditions in the financial markets of the United States would, in the Underwriters' reasonable judgment, make the offering or delivery of the Stock impracticable, (iii) suspension of trading in securities generally or a material adverse decline in value of securities generally on the New York Stock Exchange, the American Stock Exchange, The Nasdaq Stock Market, or limitations on prices (other than limitations on hours or numbers of days of trading) for securities on either such exchange or system, (iv) the enactment, publication, decree or other promulgation of any federal or state statute, regulation, rule or order of, or commencement of any proceeding or investigation by, any court, legislative body, agency or other governmental authority which in the Underwriters' reasonable opinion materially and adversely affects or will materially or adversely affect the business or operations of the Company, (v) declaration of a banking moratorium by either federal or New York State authorities or (vi) the taking of any action by any federal, state or local government or agency in respect of its monetary or fiscal affairs which in the Underwriters' reasonable opinion has a material adverse effect on the securities markets in the United States. If this Agreement shall be terminated pursuant to this Section 8, there shall be no liability of the Company or the Selling Securityholders to the Underwriters and no liability of the Underwriters to the Company and the Selling Securityholders; provided, however, that in the event of any such termination the Company agrees to indemnify and hold harmless the Underwriters from all costs or expenses incident to the performance of the obligations of the Company and the Selling Securityholders 20 under this Agreement, including all costs and expenses referred to in paragraphs (i) and (j) of Section 6 hereof. 9. Conditions of Underwriters' Obligations. The obligations of the several Underwriters to purchase and pay for the Stock shall be subject to the performance by the Company and the Selling Securityholders of all their respective obligations to be performed hereunder at or prior to the Closing Date or any later date on which Option Stock is to be purchased, as the case may be, and to the following further conditions: (a) The Registration Statement shall have become effective; and no stop order suspending the effectiveness thereof shall have been issued and no proceedings therefor shall be pending or threatened by the Commission. (b) The legality and sufficiency of the sale of the Stock hereunder and the validity and form of the certificates representing the Stock, all corporate proceedings and other legal matters incident to the foregoing, and the form of the Registration Statement and of the Prospectus (except as to the financial statements contained therein), shall have been approved at or prior to the Closing Date by Brobeck, Phleger & Harrison LLP, counsel for the Underwriters. (c) You shall have received from Morrison & Foerster LLP, counsel for the Company and the Selling Securityholders, an opinion, addressed to the Underwriters and dated the Closing Date, covering the matters set forth in Annex A hereto, from Gottlieb, Rackman & Reisman, P.C., intellectual property counsel for the Company, an opinion addressed to the Underwriters, dated the closing date and covering the matters set forth in Annex B hereto, from Oblon, Spivak, McClelland, Maier & Neustadt, P.C., patent counsel for the Company, an opinion addressed to the Underwriters, dated the closing date and covering the matters set forth in Annex C hereto and from the general counsel of the Company, an opinion, addressed to the Underwriters and dated the Closing Date, covering the matters set forth in Annex D hereto, and if Option Stock is purchased at any date after the Closing Date, additional opinions from such counsel, addressed to the Underwriters and dated the Option Closing Date, confirming that the statements expressed as of the Closing Date in such opinions remain valid as of such later date. (d) You shall be satisfied that (i) as of the Effective Date, the statements made in the Registration Statement and the Prospectus were true and correct and neither the Registration Statement nor the Prospectus omitted to state any material fact required to be stated therein or necessary in order to make the statements therein, respectively, not misleading, (ii) since the Effective Date, no event has occurred which should have been set forth in a supplement or amendment to the Prospectus which has not been set forth in such a supplement or amendment, (iii) since the respective dates as of which information is given in the Registration Statement in the form in which it originally became effective and the Prospectus contained therein, there has not been any Material Adverse Effect or any development involving a prospective Material Adverse Effect, whether or not arising from transactions in the ordinary course of business, and, since such dates, except in the ordinary course of business, the Company has not entered into any material transaction not referred to in the Registration Statement in the form in which it originally became effective and the Prospectus contained therein, (iv) the Company does not have any material contingent obligations which are not disclosed in the Registration Statement and the Prospectus, (v) there are not any pending or known threatened legal proceedings to 21 which the Company is a party or of which property of the Company is the subject which are material and which are not disclosed in the Registration Statement and the Prospectus, (vi) there are not any franchises, contracts, leases or other documents which are required to be filed as exhibits to the Registration Statement which have not been filed as required, (vii) the representations and warranties of the Company and the Parent herein are true and correct in all material respects as of the Closing Date or any later date on which Option Stock is to be purchased, as the case may be, and (viii) there has not been any material change in the market for securities in general or in political, financial or economic conditions from those reasonably foreseeable as to render it impracticable in your reasonable judgment to make a public offering of the Stock, or a Material Adverse Effect in market levels for securities in general (or those of companies in particular) or financial or economic conditions which render it inadvisable to proceed. (e) You shall have received on the Closing Date and the Option Closing Date, dated the Closing Date or the Option Closing Date, as the case may be, and signed by the President and the Chief Financial Officer of the Company, a certificate stating that the respective signers of said certificate have carefully examined the Registration Statement in the form in which it originally became effective and the Prospectus contained therein and any supplements or amendments thereto, and that the statements included in clauses (i) through (vii) of paragraph (d) of this Section 9 are true and correct. (f) You shall have received from Ernst & Young LLP, a letter or letters, addressed to the Underwriters and dated the Closing Date and the Option Closing Date, as the case may be, confirming that they are independent public accountants with respect to the Company within the meaning of the Securities Act and the Rules and Regulations and based upon the procedures described in their letter delivered to you concurrently with the execution of this Agreement (herein called the Original Letter), but carried out to a date not more than three business days prior to the Closing Date or such later date on which Option Stock is purchased (i) confirming, to the extent true, that the statements and conclusions set forth in the Original Letter are accurate as of the Closing Date or the Option Closing Date, as the case may be, and (ii) setting forth any revisions and additions to the statements and conclusions set forth in the Original Letter which are necessary to reflect any changes in the facts described in the Original Letter since the date of the Original Letter or to reflect the availability of more recent financial statements, data or information. The letters shall not disclose any change, or any development involving a prospective change, in or affecting the business or properties of the Company which, in your sole judgment, makes it impractical or inadvisable to proceed with the public offering of the Stock or the purchase of the Option Stock as contemplated by the Prospectus. The Original Letter from Ernst & Young LLP shall be addressed to or for the use of the Underwriters in form and substance satisfactory to the Underwriters and shall (i) represent, to the extent true, that they are independent certified public accountants with respect to the Company within the meaning of the Securities Act and the applicable published Rules and Regulations, (ii) set forth their opinion with respect to their examination of the consolidated balance sheet of the Company as of July 31, 1999 and related consolidated statements of operations, stockholders' equity, and cash flows for the twelve (12) months ended July 31, 1999, (iii) state that Ernst & Young LLP has performed the procedures set out in Statement on Auditing Standards No. 71 (herein called SAS 71) for a review of interim financial information and providing the report of Ernst & Young LLP as described in SAS 71 on the financial statements for each of the quarters in the two-year period 22 ended July 31, 1999 (herein called the Quarterly Financial Statements), (iv) state that in the course of such review, nothing came to their attention that leads them to believe that any material modifications need to be made to any of the Quarterly Financial Statements in order for them to be in compliance with generally accepted accounting principles consistently applied across the periods presented, (v) state that the underlying information, determinations, estimates and assumptions contained in the section of the Prospectus entitled Management Discussion and Analysis and Results of Operations provide a reasonable basis for the statements contained therein, and (vi) address other matters agreed upon by Ernst & Young LLP and you. In addition, you shall have received from Ernst & Young LLP a letter addressed to the Company and made available to you for the use of the Underwriters stating that their review of the Company's system of internal accounting controls, to the extent they deemed necessary in establishing the scope of their examination of the Company's consolidated financial statements as of July 31, 1999, did not disclose any weaknesses in internal controls that they considered to be material weaknesses. (g) You shall have been furnished evidence in usual written or telegraphic form from the appropriate authorities of the several jurisdictions, or other evidence satisfactory to you, of the qualification referred to in paragraph (f) of Section 6 hereof. (h) Prior to the Closing Date, the Stock to be issued and sold by the Company shall have been duly authorized for listing by the Nasdaq National Market upon official notice of issuance. All the agreements, opinions, certificates and letters mentioned above or elsewhere in this Agreement shall be deemed to be in compliance with the provisions hereof only if Brobeck, Phleger & Harrison LLP, counsel for the Underwriters, shall be satisfied that they comply in form and scope. In case any of the conditions specified in this Section 9 shall not be fulfilled, this Agreement may be terminated by you by giving notice to the Company and the Selling Securityholders. Any such termination shall be without liability of the Company or the Selling Securityholders to the Underwriters and without liability of the Underwriters to the Company or the Selling Securityholders; provided, however, that (i) subject to Section 7(f) hereof, in the event of such termination, the Company and the Selling Securityholders agree to indemnify and hold harmless the Underwriters from all costs or expenses incident to the performance of the obligations of the Company and the Selling Shareholders under this Agreement, including all costs and expenses referred to in paragraphs (i) and (j) of Section 6 hereof, and (ii) if this Agreement is terminated by you because of any refusal, inability or failure on the part of the Company or the Selling Securityholders to perform any agreement herein, to fulfill any of the conditions herein, or to comply with any provision hereof other than by reason of a default by any of the Underwriters, the Company will reimburse the Underwriters severally upon demand for all out-of-pocket expenses (including reasonable fees and disbursements of counsel) that shall have been incurred by them in connection with the transactions contemplated hereby. 10. Conditions of the Obligation of the Company and the Selling Securityholders. The obligation of the Company and the Selling Securityholders to deliver the Stock shall be subject to the conditions that (a) the Registration Statement shall have become effective and 23 (b) no stop order suspending the effectiveness thereof shall be in effect and no proceedings therefor shall be pending or threatened by the Commission. In case either of the conditions specified in this Section 10 shall not be fulfilled, this Agreement may be terminated by the Company and the Selling Shareholders by giving notice to you. Any such termination shall be without liability of the Company and the Selling Securityholders to the Underwriters and without liability of the Underwriters to the Company or the Selling Securityholders; provided, however, that subject to Section 7(f) hereof, in the event of any such termination the Company and the Selling Securityholders jointly and severally agree to indemnify and hold harmless the Underwriters from all costs or expenses incident to the performance of the obligations of the Company and the Selling Securityholders under this Agreement, including all costs and expenses referred to in paragraphs (i) and (j) of Section 6 hereof. 11. Reimbursement of Certain Expenses. In addition to its other obligations under Section 7 of this Agreement (and subject, in the case of a Selling Securityholder (other than Parent), to the provisions of paragraph (f) of Section 7), the Company, the Parent and the Selling Securityholders hereby jointly and severally agree to reimburse on a quarterly basis the Underwriters for all reasonable legal and other expenses incurred in connection with investigating or defending any claim, action, investigation, inquiry or other proceeding arising out of or based upon any statement or omission, or any alleged statement or omission, described in paragraph (a) of Section 7 of this Agreement, notwithstanding the absence of a judicial determination as to the propriety and enforceability of the obligations under this Section 11 and the possibility that such payments might later be held to be improper; provided, however, that (i) to the extent any such payment is ultimately held to be improper, the persons receiving such payments shall promptly refund them and (ii) such persons shall provide to the Company, upon request, reasonable assurances of their ability to effect any refund, when and if due. 12. Persons Entitled to Benefit of Agreement. This Agreement shall inure to the benefit of the Company, the Selling Securityholders and the several Underwriters and, with respect to the provisions of Section 7 hereof, the several parties (in addition to the Company, the Selling Securityholders and the several Underwriters) indemnified under the provisions of said Section 7, and their respective personal representatives, successors and assigns. Nothing in this Agreement is intended or shall be construed to give to any other person, firm or corporation any legal or equitable remedy or claim under or in respect of this Agreement or any provision herein contained. The term "successors and assigns" as herein used shall not include any purchaser, as such purchaser, of any of the Stock from any of the several Underwriters . 13. Notices. Except as otherwise provided herein, all communications hereunder shall be in writing or by facsimile and, if to the Underwriters, shall be mailed, sent via facsimile or delivered to Hambrecht & Quist LLC, One Bush Street, San Francisco, California 94104, with a copy to Brobeck, Phleger & Harrison LLP, 1633 Broadway, 47th Floor, New York, New York 10019, Attention: Alexander D. Lynch, Esq.; and if to the Company, shall be mailed, sent by facsimile or delivered to it at its office, 171 Main Street, Hackensack, New Jersey 07601, Attention: Howard S. Balter, with a copy to Morrison & Foerster LLP, 1290 Avenue of the Americas, New York, New York 10104, Attention: Allen L. Weingarten, Esq.; and if to the Parent or the Selling Securityholders, shall be mailed, sent via facsimile or delivered to the 24 Selling Securityholders in care of Morrison & Foerster LLP, 1290 Avenue of the Americas, New York, New York 10104, Attention: Allen L. Weingarten, Esq. All notices given by facsimile shall be promptly confirmed by letter. 14. Miscellaneous. The reimbursement, indemnification and contribution agreements contained in this Agreement and the representations, warranties and covenants in this Agreement shall remain in full force and effect regardless of (a) any termination of this Agreement, (b) any investigation made by or on behalf of any Underwriter or controlling person thereof, or by or on behalf of the Company or the Selling Securityholders or their respective directors or officers, and (c) delivery and payment for the Stock under this Agreement; provided, however, that if this Agreement is terminated prior to the Closing Date, the provisions of paragraphs (k) and (l) of Section 6 hereof shall be of no further force or effect. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. This Agreement shall be governed by, and construed in accordance with, the internal laws of the State of New York. 25 Please sign and return to the Company and to the Selling Securityholders in care of the Company the enclosed duplicates of this letter, whereupon this letter will become a binding agreement between the Company, the Parent and the Selling Securityholders and the several Underwriters in accordance with its terms. Very truly yours, IDT CORPORATION NET2PHONE, INC. By: ____________________________ By: __________________________________ Name: Name: Title: Title: SELLING SECURITYHOLDERS: By ___________________________________ Name: Title: The foregoing Agreement is hereby confirmed and accepted as of the date first above written. HAMBRECHT & QUIST LLC DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION DEUTSCHE BANK SECURITIES INC. BANCBOSTON ROBERTSON STEPHENS INC. BEAR, STEARNS & CO. INC. By: Hambrecht & Quist LLC By _____________________________ Managing Director Acting on behalf of the several Underwriters, including themselves, named in Schedule I hereto. 26 SCHEDULE I UNDERWRITERS
Number of Shares to Underwriters be Purchased - ----------------------------------------------------------- ------------------- Hambrecht & Quist LLC...................................... Donaldson, Lufkin & Jenrette Securities Corporation........ Deutsche Bank Securities Inc............................... BancBoston Robertson Stephens Inc.......................... Bear, Stearns & Co. Inc.................................... ------------------- Total................................................. ===================
SCHEDULE II PRIMARY SELLING SECURITYHOLDERS
Name and Address of Primary Selling Securityholder Shares to be Sold - ----------------------------------------------------------- ------------------- IDT Corporation............................................ 2,200,000 Softbank Technology Ventures IV, L.P....................... 400,000 Jewish Community Foundation of Metrowest................... 300,000 ------------------- Total................................................. 2,900,000 ===================
SCHEDULE III SECONDARY SELLING SECURITYHOLDERS
Name and Address of Secondary Selling Securityholder Shares to be Sold - ----------------------------------------------------------- ------------------- ------------------- Total................................................. 945,000 ===================
SCHEDULE IV SELLING SECURITYHOLDERS FOR PURPOSES OF REPRESENTATIONS AND WARRANTIES AND INDEMNIFICATION Name of Selling Securityholder - ------------------------------ Clifford M. Sobel Howard S. Balter Jonathan Fram David Greenblatt Ilan M. Slasky H. Jeff Goldberg Jonathan Reich Martin Rothberg Jonathan Rand James A. Courter Gary E. Reischel James R. Mellor Jesse P. King Daniel H. Schulman Michael Fischberger Harry C. McPherson, Jr. [IDT Officers and Directors] ANNEX A Matters to be Covered in the Opinion of Morrison & Foerster LLP Counsel for the Company, the Parent and the Selling Securityholders (i) Each of the Company and the Parent has been duly incorporated and is validly existing as a corporation in good standing under the laws of the jurisdiction of its incorporation, is duly qualified as a foreign corporation and in good standing in each state of the United States of America in which its ownership or leasing of property requires such qualification (except where the failure to be so qualified would not have a material adverse effect on the business, properties, financial condition or results of operations of the Company), and has full corporate power and authority to own or lease its properties and conduct its business; all the issued and outstanding capital stock of the Company has been duly authorized and validly issued and is fully paid and nonassessable, and to the best of such counsel's knowledge, no options, warrants or other rights to purchase, agreements or other obligations to issue or other rights to convert any obligations into shares of capital stock or ownership interests are outstanding; (ii) the authorized capital stock of the Company consists of 10,000,000 shares of Preferred Stock, of which there are outstanding 9,420,000 shares, 37,042,089 shares of Class A Stock, of which there are outstanding 33,924,250 shares, and 200,000,000 shares of Common Stock, $.01 par value, of which there are outstanding 17,672,616 shares (including the Underwritten Stock plus the number of shares of Option Stock issued on the date hereof); proper corporate proceedings have been taken validly to authorize such authorized capital stock; all of the outstanding shares of such capital stock (including the Underwritten Stock and the shares of Option Stock issued, if any) have been duly and validly issued and are fully paid and nonassessable; any Option Stock purchased after the Closing Date, when issued and delivered to and paid for by the Underwriters as provided in the Underwriting Agreement, will have been duly and validly issued and be fully paid and nonassessable; and other than as set forth in the Registration Statement, no preemptive rights of, or rights of refusal in favor of, stockholders exist with respect to the Stock, or the issue and sale thereof, pursuant to the Certificate of Incorporation or Bylaws of the Company and, to the knowledge of such counsel, there are no contractual preemptive rights that have not been waived, rights of first refusal or rights of co-sale which exist with respect to the Stock being sold by the Selling Securityholders or the issue and sale of the Stock by the Company; (iii) the Registration Statement has become effective under the Securities Act and, to such counsel's knowledge, no stop order suspending the effectiveness of the Registration Statement or suspending or preventing the use of the Prospectus is in effect and no proceedings for that purpose have been instituted or are pending or contemplated by the Commission; (iv) the Registration Statement and the Prospectus (except as to the financial statements and schedules and other financial data contained therein, as to which such counsel need express no opinion) comply as to form in all material respects with the requirements of the Securities Act and with the Rules and Regulations thereunder; (v) the information required to be set forth in the Registration Statement in answer to Items 9, 10 (insofar as it relates to such counsel) and 11(c) of Form S-1 is to such counsel's knowledge accurately and adequately set forth therein in all material respects or no response is required with respect to such Items, and, the description of the Company's stock option plan and the options granted and which may be granted thereunder and the options granted otherwise than under such plans set forth in the Prospectus accurately and fairly presents the information required to be shown with respect to said plan and options to the extent required by the Securities Act and the Rules and Regulations thereunder; (vi) the Company has the corporate power and authority to enter into the Underwriting Agreement and to issue, sell and deliver to the Underwriters the Stock to be issued and sold thereunder; and the Underwriting Agreement has been duly authorized, executed and delivered by the Company; (vii) the Parent has the corporate power and authority to enter into the Underwriting Agreement and to sell and deliver to the Underwriters the Stock to be issued and sold thereunder; and the Underwriting Agreement has been duly authorized, executed and delivered by the Parent; (viii) the Underwriting Agreement has been duly executed and delivered by or on behalf of the Selling Securityholders and the Custody Agreement between the Selling Securityholders and American Stock Transfer & Trust Company, as Custodian, and the Power of Attorney referred to in such Custody Agreement have been duly executed and delivered by the several Selling Securityholders. (ix) the execution and delivery of the Underwriting Agreement and the issue and sale by the Company of the shares of Stock sold by the Company and the Parent as contemplated by the Underwriting Agreement will not conflict with, or result in a breach of or default under (A) the respective Certificates of Incorporation or Bylaws of the Company or Parent, or any agreement, lease, contract, indenture or other instrument or obligation filed as an exhibit to the Registration Statement, (B) any applicable Federal, Delaware or New York law or regulation known to such counsel, or (C) any order, writ, injunction or decree, of any jurisdiction, court or government instrumentality specifically naming the Company or the Parent; (x) the information in the Prospectus under the captions "Management- Employment Agreements," "Management - 1999 Stock Incentive Plan," "Certain Transactions," and " Description of Capital Stock," to the extent that such information constitutes matters of law or legal conclusions, has been reviewed by such counsel and is a fair summary in all material respects of such matters and conclusions; and the form of certificate evidencing the Common Stock and filed as an exhibit to the Registration Statement complies with Delaware law; (xi) good and marketable title to the shares of Stock sold by the Selling Securityholders under the Underwriting Agreement, free and clear of all liens, encumbrances, equities, security interests and claims, has been transferred to the Underwriters who have severally purchased such shares of Stock under the Underwriting Agreement, assuming for the purpose of this opinion that the Underwriters purchased the same in good faith without notice of any adverse claims; (xii) based solely upon certificates of the Selling Securityholders (other than the Parent) insofar as factual matters with respect to the stock to be sold by the Selling Securityholders are concerned, the accuracy of which such counsel have no reason to question; no consent, approval, authorization or order of any Federal, New York or Delaware court or governmental agency or body is required for the consummation of the transactions contemplated in the Underwriting Agreement, except such as have been obtained under the Securities Act and such as may be required under state securities or blue sky laws in connection with the purchase and distribution of the Stock by the Underwriters; (xiii) to such counsel's best knowledge, except as set forth in the Registration Statement and Prospectus, no holders of Common Stock or other securities of the Company have registration rights with respect to securities of the Company and, except as set forth in the Registration Statement and Prospectus, all holders of securities of the Company having rights to registration of such shares of Common Stock or other securities, because of the filing of the Registration Statement by the Company have, with respect to the offering contemplated thereby, waived such rights or such rights have expired by reason of lapse of time following notification of the Company's intent to file the Registration Statement or have included securities in the Registration Statement pursuant to the exercise of and in full satisfaction of such rights; (xiv) the Stock sold by the Selling Securityholders and the Stock issued and sold by the Company has been duly authorized for listing by the Nasdaq National market upon official notice of issuance; (xv) the issuance and sales by the Company of the securities described in Item 15 of the Registration Statement were exempt from the registration requirements of the Act, and, to such counsel's best knowledge, no event (including, without limitation, the offering and sale of the Stock) has occurred or is contemplated by the Company which has rendered or will render such exemptions unavailable; and (xvi) The sale of Stock to be sold by the Selling Securityholders will not result in any "short-swing" profit under Section 16(b) of the Exchange Act. In addition, such counsel shall state that such counsel has participated in conferences with officials and other representatives of the Company, the Representatives, Underwriters' counsel and the independent certified public accountants of the Company, at which such conferences the contents of the Registration Statement and Prospectus and related matters were discussed, and although they have not verified the accuracy or completeness of the statements contained in the Registration Statement or the Prospectus, nothing has come to the attention of such counsel which caused them to believe that the Registration Statement (other than the financial statements including supporting schedules and financial derived therefrom, as to which such counsel need express no opinion), at the Effective Date and at all times subsequent thereto up to and on the Closing Date and on any later date on which Option Stock is to be purchased, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, or that the prospectus (except as aforesaid) at the Closing Date or any later date on which the Option Stock is to be purchased, as the case may be, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading. ANNEX B Matters to be Covered in the Opinion of Gottlieb, Rackman & Reisman, P.C. Intellectual Property Counsel for the Company Such counsel are familiar with the technology used by the Company in its business and the manner of its use thereof and have read the Registration Statement and the Prospectus, including particularly the portions of the Registration Statement and the Prospectus referring to patents, trade secrets, trademarks, service marks or other proprietary information or materials and: (i) such counsel have no reason to believe that the Registration Statement or the Prospectus (A) contains any untrue statement of a material fact with respect to trade secrets, trademarks, service marks or other proprietary information or materials owned or used by the Company, or the manner of its use thereof, or any allegation on the part of any person that the Company is infringing any patent rights, trade secrets, trademarks, service marks or other proprietary information or materials of any such person or (B) omits to state any material fact relating to patents, trade secrets, trademarks, service marks or other proprietary information or materials owned or used by the Company, or the manner of its use thereof, or any allegation of which such counsel have knowledge, that is required to be stated in the Registration Statement or the Prospectus or is necessary to make the statements therein not misleading; (ii) to the best of such counsel's knowledge there are no legal or governmental proceedings pending relating to patent rights, trade secrets, trademarks, service marks or other proprietary information or materials of the Company, and to the best of such counsel's knowledge no such proceedings are threatened or contemplated by governmental authorities or others; (iii) such counsel do not know of any contracts or other documents, relating to governmental regulation affecting the Company or the Company's patents, trade secrets, trademarks, service marks or other proprietary information or materials, of a character required to be filed as an exhibit to the Registration Statement or required to be described in the Registration Statement or the Prospectus that are not filed or described as required; (iv) except as set forth in the Prospectus, to the best of such counsel's knowledge, the Company is not infringing or otherwise violating any patents, trade secrets, trademarks, service marks or other proprietary information or materials, of others, and to the best of such counsel's knowledge there are no infringements by others of any of the Company's patents, trade secrets, trademarks, service marks or other proprietary information or materials which in the judgment of such counsel could affect materially the use thereof by the Company; and (v) to the best of such counsel's knowledge, the Company owns or possesses sufficient licenses or other rights to use all patents, trade secrets, trademarks, service marks or other proprietary information or materials necessary to conduct the business now being or proposed to be conducted by the Company as described in the Prospectus. ANNEX C Matters to be Covered in the Opinion of Oblon, Spivak, McClelland, Maier & Neustadt, P.C. Patent Counsel for the Company Such counsel are familiar with the technology used by the Company in its business and the manner of its use thereof and have read the Registration Statement and the Prospectus, including particularly the portions of the Registration Statement and the Prospectus referring to patents, trade secrets, trademarks, service marks or other proprietary information or materials and: (i) such counsel have no reason to believe that the Registration Statement or the Prospectus (A) contains any untrue statement of a material fact with respect to patents or other proprietary information or materials owned or used by the Company, or the manner of its use thereof, or any allegation on the part of any person that the Company is infringing any patent rights or other proprietary information or materials of any such person or (B) omits to state any material fact relating to patents or other proprietary information or materials owned or used by the Company, or the manner of its use thereof, or any allegation of which such counsel have knowledge, that is required to be stated in the Registration Statement or the Prospectus or is necessary to make the statements therein not misleading; (ii) to the best of such counsel's knowledge, except as set forth in the Registration Statement, there are no legal or governmental proceedings pending relating to patent rights or other proprietary information or materials of the Company, and to the best of such counsel's knowledge no such proceedings are threatened or contemplated by governmental authorities or others; (iii) such counsel do not know of any contracts or other documents, relating to governmental regulation affecting the Company or the Company's patents or other proprietary information or materials, of a character required to be filed as an exhibit to the Registration Statement or required to be described in the Registration Statement or the Prospectus that are not filed or described as required; (iv) except as set forth in the Prospectus, to the best of such counsel's knowledge, the Company is not infringing or otherwise violating any patents or other proprietary information or materials, of others, and to the best of such counsel's knowledge there are no infringements by others of any of the Company's patents or other proprietary information or materials which in the judgment of such counsel could affect materially the use thereof by the Company; and (v) to the best of such counsel's knowledge, the Company owns or possesses sufficient licenses or other rights to use all patents or other proprietary information or materials necessary to conduct the business now being or proposed to be conducted by the Company as described in the Prospectus. ANNEX D Matters to be Covered in the Opinion of General Counsel of the Company Such counsel shall state that such counsel has participated in conferences with officials and other representatives of the Company, the Representatives, Underwriters' counsel and the independent certified public accountants of the Company, at which such conferences the contents of the Registration Statement and Prospectus and related matters were discussed, and although they have not verified the accuracy or completeness of the statements contained in the Registration Statement or the Prospectus, nothing has come to the attention of such counsel which caused them to believe that the Registration Statement (other than the financial statements including supporting schedules and financial derived therefrom, as to which such counsel need express no opinion), at the Effective Date and at all times subsequent thereto up to and on the Closing Date and on any later date on which Option Stock is to be purchased, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, or that the prospectus (except as aforesaid) at the Closing Date or any later date on which the Option Stock is to be purchased, as the case may be, contained any untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading. EX-5.1 3 FORM OF OPINION OF MORRISON & FOERSTER LLP. EXHIBIT 5.1 [LETTERHEAD OF MORRISON & FOERSTER LLP] November __, 1999 Net2Phone, Inc. 171 Main Street Hackensack, New Jersey 07601 Ladies and Gentlemen: At your request, we have examined the Registration Statement on Form S-1 filed by Net2Phone Inc., a Delaware corporation (the "Company"), with the Securities and Exchange Commission on November 4, 1999 (Registration No. 333-90317), and the amendments thereto (the "Registration Statement"), relating to the registration under the Securities Act of 1933, as amended, of up to 7,245,000 shares of the Company's common stock, par value $0.01 per share (the "Stock"), including authorized but unissued shares being offered by the Company, presently issued and outstanding shares being offered by certain selling shareholders (the "Selling Shareholders"), and the underwriters' over-allotment option. The Stock is to be sold to the underwriters named in the Registration Statement for resale to the public. As counsel to the Company, we have examined the proceedings taken by the Company in connection with the issuance and sale by the Company of shares of the Stock. We have also examined the proceedings taken by the Company in connection with the sale of shares of Stock by the Selling Shareholders. We are of the opinion that (a) the shares of Stock to be offered and sold by the Company have been duly authorized and, when issued and sold by the Company in the manner described in the Registration Statement and in accordance with the resolutions adopted by the Board of Directors of the Company, will be legally issued, fully paid and nonassessable, and (b) the shares of Stock to be sold by the Selling Shareholders are legally and validly issued, fully paid and nonassessable. We consent to the use of this opinion as an exhibit to the Registration Statement and further consent to all references to us in the Registration Statement, the prospectus constituting a part thereof and any amendments thereto. Very truly yours, /s/ Morrison & Foerster LLP EX-10.31 4 AMENDMENT TO THE STOCK SUBSCRIPTION EXHIBIT 10.31 AMENDMENT TO THE STOCK SUBSCRIPTION WARRANT This Amendment dated November 19, 1999 between Net2Phone Inc. (the "Corporation") and America Online, Inc. ("AOL"), is intended to and does amend certain sections of the Stock Subscription Warrant between the Corporation and AOL, dated July 15, 1999 (the "Warrant"). WHEREAS, the parties desire to amend certain sections of the Warrant; NOW, THEREFORE, in consideration of the promises and the respective covenants and agreements of the parties herein contained, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Section 1(a) of the Warrant is hereby amended to read as follows: THIS CERTIFIES that, for value received, AMERICA ONLINE, INC. ("AOL") or its assigns, is entitled to subscribe for and purchase from NET2PHONE, INC., a Delaware corporation (the "Corporation"), at any time or from time to time during the period (the "Exercise Period") commencing with the date hereof and ending on November 19, 2004, on the terms and subject to the provisions hereinafter set forth, up to a maximum of that number of shares (subject to adjustment as provided herein) (the "Warrant Shares") of fully paid and non-assessable shares of Common Stock, $.01 par value, of the Corporation (the "Common Stock") as shall be determined in accordance with the provisions of Section 1(b) and Section 1(c) hereof and Exhibit A --------- hereto that shall constitute three and one half percent (3.5%) of the number of shares of voting capital stock of the Corporation outstanding on the date of exercise or exchange of this Warrant after giving effect to the exercise, exchange or conversion of all outstanding securities, rights, options, warrants (including this Warrant), calls, commitments or agreements of any nature or character (whether debt or equity) that are, directly or indirectly, exercisable or exchangeable for, or convertible into or otherwise represent the right to purchase or otherwise receive, directly or indirectly, any such capital stock or other arrangement to acquire at any time or under any circumstance, voting capital stock of the Corporation or any such other securities and assuming that all stock options and/or shares of capital stock reserved for grant or issuance to officers, directors, employees and consultants under all agreements, plans or arrangements theretofore approved by the Board of Directors of the Corporation have been so granted or issued (as the case may be) (collectively, the "Fully-Diluted Shares"). The price per share (the "Warrant Price") for the Warrant Shares shall be (i) with respect to the Warrant Shares described on Exhibit A in --------- provisions (A), (B) and (C), a price per share determined on the Designated Date (as hereinafter defined) (subject to adjustment as set forth in Section 4 hereof) of the lesser of (A) $12 per share or (B) $450,000,000 divided by the number of Fully Diluted Shares on the Designated Date, and (ii) with respect to the Warrant Shares described on Exhibit A in provision (D), 95.5% of the --------- closing price per share of the Corporation's common stock on The Nasdaq National Market (as reported in the Wall Street Journal) ------------------- on November 19, 1999 (subject to adjustment as set forth in Section 4 hereof). As used herein, the term "Designated Date" shall mean the date on which the holder of this Warrant shall first deliver notice of its intention to exercise or exchange this Warrant, in whole or in part, pursuant to the terms hereof (including Exhibit A). Upon receipt --------- of any notice of exercise the Corporation shall certify to the holder of this Warrant in writing (i) the number of Warrant Shares being issued to the holder of this Warrant pursuant to its exercise thereof, (ii) the Warrant Price and (iii) the basis for such calculations; provided, that the failure of the Corporation to deliver such -------- certification shall not effect the validity or terms of this Warrant or derogate from the rights of the holder hereunder. This Warrant is being issued pursuant to an IP Telephony Services Distribution and Interactive Marketing Agreement dated as of July 15, 1999 (the "ICQ Agreement"), between the Corporation and ICQ, Inc., a Delaware corporation, and an IP Telephony Services Distribution and Interactive Marketing Agreement dated as of November 19, 1999 (the "AIM Agreement," and collectively, the "Agreements"), between the Corporation and AOL. All terms used but not defined herein shall have the meanings set forth in the Agreements. 2. Section 1(b) of the Warrant is hereby amended to read as follows: This Warrant shall become exercisable as to that number of Warrant Shares, and at such times, as are determined in accordance with Exhibit A attached hereto; provided, however, that this Warrant shall --------- -------- ------- become exercisable as to all of the Warrant Shares immediately upon the occurrence of a Stipulated Event. As used herein, the term "Stipulated Event" shall mean (a) a Corporate Transaction (as hereinafter defined) or (b) a termination of either of the Agreements that results from a material breach by the Corporation of such Agreement (except for a termination pursuant to Section 16.6(i)(c) or Section 16.6(i)(d) of such Agreement). "Corporate Transaction" means (A) any consolidation or merger of the Corporation with or into any other corporation or other entity, other than any merger or consolidation resulting in the holders of the capital stock of the Corporation entitled to vote for the election of directors holding a majority of the capital stock of the surviving or resulting corporation or other entity entitled to vote for the election of directors, (B) subject to subsection (b)(D) below, any person or entity (including any affiliates thereof) becoming the holder of a majority of the capital stock of the Corporation entitled to vote for the election of directors, (C) any sale or other disposition by the Corporation of all or substantially all of its assets or capital stock or (D) IDT Corporation becoming the beneficial owner of 2 greater than seventy-five percent (75.0%) of the outstanding capital stock of the Corporation. 3. The first paragraph of Section 4(a) of the Warrant is hereby amended to read as follows: The Warrant Price with respect to the Warrant Shares for which this Warrant may be exercised shall be subject to adjustment as described below (i) at any time after the Designated Date with respect to the Warrant Shares described on Exhibit A in provisions (A), (B) and (C), and (ii) at any time with respect to the Warrant Shares described on Exhibit A in provision (D): 4. Section 9 of the Warrant is hereby amended to read as follows: Transfer of Warrant; Amendment. Subject to the restriction set forth ------------------------------ in Section 7, this Warrant and all rights hereunder are transferable, in whole, or in part, at the agency or office of the Corporation referred to in Section 2, by the holder hereof in person or by duly authorized attorney, upon surrender of this Warrant properly endorsed; provided that, the transferor and transferee shall promptly notify the Corporation of a transfer of the warrant. Notwithstanding the foregoing, this Warrant may not be transferred to any N2P Competitor or IDT Competitor, as those terms are defined in the Agreements. Each taker and holder of this Warrant, by taking or holding the same, consents and agrees that this Warrant, when endorsed, in blank, shall be deemed negotiable, and, when so endorsed the holder hereof may be treated by the Corporation and all other persons dealing with this Warrant as the absolute owner hereof for any purposes and as the person entitled to exercise the rights represented by this Warrant, or to the transfer hereof on the books of the Corporation, any notice to the contrary notwithstanding; but until each transfer on such books, the Corporation may treat the registered holder hereof as the owner hereof for all purposes. 5. Section 13 of the Warrant is hereby amended to read as follows: Notices. All notices, advices and communications to be given or ------- otherwise made to any party to this Warrant shall be deemed to be sufficient if contained in a written instrument delivered in person or by telecopier or duly sent by first class registered or certified mail, return receipt requested, postage prepaid, or by overnight courier, or by electronic mail, with a copy thereof to be sent by mail (as aforesaid) within 24 hours of such electronic mail, addressed to such party at the address set forth below or at such other address as may hereafter be designated in writing by the addressee to the addresser listing all parties: If to the Corporation, to: 3 Net2Phone, Inc. Address: 171 Main Street, Hackensack, NJ 07601 Attention: Clifford Sobel and Howard Balter Telecopier: (201) 907-5351 e-mail address: cliff@net2phone.com; hbalter@net2phone.com with a copy to: Allen L. Weingarten, Esq. Morrison & Foerster 1290 Avenue of the Americas New York, New York 10104 Telecopier: (212) 468-7900 e-mail address: aweingarten@mofo.com and If to AOL as follows: America Online, Inc. 22000 AOL Way Dulles, Virginia 20166 Attention: General Counsel and Senior Vice President, Business Affairs Telecopier: (703) 265-2208 and (703) 265-1202 e-mail address: PTCapp@aol.com, DKRJJ@aol.com Or to such other address as the party to whom notice is to be given may have furnished to the other parties hereto in writing in accordance herewith. Any such notice or communication shall be deemed to have been delivered and received (i) in the case of personal delivery or delivery by telecopier, on the date of such delivery, (ii) in the case of nationally-recognized overnight courier, on the next business day after the date when sent and (iii) in the case of mailing, on the third business day following that on which the piece of mail containing such communication is posted. As used in this Section 14, "business day" shall mean any day other than a day on which banking institutions in the Commonwealth of Virginia are legally closed for business. 6. The first sentence of Exhibit A to the Warrant is hereby amended to read as follows: The Warrant Shares shall vest, during the period commencing on July 15, 1999 and ending on November 19, 2003, as follows: 4 7. The chart in Exhibit A to the Warrant is hereby amended with the addition of the following: - -------------------------------------------------------------------------------- (D) 0.5% of Fully Diluted Shares Once aggregate Transaction Revenues, Net Advertising Revenue and N2P's share of Net Button Advertising Revenue exceed One Hundred Million Dollars (US$100,000,000) - -------------------------------------------------------------------------------- The terms Transaction Revenues, Net Advertising Revenue and N2P's share of Net Button Advertising Revenue in this Exhibit A shall include revenues derived from both of the Agreements and shall be aggregated for the purposes of determining whether each of the revenue thresholds have be met. 8. Section 2(e) of Exhibit B to the Warrant is hereby amended to read as follows: The obligations of the Corporation under this Section 2 shall not apply to (i) a public offering of Equity Securities of the Corporation registered pursuant to the Securities Act (an "IPO"), (ii) a Corporate Transaction (as defined in the Warrant), (iii) issuances of capital stock pursuant to Section 5 of the Series A Subscription Agreement, dated as of May 13, 1999, among the Corporation, AOL and certain other investors in the Corporation, or (iv) up to 11,040,000 shares of Common Stock issued pursuant to the Corporation's 1999 Stock Option and Incentive Plan. The obligations of the Corporation under this Section 2 shall expire upon the consummation of an underwritten public offering of Common Stock of the Corporation registered pursuant to the Securities Act of 1933, as amended, resulting in aggregate cash proceeds (prior to underwriters' commissions and expenses) of more than $15,000,000. 5 IN WITNESS WHEREOF, the undersigned have caused this Amendment to the Stock Subscription Warrant to be executed by their duly authorized officers on the date first above written. NET2PHONE, INC. By: ______________________________ Name: Title: ATTEST: ___________________________ Secretary AMERICA ONLINE, INC. By: ______________________________ Name: Title: 6 EX-23.1 5 CONSENT OF INDEPENDENT AUDITORS EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the reference to our firm under the captions "Selected Financial Data" and "Experts" and to the use of our report dated September 22, 1999, in Amendment No. 2 to the Registration Statement (Form S-1 No. 333-90317) and related Prospectus of Net2Phone, Inc. for the registration of 7,245,000 shares of its common stock. /s/ Ernst & Young LLP New York, New York November 19, 1999 EX-27 6 FINANCIAL DATA SCHEDULE
5 YEAR JUL-31-1999 AUG-01-1998 JUL-31-1999 20,379,048 0 531,536 0 0 107,331,836 20,808,396 (2,963,495) 50,816,891 21,769,134 0 0 27,929,000 48,198 (4,111,065) 50,816,891 0 33,256,457 17,818,010 57,718,335 0 0 430,753 (24,705,192) 0 (24,705,192) 0 0 0 (24,705,192) (1.73) (1.73)
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