10-Q 1 a06-22141_110q.htm QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2006

or

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Transition Period From              to             


Commission File Number 001-32887

VONAGE HOLDINGS CORP.
(Exact name of registrant as specified in its charter)

Delaware

 

11-3547680

(State or other jurisdiction of incorporation or organization)

 

(IRS Employer Identification No.)

 

 

 

23 Main Street, Holmdel, NJ

 

07733

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (732) 528-2600

(Former name, former address and former fiscal year, if changed since last report): Not Applicable

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.      Yes x    No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer

o

Accelerated filer

o

Non-accelerated filer

x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class

 

Outstanding at October 31, 2006

Common Stock, par value $0.001

 

154,922,633 shares

 

 




VONAGE HOLDINGS CORP.

INDEX

Part I. Financial Information

Page

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

A)

Consolidated Balance Sheets as of September 30, 2006 (Unaudited) and December 31, 2005

1

 

 

B)

Unaudited Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 and 2005

2

 

 

C)

Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005

3

 

 

D)

Unaudited Consolidated Statement of Stockholders’ Equity (Deficit) for the Nine Months Ended September 30, 2006

4

 

 

E)

Notes to Unaudited Consolidated Financial Statements for the Nine Months Ended September 30, 2006

5

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

32

 

 

 

 

 

Item 4.

Controls and Procedures

32

 

 

 

 

Part II. Other Information

 

 

 

 

 

 

Item 1.

Legal Proceedings

34

 

 

 

 

 

Item 1A.

Risk Factors

34

 

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

43

 

 

 

 

 

Item 3.

Defaults Upon Senior Securities

44

 

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

44

 

 

 

 

 

Item 5.

Other Information

44

 

 

 

 

 

Item 6.

Exhibits

44

 

 

 

 

 

 

Signature

46

 




Part I – Financial Information

Item 1.    Financial Statements

VONAGE HOLDINGS CORP.

CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)

 

 

Sep 30,

 

Dec 31,

 

 

 

2006

 

2005

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

154,016

 

$

132,549

 

Marketable securities

 

390,314

 

133,830

 

Accounts receivable, net of allowance of $401 and $210, respectively

 

14,589

 

7,435

 

Inventory, net of allowance of $1,036 and $732, respectively

 

17,662

 

15,687

 

Deferred customer acquisition costs, current

 

11,053

 

6,125

 

Prepaid expenses and other current assets

 

22,386

 

8,228

 

Total current assets

 

610,020

 

303,854

 

 

 

 

 

 

 

Property and equipment, net of accumulated depreciation

 

123,523

 

103,638

 

Deferred customer acquisition costs, non-current

 

31,938

 

19,899

 

Deferred financing costs, net

 

8,357

 

9,577

 

Restricted cash

 

9,355

 

7,453

 

Due from related parties

 

63

 

75

 

Intangible assets, net

 

5,035

 

 

Other assets

 

620

 

2,386

 

Total assets

 

$

788,911

 

$

446,882

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity (Deficit)

 

 

 

 

 

Liabilities

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

57,329

 

$

16,467

 

Accrued expenses

 

90,858

 

98,035

 

Deferred revenue, current portion

 

34,601

 

20,449

 

Current maturities of capital lease obligations

 

988

 

773

 

Total current liabilities

 

183,776

 

135,724

 

 

 

 

 

 

 

Convertible notes, net

 

253,420

 

247,958

 

Deferred revenue, net of current portion

 

35,230

 

21,600

 

Capital lease obligations, net of current maturities

 

23,501

 

21,658

 

Total liabilities

 

495,927

 

426,940

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Redeemable Preferred Stock

 

 

 

 

 

Series A Redeemable Convertible Preferred stock, par value $0.001 per share; authorized 8,000 shares, 8,000 shares issued and outstanding (liquidation preference $16,000)

 

 

15,968

 

Series A-2 Redeemable Convertible Preferred Stock, par value $0.001 per share; authorized 6,067 shares, 5,167 shares issued and outstanding (liquidation preference $20,667)

 

 

20,292

 

Series A-2 Redeemable Convertible Preferred Stock Warrant to purchase 900 shares

 

 

1,557

 

Series B Redeemable Convertible Preferred Stock, par value $0.001 per share; authorized 3,750 shares, 3,750 shares issued and outstanding (liquidation preference $16,200)

 

 

14,489

 

Series C Redeemable Convertible Preferred Stock, par value $0.001per share; authorized 8,000 shares, 8,000 shares issued and outstanding (liquidation preference $43,200)

 

 

38,090

 

Series D Redeemable Convertible Preferred Stock, par value $0.001per share; authorized 8,729 shares, 8,729 shares issued and outstanding (liquidation preference $113,389)

 

 

102,722

 

Series E Redeemable Convertible Preferred Stock, par value $0.001per share; authorized 9,435 shares, 9,429 shares issued and outstanding (liquidation preference $215,924)

 

 

195,736

 

Stock subscription receivable

 

 

(427

)

Total redeemable preferred stock

 

 

388,427

 

 

 

 

 

 

 

Stockholders’ Equity (Deficit)

 

 

 

 

 

Common stock, par value $0.001 per share; authorized 596,950 shares at September 30, 2006 and December 31, 2005; 156,214 and 1,642 shares issued at September 30, 2006 and December 31, 2005,  respectively; 154,920 and 1,404 shares outstanding at September 30, 2006 and December 31, 2005, respectively

 

156

 

2

 

Additional paid-in capital

 

915,413

 

14,794

 

Stock subscription receivable

 

(6,183

)

(37

)

Accumulated deficit

 

(603,764

)

(382,284

)

Treasury stock, at cost, 1,294 shares and 238 shares, respectively

 

(12,342

)

(619

)

Deferred compensation

 

 

(167

)

Accumulated other comprehensive loss

 

(296

)

(174

)

Total stockholders’ equity (deficit)

 

292,984

 

(368,485

)

Total liabilities, redeemable preferred stock and stockholders’ equity (deficit)

 

$

788,911

 

$

446,882

 

 

The accompanying notes are an integral part of the consolidated financial statements.

1




VONAGE HOLDINGS CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Operating Revenues:

 

 

 

 

 

 

 

 

 

Telephony services

 

$

154,487

 

$

71,158

 

$

402,781

 

$

167,280

 

Customer equipment and shipping

 

6,235

 

2,713

 

20,202

 

6,736

 

 

 

160,722

 

73,871

 

422,983

 

174,016

 

 

 

 

 

 

 

 

 

 

 

Operating Expenses:

 

 

 

 

 

 

 

 

 

Direct cost of telephony services (excluding depreciation and amortization of $3,022, $2,025, $8,707 and $4,405, respectively)

 

40,272

 

24,514

 

116,802

 

54,341

 

Direct cost of goods sold

 

16,934

 

9,622

 

50,561

 

30,451

 

Selling, general and administrative

 

72,052

 

45,030

 

191,036

 

98,808

 

Marketing

 

91,316

 

58,906

 

269,768

 

176,279

 

Depreciation and amortization

 

5,946

 

3,150

 

16,645

 

7,026

 

 

 

226,520

 

141,222

 

644,812

 

366,905

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(65,798

)

(67,351

)

(221,829

)

(192,889

)

 

 

 

 

 

 

 

 

 

 

Other Income (Expense):

 

 

 

 

 

 

 

 

 

Interest income

 

7,721

 

1,356

 

14,442

 

3,270

 

Interest expense

 

(3,999

)

(1

)

(13,977

)

(1

)

Other, net

 

(108

)

1

 

(116

)

 

 

 

3,614

 

1,356

 

349

 

3,269

 

 

 

 

 

 

 

 

 

 

 

Loss before income taxes

 

(62,184

)

(65,995

)

(221,480

)

(189,620

)

 

 

 

 

 

 

 

 

 

 

Income taxes

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(62,184

)

$

(65,995

)

$

(221,480

)

$

(189,620

)

 

 

 

 

 

 

 

 

 

 

Net loss per common share:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

$

(0.40

)

$

(47.79

)

$

(2.99

)

$

(138.11

)

 

 

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

154,775

 

1,381

 

73,955

 

1,373

 

 

The accompanying notes are an integral part of the consolidated financial statements.

2




VONAGE HOLDINGS CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(221,480

)

$

(189,620

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

16,412

 

7,026

 

Amortization of intangibles

 

233

 

 

Beneficial conversion on interest in kind on convertible notes

 

22

 

 

Accrued interest

 

3,295

 

(817

)

Allowance for doubtful accounts

 

191

 

(150

)

Allowance for obsolete inventory

 

827

 

42

 

Amortization of deferred financing costs

 

1,503

 

 

Loss on disposal of fixed assets

 

16

 

 

Share-based compensation

 

19,980

 

 

Other

 

(49

)

(81

)

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(7,328

)

(2,508

)

Inventory

 

(2,764

)

(8,648

)

Prepaid expenses and other current assets

 

(13,512

)

(11,284

)

Deferred customer acquisition costs

 

(16,908

)

(10,801

)

Due from related parties

 

25

 

7

 

Other assets

 

(129

)

(107

)

Accounts payable

 

40,732

 

21,601

 

Accrued expenses

 

(9,439

)

44,348

 

Deferred revenue

 

27,681

 

19,837

 

Net cash used in operating activities

 

(160,692

)

(131,155

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(33,598

)

(37,180

)

Purchase of intangible assets

 

(5,268

)

 

Purchase of marketable securities

 

(559,507

)

(177,085

)

Maturities and sales of marketable securities

 

303,043

 

156,470

 

Increase in restricted cash

 

(1,870

)

(7,119

)

Net cash used in investing activities

 

(297,200

)

(64,914

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Principal payments on capital lease obligations

 

(593

)

(44

)

Proceeds from notes issuance

 

2,047

 

 

Debt issuance costs

 

(283

)

 

Proceeds from preferred stock issuance, net

 

 

195,819

 

Proceeds from subscription receivable, net

 

131

 

170

 

Proceeds from common stock issuance, net

 

493,497

 

 

Purchase of treasury stock

 

(11,723

)

 

Payments for directed share program, net

 

(4,017

)

 

Proceeds from exercise of stock options

 

290

 

49

 

Net cash provided by financing activities

 

479,349

 

195,994

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

10

 

(23

)

Net change in cash and cash equivalents

 

21,467

 

(98

)

Cash and cash equivalents, beginning of period

 

132,549

 

43,029

 

Cash and cash equivalents, end of period

 

$

154,016

 

$

42,931

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid during the periods for:

 

 

 

 

 

Interest

 

$

8,501

 

$

1

 

 

The accompanying notes are an integral part of the consolidated financial statements.

3




VONAGE HOLDINGS CORP.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

(In thousands)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Additional

 

Stock

 

 

 

 

 

 

 

Other

 

 

 

 

 

Common

 

Paid-in

 

Subscription

 

Deferred

 

Accumulated

 

Treasury

 

Comprehensive

 

 

 

 

 

Stock

 

Capital

 

Receivable

 

Compensation

 

Deficit

 

Stock

 

Loss

 

Total

 

Balance at December 31, 2005

 

$

2

 

$

14,794

 

$

(37

)

$

(167

)

$

(382,284

)

$

(619

)

$

(174

)

$

(368,485

)

Stock option exercises

 

 

 

290

 

 

 

 

 

 

 

 

 

 

 

290

 

Share-based compensation

 

 

 

19,980

 

 

 

 

 

 

 

 

 

 

 

19,980

 

Reverse unamortized deferred compensation

 

 

 

(167

)

 

 

167

 

 

 

 

 

 

 

 

Beneficial conversion of interest in kind on convertible notes

 

 

 

214

 

 

 

 

 

 

 

 

 

 

 

214

 

Issuance of common stock, net

 

31

 

491,570

 

 

 

 

 

 

 

 

 

 

 

491,601

 

Issuance of common stock upon conversion of preferred stock

 

123

 

387,175

 

 

 

 

 

 

 

 

 

 

 

387,298

 

Conversion of preferred stock warrant to common stock warrant

 

 

 

1,557

 

 

 

 

 

 

 

 

 

 

 

1,557

 

Conversion of preferred stock subscription receivable to common stock subscription receivable

 

 

 

 

 

(411

)

 

 

 

 

 

 

 

 

(411

)

Directed share program transactions, net

 

 

 

 

 

(5,850

)

 

 

 

 

(11,723

)

 

 

(17,573

)

Stock subscription receivable payments

 

 

 

 

 

115

 

 

 

 

 

 

 

 

 

115

 

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in unrealized loss on available-for-sale investments

 

 

 

 

 

 

 

 

 

 

 

 

 

(29

)

(29

)

Foreign currency translation adjustment

 

 

 

 

 

 

 

 

 

 

 

 

 

(93

)

(93

)

Net loss

 

 

 

 

 

 

 

 

 

(221,480

)

 

 

 

 

(221,480

)

Total comprehensive loss

 

 

 

 

 

(221,480

)

 

(122

)

(221,602

)

Balance at September 30, 2006

 

$

156

 

$

915,413

 

$

(6,183

)

$

 

$

(603,764

)

$

(12,342

)

$

(296

)

$

292,984

 

 

The accompanying notes are an integral part of the consolidated financial statements.

4




VONAGE HOLDINGS CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except per share amounts) (Unaudited)

Note 1.   Basis of Presentation and Significant Accounting Policies

Nature of Operations

Vonage Holdings Corp. (“Vonage”, “We, “Our”, “Us”) is incorporated as a Delaware corporation. The original Certificate of Incorporation was filed in May 2000 as MIN-X.COM, INC., our original name, which was changed in February 2001 to Vonage Holdings Corp. We are a provider of broadband Voice over Internet Protocol (“VoIP”) services to residential and small and home office customers. We launched service in the United States in October 2002, in Canada in November 2004 and in the United Kingdom in May 2005.

We have incurred significant operating losses since inception. As a result, we have generated negative cash flows from operations, and have an accumulated deficit at September 30, 2006. Our primary source of funds to date has been the issuance of equity and debt securities, including net proceeds from our initial public offering (“IPO”) consummated in May 2006.

Unaudited Interim Financial Information

The accompanying unaudited interim consolidated financial statements and information have been prepared in accordance with accounting principles generally accepted in the United States and in accordance with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, these financial statements contain all normal and recurring adjustments considered necessary to present fairly the financial position, results of operations, cash flows and statement of stockholders’ equity (deficit) for the periods presented. The results for the three and nine month periods ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year.

These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Registration Statement on Form S-1 (Registration No. 333-131659).

Significant Accounting Policies

Basis of Consolidation

The consolidated financial statements include the accounts of Vonage and our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported and disclosed in the consolidated financial statements and the accompanying notes. Actual results could differ materially from these estimates.

On an ongoing basis, we evaluate our estimates including the following:

·                  those related to the average period of service to a customer (the “customer relationship period”) used to amortize deferred revenue and deferred customer acquisition costs associated with customer activation;

·                  the useful lives of property and equipment and intangible assets; and

·                  assumptions used for the purpose of determining stock-based compensation using the Black-Scholes option model (“Model”), and on various other assumptions that we believed to be reasonable. The key inputs for this Model are stock price at valuation date, strike price for the option, the dividend yield, risk-free interest rate, life of option in years and volatility.

We base our estimates on historical experience, available market information, appropriate valuation methodologies, and on various other assumptions that we believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities.

Restricted Cash and Letters of Credit

We report the collateralization of certain letters of credit as restricted cash. The amount of collateralized letters of credit primarily related to lease deposits for our offices and certain purchased customer equipment were $8,743 and $7,210 at September 30, 2006 and December 31, 2005, respectively, with corresponding restricted cash of $9,355 and $7,453 at September 30, 2006 and December 31, 2005, respectively.

5




Patents

The three patents we acquired on June 27, 2006 are directed to the compression of packetized digital signals commonly used in VoIP technology. In July 2006, we began amortizing the acquisition cost of these patents over their estimated useful lives of 5.6 years.  Amortization for the three and nine months ended September 30, 2006 was $233. Annual amortization will be approximately $932.

Fair Value of Financial Instruments

The carrying amounts of our financial instruments, including cash and cash equivalents, marketable securities, accounts receivable and accounts payable, approximate fair value because of their short maturities. The carrying amounts of our capital leases approximate fair value of these obligations based upon management’s best estimates of interest rates that would be available for similar debt obligations at September 30, 2006 and December 31, 2005. Our convertible notes are carried at estimated fair value less any unamortized discount.

Loss per Share

Basic and diluted loss per common share is calculated by dividing loss to common stockholders by the weighted average number of common shares outstanding during the period. The effects of potentially dilutive common shares, including shares issued under our 2001 Stock Incentive Plan and 2006 Incentive Plan using the treasury stock method and our convertible notes, common stock warrants, and our convertible preferred stock using the if-converted method, have been excluded from the calculation of diluted loss per common share because of their anti-dilutive effects.

The following were excluded from the calculation of diluted earnings per common share because of their anti-dilutive effects:

 

Three and Nine Months Ended

 

 

 

September 30,

 

 

 

2006

 

2005

 

Redeemable preferred stock as if converted at 2.86 to 1

 

 

123,071

 

Common stock warrants

 

3,085

 

3,085

 

Convertible notes

 

17,835

 

 

Restricted stock units

 

983

 

 

Employee stock options

 

16,569

 

13,050

 

 

 

38,472

 

139,206

 

 

Stock-Based Compensation

Prior to the adoption of Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”) as allowed under Statement of Financial Accounting Standards No. 123. Under the intrinsic value method, no stock-based compensation expense for employee stock options had been recognized in our results of operations in prior periods. In accordance with the modified prospective transition method that we used in adopting SFAS 123(R) as of January 1, 2006, the consolidated financial statements prior to 2006 have not been restated to reflect, and do not include, the possible impact of SFAS 123(R). The table below reflects the pro forma net loss and net loss per share for the three and nine months ended September 30, 2005:

6




 

 

Three Months
Ended

 

Nine Months
Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2005

 

Net loss attributable to common shareholders, as reported

 

$

(65,995

)

$

(189,620

)

Deduct total stock-based employee compensation expense determined under fair value based method for all awards

 

(2,999

)

(4,384

)

Net loss, proforma

 

$

(68,994

)

$

(194,004

)

 

 

 

 

 

 

Net loss per common share:

 

 

 

 

 

As reported - basic and diluted

 

$

(47.79

)

$

(138.11

)

Pro forma - basic and diluted

 

$

(49.96

)

$

(141.30

)

 

 

 

 

 

 

Weighted-average common shares outstanding:

 

 

 

 

 

Basic and diluted

 

1,381

 

1,373

 

 

The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model. Expected volatilities are based on a combination of historical volatilities experienced by companies considered representative of us in terms of industry. Prior to the adoption of FAS 123(R), we used 0% expected volatility while we were a private company. We also use historical data to estimate the term that options are expected to be outstanding and the forfeiture rate of options granted. The risk-free interest rate is based on the U.S. Treasury zero-coupon securities with a term approximating the expected term. The assumptions used to value options are as follows:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Risk-free interest rate

 

4.70

%

4.16

%

4.70-5.10

%

4.16-4.36

%

Expected stock price volatility

 

52.50

%

0.00

%

50.18-52.50

%

0.00

%

Dividend yield

 

0.00

%

0.00

%

0.00

%

0.00

%

Expected life (in years)

 

8.40

 

9.06

 

8.40-8.90

 

8.83-9.06

 

 

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standard Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157 “Fair Value Measurements.”  The Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements.  This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  We are currently assessing the impact of adopting SFAS 157 on the consolidated financial statements.

On July 13, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. Earlier application is permitted as long as the enterprise has not yet issued financial statements, including interim financial statements, in the period of adoption. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 should be reported as an adjustment to the opening balance of retained earnings (or other appropriate components of equity) for that fiscal year. We believe the adoption of FIN 48 will not have a material effect on our consolidated financial statements.

Note 2. Income Taxes

As of September 30, 2006, we had net operating loss carryforwards for U.S. federal and state tax purposes of $491,020 and $476,824, respectively, expiring at various times from years ending 2020 through 2026. In addition, we have net operating loss

7




carryforwards for Canadian tax purposes of $38,027 expiring through 2013. We also have net operating loss carryforwards for United Kingdom tax purposes of $13,739 with no expiration date.

Under Section 382 of the Internal Revenue Code, if a corporation undergoes an “ownership change” (generally defined as a greater than 50% change (by value) in its equity ownership over a three-year period), the corporation’s ability to use its pre-change of control net operating loss carryforward and other pre-change tax attributes against its post-change income may be limited. The Section 382 limitation is applied annually so as to limit the use of pre-change net operating loss carryforwards to an amount that generally equals the value of a corporation’s stock immediately before the ownership change multiplied by a designated federal long-term tax-exempt rate. In addition, we may be able to increase the base Section 382 limitation amount during the first five years following the ownership change to the extent we realize built-in gains during that time period. A built-in gain generally is gain or income attributable to an asset that was held at the date of the ownership change and that had a fair market value in excess of the tax basis at the date of the ownership change. Section 382 provides that any unused Section 382 limitation amount can be carried forward and aggregated with the following year’s available net operating losses. Due to the cumulative impact of our equity issuances over the past three years, a change of ownership occurred upon the issuance of our Series E Preferred Stock at the end of April 2005. As a result, $171,147 of the total U.S net operating losses will be subject to an annual base limitation of $39,374. As noted above, we believe we may be able to increase the base Section 382 limitation for built-in gains during the first five years following the ownership change.

We are currently conducting research to evaluate the impact of Section 382 in relation to our May 2006 IPO, the results of which may indicate a further limitation on the utilization of the $319,873 in U.S. net operating losses accumulated since our Series E preferred stock issuance in April 2005.

Note 3. Convertible Notes

In December 2005 and January 2006, we issued $249,900 aggregate principal amount of convertible notes due December 1, 2010 (the “Notes”). We are using the proceeds from the offering of the Notes for working capital and other general corporate purposes (including the funding of our operating losses).

The holders may require us to repurchase all or any portion of the Notes on December 16, 2008 at a price in cash equal to 100% of the principal amount of the Notes plus any accrued and unpaid interest and late charges.

We may, at our option, pay interest on the Notes in cash or in kind. If paid in cash, interest will accrue at a rate of 5% per annum and be payable quarterly in arrears. If paid in kind, the interest will accrue at a rate of 7% per annum and be payable quarterly in arrears. Interest paid in kind will increase the principal amount outstanding and will thereafter accrue interest during each period. The first interest payment was made on March 1, 2006. We elected to pay this interest in kind in the amount of $3,645. The interest payments due on June 1, 2006 for $3,170 and September 1, 2006 for $3,170 were paid in cash.

Upon an event of default, the interest rate will be the greater of the interest rate then in effect or 15% per annum. If interest on the Notes is not paid in full on any interest payment date, the principal amount of the Notes will be increased for subsequent interest accrual periods by an amount that reflects the accretion of the unpaid interest at an annual rate equal to the interest rate then in effect plus 2%, calculated on a quarterly basis, from, and including, the first day of the relevant interest accrual period.

We may redeem any or all of the Notes at any time beginning June 16, 2007, provided that, among other things, the Common Stock has traded at a price greater than 150% of the then applicable conversion price of the Notes for 20 consecutive trading days. The Notes are redeemable at a price equal to 100% of the principal amount plus accrued and unpaid interest and any late charges, plus the aggregate net present value of the remaining scheduled interest payments through December 16, 2008, if any, calculated as provided in the Notes.

We also may redeem any or all of the Notes at any time after December 16, 2008 at a price equal to 100% of the principal amount plus accrued and unpaid interest and any late charges, subject to certain conditions.

Following a change of control (as defined in the Notes) the holders of the Notes may require us to redeem the Notes at a price equal to 100% of the principal amount plus accrued and unpaid interest and late charges. In addition, upon conversions in connection with certain transactions, including certain changes of control, holders of the Notes will be entitled to receive a make-whole premium as calculated in the Notes.

The Notes may, at the option of the holder, be converted into shares of Common Stock at any time. Upon the completion of our IPO in May 2006, the conversion price was fixed at $14.22, subject to certain anti-dilution adjustments.

Following an event of default, the Notes will become due and payable, either automatically or upon declaration by holders of more than 25% of the aggregate principal amount of the Notes.

8




We have agreed to file resale shelf registration statements covering the shares of Common Stock issuable upon conversion of the Notes within 90 calendar days after the IPO and use reasonable best efforts to have such registration statement be declared effective within 180 calendar days after the IPO. Should we fail to meet this timetable, we will pay the holders of the Notes a fee of 1% of the principal amount of the Notes on the day that this timetable has not been met and a fee of 2% of the principal amount of the Notes every 30th day thereafter until the failure is cured. The shelf registration statement was filed on August 21, 2006 but was not declared effective as of September 30, 2006. We believe we will meet these required deadlines and will not incur these fees.

We evaluate the provisions of the Notes periodically to determine whether any of the provisions would be considered embedded derivatives that would require bifurcation under Statement of Financial Accounting Standards No. 133, (“Accounting for Derivative Instruments and Hedging Activities”) (“SFAS 133”). Because the shares of Common Stock underlying the Notes have not been registered for resale, they are not readily convertible to cash. Thus, the conversion option does not meet the net settlement requirement of SFAS No. 133 and would not be considered a derivative if freestanding. Accordingly, the Notes do not contain an embedded conversion feature that must be bifurcated. Once the underlying shares of Common Stock are registered we may determine that our Notes contain an embedded conversion feature that would require bifurcation from the Notes. At that time, the fair value of the embedded derivatives would be bifurcated from the Notes and recorded as a non-current liability with an offset recorded as a discount to the Notes that would be amortized to interest expense over the remaining life of the Notes using the effective interest method. The fair value of the embedded derivatives would be revalued each reporting period with the change in the fair value recorded as other income or expense in the statement of operations. We identified certain other embedded derivatives and concluded their value was de minimis.

Since the Notes issued in December 2005 and January 2006 did not contain an embedded conversion feature that required bifurcation, we evaluated the conversion feature to determine if it was a beneficial conversion feature under EITF 98-5 and 00-27. The conversion price equaled the fair value of the underlying Common Stock. As such, there was no beneficial conversion feature for those issuances. For the Notes issued on March 1, 2006 for the payment of interest in kind, the fair market value of the underlying Common Stock exceeded the conversion price. Accordingly, in March 2006 we recorded the intrinsic value of the beneficial conversion feature on 256 shares in the amount of $214 as a discount to the Notes with an offsetting amount increasing additional paid-in-capital. This beneficial conversion feature will be amortized to interest expense over the remaining life of the Notes on our consolidated statement of operations using the effective interest method. The amortization for the three and nine months ended September 30, 2006 was $13 and $22, respectively.

Note 4. Directed Share Program

In connection with our IPO, we requested that our underwriters reserve 4,219 shares for our customers to purchase at the initial public offering price of $17.00 per share through the Vonage Customer Directed Share Program (“DSP”). In connection with our IPO, we also entered into an Underwriting Agreement, dated May 23, 2006, pursuant to which we agreed to indemnify the Underwriters for any losses caused by the failure of any participant in the DSP to pay for and accept delivery of the shares that had been allocated to such participant in connection with our IPO. In the weeks following the IPO, certain participants in the DSP that had been allocated shares failed to pay for and accept delivery of such shares. As a result of this failure and as part of the indemnification obligations, we acquired from the Underwriters or their affiliates 1,056 shares of our common stock which had an aggregate fair market value of $11,723. These shares were recorded as treasury stock on the consolidated balance sheet. We do not anticipate making any further purchases of securities pursuant to our indemnification obligations under the Underwriting Agreement. Because we are pursuing the collection of monies owed from the DSP participants who failed to pay for their shares, we recorded a stock subscription receivable of $6,044 representing the difference between the aggregate IPO price value of the unpaid DSP shares and the $11,723 we paid for these shares.

In September 2006, we reimbursed $4,211 of the indemnification due to the Underwriters and expect to pay the remainder of approximately $1,800 to the Underwriters in the fourth quarter of 2006 in accordance with the Underwriting Agreement. We also received $194 in payments from certain participants in the DSP that had been allocated shares and failed to pay for such shares.

Note 5. Employee Benefit Plans

Stock-Based Compensation

On January 1, 2006, we adopted SFAS 123(R), which requires recognition of compensation expense for all stock-based awards made to employees in our consolidated financial statements. Prior to the adoption of SFAS 123(R), we accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under SFAS 123. Under the intrinsic value method, no stock-based compensation expense for employee stock options had been recognized in our results of operations in prior periods, unless the exercise price of the stock options granted to employees and directors was less than the fair market value of the underlying stock at the date of grant. In accordance with the modified prospective transition method that we used in adopting SFAS 123(R), our consolidated financial statements prior to fiscal year 2006 have not been restated to reflect, and do not include, the possible impact of SFAS 123(R).

9




Beginning January 1, 2006, we estimated the volatility of our stock using historical volatility of comparable public companies in accordance with guidance in SFAS 123(R) and Staff Accounting Bulletin No. 107 (“SAB 107”). We will continue to use the volatility of comparable companies until historical volatility is relevant to measure expected volatility for future option grants. The expected volatilities of comparable public companies used for the third quarter were between 35.67% - 68.90%. Prior to the adoption of FAS 123(R), we used 0% expected volatility while we were a private company.

The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of our employee stock options. The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding, which we derive based on our historical settlement experience.

As stock-based compensation expense recognized in our results is based on awards ultimately expected to vest, the amount has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on our historical experience. Prior to January 1, 2006, we also used historical experience to estimate forfeitures for the purposes of our pro forma information under SFAS 123.

2001 Stock Incentive Plan

In February 2001, we adopted the 2001 Stock Incentive Plan, which is an amendment and restatement of the 2000 Stock Incentive Plan of MIN-X.COM, INC. The 2001 Stock Incentive Plan provides for the granting of options or restricted stock awards to our officers, directors and employees. The objectives of the 2001 Stock Incentive Plan include attracting and retaining personnel, providing for additional performance incentives, and promoting our success by providing employees the opportunity to acquire stock. During 2004, we increased the number of shares authorized for issuance pursuant to options or restricted stock awards from 4,286 to 7,503 shares under the plan, as amended. During 2005, the number of shares authorized for issuance pursuant to options or restricted stock awards was increased from 7,503 to 28,286. At September 30, 2006, 5,595 shares were subject to exercisable options or restricted stock awards under the 2001 Stock Incentive Plan. In management’s opinion, all stock options were granted with an exercise price at or above the fair market value of our common stock at the date of grant with the exception of a grant in 2005 for 125 shares. Initially, we recorded deferred compensation in 2005 related to this option grant. On January 1, 2006, we reversed the remaining deferred compensation balance in accordance with SFAS 123(R). Stock options generally vest over a four-year period and expire ten years after the grant date.

Stock option activity was as follows:

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

 

 

Average

 

 

 

 

 

 

 

 

 

 

 

Weighted

 

Remaining

 

 

 

Weighted

 

 

 

 

 

Range of

 

Average

 

Contractual

 

Aggregate

 

Average

 

 

 

Number

 

Exercise

 

Exercise

 

Term in

 

Intrinsic

 

Grant Date

 

(Shares and Intrinsic Value in Thousands)

 

of Shares

 

Prices

 

Price

 

Years

 

Value

 

Fair Value

 

Awards outstanding at December 31, 2005

 

13,372

 

$

0.70 - $35.00

 

$

5.88

 

8.8

 

$

112,051

 

$

1.82

 

Granted

 

4,485

 

$

6.76 - $18.00

 

$

14.63

 

 

 

 

 

$

9.35

 

Exercised

 

(223

)

$

 0.70 - $ 7.42

 

$

1.30

 

 

 

$

1,877

 

$

0.38

 

Canceled

 

(1,339

)

$

0.70 - $35.00

 

$

8.80

 

 

 

$

1,389

 

$

3.95

 

Awards outstanding at September 30, 2006

 

16,295

 

$

0.70 - $35.00

 

$

8.10

 

8.4

 

$

24,996

 

$

3.78

 

Shares exercisable at September 30, 2006

 

5,595

 

 

 

$

5.15

 

7.5

 

$

16,190

 

$

1.95

 

Unvested shares at December 31, 2005

 

10,207

 

 

 

$

6.75

 

 

 

$

76,443

 

$

2.10

 

Unvested shares at September 30, 2006

 

10,700

 

 

 

$

9.65

 

 

 

$

8,806

 

$

4.74

 

 

At September 30, 2006, 11,720 options were available for future grant under the 2001 Stock Incentive Plan. However, upon the closing of our IPO, our board of directors limited the total amount of stock options and other equity-based awards that may be granted to 2,000 shares of which 1,574 shares are currently available.

The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2006 was $5.04 and $9.35, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $1,020 and $1,877, respectively. The total fair value of options that vested during the three and nine months ended September 30, 2006 was $3,252 and $8,331, respectively.

Total stock option compensation expense recognized for the 2001 Stock Incentive Plan for the three and nine months ended September 30, 2006 was $6,859 and $19,501, respectively. As of September 30, 2006, total unamortized stock-based compensation under the 2001 stock incentive plan was $28,099, which is expected to be amortized over the remaining vesting

10




period of each grant, up to the next 48 months. Compensation costs for all stock-based awards are recognized using the ratable single-option approach on an accrual basis.

The following is a summary of the status of stock options outstanding at September 30, 2006:

 

Outstanding Options

 

Exercisable Options

 

Exercise
Price Range

 

Number
of Shares

 

Weighted
Average
Remaining
Contractual
Life

 

Weighted
Average
Exercise
Price

 

Number
of Shares

 

Weighted
Average
Exercise
Price

 

$0.00 - $3.50

 

4,639

 

7.1

 

$

1.51

 

2,965

 

$

1.38

 

$3.51 - $7.80

 

2,231

 

8.0

 

$

6.94

 

805

 

$

6.83

 

$7.81 - $11.00

 

5,296

 

8.9

 

$

8.97

 

1,381

 

$

8.96

 

$11.01 - $19.00

 

4,114

 

9.4

 

$

14.96

 

429

 

$

14.81

 

$19.01 - $35.00

 

15

 

4.9

 

$

33.33

 

15

 

$

33.33

 

 

 

16,295

 

8.4

 

$

8.10

 

5,595

 

$

5.15

 

 

2006 Incentive Plan

In May 2006 we adopted the 2006 Incentive Plan. The 2006 Incentive Plan permits the grant of stock options, restricted stock, restricted stock units, stock appreciation rights, performance stock, performance units, annual awards and other awards based on, or related to, shares of our common stock. Options awarded under our 2006 Incentive Plan may be nonstatutory stock options or may qualify as incentive stock options under Section 422 of the Internal Revenue Code of 1986, as amended. Our 2006 Incentive Plan contains various limits with respect to the types of awards, as follows:

·                  a maximum of 20,000 shares may be issued under the plan pursuant to incentive stock options;

·                  a maximum of 10,000 shares may be issued pursuant to options and stock appreciation rights granted to any participant in a calendar year;

·                  a maximum of $5,000 may be paid pursuant to annual awards granted to any participant in a calendar year; and

·                  a maximum of $10,000 may be paid (in the case of awards denominated in cash) and a maximum of 10,000 shares may be issued (in the case of awards denominated in shares) pursuant to awards, other than options, stock appreciation rights or annual awards, granted to any participant in a calendar year.

The maximum number of shares of our common stock that are authorized for issuance under our 2006 Incentive Plan will be determined under a formula set forth in the plan, and will equal approximately 17.65% of the number of shares that are issued and outstanding from time to time, less the number of shares that are available for issuance under our 2001 Stock Incentive Plan. Following termination of our 2001 Stock Incentive Plan, the number of remaining shares available for issuance under our 2001 Stock Incentive Plan, or that becomes available for issuance upon expiration or cancellation, without payment or settlement, of awards under our 2001 Stock Incentive Plan, also will become available for issuance under our 2006 Incentive Plan. Shares issued under the plan may be authorized and unissued shares or may be issued shares that we have reacquired. Shares covered by awards that are forfeited, cancelled or otherwise expire without having been exercised or settled, or that are settled by cash or other non-share consideration, will become available for issuance pursuant to a new award. Shares that are tendered or withheld to pay the exercise price of an award or to satisfy tax withholding obligations will not be available for issuance pursuant to new awards.  At September 30, 2006, 15,619 shares were available for future grant under the 2006 Stock Incentive Plan.

11




Stock option activity was as follows:

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

 

 

Average

 

 

 

 

 

 

 

 

 

 

 

Weighted

 

Remaining

 

 

 

Weighted

 

 

 

 

 

Range of

 

Average

 

Contractual

 

Aggregate

 

Average

 

 

 

Number

 

Exercise

 

Exercise

 

Term in

 

Intrinsic

 

Grant Date

 

(Shares and Intrinsic Value in Thousands)

 

of Shares

 

Prices

 

Price

 

Years

 

Value

 

Fair Value

 

Awards outstanding at December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

275

 

$

6.50 - $8.90

 

$

7.44

 

 

 

 

 

$

4.75

 

Exercised

 

 

 

 

 

 

 

 

 

 

 

 

Canceled

 

(1

)

$

6.50 - $7.08

 

$

6.69

 

 

 

 

 

 

 

Awards outstanding at September 30, 2006

 

274

 

$

6.50 - $8.90

 

$

7.44

 

9.7

 

$

20

 

$

4.75

 

Shares exercisable at September 30, 2006

 

 

 

 

 

 

 

 

 

 

 

 

Unvested shares at December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

Unvested shares at September 30, 2006

 

274

 

$

6.50 - $8.90

 

$

7.44

 

9.7

 

$

20

 

$

4.75

 

 

The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2006 was $4.75. Compensation costs for all stock-based awards are recognized using the ratable single-option approach on an accrual basis.

The following is a summary of the status of stock options outstanding at September 30, 2006:

 

Outstanding Options

 

Exercisable Options

 

Exercise
Price Range

 

Number
of Shares

 

Weighted
Average
Remaining
Contractual
Life

 

Weighted
Average
Exercise
Price

 

Number
of Shares

 

Weighted
Average
Exercise
Price

 

$0.00 - $3.50

 

 

 

 

 

 

 

 

 

 

 

$3.51 - $7.80

 

175

 

9.7

 

$

6.88

 

 

$

0.00

 

$7.81 - $11.00

 

99

 

9.7

 

$

8.44

 

 

$

0.00

 

$11.01 - $19.00

 

 

 

 

 

 

 

 

 

 

 

$19.01 - $35.00

 

 

 

 

 

 

 

 

 

 

 

 

 

274

 

9.7

 

$

7.44

 

 

$

0.00

 

 

Restricted stock and restricted stock unit activity was as follows:

 

 

 

Weighted

 

 

 

 

 

 

 

Average

 

Aggregate

 

 

 

Number

 

Grant Date

 

Intrinsic

 

(Shares in Thousands)

 

of Shares

 

Fair Value

 

Value

 

Awards outstanding at December 31, 2005

 

 

 

 

 

 

Granted

 

1,004

 

$

6.46

 

$

6,909

 

Vested

 

 

 

 

 

 

Canceled

 

(21

)

$

6.38

 

$

145

 

Awards outstanding at September 30, 2006

 

983

 

$

6.46

 

$

6,764

 

 

The weighted average grant date fair value of restricted stock and restricted stock units granted during the three and nine months ended September 30, 2006 was $6.46. Compensation costs for all stock-based awards are recognized using the ratable single-option approach on an accrual basis.

Total compensation expense recognized under the 2006 Incentive Plan for the three and nine months ended September 30, 2006 was $479. As of September 30, 2006, total unamortized stock-based compensation under the 2006 Incentive Plan was $5,444, which is expected to be amortized over the remaining vesting period of each grant, up to the next 48 months.

12




Note 6. Commitments and Contingencies

Vendor Commitments

We have engaged a vendor to assist us with our customer care and inbound sales calls and have committed to pay this vendor a total of $1,500 in 2007 for configuration and installation services.  This agreement will remain in effect for three years and after the first twelve months that the agreement has been in effect we have the ability to terminate the agreement for any reason with sixty days prior written notice, subject to a termination fee.

We are currently in negotiations with a vendor for certain television commercials, related media and sponsorship of certain sporting events with an estimated cost of $5,000 in 2007 and $6,000 in 2008.

Litigation

IPeria, Inc.    On October 10, 2003, we terminated our contract with IPeria, Inc., our former voicemail vendor. Under the terms of the contract, we were permitted to terminate the contract for any reason. On April 12, 2004, IPeria filed a complaint against Vonage in the Superior Court for the County of Suffolk, Massachusetts. IPeria asserted a number of different claims, including breach of contract, copyright infringement, breach of implied covenant of good faith and fair dealing, negligent misrepresentations, fraud and unfair and deceptive trade practices. In support of these claims, IPeria essentially alleges that it provided voicemail services to Vonage consistent with the terms of the contract and that Vonage failed to pay for those services in violation of the contract. The complaint seeks payment of $619 plus accrued interest that IPeria asserts it is owed on the contract and treble damages.

We answered IPeria’s complaint on May 10, 2004 and denied all material allegations. In addition, we asserted counterclaims against IPeria. Specifically, we alleged that IPeria assured us that its voicemail system would meet minimum performance and scaleability standards, and that the voicemail system failed to meet those standards. We are seeking payment of all damages we suffered as the result of IPeria’s failures, treble damages and attorneys’ fees.

Discovery in this matter began in June 2004 and has now been completed. On December 1, 2005, IPeria filed a motion for summary judgment, and on December 2, 2005, we filed a motion for summary judgment on IPeria’s copyright and unfair trade practices claims. IPeria subsequently dismissed its copyright claim. Oppositions to the motions for summary judgment were served on January 23, 2006, and replies were submitted on February 8, 2006. Oral argument on the motions took place on February 16, 2006, and the court has now taken the motions under advisement. We contested liability in this matter and expect to continue to defend the case vigorously. We have engaged in settlement discussions on this matter and, in any event, we believe an unfavorable outcome would not have a material adverse effect on our results of operations and cash flows in the period in which the matter is resolved. We have recorded a reserve to cover the potential exposure relating to this litigation, which reserve was not material to our financial statements.

Joshua B. Tanzer.   On October 18, 2005, Joshua B. Tanzer commenced a suit against Vonage in the United States District Court for the Southern District of New York seeking damages of approximately $14,240  and has subsequently sent us a letter increasing his claim to $26,750.  Mr. Tanzer claims that damages are due with respect to our sale of Series D Convertible Preferred Stock and Series E Convertible Preferred Stock and convertible notes pursuant to the terms of an engagement letter governing Nanes Delorme Capital Management's services in connection with our placement of Series B and C Convertible Preferred Stock. Mr. Tanzer's complaint further seeks a declaratory judgment that he is entitled to be paid additional fees in connection with any future private placements of our securities. The engagement letter states that Mr. Tanzer was "associated" with Nanes Delorme and was a registered representative of that firm. We believe that our obligations with respect to Mr. Tanzer and Nanes Delorme were completely performed at the conclusion of the Series C offering, and no further amount is owed to Mr. Tanzer or Nanes Delorme on account of the Series D, Series E or convertible note offerings. We filed our answer to the complaint on December 7, 2005 and denied all material allegations. On February 17, 2006, we filed counterclaims against Tanzer and a third-party complaint against Nanes Delorme. Among other things we seek the return of all fees paid to Nanes Delorme. On March 13, 2006, Nanes filed an answer and is seeking declaratory judgment regarding the parties' respective rights and obligations under the engagement letter and damages of approximately $14,250 in payment of investment banking fees related to our sale of Series D and Series E Preferred Stock. On April 5, 2006, we filed our answer to Nanes Delorme's counterclaim. In June 2006, we filed a motion for summary judgment requesting the dismissal of the claims asserted against us. On July 21, 2006, we filed a statement of undisputed facts with the court and subsequently filed a reply statement to Tanzer's and Delorme’s statement of undisputed facts. We intend to defend this matter vigorously and believe an unfavorable outcome would not have a material adverse effect on our results of operations and cash flows in the period in which the matter is resolved. Based upon prior settlement discussions with Tanzer, we have recorded a reserve to cover the potential exposure relating to this litigation, which reserve was not material to our financial statements. The amount was recorded as an offset against the Series D Preferred Stock as these fees relate to the placement of those securities.

Shaw Communications Inc. and Shaw Cablesystems G.P.   On March 27, 2006, Shaw Communications Inc. and Shaw Cablesystems G.P. (collectively "Shaw") filed a Statement of Claim with the Court of the Queen's Bench of Alberta, Judicial Centre of Calgary. The Statement of Claim alleges that certain statements attributed to Vonage Canada regarding Shaw's "Quality of Service Enhancement" fee are false, misleading and defamatory and have interfered with Shaw's relations with its customers. Shaw is seeking an injunction, damages and attorney's fees. We believe Shaw's claims have no merit and intend to vigorously defend the lawsuit.

Patent Litigation.

·                  Sprint.    On October 16, 2005, a lawsuit was filed against us by Sprint Communications Company L.P. in the United States District Court for the District of Kansas. Sprint alleges that we have infringed seven patents in connection with providing VoIP services. Sprint seeks injunctive relief, compensatory and treble damages and attorney's fees in unspecified amounts. In our answer filed on November 3, 2005, we have denied Sprint's allegations and have counterclaimed for a declaration of non-infringement, invalidity and unenforceability of the patents. We believe that we have meritorious defenses against the claims asserted by Sprint and intend to vigorously defend the lawsuit. The matter is presently in the discovery stage.

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·                  Rates Technology.    On October 6, 2005, a lawsuit was filed against us by Rates Technology Inc. in the United States District Court for the Eastern District of New York. Rates alleges that we have infringed two patents in connection with the least cost routing of telephone calls over the public switched telephone network. Rates seeks injunctive relief, attorney’s fees, compensatory damages in excess of one billion dollars and a trebling thereof. In our answer filed on November 22, 2005, we have denied Rates’ allegations and have counterclaimed for a declaration of non-infringement, invalidity and unenforceability of the patents. We believe that we have meritorious defenses against the claims asserted by Rates and intend to vigorously defend the lawsuit.

·                  Barry W. Thomas.    On December 6, 2005, Barry W. Thomas filed a lawsuit in the United States District Court for the Western District of North Carolina. The plaintiff alleged that we had infringed one patent in connection with providing utility services using a pre-programmed smart card. Mr. Thomas sought injunctive relief, compensatory and treble damages and attorney’s fees in unspecified amounts. Mr. Thomas has agreed to dismiss this lawsuit with prejudice and executed a settlement agreement with us on August 4, 2006.

·                  Verizon.     On June 12, 2006, a lawsuit was filed against us and our subsidiary Vonage America Inc., or Vonage America, by Verizon Services Corp. and Verizon Laboratories Inc., or collectively, Verizon, in the United States District Court for the Eastern District of Virginia. Verizon alleges that we have infringed seven patents in connection with providing VoIP services. Verizon seeks injunctive relief, compensatory and treble damages and attorney’s fees. In our answer filed on July 19, 2006, we have denied Verizon’s allegations and have counterclaimed for a declaration of non-infringement, invalidity and unenforceability of the patents. We believe that we have meritorious defenses against the claims asserted by Verizon, and intend to vigorously defend the lawsuit. The matter is presently in the discovery stage.

·                  Klausner Technologies.     On July 10, 2006, a lawsuit was filed against us and Vonage America by Klausner Technologies, Inc., or Klausner, in the United States District Court for the Eastern District of Texas. Klausner alleges that we have infringed one of its patents with voice mail technology. Klausner seeks injunctive relief, compensatory and treble damages and attorney’s fees. In our answer filed on September 14, 2006, we have denied Klausner’s allegations and have counterclaimed for a declaration of non-infringement, invalidity and unenforceability of the patent. We believe that we have meritorious defenses against the claims asserted by Klausner, and intend to vigorously defend the lawsuit.

With respect to the patent litigation identified above, we believe that we have meritorious defenses against the claims. However, we might not ultimately prevail in these actions. Whether or not we ultimately prevail, litigation could be time-consuming and costly and injure our reputation. If any of the plaintiffs prevail in their respective actions, we may be required to negotiate royalty or license agreements with respect to the patents at issue, and may not be able to enter into such agreements on acceptable terms, if at all. Any limitation on our ability to provide a service or product could cause us to lose revenue-generating opportunities and require us to incur additional expenses. These potential costs and expenses, as well as the need to pay additional damages awarded in the favor of the plaintiffs could materially adversely affect our business.

IPO Litigation.     During June 2006 and July 2006, Vonage, several of our officers and directors, and the firms who served as the underwriters in our IPO were named as defendants in Lang v. Vonage Holdings Corp. et al., a purported class action lawsuit filed in the United States District Court for the District of New Jersey. Subsequently, several similar purported class action lawsuits were filed in the United States District Court for the District of New Jersey, one was filed in the United States

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District Court for the Southern District of New York and another was filed in the Supreme Court of the State of New York and subsequently removed to the United States District Court for the Eastern District of New York.

The complaints assert claims under the federal securities laws on behalf of a professed class consisting of all those who were allegedly damaged as a result of acquiring our common stock in connection with our IPO. The complaints allege, among other things, that we omitted and/or misstated certain facts concerning the IPO’s Customer Directed Share Program. Some complaints also allege the IPO prospectus contained misrepresentations or omissions concerning certain of our products and/or the prior experience of some of our management. One complaint (Inouye v. Vonage Holdings Corp. et al.), which was filed in the United States District Court for the Southern District of New York and subsequently voluntarily dismissed, included an allegation of open market securities fraud during a purported class period of May 24, 2006 to June 19, 2006 in addition to claims arising out of the IPO. Although Lang, Inouye and one other complaint were voluntarily dismissed, we expect the remaining complaints to be consolidated at some time in the future.

On July 14, 2006, Vonage and the firms who served as the underwriters in our IPO were named as defendants in a separate lawsuit filed in the United States District Court for the District of New Jersey (Norsworthy v. Vonage Holdings Corp. et al.). This purported class action lawsuit asserts state law breach of contract and negligence claims relating to the alleged inability of participants in our Customer Directed Share Program to trade their shares after the IPO.

Although we believe that we and the individual defendants have meritorious defenses to the claims made in each of the aforementioned complaints and intend to contest each lawsuit vigorously, an adverse resolution of any of the lawsuits may have a material adverse effect on our financial position and results of operations in the period in which the lawsuits are resolved. We are not presently able to reasonably estimate potential losses, if any, related to the lawsuits.

We also are involved in certain other threatened and pending legal proceedings and, from time to time, receive subpoenas or civil investigative demands from governmental agencies for information that may be pertinent to their confidential investigations. Although the results of litigation claims and investigations cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our business. Regardless of outcome, litigation can have an adverse impact on us because of defense costs, diversion of management resources and other factors.

State and Municipal Taxes

Until recently, we did not collect or remit state or municipal taxes (such as sales, excise, and ad valorem taxes), fees or surcharges (“Taxes”) on the charges to our customers for our services, except that we have historically complied with the New Jersey sales tax. We have received inquiries or demands from a number of state and municipal taxing and 911 agencies seeking payment of Taxes that are applied to or collected from customers of providers of traditional public switched telephone network services. Although we have consistently maintained that these Taxes do not apply to our service for a variety of reasons depending on the statute or rule that establishes such obligations, a number of states have changed their statutes as part of the streamlined sales tax initiatives and numerous other states have entered into sales tax agreements with us. As of September 30, 2006, we are collecting and remitting sales taxes in forty-one states. In addition, a few states address how VoIP providers should contribute to support public safety agencies, and in those states we began to remit fees to the appropriate state agencies. We have also contacted authorities in each of the other states to discuss how we can financially contribute to the 911 system. We do not know how all these discussions will be resolved, but there is a possibility that we will be required to pay or collect and remit some or all of these Taxes in the future. Additionally, some of these Taxes could apply to us retroactively. As such, we have recorded a reserve of $11,228 at September 30, 2006 as our best estimate of the potential tax exposure for any retroactive assessment. We believe the maximum estimated exposure for retroactive assessments is $24,153 as of September 30, 2006.

Universal Service Fund

In late June 2006, the FCC released an Order in which it would require VoIP service providers to contribute to the Universal Service Fund (“USF”). This Order was effective upon publication in the Federal Register, and requires the first filing by August 1, 2006, with USF contributions effective for the fourth quarter of 2006. Vonage will register with the FCC and report revenue for contribution using one of three methods, (1) using the interim safe harbor of 64.9%; (2) report based on our actual interstate telecommunications revenues; or (3) rely on traffic studies based on certain conditions. We began recouping our contributions through a customer surcharge on October 1, 2006. We have also filed an appeal with respect to this Order.

 State Attorney General Proceedings

Several state attorneys general have initiated investigations and, in two states, have commenced litigation concerning our marketing disclosures and advertising. We are cooperating with those investigations and are pursuing joint settlement negotiations with the attorneys general of Florida, Illinois, Massachusetts, Texas, Michigan and North Carolina and separate negotiations with the attorney general of Connecticut. While these complaints seek awards of damages and penalties, no particular amounts have been specified at this time. In July 2006 we reached an agreement in principle to settle the litigation with

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the state attorney general of Texas, and the investigations being conducted by the state attorneys general of Florida, Illinois, Massachusetts, Michigan and North Carolina. This agreement in principle is subject to finalizing the documentation memorializing the settlement and executing such settlement documentation.  With respect to our joint settlement negotiations, we have recorded a reserve to cover the potential exposure relating to these investigations, which was not material to our September 30, 2006 financial statements.

·                  On May 3, 2005, the Office of the Attorney General for the State of Connecticut filed a complaint against us, alleging that our advertising and provision of emergency calling service violated the Connecticut Unfair Trade Practices Act and certain state regulations. We answered the complaint on July 7, 2005 and denied its allegations. We have undertaken settlement discussions with the Connecticut Attorney General and have voluntarily provided information requested during the course of those discussions. If these discussions are not successful, we intend to vigorously defend against the lawsuit.

·                  On March 7, 2006, the Attorney General of Missouri issued a civil investigative demand for documents related to our emergency calling service. We responded to the civil investigative demand on April 3, 2006. The Missouri Attorney General has not filed a complaint against us or taken other formal action.

·                  We received a subpoena dated June 29, 2006 from the Commonwealth of Pennsylvania, Office of Attorney General, Bureau of Consumer Protection seeking a wide variety of documents. The Attorney General’s office has since agreed to narrow the scope of documents it seeks to certain materials relating to advertising to, and subscriptions by, Pennsylvania consumers, and the training and general form of compensation paid to personnel that market and provide customer care functions for our service. We are making a rolling production of responsive materials, and we made our first production on July 27, 2006.

Federal Trade Commission Investigation

On August 31, 2005, the Federal Trade Commission, or FTC, issued a Civil Investigative Demand to us which requested information regarding our 911 service and complaints or notices pertaining to that service, our residential unlimited calling plan and our compliance and our telemarketing vendors’ compliance with the FTC’s Telemarketing Sales Rule including, but not limited to, the requirement to refrain from telemarketing to persons who appear on the National Do Not Call Registry. No formal action has been filed against Vonage at this time. We are unable at this time to predict the outcome of the FTC’s investigation, whether a formal action will be filed against Vonage, to assess the likelihood of a favorable or unfavorable outcome in that event, or to estimate the amount of liability in the event of an unfavorable outcome.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion together with our consolidated financial statements and the related notes included elsewhere in this Form 10-Q and our audited financial statements included in our Registration Statement on Form S-1 (File No. 333-31659). This discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results may differ materially from those we currently anticipate as a result of many factors, including the factors we describe under “Risk Factors,” and elsewhere in this Form 10-Q.

Overview

We are a leading provider of broadband telephone services with over 2.0 million subscriber lines as of September 30, 2006. Our services use Voice over Internet Protocol, or VoIP, technology, which enables voice communications over the Internet through the conversion and compression of voice signals into data packets. In order to use our service offerings, customers must have access to a broadband Internet connection with sufficient bandwidth (generally 60 kilobits per second or more) for transmitting those data packets.

We earn revenue and generate cash primarily through our broadband telephone service plans, each of which offers a different pricing structure based on a fixed monthly fee. We generate most of our revenue from those fees, substantially all of which we bill to our customers’ credit cards one month in advance.

We have invested heavily in an integrated marketing strategy to build strong brand awareness that supports our sales and distribution efforts. We acquire customers through a number of sales channels, including our websites, toll free numbers and a presence in major retailers located in the United States, Canada and the United Kingdom. We also acquire a significant number of new customers through Refer-a-Friend, our online customer referral program.

We launched our service in the United States in October 2002, in Canada in November 2004 and in the United Kingdom in May 2005. Since our U.S. launch, we have experienced rapid revenue and subscriber line growth. While our revenue has grown rapidly, we have incurred an accumulated deficit of $603.8 million from our inception through September 30, 2006. Although our net losses initially were driven primarily by start-up costs and the cost of developing our technology, more recently our net losses have been driven by our growth strategy. In order to grow our customer base and revenue, we have chosen to increase our marketing expenses significantly, rather than seeking to generate net income. In addition, we plan to continue to invest in research and development and customer care. We are pursuing growth, rather than profitability, in the near term to capitalize on the current expansion of the broadband and VoIP markets, and to establish and maintain a leading position in the market for broadband telephone services. We incurred marketing expense of $91.3 million and $269.8 million and a net loss of $62.2 million and $221.5 million for the three and nine months ended September 30, 2006, respectively. We intend to continue to pursue growth because we believe it will position us as a strong competitor in the long term. Although we believe we will achieve profitability in the future, we ultimately may not be successful and we may never achieve profitability.

Trends in Our Industry and Business

A number of trends in our industry and business have a significant effect on our results of operations and are important to an understanding of our financial statements. These trends include:

Broadband adoption.   The number of U.S. households with broadband Internet access has grown significantly. We expect this trend to continue. We benefit from this trend because our service requires a broadband Internet connection and our potential addressable market increases as broadband adoption increases.

Changing competitive landscape.   We are facing increasing competition from other companies that offer multiple services such as cable television, voice and broadband Internet service. Several of these competitors are offering VoIP or other voice services as part of a bundle, in which they offer voice services at a lower price than we do to new subscribers. In addition, several of these competitors are working to develop new integrated offerings that we cannot provide and that could make their services more attractive to customers. We also compete against established alternative voice communication providers and independent VoIP service providers. Some of these service providers may choose to sacrifice revenue in order to gain market share and have offered their services at lower prices or for free. These offerings could negatively affect our ability to acquire new customers or retain our existing customers.

Subscriber line growth.   Since our launch, we have experienced rapid subscriber line growth. For example, we grew from 85,717 subscriber lines as of December 31, 2003 to 390,566 as of December 31, 2004 to 1,269,038 as of December 31, 2005. In addition, we grew from 1,061,786 subscriber lines as of September 30, 2005 to 2,057,844 as of September 30, 2006 or approximately 1 million incremental subscriber lines. We believe we will continue to add a significant number of subscriber lines in future periods; however, we do not expect to sustain our historical subscriber line growth rate on a percentage basis due to a combination of increased competition, a significantly larger and growing customer base and increasing saturation among our initial target customer base, which included many early adopters.

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Average monthly customer churn.   For the three months ended September 30, 2006, we experienced average monthly customer churn of 2.6% compared to 2.3% for the three months ended September 30, 2005. We believe this increase was driven, in part, by increased competition and our continued rapid growth and inability to hire enough qualified customer care employees, which led to less than satisfactory customer care during the first three quarters of 2006. We are working to improve our customer care. We believe that our churn will fluctuate over time and may increase as we shift our marketing focus from early adopters to mainstream customers and acquire customers from new sources, such as outbound telemarketing, that historically have had a higher churn rate.

Average monthly revenue per line.   Our average monthly revenue per line increased to $27.40 for the three months ended September 30, 2006 compared to $25.79 for the three months ended September 30, 2005. For the remainder of 2006, we believe that our average monthly revenue per line will remain steady or slightly increase. In March 2006, we began charging customers an Emergency 911 Cost Recovery fee, which has increased average monthly revenue per line. In addition, an increasing number of customers are choosing the residential unlimited plan as a result of the first month free promotion which has a positive effect on longer term average monthly revenue per line. These increases could be negatively impacted by the timing and duration of promotions such as the second line promotion introduced in late May 2006. In addition, in May 2006 we started offering free calls to certain countries in Europe for customers on our unlimited plans, which will decrease average monthly revenue per line.

Average monthly direct cost of telephony services per line.   Our average monthly direct cost of telephony services per line decreased to $6.86 for the three months ended September 30, 2006 compared to $8.56 for the three months ended September 30, 2005. This decrease has been driven by changes in customers’ calling patterns as international calling is a lower portion of our overall call volume and our fixed network costs are being spread over a larger subscriber line base. These decreases were partially offset by the costs of E-911 compliance.

Regulation.   Our business has developed in an environment largely free from regulation. However, the United States and other countries have begun to examine how VoIP services should be regulated, and a number of initiatives could have an impact on our business. For example, the FCC has concluded that wireline broadband Internet access, such as DSL and Internet access provided by cable companies, is an information service and is subject to lighter regulation than telecommunications services. This order may give providers of wireline broadband Internet access the right to discriminate against our services, charge their customers an extra fee to use our service or block our service. We believe it is unlikely that this will occur on a widespread basis, but if it does it would have a material adverse effect on us. Other regulatory initiatives include the assertion of state regulatory authority over us, FCC rulemaking regarding emergency calling services and proposed reforms for the intercarrier compensation system. In addition, the FCC recently concluded that VoIP providers must begin contributing to the Universal Service Fund on October 1, 2006, an order that we are appealing. The Internal Revenue Service, however, has discontinued the requirement to collect the Federal Excise Tax, which we stopped collecting on June 24, 2006. Complying with regulatory developments will impact our business by increasing our operating expenses, including legal and consulting fees, requiring us to make significant capital expenditures or increasing the taxes and regulatory fees we pay.

E-911 roll-out.   As of September 30, 2006, we were providing E-911 services to over 90% of our U.S. subscriber lines. We expect to complete the E-911 roll-out to nearly all of our remaining subscriber lines within the year. If the FCC orders us to disconnect customers or stop accepting new customers in areas where we have not yet implemented E-911 capability, it would reduce our subscriber growth while we work to complete the roll-out. This may result in an increase in our marketing cost per gross subscriber line addition, since most of our marketing programs are national in nature and we cannot significantly reduce our marketing costs in areas in which we could not accept new customers.

Operating Revenues

Operating revenues consists of telephony services revenue and customer equipment and shipping revenue.

Telephony services revenue.    Substantially all of our operating revenues are telephony services revenue. In the United States, we offer two residential plans, “Residential Premium Unlimited” and “Residential Basic 500,” and two small office and home office plans, “Small Business Unlimited” and “Small Business Basic.” Each of our unlimited plans offers unlimited domestic calling as well as Puerto Rico and Canada, subject to certain restrictions, and each of our basic plans offers a limited number of domestic calling minutes per month. Under our basic plans, we charge on a per minute basis when the number of domestic calling minutes included in the plan is exceeded for a particular month. International calls (except for calls to certain European countries) under our unlimited plans are charged on a per minute basis. These per minute fees are not included in our monthly subscription fees. We offer similar plans in Canada and the United Kingdom.

We derive most of our telephony services revenue from monthly subscription fees that we charge our customers under our service plans. We also offer residential fax service, virtual phone numbers, toll free numbers and other services, for each of which we charge an additional monthly fee. One business fax line is included with each of our two small office and home office plans, but we charge monthly fees for additional business fax lines. We automatically charge these fees to our customers’ credit cards monthly in advance. We automatically charge the per minute fees not included in our monthly subscription fees to our customers’ credit cards monthly in arrears unless they exceed a certain dollar threshold, in which case they are charged immediately.

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By collecting monthly subscription fees in advance and certain other charges immediately after they are incurred, we are able to reduce the amount of accounts receivable that we have outstanding, thus allowing us to have lower working capital requirements. Collecting in this manner also helps us mitigate bad debt exposure, which is recorded as a reduction to revenue. If a customer’s credit card is declined, we generally suspend international calling capabilities as well as the customer’s ability to incur domestic usage charges in excess of their plan minutes. Historically, in most cases, we are able to correct the problem with the customer within the current monthly billing cycle. If the customer’s credit card cannot be successfully processed during two billing cycles (i.e., the current and subsequent month’s billing cycle), we terminate the account.

We also generate revenue by charging a fee for activating service. Through June 2005, we charged an activation fee to our direct channel customers, or those customers who purchase equipment directly from us. Beginning in July 2005, we also began charging an activation fee to our retail channel customers, or customers who purchase equipment from retail stores. For our direct channel customers, activation fees, together with the related customer acquisition amounts for equipment, are deferred and amortized over the estimated average customer relationship period. For our retail channel customers, rebates and retailer commissions up to but not exceeding the activation fee, are also deferred and amortized over the estimated average customer relationship period. The amortization of deferred customer equipment expense is recorded to direct cost of goods sold. The amortization of deferred rebates is recorded as a reduction to telephony services revenue. The amortization of deferred retailer commissions is recorded as marketing expense. Through December 31, 2004, we estimated that the average customer relationship period would be 30 months based upon comparisons to other telecommunications companies. For 2005, this period was reevaluated based on our experience to date and we now estimate it will be 60 months. We have applied the 60-month customer relationship period on a prospective basis beginning January 1, 2005. For 2006, we have confirmed that the customer relationship period should be 60 months.

In the United States, we charge regulatory recovery fees on a monthly basis to defray the costs associated with regulatory consulting and compliance as well as related litigation, E-911 compliance and to cover taxes that we are charged by the suppliers of telecommunications services. We record these fees as revenue.

Prior to June 30, 2005, we generally charged a disconnect fee to customers who did not return their customer equipment to us upon termination of service, regardless of the length of time between activation and termination. On July 1, 2005, we changed our termination policy. We no longer accept returns of any customer equipment after 30 days, and we charge a disconnect fee to customers who terminate their service within one year of activation. Disconnect fees are recorded as revenue and are recognized at the time the customer terminates service.

Telephony services revenue is offset by the cost of certain customer acquisition activities, such as rebates and promotions.

Customer equipment and shipping revenue.    Customer equipment and shipping revenue consists of revenue from sales of customer equipment to our wholesalers or directly to customers and retailers. In addition, customer equipment and shipping revenue includes the fees that we charge our customers for shipping any equipment to them.

Operating Expenses

Operating expenses consist of direct cost of telephony services, direct cost of goods sold, selling, general and administrative expense, marketing expense and depreciation and amortization.

Direct cost of telephony services.   Direct cost of telephony services primarily consists of fees that we pay to third parties on an ongoing basis in order to provide our services. These fees include:

·                  Access charges that we pay to other telephone companies to terminate domestic and international calls on the public switched telephone network. These costs represented approximately 59% and 64% of our direct cost of telephony services for the three months ended September 30, 2006 and 2005, respectively, with a portion of these payments ultimately being made to incumbent telephone companies. When a Vonage subscriber calls another Vonage subscriber, we do not pay an access charge.

·                  The cost of leasing interconnections to route calls over the Internet and transfer calls between the Internet and the public switched telephone networks of various long distance carriers.

·                  The cost of leasing from other telephone companies the telephone numbers that we provide to our customers. We lease these telephone numbers on a monthly basis.

·                  The cost of co-locating our regional data connection point equipment in third-party facilities owned by other telephone companies, internet service providers, or collocation facility providers.

·                  The cost of providing local number portability, which allows customers to move their existing telephone numbers from another provider to our service. Only regulated telecommunications providers have access to the centralized number databases that facilitate this process. Because we are not a regulated telecommunications provider, we must pay other telecommunications providers to process our local number portability requests.

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·                  The cost of complying with the new FCC regulations regarding VoIP emergency services, which require us to provide enhanced emergency dialing capabilities to transmit 911 calls for all of our customers.

·                  Taxes that we pay on our purchase of telecommunications services from our suppliers.

Direct cost of goods sold.   Direct cost of goods sold primarily consists of costs that we incur when a customer first subscribes to our service. These costs include:

·                  The cost of the equipment that we provide to customers who subscribe to our service through our direct sales channel in excess of activation fees. The remaining cost of customer equipment is deferred and amortized over the estimated average customer relationship period.

·                  The cost of the equipment that we sell directly to retailers.

·                  The cost of shipping and handling for customer equipment, together with the installation manual, that we ship to customers.

·                  The cost of products or services that we give customers as promotions.

Selling, general and administrative expense.    Selling, general and administrative expense includes:

·                  Compensation and benefit costs for all employees, which is the largest component of selling, general and administrative expense and includes customer care, research and development, network engineering and operations, sales and marketing, executive, legal, finance, human resources and business development personnel.

·                  Compensation expense related to stock-based awards to employees and directors.

·                  Outsourced labor related to customer care and retail in-store support activities.

·                  Transaction fees paid to credit card companies, which include a per transaction charge in addition to a percent of billings charge.

·                  Rent and related expenses.

·                  Professional fees for legal, accounting, tax, public relations, lobbying and development activities.

We anticipate an increase in our selling, general and administrative expense as we hire additional personnel to address our growing subscriber base and to handle the obligations of a public company but expect selling, general and administrative expense to decrease as a percentage of revenue in 2006 compared to 2005.

Marketing expense.   Marketing expense consists of:

·                  Advertising costs, which comprise a majority of our marketing expense and include online, television, print and radio advertising, direct mail, alternative media, promotions, sponsorships and inbound and outbound telemarketing.

·                  Creative and production costs.

·                  The costs to serve and track our online advertising.

·                  Certain amounts we pay to retailers for newspaper insert advertising, product placement and activation commissions.

·                  The cost associated with our customer referral program.

For 2006, we expect to spend between $360 million and $380 million for marketing expense, compared to $243.4 million in 2005. Because our marketing commitments are generally six weeks or less in duration, we are able to significantly reduce marketing expense relatively quickly if it becomes prudent to do so.

Depreciation and amortization expenses.    Depreciation and amortization expenses include:

·                  Depreciation of our network equipment, furniture and fixtures, and employee computer equipment.

·                  Amortization of leasehold improvements and purchased software.

·                  Amortization of intangible assets (patents).

Other Income (Expense)

Other Income (Expense) consists of:

·                  Interest income on cash, cash equivalents and marketable securities.

·                  Interest expense on notes payable and capital leases.

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·                  Amortization of deferred financing costs.

·                  Accretion of convertible notes.

·                  Gain or loss on disposal of property and equipment.

·                  Debt conversion expense relating to the conversion of notes payable to equity.

For 2006 and subsequent years through 2010, we will have annual interest expense on our convertible notes of at least
$12.7 million unless the convertible notes are converted or repaid prior to maturity date. This amount will increase if we pay interest in kind on these notes.

Key Operating Data

The following table contains certain key operating data that our management uses to measure the growth of our business and our operating performance:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Gross subscriber line additions

 

359,148

 

282,176

 

1,158,044

 

824,609

 

Net subscriber line additions

 

204,591

 

213,937

 

788,806

 

671,220

 

Subscriber lines (at period end)

 

2,057,844

 

1,061,786

 

2,057,844

 

1,061,786

 

Average monthly customer churn

 

2.6

%

2.3

%

2.4

%

2.1

%

Average monthly revenue per line

 

$

27.40

 

$

25.79

 

$

28.25

 

$

26.63

 

Average monthly telephony services revenue per line

 

$

26.33

 

$

24.84

 

$

26.90

 

$

25.60

 

Average monthly direct cost of telephony services per line

 

$

6.86

 

$

8.56

 

$

7.80

 

$

8.31

 

Marketing costs per gross subscriber line addition

 

$

254.26

 

$

208.76

 

$

232.95

 

$

213.77

 

Employees (excluding temporary help) (at period end)

 

1,675

 

1,393

 

1,675

 

1,393

 

 

Gross subscriber line additions.   Gross subscriber line additions for a particular period are calculated by taking the net subscriber line additions during that particular period and adding to that the number of subscriber lines that terminated during that period. This number does not include subscriber lines both added and terminated during the period, where termination occurred within the first 30 days after activation. The number does include, however, subscriber lines added during the period that are terminated within 30 days of activation but after the end of the period.

Net subscriber line additions.   Net subscriber line additions for a particular period reflect the number of subscriber lines at the end of the period, less the number of subscriber lines at the beginning of the period.

Subscriber lines.   Our subscriber lines include, as of a particular date, all subscriber lines from which a customer can make an outbound telephone call on that date. Our subscriber lines include fax lines and SoftPhones but do not include our virtual phone numbers or toll free numbers, which only allow inbound telephone calls to customers. We added approximately 1 million subscribers from 1,061,786 subscriber lines as of September 30, 2005 to 2,057,844 as of September 30, 2006. The increase in our subscriber lines was directly related to an increase in our advertising spending and our expansion to other media, such as television, direct mail, alternative media and outbound telemarketing, which have a broader customer reach.

Average monthly customer churn.   Average monthly customer churn for a particular period is calculated by dividing the number of customers that terminated during that period by the simple average number of customers during the period, and dividing the result by the number of months in the period. The simple average number of customers during the period is the number of customers on the first day of the period, plus the number of customers on the last day of the period, divided by two. Terminations, as used in the calculation of churn statistics, do not include customers terminated during the period if termination occurred within the first 30 days after activation. Our average monthly customer churn was 2.6% for the three months ended September 30, 2006 compared to 2.3% for the three months ended September 30, 2005. We monitor churn on a daily basis and use it as an indicator of the level of customer satisfaction. Other companies may calculate churn differently, and their churn data may not be directly comparable to ours. Customers who have been with us for a year or more tend to have a significantly lower churn rate than customers who have not. This means that during periods of rapid customer growth or if we fail to address issues with our customer care our churn rate is likely to increase. In addition, our churn will fluctuate over time and may increase as we shift our marketing focus from early adopters to mainstream customers and acquire customers from new sources, such as outbound telemarketing, that historically have had a higher churn rate. Also, our churn rate could be negatively affected by increased competition.

Average monthly revenue per line.   Average monthly revenue per line for a particular period is calculated by dividing our total revenue for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. The simple average number of subscriber lines for the period is the number of subscriber lines on

21




the first day of the period, plus the number of subscriber lines on the last day of the period, divided by two. Our average monthly revenue per line was $27.40 for the three months ended September 30, 2006 compared to $25.79 for the three months ended September 30, 2005.

Average monthly telephony services revenue per line.   Average monthly telephony services revenue per line for a particular period is calculated by dividing our total telephony services revenue for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. Our average monthly telephony services revenue per line was $26.33 for the three months ended September 30, 2006 compared with $24.84 for the three months ended September 30, 2005.

Average monthly direct cost of telephony services per line.   Average monthly direct cost of telephony services per line for a particular period is calculated by dividing our direct cost of telephony services for that period by the simple average number of subscriber lines for the period, and dividing the result by the number of months in the period. We use the average monthly direct cost of telephony services per line to evaluate how effective we are at managing our costs of providing service. Our average monthly direct cost of telephony services per line decreased from $8.56 for the three months ended September 30, 2005 to $6.86 for the three months ended September 30, 2006.

Marketing cost per gross subscriber line addition.   Marketing cost per gross subscriber line addition is calculated by dividing our marketing expense for a particular period by the number of gross subscriber line additions during the period. Marketing expense does not include the cost of certain customer acquisition activities, such as rebates and promotions, which are accounted for as an offset to revenues, or customer equipment subsidies, which are accounted for as direct cost of goods sold. As a result, it does not represent the full cost to us of obtaining a new customer. Our marketing cost per gross subscriber line addition has fluctuated over time and may increase in 2006 for several reasons. We will increase our advertising spending and have added advertising in more expensive media with a broader reach, such as television, to enhance our brand awareness. In addition, we believe it is generally more expensive to acquire mainstream consumers than early adopters of new technologies and we have increased our focus on more mainstream consumers.

When we increase our total marketing expense, we generally experience, over the short term, a significant increase in marketing cost per gross subscriber line addition. However, we track the efficiency of our marketing programs and make adjustments on how we allocate our funds. These adjustments can result in a subsequent slight decrease in marketing cost per gross subscriber line addition after the initial increase in marketing expense.

Employees.   Employees represent the number of personnel that are on our payroll and exclude temporary or outsourced labor. One challenge we face in enhancing the efficiency of our selling, general and administrative expense is our high turnover among our customer care employees.

22




Results of Operations

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Operating Revenues:

 

 

 

 

 

 

 

 

 

Telephony services

 

96

%

96

%

95

%

96

%

Customer equipment and shipping

 

4

 

4

 

5

 

4

 

 

 

100

 

100

 

100

 

100

 

 

 

 

 

 

 

 

 

 

 

Operating Expenses:

 

 

 

 

 

 

 

 

 

Direct cost of telephony services (excluding depreciation and amortization)

 

25

 

33

 

28

 

31

 

Direct cost of goods sold

 

11

 

13

 

12

 

17

 

Selling, general and administrative

 

45

 

61

 

45

 

57

 

Marketing

 

57

 

80

 

64

 

101

 

Depreciation and amortization

 

4

 

4

 

4

 

4

 

 

 

142

 

191

 

153

 

210

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(42

)

(91

)

(53

)

(110

)

 

 

 

 

 

 

 

 

 

 

Other Income (Expense):

 

 

 

 

 

 

 

 

 

Interest income

 

5

 

2

 

3

 

2

 

Interest expense

 

(2

)

 

(3

)

 

 

 

3

 

2

 

 

2

 

 

 

 

 

 

 

 

 

 

 

Loss before income taxes

 

(39

)

(89

)

(53

)

(108

)

 

 

 

 

 

 

 

 

 

 

Income taxes

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

(39

)%

(89

)%

(53

)%

(108

)%

 

Three Months Ended September 30, 2006 Compared to the Three Months Ended September 30, 2005

Telephony Services Revenue and Direct Cost of Telephony Services

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Telephony services

 

$

154,487

 

$

71,158

 

$

83,329

 

117

%

Direct cost of telephony services (excluding depreciation and amortization of $3,022 and $2,025, respectively)

 

40,272

 

24,514

 

15,758

 

64

%

 

Telephony services revenue.   The increase in telephony services revenue of $83.3 million, or 117%, was primarily due to an increase of $63.2 million in monthly subscription fees resulting from an increased number of subscriber lines, which grew from 1,061,786 at September 30, 2005 to 2,057,844 at September 30, 2006. Also, the growing number of subscriber lines generated additional revenue from activation fees of $2.1 million, increased revenue of $5.0 million from a higher volume of international calling, increased revenue of $1.7 million from customers exceeding their plan minutes and increased revenue of $7.1 million in regulatory fees we collected from customers. Additionally, add-on features to our service plans generated an increase of $2.4 million. We also had a $2.3 million increase in the fees we charge for disconnecting our service and a $2.2 million reduction in credits we issued offset by $2.8 million increase in bad debt expense. We believe that telephony services revenue will continue to increase in 2006, as we expect an increase in the number of subscribers. However, we might not experience the same rapid growth as in prior years.

Direct cost of telephony services.    The increase in direct cost of telephony services of $15.8 million, or 64%, was primarily due to the increase in the number of subscriber lines, which increased the costs that we pay other phone companies for terminating phone calls by $9.5 million. We also incurred increased costs of $2.9 million for establishing compliance systems for E-911 services and for E-911 call processing. Our network costs, which includes costs for co-locating in other carriers’ facilities,

23




for leasing phone numbers, routing calls on the Internet, and transferring calls to and from the Internet to the public switched telephone network, increased by $3.0 million. This was offset by the reduction in the cost of porting phone numbers for our customers by $0.7 million.

Customer Equipment and Shipping Revenue and Direct Cost of Goods Sold

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Customer equipment and shipping

 

$

6,235

 

$

2,713

 

$

3,522

 

130

%

Direct cost of goods sold

 

16,934

 

9,622

 

7,312

 

76

%

Customer equipment and shipping gross loss

 

$

(10,699

)

$

(6,909

)

$

(3,790

)

55

%

 

Customer equipment and shipping revenue.    Our customer equipment and shipping revenue increased by $3.5 million, or 130%, primarily due to an increase in the number of new customers subscribing to our services, resulting in incremental shipping revenue of $1.7 million. In addition, we changed our default shipping option to second day shipping in late February 2006 resulting in higher shipping fees. Customer equipment sales increased by $1.8 million, as in the fourth quarter of 2005 we began to offer our direct customers the option of upgrading their customer equipment at the time of customer sign-up for an additional fee. We expect that customer equipment and shipping revenue will continue to increase in 2006 as a result of growth in our customer base and customer equipment upgrades.

Direct cost of goods sold.    The increase in direct cost of goods sold of $7.3 million, or 76%, was due largely to the increase in the number of new customers subscribing to our services, which resulted in additional costs of $6.4 million associated with our provision of customer equipment, as well as additional costs for shipping customer equipment of $0.9 million, including incremental costs associated with second day shipping.

Selling, General and Administrative

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Selling, general and administrative

 

$

72,052

 

$

45,030

 

$

27,022

 

60

%

 

Selling, general and administrative.    The increase in selling, general and administrative expenses of $27.0 million, or 60%, was primarily due to an increase in the number of our employees, which grew to 1,675 full time employees at September 30, 2006 from 1,393 at September 30, 2005, and an increase in outsourced labor. This increase resulted in higher wages, employee-related benefits, fees for recruitment of new employees and outsourced labor costs of $16.5 million. On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), and accordingly have recognized $7.3 million of compensation expense for stock-based awards for the three months ended September 30, 2006. As a result of our high turnover among our customer care employees, we have experienced an increase in training and recruiting costs. Also, we experienced an increase in our facility maintenance and other administrative expenses of $5.1 million partially due to the relocation of our headquarters. As we continued to add customers, our credit card fees have increased as well by $2.4 million.  We also experienced a reduction in professional fees of $2.4 million primarily related to legal fees and a reduction of $2.2 million in tax expense for what we potentially might owe for sales tax.

While selling, general and administrative expenses have increased, they have decreased as a percentage of revenue from 61% for the three months ended September 30, 2005 to 45% for the three months ended September 30, 2006. For the remainder of 2006, we believe that selling, general and administrative expenses will continue to increase as we expect an increase in the number of our employees and outsourced labor. We also expect to incur additional costs related to being a public company, and we expect an increase in credit card fees as the number of our subscribers and revenues grow. However, we expect these expenses to continue to decrease as a percentage of revenue.

24




Marketing

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Marketing

 

$

91,316

 

$

58,906

 

$

32,410

 

55

%

 

Marketing.    The increase in marketing expense of $32.4 million, or 55%, was primarily due to an increase in television advertising, direct mail campaigns and telemarketing fees of $35.8 million offset by a decrease of $12.3 million in online and radio advertising. We have slightly shifted our focus of advertising to reach out to the mainstream consumer and increase brand awareness, primarily with new television commercials during National Football League and University of Notre Dame football games and by sponsoring events such as Ryder Cup Golf and the WNBA all-star game.

We also had increased costs of $6.7 million for alternative media and $6.1 million for other miscellaneous marketing fees. This was offset by decreased costs of $3.8 million related to our retail channel, which includes the costs of advertisements and in-store placement fees as well as activation commissions to retailers.

For the remainder of 2006, we will continue to incur a significant amount of marketing costs as we pursue our growth strategy of increasing our subscriber and revenue base.

Depreciation and Amortization

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Depreciation and amortization

 

$

5,946

 

$

3,150

 

$

2,796

 

89

%

 

Depreciation and amortization.    The increase in depreciation and amortization of $2.8 million, or 89%, was primarily due to an increase in capital expenditures for the continued expansion of our network, computer equipment for our new employees and leasehold improvements for our Holmdel, New Jersey headquarters.

Other Income (Expense)

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Interest income

 

$

7,721

 

$

1,356

 

$

6,365

 

469

%

Interest expense

 

(3,999

)

(1

)

(3,998

)

*

 

Other, net

 

(108

)

1

 

(109

)

*

 

 

 

$

3,614

 

$

1,356

 

$

2,258

 

 

 

 

Interest income.    The increase in interest income of $6.4 million was due to an increase in cash, cash equivalents and
marketable securities from our convertible notes issued in December 2005 and January 2006 and our initial public offering in May 2006.

Interest expense.    The increase in interest expense of $4.0 million was primarily related to interest on our convertible notes that were issued in December 2005 and January 2006.

Provision for Income Taxes

We have net losses for financial reporting purposes. Recognition of deferred tax assets will require generation of future taxable income. There can be no assurance that we will generate sufficient taxable income in future years. Therefore, we established a valuation allowance on net deferred tax assets of $238.3 million as of September 30, 2006.

As of September 30, 2006, we had net operating loss carryforwards for U.S. federal and state tax purposes of $491.0 million and $476.8 million, respectively, expiring at various times from years ending 2020 through 2026. In addition, we had net

25




operating loss carryforwards for Canadian tax purposes of $38.0 million expiring through 2013. We also had net operating loss carryforwards for United Kingdom tax purposes of $13.7 million with no expiration date.

Net Loss

 

Three Months Ended

 

 

 

 

 

 

 

September 30,

 

$

 

%

 

 

 

2006

 

2005

 

Change

 

Change

 

 

 

(dollars in thousands)

 

Net loss

 

$

(62,184

)

$

(65,995

)

$

3,811

 

(6

)%

 

Net Loss.    Based on the explanations described above, our net loss of $62.2 million for the three months ended September 30, 2006 decreased by $3.8 million, or 6%, from $66.0 million for the three months ended September 30, 2005.

Nine Months Ended September 30, 2006 Compared to the Nine Months Ended September 30, 2005

Telephony Services Revenue and Direct Cost of Telephony Services

 

Nine Months Ended

 

 

 

 

 

 

 

September 30,