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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_______________
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JULY 31, 1999
Commission File Number: 000-26763
NET2PHONE, INC.
(Exact name of registrant as specified in its charter)
Delaware 22-3559037
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
171 Main Street
Hackensack, New Jersey 07601
(Address of registrant's principal executive offices) (Zip Code)
Registrant's telephone number, including area code (201) 530-4000
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
(Title of class)
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. X Yes ____ No
---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the registrant's common stock held by non-
affiliates of the registrant on November 2, 1999, was approximately $399
million. On such date, the last sale price of registrant's common stock was
$51.50 per share. Solely for the purposes of this calculation, shares
beneficially owned by directors and officers of the registrant and persons
owning 5% or more of the registrant's common stock have been excluded, in that
such persons may be deemed to be affiliates of the registrant. Such exclusion
should not be deemed a determination or admission by registrant that such
individuals or entities are, in fact, affiliates of registrant. This calculation
includes shares of the registrant's Class A stock, which may be converted at the
option of the holder into shares of the registrant's common stock on a one-to-
one basis at any time.
The number of shares outstanding of each of the registrant's classes of common
stock, as of November 2, 1999 (latest practicable date), was 11,672,616 shares
of common stock and 36,524,250 shares of Class A stock.
NET2PHONE, INC.
1999 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
Item 1. Business............................................................................. 1
Item 2. Properties........................................................................... 20
Item 3. Legal Proceedings.................................................................... 20
Item 4. Submission of Matters to a Vote of Security Holders.................................. 20
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................ 21
Item 6. Selected Financial Data.............................................................. 22
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 24
Item 7A. Quantitative And Qualitative Disclosures About Market Risk........................... 45
Item 8. Financial Statements and Supplementary Data.......................................... 45
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 45
PART III
Item 10. Directors and Executive Officers of the Registrant................................... 46
Item 11. Executive Compensation............................................................... 49
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 54
Item 13. Certain Relationships and Related Transactions....................................... 57
PART IV
Item 14. Exhibits, Financial Statement Shedules and Reports on Form 8-K....................... 65
Signatures........................................................................................ 68
Index to Financial Statements..................................................................... F-1
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PART I.
ITEM 1. BUSINESS
General Description of Business
We began our operations in January 1996, launched our first Net2Phone
product in August 1996, and were incorporated in Delaware as a separate
subsidiary of IDT in October 1997. We are a leading provider of services
enabling users to make high-quality, low-cost telephone calls over the Internet.
This service is commonly referred to as Internet telephony. Our Internet
telephony services enable our customers to call individuals and businesses
worldwide using their personal computers or traditional telephones. We are
leveraging our Internet telephony expertise to integrate real-time voice
communication capabilities into the Web. We currently offer Web-based Internet
telephony services, which enable customers to make calls and send faxes over the
Internet using their personal computers, and basic Internet telephony services,
which enable customers to make calls using traditional telephones and fax
machines.
We have developed a sophisticated PC2Phone software application that
enables the use of our Web-based Internet telephony services. We distribute this
software free of charge through the Internet and through agreements to include
our software with products sold by our strategic partners. In January 1999,
Netscape agreed to integrate our PC2Phone software on an exclusive basis into
future versions of Netscape's Internet browser released during the term of our
agreement, including the Netscape Communicator products. Netscape also agreed to
include a Net2Phone icon on the Netscape Navigator Personal Toolbar. In
addition, we have entered into an agreement with ICQ, a subsidiary of America
Online, to provide Internet telephony services to users of ICQ's instant
messaging service. ICQ will integrate some of our Internet telephony software
into ICQ's Instant Messenger software on an exclusive basis, allowing ICQ users
to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC calls. We will
also co-brand a pre-paid phone-to-phone calling card with ICQ, allowing users to
place calls from the United States and 19 other countries to virtually anywhere
in the world.
In addition, we have entered into strategic marketing and distribution
relationships with leading Internet companies, including Yahoo!, Go2Net,
InfoSpace.com, Snap.com, Excite, and ZDNet. We have also entered into
arrangements with leading computer equipment and software companies, such as
IBM, Compaq and Packard Bell-NEC Europe to include our software with their
products. We promote our services through direct sales and marketing and through
international resellers who buy minutes of use from us in bulk, and resell them
to customers in their respective countries. Our software is currently available
in ten languages (English, Spanish, Japanese, French, Dutch, Portuguese,
Italian, German, Swedish and Chinese). We intend to make our software available
in additional languages as we expand our international customer base and
distribution channels.
As of July 31, 1999, we served over 325,000 active customers who made an
average of approximately 60 minutes of calls per month and handled over 20
million minutes of use per month. Our net loss increased from approximately
$500,000 in fiscal 1996, $1.7 million in fiscal 1997 and $3.5 million in fiscal
1998 to $24.7 million in fiscal 1999. Our total assets increased from $916,000
at July 31, 1997 and $7.0 million at July 31, 1998 to $50.8 million at July 31,
1999. Our revenue has grown substantially, increasing from approximately $2.7
million in fiscal 1997 to approximately $12.0 million in fiscal 1998. Our
revenue for fiscal 1999 was approximately $33.3 million.
We registered 6,210,000 shares of our common stock on a Form S-1
registration statement, which became effective of July 29, 1999. We received net
proceeds of approximately $85.3 million from the sale of the 6,210,000 shares at
the initial public offering price of $15.00 per share on August 3, 1999. The
managing underwriters for this offering were Hambrecht & Quist LLC, BT Alex.
Brown Incorporated and Bear. Stearns & Co. Inc.
On November 4, 1999, we filed a registration statement with the
Securities and Exchange Commission (Registration No. 333-90317) for the sale of
6,300,000 shares of common stock. Of the 6,300,000 shares to be sold in the
offering, 3,400,000 shares are being sold by us. The remaining 2,600,000 shares
are being sold by selling stockholders, including IDT, which will be selling
2,200,000 shares. The underwriters have also been granted an option for a period
of 30 days to purchase up to 945,000 additional shares of common stock from
other selling stockholders to cover over-allotments, if any.
Industry Segments
We only report in one industry segment. See "Notes to Financial Statements
- -- Note 3."
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Description of Business
The Internet is experiencing unprecedented growth as a global medium for
communications and commerce. International Data Corporation estimates that the
number of Internet users worldwide will grow from approximately 142 million at
the end of 1998 to 399 million by the end of 2002. These users are increasingly
using the Internet as a communications medium. A study by E-Marketer, a market
research firm, estimated that 9.4 billion e-mail messages are delivered daily.
Instant text communication through online "chat" rooms is also gaining
widespread acceptance.
Online commerce is also becoming widely accepted as a means of doing business.
According to International Data Corporation, Internet users worldwide purchased
more than $50 billion of goods and services in 1998. International Data
Corporation projects that commerce over the Internet will grow to approximately
$1.3 trillion in 2003.
Emergence of Internet Telephony
TeleGeography, a market research firm, estimates that the international long
distance market will grow to $79 billion in 2001, with consumers and businesses
making an estimated 143 billion minutes of international long distance calls.
Despite the large size of this market and the number of minutes of calls made,
traditional international long distance calls are still relatively expensive for
the consumer. The primary reason for this expense is tariffs set by foreign
governments and carriers that are passed on to consumers in the form of higher
long distance rates.
Internet telephony has emerged as a low cost alternative to traditional long
distance calls. International Data Corporation projects that the Internet
telephony market will grow rapidly to over $23.4 billion in 2003, from
approximately $1.1 billion in 1998.
Internet telephone calls are less expensive than traditional international
long distance calls primarily because these calls are carried over the Internet
or our network and therefore bypass a significant portion of international long
distance tariffs. The technology by which Internet phone calls are made is also
more cost-effective than the technology by which traditional long distance calls
are made.
We use a technology called "packet-switching" to break voice and fax calls
into discrete data packets, route them over the Internet or our network and
reassemble them into their original form for delivery to the recipient.
Traditional international long distance calls, in contrast, are made using a
technology called "circuit switching" which carries these calls over
international voice telephone networks. These networks are typically owned by
governments or carriers who charge a tariff for their use. Circuit switching
requires a dedicated connection between the caller and the recipient that must
remain open for the duration of the call. As a result, circuit-switching
technology is inherently less efficient than packet-switching technology which
allows data packets representing multiple conversations to be carried over the
same line. This greater efficiency creates network cost savings that can be
passed on to the consumer in the form of lower long distance rates.
Integration of Voice into the Web
We believe that Internet telephony offers significant benefits to consumers
and businesses over and above international long distance cost savings. The
technologies that enable Internet telephony can be applied to integrate live
voice capabilities into the Web. We believe that this integration can enhance
the potential for the Internet to become the preferred medium for both
communications and commerce. For example, the integration of voice into the Web
would supplement existing text-based modes of Internet communication such as e-
mail and online chat by adding a live, secure, low-cost or free voice
alternative. We believe that this will be attractive both to consumers and
businesses.
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In addition, voice-enabling the Web would give Internet shoppers the ability
to speak directly with customer service representatives of online retailers in
order to ask questions and alleviate concerns about online security. This may
increase the probability that a sale is made and may give online retailers a key
competitive advantage by providing them with opportunities to sell higher margin
and additional products to these customers. Voice-enabling a commercial Web site
may also give online retailers the ability to provide more responsive customer
support and service.
Integrating live voice capabilities into the Web would also enable Internet
companies to offer enhanced communications services, such as providing Internet
users with a central source for retrieving voicemail, e-mail, faxes and pages.
We believe this would allow these companies to attract more users to their sites
and to increase the amount of time these users spend on their sites. This
increased usage will allow these Internet companies to attract advertisers and
secure higher advertising rates, thereby increasing revenue.
Limitations of Existing Internet Telephony Solutions
The growth of Internet telephony has been limited to date due to poor sound
quality attributable to technological issues such as delays in packet
transmission and network capacity limitations. However, recent improvements in
packet-switching technology, new software algorithms and improved hardware have
substantially reduced delays in packet transmissions. In addition, the use of
private networks to transmit calls as an alternative to the public Internet is
helping to alleviate network capacity constraints. Finally, the emergence of
new, lower cost Internet access technologies, such as high-speed modems, are
addressing local Internet access issues.
Several large long distance carriers, including AT&T and Sprint, have
announced Internet telephony service offerings. However, many of these service
offerings have not been deployed on a large scale. Many also require users to
purchase other telecommunications services or allow only domestic calling.
Smaller Internet telephony service providers also offer low-cost Internet
telephony services from personal computers to telephones and from telephones to
telephones. These services, however, are available only in limited geographic
areas and require payment by credit card which may preclude many international
customers from signing up for these services. We also believe that existing
Internet telephony service providers rely upon technologies and systems that
lack large-scale billing, network management and monitoring systems, and
customer service capabilities required for the integration of voice
communication into the Web.
In addition, many companies currently provide Internet telephony software and
services that allow Internet telephone calls to be made between personal
computers. However, most of these companies require both the initiator and the
recipient of the call to have the same software installed on their personal
computers and to be online at the same time.
The Net2Phone Solution
We deliver high-quality Internet telephony services and voice-enabling Web
applications to consumers and businesses. Our solution provides the following
benefits to our customers:
. Low Cost. Our PC2Phone software is distributed free of charge, and our
services allow our customers to make telephone calls often at a fraction of
the cost of traditional long distance service. Because international long
distance calls routed over the Internet bypass the international settlement
process, we are able to charge lower rates than traditional long distance
carriers.
. High Voice Quality. We offer high voice quality through our proprietary
packet-switching technologies, which reduce packet loss and delay, route
packets efficiently and perform quality enhancing functions, such as echo
cancellation. We intend to continue to enhance the voice quality of our
services as our customer base and business grow.
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. Ease of Use and Access. Our services are designed to be convenient and
easy to access from anywhere in the world. To make a call using our Web-
based services, a customer need only install our free software on a sound-
enabled personal computer, register and be connected to the Internet. No
additional telephone lines or special equipment are required. Our
Phone2Phone service is also easy to use and requires a customer only to
register and dial a toll-free or local access number from any telephone or
fax machine.
. Voice-Enabled Online Retailing. Our services enable users anywhere in the
world to speak with sales or customer service representatives of online
retailers and other Web-based businesses while visiting their Web sites.
This provides customers an opportunity to ask questions of and to provide
credit card information directly to a customer service representative if
they are concerned about Internet security, thereby increasing the
likelihood of consummating an online sale. In addition, our services allow
our customers outside of the United States and Canada to access telephone
numbers that might otherwise be inaccessible to them through their local
carriers. For example, users of our services in other countries may call
United States or Canadian toll-free numbers (i.e., telephone numbers with
800, 877 or 888 prefixes), which are not otherwise available to them, at no
charge. The ability to communicate with international customers in this
manner provides United States and Canadian-based online retailers and other
Web-based businesses with cost effective access to an expansive
international customer base.
. Reliable Service. Our network is reliable because of its technologically
advanced design. This design allows us to expand our network and add
capacity by adding switches to the existing network. Our system also
provides seamless service and high-quality voice transmission through our
ability to reroute packets if problems arise. We believe that our ability
to provide reliable service is essential to voice-enable the Web.
. Ease of Payment and Online Account Access. Once registered, our customers
are able to make unlimited toll-free calls. In addition, they can make toll
calls by opening a prepaid account using credit cards, wire transfers or
checks payable in United States dollars. Acceptance of payment in multiple
forms enables international customers who may not necessarily have credit
cards to use our services. Our customers can access their accounts via the
Internet in order to view their call history and account balances, and to
increase their prepaid amounts.
. Customer Support. We offer live customer support 24 hours a day, seven
days a week in multiple languages. Our customer support center can be
accessed from anywhere in the world at no charge either by calling our
toll-free number, where available, or by using our Web-based Internet
telephony service. Our integrated customer billing software and call
management system provide our customer support staff with immediate access
to user accounts, calling patterns and billing history to help us provide
better, more responsive customer support.
Strategy
Our mission is to become the premier Web-based communications enabler. We
intend to leverage our leadership position in the Internet telephony market to
make our communications services readily available worldwide on the Internet and
to develop and market online commerce and related products. Our strategy
includes the following key elements:
. Drive Usage through Resellers and Strategic Partners. We promote our
services through direct sales and marketing and through relationships with
international resellers and leading Internet hardware, software and content
companies. We intend to build on these relationships and to add more
partners and resellers to drive usage of our Internet telephony services.
We also intend to partner with large telecommunications companies to enable
them to offer our Internet telephony services under their brand.
. Pursue Multiple Sources of Revenue. In addition to our minutes-based
revenue, we intend to pursue new Web-based revenue opportunities
from banner and audio advertising, as well as sponsorship opportunities
4
on our PC2Phone software user interface and our EZSurf.com Web site. We
also intend to explore the availability of revenue-sharing opportunities
with online retailers.
. Enhance Brand Recognition. We have established strong brand identity in
the Internet telephony market in large part due to the high-quality of our
services and our marketing efforts. We have entered into advertising
relationships with leading Web companies such as Netscape, ICQ, Go2Net
InfoSpace.com, Yahoo! and Excite in order to promote our services. We
intend to continue to implement aggressive advertising and sales campaigns
to increase brand awareness. In addition, we intend to enhance our brand
recognition by cooperatively marketing our Internet telephony services with
leading computer hardware and software companies and Internet services
providers.
. Make Our Software Readily Available Worldwide. We have entered into
strategic distribution relationships with leading computer equipment and
software companies to expand the availability of our software. For example,
our software will be embedded into future versions of Netscape's Internet
browser and a Net2Phone icon will be prominently positioned next to AOL's
Instant Messenger icon on the Netscape Navigator Personal Tool Bar. In
addition, customized versions of some of our Internet telephony services
will be integrated into ICQ's instant messaging software and distributed by
ICQ. Our software is included with IBM's Internet services and may be pre-
loaded on computers sold by Compaq internationally. We intend to build upon
these relationships and enter into new distribution relationships with
other leading companies in order to enhance the distribution of our
software worldwide.
. Expand and Enhance Products and Services. We have committed significant
resources to expand our network, enhance our existing product and service
offerings and to develop and market additional products and services in
order to continue to provide customers with high-quality Internet telephony
services. For example, we plan to introduce new products and services,
including:
. PC2PC, which will allow high-quality Internet telephony from one
personal computer to another;
. Phone2PC, which will allow calls from a traditional telephone to a
personal computer;
. voice-enabled chat, which will allow two participants in an online chat
room discussion to establish direct voice communication with each other
while maintaining anonymity;
. unified messaging services, which will include voice, fax and electronic
messaging with multiple points of access, including the Web and
conventional telephones;
. online commerce applications, which will provide customer service
representatives of online retailers with real-time access to a caller's
profile and enable them to "push" specific content onto a caller's
personal computer screen in order to better assist the caller in
answering their inquiries;
. customer payment applications, which will allow customers to pay for
online commerce transactions by debiting their Net2Phone account; and
. video conferencing between two or more personal computer users over the
Internet.
Strategic Relationships
We have entered into strategic distribution, integration and advertising
relationships with leading Internet and computer hardware and software
companies. These relationships typically include arrangements under which we
share with our strategic partners a portion of the revenue they bring to us. We
believe that these relationships are important because they provide incentive to
our partners and allow us to leverage the strong brand names and distribution
channels of these companies to market our products and services. Our strategic
partners include:
5
Netscape
Netscape has agreed to embed our PC2Phone software on an exclusive basis in
future versions of Netscape's Internet browser released during the term of our
agreement, including the Netscape Communicator products. Netscape also has
agreed to:
. place a Net2Phone icon on the Netscape Navigator Personal Toolbar
immediately to the right of the AOL Instant Messenger icon, which will
allow Netscape users to use our Web-based Internet telephony services from
anywhere on the Web simply by clicking on our icon;
. integrate our services into, and display our services on, the Netscape
Netcenter site, including Netscape's Contacts section and Address Book
section, which will allow Netscape users to make calls using our services
simply by clicking on a displayed telephone number; and
. include the software for our Web-based Internet telephony services in
Netscape's suite of online plug-in software and Netscape Smart Update
programs (both domestically and when available internationally) for
downloading by Netscape users from centralized locations on Netscape's Web
site.
We also have the right to place a specified number of banner and other
advertisements on Web pages of our choice on Netscape's domestic and
international Web sites. The two-year term of our exclusive agreement with
Netscape commences with the beta release of the next version of Netscape's
Internet browser. This next version of Netscape's Internet browser has not yet
been released, and our agreement with Netscape does not provide for a date by
which it will be released. Accordingly, we would not expect any potential
PC2Phone revenue related to our agreement with Netscape until their product is
released.
ICQ
In July 1999, we entered into an exclusive, four-year distribution and
marketing agreement with ICQ, a subsidiary of America Online. Under this
agreement, ICQ has agreed to:
. co-brand and promote our phone-to-phone Internet telephony services in the
United States and in 19 other countries;
. integrate customized versions of some of our Internet telephony services on
an exclusive basis into ICQ's instant messaging software to allow ICQ
customers to make PC-to-phone and PC-to-PC calls and to receive phone-to-PC
calls;
. share revenue from some advertisements and sponsorships sold by ICQ within
Internet-telephony-related areas within ICQ's instant messaging software;
and
. promote our services on some of ICQ's Web sites.
All of our Internet telephony services that ICQ promotes under our agreement
will be co-branded under both of our labels. Although our agreement with ICQ
does not provide for definitive launch dates, we believe the phone-to-phone
services will be launched in the United States later this year and
internationally by early 2000. We also believe that the PC-based Internet
telephony services will be launched in mid-2000.
Go2Net
In October 1999, we entered into an exclusive three-year distribution and
marketing agreement with Go2Net, a network of branded, technology-and community-
driven Web sites. Under this agreement, Go2Net has agreed to integrate co-
branded versions of our Internet telephony products and services into the Go2Net
Network. In addition, together with Go2Net and CommTouch Software Ltd., a
provider of email solutions, we will create a unified
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communication and messaging platform on the Go2Net Network that will enable
users to send and receive voice mail, faxes, email and telephone calls over the
Internet. In addition, in the event Go2Net provides start pages or customized
portal offerings for third parties distributed through set-top devices, cellular
phones, personal digital assistants (also known as PDAs) and similar devices, we
have the exclusive option to incorporate our services into such offerings to the
extent Go2Net has the right to include Internet telephony services in such
offerings.
InfoSpace.com
In March 1999, we entered into an agreement with Infospace.com, a leading
Internet infrastructure company. Under this agreement, for a period of 30
months, one or more textual or graphical links to our www.net2phone.com Web site
will be displayed on all then existing and future versions of Infospace.com's
Web sites and its affiliate network sites, including Netscape's Netcenter Web
site, the Microsoft Network, the GO Network and Xoom.com. In addition, our
software is integrated into InfoSpace.com's network of white and yellow page
directory services.
In August 1999, we amended our agreement with InfoSpace.com under which
InfoSpace.com will place on its affiliate network sites and, on an exclusive
basis, on its own Web site, for a period of two years, advertisements,
promotions, links, banners, logos and integrated access to our PC2Phone service
and, upon release, our new unified messaging service.
Priceline.com
In November 1999, we entered into a memorandum of understanding and a co-
marketing agreement with priceline.com, an Internet commerce service that allows
users to name their own price to purchase goods and services over the Internet.
Under the terms of our memorandum of understanding, we expect to offer our
international and domestic Phone2Phone services as a premier provider through
priceline.com, enabling priceline.com customers to name their own price to
purchase blocks of minutes of our Phone2Phone services.
It is expected that our Phone2Phone services will be offered for sale through
priceline.com in the following manner:
. domestic time blocks, where customers can name their own price for
blocks of domestic long distance Phone2Phone minutes;
. international time blocks, where customers can name their own price for
blocks of international long distance Phone2Phone minutes to a
specified country;
. priceline.com's "Call Anywhere" program, where customers can name their
own price for blocks of Phone2Phone minutes that can be used to call
multiple designated locations; the actual amount of time purchased will
vary per location.
We also expect to work with priceline.com to develop an offer-by-phone service
which will enable consumers to make offers to purchase Phone2Phone services from
us on a per-call basis. Under the terms of the co-marketing agreement, we will
participate in a co-marketing program with priceline.com through December 31,
1999.
Yahoo! and Excite
In 1998, we signed an agreement with Yahoo!, which was recently renewed
through 2000. Our Web-based Internet telephony service is integrated into the
Yahoo! People Search online telephone directory. As a result of this
integration, an Internet user who performs a search on Yahoo! People Search can,
after installing our software, simply click on a displayed telephone number to
initiate a call to that number. Under this agreement, we also have the right to
have our banner advertising appear when an Internet user performs a word- or
category-search for "Internet Telephony" or related phrases on Yahoo!
Additionally, our PC2Phone service is integrated into the Yahoo! Yellow Pages
online directory.
Our Web-based Internet telephony software is also integrated into Excite's Web
sites in its International Network, which includes the United Kingdom, Germany,
France, Japan, Italy, Australia, Sweden and the Netherlands. As a result, an
Internet user in any of these countries will be able to click on any telephone
number that appears on any page on these sites to initiate a call to that number
using our PC2Phone service. In addition, our services will be prominently
featured within the Excite International Network via advertising and promotion
on various channels, including each member's homepage, business,
technology/computer and travel channels, as well as the localized versions of My
Excite, What's New/What's Cool and Mail Excite. We are negotiating with Excite
to have our services integrated into Excite's United States Web sites as well.
Other Strategic Relationships
We also have entered into other important strategic relationships with other
leading Internet and computer hardware and software companies, including:
. Compaq. Our software is featured as a download from a special Compaq Web
site accessible directly from the Compaq-branded keyboard, may be pre-
installed on Compaq-branded computers distributed internationally and may
be included with their other products.
. Snap.com. Promotions for our services and a link to our Web site will be
prominently displayed on the Snap.com Web site, and we are their preferred
provider of PC-to-phone services.
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. ZDNet. We are the preferred provider of Internet telephony services for
ZDNet and our Web-based Internet telephony service will be integrated
throughout the ZDNet Web site.
. WebHosting.com, 9Net Avenue, and Advanced Internet Technologies. Web
hosting companies webhosting.com, 9Net Avenue, and Advanced Internet
Technologies will resell our Click2Talk and Click2CallMe services to
their clients.
. AT&T. We have entered into an agreement with AT&T to be the exclusive
provider of PC-to-phone service on the AT&T WorldNet Beta Site for a
period of 90 days through January 15, 2000. Under the terms of the
agreement, we will also provide 200 minutes of free calling time for
calls that terminate in the United States to one AT&T WorldNet Beta Site
member per household who has not previously used our PC-to-phone
service.
. Sprint. Sprint is testing our Internet telephony technology and
international network for international consumer long distance calls to
Asia through a service called Sprint Callternatives. As part of this
test, we provide dedicated customer service, 24 hours a day, seven days
a week to assist customer inquiries in multiple languages, including
Mandarin, Cantonese and Korean. In addition, our advanced billing
technology allows users of this service to view their telephone accounts
in real time from our Web site.
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Products and Services
Our services enable our customers to make low-cost, high-quality phone
calls over the Internet using their personal computers or traditional
telephones. Our principal current product and service offerings are described in
the table below.
Product/Service Description Benefits
Basic Internet
Telephony Services:
. Phone2Phone . Enables customers to make calls over . International long distance rates
traditional telephones and fax machines routed over are typically 50% to 70% lower than
. Fax2Fax the Internet. Customers must dial a local or the rate charged by traditional long
domestic toll-free access number to access the distance carriers for calls
. Net2Phone Pro Net2Phone network. originating in the United States, and
up to 95% lower for calls originating
. Customers are charged for toll and long outside the United States.
distance calls on a per-minute basis. There is no
charge for calling United States and Canadian . Users do not need to purchase
toll-free numbers. expensive hardware or software.
. Available in the United States and in many . High voice quality.
international locations.
. Faxes are transmitted without
. We market Phone2Phone under the brand delay and users receive immediate
"Net2Phone Direct." delivery confirmations.
Web-based Internet
Telephony Services:
. PC2Phone . Enables customers to make calls and send faxes . Services are available to any
over the Internet using their personal computers. Internet user with a sound-equipped
. Click2Talk Customers must install our software on their personal computer.
personal computers, register with us and be online
. PC2Fax in order to make calls. . Facilitates online commerce by
providing live voice contact between
. Click2CallMe . When browsing Web sites that have a Click2Talk online retailers and Internet
icon, customers may initiate calls to a company shoppers.
whose site they are browsing simply by clicking on
the Click2Talk icon. . Customers do not require multiple
telephone lines and need not log off
. Using Click2CallMe, customers can request return the Internet to initiate a call.
telephone calls at a specified time from a
company's Web site they are browsing simply by . International long distance rates
clicking on the Click2CallMe icon. are typically 50% to 70% lower than
the rates charged by traditional long
. Customers are charged for toll and long distance carriers for calls
distance calls on a per-minute basis. There is no originating in the United States, and
charge for calling United States and Canadian up to 95% lower for calls originating
toll-free numbers. outside the United States.
. United States and Canadian
toll-free numbers can be accessed
from outside the United States and
Canada.
EZSurf.com . A Web-based shopping directory powered by our . Enables voice communications with
Web-based Internet telephony services from which over 300 Web sites.
Internet users can initiate calls to listed online
retailers by clicking on an icon on the Web site. . Educates users by providing them
with essential information required
. Lists useful information for key online to buy products online.
retailers, including payment and shipping options
and return policies.
9
Sales, Marketing and Distribution
We distribute our software through the Internet, strategic partnerships and
international resellers. In addition, our software will be embedded into future
versions of Netscape's browser, which, according to International Data
Corporation, was used by 41.5% of all consumer Internet users in mid-1998.
Additionally, our software will be distributed into future versions of ICQ's
Instant Messenger software. Customers can also download our software at no
charge from our Web site and through links on other Web sites, including
Yahoo!'s People Search and Lands' End's home page.
We also distribute our software through strategic relationships with
leading Internet and computer hardware and software companies, including IBM,
Compaq and Packard Bell-NEC Europe. Our software is included with our partners'
products and services and distributed domestically and internationally. We
expect to distribute over 20 million units of our software in 1999 as a result
of these and other distribution arrangements.
We have also entered into agreements with three Web hosting companies,
WebHosting.com, 9Net Avenue and Advanced Internet Technologies, under which they
will resell our Click2Talk and Click2CallMe services to their customers.
We promote our services through online and Internet-based advertising
venues and traditional print advertising in domestic and international
publications. We will also be advertising our services on the NBC television
network. Another way we sell our services internationally is by entering into
exclusive agreements with resellers in other countries. We sell these resellers
bulk amounts of minutes of use of our products and services to be resold in the
resellers' respective countries. For example, in Asia, we have agreements with
Daewoo and Naray Mobile Telecom in South Korea and Marubeni in Japan. In Europe
and the Middle East, we have agreements with CAPCOM in Spain and Dot.LB in
Lebanon, among others. To facilitate distribution and attract users in foreign
countries, we have developed our software in ten languages (English, Spanish,
Japanese, French, Dutch, Portuguese, Italian, German, Swedish and Chinese) and
intend to increase the number of languages as our distribution broadens.
Customer Service
As part of our goal to attract and retain customers, we offer free live
customer support in multiple languages. We employ approximately 101 customer
service representatives, who offer customer support to our users 24 hours a day,
seven days a week. These services can be reached from anywhere in the world at
no cost using either our toll-free number, where available, or our Web-based
Internet telephony services. The customer support staff provides technical
assistance, as well as general service assistance, for all of our products and
services. We also offer customer support via e-mail and fax. Our integrated
customer billing software and call management system provide our customer
support staff with immediate access to user accounts, calling patterns and
billing history, thereby enhancing the quality of service provided to our
customers. In addition, our international resellers typically provide their own
front-line customer support.
Technology
PC2Phone Software
Our PC2Phone software is simple to install and to use and has won various
industry awards. The installation process is wrapped in the industry-standard
"Install Shield" product. During installation, the Net2Phone "wizard"
verifies that the user's microphone and speakers are properly set for Internet
telephony. The installation also has a service registration process that allows
the customer to quickly register for paid time with the product. Our software
has several buttons and drop down headings to enable customization. These
buttons allow the user to change specific properties, access and modify customer
account information, program and use speed dialing and verify rates.
10
Our PC2Phone software has gone through fourteen releases, each improving
upon our Internet telephony capabilities. The software is a Windows-compliant,
32-bit application written in a high-level PC language. The code is extendible
allowing us to easily add new functionality, yet is relatively compact. The
newest version of our software can record and play sound files allowing us to
deliver voice-mail services and can interface with third party PC mail software
applications such as Eudora and Microsoft Outlook. We expect this to be released
in beta form by November 30, 1999 and commercially by December 31, 1999.
We also have developed a software development kit allowing other companies
to quickly and easily integrate their products with our PC2Phone software. For
example, our services have been successfully integrated with Quicknet's line of
sound cards and telephone interface cards. This integration enables Internet
telephony service to be deployed through inexpensive equipment currently used
throughout the world.
Call Management System
To maintain our leadership position in the Internet telephony market, we
believe that reliable and flexible billing, information management, monitoring
and control systems are critical. Accordingly, we have invested substantial
resources to develop and implement our sophisticated real-time call management
information system. Key elements of this system include:
. Customer Provisioning. The system provides automated online customer
registration and customer registration through call centers and
resellers. It also provides online credit card authorization and batch
billing capabilities that streamline customer registration. A special
remote access application program allows other people access to our
database, enabling sophisticated partners to remotely service customers
through our system, and to tie our system directly to their own business
systems. This remote capability includes remote account management and
continuous real-time call detail and billing information. Additionally,
the system makes customer account records readily available to call
center representatives in the event of customer billing problems.
. Customer Access. Our system allows customers to independently access
their billing records online without the need to contact customer
service representatives.
. Fraud Control. Fraud detection and prevention features include caller
authentication, prevention of multiple simultaneous calls using the same
account, pin code verification and call duration timers. We also
generate reports on suspicious calling patterns to detect caller
registration fraud. We routinely scan for fraudulent content before
credit card purchases are allowed.
. Network Security. Firewalls are employed to prevent attacks on our
network. We use sophisticated techniques to safeguard sensitive database
information. In addition, we encrypt call requests and portions of the
call to prevent "network sniffers" from unauthorized access to data.
. Call Routing. The network management system identifies and routes calls
to the most efficiently priced carrier. The system also automatically
routes calls around links or servers that are experiencing problems,
have failed or have been manually taken out of service for maintenance
or upgrades. This system provides remote administration facilities for
maintaining routing tables and system monitoring.
. Monitoring. The management system provides for real-time monitoring of
all call information. We are able to track potential problems such as
too many short calls on a server or a low percentage of call
completions. The system also provides remote management that allows
partners to monitor and manage their own accounts.
. Reliability. We maintain two separate network operations centers in
Hackensack and Lakewood, New Jersey. These facilities house redundant
equipment and have the ability to track calls simultaneously. This
11
redundant system gives our network a high degree of reliability,
enabling each network operations center to serve as a back-up to the
other.
. Detailed Call Records. The management software maintains detailed
records for each call, including the account number of the caller, the
caller's phone number, access number used, the point at which the call
enters and exits our network, the account owner, the calling party, the
server/service phone number, the number of the called party, a running
account balance, and rate and billing information, including surcharges.
The Net2Phone Network
Through an agreement with IDT, we lease capacity on an Internet network
comprised of leased high-speed fiber optic lines connecting eight major cities
across the United States, and lease high-speed fiber optic lines connecting
smaller cities to the network. We have a right to use network capacity leased by
IDT. The network backbone uses state-of-the-art hardware including Cisco Series
7000 routers and Nortel Passport switches. Our high-speed backbone connects
traffic at four major public Internet exchange points and is also facilitated by
a growing number of private peering or exchange points with other networks.
Through peering arrangements, we exchange Internet traffic with 25 other
Internet backbone providers at these points. We operate IDT's network, one of
the largest Internet access networks, providing local dial-up access through 36
locations. Our Internet network also includes more than 700 additional network
access locations owned by local and regional Internet service providers.
In addition, we entered into an agreement with AT&T Global Network
Services, under which AT&T will provide us with managed IP networking services
and collocation services, enabling us to extend the international reach of our
Internet telephony services over AT&T's global network to 17 countries, with a
dozen other countries under consideration for future expansion. AT&T will also
provide collocation services for our servers at AT&T's Local Interface Gateway
locations (or points of presence) in those countries.
We are able to provide service in areas where we do not have dial-up
equipment by utilizing call-forwarding technology to expand our coverage areas
by increasing the total number of local access numbers. We have been closing
down multiple network access points in a number of states in order to
consolidate our equipment into central "Super Point of Presence" locations.
For example, one Super Point of Presence in New Jersey can supply local access
for the entire state of New Jersey.
We seek to retain flexibility by utilizing dynamic call routing
alternatives. This approach is intended to enable us to take advantage of the
rapidly evolving Internet market in order to provide low-cost service to our
customers. Accordingly, our network employs an "Open Shortest Path First"
protocol that promotes efficient routing of traffic. Additionally, we have
placed redundant hardware for reliability in high traffic areas to minimize loss
of data packets. Each network data exchange point employs hardware to direct
network traffic and a minimum of two dedicated leased data lines to increase
reliability.
We manage our network hardware remotely. It is compatible with a variety of
local network systems around the world. We believe our Internet telephony
network can currently support approximately 5,000 simultaneous calls. We believe
our systems are scalable to 10 times their current capacity through the purchase
and installation of certain additional hardware. To date, the highest number of
simultaneous calls serviced by our network was 1,975 simultaneous calls made on
September 15, 1999.
The Network Operations Center
Our Network Operations Center, located in Hackensack, New Jersey, currently
employs a staff of 34 people. There are two groups that work within the network
operations center, the network analysis group and the Internet
12
telephony monitoring group. Both groups have 24 hours a day, seven days a week
coverage to quickly respond to any issues.
The network analysis group works around-the-clock monitoring network
issues, handling customer requests, repairing outages and solving security
problems. Our monitoring group oversees a nationwide real-time network analysis
map, which notifies our staff of network errors. They also use software we
developed to monitor our hardware around the world. This group can dynamically
turn on or turn off equipment and re-route Internet telephony traffic, as
necessary.
Customers
We have a diverse, global customer base. As of July 31, 1999, approximately
69% of our customers were based outside of the United States. As of July 31,
1999, we served over 325,000 active customers who had used our services during
the preceding three months. In addition, as of October 10, 1999, we had
installed the Click2Talk service on approximately 176 commercial Web sites.
Competition
Long Distance Market
The long distance telephony market and, in particular, the Internet
telephony market, is highly competitive. There are several large and numerous
small competitors, and we expect to face continuing competition based on price
and service offerings from existing competitors and new market entrants in the
future. The principal competitive factors in the market include price, quality
of service, breadth of geographic presence, customer service, reliability,
network capacity and the availability of enhanced communications services. Our
competitors include AT&T, MCI WorldCom and Sprint in the United States and
foreign telecommunications carriers.
Many of our competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than we
have. As a result, certain of these competitors may be able to adopt more
aggressive pricing policies, which could hinder our ability to market our
Internet telephony services. One of our key competitive advantages is the
ability to route calls through Internet service providers, which allows us to
bypass the international settlement process and realize substantial savings
compared to traditional telephone service. Any change in the regulation of an
Internet service provider could force us to increase prices and offer rates that
are comparable to traditional telephone call providers.
Web-Based Internet Telephony Services
As consumers and telecommunications companies have grown to understand the
benefits that may be obtained from transmitting voice over the Internet, a
substantial number of companies have emerged to provide voice over the Internet.
In addition, companies currently in related markets have begun to provide voice
over the Internet services or adapt their products to enable voice over the
Internet services. These related companies may potentially migrate into the
Internet telephony market as direct competitors.
. Internet Telephony Service Providers. During the past several years, a
number of companies have introduced services that make Internet
telephony services available to businesses and consumers. In addition to
us, AT&T Jens (a Japanese affiliate of AT&T), deltathree.com (a
subsidiary of RSL Communications), I-Link, iBasis (formerly known as VIP
Calling), ICG Communications, IPVoice.com, ITXC and OzEmail (which was
acquired by MCI WorldCom) provide a range of voice over the Internet
services. These companies offer PC-to-phone or phone-to-phone services
that are similar to the services we offer. Some, such as AT&T Jens and
OzEmail, offer these services within limited geographic areas.
13
Additionally, a number of companies have recently introduced Web-based
voice-mail services and voice-chat services to Internet users.
. Software/Hardware Providers. Many companies produce software and other
computer equipment that may be installed on a user's computer to permit
voice communications over the Internet. These products generally require
each user to have compatible software and hardware equipment and rely on
the public Internet for the transmission of traffic, which often results
in reduced quality of communications. Representative companies include
VocalTec, Netspeak and e-Net. We believe VocalTec's software and
hardware are unable to handle large numbers of simultaneous calls.
Netspeak focuses on delivering solutions targeted at traditional call
centers that require significant customization.
. Telecommunications Companies. A number of telecommunications companies,
including AT&T, Deutsche Telekom, MCI WorldCom and Qwest, currently
maintain, or plan to maintain, packet-switched networks to route the
voice traffic of other telecommunications companies. These companies,
which tend to be large entities with substantial resources, generally
have large budgets available for research and development and therefore
may enhance the quality and acceptance of the transmission of voice over
the Internet. However, many of these companies are new to the Internet
telephony market, and therefore may not build brand recognition among
consumers for these services. These companies also may not have the
range of product and service offerings that are necessary to
independently provide a broad set of voice-enabled Web services. AT&T,
for example, has attempted to enter the market but has focused its
effort on the cable market and it is unclear if it will continue to
pursue voice over the Web. Qwest has taken steps to enter the market by
building a high capacity network in the United States. In addition,
Qwest has also entered into a three-year strategic alliance with
Netscape to provide one-stop access to Internet services including long
distance calling, e-mail, voice mail, faxes, Internet access and
conference calls.
. Network Hardware Manufacturers. Several of the world's major providers
of telecommunications equipment, such as Alcatel, Cisco, Lucent,
Northern Telecom and Dialogic (which was acquired by Intel) have
developed or plan to develop network equipment that may be used in
connection with the provision of voice over the Web services, including
routers, servers and related hardware and software. By developing this
equipment, these manufacturers may exert substantial influence over the
technology that is used in connection with transmission of voice over
the Web and may develop products that facilitate the quality and timely
roll-out of these networks. However, these companies are dependent upon
the operators of Internet telephony networks to purchase and install
their equipment into their networks. They are also dependent upon the
developers of hardware and software to market their systems to end
users. Cisco currently manufactures Internet telephony equipment for low
to medium scale networking, but does not manufacture high-end Internet
telephony equipment for large networks. However, Cisco recently acquired
two companies that produce devices to help Internet service providers
transition voice and data traffic to packet networks while maintaining
traditional phone usage and network equipment. Lucent has recently co-
developed with VocalTec a set of industry standards that have been
adopted by major competitors and is currently marketing Internet
telephony hardware, including servers that allow the transmission of
calls and faxes over the Internet. Lucent also offers related support
products, such as billing centers and "Internet call centers," which
allow Internet access and conversation with a customer support agent on
a single line.
. Voice-Enabled Online Commerce Providers. Several providers have begun to
apply Internet telephony technologies in connection with e-commerce
transactions. These providers compete with services of ours such as
Click2Talk by integrating voice communications into commercial Web
sites. These competitors include USA Global Link, which introduced its
Instant Call service in 1998, a system that permits voice communications
between a customer on the Web and customer service representatives. In
addition, AT&T's Inter@active Communications is a group of services that
integrates voice into the Web, including AT&T Chat'N Talk, a voice-
enabled chat service, and Click2Dial Conferencing Services, which
initiates and manages conference calls. These services may emerge as
significant competitors to our current and planned offerings.
14
Research and Development
Strategic Research and Development
At our primary research and development center in Lakewood, New Jersey, we
currently employ 17 engineers, whose specialties include software, hardware,
switching, Internet security, voice compression, engineering real-time online
transactions, billing, and network and call management. This staff is devoted to
the improvement and enhancement of our existing product and service offerings,
as well as to the development of new products and services. Current research and
development activities include the following:
. development of unified messaging services, PC2PC and Phone2PC products
and voice-enabled chat;
. enhancements to our customer billing software and call management system
to increase the capacity of these systems;
. improvements to our Internet telephony hardware to increase capacity;
and
. modifications to our PC2Phone software to increase functionality.
Our future success will depend, in part, on our ability to improve existing
technology and develop new products and services that incorporate leading
technology.
We incurred $473,000, $481,000 and $757,000 in product development expenses
during fiscal 1997, fiscal 1998 and fiscal 1999, respectively.
Management Information Systems Research and Development
Our management information systems development team, located in Hackensack,
New Jersey, has eleven programmers and a development manager dedicated to
traditional management information systems development and upgrades. The group
supports back-office accounting and reporting software, customer service support
software and database support. The development schedule is primarily focused on
a detailed list of upgrades that have been identified and prioritized by a team
manager. The database architecture is managed by a senior developer in our
Lakewood laboratory who was responsible for similar database functions at AT&T's
WorldNet division.
Web Research and Development
The majority of our Web research and development is done by a separate Web
development group located in our headquarters in Hackensack. The group of nine
consists of five developers, two programmers, one graphics designer and one
development manager. The team is responsible for our multiple language Web site,
the EZSurf.com Web site and specialized Web interfaces, including the
integration of our PC2Phone client software into Netscape's Internet browser.
Regulation
Regulation of Internet Telephony
The use of the Internet to provide telephone service is a recent market
development. Currently, the Federal Communications Commission is considering
whether to impose surcharges or additional regulations upon certain providers of
Internet telephony. On April 10, 1998, the FCC issued its report to Congress
concerning the implementation of the universal service provisions of the
Telecommunications Act. In the report, the FCC indicated
15
that it would examine the question of whether certain forms of phone-to-phone
Internet telephony are information services or telecommunications services. The
FCC noted that it did not have, as of the date of the report, an adequate record
on which to make a definitive pronouncement, but that the record suggested that
certain forms of phone-to-phone Internet telephony appear to have the same
functionality as non-Internet telecommunications services and lack the
characteristics that would render them information services. If the FCC were to
determine that certain services are subject to FCC regulation as
telecommunications services, the FCC may require providers of Internet telephony
services to make universal service contributions, pay access charges or be
subject to traditional common carrier regulation. It is also possible that
PC-to-phone and phone-to-phone services may be regulated by the FCC differently.
In addition, the FCC sets the access charges on traditional telephony traffic
and if it reduces these access charges, the cost of traditional long distance
telephone calls will probably be lowered, thereby decreasing our competitive
pricing advantage.
Changes in the legal and regulatory environment relating to the Internet
connectivity market, including regulatory changes which affect
telecommunications costs or that may increase the likelihood of competition from
the regional Bell operating companies or other telecommunications companies,
could increase our costs of providing service. For example, the FCC recently has
determined that subscriber calls to Internet service providers should be
classified for jurisdictional purposes as interstate calls. This determination
could affect a telephone carrier's costs for provision of service to these
providers by eliminating the payment of reciprocal compensation to carriers
terminating calls to these providers. The FCC has pending a proceeding to
encourage the development of cost-based compensation mechanisms for the
termination of calls to Internet service providers. Meanwhile, state agencies
will determine whether carriers receive reciprocal compensation for these calls.
If new compensation mechanisms increase the costs to carriers of terminating
calls to Internet service providers or if states eliminate reciprocal
compensation payments, the affected carriers could increase the price of service
to Internet service providers to compensate, which could raise the cost of
Internet access to consumers.
In addition, although the FCC to date has determined that providers of
Internet services should not be required to pay interstate access charges, this
decision may be reconsidered in the future. This decision could occur if the FCC
determines that the services provided are basic interstate telecommunications
services and no longer subject to the exemption from access charges that are
currently enjoyed by providers of enhanced services. Access charges are assessed
by local telephone companies to long-distance companies for the use of the local
telephone network to originate and terminate long-distance calls, generally on a
per minute basis. The FCC has stated publicly that it would be inclined to hold
the provision of phone-to-phone Internet protocol telephony to be a basic
telecommunications service and therefore subject to access charges and universal
service contribution requirements. In a Notice of Inquiry released September 29,
1999, the FCC again asked for comment on the regulatory status of Internet
telephony. Specifically, the FCC asks commenters to address whether Internet
telephony service generally, and phone-to-phone service in particular, may be
regulated as a basic telecommunications service. If the Commission concludes
that any or all Internet telephony should be regulated as basic communications
service, it eventually could require that Internet telephony providers must
contribute to universal service funds and pay access charges to local telephone
companies. The imposition of access charges or universal service contributions
would substantially increase our costs of serving dial-up customers.
To our knowledge, there are currently no domestic and few foreign laws or
regulations that prohibit voice communications over the Internet. State public
utility commissions may retain jurisdiction to regulate the provision of
intrastate Internet telephony services. A number of countries that currently
prohibit competition in the provision of voice telephony have also prohibited
Internet telephony. Other countries permit but regulate Internet telephony. If
Congress, the FCC, state regulatory agencies or foreign governments begin to
regulate Internet telephony, such regulation may materially adversely affect our
business, financial condition or results of operations.
In addition, access to our services may also be limited in foreign
countries where laws and regulations otherwise do not prohibit voice
communication over the Internet. For example, access to our PC2Phone service was
recently blocked in certain countries in Asia and the Middle East by government-
controlled telecommunications companies. These actions prevented our customers
originating PC2Phone calls in these countries. We have experienced similar
actions in the past in other countries. In each case, we were able to negotiate
agreements to continue to provide our services in these countries. We intend to
do the same in these countries as well, but no assurances can be
16
given that we will be successful in these negotiations. We have resumed service
to our customers in these countries by providing alternative means of access to
our service, which may also be blocked by the government-controlled
telecommunications companies. Furthermore, one of our competitors, iBasis, has
recently disclosed that it has received a letter from the Israel Minister of
Communications requesting that it cease and desist terminating international
calls over the Internet in Israel.
Regulation of the Internet
Congress has recently adopted legislation that regulates certain aspects of
the Internet, including online content, user privacy, taxation, access charges,
liability for third-party activities and jurisdiction. In addition, a number of
initiatives pending in Congress and state legislatures would prohibit or
restrict advertising or sale of certain products and services on the Internet,
which may have the effect of raising the cost of doing business on the Internet
generally. The European Union has also enacted several directives relating to
the Internet, one of which addresses online commerce. In addition, federal,
state, local and foreign governmental organizations are considering other
legislative and regulatory proposals that would regulate the Internet. Increased
regulation of the Internet may decrease its growth, which may negatively impact
the cost of doing business via the Internet or otherwise materially adversely
affect our business, results of operations and financial condition.
The Federal Trade Commission has proposed regulations regarding the
collection and use of personal identifying information obtained from individuals
when accessing Web sites, with particular emphasis on access by minors. These
regulations may include requirements that companies establish certain procedures
to disclose and notify users of privacy and security policies, obtain consent
from users for certain collection and use of information and to provide users
with the ability to access, correct and delete personal information stored by
the company. These regulations may also include enforcement and redress
provisions. There can be no assurance that we will adopt policies that conform
with any regulations adopted by the FTC. Moreover, even in the absence of those
regulations, the FTC has begun investigations into the privacy practices of
companies that collect information on the Internet. One investigation resulted
in a consent decree pursuant to which an Internet company agreed to establish
programs to implement the principles noted above. We may become subject to a
similar investigation, or the FTC's regulatory and enforcement efforts may
adversely affect the ability to collect demographic and personal information
from users, which could have an adverse effect on our ability to provide highly
targeted opportunities for advertisers and electronic commerce marketers. Any of
these developments would materially adversely affect our business, results of
operations and financial condition.
The European Union has adopted a directive that imposes restrictions on the
collection and use of personal data. Under the directive, citizens of the
European Union are guaranteed rights to access their data, rights to know where
the data originated, rights to have inaccurate data rectified, rights to
recourse in the event of unlawful processing and rights to withhold permission
to use their data for direct marketing. The directive could, among other things,
affect United States companies that collect information over the Internet from
individuals in European Union member countries, and may impose restrictions that
are more stringent than current Internet privacy standards in the United States.
In particular, companies with offices located in European Union countries will
not be allowed to send personal information to countries that do not maintain
adequate standards of privacy. The directive does not, however, define what
standards of privacy are adequate. As a result, the directive may adversely
affect the activities of entities such as us that engage in data collection from
users in European Union member countries.
Intellectual Property
Our performance and ability to compete are dependent to a significant
degree on our proprietary and licensed technology. We rely on a combination of
patent, copyright, trademark and trade secret laws and contractual restrictions
to establish and protect our technology. All key employees have signed
confidentiality agreements and we intend to require each newly hired employee to
execute a confidentiality agreement. These agreements provide that confidential
information developed by or with an employee or consultant, or disclosed to such
person during his or her relationship with us, may not be disclosed to any third
party except in certain specified circumstances. These
17
agreements also require our employees to assign their rights to any inventions
to us. The steps taken by us may not, however, be adequate to prevent the
misappropriation of our proprietary rights or technology. In addition, our
competitors may independently develop technologies that are substantially
equivalent or superior to our technology.
We do not currently have any issued patents or registered copyrights. We
own the registered service mark for three of the marks used in our business and
have applications pending to register 29 other service marks used in our
business. There can be no assurance that we will be able to secure significant
protection for all our service marks. Competitors of ours or others could adopt
product or service marks similar to our marks, or try to prevent us from using
our marks, thereby impeding our ability to build brand identity and possibly
leading to customer confusion.
We have not taken steps to file applications in foreign countries to obtain
protection of our trademarks, except for our recent filing of a Community
Trademark application for registration of the "Net2Phone" mark, which covers
certain European countries, and an application for the "Net2Phone" mark in
Australia, Ecuador and Venezuela. To the extent trademark rights are acquired
through registration in countries outside the United States, we may not be able
to protect our marks or assure that we are not infringing other parties' marks
in those countries. Moreover, although we have taken some steps to commence the
registration of "net2phone" as a domain name with the various international
registries, we cannot assure you that this will be accomplished.
We have been assigned the rights to patent applications claiming a number
of the technologies underlying our products and services. Our two United States
utility patent applications have been rejected, but we are continuing to pursue
patent protection for the claimed subject material. There can be no assurance
that the applications will result in the issuance of patents or that, if issued,
such patents would adequately protect us against competitive technology or that
they would be held valid and enforceable against a challenge. In addition, it is
possible that our competitors may be able to design around any such patents.
Also, our competitors may obtain patents that we would need to license or
circumvent in order to make, use, sell or offer for sale the technology.
We have received correspondence from a company, NetPhone Inc., claiming
that our use of the mark "Net2Phone" in connection with Internet telephony
services infringes that company's "NetPhone" registered trademark and
requesting that we cease and desist from using the "Net2Phone" mark. We
responded by denying any infringement. No legal proceedings have been commenced
against us with respect to this matter. This entity currently operates a Web
site at www.netphone.com. There can be no assurance that the existence of this
entity's claim, its business and Web site will not materially adversely affect
our business.
AT&T, who may have rights in the terms "Click2Dial," Click2Whisper" and
"Click2Interact," has filed with the United States Patent and Trademark Office
a request to extend its time limit for opposing the registration of our
"Click2Talk" mark. AT&T could oppose registration of our "Click2Talk" mark
or take other action aimed at restricting us from using this mark. We have
negotiated an agreement with AT&T by which AT&T will agree not to file the
opposition if we consent to the registration of one of AT&T's marks. There can
be no assurance that any agreement, or the exact terms thereof, will be signed
until one is in place.
We are also aware of several other parties that use marks that are the same
or similar to marks that we use, though in some instances, to the best of our
knowledge, these parties are not in the same business as we are. There can be no
assurance that the companies that notified us or other companies with marks
similar to our marks will not bring suit to prevent us from using the
"Net2Phone" mark or other marks. Defending or losing any litigation relating to
intellectual property rights could materially adversely affect our business,
results of operations and financial condition.
In addition, a company known as ITM, Inc. operates a Web site at
www.net2phone.net without our permission or authorization, and in violation of
the agency agreement ITM entered into with us for the distribution of the
Net2Phone software with certain ITM software. ITM had also taken steps to secure
registration and ownership of the "Net2Phone" mark in France. We have reached
an agreement with ITM by which ITM agreed to assign the French trademark
application that it filed to us, as well as execute and deliver to us a
Registrant Name Change Agreement to transfer the domain name net2phone.net to
us. This document has been submitted to Network Solutions Inc. and we expect
that Network Solutions will soon process the transfer. Because the French
trademark
18
application has been assigned to us, we have withdrawn the trademark opposition
proceeding that we commenced against ITM.
We are taking steps to secure our rights in Ecuador and in Venezuela
against two parties that are attempting to register the "Net2Phone" mark or a
confusingly similar mark in these countries.
We believe that we do not infringe upon the patent rights of any third
party. The only third party that has asserted a patent infringement claim
against us is TechSearch for what it alleges is a patent directed to Web sites.
TechSearch has asked for a one time licensing fee. Our initial investigation has
led us to believe that we do not infringe and /or the patent is invalid. If we
do not accept the offer for a license and we are sued, we may incur substantial
legal fees in defending the suit and may be enjoined from using our Web site if
it is found to be infringing. If we do agree to the licensing fee, it may
detract from our ability to support other projects. It is possible, however,
that other patent infringement claims might be asserted successfully against us
in the future. Our ability to make, use, sell or offer for sale our products and
services depends on our freedom to operate. That is, we must ensure that we do
not infringe upon the patents of others or have licensed all such rights. We
have not requested or obtained an opinion from our outside counsel as to whether
our products and services infringe upon the patent rights of any third parties.
We are aware that patents have recently been granted to others based on
fundamental technologies in the Internet telephony area. In addition, we are
aware of at least one other patent application involving potentially similar
technologies to our own which if issued could materially adversely affect our
business. Because patent applications in the Unites States are not publicly
disclosed until issued, other applications may have been filed which, if issued
as patents, could relate to our services and products. However, foreign patent
applications do publish before issuance. We are aware of several such
publications that relate to Internet telephony. One such published application
claims as an inventor a previous consultant to IDT and has been assigned to
another company. Issuance of a patent or patents from this application could
materially adversely affect our ability to operate. A party making an
infringement claim could secure a substantial monetary award or obtain
injunctive relief which could effectively block our ability to provide services
or products in the United States or abroad. If any of these risks materialize,
we could be forced to suspend operations, to pay significant amounts to defend
our rights, and a substantial amount of the attention of our management may be
diverted from our ongoing business, each of which could materially adversely
affect our ability to operate.
We rely on a variety of technology, primarily software, that we license
from third parties. Most of this technology was purchased or licensed on our
behalf by IDT. Continued use of this technology by us may require that we
purchase new or additional licenses from third parties or obtain consents from
third parties to assign the applicable licenses from IDT. There can be no
assurances that we can obtain those third party licenses needed for our business
or that the third party technology licenses that we do have will continue to be
available to us on commercially reasonable terms or at all. The loss or
inability to maintain or obtain upgrades to any of these technology licenses
could result in delays or breakdowns in our ability to continue developing and
providing our products and services or to enhance and upgrade our products and
services.
Employees
As of October 1, 1999, we had approximately 333 full-time employees,
including approximately 146 in technical support and customer service, 84 in
sales and marketing, 24 in management and finance, 30 in operations, and 49 in
research and development. Our employees are not represented by any union, and we
consider our employee relations to be good. We have never experienced a work
stoppage.
Revenues and Assets by Geographic Area
For the year ended July 31, 1999, 62% of our revenue was derived from
international customers and 38% from customers in the United States. All our
long-lived assets are located in the United States.
We face certain risks inherent in doing business on an international basis,
including:
. changing regulatory requirements, which vary widely from country to
country;
. action by foreign governments or foreign telecommunications companies to
limit access to our services;
. increased bad debt and subscription fraud;
. legal uncertainty regarding liability, tariffs and other trade barriers;
. political instability; and
. potentially adverse tax consequences.
19
ITEM 2. PROPERTIES
Our primary facilities consist of approximately 15,445 square feet, which
comprise our headquarters, executive offices and customer service and technical
support centers, and are located in two buildings in Hackensack, New Jersey
leased from corporations that are owned and controlled by Howard S. Jonas.
Mr. Jonas is one of our directors, a director of IDT and the controlling
stockholder of IDT. These leases expire at the end of February 2002 and require
us to make annual rental payments of $186,144. We also sublease space for some
of our computer equipment in Piscataway, New Jersey from IDT, which leases this
space from a company also owned and controlled by Mr. Jonas. This lease runs for
a three-year term, beginning in May 1999, with monthly rent of $8,400. In
addition, we lease office space in Lakewood, New Jersey for our research and
development center. Pursuant to this lease, which expires at the end of August
2001, we are required to make annual rental payments of $48,125.
ITEM 3. LEGAL PROCEEDINGS
We are not currently a party to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of the fiscal year ended July 31, 1999, the
following items were submitted for the approval of our security holders:
. On June 25, 1999, our security holders, by written consent, adopted an
amendment to our certificate of incorporation that increased our
authorized capital stock to 200,000,000 shares of common stock,
37,042,089 shares of Class A stock and 10,000,000 shares of preferred
stock and effected a three-for-one stock split for our common and Class
A stock. Our security holders also voted to increase the number of
shares of common stock available under our 1999 Stock Option and
Incentive Plan by 6,000,000. These resolutions were voted in favor of by
a majority of our security holders.
. On July 13, 1999, a majority of our security holders voted by written
consent to adopt an amendment to Article Fourth Section (e)(11) of our
certificate of incorporation, clarifying the automatic conversion
provision of our Series A convertible preferred stock.
20
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Our common stock has traded on the Nasdaq National Market under the symbol
NTOP since July 29, 1999. The following table sets forth the per share range of
high and low closing sales prices of our common stock for the periods indicated:
Fiscal 1999 High Low
----------- ------- ------
Fourth Quarter (July 29 and July 30 only) ....................................... $27.38 $26.56
Fiscal 2000 High Low
----------- ------ ------
First Quarter ................................................................... $84.94 $16.50
Second Quarter (November 1 and November 2 only).................................. 52.94 51.50
On November 2, 1999, the last reported sale price for our common stock on
the Nasdaq National Market was $51.50 per share. The market price for our stock
is highly volatile and fluctuates in response to a wide variety of factors. If
our stock price remains volatile, we may become subject to securities
litigation, which is expensive and could divert our resources.
Holders
As of November 2, 1999, we had approximately 79 holders of record of our
common stock. This does not reflect persons or entities who hold their stock in
nominee or "street" name through various brokerage firms.
Dividend Policy
We have not paid any dividends in the past and do not intend to pay cash
dividends on our capital stock for the foreseeable future. Instead, we intend to
retain all earnings for use in the operation and expansion of our business.
Recent Sales of Unregistered Securities
In October 1997, in connection with our initial organization, IDT
Corporation purchased 27,864,000 shares of our common stock for nominal
consideration. This transaction was exempt from registration under Section 4(2)
of the Securities Act, as amended.
In January 1998, pursuant to the terms of his employment agreement with IDT
Corporation, Mr. Clifford M. Sobel purchased 3,096,000 shares of our common
stock for $100,000. This transaction was exempt from registration under Section
4(2) of the Securities Act of 1933.
In May 1999, we issued and sold an aggregate of 3,140,000 shares of Series
A convertible preferred stock at $10.00 per share, which were converted into
9,420,000 shares of our common stock in August 1999 at the closing of our
initial public offering. In connection with this transaction, we also issued
warrants to purchase up to 180,000 shares of our class A stock (of which 44,248
were exercised prior to the closing of our initial public offering with the
remaining warrants having terminated at the closing of our initial public
offering) to several investors for an aggregate of $31,400,000, pursuant to
Series A Subscription Agreements, dated as of May 13, 1999. These transactions
were exempt from registration under Section 4(2) of the Securities Act of 1933.
We also issued a warrant to purchase up to 92,400 shares of our common
stock to the placement agent as partial consideration for its services. This
warrant was exercised in its entirety prior to the closing of our initial public
offering. These transactions were exempt from registration under Section 4(2) of
the Securities Act of 1933.
In May 1999, we issued options to purchase 5,040,000 shares pursuant to our
1999 Stock Option and Incentive Plan, and issued 1,420,218 shares of common
stock upon exercise of some of these options. In July 1999, we issued options to
purchase an additional sum of 920,000 shares under the Plan to our President. In
July 1999, we issued options to purchase an additional 2,851,500 shares under
the plan, and issued 50,000 shares of common stock upon exercise of some of
these options. Since July 1999, we have granted options to purchase an aggregate
of 183,250 shares of our common stock. These transactions were exempt from
registration under Section 4(2) of the Securities Act of 1933.
In July 1999, in connection with our distribution and marketing agreement
with ICQ, we issued a warrant to America Online, enabling it to acquire shares
of common stock representing up to 3% of our outstanding capital on a fully-
diluted basis. This transaction was exempt from registration under Section 4(2)
of the Securities Act of 1933.
21
Use of Proceeds
On July 29, 1999, we offered 6,210,000 shares of our common stock in an
initial public offering. These shares were registered with the Securities and
Exchange Commission on a registration statement on Form S-1 (file number
333-78713), which became effective on July 29, 1999. We received net proceeds of
approximately $85.3 million from the sale of the 6,210,000 shares at the initial
public offering price of $15.00 per share after deducting underwriting
commissions and discounts and expenses of approximately $1.5 million. The
managing underwriters for our initial public offering were Hambrecht & Quist
LLC, BT Alex. Brown Incorporated and Bear. Stearns & Co. Inc.
$7.0 million of the net proceeds from our initial public offering was used
to repay a portion of the $14.0 million note payable to IDT. $3.5 million was
used to pay ICQ, a subsidiary of America Online, in connection with our
distribution and marketing agreement. As of the date of this report, we have not
made any other specific allocations with respect to the proceeds. We expect to
use the balance of the net proceeds of our initial public offering for:
. developing and maintaining strategic Internet relationships;
. advertising and promotion;
. research and development;
. upgrading and expanding our network; and
. general corporate purposes, including working capital.
Pending any use, the net proceeds of our offering have been invested in
short-term, interest-bearing securities.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with
our financial statements and related notes thereto and "Management's Discussion
and Analysis of Financial Condition and Results of Operations" included in Item
7. The statement of operations data for the period from January 2, 1996
(inception) to July 31, 1996, fiscal 1997, fiscal 1998 and fiscal 1999 and the
balance sheet data as of July 31, 1998 and 1999 are derived from our financial
statements.
22
Period from
January 2, 1996 Fiscal Year Ended July 31,
(inception) to -----------------------------------------------
July 31, 1996 1997 1998 1999
------------- ------------ ----------- ----------
Statement of Operations Data:
Revenue:
PC2Phone ........................................ $ -- $ 2,170,442 $ 7,962,821 $ 19,733,569
Phone2Phone ..................................... -- 272 2,030,516 10,306,617
Other ........................................... -- 481,589 2,012,635 3,216,271
----------- ----------- ----------- ------------
Total revenue ................................ -- 2,652,303 12,005,972 33,256,457
----------- ----------- ----------- ------------
Costs and expenses:
Direct cost of revenue, excluding
depreciation .................................. -- 1,553,443 6,848,759 17,818,010
Selling and marketing ........................... 34,468 76,724 2,887,766 8,828,167
General and administrative ...................... 465,015 2,599,283 5,087,628 10,836,072
Depreciation and amortization ................... 8,275 120,500 726,508 2,316,545
Compensation charge from the issuance of
stock options ................................. -- -- -- 17,919,541
----------- ----------- ----------- ------------
Total costs and expenses ..................... 507,758 4,349,950 15,550,661 57,718,335
----------- ----------- ----------- ------------
Loss from operations .............................. (507,758) (1,697,647) (3,544,689) (24,461,878)
Interest expense--net ............................. -- -- -- (243,314)
----------- ----------- ----------- ------------
Net loss .......................................... (507,758) (1,697,647) (3,544,689) (24,705,192)
Redeemable preferred stock dividends .............. -- -- -- (29,219,362)
----------- ----------- ----------- ------------
Net loss available to common stockholders ......... $ (507,758) $(1,697,647) $(3,544,689) $(53,924,554)
=========== =========== =========== ============
Net loss per common share--basic and
diluted .......................................... $ (0.02) $ (0.06) $ (0.12) $ (1.73)
=========== =========== =========== ============
Pro forma net loss per common share--basic and
diluted(1) ....................................... $ (0.74)
============
Weighted average number of common shares
used in calculation of basic and diluted net
loss per common share ............................ 27,864,000 27,864,000 30,186,000 31,236,415
=========== =========== =========== ============
Pro forma weighted average number of common
shares used in calculation of basic and diluted
pro forma net loss per common share(1) .............. 33,172,031
============
- --------------------
(1) The pro forma net loss and net loss per share assume that the conversion of
the redeemable preferred stock into Class A stock took place when the stock
was issued in May 1999.
July 31,
-----------------------------------------------------------------------------------
1996 1997 1998 1999
------------ --------- ----------- ----------------------------
Actual Pro Forma(2)
Balance Sheet Data:
Cash and cash equivalents ............... $ -- $ -- $ 10,074 $20,379,048 $ 99,638,298
Working capital ......................... (681,532) (3,104,830) (11,149,553) 6,303,452 92,562,702
Total assets ............................ 174,674 916,025 6,975,108 50,816,891 130,076,141
Accounts payable to IDT ................. 681,532 2,960,429 11,814,988 3,735,395 3,735,395
Loan payable to IDT ..................... -- -- -- 14,000,000 7,000,000
Total stockholders' (deficit) equity...... (507,758) (2,205,305) (5,649,994) (4,062,867) 110,125,383
- --------------------
(2) On August 3, 1999, the Company completed an initial public offering of
6,210,000 shares of common stock at an initial public offering price of
$15.00 per share, resulting in net proceeds of approximately $85 million.
These numbers give effect to the following as if they occurred on July 31,
1999:
. the sale of 6,210,000 shares of common stock in our initial public
offering;
. the application of $7.0 million of the net proceeds from our initial
public offering to pay a portion of the note payable to IDT;
. the conversion of 517,839 shares of Class A stock to common stock;
. the exercise of options to purchase 75,000 shares of common stock at a
price of $3.33 per share and options to purchase 50,000 shares of common
stock at $15.00 per share; and
. the conversion of 3,140,000 shares of Series A convertible preferred
stock into 9,420,000 shares of Class A stock upon the closing of our
initial public offering.
23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our financial
statements and notes thereto. The historical financial information included in
this report does not necessarily reflect what our financial condition and
results of operations would have been had we been operated as an independent
entity during the periods presented.
Overview
We began our operations in January 1996, launched our first Net2Phone
product in August 1996, and were established as a separate subsidiary of IDT in
October 1997. We have incurred net operating losses since inception and expect
to incur additional losses for the foreseeable future, primarily as a result of
increased sales and marketing efforts. As of July 31, 1999, we had an
accumulated deficit of approximately $30.5 million.
We recognized significant charges relating to non-cash executive
compensation expense in the fourth quarter of 1999 and will recognize additional
significant charges on an ongoing basis, in connection with the grants of
options to purchase shares of our common stock in May and July 1999. With
respect to these options, we recognized a charge of approximately $17.9 million
in the fourth quarter of fiscal 1999, and will recognize charges of
approximately $11.8 million during fiscal 2000, approximately $11.8 million
during fiscal 2001 and approximately $8.3 million during fiscal 2002.
In May 1999, we issued 3,140,000 shares of Series A convertible preferred
stock which were converted into 9,420,000 shares of Class A stock at $3.33 per
share at the time of our initial public offering. The Series A convertible
preferred stock contains beneficial conversion features. The total value of the
beneficial conversion features is approximately $75 million. For accounting
purposes, the value of the beneficial conversion features was limited to the
amount of proceeds allocated to the Series A convertible preferred stock. We
recorded a reduction in net income available to common stockholders in the
quarter ended July 31, 1999 of approximately $29.2 million. In connection with
the issuance of the Series A convertible preferred stock, we issued warrants to
purchase up to 272,400 shares of common stock at an exercise price of $3.33 per
share. The fair value of warrants on the date of issuance was $2.1 million.
These warrants were exercised to purchase an aggregate of 136,648 shares of
common stock at the time of our initial public offering. The fair value of the
warrants was recorded as an increase to additional paid in capital and a
decrease to the carrying value of the Series A convertible preferred stock. The
decrease in the carrying value of the Series A convertible preferred stock will
be accreted, with a corresponding reduction of additional paid-in capital, over
the period to the initial redemption date in May 2006. At the closing of our
initial public offering in August 1999, the balance of the unamortized discount
was recorded as a reduction of the amount of income available for common
shareholders.
In connection with our distribution and marketing agreement with ICQ, we
issued a warrant to America Online to purchase up to 3% of our outstanding
capital stock on a fully-diluted basis. This warrant will vest in 1% increments
upon the achievement of each of three incremental thresholds of revenue
generated under the agreement during the first four years that the warrant is
outstanding. The per share exercise price under the warrant will be equal to the
lesser of $12.00 per share or $450 million divided by the number of our fully-
diluted shares on the initial exercise date. If one or more of the revenue
thresholds set forth in the warrant are achieved, we will recognize additional
non-cash charges in an amount equal to the value of the warrant, as determined
at the time that these thresholds are met.
We offered 6,210,000 shares of our common stock in an initial public
offering, which became effective of July 29, 1999. On August 3, 1999 we received
net proceeds of approximately $85.3 million from the sale of the 6,210,000
shares at the initial public offering price of $15.00 per share. The managing
underwriters for this offering were Hambrecht & Quist LLC, BT Alex. Brown
Incorporated and Bear. Stearns & Co. Inc.
On November 4, 1999, we filed a registration statement with the Securities
and Exchange Commission for the sale of 6,300,000 shares of common stock. Of the
6,000,000 shares to be sold in the offering, 3,400,000 shares are being sold by
us. The remaining 2,600,000 shares are being sold by selling stockholders,
including IDT, which will be selling 2,200,000 shares. The underwriters have
also been granted an option for a period of 30 days to purchase up to 945,000
additional shares of common stock from other selling stockholders to cover over-
allotments, if any.
Sources of Revenue
During fiscal 1999, approximately 59.3% of our revenue was derived from
per-minute charges we billed to our customers on a prepaid basis to use our
PC2Phone service, and approximately 31.0% of our revenue was derived from
per-minute charges we billed to our customers and our international resellers on
a prepaid basis to use our Phone2Phone service. The remainder of our revenue was
derived from the sale of Internet telephony gateways, technology licensing and
for services we provide to IDT and other carriers. In the future, in order to
diversify and enhance our revenue sources, we plan to introduce a variety of
value-added services and Internet commerce solutions. In addition, we plan to
sell Web-based advertising to leverage our customer reach. To date, these
additional products and services have provided no revenue and we do not
anticipate material revenue from these additional products and services through
at least December 1999.
Approximately 90.3% of our revenue in fiscal 1999 was generated from
per-minute charges we charge our customers on a prepaid basis to use our
PC2Phone and Phone2Phone services. During fiscal 1999, approximately
24
62% of our revenue was derived from customers based outside of the United
States. As of July 31, 1999, we served over 325,000 active customers who spent
an average of approximately 60 minutes per month placing calls over the
Internet. We recognize revenue as our customers utilize the balances in their
prepaid accounts by placing calls. As such, we have deferred revenue for all
unutilized balances in our customers' accounts. The remaining 9.7% of our
revenue, which is derived from the sale of Internet telephony gateways,
technology licensing and from services provided to IDT and other carriers, is
recognized upon installation of the equipment and performance of the services.
Cost Structure
Our costs and expenses include:
. direct cost of revenue, excluding depreciation;
. selling and marketing;
. general and administrative; and
. depreciation.
Direct Cost of Revenue
Direct cost of revenue consists primarily of network costs associated with
carrying our customers' traffic on our network and leased networks, and routing
their calls through a local telephone company to reach their final destination.
These costs exclude depreciation and include:
. amounts paid to other carriers to terminate traffic on a per-minute
basis;
. the cost of leased routers and access servers;
. telecommunications costs, including the cost of local telephone lines to
carry subscriber calls to our network;
. the costs associated with leased lines connecting our network directly
to the Internet or to our operations centers and connecting our
operations centers to the Internet; and
. Internet backbone costs, which are the amounts we pay to Internet
service providers for capacity.
We expect our direct cost of revenue to increase in absolute terms over
time to support our growing customer base. While some of these costs are fixed,
other costs vary on a per minute basis. Therefore, there may be some volatility
in our direct cost of revenue as a percentage of revenue, particularly as we
expand our network. We try to terminate calls on our own network whenever
possible. When we cannot terminate calls on our network, we terminate calls on
the network of other suppliers, primarily IDT. We expect to continue to utilize
this process. We also expect the percentage of our traffic that we terminate
with IDT will decline in the future as we expand our own network.
Selling and Marketing. Selling and marketing includes the expenses
associated with acquiring customers, including commissions paid to our sales
personnel, advertising costs, referral fees and amounts paid to our strategic
partners in connection with revenue-sharing arrangements. We expect selling and
marketing expenses to increase over time as we aggressively market our products
and services. Historically, selling and marketing expenses have been a
relatively variable cost and are expected to increase both in terms of absolute
dollars and as a percentage of revenue as our revenue grows. We expect to spend
significant capital to build brand recognition. Most of our sales
25
and marketing expenses will go toward securing significant and strategic
relationships with a variety of Internet companies. We have strategic alliances
with Netscape, ICQ, InfoSpace.com, Yahoo! and Excite and intend to continue to
pursue relationships with other companies.
General and Administrative. General and administrative expenses consist of
the salaries of our employees and associated benefits, and the cost of
insurance, travel, entertainment, rent and utilities. A large portion of our
general and administrative expenses include operations and customer support.
These include the expenses associated with customer service and technical
support, and consist primarily of the salaries and employment costs of the
employees responsible for those efforts. We expect operations and customer
support expenses to increase over time to support new and existing customers. We
expect general and administrative costs to increase to support our growth,
particularly as we establish a larger organization to implement our business
plan. We include our research and development costs, comprised primarily of
payroll expenses for our technical team of engineers and developers, in general
and administrative expenses. We plan to incur additional costs for research and
development, though they are not expected to increase as a percentage of
revenue. Over time, we expect these relatively fixed general and administrative
expenses to decrease as a percentage of revenue.
Depreciation and Amortization. Depreciation and amortization primarily
relates to our hardware infrastructure. We depreciate our network equipment over
its estimated five-year useful life using the straight-line method. We plan to
acquire a domestic high capacity network to provide additional capacity to
handle the expected increase in customer traffic as our business grows. In
addition, we will be adding more network hardware as traffic volumes justify. We
expect depreciation to increase in absolute terms as we expand our network to
support new and acquired customers, but to decrease as a percentage of total
revenue. We have also entered into a strategic agreement with Netscape, part of
which includes the purchase of software and trademark licenses. We expect to
amortize the costs relating to the software and trademark licenses acquired from
Netscape over the two-year term of the agreement.
Dependence on IDT. Historically, we have been dependent on IDT for working
capital, its telecommunications network and for various services. In connection
with establishing ourselves as an independent operating entity, we recently
contracted with IDT for telecommunications services and administrative support.
We believe that the terms of our agreements with IDT are no less favorable than
those we would have obtained from unaffiliated third parties.
26
Results of Operations
The following table sets forth certain items in our statement of operations
as a percentage of total revenue for the periods indicated:
Fiscal Year Ended July 31,
---------------------------------------
1997 1998 1999
-------- -------- --------
Revenue:
PC2Phone ................................................................ 81.8% 66.3% 59.3%
Phone2Phone ............................................................. -- 16.9 31.0
Other ................................................................... 18.2 16.8 9.7
------ ------ ------
Total revenue ........................................................ 100.0 100.0 100.0
------ ------ ------
Costs and expenses:
Direct cost of revenue, excluding depreciation and amortization ......... 58.6 57.0 53.6
Selling and marketing ................................................... 2.9 24.1 26.5
General and administrative .............................................. 98.0 42.4 32.6
Depreciation and amortization ........................................... 4.5 6.1 7.0
Compensation charge from issuance of stock options ...................... -- -- 53.9
------ ------ ------
Total costs and expenses ............................................. 164.0 129.6 173.6
Loss from operations ...................................................... (64.0) (29.6) (73.6)
Interest--net ............................................................. -- -- (0.7)