-----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, MxjhC+XtozW6RtkyAR4SD9JP7w0hv46y2J3WKlk0kArAfkHBF5knaFhO4NUfDc5s +9ooluHnFIxB8qC6DWU2dA== 0000950130-99-004024.txt : 19990715 0000950130-99-004024.hdr.sgml : 19990715 ACCESSION NUMBER: 0000950130-99-004024 CONFORMED SUBMISSION TYPE: S-1/A PUBLIC DOCUMENT COUNT: 6 FILED AS OF DATE: 19990714 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: 333-78713 FILM NUMBER: 99664537 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 AMENDMENT NO.2 TO FORM S-1 As filed with the Securities and Exchange Commission on July 14, 1999 Registration No. 333-78713 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 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 jurisdiction of (Primary Standard Industrial (I.R.S. Employer incorporation or organization) Classification Code Number) Identification No.)
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) 907-5304 (Name, address, including zip code, and telephone number, including area code, of agent for service) -------------- Copies to: Ira A. Greenstein, Esq. Alexander D. Lynch, Esq. Morrison & Foerster LLP Kenneth R. McVay, Esq. 1290 Avenue of the Americas Brobeck, Phleger & Harrison LLP New York, New York 10104 1633 Broadway, 47th Floor (212) 468-8000 New York, New York 10019 (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 JULY 14, 1999 PROSPECTUS 4,800,000 Shares [NET2PHONE LOGO] Common Stock This is an initial public offering of common stock by Net2Phone, Inc. Net2Phone is selling 4,800,000 shares of common stock. The estimated initial public offering price is between $10.00 and $12.00 per share. -------- At the request of Net2Phone, the underwriters intend to reserve up to 300,000 shares of common stock to be sold in this offering to National Broadcasting Company, Inc., up to 200,000 shares of common stock to be sold in this offering to GE Capital Equity Investments, Inc. and up to 100,000 shares of common stock to be sold to Jonathan Fram, our President, each at the initial offering price. Any reserved shares not sold to NBC, GE Capital or Mr. Fram will be offered to the general public on the same basis as the other shares offered hereby. We have applied for listing of Net2Phone's common stock on the Nasdaq National Market under the symbol NTOP. --------
Per Share Total Initial public offering price................................... $ $ Underwriting discounts and commissions.......................... $ $ Proceeds to Net2Phone, before expenses.......................... $ $
Net2Phone has granted the underwriters an option for a period of 30 days to purchase up to 720,000 additional shares of our common stock. -------- Investing in the common stock involves a high degree of risk. See "Risk Factors" beginning on page 5. -------- 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 BT Alex. Brown -------- Bear, Stearns & Co. Inc. , 1999 TABLE OF CONTENTS
Page ---- Prospectus Summary................................................... 1 Risk Factors......................................................... 5 Forward-Looking Statements........................................... 13 Use of Proceeds...................................................... 14 Dividend Policy...................................................... 14 Capitalization....................................................... 15 Dilution............................................................. 16 Selected Financial Data.............................................. 17 Management's Discussion and Analysis of Financial Condition and Results of Operations....................... 18 Business............................................................. 27 Management........................................................... 44 Principal Stockholders............................................... 53 Certain Transactions................................................. 55 Description of Capital Stock......................................... 62 Shares Eligible for Future Sale...................................... 65 Underwriting......................................................... 67 Legal Matters........................................................ 70 Experts.............................................................. 70 Where You Can Find More Information.................................. 70 Index to Financial Statements ....................................... F-1
We maintain Web sites at www.Net2Phone.com and www.EZSurf.com. Information contained on our Web sites does not constitute part of this prospectus. "Net2Phone" and "Net2Fax" are our registered marks. Applications to register the service marks "Phone2Phone," "Click2Talk," "N2P," "Net2Phone Pro" and "Fax2Fax" have been filed with the United States Patent and Trademark Office. This prospectus also includes references to registered service marks and trademarks of other entities. 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 Frost & Sullivan, a leading market research firm, we were the largest provider of Internet calls in the world in 1997 with a 30% market share. 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. 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. For example, our PC2Phone software will be embedded on an exclusive basis into future versions of Netscape's Internet browser, including Netscape Navigator and Netscape Communicator, for the term of our agreement. Netscape will also include a Net2Phone icon on the Netscape Navigator Personal Toolbar and integrate our services into Netscape Netcenter, allowing Netscape users to access our services from anywhere on the Web. 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: . marketing our services widely; . pursuing multiple sources of revenue; . enhancing brand recognition; . making our software readily available worldwide; and . expanding and enhancing our products and services. Upon completion of this offering, IDT will own approximately 58.2% 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 65.2% 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) 907-5304. 1 Recent Developments The Offering Common stock offered by Net2Phone............ 4,800,000 shares Capital stock to be outstanding after this offering.................................... 46,797,619 shares Common stock................................ 10,161,429 shares Class A stock............................... 36,636,190 shares Use of proceeds.............................. $7.0 million of the net proceeds from this offering will be used to repay a portion of a note outstanding to IDT Corporation. $1.5 million will be used to pay to NBC for the purchase of television advertising. We have not made any other specific allocations with respect to the proceeds. We expect to use the balance of the proceeds: for developing and maintaining strategic Internet relationships; for advertising and promotion; for research and development; for upgrading and expanding our network; and for general corporate purposes, including working capital. Nasdaq National Market symbol................ NTOP
-------------------- This information excludes: . 3,666,366 shares subject to options outstanding as of July 13, 1999 at a weighted average exercise price of $3.33 per share; and . an additional 920,000 shares subject to options granted to Mr. Fram as of July 13, 1999, of which 460,000 shares were granted at an exercise price of $3.33 per share and the remaining 460,000 shares were granted at the lower of our initial public offering price or $11.00 per share. . 6,030,378 shares reserved for issuance under our 1999 Stock Incentive Plan, as of July 13, 1999, approximately 2,011,000 of which we expect to grant prior to the closing of this offering. Unless otherwise noted, the information in this prospectus: . reflects a 10,320-for-one stock split on our common stock, which took place in April 1999; . reflects a three-for-one stock split on our common stock and Class A stock, which took place in June 1999; 2 . assumes 4,683,237 shares of common stock outstanding in June 1999; . assumes 27,621,982 shares of Class A stock outstanding in June 1999; . assumes the exercise of warrants to purchase 272,400 shares of our common stock at a price of $3.33 per share prior to the closing of this offering for proceeds of $907,092; . gives effect to the conversion of 405,792 shares of Class A stock to common stock upon the transfer of these shares from IDT to Clifford M. Sobel, our Chairman, at the closing of this offering; and . gives effect to the conversion of all 3,140,000 outstanding shares of our Series A convertible preferred stock into 9,420,000 shares of Class A stock at the closing of this offering. Each share of Class A stock entitles the holder to two votes, while holders of our common stock are entitled to only 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 1998" refers to the fiscal year ended July 31, 1998. 3 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
Period from Year Ended Nine Months Ended January 2, 1996 July 31, April 30, (inception) to ------------------------ ----------------------- July 31, 1996 1997 1998 1998 1999 --------------- ----------- ----------- ---------- ----------- Statement of Operations: Revenue............... $ -- $ 2,652,303 $12,005,972 $7,954,374 $22,203,257 Loss from operations.. (507,758) (1,697,647) (3,544,689) (673,922) (2,905,966) Net loss.............. $(507,758) $(1,697,647) $(3,544,689) $ (673,922) $(2,905,966) Net loss per share-- basic and diluted.... $ (0.02) $ (0.06) $ (0.12) $ (0.02) $ (0.09) Shares used in calculation of basic and diluted loss per share................ 27,864,000 27,864,000 30,186,000 29,928,000 30,960,000
The pro forma balance sheet data summarized below gives effect to: . the sale of 3,140,000 shares of Series A convertible preferred stock, which are convertible into 9,420,000 shares of our Class A common stock, and warrants to purchase 180,000 shares of our common stock in May 1999 for net proceeds of $29.9 million; . the conversion of all outstanding shares of our Series A convertible preferred stock into shares of our Class A stock at the closing of this offering; . the issuance of warrants to purchase 92,400 shares of our common stock granted to the placement agent in May 1999 in connection with the sale of our Series A convertible preferred stock; . the repayment of $8.0 million of the amounts owed to IDT in May 1999; and . the exercise of options to purchase 1,345,219 shares of common stock in May 1999 in exchange for $3.1 million in promissory notes and $1.3 million in cash. The pro forma as adjusted balance sheet summarized below reflects: . the sale of 4,800,000 shares of common stock in this offering; . the application of $7.0 million of the estimated net proceeds from this offering to pay a portion of the amounts due to IDT; . the application of $1.5 million of the estimated net proceeds from this offering to pay NBC for television advertising; . the exercise of warrants to purchase 272,400 shares of common stock prior to the closing of this offering for proceeds of $907,092; and . the loan of $1.0 million to our President to purchase stock
April 30, 1999 -------------------------------------- Pro Forma Actual Pro Forma As Adjusted ------------ ----------- ------------ Balance Sheet Data: Cash and cash equivalents.............. $ 1,782,194 $25,016,264 $62,237,356 Working capital........................ (17,255,452) 13,978,618 58,199,710 Total assets........................... 19,818,328 43,052,398 83,773,490 Due to IDT............................. 22,000,000 14,000,000 7,000,000 Total stockholders' (deficit) equity... (3,926,122) 27,307,948 75,029,040
4 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 $8.7 million as of April 30, 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. Further, it is probable that we will have to recognize significant additional charges relating to non-cash compensation in connection with options that we granted in May 1999 and that we expect to grant prior to the closing of this offering. 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. 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, and financial and accounting systems and controls; 5 . 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, we will diminish our chances of achieving profitability. If we fail to establish and maintain strategic relationships our ability to increase our sales would suffer. We currently have strategic relationships with Netscape, Compaq, 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. If any of our strategic relationships are discontinued, sales of our products and services and our ability to maintain or increase our customer base may be substantially diminished. 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. Current product offerings include VocalTec Communications' Internet Phone, QuarterDeck's WebPhone and Microsoft's NetMeeting. In addition, a number of large telecommunications providers and equipment manufacturers, such as Alcatel, Cisco, Lucent, Northern Telecom and Dialogic (which has entered into an agreement to be acquired by Intel), have announced that they intend to offer similar products. 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 further 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. Other competitors of ours, such as ICG Communications, IPVoice.com, ITXC, RSL Communications (through its Delta Three subsidiary) and VIP Calling, route voice traffic worldwide over the Internet. In addition, major long distance providers, such as AT&T, Deutsche Telekom, MCI WorldCom and Qwest Communications, as well as other major companies such as Motorola and Intel, have all entered or plan to enter the market for carrying voice over the Internet. These companies are larger than we are and have substantially greater financial, distribution and marketing resources than we do. We may not be able to compete successfully in this market. 6 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. In recent years, the price of long distance calls has fallen. In response, we have lowered the price of our service offerings. 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. 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 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 one of our executive officers, Clifford M. Sobel, our Chairman and 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. 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 April 30, 1999, approximately 65% of our customers were based outside of the United States, generating approximately 58% of our revenues during the nine months ended on that date. 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; . 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 some domestic and all international calls made by our customers at least in part over leased transmission facilities. Further, because our network does not 7 extend to homes or businesses, we must route calls made by our customers 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 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 competitors. However, the incumbent local telephone companies can be expected to bring further 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. 8 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, telecommunication 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 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 validity, enforceability and scope of protection of intellectual property in Internet-related industries is uncertain and still evolving. The laws of some foreign countries are uncertain or do not protect intellectual property rights to the same extent as do the laws of the United States. 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 do not or will not infringe upon valid patents, trademarks, copyrights or other intellectual property rights held 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. 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. 9 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. 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. We may experience conflicts of interest with IDT, which may not be resolved in our favor. Two members of our board of directors are officers and 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 "Certain Transactions." 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 58.2% of our outstanding capital stock. Because IDT owns Class A stock, which entitles the holder to two votes per share, IDT will control 65.2% 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 further 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 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 owns 72 hours after the consummation of this offering. If IDT defaults in its obligations under the credit facility, then a third party could acquire the voting 10 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 further 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 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. To date, governmental regulations have not materially restricted use of the Internet in our market. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. New regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet. 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; . consumer protection; . contribution to the universal service fund, a 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. 11 In September 1998, two regional Bell operating companies advised Internet telephony providers that these companies would impose access charges on Internet telephony traffic. One of these operating companies also petitioned the FCC for a declaratory ruling that providers of interstate Internet telephony must pay federal access charges, and has petitioned the public utilities commissions of Nebraska and Colorado for similar rulings concerning payment of access charges for intrastate Internet telephone calls. The outcome of these proceedings is uncertain. If these states decide that access charges may be levied against Internet telephony providers, we would have to pay money for access in those states. If additional state utility commissions make similar rulings, we may not be able to operate profitably in any states that assesses access charges against us. 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. Risks Related to this Offering Our stock price is likely to be highly volatile and could drop unexpectedly. Following this offering, the price for our common stock could be highly volatile and subject to wide fluctuations 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 is 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. 12 We may use the proceeds from this offering in ways with which you may not agree. We have significant flexibility in applying the proceeds we receive in this offering. Other than the repayment of $7.0 million on an outstanding note to IDT and the payment of $1.5 million to NBC for television advertising, the proceeds are not required to be allocated to any specific investment or transaction. Therefore, 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. 13 USE OF PROCEEDS Net2Phone will receive net proceeds of approximately $47.8 million from the sale of 4,800,000 shares of common stock (and an additional approximately $7.4 million from the sale of 720,000 shares if the underwriters over-allotment option is exercised in full) at an assumed initial public offering price of $11.00 per share after deducting underwriting commissions and discounts of $3.5 million (and an additional $554,400 if the underwriters' over-allotment option is exercised in full) and estimated expenses of $1.5 million. $7.0 million of the net proceeds from this offering will be used to repay a portion of the $14.0 million note outstanding to IDT. $1.5 million will be used to pay NBC for television advertising. As of the date of this prospectus, we have not made any other specific allocations with respect to the proceeds. 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 balance of the net proceeds of this offering for: . developing and maintaining strategic Internet relationships; . advertising and promotion; . research and development; . upgrading and expanding our network; 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. 14 CAPITALIZATION The following table sets forth: . our actual capitalization as of April 30, 1999; . our pro forma capitalization to give effect to: . the conversion of IDT's 27,864,000 shares of our common stock into 27,864,000 shares of Class A stock in May 1999, . the sale of 3,140,000 shares of Series A convertible preferred stock, which are convertible into 9,420,000 shares of our Class A common stock, and warrants to purchase 180,000 shares of our common stock in May 1999 for net proceeds of $29.9 million, . the conversion of all outstanding shares of our Series A convertible preferred stock into shares of our Class A stock at the closing of this offering, . the issuance of warrants to purchase 92,400 shares of our common stock granted to the placement agent in May 1999 in connection with the sale of our Series A convertible preferred stock, . the repayment of $8.0 million of the amounts owed to IDT in May 1999, . the conversion of 242,018 shares of Class A stock to common stock upon the transfer of these shares from IDT to Clifford M. Sobel in May 1999, . the exercise of stock options to purchase 1,375,219 shares of common stock in May 1999 in exchange for $3.1 million in promissory notes and $1.3 million in cash; and . the pro forma as adjusted balance sheet summarized below reflects: . the sale of 4,800,000 shares of common stock in this offering, . the application of $7.0 million of the estimated net proceeds from this offering to pay a portion of the amounts due to IDT, . the conversion of 405,792 shares of Class A stock to common stock upon the transfer of those shares from IDT to Clifford M. Sobel at the closing of this offering, . exercise of warrants prior to the closing of this offering to purchase 272,400 shares of common stock, and . the loan of $1.0 million to our President to purchase shares of stock The information set forth in the table below excludes 3,666,366 shares of common stock issuable upon exercise of options to purchase our common stock at a weighted average exercise price of $3.33 per share. This information also excludes an additional 920,000 shares subject to options granted to Fram, of which 460,000 shares were granted at an exercise price of $3.33 per share and the remaining 460,000 shares were granted at the lower of our initial public offering price or $11.00 per share. This information also excludes the effect of non-cash compensation in connection with options to purchase 5,040,000 shares of our common stock that were granted in May 1999, and options to purchase 2,011,000 shares of our common stock that are expected to be granted prior to the closing of this offering and options to purchase 920,000 granted to our President. See "Management--1999 Stock Incentive Plan" and "Certain Transactions--Relationship with Other Investors."
April 30, 1999 ------------------------------------- Pro Forma Actual Pro Forma As Adjusted ----------- ----------- ----------- Due to IDT.............................. $22,000,000 $14,000,000 $ 7,000,000 Redeemable convertible preferred stock, Series A, $.01 par value; 3,150,000 shares authorized, no shares issued and outstanding............................ -- -- -- Stockholders' (deficit) equity: 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 (actual) 4,683,237 (pro forma) and 10,161,429 (pro forma as adjusted) shares issued and outstanding............................ 309,600 46,832 101,614 Class A stock, $.01 par value; 37,042,089 shares authorized; none (actual) 37,041,982 (pro forma) and 36,636,190 (pro forma as adjusted) shares issued and outstanding.......... -- 370,420 366,362 Additional paid-in capital.............. 4,420,338 38,696,746 87,367,114 Loans to stockholders................... -- (3,149,990) (4,149,990) Accumulated deficit..................... (8,656,060) (8,656,060) (8,656,060) ----------- ----------- ----------- Total stockholders' (deficit) equity.... (3,926,122) 27,307,948 75,029,040 ----------- ----------- ----------- Total capitalization.................... $18,073,878 $41,307,948 $82,029,040 =========== =========== ===========
15 DILUTION The net tangible book value of Net2Phone common stock and Class A stock as of April 30, 1999, as adjusted to give effect to a private placement of 3,140,000 shares of Series A convertible preferred stock in May 1999 and the conversion of those shares into Class A stock and the exercise of stock options to purchase 1,345,219 shares of common stock, was $22.3 million, or $0.53 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 and the receipt of an assumed $47.8 million of net proceeds from this offering (based on an assumed initial public offering price of $11.00 per share), the issuance of 3,140,000 shares of Series A convertible preferred stock in May 1999, the conversion of the Series A convertible preferred stock into 9,420,000 shares of Class A stock and the exercise of warrants to purchase 272,400 shares of common stock, the pro forma net tangible book value of the common stock and Class A stock as of April 30, 1999 would have been $70.0 million, or $1.47 per share. This amount represents an immediate increase in net tangible book value of $1.13 per share to the existing stockholders and an immediate dilution in net tangible book value of $9.53 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: Assumed initial public offering price per share................. $11.00 Net tangible book value per share at April 30, 1999 .......... $0.53 Increase per share attributable to new investors.............. 0.94 ----- Pro forma net tangible book value per share after this offering........................................................ 1.47 ------ Dilution per share to new investors............................. $ 9.53 ======
The following table sets forth, as of April 30, 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 estimated underwriting discounts and commissions and offering expenses.
Shares Purchased Total Consideration ------------------ ------------------- Average Price Number Percent Amount Percent Per Share ---------- ------- ------------ ------- ------------- Existing stockholders.. 41,725,219 89.7% $ 88,742,182 62.7% $ 2.11 New investors.......... 4,800,000 10.3% 52,800,000 37.3% 11.00 ---------- ----- ------------ ----- Total.............. 46,797,619 100.0% $141,542,182 100.0% ========== ===== ============ =====
16 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 and fiscal 1998 and the balance sheet data as of July 31, 1997 and 1998 are derived from our financial statements that have been audited by Ernst & Young LLP, independent auditors, which are included elsewhere in this prospectus. The statement of operations data for the nine months ended April 30, 1998 and 1999 and the balance sheet data as of April 30, 1999 have been derived from our unaudited financial statements that have been prepared on the same basis as the audited financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the financial data for the periods presented. The financial data for the interim periods is not necessarily indicative of results that may be expected for any other interim period or for the year as a whole.
Period from Year Ended Nine Months Ended January 2, 1996 July 31, April 30, (inception) ------------------------ ------------------------- to July 31, 1996 1997 1998 1998 1999 ---------------- ----------- ----------- ------------ ----------- Statement of Operations Data: Revenue: PC2Phone.............. $ -- $ 2,170,442 $ 7,962,821 $ 5,085,176 $13,774,837 Phone2Phone........... -- 272 2,030,516 1,018,835 6,503,697 Other................. -- 481,589 2,012,635 1,850,363 1,924,723 ---------- ----------- ----------- ------------ ----------- Total revenue....... -- 2,652,303 12,005,972 7,954,374 22,203,257 ---------- ----------- ----------- ------------ ----------- Cost and expenses: Direct cost of revenue, excluding depreciation......... -- 1,553,443 6,848,759 3,589,301 11,848,089 Sales and marketing... 34,468 76,724 2,887,766 1,363,060 4,746,316 General and administrative....... 465,015 2,599,283 5,087,628 3,254,287 7,298,106 Depreciation.......... 8,275 120,500 726,508 421,648 1,216,712 ---------- ----------- ----------- ------------ ----------- Total costs and expenses........... 507,758 4,349,950 15,550,661 8,628,296 25,109,223 ---------- ----------- ----------- ------------ ----------- Loss from operations and net loss.......... $(507,758) $(1,697,647) $(3,544,689) $ (673,922) $(2,905,966) ========== =========== =========== ============ =========== Net loss per share-- basic and diluted..... $ (0.02) $ (0.06) $ (0.12) $ (0.02) $ (0.09) ========== =========== =========== ============ =========== Shares used in calculation of basic and diluted net loss per share............. 27,864,000 27,864,000 30,186,000 29,928,000 30,960,000 July 31, April 30, -------------------------------------- ----------- 1996 1997 1998 1999 ----------- ----------- ------------ ----------- Balance Sheet Data: Cash and cash equivalents............... $ -- $ -- $ 10,074 $ 1,782,194 Working capital......................... (681,532) (3,104,830) (11,149,553) (17,255,452) Total assets............................ 174,674 916,025 6,975,108 19,818,328 Due to IDT.............................. 681,532 2,960,429 11,814,988 22,000,000 Total stockholders' (deficit)........... (507,758) (2,205,305) (5,649,994) (3,926,122)
17 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. During the period ended July 31, 1996, we incurred approximately $500,000 in start-up costs, primarily for research and development. 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 April 30, 1999, we had accumulated net losses of approximately $8.7 million. We will recognize a significant charge relating to non-cash executive compensation expense in the current fiscal quarter ending July 31, 1999, and on an ongoing basis. In connection with 5,040,000 options granted with an exercise price of $3.33 per share on May 17, 1999, including options granted to IDT employees, we will recognize approximately $41 million of non-cash charges over the vesting period of these options. We will recognize a charge of $13 million in the current quarter, $10 million during fiscal 2000, and $10 million during fiscal 2001 and $8 million during fiscal 2002. We also plan to grant options to purchase 2,011,000 shares of our common stock to our employees, consultants and others prior to the closing of this offering. In addition, in connection with the 460,000 options granted to our President with an exercise price of $3.33 per share, we will recognize approximately $3.6 million of non-cash charges over the vesting period of these options. We will recognize a charge of $1.2 million during the current quarter, $800,000 during fiscal 2000, $800,000 during fiscal 2001 and $800,000 during fiscal 2002. In connection with the remaining 460,000 options granted to our President with an exercise price equal to the lower of our initial offering price or $11.00 per share. We will recognize a compensation charge if our initial offering price is more than $11.00 per share. The non cash compensation charge will be equal to the excess of our initial offering price over $11.00 times the 460,000 shares and will be amortized over the vesting period of the options. Sources of Revenue For the first nine months of fiscal 1999, approximately 62% of our revenue has been derived from per-minute charges we billed to our customers on a prepaid basis to use our PC2Phone service, and approximately 29% of our revenue has been derived from per-minute charges we billed to our customers and our international resellers on a prepaid basis to use our Phone2Phone service. The remainder of our revenue has been derived from the sale of Internet telephony equipment for Net2Phone Pro, a product that integrates our software into hardware for the personal computer, and for services we provide to IDT and other carriers. In the future, in order to diversify and further 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 further 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 91% of our revenue is generated from per-minute charges we charge our customers on a prepaid basis to use our PC2Phone and Phone2Phone services. As of April 30, 1999, we served over 250,000 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% of our revenue, which is derived from equipment sales and from services provided to IDT and other carriers, is recognized upon installation of the equipment and performance of the services. 18 Cost Structure Our costs and expenses include: . direct cost of revenue, excluding depreciation; . sales 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. Sales and Marketing. Sales 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 sales and marketing expenses to increase over time as we aggressively market our products and services. Historically, sales 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, Snap.com, Yahoo!, ZDNet, and InfoSpace.com, 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. Depreciation 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 19 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. 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:
Percentage of Revenue ----------------------------------------------- Period from January 2, 1996 Year Ended Nine Months Ended (inception) July 31, April 30, to July 31, ------------- ------------------- 1996 1997 1998 1998 1999 ----------- ----- ----- -------- -------- Revenue: PC2Phone................. -- 81.8% 66.3% 63.9% 62.0% Phone2Phone.............. -- -- 16.9 12.8 29.3 Other.................... -- 18.2 16.8 23.3 8.7 ----- ----- ----- -------- -------- Total revenue........ -- 100.0 100.0 100.0 100.0 ----- ----- ----- -------- -------- Cost and expenses: Direct cost of revenue, excluding depreciation.. -- 58.6 57.0 45.1 53.4 Sales and marketing...... -- 2.9 24.1 17.1 21.4 General and administrative........... -- 98.0 42.4 40.9 32.8 Depreciation............. -- 4.5 6.1 5.3 5.5 ----- ----- ----- -------- -------- Total costs and expenses............ -- 164.0 129.6 108.4 113.1 ----- ----- ----- -------- -------- Loss from operations and net loss...................... -- (64.0)% (29.6)% (8.4)% (13.1)% ===== ===== ===== ======== ========
Comparison of Nine Months Ended April 30, 1998 and 1999 Revenue. Revenue increased approximately 178% from approximately $8.0 million for the nine months ended April 30, 1998 to approximately $22.2 million for the nine months ended April 30, 1999. Of total revenue for the nine months ended April 30, 1999, PC2Phone generated approximately $13.8 million and Phone2Phone generated approximately $6.5 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 171% from approximately $5.1 million for the nine months ended April 30, 1998 to approximately $13.8 million in revenue for the corresponding nine-month period in fiscal 1999. Revenue from Phone2Phone increased approximately 550% from approximately $1.0 million for the nine months ended April 30, 1998 to approximately $6.5 million for the nine months ended April 30, 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. 20 In addition, we recognized revenue from certain amounts charged to IDT and other carriers and from equipment sales, as shown above in the category "Other." From these transactions, including monitoring IDT's network operations center for Internet customers, we recognized revenue of approximately $329,000 and $680,000 for the nine months ended April 30, 1998 and 1999, respectively. We also realized revenue from the sale of equipment, totaling approximately $1.5 million for the nine months ended April 30, 1998 as compared to equipment sales of approximately $446,000 for the nine months ended April 30, 1999. Equipment sales for the nine months ended April 30, 1999 were derived from our Net2Phone Pro product, while equipment sales for the nine months ended April 30, 1998 represented Internet telephony servers sold, on a one-time non-recurring basis, to an international Phone2Phone reseller for deployment abroad. Revenue from equipment sales, particularly revenue from sales of Internet telephony servers, reflect sales that we believe to be non-recurring and do not represent any trend. Direct Cost of Revenue, Excluding Depreciation. Total cost of revenue, excluding depreciation increased by 228% from $3.6 million for the nine months ended April 30, 1998 to approximately $11.8 million for the nine months ended April 30, 1999. As a percentage of total revenue, these costs increased from approximately 45.1% for the nine months ended April 30, 1998 to approximately 53.4% for the nine months ended April 30, 1999. This increase is primarily attributable to the fact that we sold approximately $1.5 million of equipment in the nine months ended April 30, 1998 as compared to approximately $446,000 in the nine months ended April 30, 1999. Such equipment sales have a low cost of sales associated with them. 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 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. Sales and Marketing. Sales and marketing expenses increased approximately 236% from approximately $1.4 million for the nine months ended April 30, 1998 to approximately $4.7 million for the nine months ended April 30, 1999. As a percentage of total revenue, these costs increased from approximately 17.1% for the nine months ended April 30, 1998 to approximately 21.4% for the nine months ended April 30, 1999. 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 our advertising and marketing expenditures to further build brand recognition, and to enhance the distribution of our products and services. General and Administrative. General and administrative expenses increased approximately 121% from approximately $3.3 million for the nine months ended April 30, 1998 to approximately $7.3 million for the nine months ended April 30, 1999. As a percentage of total revenue, these costs decreased from approximately 40.9% for the nine months ended April 30, 1998 to approximately 32.8% for the nine months ended April 30, 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 further 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. Depreciation increased from approximately $422,000 for the nine months ended April 30, 1998 to approximately $1.2 million for the nine months ended April 30, 1999. This increase is primarily attributable to the increase in capital expenditures for the deployment of network equipment both 21 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. Loss from Operations. Loss from operations was approximately $674,000 for the nine months ended April 30, 1998 as compared to loss from operations of approximately $2.9 million for the nine months ended April 30, 1999. This change is due to the substantial increase in both sales and marketing expenses as well as general and administrative expenses we incurred as we expanded our corporate infrastructure and human resources. We anticipate continued and increasing losses as we pursue our growth strategy. Comparison of Fiscal Years Ended July 31, 1997 and 1998 Revenue. Revenue increased approximately 344% 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. Specifically, revenue from PC2Phone services increased approximately 264% 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 $453,000, 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. Total cost of revenue, excluding depreciation increased by approximately 325% 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. Sales and Marketing. Sales 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 further build 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. 22 Depreciation. Depreciation increased from approximately $121,000 for fiscal 1997 to approximately $727,000 for 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. Period from January 2, 1996 (inception) to July 31, 1996 During the period from January 2, 1996 (inception) to July 31, 1996, we did not generate any revenue. During this period, we incurred approximately $500,000 in start-up costs, primarily for research and development, as we prepared to introduce our products and services. Quarterly Results of Operations The following table sets forth certain quarterly financial data for the seven quarters ended April 30, 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, 1997 1998 1998 1998 1998 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 Phone2Phone............ 70,939 148,572 799,324 1,011,681 1,287,415 2,280,366 2,935,916 Other.................. 825,000 905,000 120,363 162,272 599,227 412,456 913,040 ---------- ---------- ----------- ----------- ----------- ---------- ---------- Total revenue........ 2,267,537 2,747,384 2,939,453 4,051,598 5,663,419 7,502,466 9,037,372 Cost and expenses: Direct cost of revenue, excluding depreciation.......... 602,389 1,070,051 1,916,861 3,259,458 3,353,247 3,970,504 4,524,338 Sales and marketing.... 133,963 316,141 912,956 1,524,706 1,299,903 1,691,810 1,754,603 General and administrative........ 730,893 1,073,165 1,450,229 1,833,341 1,900,234 2,286,770 3,111,102 Depreciation........... 68,169 123,844 229,635 304,860 338,469 400,584 477,659 ---------- ---------- ----------- ----------- ----------- ---------- ---------- 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 ---------- ---------- ----------- ----------- ----------- ---------- ---------- Income (loss) from operations and net income (loss).......... $ 732,123 $ 164,183 $(1,570,228) $(2,870,767) $(1,228,434) $ (847,202) $ (830,330) ========== ========== =========== =========== =========== ========== ========== As a Percentage of Revenue ----------------------------------------------------------------------------------------- Revenue: PC2Phone............... 60.5% 61.7% 68.7% 71.0% 66.7% 64.1% 57.4% Phone2Phone............ 3.1 5.4 27.2 25.0 22.7 30.4 32.5 Other.................. 36.4 32.9 4.1 4.0 10.6 5.5 10.1 ---------- ---------- ----------- ----------- ----------- ---------- ---------- Total revenue........ 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Cost and expenses: Direct cost of revenue, excluding depreciation.......... 26.6 38.9 65.2 80.4 59.2 52.9 50.1 Sales and marketing.... 5.9 11.5 31.1 37.6 23.0 22.6 19.4 General and administrative........ 32.2 39.1 49.3 45.2 33.6 30.5 34.4 Depreciation........... 3.0 4.5 7.8 7.5 6.0 5.3 5.3 ---------- ---------- ----------- ----------- ----------- ---------- ---------- Total costs and expenses............ 67.7 94.0 153.4 170.7 121.8 111.3 109.2 ---------- ---------- ----------- ----------- ----------- ---------- ---------- Income (loss) from operations and net income (loss).......... 32.3% 6.0% (53.4)% (70.7)% (21.8)% (11.3)% (9.2)% ========== ========== =========== =========== =========== ========== ==========
23 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. Since we derive revenue from more than one source, we have experienced volatility in our direct costs of revenue. Specifically, our direct cost of revenue in the first two quarters of fiscal 1998 were low as a percentage of total revenue due to sales of equipment in these quarters. Since 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 5% of total revenue in the first half of the year to approximately 26% 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 the first three quarters of 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 50% as compared to approximately 80% in the quarter ended July 31, 1998. Our increased sales and marketing expenses reflect the relationships we have with various online strategic partners with whom we advertise our PC2Phone and Phone2Phone services. We anticipate increased investment in sales and marketing to further build brand 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. Liquidity and Capital Resources Since inception in January 1996, we have financed our operations through advances from IDT. During the nine months ended April 30, 1999 we also received capital contributions from IDT of approximately $4.6 million. As of April 30, 1999, we had approximately $1.8 million in cash and cash equivalents. In May 1999 we raised net proceeds of approximately $29.9 million from the sale of Series A convertible preferred stock and warrants. Our operating activities generated negative cash flow of approximately $409,000 in the nine months ended April 30, 1998 compared to negative cash flow of approximately $4.0 million in the nine months ended April 30, 1999. Cash used in investing activities was approximately $4.2 million and approximately $9.0 million for the nine months ended April 30, 1998 and 1999, respectively. 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 the 1999 period. 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. 24 Our principal commitments following the closing of this offering are expected to consist of: . the repayment of $7.0 million with respect to the $14.0 million note due to IDT; . the payment of $1.5 million to NBC for television advertising; . the $7.0 million note described above, which is payable to IDT in 60 monthly installments of principal and interest at a rate of 9% per annum, commencing in June 1999; . the acquisition of a new network with expanded capacity from IDT in exchange for a $6.0 million note, payable in 60 monthly installments of principal and interest at a rate of 9% per annum; . other costs relating to network equipment and expansion; and . payments to Internet companies in connection with marketing our products and services, which as of April 30, 1999, were approximately $15 million. 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 12 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. 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. In connection with IDT's review of its own operations and the operations of its subsidiaries, 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. 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 consisted of the following phases: . conducting a comprehensive inventory of internal systems; . assessing and prioritizing any required remediation; 25 . 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 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. 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. Impact of Recently Issued Accounting Standards SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, was issued in June 1997. We will be required to adopt this new statement for fiscal 1999. 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 disaggregates a company. We do not anticipate that the adoption of this statement will have significant impact on our financial statements. 26 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 embed our PC2Phone software on an exclusive basis into all versions of Netscape's Internet browser released during the term of our agreement, including Netscape Navigator and Netscape Communicator. Netscape also agreed to include a Net2Phone icon on the Netscape Navigator Personal Toolbar. We also have entered into strategic marketing and distribution relationships with leading Internet companies, including, Excite, InfoSpace.com, Snap.com, Yahoo! and ZDNet. We have also entered into arrangements with leading computer equipment and software companies, such as IBM, Compaq, Packard Bell-NEC Europe and Creative Labs 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 eight languages (English, Spanish, Japanese, French, Dutch, Portuguese, Italian and German). We intend to make our software available in additional languages as we expand our international customer base and distribution channels. As of April 30, 1999, we served over 250,000 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 and $1.7 million in fiscal 1997 to $3.5 million in fiscal 1998. Our total assets increased from $916,000 at July 31, 1997 to $7.0 million at July 31, 1998. 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 the nine months ended April 30, 1999 was approximately $22.2 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. 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 to grow to approximately $1.3 trillion in 2003. 27 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 $23.4 billion in 2003, from approximately $1.1 billion in 1998. 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 further 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, 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. 28 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, 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 29 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, 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 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, our software is included with IBM's Internet services and may be pre-loaded on computers sold by Compaq internationally. 30 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, . 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 we anticipate 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 Netscape Navigator and Netscape Communicator. 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 prominently display our services on, Netscape Netcenter, including Netscape's Address Book Contacts section and Voice Communications section, which will allow Netscape users to make calls using our services simply by clicking on a displayed telephone number; and . 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 amount of banner and other advertisements on Web pages of our choice on Netscape's domestic and international Web site. The two-year term of our exclusive agreement with Netscape commences with the beta release of the next version of Netscape's Internet browser, which we believe will occur later this year. 31 Yahoo!, Excite and InfoSpace.com In 1998 we signed an agreement with Yahoo!, which was recently renewed through 2000. Our Web-based Internet telephony service is integrated into Yahoo!'s People Search online telephone directory. As a result of this integration, an Internet user who performs a search on Yahoo! People Search can 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, we have contracted with Yahoo! to integrate our PC2Phone service into Yahoo!'s Yellow Pages and White Pages online directories. 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. In addition, our Web-based Internet telephony software is integrated into InfoSpace.com's network of white and yellow page directory services. This network of sites includes all the white and yellow page listings in Netscape's Netcenter Web site, the Microsoft Network, the GO Network and Xoom.com. 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. . Quicknet Technologies. Our PC2Phone software is integrated into Quicknet's telephone handset product called Internet PhoneJACK. . Bigfoot International, WorldPages/Web YP and Internet 800 Directory. Our PC2Phone service is integrated into these three popular online directories, which allow Internet users to call any listed telephone number simply by clicking on the displayed number. Products and Services Current 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. 32 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 is no charge for calling United States . Users do not need and Canadian toll-free to purchase numbers. expensive hardware or software. . Available in the United States and in many . High voice quality. international locations. . Faxes are transmitted without . We market Phone2Phone delay and users under the brand receive immediate "Net2Phone Direct." delivery confirmations. - -------------------------------------------------------------------------------- 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 . International long software on their distance rates are personal computers, typically 50% to register with us and be 70% lower than the online in order to make rates charged by calls. When browsing traditional long Web sites that have a distance carriers Click2Talk icon, for calls customers may initiate originating in the calls to a company United States, and whose site they are up to 95% lower for browsing simply by calls originating clicking on the outside the United Click2Talk icon. States. . United States and . Customers are charged Canadian toll-free for toll and long numbers can be distance calls on a accessed from per-minute basis. There outside the United is no charge for States and Canada. calling United States and Canadian toll-free . Facilitates online numbers. commerce by providing live voice contact between online retailers and Internet shoppers. . Customers do not require multiple telephone lines and need not log off the Internet to initiate a call. - -------------------------------------------------------------------------------- EZSurf.com . A Web-based shopping . Enables voice directory powered by communications with our Web-based Internet over 300 Web sites. telephony services from which Internet users can initiate calls to . Educates users by listed online retailers providing them with by clicking on an icon essential on the Web site. information required to buy . Lists useful products online. information for key online retailers, including payment and shipping options and return policies. 33 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. Customers can also download our software at no charge from our Web site and 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, Packard Bell-NEC Europe and Creative Labs. Our software is included with our partners' products and services and distributed domestically and internationally. We expect to distribute over 25 million units of our software in 1999 as a result of these and other distribution arrangements. 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 eight languages (English, Spanish, Japanese, French, Dutch, Portuguese, Italian and German) 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 67 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. 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 release 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. 34 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. . 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. 35 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. 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. [Chart showing work flow within Company] 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 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 further 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 approximately 1,660 simultaneous calls made on Father's Day in June 1999. 36 The Network Operations Center Our Network Operations Center, located in Hackensack, New Jersey, currently employs a staff of 25 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. Their key objective is to provide quality service upon which customers can rely. 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 April 30, 1999, approximately 65% of our customers are based outside of the United States. As of April 30, 1999, we served over 250,000 active customers who had used our services during the preceding three months. In addition, as of June 25, 1999, we had installed the Click2Talk service on approximately 150 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. 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), ICG Communications, IPVoice.com, ITXC, OzEmail (which was recently acquired by MCI WorldCom), RSL Communications (through 37 its Delta Three subsidiary) and VIP Calling 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 and Netspeak. 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 further 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 has entered into an agreement to be 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 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. 38 Research and Development Strategic Research and Development At our primary research and development center in Lakewood, New Jersey, we currently employ 12 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 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 services that incorporate leading technology. We incurred $473,000 and $481,000 in product development expenses during fiscal 1997 and fiscal 1998, respectively. For the nine months ended April 30, 1999, we incurred product development expenses of $466,000. 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. 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 PC2Phone and Phone2Phone 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. 39 In September 1998, two regional Bell operating companies, U S WEST and BellSouth, advised Internet telephony providers that the regional companies would impose access charges on Internet telephony traffic. In addition, U S WEST has petitioned the FCC for a declaratory ruling that providers of interstate Internet telephony must pay federal access charges, and has petitioned the public utilities commissions of Nebraska and Colorado for similar rulings concerning payment of access charges for intrastate Internet telephone calls. At this time, it is not known whether these companies, U S WEST and BellSouth, will actually impose access charges or when such charges will become effective. If these companies succeed in imposing access charges that may reduce the cost savings of using Internet telephony as compared to traditional telephone service. The existence of these access charges would materially adversely affect the development of our Internet telephony business. In February 1999, the FCC adopted an order concerning payment of reciprocal compensation that provides support for a possible finding by the FCC that providers of Internet telephony must pay access charges for at least some subset of Internet telephony services. If the FCC were to make such a finding, the payment of access charges could materially adversely effect our business, results of operations and financial condition. Many of our competitors are lobbying the FCC for the imposition of access charges on Internet telephony traffic. 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. 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. 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 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 40 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. We do not currently have any issued patents or registered copyrights. 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 own the registered service mark for two of the marks used in our business and have applications pending to register several other service marks relating to our business. We have received correspondence from a company claiming that our use of the mark "Net2Phone" in connection with Internet telephony services infringes one of that company's United States registered trademarks, and requesting that we cease and desist from using the Net2Phone mark. We have responded by denying any infringement and no legal proceedings have been commenced against us with respect to this matter. AT&T, which uses the terms "Click2Dial", "Click2Whisper" and "Click2Interact" in its business, has filed with the United States Patent and Trademark Office for an extension of the time limit for opposing the service mark application filed by us for our "CLICK2TALK" mark. AT&T could oppose registration of our CLICK2TALK mark or take other action aimed at restricting us from using our CLICK2TALK mark. We are also aware of several other parties that employ marks that are the same or similar to marks that we employ, though these parties are not in the same business as us. There can be no assurance that the company which notified us or other companies with similar marks 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, one of our international resellers, a company known as ITM, operates 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. Furthermore, ITM has also taken steps to secure registration and ownership of the Net2Phone mark in France. We have notified ITM of this violation, taken some initial actions to oppose ITM's use of the Net2Phone mark, and will pursue our claim against them, if necessary, but there can be no assurances that we can prevent, through litigation or otherwise, ITM from continuing its operation of the net2phone.net Web site or from obtaining registration and ownership of the Net2Phone mark in France. Another company, NetPhone, currently operates a Web site at www.netphone.com where it sells a family of computer telephony hardware and applications. There can be no assurance that the existence of NetPhone's business and Web site will not materially adversely affect our business. Furthermore, we have not taken steps to assure foreign protection of our trademarks, except for our recent filing for registration of 41 the Net2Phone mark in certain European countries. 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. There can be no assurance that we will be able to secure significant protection for all our service marks or trademarks. It is possible that competitors of ours or others will adopt product or service names similar to our marks, or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possible leading to customer confusion. We have been assigned the rights to patent applications claiming a number of the technologies underlying our products and services. Our two United States 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 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 believe that we do not infringe upon the proprietary rights of any third party, and no third party has asserted a patent infringement claim against us. It is possible, however, that such a claim 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 proprietary rights 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 intellectual property 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 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 May 31, 1999, we had approximately 171 full-time employees, including approximately 66 in technical support and customer service, 26 in sales and marketing, 20 in management and finance, 47 in operations, and 12 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. 42 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. 43 MANAGEMENT Executive Officers, Directors and Key Employees The following persons are our executive officers, directors and director nominees:
Name Age Position ---- --- -------- Clifford M. Sobel......... 49 Chairman of the Board Howard S. Balter.......... 37 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 Stephen A. Oxman.......... 54 Director Nominee Raphael S. Grunfeld....... 52 Director Nominee
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 by Bear, Stearns & Co. Inc. 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 January 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 since 1996, where he was responsible for Bloomberg's Internet strategy. Prior to that, Mr. Fram was employed as General Manager of Bloomberg's Television and Radio Group from 1991 through 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 from 1996 to 1997. From January 1984 to August 1996, Mr. Greenblatt was a principal of Financial 44 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 and Treasurer since January 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 has been a director since 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 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. 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 45 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. Stephen A. Oxman is expected to become a director after the closing of this offering. Mr. Oxman currently serves as a managing director in the mergers, acquisitions and corporate advisory group of Deutsche Bank Securities Inc., an affiliate of BT Alex. Brown Incorporated. He heads the group's telecommunications practice and also focuses on the firm's work in Europe. In 1995, Mr. Oxman became a partner in the investment banking firm of James D. Wolfensohn Incorporated, which merged in 1996 with Bankers Trust, which in turn merged with Deutsche Bank in 1999. From 1993 to 1994, Mr. Oxman served as Assistant Secretary of State for European and Canadian Affairs. From 1988 to 1993, Mr. Oxman was a managing director of Wasserstein Perella & Co. and Deputy Chairman of Wasserstein Perella International. From 1980 to 1988, he was a partner in the law firm of Shearman & Sterling. During the Carter administration, Mr. Oxman was Executive Assistant to the Deputy Secretary of State, and subsequently a consultant to the Secretary of State concerning the Iran hostage crisis. Raphael S. Grunfeld is expected to become a director after the closing of this offering. Mr. Grunfeld has served as a partner in the Corporate Department of Morrison & Forester LLP since March 1999. Since November 1995, Mr. Grunfeld has served as General Counsel and Secretary of Genesis Direct, Inc., a catalog and Internet direct marketer. He also served as Vice President of Genesis Direct from November 1995 until March 1999. From 1992 to 1995, Mr. Grunfeld was General Counsel and Secretary of First Capital Asset Management, Inc. and its operating subsidiaries, including newspaper, media, money management and broker dealer companies. From 1992 to 1994 he also served as Executive Vice President, General Counsel and Secretary to DSI Industries, Inc., a public holding company, and to its operating subsidiaries engaged in the businesses of medical diagnostic imagery, oil drilling equipment leasing and plant nurseries. In addition, we employ the following additional key employees: Ira A. Greenstein has been our General Counsel and Secretary since May 1999. Mr. Greenstein has been a partner in the law firm of Morrison & Foerster LLP since 1997 where he serves as the chair of that firm's New York office's Corporate Department. Prior to 1997, Mr. Greenstein was an associate in the New York and Toronto offices of Skadden, Arps, Slate, Meagher & Flom LLP. From 1991 to 1992, Mr. Greenstein served as counsel to the Ontario Securities Commission advising on the implementation of the Multijurisdictional Disclosure System with the Securities and Exchange Commission. Mr. Greenstein also served on the Securities Advisory Committee to the Ontario Securities Commission from 1992 to 1996. Mr. Greenstein has testified as an expert in the U.S. securities laws in U.S. District Court. Chaim Ackerman has been a senior software engineer of ours since February 1996. Prior to his employment with us, Mr. Ackerman was a member of the technical staff at AT&T Bell Laboratories from 1986 to 1996. From 1984 to 1986, Mr. Ackerman was a member of the technical staff at AT&T Consumer Products. From 1980 to 1984, Mr. Ackerman worked for Computer Horizons Corporation as a consultant to Bell Laboratories. 46 Sarah Hofstetter has been our Vice President-Corporate Communications since May 1999. Prior to her employment with us, Ms. Hofstetter was IDT's Vice President of Corporate Communications, in charge of public relations and brand imaging from April 1996 to January 1999. From 1995 to 1996, Ms. Hofstetter worked at The New York Times Syndicate as an editor of the New America News Service, a wire service specializing in issues related to diversity in the marketplace. Ms. Hofstetter sits on the editorial boards of Telecom Business and TeleCard World magazines, and on the Editorial Roundtable of Intel-Card News magazine. 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 six. Two additional individuals have been nominated to serve as directors. We also anticipate that one additional director will be elected after the closing of this offering. Upon consummation of this offering, the board of directors will be divided into three classes, with each class to be 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. Neither GE nor NBC has nominated a director. We have established an audit committee and a compensation committee, the initial member of each of which will be James R. Mellor. We expect to appoint one or more additional directors to each of these committees after the closing of this offering. 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 board of directors does not have a nominating committee. However, the board of directors will consider nomination recommendations from stockholders, which should be addressed to our corporate secretary at our principal executive offices. Executive Compensation The following table identifies our most highly compensated executive officers whose salaries and bonuses exceeded $100,000 during fiscal 1998 and who served as executive officers of Net2Phone during fiscal 1998. Our Chief Executive Officer, Howard S. Balter was employed as the Chief Operating Officer and Vice Chairman of IDT during fiscal 1998 and did not serve as an executive officer of Net2Phone during fiscal 1998. All of the named executive officers listed below were compensated by IDT during fiscal 1998. 47 Summary Compensation Table
Long-Term Annual Compensation Compensation Awards ------------------ -------------- Securities Name and Principal Fiscal Underlying All Other Position Year Salary($) Bonus($) IDT Options(#) Compensation($) - ------------------ ------ --------- -------- -------------- --------------- Clifford M. Sobel(1).... 1998 100,000 -- -- -- Chairman and President David Greenblatt........ 1998 113,174 -- 20,000 -- Chief Operating Officer H. Jeff Goldberg........ 1998 206,169 -- 50,000 -- Chief Technology Officer
- --------------------- (1) Mr. Sobel served as our Chief Executive Officer from October 1997 to January 1999 and our President from October 1997 to July 1999. Option Grants During Fiscal 1998 No options to purchase shares of Net2Phone were granted to the executive officers named above during fiscal 1998. The following table describes the options to acquire shares of common stock of IDT granted to the individuals named above during fiscal 1998:
Potential Realizable Value % of at Number of Total Assumed Annual Securities Options Rates of Stock Under- Granted Price lying IDT to Exercise Appreciation Options Employees of for Option Term Granted in Fiscal Base Price Expiration ----------------- Name (#) Year (%) ($/Sh) Date 5% ($) 10% ($) - ---- ---------- --------- ---------- ---------- ------- --------- David Greenblatt.. 20,000 1.6 $18.00 Nov. 2007 226,402 573,747 H. Jeff Goldberg.. 50,000 4.0 $24.25 June 2008 762,534 1,932,413
Value of IDT Options at Year End The following table describes the value of IDT options exercised in fiscal 1998 and the value of unexercised options held by the individuals named above at July 31, 1998:
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 --------------------------- ----------------------------- Names Exercise Value Realized Exercisable/Unexercisable Exercisable/Unexercisable (1) - ----- ----------- -------------- --------------------------- ----------------------------- Clifford M. Sobel(2).... 100,000 $1,701,500 100,000/875,000 $1,775,000/-- David Greenblatt........ -- -- 20,000/0 125,000/-- H. Jeff Goldberg........ 5,000 111,250 210,000/50,000 3,556,500/0
- --------------------- (1) The closing price of IDT's common stock on July 31, 1998, as reported on the Nasdaq National Market, was $24.25 per share. (2) Mr. Sobel has an option that may be exercised beginning in September 1999, to transfer his shares of Net2Phone to IDT in exchange for an option to acquire 875,000 shares of IDT common stock at a purchase price of $6.50 per share. Mr. Sobel will be prohibited by an agreement with the underwriters from exercising this option during the 180-day period following the date of this prospectus. 48 Value of Net2Phone Options at Year End The following table describes the value of Net2Phone options exercised in fiscal 1998 and the value of unexercised options held by Clifford M. Sobel, our Chairman and President, at July 31, 1998. None of the other individuals named in the Summary Compensation Table were granted options to purchase shares of Net2Phone prior to fiscal 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 Value ---------------------------- ---------------------------- Names Exercise Realized(1) Exercisable/Unexercisable(2) Exercisable/Unexercisable(2) - ----- --------- ----------- ---------------------------- ---------------------------- Clifford M. Sobel....... 3,096,000 $ 0 0/347,865 0/--
- --------------------- (1) For purposes of this table, the per share value of each share of Net2Phone common stock in January 1998 is assumed to be $.03 per share, based upon a valuation report prepared by an independent appraiser. (2) Mr. Sobel received options to purchase an aggregate of 11% of Net2Phone's capital stock in connection with his May 1997 employment agreement. Mr. Sobel exercised his option to purchase 10% of Net2Phone's capital stock in January 1998, and his option to purchase the additional 1% of Net2Phone's capital stock terminated under an amendment to his employment agreement entered into in May 1999. Mr. Sobel does not currently own any options to purchase shares of Net2Phone. Compensation of Directors We intend to grant options to purchase shares of common stock to all of our non-employee directors under the 1999 Stock Incentive Plan, other than non- employee directors who serve as officers of IDT. See "1999 Stock Incentive Plan." Other than as will be provided in that plan and the reimbursement of reasonable expenses incurred with attending board and committee meetings, we have not yet adopted specific policies on directors' compensation and benefits following the closing of this offering. 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. On the closing date of this offering, Mr. Sobel will receive from IDT that number of shares of our common stock which will maintain his holdings, when combined with shares owned by a trust for the benefit of his offspring, at 8% of our total outstanding capital stock as of that date. Mr. Sobel's employment agreement also 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 will be prohibited by an agreement with the underwriters from exercising this option during the 180-day period following the date of this prospectus. On July 2, 1999, we signed a three-year employment agreement with Jonathan Fram, who has become our President. After the initial term, 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 49 vested and exercisable. The options to purchase the remaining 460,000 shares were granted at the lower of our initial public offering price or $11.00. Other than those options vesting July 20, 1999, the remaining 766,667 options will vest in three equal annual installments, commencing on July 20, 2000. We also have agreed to extend a three-year, non-recourse, 7% loan to Mr. Fram in the amount of $1,000,000 to purchase shares of our common stock in this offering. Mr. Fram has agreed not sell any of his shares of our stock during the 180-day period following the date of this prospectus. See also "Certain Transactions-- Officer Loans." 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 through June 21, 1999, and 1,345,219 of which have been exercised. 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 6,996 shares were cancelled in connection with the termination of the employment of four grantees. We expect to grant options to purchase approximately 2,011,000 additional shares of our common stock upon the consummation of this offering. 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 will be granted to each eligible 50 non-employee director upon consummation of this offering 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. 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 further 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. 51 Compensation Committee Interlocks and Insider Participation. We did not have a compensation committee during fiscal 1998. Compensation decisions relating to our executive officers, key employees and other senior personnel were made primarily by IDT, which owned all of our outstanding capital stock at the beginning of fiscal 1998. During fiscal 1998, Howard S. Jonas, who was serving as our chairman, and Howard S. Balter, who was serving as our treasurer, also served as directors of IDT. 401(k) Plan Prior to May 1999, our employees participated in IDT's 401(k) Savings and Retirement Plan. We are in the process of establishing our own 401(k) plan that is intended to qualify for preferential tax treatment under section 401(k) of the Internal Revenue Code. We intend that most of our employees will be eligible to participate in our 401(k) Savings and Retirement Plan upon adoption. 52 PRINCIPAL STOCKHOLDERS The following table sets forth information with respect to the beneficial ownership of our outstanding common stock as of July 13, 1999 and as adjusted to reflect the sale of the common stock offered hereby by: . each person who is the beneficial owner of more than 5% of our capital stock; . each of our directors and director nominees; . each of our named executive officers; and . all of our named executive officers, directors and director nominees as a group. Except as otherwise indicated, all of the shares indicated in the table are shares of common stock.
Percentage Number of Shares Beneficially Beneficially Owned Owned(1) --------------------- ----------------- Prior to After Prior to After Holders Offering Offering Offering Offering - -------------------------------------- ---------- ---------- -------- -------- IDT Corporation(2).................... 27,621,982 27,237,979 65.8% 58.2% 190 Main Street Hackensack, New Jersey 07601 Howard S. Jonas(3).................... 27,621,982 27,237,979 65.8% 58.2% c/o IDT Corporation 190 Main Street Hackensack, New Jersey 07601 James A. Courter(4)................... 27,657,982 28,041,985 65.9% 59.9% c/o IDT Corporation 190 Main Street Hackensack, New Jersey 07601 SOFTBANK Technology Ventures IV, L.P.(5).............................. 4,590,000 4,590,000 10.9% 9.8% 333 West San Carlos Street, Suite 1225 San Jose, California 95110 Gary E. Rieschel(6)(7)................ 4,590,000 4,600,000 10.9% 9.8% c/o SOFTBANK Technology Ventures IV, L.P. 333 West San Carlos Street, Suite 1225 San Jose, California 95110 Clifford M. Sobel(8).................. 3,359,806 3,743,809 8.0% 8.0% c/o Net2Phone, Inc. 171 Main Street Hackensack, New Jersey 07601 America Online, Inc.(9)............... 2,295,000 2,295,000 5.5% 4.9% 22000 AOL Way Dulles, Virginia 20166 General Electric Company Group(10).... 2,295,000 2,795,000 5.5% 6.0% 120 Long Ridge Road Stamford, Connecticut 06927 Howard S. Balter(7)(11)............... 714,978 782,028 1.7% 1.7% David Greenblatt(7)(12)............... 105,840 135,840 * * H. Jeff Goldberg(7)(13)............... 105,840 120,840 * * James R. Mellor(7).................... -- 10,000 * * Stephen A. Oxman(7)................... -- 10,000 * * Raphael S. Grunfeld................... -- -- * * Officers, Directors and Director Nominees as a Group (15 Persons)(14)..................... 36,736,461 36,836,461 87.5% 78.6%
53 - --------------------- * Less than one percent. (1) Percentage of beneficial ownership prior to this offering is based on 4,683,237 shares of common stock and 27,621,982 shares of Class A stock outstanding at June 25, 1999 plus 9,420,000 shares of Class A stock issuable upon conversion of the Series A convertible preferred stock at the same date and the exercise of 272,400 warrants to purchase our common stock. Percentage of beneficial ownership after this offering is based on 46,797,619 total shares outstanding, which includes all shares outstanding prior to this offering, plus 4,800,000 shares of common stock to be sold in this offering at an assumed price of $10 per share. All percentage calculations assume that all shares of Net2Phone's Class A stock have been converted into shares of Net2Phone's 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 consummation of this offering. Unless IDT defaults in its obligations under the pledge agreement, it has the voting rights with respect to the pledged stock. In addition, in connection with the employment agreement between IDT, Mr. Sobel and Net2Phone, IDT will transfer to Mr. Sobel the number of shares of stock upon consummation of this offering that is necessary to maintain Mr. Sobel's percentage ownership of our outstanding stock, together with a trust for the benefit of his offspring, at 8%. (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. As a result, he may be deemed to be the beneficial owner of the shares of Net2Phone 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 Net2Phone capital stock owned by IDT. Mr. Courter disclaims beneficial ownership of these additional shares. (5) Includes 4,415,400 shares of Class A stock and 88,308 shares of common stock issuable upon conversion of shares of Series A convertible preferred stock and presently exercisable warrants, respectively, that have been issued to SOFTBANK Technology Ventures IV, L.P. Also includes 84,600 shares of Class A stock and 1,692 shares of common stock issuable upon conversion of shares of Series A preferred stock and presently exercisable warrants, respectively, that have been issued to 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. (7) Shares owned after the offering include 10,000, 67,050, 30,000, 15,000, 10,000 and 10,000, shares of common stock that will be issuable upon the exercise of stock options that we expect to issue to Messrs. Rieschel, Balter, Greenblatt, Goldberg, Mellor and Oxman, respectively, upon the closing of this offering that will be immediately exercisable. (8) Clifford M. Sobel transferred 1% of our common stock to a trust for the benefit of his offspring. All of these shares are deemed to be beneficially owned by Mr. Sobel. In addition, in connection with the employment agreement between IDT, Mr. Sobel and Net2Phone, IDT will transfer to Mr. Sobel the number of shares of stock upon consummation of this offering that is necessary to maintain Mr. Sobel's percentage ownership of our outstanding stock, together with a trust for the benefit of his offspring, at 8%. (9) Includes 2,250,000 shares of Class A stock and 45,000 shares of common stock issuable upon conversion of shares of Series A convertible preferred stock and issuable upon exercise of presently exercisable warrants, respectively. (10) Includes 1,125,000 of Class A stock issuable upon conversion of shares of Series A convertible preferred stock that are held of record by GE Capital Equity Investments, Inc., which shares beneficial ownership with its parent General Electric Capital Corporation, which is a wholly-owned subsidiary of the General Electric Company. Also includes 1,125,000 shares of Class A stock issuable upon exercise of shares of Series A convertible preferred stock that are beneficially owned by NBC, a wholly-owned indirect subsidiary of the General Electric Company, of which 300,000 shares are issuable upon conversion of shares of Series A convertible preferred stock that are held of record by Snap! LLC, an Internet portal service of NBC and CNET, Inc. Includes 22,500, 16,500 and 6,000 shares of common stock issuable upon exercise of warrants held by GE Capital Equity Investments, NBC and Snap! LLC, respectively. Includes the purchase by NBC of 300,000 shares in this offering and the purchase by GE Capital of 200,000 shares in this offering. (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 183,840 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. (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. (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. (14) Includes the shares of Class A stock held by IDT and the shares of Class A stock and the shares of common stock issuable upon exercise of presently exercisable warrants held by SOFTBANK. Also includes 195,050 shares of common stock that will be granted to our directors and executive officers upon the closing of this offering. Includes the issuance of 153,333 options to Mr. Fram prior to the offering. Includes the purchase by Mr. Fram of 100,000 shares in this offering. 54 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 58.2% 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 65.2% 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. 55 Net2Phone Services Agreement In connection with this agreement, we will support IDT's debit card platform, provide technical support for the debit card platform, order lines to handle calls, manage the debit card database and monitor 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 debit 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 debit 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. In the event 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 56 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. 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 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 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. Further, IDT has 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; 57 . 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. 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. Expenses We have agreed to pay all third-party costs, fees and expenses relating to this offering, all of the reimbursable expenses of the underwriters pursuant to the underwriting agreement, all of the costs of 58 producing, printing, mailing and otherwise distributing this prospectus, as well as the underwriters' discount as provided in the underwriting agreement. See "Underwriting." Except as expressly set forth in the agreements between us and IDT, whether or not this offering is consummated, each party shall bear its own respective third-party fees, costs and expenses paid or incurred in connection with this offering. 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). These advances have been converted into a note that is payable in 60 monthly installments of principal and interest. $7.0 million of the proceeds of this offering will be used to prepay a portion of the note. The balance of the note is payable in 60 monthly installments of principal and interest at a rate of 9% per annum. Relationship with Other Investors Series A Subscription Agreements Pursuant to Series A Subscription Agreements, dated as of May 13, 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 180,000 shares of our common stock, which expire upon the closing of this offering, for a net aggregate purchase price of $29.9 million. 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. This warrant expires upon the closing of this 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 on or after the earlier to occur of the second anniversary of the Series A offering or 180 days following the consummation of this offering. 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. 59 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 for a period of 180 days following this offering. 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, and thereafter only subject to our right of first refusal. However, the stockholders agreement does permit transfers between Series A investors. Agreements with NBC 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. Upon the closing of this offering, assuming that NBC purchases 300,000 shares in this offering, NBC will beneficially own 1,125,000 shares of our Series A stock and 316,500 shares of our common stock. Agreements with Netscape We signed a series of related agreements with Netscape 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 Netscape Netcenter 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% of our common stock upon the closing of this offering. Agreement with Snap We entered into an agreement with Snap on May 17, 1999. Snap, an Internet postal 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 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. 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. 60 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 Net2Phone 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 agreed to surrender their respective right to exercise 8,862, 2,160, 2,160, 2,160, 2,160, 600 and 270 immediately exercisable options, respectively. Additionally, in July 1999 we agreed to extend a three-year, non- recourse, 7% loan to Jonathan Fram, our President, in the amount of $1,000,000 to purchase shares of our common stock in this offering. Relationship with Law Firm Ira A. Greenstein, our General Counsel and Secretary, and Raphael S. Grunfeld, a director nominee, are partners of the law firm Morrison & Foerster LLP, which has provided legal services to us and to IDT and its subsidiaries since December 1996, and in connection with this offering. 61 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: . 6,850,000 shares of preferred stock, $0.01 par value; . 3,150,000 shares of Series A convertible 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, 4,800,000 shares of our common stock are being offered through this prospectus. Immediately following the closing of the offering, 10,161,429 shares of common stock and 36,636,190 shares of Class A stock will be outstanding. As of July 7, 1999, there were 17 holders of our Series A convertible preferred stock, one holder of our Class A stock and 33 holders of our common stock. 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 June 25, 1999, there were 4,683,129 shares of common stock outstanding and 27,622,089 shares of Class A stock outstanding. An additional 9,420,000 shares of Class A stock are issuable upon conversion of our outstanding Series A convertible preferred stock. 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. IDT will hold 58.2% of our Class A stock upon consummation of this offering. Accordingly, IDT will retain effective control of us through holding approximately 65.2% 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 62 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. 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 further vote or action by the stockholders. 3,150,000 shares of the preferred stock have been designated as Series A. 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 will automatically convert into 9,420,000 shares of our Class A stock at the closing of this offering. 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 further 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 63 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. 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. 64 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 will be the transfer agent and registrar for the common stock. SHARES ELIGIBLE FOR FUTURE SALE Of the 10,161,429 shares of common stock and 36,636,190 shares of Class A stock to be outstanding on the closing of the offering (10,939,029 shares of common stock if the underwriters exercise their over-allotment option in full), the 4,800,000 shares of common stock sold in the offering (5,520,000 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. On the closing of the offering, IDT will own 27,216,190 shares of Class A stock, which will constitute approximately 58.2% of our outstanding capital stock (approximately 57.2% if the underwriters exercise their over-allotment option in full). 65 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. Upon closing of this offering, we intend to file a registration statement for the resale of 11,040,000 shares of common stock that are authorized for issuance under our stock option plan. We expect this registration statement to become effective immediately upon filing. Shares issued pursuant to our stock option plan after the effective date of this registration statement (other than shares issued to our affiliates) generally will be freely tradable without restriction or further registration under the Securities Act of 1933. As of the date of this prospectus, options to purchase 5,040,000 shares of common stock under our stock option plan have been granted, of which 1,375,218 have been exercised. See "Management--1999 Stock Incentive Plan" for a more complete description of our employee benefit plans. 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 each of our security-holders, our directors and executive officers, IDT and the Series A investors have agreed, for a period of 180 days after the date of this 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." Upon closing of this offering, the holders of 9,420,000 shares of our Class A stock, or their transferees, will be entitled to request that we register their shares under the Securities Act. See "Certain Transactions--Relationship with Other Investors--Registration Rights Agreement." 66 UNDERWRITING Subject to the terms and conditions of the Underwriting Agreement, the underwriters named below, through their representatives, Hambrecht & Quist LLC, BT Alex. Brown Incorporated and Bear, Stearns & Co. Inc., have severally agreed to purchase from Net2Phone the following respective number of shares of common stock:
Number of Name Shares ---- --------- Hambrecht & Quist LLC................... BT Alex. Brown Incorporated............. Bear, Stearns & Co. Inc................. --------- Total................................... 4,800,000 =========
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 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
With Without 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 $1.5 million. The underwriters propose to offer the shares of common stock directly to the public at the initial 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 the initial public offering of the shares, the offering price and other selling terms may be changed by the underwriters. We have granted to the underwriters an option, exercisable no later than 30 days after the date of this prospectus, to purchase up to 720,000 additional shares of common stock at the initial 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 table bears to the total number of shares of common stock offered hereby. We 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 offered by us. 67 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 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. All of our security-holders, including the Series A investors, IDT, and our executive officers and directors have 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 the date of this prospectus. We have agreed that we 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 for a period of 180 days following the date of this prospectus, 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 during this 180-day period. 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. Prior to this offering, there has been no public market for our common stock. The initial public offering price for the common stock will be determined by negotiations among us and the representatives. Among the factors to be considered in determining the initial public offering price will be prevailing market and economic conditions, our revenue and earnings, market valuations of other companies engaged in activities similar to our business operations and our management. The estimated initial public offering price range set forth on the cover of this preliminary prospectus is subject to change as a result of market conditions or other factors. At our request the underwriters have reserved at the initial public offering price the number of shares of common stock that may be purchased for $3.0 million for sale to NBC and the number of shares of common stock that may be purchased for $2.0 million for sale to GE Capital. Based upon the low end of the estimated range on the front cover of this prospectus, NBC may therefore purchase up to 300,000 shares of our common stock and GE Capital may therefore purchase up to 200,000 shares of our common stock. NBC and GE Capital have expressed an interest in purchasing these shares, which will be subject to a lock-up agreement that each company has entered into with the underwriters, under which they agreed not to sell shares for 180 days after the date of this prospectus. There can be no assurance that any of the reserved shares will be purchased. The number of shares available for sale to the general public in this offering will be reduced by the number of reserved shares sold. Any reserved shares not so purchased will be offered to the general public on the same basis as the other shares offered hereby. 68 In addition, at our request, the underwriters have reserved up to 240,000 shares of common stock for sale at the initial public offering price to our directors, officers, employees, business associates and related persons. The number of shares of common stock available for sale to the general public will be reduced if such persons purchase the reserved shares. Any reserved shares which are not so purchased will be offered by the underwriters to the general public on the same basis as the other shares offered hereby. 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 20,000 shares of Series A convertible preferred stock and warrants to purchase 92,400 shares of common stock at an exercise price of $3.33 per share, which warrants expire upon the closing of this offering. Additionally, Access Technology Partners, L.P., a fund of outside investors that is managed by a subsidiary of Hambrecht & Quist California, owns 80,000 shares of Series A convertible preferred stock. BT Alex. Brown Incorporated and persons associated with BT Alex. Brown Incorporated own 40,000 shares of Series A convertible preferred stock. Additionally, Stephen A. Oxman, one of our director nominees, and a managing director at Deutsche Bank Securities Inc., an affiliate of BT Alex. Brown Incorporated, will receive options to purchase 10,000 shares of common stock at the offering price upon the closing of this offering. Denis Bovin, Vice Chairman-Investment Banking of Bear, Stearns & Co. Inc., owns options to purchase 75,000 shares of common stock at an exercise price of $3.33 per share, which expire in May 2009. Addition- ally, Mr. Bovin will receive options to purchase 50,000 shares of common stock at the offering price upon the consummation of this offering. Prior to the closing of this offering, each of Hambrecht & Quist LLC and persons associated with it, BT Alex. Brown Incorporated and persons associated with it, Denis Bovin and Stephen A. Oxman will enter into written agreements with Net2Phone, whereby each of them will agree, for a period of one year from the date of this prospectus, not to sell or otherwise transfer any shares of capital stock, or options or warrants to purchase common stock, owned by them that are deemed to be underwriting compensation. Hambrecht & Quist LLC and BT Alex. Brown Incorporated have provided financial advisory services to Net2Phone and IDT in the past and have received compensation at market rates for these services. 69 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. Ira A. Greenstein, our General Counsel and Secretary, and Raphael S. Grunfeld, one of our director nominees, are partners of Morrison & Foerster LLP. 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, July 31, 1997 and July 31, 1998 and for the period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998, 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. 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 further 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. On the closing of the offering, we will be 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. 70 INDEX TO FINANCIAL STATEMENTS
Page ---- Report of Independent Auditors............................................ F-2 Balance Sheets as of July 31, 1997 and 1998 and April 30, 1999 (Unaudited).............................................................. F-3 Statements of Operations for the period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999 (Unaudited)............ F-4 Statements of Stockholders' Deficit for the period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1999 (Unaudited)............ F-5 Statements of Cash Flows for the period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999 (Unaudited)............ 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. and, for the periods prior to its incorporation, the Net2Phone division of IDT Corporation (the "Company") as of July 31, 1997 and 1998, and the related statements of operations, stockholders' deficit and cash flows for the period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998. 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, 1997 and 1998 and the results of its operations and its cash flows for the period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998, in conformity with generally accepted accounting principles. Ernst & Young LLP New York, New York May 11, 1999, except for Note 9, the date of which is June 25, 1999 F-2 Net2Phone, Inc. BALANCE SHEETS
July 31 April 30 ------------------------ ----------- 1997 1998 1999 ----------- ----------- ----------- (Unaudited) Assets Current assets: Cash and cash equivalents............. $ -- $ 10,074 $ 1,782,194 Trade accounts receivable, net........ 16,500 1,465,475 329,577 Due from IDT Corporation.............. -- -- 346,176 Prepaid contract deposits............. -- -- 4,000,000 Other current assets.................. -- -- 31,051 ----------- ----------- ----------- Total current assets................ 16,500 1,475,549 6,488,998 Property and equipment, net............. 899,525 5,409,061 8,228,218 Trademark, net.......................... -- -- 5,000,000 Other assets............................ -- 90,498 101,112 ----------- ----------- ----------- Total assets........................ $ 916,025 $ 6,975,108 $19,818,328 =========== =========== =========== Liabilities and stockholders' deficit Current liabilities: Accounts payable...................... $ -- $ -- $ 248,675 Deferred revenue...................... 161,001 810,114 1,495,775 Due to IDT Corporation................ 2,960,429 11,814,988 22,000,000 ----------- ----------- ----------- Total current liabilities........... 3,121,430 12,625,102 23,744,450 Commitments and contingencies Redeemable convertible preferred stock, Series A, $.01 par value; authorized shares-- 3,150,000; no shares issued and outstanding.......................... -- -- -- Stockholders' deficit: Preferred stock, $.01 par value; authorized shares--6,850,000; no shares issued and outstanding........ -- -- -- Common stock, $.01 par value; authorized shares-- 200,000,000; 30,960,000 shares issued and outstanding at July 31, 1998 and April 30, 1999 (None at July 31, 1997)................................ -- 100,100 309,600 Class A stock, $.01 par value; authorized shares 37,042,089; no shares issued and outstanding........ -- -- -- Additional paid-in capital............ -- -- 4,420,338 Accumulated deficit................... (2,205,405) (5,750,094) (8,656,060) ----------- ----------- ----------- Total stockholders' deficit......... (2,205,405) (5,649,994) (3,926,122) ----------- ----------- ----------- Total liabilities and stockholders' deficit............................ $ 916,025 $ 6,975,108 $19,818,328 =========== =========== ===========
See accompanying notes. F-3 Net2Phone, Inc. STATEMENTS OF OPERATIONS
Period from January 2, 1996 (date of inception) Nine months ended April to July 31 Year ended July 31 30 ------------------- ------------------------- ------------------------- 1996 1997 1998 1998 1999 ------------------- ----------- ------------ ----------- ------------ (Unaudited) Revenues: Service revenue....... $ -- $ 2,652,303 $ 10,490,972 $ 6,439,374 $ 21,757,721 Product revenue....... -- -- 1,515,000 1,515,000 445,536 ---------- ----------- ------------ ----------- ------------ Total revenue....... -- 2,652,303 12,005,972 7,954,374 22,203,257 Costs and expenses: Direct cost of revenue: Service cost of revenue*............. -- 1,547,443 6,576,523 3,317,065 11,787,689 Product cost of revenue*............. -- 6,000 272,236 272,236 60,400 ---------- ----------- ------------ ----------- ------------ Total direct cost of revenue*........... -- 1,553,443 6,848,759 3,589,301 11,848,089 Selling and marketing............ 34,468 76,724 2,887,766 1,363,060 4,746,316 General and administrative....... 465,015 2,599,283 5,087,628 3,254,287 7,298,106 Depreciation.......... 8,275 120,500 726,508 421,648 1,216,712 ---------- ----------- ------------ ----------- ------------ Total costs and expenses........... 507,758 4,349,950 15,550,661 8,628,296 25,109,223 ---------- ----------- ------------ ----------- ------------ Loss from operations before provision for income taxes........... (507,758) (1,697,647) (3,544,689) (673,922) (2,905,966) Provision for income taxes.................. -- -- -- -- -- ---------- ----------- ------------ ----------- ------------ Net loss................ $ (507,758) $(1,697,647) $ (3,544,689) $ (673,922) $ (2,905,966) ========== =========== ============ =========== ============ Net loss per share-- basic and diluted...... $ (0.02) $ (0.06) $ (0.12) $ (0.02) $ (0.09) ========== =========== ============ =========== ============ Weighted average number of shares used in calculation of basic and diluted net loss per share.............. 27,864,000 27,864,000 30,186,000 29,928,000 30,960,000 ========== =========== ============ =========== ============
- -------- * Excludes depreciation and amortization See accompanying notes. F-4 Net2Phone, Inc. STATEMENTS OF STOCKHOLDERS' DEFICIT Period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1999 (unaudited with respect to the nine months ended April 30, 1999)
Common Stock Additional Total ------------------- Paid-In Accumulated Stockholders' Shares Amount Capital Deficit Deficit ---------- -------- ---------- ----------- ------------- Net loss for the period January 2, 1996 (date of inception) to July 31, 1996............. -- $ -- $ -- $ (507,758) $ (507,758) ---------- -------- ---------- ----------- ----------- Balance at July 31, 1996 ....................... -- -- -- (507,758) (507,758) Net loss for the year ended July 31, 1997.. -- -- -- (1,697,647) (1,697,647) ---------- -------- ---------- ----------- ----------- Balance at July 31, 1997................... -- -- -- (2,205,405) (2,205,405) Issuance of Stock to IDT Corporation...... 27,864,000 100 -- -- 100 Sale of Common Stock to officer........... 3,096,000 100,000 -- -- 100,000 Net loss for the year ended July 31, 1998........ -- -- -- (3,544,689) (3,544,689) ---------- -------- ---------- ----------- ----------- Balance at July 31, 1998................... 30,960,000 100,100 -- (5,750,094) (5,649,994) Capital contributions from IDT Corporation.......... -- 209,500 4,420,338 -- 4,629,838 Net loss for the nine months ended April 30, 1999............. -- -- -- (2,905,966) (2,905,966) ---------- -------- ---------- ----------- ----------- Balance at April 30, 1999................... 30,960,000 $309,600 $4,420,338 $(8,656,060) $(3,926,122) ========== ======== ========== =========== ===========
See accompanying notes. F-5 Net2Phone, Inc. STATEMENTS OF CASH FLOWS
Period from January 2, 1996 (date of Nine months ended inception) Year ended July 31 April 30 to July 31 ------------------------ ----------------------- 1996 1997 1998 1998 1999 --------------- ----------- ----------- ---------- ----------- (Unaudited) Operating activities Net loss................ $(507,758) $(1,697,647) $(3,544,689) $ (673,922) $(2,905,966) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation........... 8,275 120,500 726,508 421,648 1,216,712 Changes in assets and liabilities: Accounts receivable.. -- (16,500) (1,448,975) (555,000) 1,135,898 Due from IDT Corporation......... -- -- -- -- (346,176) Prepaid contract deposits............ -- -- -- -- (4,000,000) Other current assets.............. -- -- -- -- (31,051) Other assets......... -- -- (90,498) (73,323) (10,614) Accounts Payable..... -- -- -- -- 248,675 Deferred revenue..... -- 161,001 649,113 471,524 685,661 --------- ----------- ----------- ---------- ----------- Net cash used in operating activities... (499,483) (1,432,646) (3,708,541) (409,073) (4,006,861) Investing activities Purchase of trademark... -- -- -- -- (5,000,000) Purchases of property and equipment.......... (182,949) (845,351) (5,236,044) (4,230,909) (4,035,869) --------- ----------- ----------- ---------- ----------- Net cash used in investing activities... (182,949) (845,351) (5,236,044) (4,230,909) (9,035,869) Financing activities Proceeds from issuance of Common Stock to IDT Corporation -- -- 100 100 -- Proceeds from issuance Common Stock to officer................ -- -- 100,000 -- -- Capital contributions from IDT Corporation... -- -- -- -- 4,629,838 Net advances from IDT Corporation............ 682,432 2,277,897 8,854,559 4,639,882 10,185,012 --------- ----------- ----------- ---------- ----------- Net cash provided by financing activities... 682,432 2,277,987 8,954,659 4,639,982 14,814,850 --------- ----------- ----------- ---------- ----------- Net increase in cash and cash equivalents....... -- -- 10,074 -- 1,772,120 Cash and cash equivalents at beginning of period.... -- -- -- -- 10,074 --------- ----------- ----------- ---------- ----------- Cash and cash equivalents at end of period................. $ -- $ -- $ 10,074 $ -- $ 1,782,194 ========= =========== =========== ========== =========== 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, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 1. Description of Business and Basis of Presentation The accompanying financial statements reflect the historical financial information of Net2Phone, Inc. and, for the periods prior to its incorporation, the Net2Phone division of IDT Corporation (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 4). 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. 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. Interim Financial Information The unaudited interim information as of April 30, 1999 and for the nine months ended April 30, 1998 and 1999 has been prepared on the same basis as the annual financial statements and, in the opinion of the Company's management, contains all adjustments (consisting of normal recurring accruals) necessary for a fair presentation. Operating results for any interim period are not necessarily indicative of results to be expected for the entire year. 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 4) 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. F-7 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 2. Summary of Significant Accounting Policies (continued) Advertising Costs The Company expenses the costs of advertising as incurred. For the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999, advertising expense totaled approximately $6,000, $1,962,000, $888,000, and $3,165,000, respectively. There was no advertising expense for the period from January 2, 1996 (date of inception) to July 31, 1996. 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. To date, the Company has essentially completed its software development concurrently with the establishment of technological feasibility and, accordingly, no such costs have been capitalized to date. Software development costs are the Company's only research and development expenditures. For the period from January 2, 1996 (date of inception) to July 31, 1996, software development costs of $340,000 were expensed. No software development costs were expensed for the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999. Capitalized Internal Use Software Costs In March 1998, the Accounting Standards Executive Committee of the AICPA issued Statement of Position ("SOP") 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. The SOP, which has been adopted by the Company requires the capitalization of certain costs incurred in connection with developing or obtaining internal use software. The Company's policy prior to the adoption of the SOP was to capitalize substantially all internal use software costs. These costs consisted of payments made to third parties and the salaries of employees working on such software development. Therefore, the adoption of the SOP did not have a material effect on the Company's financial position or results of operations. At July 31, 1997 and 1998 and April 30, 1999, the Company has capitalized $493,000, $2,198,000 and $3,598,000, 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 two year term of the agreement. 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 applies the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation. The Company accounts for stock options using APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. Options issued to non-employees are accounted for in accordance with SFAS No. 123. F-8 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 2. Summary of Significant Accounting Policies (continued) Earnings (Loss) Per Share Earnings (loss) per share is calculated in accordance with FASB Statement No. 128, Earnings 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. Recently Issued Financial Accounting Standards SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, was issued in June 1997. The Company will be required to adopt the new statement for the year ending July 31, 1999. 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 disaggregates a company. The Company intends to adopt this statement in fiscal 1999 and does not anticipate that the adoption of the statement will have significant impact on its financial statements. 3. Property and Equipment Property and equipment consists of the following:
July 31 April 30 --------------------- ---------- 1997 1998 1999 --------- ---------- ---------- Equipment............................... $ 348,625 $3,631,140 $6,094,189 Computer software....................... 679,484 2,595,572 4,118,590 Furniture and fixtures.................. 191 37,632 87,415 --------- ---------- ---------- 1,028,300 6,264,344 10,300,194 Accumulated depreciation................ (128,775) (855,283) (2,071,976) --------- ---------- ---------- Property and equipment, net............. $ 899,525 $5,409,061 $8,228,218 ========= ========== ==========
4. 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. F-9 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 4. Related Party Transactions (continued) 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. 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 to IDT's total payroll and the Company's total revenue to IDT's total 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 period from January 2, 1996 (date of inception) to July 31, 1996 and the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999, all of the Company's operations were financed by IDT. For the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999, the Company recognized revenue for services provided to IDT of $297,000, $453,000, $323,000, and $680,000, respectively. At July 31, 1997 and 1998 and April 30, 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 period from January 2, 1996 (date of inception) to July 31, 1996, the years ended July 31, 1997 and 1998, and the nine months ended April 30, 1999 and 1998 were $341,000, $1,821,000, $7,388,000, $16,907,000 and $5,280,000, respectively. F-10 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 4. Related Party Transactions (continued) The activity in the intercompany account with IDT was as follows:
Period from Nine months January 2, 1996 Year Ended July 31 ended (date of inception) ----------------------- April 30, to July 31, 1996 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... 315,565 1,225,771 6,955,525 7,234,992 Net charges to the Company for services provided by IDT........ 366,867 1,349,226 2,351,934 3,420,520 Revenue recognized by the Company for services provided to IDT.................... -- (297,000) (453,000) (680,000) Capital contribution from IDT............... -- -- 100 209,500 -------- ---------- ----------- ----------- Ending balance.......... $682,432 $2,960,429 $11,814,988 $22,000,000 ======== ========== =========== ===========
5. Income Taxes The Company files a consolidated Federal income tax return with IDT 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. When IDT's ownership interest in the Company falls below 80%, 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 April 30 ------------------ --------- 1997 1998 1999 -------- --------- --------- Deferred tax assets: Net operating loss carryforwards.......... $ -- $ 314,000 $ 670,000 Deferred tax liabilities: Depreciation.............................. -- (300,000) (609,000) -------- --------- --------- Net deferred tax assets................... -- 14,000 61,000 Valuation allowance....................... -- (14,000) (61,000) -------- --------- --------- 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 April 30, 1999, the Company had net operating loss carryforwards for state income tax purposes of approximately $7.5 million expiring in years through 2006. These net operating loss carryforwards may be limited to future taxable earnings of the Company.
Period from Year Ended Nine Months January 2, 1996 July 31 Ended April 30 (date of inception) -------------------- ------------------ to July 31, 1996 1997 1998 1998 1999 ------------------- -------- ---------- -------- -------- Tax at effective rate... (173,000) (577,000) (1,205,000) (229,000) (988,000) Benefit used by IDT for which the Company received no compensation........... 173,000 577,000 1,205,000 229,000 988,000 -------- -------- ---------- -------- -------- Tax provision........... -- -- -- -- -- ======== ======== ========== ======== ========
F-11 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 6. Stockholders' Deficit In April 1999, the Company amended and restated its Certificate of Incorporation (the "Amendment"). As a result of the Amendment, the Company increased its authorized shares of capital stock from 1,500 to 110,000,000, of which 100,000,000 shares are designated as common stock and 10,000,000 shares are designated as preferred stock. Subject to any voting rights which may be provided to future holders of preferred stock, the holders of common stock have exclusive voting rights on all matters requiring a vote of the Company and are entitled to one vote per share of common stock held. In conjunction with the Amendment, the Company effectuated a 10,320 for one stock split. The accompanying financial statements give retroactive effect to the stock split. 7. 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 $2.85 million through April 30, 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 $2.1 million attributable to monthly payments for advertising and the maintenance of the link was expensed monthly as incurred. As of April 30, 1999, the Company was required to make an additional payment of $150,000 in fiscal 1999 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 its Internet 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 $495,000 through April 30, 1999 for the Company advertisements on such site. As of April 30, 1999, the Company is required to make additional payments of $213,000 in fiscal 1999, $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. Advertising expense is recorded as payments are made, over two years, which the Company believes is the period over which the guaranteed advertising impressions will be provided. 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. Pursuant to such agreement, the Company has made payments of $1 million through April 30, 1999 which have been reflected on the consolidated balance sheets as prepaid contract deposits. As of April 30, 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. F-12 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 7. Commitments (continued) 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 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 April 30, 1999, the Company had paid $5 million for the right to use the trademark and $3 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. The agreement is automatically renewable on an annual basis after its initial three year term unless terminated by either party. 8. Customer and Geographical Area Revenue from customers outside the United States represented approximately 44%, 72%, 63%, and 58% of total revenue during the years ended July 31, 1997 and 1998 and the nine months ended April 30, 1998 and 1999, respectively. During the year ended July 31, 1998 and the nine months ended April 30, 1998, revenues derived from equipment sales to a customer in Korea represented approximately 14% and 19%, respectively, of total revenue. No single geographic area accounted for more than 10% of total revenue during the year ended July 31, 1997 and the nine months ended April 30, 1999. No customer accounted for more than 10% of revenue during the year ended July 31, 1997 and the nine months ended April 30, 1999. 9. Subsequent Events 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 or transferability. The Class A stock is entitled to two votes per share. 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. F-13 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Continued) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 9. Subsequent Events (continued) 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 will be repaid within 10 days of the consummation of a proposed initial public offering of the Company's common 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 entitles its holders to a non-cumulative dividend of 8% per annum on the original issue price. Each share of Series A Stock is convertible into three shares of Class A stock at the option of the holder, subject to certain adjustments as, defined. Each share of Series A stock also entitles its holders to vote on corporate matters on an as if converted basis. Holders of Series A Stock have priority over common stock and Class A stock with respect to the payment of dividends and in the event of the liquidation or dissolution of the Company. The liquidation preference of the Series A Stock is equivalent to the original issue price plus an amount equal to 8% of the original issue price compounded on an annual basis from the date of issuance plus any declared, but unpaid dividends. 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 contain a provision whereby they are automatically terminated upon a merger or sale of the Company or an initial public offering of the Company's stock. As a result, the warrants are expected to be exercised prior to the proposed initial public offering of the Company's common stock. 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 incentive and non-qualified stock options, stock appreciation rights, limited stock appreciation rights and restricted stock. In May 1999, a total of 5,040,000 shares of common stock were authorized for issuance under the plan to employees of the Company and to employees and consultants of IDT, all of which were granted with an exercise price of $3.33 per share and 1,345,219 of which were exercised through June 25, 1999. 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 $3,150,000 in loans to employees. In order to obtain such loans, the optionees agreed to the cancellation of 23,382 outstanding options. Compensation expense in connection with the options to purchase 3,718,503 shares of common stock issued to employees of the Company will be computed in accordance with APB 25. The expense will be computed as the difference between the exercise price of $3.33 per share and the fair market value of the stock on the date of grant ($1 per share). The deferred compensation expense of approximately $28.5 million will be amortized over the vesting period of the options. Compensation expense in connection with the options to purchase 1,321,497 shares of common stock issued to employees and consultants of IDT will be computed in accordance with F-14 Net2Phone, Inc. NOTES TO FINANCIAL STATEMENTS--(Concluded) July 31, 1998 (unaudited with respect to the nine months ended April 30, 1998 and 1999) 9. Subsequent Events (continued) FAS 123. The expense will be computed using the black scholes model with the fair market value of the common stock on date of grant equal to $11.00 per share. The deferred compensation expense of approximately $12.4 million will be amortized over the vesting period of the options. Compensation expense from both the options issued to the Company's employees and employees and consultants to IDT will be charged to expense over the vesting period: fiscal 1999, $14.8 million; fiscal 2000, $9.8 million; fiscal 2001, $9.8 million; and fiscal 2002, $6.5 million. On June 25, 1999 the shares authorized for issuance under the plan was increased by 6,000,000 shares. The Company entered into an agreement with Snap, an Internet postal 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 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 time 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. 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 the lower of the initial public offering price or $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 has also agreed to extend a three-year, 7% non-recourse loan to its President in the amount of $1,000,000 to purchase shares of its common stock upon the closing of this offering. The Company will record compensation in connection with (i) the issuance of options with an exercise price less than the fair market value of the stock and (ii) the non-recourse loan issued to purchase common stock. F-15 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 4,800,000 Shares [NET2PHONE LOGO] Common Stock ---------------- PROSPECTUS ---------------- HAMBRECHT & QUIST BT ALEX. BROWN ---------------- BEAR, STEARNS & CO. INC. ---------------- , 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. Until , 1999, all dealers that buy, sell or trade in our common stock, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers' obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 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........... $ 18,415 NASD filing fee............................................... 7,124 Nasdaq National Market listing fee............................ 5,000 Blue Sky filing fees and expenses............................. 20,000 Accounting fees and expenses.................................. 300,000 Legal fees and expenses....................................... 500,000 Transfer agent fees and expenses.............................. 3,500 Printing and engraving expenses............................... 400,000 Miscellaneous expenses........................................ 245,961 ---------- Total....................................................... $1,500,000 ==========
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 are convertible into 9,420,000 shares of our common stock, together with warrants to purchase 180,000 shares of our class A stock to several investors for an aggregate of $31,400,000, pursuant to Series A Subscription Agreements, dated as of May 13, 1999. This transaction was exempt from registration under Section 4(2) of the Securities Act of 1933. We also issued a warrant to purchase 92,400 shares of our common stock to the placement agent as partial consideration for its services. This transaction was 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 approximately 1,345,219 shares of common stock upon exercise of these options. These transactions were exempt from registration under Section 4(2) of the Securities Act of 1933. II-1 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. 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. 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.
II-2
Exhibit Number Description of Exhibit ------- ---------------------- 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. 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 (set forth on the signature page to this registration statement). 27.1+ Financial Data Schedule. 99.1+ Consent of Director Nominee, Raphael S. Grunfeld. 99.2+ Consent of Director Nominee, Stephen A. Oxman.
- -------- *To be filed by amendment. # Confidential treatment has been requested with respect to certain portions of the Exhibit. Omitted portions will be filed separately with the Securities and Exchange Commission. + Previously filed. 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 Purchase 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 II-3 497(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 June 28, 1999. Net2Phone, Inc. /s/ Howard S. Balter By: _________________________________ Howard S. Balter Chief Executive Officer POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints and hereby authorizes Howard S. Balter and Ilan M. Slasky, severally, such person's true and lawful attorneys-in-fact, with full power of substitution or resubstitution, for such person and in such person's name, place and stead, in any and all capacities, to sign on such person's behalf, individually and in each capacity stated below, any and all amendments, including post-effective amendments to this registration statement and to sign any and all additional registration statements relating to the same offering of securities as this registration statement that are filed pursuant to Rule 462(b) of the Securities Act of 1933, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as such person might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof. 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 July , 1999 ___________________________________________ Clifford M. Sobel* /s/ Howard S. Balter Chief Executive Officer July , 1999 ___________________________________________ and Director (Principal Howard S. Balter Executive Officer) /s/ Ilan M. Slasky Chief Financial Officer July , 1999 ___________________________________________ (Chief Accounting Ilan M. Slasky* Officer) /s/ James R. Mellor Director July , 1999 ___________________________________________ James R. Mellor
*Executed by attorney-in-fact: Howard S. Balter II-5
Name and Signatures Title Date ------------------- ----- ----
/s/ Howard S. Jonas Director July , 1999 ___________________________________________ Howard S. Jonas* Director July , 1999 ___________________________________________ Gary E. Rieschel /s/ James A. Courter Director July , 1999 ___________________________________________ James A. Courter*
*Executed by attorney-in-fact: Howard S. Balter II-6 INDEX OF EXHIBITS
Sequentially Exhibit Numbered Number Description of Exhibit Page ------- ---------------------- ------------ 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. 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. 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. 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.
Sequentially Exhibit Numbered Number Description of Exhibit Page ------- ---------------------- ------------ 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. 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 (set forth on the signature page to this registration statement). 27.1+ Financial Data Schedule. 99.1+ Consent of Director Nominee, Raphael S. Grunfeld. 99.2+ Consent of Director Nominee, Stephen A. Oxman.
- -------- *To be filed by amendment. # Confidential treatment has been requested with respect to certain portions of the Exhibit. Omitted portions will be filed separately with the Securities and Exchange Commission. + Previously filed. 2 EX-1.1 2 UNDERWRITING AGREEMENT EXHIBIT 1.1 NET2PHONE, INC. _________ Shares/1/ Common Stock UNDERWRITING AGREEMENT ---------------------- _____ __, 1999 HAMBRECHT & QUIST LLC BT ALEX. BROWN INCORPORATED 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 _________ shares of its authorized but unissued Common Stock, $.01 par value (herein called the Common Stock) (said _________ shares of Common Stock being herein called the Underwritten Stock). The Company proposes to grant to the Underwriters (as hereinafter defined) an option to purchase up to _________ 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 hereby confirms 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. 333-78713), 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. - -------------- /1/ Plus an option to purchase from the Company up to __________ additional shares to cover over-allotments. 1 The term Registration Statement as used in this agreement shall mean such registration statement, including 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 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 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 and the Parent. (a) Each of the Company and IDT Corporation, a Delaware corporation (herein call the Parent), hereby jointly and severally represent and warrant 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 would not have a material adverse effect on the condition (financial or otherwise) earnings, 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 to be issued and sold by the Company have been duly authorized and, when issued and paid for as contemplated herein, will be 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 2 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 and the Parent, 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 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 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 and the Parent, threatened against the Company or any of their respective officers or properties, before any court or administrative agency or otherwise, which if determined 3 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 or the Parent'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 reflected in the financial statements (or as described in the Registration Statement) 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 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 and the Parent and is a valid and binding agreement of the Company and the Parent, enforceable in accordance with its terms except insofar as indemnification and contribution provisions may be limited by applicable law or equitable principles and 4 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 or the Parent 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 and the Parent, any law, order, rule or regulation, injunction, judgment, or decree applicable to the Company or the Parent of any court or of any regulatory body or administrative agency or other governmental body having jurisdiction over the Company or the Parent, 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 and the Parent 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 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 and Parent'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 and the Parent'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 5 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; 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 the Company is not aware of the 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. 6 (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 has been approved for listing on the Nasdaq National Stock Market. (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. (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. All internal computer systems and each Constituent Component (as defined below) of those systems 7 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 nor the Parent 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. (xxviii) The Company has not incurred any liability for any finder's fees or similar payments in connection with the transactions contemplated hereby. 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 _________ shares of the Underwritten Stock to the several Underwriters and each of the Underwriters agrees to purchase from the Company 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 purchased by the several Underwriters shall be $___ per share. In making this Agreement, each Underwriter is contracting severally and not jointly; except as 8 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 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 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 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 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 to any non-defaulting Underwriter and without any liability on the part of any non-defaulting Underwriter to the Company. 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 Company grants an option to the several Underwriters to purchase, severally and not jointly, up to _________ shares in the aggregate of the Option Stock from the Company at the same price per share as the Underwriters shall pay for the Underwritten Stock. Said option may be exercised only to cover 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 setting forth the aggregate number of shares of the Option Stock as to which the several Underwriters are 9 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 initial 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 initial 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 by 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 10 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 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. The Company 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 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 11 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 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 12 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 agrees to pay all costs and expenses incident to the performance of its 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. (j) The Company agrees 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 Company hereby agrees and shall use its best efforts to cause all directors, officers and stockholders to agree that, without the prior written consent of Hambrecht & Quist LLC on behalf of the Underwriters, the Company will not, and such person or entity will not, for a period of 180 days following the commencement of the public offering of the Stock by the Underwriters, directly or indirectly, (i) sell, offer, contract to sell, make any short sale, pledge, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant to purchase or otherwise transfer or dispose of any shares of capital stock or any securities convertible into or exchangeable or exercisable for or any rights to purchase or acquire capital stock or (ii) enter into any swap or other agreement that transfers, in whole or in part, any of the economic consequences or ownership of capital stock, whether any such transaction described in clause (i) or (ii) above is to be settled by delivery of capital stock or such other securities, in cash or otherwise. The foregoing sentence shall not apply to (I) the Stock to be sold to the Underwriters pursuant to this Agreement, and (ii) the granting of options to purchase Common Stock under the Company's stock option plan. (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. 13 (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 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) The Company and the Parent 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 agrees 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 defending against any such losses, claims, damages or liabilities or 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 and the Parent 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 14 with information furnished as herein stated or otherwise 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 and (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 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. The indemnity agreements of the Company and the Parent contained in this paragraph (a) and the representations and warranties of the Company and the Parent 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, 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 defending against any such losses, claims, damages or liabilities or 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 indemnifying Underwriter expressly 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. 15 (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 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 16 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 and the Underwriters 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 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 may have hereunder or otherwise (except as specifically provided in paragraph (c) of this Section 7). (e) The Company will not, 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 17 an unconditional release of such Underwriter and each such controlling person from all liability arising out of such claim, action, suit or proceeding. 8. Termination. This Agreement may be terminated by you at any time prior to the Closing Date by giving written notice to the Company 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 to the Underwriters and no liability of the Underwriters to the Company; 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 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 of all its 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. 18 (c) You shall have received from Morrison & Foerster LLP, counsel for the Company, an opinion, addressed to the Underwriters and dated the Closing Date, covering the matters set forth in Annex A hereto, and 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 B hereto, and if Option Stock is purchased at any date after the Closing Date, an 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 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. 19 (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, 1998 and related consolidated statements of operations, stockholders' equity, and cash flows for the twelve (12) months ended July 31, 1998, (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 period ended July 31, 1998 and each of the two quarters in the period ended January 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 January 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. 20 (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. (i) On or prior to the Closing Date, you shall have received from all directors, officers and beneficial holders of the outstanding capital stock agreements, in form reasonably satisfactory to Hambrecht & Quist LLC, stating that without the prior written consent of Hambrecht & Quist LLC on behalf of the Underwriters, such person or entity will not, for a period of 180 days following the commencement of the public offering of the Stock by the Underwriters, directly or indirectly, (i) sell, offer, contract to sell, make any short sale, pledge, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant to purchase or otherwise transfer or dispose of any shares of capital stock or any securities convertible into or exchangeable or exercisable for or any rights to purchase or acquire capital stock or (ii) enter into any swap or other agreement that transfers, in whole or in part, any of the economic consequences or ownership of capital stock, whether any such transaction described in clause (i) or (ii) above is to be settled by delivery of capital stock or such other securities, in cash or otherwise. 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. Any such termination shall be without liability of the Company to the Underwriters and without liability of the Underwriters to the Company; provided, however, that (i) in the event of 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 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 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. The obligation of the Company to deliver the Stock shall be subject to the conditions that (a) the Registration Statement shall have become effective and (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 by giving notice to you. Any such termination shall be without liability of the Company to the Underwriters and without liability of the Underwriters to the Company; 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 21 incident to the performance of the obligations of the Company 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, the Company hereby agrees 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 and the several Underwriters and, with respect to the provisions of Section 7 hereof, the several parties (in addition to the Company 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 telegraph and, if to the Underwriters, shall be mailed, telegraphed 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, telegraphed 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: Ira A. Greenstein, Esq. All notices given by telegraph 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 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. 22 This Agreement shall be governed by, and construed in accordance with, the internal laws of the State of New York. Please sign and return to the Company the enclosed duplicates of this letter, whereupon this letter will become a binding agreement between the Company and the several Underwriters in accordance with its terms. Very truly yours, IDT CORPORATION NET2PHONE, INC. By By --------------------- -------------------- Name: Name: Title: Title: The foregoing Agreement is hereby confirmed and accepted as of the date first above written. HAMBRECHT & QUIST LLC BT ALEX. BROWN INCORPORATED 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. 23 SCHEDULE I UNDERWRITERS Underwriters Number of Shares to be Purchased - ------------------------------------------- ---------------------- Hambrecht & Quist LLC...................... BT Alex. Brown Incorporated................ Bear, Stearns & Co. Inc.................... ---------------------- Total................................. ====================== EX-4.1 3 SPECIMEN COMMON STOCK CERTIFICATE OF REGISTRANT EXHIBIT 4.1 NET2PHONE Net2Phone, Inc. NUMBER SHARES ------------------- ----------------- ------------------- ----------------- INCORPORATED UNDER THE LAWS OF SEE REVERSE FOR THE STATE OF DELAWARE CERTAIN DEFINITIONS - ------------------------------------------------------------------------------- THIS CERTIFIES that CUSIP 64108N 10 6 is the owner of - -------------------------------------------------------------------------------- FULLY PAID AND NON-ASSESSABLE SHARES OF THE COMMON STOCK, PAR VALUE $0.01 PER SHARE, OF - -------------------------- ------------------------------ - -------------------------- Net2Phone, Inc. ------------------------------ - -------------------------- ------------------------------ transferable on the books of the Corporation by the holder hereof in person or by duly authorized attorney, upon surrender of this certificate properly endorsed. This certificate is not valid until countersigned and registered by the Transfer Agent and Registrar. WITNESS the facimile seal of the corporation and the facsimile signatures of its duly authorized officers. Dated: COUNTERSIGNED AND REGISTERED: AMERICAN STOCK TRANSFER AND TRUST COMPANY TRANSFER AGENT AND REGISTAR BY AUTHORIZED SIGNATURE /s/ Ira Greenstein NET2PHONE, INC. /s/ Clifford M. Sobel SECRETARY CORPORATE SEAL CHAIRMAN OF THE BOARD DELAWARE 1997 EX-5.1 4 OPINION OF MORRISON & FOERSTER LLP EXHIBIT 5.1 [Morrison & Foerster LLP Letterhead] July __, 1999 Net2Phone, Inc. 171 Main Street Hackensack, NJ 07601 Ladies and Gentlemen: At your request, we have examined the Registration Statement on Form S-1 of Net2Phone, Inc., a Delaware corporation (the "Company"), to be filed with the Securities and Exchange Commission (the "Registration Statement"), relating to the registration under the Securities Act of 1933, as amended, of up to _____________ shares of the Company's common stock, $.01 par value (the "Stock"), including up to ________ authorized but unissued shares being offered by the Company (including up to ______________ shares subject to 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 up to _____________ shares of Stock. We are of the opinion that 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. 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, Morrison & Foerster LLP EX-10.27 5 EMPLOYMENT AGREEMENT, DATED JULY 2, 1999 EXHIBIT 10.27 EMPLOYMENT AGREEMENT This Agreement is made as of the 2nd day of July, 1999, between Net2Phone, Inc., a Delaware corporation (the "Company"), and Jonathan Fram, an individual residing at 20 West 10th Street, New York, NY 10011 (the "Executive"). RECITALS: WHEREAS, the Company desires to employ the Executive as the President of the Company, and the Executive desires to serve as the President of the Company, on the terms and conditions hereinafter set forth. NOW, THEREFORE, in consideration of the mutual covenants and promises contained herein, the parties hereto, each intending to be legally bound hereby, agree as follows: 1. EMPLOYMENT. The Company hereby employs the Executive as an employee of the Company as of July 20, 1999 (or such other date as the parties may agree, the "Effective Date"), and the Executive accepts such employment for the term of employment specified in Section 3 below (the "Employment Term"). Upon the Effective Date, the Executive shall become President of the Company. During the Employment Term, as the President of the Company, the Executive shall, subject to the direction of the Chief Executive Officer of the Company, perform such duties consistent with those duties ordinarily and customarily performed by a person holding such position in similar organizations, as may from time to time be reasonably assigned to him by the Chief Executive Officer or the Board of Directors of the Company. During the Employment Term, the Executive will supervise the Chief Operating Officer of the Company and the Chief Operating Officer will report to the Executive. 2. PERFORMANCE; LOCATION OF EMPLOYMENT; OTHER ACTIVITIES. (a) The Executive agrees to devote his reasonable best efforts and substantially all of his business time to the performance of his duties hereunder during the Employment Term. During the Employment Term, the Executive will perform his duties hereunder at the Company's executive offices located in Hackensack, New Jersey or other such corporate headquarters in the event that the company relocates to a different corporate headquarters. (b) During the Employment Term, the Executive agrees that, unless he has the express prior written approval of the Chief Executive Officer of the Company, he shall not accept a membership on a Board of Directors of, or act as an officer, employee or consultant to, any entity which is in a similar or competing business of the Company that would in any way conflict with the business of the Company or the time needed by the Executive to perform his duties hereunder. Page 1 3. EMPLOYMENT TERM. The term of employment under this Agreement shall begin on the date of this Agreement and continue until June 30, 2002 (the "Initial Employment Term"). The Employment Term shall thereafter continue on the basis hereby established for successive one year terms unless, more than ninety days prior to the expiration of the Initial Employment Term or any successive one year term, either the Executive or the Company provides the other with written notice that this Agreement will not be renewed (the "Subsequent Employment Term" and with the Initial Employment Term, the "Employment Term"). Employment during the Employment Term shall be subject to earlier termination in accordance with the terms of this Agreement. 4. COMPENSATION. (a) SALARY. During the Employment Term, the Company shall pay the Executive a base salary, payable in equal installments in accordance with the Company's then current compensation practices for all of its executives (but in no case longer than monthly installments), subject to withholding and other applicable taxes, at an annual rate of Three Hundred Fifty Thousand Dollars ($350,000.00). The base salary may be reviewed annually by the Board of Directors or the Compensation Committee elected thereby, provided that the base salary shall not be decreased during the Employment Term. (b) BONUS. The Executive shall be entitled to receive an annual bonus computed as follows: A maximum bonus of $100,000 shall be paid to the Executive if the Company's actual gross revenue for the year ending July 31, 2000 is at least 50% more than the $84.3 million projected gross revenue for that year (the "Target"). No bonus will be paid if the actual gross revenue for the year ending July 31, 2000 is less than 11% more than the Target. If actual gross revenue is at least 11% more than the Target but less than 50% more than the Target, the potential bonus shall be paid pro rata. Any Bonus due hereunder will be paid to the Executive as soon as practicable after the end of the year ending July 31, 2000. For the remainder of the Employment Term, the Employee and the Company shall mutually agree to similarly constructed bonus plans whose performance objectives will be set forth prior to the start of subsequent fiscal years covered by this Agreement. (c) STOCK OPTIONS. Upon the execution and delivery of this Agreement, the Executive shall be granted stock options (the "Options"), to purchase 920,000 shares of Common Stock of the Company (the "Common Stock") pursuant to the Company's 1999 Stock Option and Incentive Plan. Of the Options, (i) 460,000 of the Options will be granted at an exercise price equal to $3.33 per share, 153,333 of which shall be immediately vested and exercisable on the Effective Date, (ii) Options to purchase the remaining 460,000 shares of Common Stock will be granted at an exercise price equal to a the lower of (x) the Company's initial public offering price or (y) the $11 price per share indicated as the mid-point of the filing Page 2 range specified in the Company's amended S-1, filed with the Securities and Exchange Commission on June 28, 1999. The 766,667 remaining Options shall vest in three (3) annual installments of 255,555 Options, 255,555 Options, and 255,556 Options, respectively, commencing on the first anniversary of the Effective Date. In the event the Executive's employment is terminated by the Company without Cause (as defined herein) or by the Executive for Good Reason (as defined herein), all Options shall immediately become vested and exercisable. In the event that the Company accelerates the vesting of any options held by any other employee of the Company in connection with a change of control of the Company, then all Options held by the Executive shall be accelerated and become vested and exercisable in the same manner as such other options are accelerated. (d) LOAN TO PURCHASE STOCK In the event that the company successfully completes an initial public offering (an "IPO") during the term of the Executive's employment, the Company agrees to extend to the Executive a loan (the "Loan") upon consummation of the IPO in an amount of up to $1,000,000 for the purchase of common shares to be issued by the Company at a price not to exceed the IPO price (the "Effective Price") of common shares. The Loan, once drawn by the Executive for the purchase of stock, shall be for a term of three (3) years and shall bear interest at the rate of 7% compounded annually. Interest on the Loan shall accrue until such time as the Executive effects a sale of Company stock purchased in connection with the Loan, at which time the Executive shall pay the Company all accrued interest on the Loan up to such date of sale, and after which time he shall pay interest on the Loan currently through the term of the Loan. The Executive hereby agrees to use the Loan only to purchase common stock of the Company. This Loan will be secured solely by the common stock of the company purchased by the Executive with the proceeds of the Loan. (e) LOCK UP. The Executive hereby further agrees not to, directly or indirectly, sell, offer, contract to sell, transfer the economic risk of ownership in, make any short sale, pledge or otherwise dispose of any shares of capital stock of the Company or any securities convertible into or exchangeable or exercisable for or any other rights to purchase or acquire capital stock of the Company for a period of 180 days from the effective date of the Registration Statement related to the IPO. The Executive further agrees to enter into a "lock up" agreement with the underwriters of the IPO in form and substance acceptable to such underwriters. (f) INSURANCE; OTHER BENEFITS. The Executive and his dependants shall be entitled to receive those benefits available to other Company employees at the Company's expense. The Executive shall also be entitled to participate in all executive benefit plans now existing or hereinafter established by the Company, including, but not limited to, family medical and dental plans, group life and disability insurance plans, life insurance plan, pension, 401(k), profit sharing or bonus plans, and any other benefit plan or arrangement made available to executive officers of the Company. (g) VACATION. The Executive shall be entitled to the same paid vacation benefits as the other executive officers of the Company, but in no case shall it be less than three weeks of paid Page 3 vacation during each year of the Employment Term, to be taken at such time or times as shall be mutually convenient and consistent with his duties and obligations to the Company. 5. EXPENSES. The Executive shall be reimbursed by the Company for all reasonable out of pocket expenses incurred by him in connection with the performance of his duties hereunder in accordance with policies established by the Board of Directors from time to time and upon receipt of appropriate documentation. Travel, lodging and meals while travelling on behalf of the Company, client entertainment and cellular phone expenses will be directly billed to, and paid by, the Company. 6. TERMINATION. (a) TERMINATION AT END OF TERM. The employment of the Executive hereunder shall terminate at the end of the Initial Employment Term or any Subsequent Employment Term if either party provides notice of termination at least 90 days prior to expiration of the Initial Employment Term or Subsequent Employment Term, or if earlier terminated by the Board of Directors of the Company pursuant to this Section 6. (b) TERMINATION BY THE COMPANY WITH CAUSE. The Company shall have the right at any time to terminate the Executive's employment hereunder upon the occurrence of any of the following (any such termination being referred to as a termination for "Cause"): (i) the Executive has misappropriated or done material, intentional damage to the Company or its business or financial situation, (ii) the Executive has been convicted of a felony involving moral turpitude, (iii) any breach by the Executive of Section 2 of this Agreement which breach is not cured by the Executive within ten (10) business days after written notice thereof is delivered to the Executive by the Company or (iii) any material malfeasance, willful misconduct, active fraud or gross negligence (in each case as may be decided by a court of law) by the Executive in connection with his employment hereunder, which conduct is not corrected to the reasonable satisfaction of the Company within ten (10) business days after written notice thereof is delivered to the Executive by the Company. (c) TERMINATION UPON DEATH OR DISABILITY. The Executive's employment hereunder shall automatically terminate upon the Executive's death or upon his inability to perform his duties hereunder by reason of any mental, physical or other disability for a period of at least three consecutive months, or any six months within any 18 month period, as determined by a qualified physician selected by the Company. (d) TERMINATION BY THE COMPANY WITHOUT CAUSE. The Company shall have the right to terminate the Executive's employment at any time with ten (10) business days written notice. In the event that the Company terminates the Employee without cause, the company will give the Executive the opportunity to resign prior to such involuntary termination. (e) TERMINATION BY THE EXECUTIVE FOR GOOD REASON. The Executive shall have the right to terminate his employment at any time for Good Reason upon written notice to the Page 4 Company. For purposes of this Agreement, "Good Reason" shall mean (a) the Executive's authority or duties are materially changed without the prior consent of the Executive, which change is not remedied within ten (10) business days after written notice thereof is delivered to the Company by the Executive, (b) any material breach of this Agreement by the Company, which breach is not remedied within ten (10) business days after written notice thereof is delivered to the Company by the Executive, or (c) the relocation of Executive's place of work more than 50 miles from the Hackensack, New Jersey area. For purposes of this Agreement, the Executive's authority or duties shall be deemed to be "materially changed" if, without the Executive's consent, there is any material diminution in the Executive's responsibilities or an adverse modification to the Executive's title, compensation, or reporting relationship. (f) VOLUNTARY RESIGNATION. In addition to the right to terminate his employment for Good Reason under Section 6(e) above, the Executive may voluntarily terminate his employment at any time upon ten (10) business days notice, which resignation will result in the immediate loss of all benefits and responsibilities hereunder other than as afforded by statute. 7. EFFECT OF TERMINATION OF EMPLOYMENT. (a) WITH CAUSE; RESIGNATION; DEATH OR DISABILITY. If the Executive's employment is terminated with Cause pursuant to Section 6(b), if the Executive's employment is terminated by the death or disability of the Executive pursuant to Section 6(c) or if the Executive elects to terminate his employment voluntarily under Section 6(f) (other than for Good Reason), the Executive's salary and other benefits specified in Section 4 shall cease at the time of such termination; provided, however, that the Executive shall be entitled to continue to participate in the Company's medical benefit plans to the extent required by law and shall be entitled to the reimbursement for expenses incurred by him through the date of termination pursuant to Section 5. (b) WITHOUT CAUSE BY THE COMPANY. If the Executive's employment is terminated either by the Company without Cause pursuant to Section 6(d) or by the Executive for Good Reason pursuant to Section 6(e), in each case, prior to the expiration of the Initial Employment Term or any Subsequent Employment Term, the Executive's salary and other benefits specified in Section 4 shall cease at the time of such termination, and the Executive shall be entitled to receive a severance amount (the "Severance Amount") equal to the amounts set forth in the following schedule:
Termination Date: Severance Amount: - ----------------- ----------------- During the first 6 months of employment 9 months of base salary After 6 months from the initial date of employment 6 months of base salary
In addition, in any of such events or if the Company does not renew this Agreement beyond the Initial Employment Term or Subsequent Employment Term (i) the Executive shall also be entitled to receive any guaranteed bonus and any bonus accrued or earned by the Page 5 Executive through the date of termination based on achieving the performance goals set forth in Section 4(b) and the amount of any expenses incurred by the Executive through the date of termination pursuant to Section 5, (ii) all stock options then held by the Executive shall immediately vest and become exercisable, and (iii) the Executive shall continue to receive the insurance benefits specified in Section 4, at the Company's expense, covering the same period of time as any Severance Amount the Executive may receive as set forth above. 8. NOTICE. Any notices required or permitted hereunder shall be in writing and shall be deemed to have been given when personally delivered or when mailed, certified or registered mail, postage prepaid, to the following addresses or such other address as to which notice is given in the manner provided herein: If to the Executive: Jonathan Fram, 20 West 10th Street, New York, NY 10011. If to the Company: Net2Phone, 171 Main Street, Hackensack, NJ 07601, Attn: Howard S. Balter. 9. GENERAL (a) GOVERNING LAW; SUBMISSION TO JURISDICTION. The terms of this Agreement shall be governed by and construed under the laws of the State of New York without regard to its principles of conflicts of laws. Accordingly, to the extent a restriction contained in this Agreement is more restrictive than permitted by the laws of any jurisdiction where this Agreement may be subject to review and interpretation, the terms of such restriction, for the purpose only of the operation of such restriction in such jurisdiction, shall be the maximum restriction allowed by the laws of such jurisdiction and such restriction shall be deemed to have been revised accordingly herein. The parties hereto irrevocably agree that all claims relating to this Agreement shall be submitted exclusively to federal and state courts located in State of New York and irrevocably consent to the jurisdiction and venue of such courts and service of process by certified or registered mail, return receipt requested, directed to the parties at the addresses set forth herein or as otherwise provided by law. (b) ENTIRE AGREEMENT; MODIFICATION. This Agreement constitutes the entire agreement of the parties hereto with respect to the subject matter hereof and they and may not be modified or amended in any way except in writing by the parties hereto. (c) DURATION. Notwithstanding the term of employment hereunder, this Agreement shall continue for so long as any obligations remain under this Agreement. Page 6 IN WITNESS WHEREOF, the parties hereto, intending to be legally bound, have hereunto executed this Agreement the day and year first written above. NET2PHONE, INC. By: /s/ Clifford M. Sobel --------------------- Name: Clifford M. Sobel Title: Chairman EXECUTIVE /s/ Jonathan Fram - ----------------- Jonathan Fram Page 7 EX-23.1 6 CONSENT OF ERNST & YOUNG LLP 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 May 11, 1999 (except for Note 9, as to which the date is June 25, 1999), in the Registration Statement (Form S-1 No. 333-78713) and related Prospectus of Net2Phone, Inc. for the registration of shares of its common stock. /s/ Ernst & Young LLP New York, New York July 14, 1999 -----END PRIVACY-ENHANCED MESSAGE-----