10-Q 1 d10q.txt QUARTERLY REPORT ENDED 9/30/01 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 __________________ FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to _____________ Commission file number 000-29295 BUY.COM INC. (Exact name of registrant as specified in its charter) Delaware 33-0816584 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 27 Brookline Aliso Viejo, California 92656 (Address of principal executive office) (Zip code) (949) 389-2000 (Registrant's telephone number, including area code) 85 Enterprise Aliso Viejo, California 92656 (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant: (1) has filed all documents and reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____ --- The number of shares outstanding of the Registrant's Common Stock, par value $0.0001, as of November 7, 2001 was 136,973,597. INDEX -----

In this report, "BUY.COM," the "Company," "we," "us" and "our" collectively refers to BUY.COM INC. and its subsidiaries. i BUY.COM INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of these consolidated balance sheets. 1 BUY.COM INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of these consolidated statements. 2 BUY.COM INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of these consolidated statements. 3 Supplemental cash flow information: Cash paid for interest $ 40 $ 1,358 =============== =============== Stock issued in connection with domain purchases $ - $ 316 =============== =============== Reduction in value of stock issued to PGA Tour $ - $ (7,151) =============== =============== Assumption of liabilities in connection with acquisition $ (313) $ - =============== =============== Net settlement of joint venture receivable $ 730 $ - =============== =============== ACQUISITION Acquired all of the outstanding capital stock of Telstreet.com, Inc. The following table outlines the assets acquired, liabilities assumed and cash received: Fair value of assets acquired $ - $ 8,470 Less: Liabilities assumed - (1,641) Fair value of common stock issued - (7,050) --------------- --------------- Cash received in connection with acquisition $ - $ 221 =============== ===============

The accompanying notes are an integral part of these consolidated statements. 4 BUY.COM, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. COMPANY BACKGROUND BUY.COM INC. and its subsidiaries, (collectively the "Company" or "BUY.COM"), is a multi-category Internet superstore, offering a selection of brand name computer hardware and peripherals, software, books, videos, DVDs, computer games, music, clearance equipment, consumer electronics and wireless products and services. Through its online specialty stores, the Company offers products in a convenient, intuitive shopping interface that features extensive product information and multi-media presentations. The Company's e-commerce portal, www.buy.com, links all of its specialty stores and is designed to enhance the customer's online shopping experience 24 hours a day, seven days a week. BUY.COM uses a business model that includes outsourcing the majority of its operating infrastructure, such as distribution and fulfillment functions, customer service and support, credit card processing, and the hosting of the Company's system infrastructure and database servers. BUY.COM (formerly BuyComp, LLC and Buy Corp.) was organized in June 1997 and began offering products for sale through its web site in November 1997. From BUY.COM's inception through mid-November 1997, the Company had no sales. During this period, the Company's operating activities primarily involved the development of the necessary infrastructure and the original BuyComp.com web site. In August 1998, the Company changed its web site designation to www.buy.com. ----------- 2. BASIS OF PRESENTATION These financial statements were prepared based on the assumption that the Company will continue as a going concern. On August 10, 2001, the Company signed a definitive merger agreement with SB Acquisition Inc., a company wholly-owned by Scott A. Blum, its founder. The merger is subject to approval of the Company's stockholders and other closing conditions. Provided that the merger is approved by the Company's stockholders and all other conditions to closing are satisfied or waived, the merger is expected to be completed by the end of November 2001. However, because many of the closing conditions are beyond the Company's control, there can be no assurance that the merger will be completed by the end of November 2001, if at all. If the Company is unable to close the merger or obtain additional financing or complete another sale or merger transaction, it is unlikely that the Company would be able to continue as a going concern. (see Note 4) In connection with the execution of the merger agreement, the Company also entered into a credit agreement and a security agreement with a trust controlled by Scott A. Blum, pursuant to which it has access to a $4,000,000 line of credit and up to an additional $5,000,000 to establish stand by letters of credit for the benefit of its distributor and vendor partners. As of September 30, 2001 the Company has not drawn any amounts under this credit facility. The security agreement grants the Blum trust a security interest in substantially all of the Company's assets to secure payment and performance of its obligations under the credit agreement. In the event the merger agreement is terminated prior to completion of the transaction, under substantially all circumstances, all outstanding debt under the line of credit and letters of credit will become immediately due and payable, and the Company will need to obtain additional financing or complete another merger or sale transaction to repay its indebtedness in order to continue as a going concern. If the Company is unable to repay its indebtedness under this credit facility, the Blum trust may foreclose on substantially all of the Company's assets. (see Note 4) In addition, since August 30, 2001, Mr. Blum has agreed to guarantee certain obligations of the Company to its credit card processors. In connection with those guarantees, the Company entered into reimbursement agreements and security agreements with Mr. Blum, which agreements require that the Company repay any amounts he pays under the 5 guarantees and that such obligations are secured by security agreements for substantially all of its assets. Mr. Blum has not paid any amounts under these guarantees as of September 30, 2001. If the Company is unable to repay any of these amounts paid by Mr. Blum on its behalf, Mr. Blum may foreclose on substantially all of the Company's assets. Also, if the Company is unable to successfully complete its merger with SB Acquisition Inc., it is uncertain whether it will be able to maintain its credit card processing relationships. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Unaudited Interim Financial Information The interim consolidated financial statements as of September 30, 2001 have been prepared by BUY.COM pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC") for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary to present fairly the consolidated balance sheets, consolidated operating results, and consolidated cash flows for periods presented in accordance with generally accepted accounting principles. The consolidated balance sheet at December 31, 2000 has been derived from the audited consolidated financial statements at that date. Operating results for the quarter and nine month period ended September 30, 2001 may not be indicative of the results for the year ending December 31, 2001. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted in accordance with the rules and regulations of the SEC. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements, and accompanying notes, included in the Company's Form 10- K for the year ended December 31, 2000, as amended. Certain prior period amounts have been reclassified to conform to the current year presentation. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the amounts of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents For the purposes of consolidated statements of cash flows, the Company considers investment instruments with an original maturity of three months or less to be cash equivalents. The carrying amount of cash equivalents approximates fair value because of the short-term maturity of those instruments. Cash equivalents are comprised of investments in money market funds, government mortgage backed bonds and highly rated corporate securities. Restricted Cash Restricted cash is comprised of cash which is restricted to secure certain letter of credit obligations. Revenue Recognition Net revenues include product sales net of returns and allowances, advertising sales, warranty sales net of amounts paid to the national insurance provider, and gross outbound shipping and handling charges. The Company recognizes revenue from product sales, net of discounts, coupon redemption and estimated sales returns, when the products are shipped to customers. Gross outbound shipping and handling charges are included in net sales. The Company provides an allowance for sales returns, which is based on historical experience. In certain cases, credit card companies require the Company to charge customers' credit cards to obtain authorization. In such cases, the Company defers revenue recognition until it has confirmed shipment of the goods to the customer. For all product sales transactions with its customers, the Company acts as a principal, takes title to all products sold upon shipment, bears credit risk, and bears inventory risk for 6 returned products that the Company is not able to return to suppliers, although these risks are mitigated through arrangements with credit card issuers, shippers and suppliers. The Company recognizes revenue from advertising sales ratably over the term of the advertising campaigns, which usually range from one to twelve months. To the extent that advertising customers have paid the Company for advertisements that have yet to be published on the Company's Web site, the Company defers revenue recognition until such advertisements are delivered. The Company has no advertising contracts with a term in excess of one year. The Company receives activation commissions from wireless carriers for each new wireless phone subscription it sells. New subscription activation fees and commissions generally are fully refundable if the subscriber cancels service within the minimum period of continuous active service (generally 90 to 180 days). The Company recognizes net commission revenue from activation fees and commissions when the subscription is activated. The Company provides an allowance for deactivation that is based on historical experience. The Company believes it operates under one segment. Recent Accounting Pronouncements In April 2001, the Emerging Issues Task Force ("EITF") of the Financial Accounting Standards Board reached a consensus on EITF Issue 00-25, "Accounting for Consideration from a Vendor to a Retailer in Connection with the Purchase or Promotion of the Vendor's Products." The consensus provides guidance on the income statement classification of costs that are incurred by a vendor to or on behalf of a customer in connection with the customer's purchase or promotion of the vendor's products. The consensus is effective for quarters beginning after December 15, 2001. Management believes the impact of the adoption of this consensus will be immaterial. In June 2001 the Financial Accounting Standards Board (FASB) issued Statement of Financial Standards (SFAS) No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible Assets." SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against this new criteria and may result in certain intangibles being subsumed into goodwill, or alternatively, amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill. SFAS No. 142 requires the use of a non-amortization approach to account for purchased goodwill and certain intangibles. Under a non-amortization approach, goodwill and certain intangibles will not be amortized into results of operations, but instead would be reviewed for impairment and written down and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value. The provisions of each statement that apply to goodwill and intangible assets acquired prior to June 30, 2001 will be adopted by the Company on January 1, 2002. Management has not determined the amount of impairment, if any, that would be required upon adoption. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long- lived asset, except for certain obligations of lessees. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. SFAS 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002 (with earlier application being encouraged). The Company does not expect the adoption of SFAS 143 to have a material impact on its financial condition and results of operations. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring 7 Events and Transactions," for the disposal of a segment of a business (as previously defined in that Opinion). The provisions of SFAS 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001, with early application encouraged and generally are to be applied prospectively. The Company does not expect the adoption of SFAS 144 to have a material impact on its financial condition and results of operations. 4. DEFINITIVE MERGER AGREEMENT On August 10, 2001, the Company signed a definitive merger agreement with SB Acquisition Inc., a company wholly-owned by Scott A. Blum, the Company's founder and major stockholder. The merger agreement provides for the Company to merge with a subsidiary of SB Acquisition, after which it will continue its operations as a wholly-owned subsidiary of SB Acquisition. The merger is subject to approval of the Company's stockholders and other closing conditions. If the merger is approved by the Company's stockholders and all other closing conditions are satisfied or waived, the merger is expected to be completed by the end of November 2001. If the merger is completed, each outstanding share of the Company's common stock will be cancelled and converted into the right to receive $0.17 in cash from SB Acquisition. In connection with the execution of the merger agreement, the Company also entered into a credit agreement and a security agreement with a trust controlled by Scott A. Blum, pursuant to which it has access to a $4,000,000 line of credit and up to an additional $5,000,000 to establish stand by letters of credit for the benefit of its distributor and vendor partners. As of September 30, 2001 the Company has not drawn any amounts under this credit facility. The security agreement grants the Blum trust a security interest in substantially all of the Company's assets to secure payment and performance of its obligations under the credit agreement. In the event the merger agreement is terminated prior to completion of the transaction, under substantially all circumstances, all outstanding debt under the line of credit and letters of credit will become immediately due and payable. In addition, if the Company cannot repay all of the outstanding amounts due, including commitment fees and possible termination fees, the Blum trust may foreclose on the Company's assets. In addition, since August 30, 2001, Mr. Blum has agreed to guarantee certain obligations of the Company to its credit card processors. In connection with those guarantees, the Company entered into reimbursement agreements and security agreements with Mr. Blum, which agreements require that the Company repay any amounts he pays under the guarantees and that such obligations are secured by security agreements for substantially all of its assets. Mr. Blum has not paid any amounts under these guarantees as of September 30, 2001. If the Company is unable to repay any of these amounts paid by Mr. Blum on its behalf, Mr. Blum may foreclose on substantially all of the Company's assets. Also, if the Company is unable to successfully complete its merger with SB Acquisition Inc., it is uncertain whether it will be able to maintain its credit card processing relationships. 5. BUSINESS ACQUISITIONS, DISPOSITIONS, AND INVESTMENTS International Joint Ventures On March 7, 2001, the Company sold its interest in its United Kingdom joint venture for $4.0 million to the John Lewis Partnership, a large retailer in the United Kingdom. In connection with the sale, the Company applied its proceeds to the repayment of the Company's loan obligations to its joint venture partner. The income recorded in the line item "Equity in income (losses) of joint ventures, net" represents the Company's 50% share of joint venture losses that the Company recorded during 1999 and 2000. The Company's recorded losses in 1999 and 2000 were greater than the Company's liability required to fund such losses. On May 23, 2001, the Company made a final payment of $780,000 for their remaining obligation to their Australian joint venture partner. As of September 30, 2001, the Company has no further obligations to any of its joint venture partners. Restructuring Charge During the first quarter 2001, the Company initiated a restructuring of its business and implemented a new operating plan. The Company recorded a $34.7 million charge associated with such restructuring plan. The charge is 8 substantially attributable to the impairment of goodwill associated with the BuyGolf acquisition of $13.1 million, payment of severance and benefits for the employees that were terminated during the first quarter of $2.1 million, the write off of certain assets of $2.8 million, the write off of contract and lease cancellation fees of $1.8 million and the remaining sponsorship fees related to the Buy.com Tour of $14.9 million, as the Company does not believe that any further benefits will be derived from its sponsorship agreement with the PGA Tour. During the third quarter, the Company initiated a further reduction in its workforce resulting in an additional severance and benefit charge of $630,000. The Company also wrote-off excess property and equipment of $363,000 and accrued for contract and lease cancellation fees of $1.5 million in connection with the Company's decision to relocate its corporate offices. The Company has made certain assumptions in its accrual of additional contract and lease cancellation fees with regard to the timing and amount that the Company may receive for a sublease of its previous corporate offices. Actual results could differ significantly from the Company's estimates. As of September 30, 2001, the restructuring accrual is $2.3 million, which primarily relates to the Company's contractual and lease obligations. The Company also reversed approximately $914,000 of its restructuring charge, of which $400,000 related to a reimbursement from the PGA Tour due to a shortfall in the number of required tournament events. Restructuring Charge-Rollforward Quarter Ending September 30, 2001 (in thousands)

Restructuring Charge-Rollforward Nine Months Ending September 30, 2001 (in thousands)

The Company performed an impairment analysis on its long-lived assets and goodwill at March 31, 2001, during the quarter in which the restructuring was initiated. The restructuring was determined to be a triggering event for the analysis under SFAS 121. At that time, the Company had made the decision to exit the sporting goods e-retail business and therefore determined that all goodwill associated with the BuyGolf.com acquisition would have no future benefit. Additionally, it was determined that the triggering event of the restructure did not have an impact on the remaining two components of goodwill, which relate to the Company's Speedserve and Telstreet acquisitions. Speedserve was acquired in November 1998, which enabled the Company to enter the book, video, and game retail markets, and continues to have 9 a benefit to the Company that was not altered by the restructuring. Telstreet was acquired in August 2000, which enabled the Company to enter into the wireless/cellular telephone retail markets and continues to have a benefit to the Company that was not altered by the restructuring. In addition, Telstreet having been acquired within 12 months qualified as a current acquisition and is presumed to not be impaired by the restructure. At September 30, 2001 the Company re-evaluated the existence of triggering events and determined that nothing had occurred during the second or third quarter that would cause further impairment of the Company's long-lived assets beyond that included in the amount at March 31, 2001. 6. MARKETABLE SECURITIES The Company's marketable securities, which consist primarily of high- quality short-to-intermediate-term securities are classified as available-for- sale and are reported at fair value. The cost of these securities approximate fair value; therefore, any unrealized gains or losses are immaterial. 7. COMMITMENTS AND CONTINGENCIES On February 28, 2001, the Company filed suit against the PGA Tour in federal district court, Central District of California, for breach of contract based on its Buy.com Tour sponsorship agreement with the PGA Tour. The Company claims that the PGA Tour entered into an agreement with another party to provide e-commerce services to them in violation of the Company's agreement. The Company is seeking rescission of its agreement, a return of its sponsorship fees, including those secured by a $17,000,000 letter of credit, and additional damages. In March 2001, the PGA Tour filed a counterclaim against the Company in the federal district court in the Central District of California. The counterclaim alleges that the Company breached its contract by declaring the sponsorship agreement to be terminated, by demanding that the PGA Tour cease all uses of the Company's trademark, by breaching the confidentiality provisions of the sponsorship agreement and by taking action that adversely affects the goodwill of the Buy.Com Tour. The PGA Tour seeks damages in excess of $75,000 and attorneys' fees. Discovery is underway and a trial is set for February 2002. On July 11, 2001, a class action complaint, titled Joel Abrams v. BUY.COM, was filed against the Company alleging violations of the federal securities laws by the Company, certain of its officers and/or directors, and the Company's underwriters that participated in the IPO process. Since July 11, 2001, several other similar class action complaints have been filed against the Company including: Richard Taylor v. BUY.COM (filed July 23, 2001), Robert Berkowitz v. BUY.COM (filed July 16, 2001), Rutherford Dawson v. BUY.COM (filed August 1, 2001), Haas v. BUY.COM (filed August 15, 2001), Goodman Espstein v. BUY.COM (filed August 10, 2001), Leo and Josie Castillo v. BUY.COM (filed August 15, 2001) and Mohammad Jawed Akhtar v. BUY.COM (filed August 17, 2001). Each of the class actions were filed in the United States District Court, Southern District of New York on behalf of purchasers of BUY.COM securities during the period between February 7, 2000 and December 6, 2000. The complaints allege that the Company's prospectus was materially false and misleading because it failed to disclose, among other things, that the Company's underwriters had solicited and received excessive and undisclosed commissions from certain investors. The lawsuits also allege that the underwriters engaged in actions that artificially inflated the price of the stock. Greg Hawkins and Mitch Hill have been named as defendants in each of these cases in connection with their capacity as former officers and/or directors of the Company. Mr. Hawkins and Mr. Hill have indemnification agreements with the Company. The Company believes that other similar cases may have been filed against the Company that are not yet known to it. As of the date of this quarterly report, the Company has not yet responded to any of these complaints and each case is in its early stage. Several former employees of the Company have incurred adverse tax consequences as a result of their exercise of non-qualified stock options. One of such employees has filed suit against the Company claiming that the Company misrepresented the nature of the options and therefore should be responsible for the adverse tax consequences. Another employee has provided a written demand to the Company for relief from the adverse tax consequences incurred by such employee. The Company could receive similar demands from other similarly situated employees in the future. 10 Management is unable to determine or predict the outcome of the above litigation and claims, or their impact on the Company's financial condition or results of operation. Accordingly, the Company has not recorded a provision for these matters in its financial statements. 8. LOSS PER SHARE Basic earnings per share is computed by dividing the net earnings available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing the net earnings for the period by the weighted average number of common and common equivalent shares outstanding during the period. The following represents the calculations for basic and diluted net loss per share (amounts in thousands, except share and per share data):

All of the Company's stock options and warrants are excluded from diluted loss per share since their effect is anti-dilutive. 9. INCOME TAXES The Company incurred taxable losses for federal and state purposes for the quarter and nine month period ended September 30, 2001 and quarter and nine month period ended September 30, 2000. Accordingly, the Company did not incur any federal income tax expense for those periods other than the minimum required taxes for certain state and local jurisdictions. At September 30, 2001, the Company has net operating loss carryforwards related to federal and state income taxes for which the Company has established a full valuation allowance for the corresponding tax assets. 10. STOCKHOLDERS' EQUITY Restricted Stock Program During the first quarter of 2001, the Company recorded a reversal of deferred compensation of approximately $2.5 million due to the termination of certain of its employees. The deferred compensation was related to restricted stock awards that were designated, and reserved for issuance subject to individual vesting schedules, for certain employees. The Company terminated the employment of approximately 115 employees during the first quarter 2001, and as a result, cancelled approximately 3.5 million shares that were reserved for issuance under the Company's Restricted Stock Program. The Company also incurred an expense of $269,000 related to the acceleration of the vesting schedules for two employees' restricted stock awards. During the second quarter of 2001, the Company recorded a reversal of approximately $277,000 due to the resignation of one of its employees. During the third quarter of 2001, the Company recorded a reversal of approximately $231,000 due to the further reduction of the workforce. The remaining deferred compensation charge related 11 to the Company's Restricted Stock Program is approximately $265,000, which is being amortized using the straight-line method over the remaining five quarters of vesting. In connection with the completion of the proposed merger, the vesting of all outstanding Company stock options and other stock awards will accelerate and such stock options and stock awards will become exercisable. Accordingly, holders who exercise their stock options or other stock awards and pay the exercise or purchase price therefore prior to completion of the proposed merger will receive shares of Company common stock and will be entitled to receive the merger consideration. If the merger is completed, all Company stock options or other stock awards will be cancelled upon completion of the merger. Deferred compensation will be recorded in connection with this acceleration and other change in control benefits will be recorded under existing employee agreements. The Company uses the intrinsic value method of accounting for its employee stock-based compensation plans. Accordingly, no deferred compensation charge is recognized for any of its stock options when the exercise price of each option equals or exceeds the fair value of the underlying common stock as of the grant date for each stock option. The Company records deferred compensation for the difference at the grant date between the exercise price and the fair value of the common stock underlying the options. This amount is being amortized over the vesting period of the individual options, which is generally 3 to 4 years. Nasdaq Delisting On August 14, 2001, the Company's securities were delisted from the Nasdaq National Market, and are now quoted on the OTC Bulletin Board. 11. RELATED PARTY TRANSACTIONS In August 2001, the Company executed a non-exclusive marketing agreement with Thinkbig Marketing Group LLC, an agent retained to requisition, manage, create and produce advertising for the Company. The Company has agreed to pay Thinkbig a retainer fee of $50,000 per month, a ten percent commission on all advertising placements made on its behalf, and their actual costs incurred in performing their services under the agreement. The term of the agreement is for 90 days with an automatic thirty-day renewal period unless otherwise terminated. Mr. Blum indirectly has a 50% interest in Thinkbig Marketing Group LLC. Since August 30, 2001, Mr. Blum has agreed to guarantee certain obligations of the Company to its credit card processors. In connection with those guarantees, the Company entered into reimbursement agreements and security agreements with Mr. Blum, which agreements require that the Company repay any amounts he pays under the guarantees and that such obligations are secured by security agreements for substantially all of its assets. Mr. Blum has not paid any amounts under these guarantees as of September 30, 2001. If the Company is unable to repay any of these amounts paid by Mr. Blum on its behalf, Mr. Blum may foreclose on substantially all of the Company's assets. In September 2001, the Company entered into a facilities lease agreement with the Blum separate property trust for approximately 20,000 square feet of office space located in Aliso Viejo, California to serve as its corporate headquarters. Under the terms of the lease agreement, the Company pays approximately $30,000 per month and it has the option to terminate such lease upon 30 days notice. 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This report contains forward-looking statements which include, but are not limited to, statements concerning our ability to operate the business to positive operating cash flow, the ability to successfully execute our operating plan, the need for additional capital, the ability to raise additional working capital on acceptable terms, the ability to retain key employees, management personnel and our Board of Directors, the ability to effectively transition a new management team, the ability to maintain the support of our distributor and vendor partners, the ability to maintain other key corporate relationships, the ability to achieve our revenue goals in light of softening demand for consumer products, projected revenues, expenses, gross profit and income and the success of pending litigation. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management's beliefs, and certain assumptions made by us. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," "may," "will" and variations of these words or similar expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. The section entitled "Risk Factors" set forth at the end of Part I, Item 2 of this report, the "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this report and similar discussions in our other filings with the Securities and Exchange Commission ("SEC") discuss some of the important risk factors that may affect our business, results of operations and financial condition. In addition, with respect to our merger with SB Acquisition, Inc., the following factors, among others, could cause actual events to differ materially from those described herein: our inability to satisfy various conditions to the closing of the merger, including failure of our stockholders to approve the merger or failure to obtain any necessary regulatory approvals; the costs related to the merger; the effect of the merger and/or interim financing on creditor, vendor, supplier, customer or other business relationships; and the results and effects of our inability to pay any amounts under the interim financing if the merger is not consummated. You should carefully consider all of these risks, in addition to the other information in this report and in our other filings with the SEC, before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. OVERVIEW BUY.COM is a multi-category Internet superstore that offers a broad selection of brand name computer hardware and peripherals, software, books, videos, DVDs, computer games, music, clearance products, consumer electronics and wireless products and services at everyday low prices. BUY.COM was organized as a California limited liability company in June 1997 under the name BuyComp LLC and was incorporated in Delaware as Buy Corp. in August 1998. In November 1998, we changed our name to BUY.COM INC. We derive revenues principally from the sale of products and, to a lesser extent, from paid advertisements on our Web site. We recognize product revenue upon shipment of products. We generally recognize advertising revenue straight line over the period of time an advertisement runs on our site. In some circumstances, our agreements with advertisers require consumer action, in which case, we recognize advertising revenue when the consumer action is completed. We have employed a business model that includes outsourcing the majority of our infrastructure to leading national distribution and fulfillment providers with established expertise. Through this model, we capitalize on the cost efficiencies achieved by our distribution providers and minimize our infrastructure and operating expenses, enabling us to pass significant savings on to our customers. Additionally, by aligning with leading distributors in each of our product categories, we can use their significant inventories and distribution capabilities to offer a broader selection of products at lower costs than traditional retailers can. Consistent with our merchandising strategy, we have raised prices on many of our products. We intend to continue these selective price increases, and as a result, may experience decreased sales volumes. For this reason, our ability to 13 become and remain profitable depends upon our ability to maintain our net revenues and gross margins consistent with the assumptions underlying our new operating plan. Over recent quarters we have not achieved revenue growth and in fact, we expect our net revenue for 2001 to be significantly less than our net revenue for the year ended December 31, 2000, and we cannot be certain that we will ever become profitable. To date, our sales of computer hardware and software products have accounted for the vast majority of our net revenues. Our sales of products in other categories constituted less than 20% of our net revenues for the quarter and nine months ended September 30, 2001 and for the quarter and nine months ended September 30, 2000. None of our other product categories individually constituted more than 10% of our net revenues during these periods. Product sales, including shipping and handling, accounted for 95.2% and 94.7% of net revenues for the quarter and nine month period ended September 30, 2001, respectively, and 95.9% and 95.8% of net revenues for the quarter and nine month period ended September 30, 2000, respectively. Shipping and handling net revenues were $3.3 million and $12.4 million for the quarter and nine month period ended September 30, 2001, respectively, and $6.8 million and $21.6 million for the quarter and nine month period ended September 30, 2000, respectively. Shipping and handling results are a direct function of our product sales and are an integral part of our merchandising and pricing strategy and may fluctuate based on promotional programs. Accordingly, we believe shipping and handling net revenues and the corresponding gross profit on these net revenues cannot be viewed independent of product sales and gross profit. The gross profit on our shipping and handling net revenues was $279,000 and $1.1 million for the quarter and nine month period ended September 30, 2001, respectively, and $176,000 and $3.2 million for the quarter and nine month period ended September 30, 2000, respectively. We currently generate additional revenues from vendor co-op advertising as well as media advertising. Vendor co-op advertising is a standard practice in the retailing sector, where product vendors set aside certain amounts of advertising funds to be paid to retailers in exchange for specific marketing and in-store placement of their products. We also generate advertising media revenue from click-through advertisements that direct the customer to the advertiser's Web site. These media advertising revenues are generally derived from short-term advertising contracts in which we typically guarantee a minimum number of advertising impressions to be delivered to users over a specified period of time for a fixed fee. In the cases where we guarantee a minimum number of advertising impressions, we defer a portion of the advertising revenues until the minimum number of impressions has been achieved. Advertising sales accounted for 5.5% and 6.2% of net revenues for the quarter and nine month period ended September 30, 2001, respectively, and 5.9% and 5.5% of net revenues for the quarter and nine month period ended September 30, 2000, respectively. Our net revenues are also net of coupon redemptions. Coupon redemptions result in a reduction of gross revenues in the period the coupons are redeemed by an amount equal to the value of the coupons redeemed. Coupon redemptions were $541,000 and $2.6 million, or 0.7% and 0.9% of net revenues, for the quarter and nine month period ended September 30, 2001, respectively, and $3.4 million and $7.8 million, or 1.8% and 1.3% of net revenues, for the quarter and nine month period ended September 30, 2000, respectively. We have incurred significant losses since our inception and our cost of sales and operating expenses have increased dramatically. This trend reflects the costs associated with our increased efforts to promote the BUY.COM brand, build market awareness, attract new customers, recruit personnel, build operating infrastructure, and develop and expand our Web site and related transaction processing systems. In February 2001, we initiated a restructuring plan to reduce costs and conserve our cash resources. Further, in August 2001, we terminated approximately 50 other employees to further reduce our operating expenses. Consistent with our plan, we have reduced our expenses in the areas of marketing and advertising, product development and general and administrative. We still believe, however, that we will continue to incur substantial operating losses in the near term, and we may never achieve profitability. On August 10, 2001, we signed a definitive merger agreement with SB Acquisition Inc., a company wholly-owned by Scott A. Blum, our founder. The merger agreement provides for us to merge with a subsidiary of SB Acquisition, after which we will continue our operations as a wholly-owned subsidiary of SB Acquisition. The merger is subject to the approval of our stockholders and to other closing conditions. If the merger is approved by our stockholders and all other conditions to closing are satisfied or waived, the merger is expected to be completed by the end of November 14 2001. However, because many of the closing conditions are beyond our control, there can be no assurance that the merger will be completed by the end of November 2001, if at all. If we are unable to close the merger or obtain additional financing or complete another sale or merger transaction, it is unlikely that we would be able to continue as a going concern. If the merger is completed, each outstanding share of our common stock will be canceled and converted into the right to receive $0.17 in cash from SB Acquisition. Upon completion of the merger, we will be required to amortize deferred compensation for all remaining employees who hold options or restricted stock awards. Additionally, certain employees may be entitled to receive certain change in control benefits upon the closing of the merger that will be recorded as a compensation expense. In connection with the execution of the merger agreement, we also entered into a credit agreement with a trust owned by Scott A. Blum, pursuant to which we have access to a $4,000,000 line of credit and up to $5,000,000 to establish standby letters of credit for the benefit of our distributor and vendor partners. As of the date of this report, there were no amounts outstanding under the credit agreement. We have also entered into a security agreement with Blum's trust, pursuant to which we granted Blum's trust a security interest in substantially all of our assets to secure payment and performance of all of our obligations under the credit agreement. If the merger agreement is terminated prior to completion of the transaction, under substantially all circumstances, all outstanding debt under the line of credit and letters of credit will become immediately due and payable. In addition, if we cannot repay all of the outstanding amounts due, including commitment fees and possible termination fees, the Blum trust may foreclose on our assets. In addition, since August 30, 2001, Mr. Blum has agreed to guarantee certain obligations of ours to our credit card processors. In connection with these guarantees, we entered into reimbursement agreements and security agreements with Mr. Blum, which agreements require that we repay any amounts he pays under the guarantees and that such obligations are secured by security agreements for substantially all of our assets. If we are unable to repay any of these amounts paid by Mr. Blum on our behalf, Mr. Blum may foreclose on substantially all of our assets. As of the date of this report, Mr. Blum has not paid any amounts under these guarantees. RESULTS OF OPERATIONS Net revenues Net revenues were $75.5 million and $295.0 million for the quarter and nine month period ended September 30, 2001, respectively, and $190.2 million and $591.0 million for the quarter and nine month period ended September 30, 2000, respectively, representing 60% and 50% decrease, respectively. We believe the decrease in net revenues is primarily attributable to decreased product sales as a result of price increases on many of our products, a reduction in our sales and marketing expenditures and an overall weakening in consumer demand for technology products. We intend to continue selective price increases, and as a result, we may continue to experience decreased sales volumes. Gross profit Gross profit is calculated as net revenue less the cost of sales, which includes the cost of products sold, shipping costs and the related distribution and fulfillment costs. Gross profits were $8.4 million and $33.9 million for the quarter and nine month period ended September 30, 2001, respectively, and $12.7 million and $33.3 million for the quarter and nine month period ended September 30, 2000, respectively. Gross margins increased to 11.1% and 11.5% for the quarter and nine month period ended September 30, 2001, respectively, as compared to 6.7% and 5.6% for the quarter and nine month period ended September 30, 2000, respectively. We believe the increase in gross margin was primarily due to the price increases on many of our product sales. Sales and marketing expenses Sales and marketing expenses consist primarily of advertising and promotional expenses, as well as credit card fees, outsourced customer service fees, and payroll associated with our advertising and marketing personnel. Sales and marketing expenses were $7.4 million and $29.1 million for the quarter and nine month period ended September 30, 2001, respectively, and $21.2 million and $67.8 million for the quarter and nine month period ended September 30, 2000, 15 respectively, representing a decrease of 65% and 57%, respectively. Sales and marketing expenses as a percentage of net revenues decreased to 9.7% and 9.9% the quarter and nine month period ended September 30, 2001, respectively, as compared to 11.2% and 11.5% for the quarter and nine month period ended September 30, 2000, respectively. The decrease, both as a percentage of net revenues and in absolute dollars, was primarily attributable to the reduction of our advertising campaigns consistent with our restructuring plan implemented during the first quarter of 2001. We expect marketing and sales expenses to continue to decrease in absolute dollars as compared to the same periods in the previous year. Product development expenses Product development expenses consist primarily of personnel and other expenses associated with developing and enhancing our web site, as well as associated facilities and related expenses. Product development expenses were $1.5 million and $7.5 million for the quarter and nine month period ended September 30, 2001, respectively, and $7.1 million and $17.3 million for the quarter and nine month period ended September 30, 2000, respectively, representing a decrease of 78% and 57%, respectively. Product development expenses as a percentage of net revenues decreased to 2.0% for the quarter ended September 30, 2001, as compared to 3.7% for the quarter ended September 30, 2000. Product development expenses as a percentage of net revenues decreased to 2.5% for the nine month period ended September 30, 2001, as compared to 2.9% for the nine month period ended September 30, 2000. The decrease, both as a percentage of net revenues and in absolute dollars, was primarily due to a decrease in outside consulting costs. We intend to continue to enhance our Web site and technology and information systems, however consistent with our restructuring plan, we expect product development expenses to decrease in absolute dollars as compared to the same periods in the previous year. Also, in accordance with authoritative guidance, certain costs are capitalized and amortized over the estimated useful lives of the applicable assets. General and administrative expenses General and administrative expenses consist primarily of payroll and related expenses for executive and administrative personnel, facilities expenses, professional fees, depreciation and amortization, and other general corporate expenses. General and administrative expenses were $6.9 million and $27.5 million for the quarter and nine month period ended September 30, 2001, respectively, and $11.7 million and $35.4 million for the quarter and nine month period ended September 30, 2000, respectively, representing a decrease of 41% and 22%, respectively. General and administrative expenses as a percentage of net revenues increased to 9.2% and 9.3% for the quarter and nine month period ended September 30, 2001, respectively, as compared to 6.2% and 6.0% for the quarter and nine month period ended September 30, 2000, respectively. Consistent with our restructuring plan, we expect general and administrative expenses to continue to decrease in absolute dollars, as compared to the same periods in the previous year, due to our staff reduction and our reductions of other general and corporate expenses. Restructuring charge During the first quarter 2001, we initiated a restructuring of our business and implemented a new operating plan. We recorded a $34.7 million charge associated with such restructuring plan. The charge is substantially attributable to the impairment of goodwill associated with the BuyGolf acquisition of $13.1 million, payment of severance and benefits for the employees that were terminated during the first quarter of $2.1 million, the write off of certain assets of $2.8 million, the write off of contract and lease cancellation fees of $1.8 million and the remaining sponsorship fees related to the Buy.com Tour of $14.9 million, as we does not believe that any further benefits will be derived from our sponsorship agreement with the PGA Tour. During the third quarter, we initiated a further reduction in our workforce resulting in an additional severance and benefit charge of $630,000. We also wrote-off excess property and equipment of $363,000 and accrued for contract and lease cancellation fees of $1.5 million in connection with our decision to relocate our corporate offices. We have made certain assumptions in our accrual of additional contract and lease cancellation fees with regard to the timing and amount that we may receive for a sublease of our previous corporate offices. As of September 30, 2001, the restructuring accrual is $2.3 million, which primarily relates to our contractual and lease obligations. We also reversed approximately $914,000 of our restructuring charge, of which $400,000 related to a reimbursement from the PGA Tour due to a shortfall in the number of required tournament events. 16 Merger related expenses We incurred merger related expenses of $1.5 million during the third quarter 2001. These expenses are primarily attributable to legal and accounting costs, as well as fees paid to our financial advisor in connection with our proposed merger with SB Acquisition, Inc. Other income (expense) Total other income was $215,000 and $1.4 million for the quarter and nine month period ended September 30, 2001, respectively, and $2.0 million and $4.9 million for the quarter and nine month period ended September 30, 2000, respectively. The decrease was largely due to the decrease in interest income during the quarter and nine month period ended September 30, 2001 as a result of lower cash balances in our accounts. Equity in income (losses) of joint ventures, net Equity in income (losses) of joint ventures, net, was $0.0 and $5.3 million for the quarter and nine month period ended September 30, 2001, respectively, and negative $5.2 million and negative $14.8 million for the quarter and nine month period ended September 30, 2000, respectively. During 2000, we decided to discontinue our joint venture in Australia, and in March 2001, we sold our United Kingdom joint venture. The income during the quarter and nine month period ended September 30, 2001 relates to the amounts previously expensed during 1999 and 2000 as our share of the operating losses for the joint ventures, which upon the sale of the United Kingdom joint venture, was greater than the amount required to fund these joint ventures. The losses during the quarter and nine month period ended September 30, 2000 consisted of 50% of the losses of the international joint ventures and BuyTravel.com LLC during that period. The joint ventures were at an early stage of operations and were incurring net losses, which we recorded as an equity method investment. Liquidity and Capital Resources As of September 30, 2001, our principal sources of liquidity consisted of $5.4 million of cash and cash equivalents compared to $29.7 million of cash and cash equivalents, $27.0 million of restricted cash and $10.8 million of marketable securities at December 31, 2000. Net cash used in operating activities was $60.8 million and $76.0 million for the nine month period ended September 30, 2001 and 2000, respectively. Net operating cash flows for the nine month period ended September 30, 2001 were primarily attributable to the net losses of $61.2 million partially offset by non-cash charges of $22.9 million related to depreciation and amortization, equity in income (losses) of joint ventures, and a non-cash restructuring charge, as well as $22.5 million of cash used in changes in operating assets and liabilities and the loss from the disposal of property and equipment. Cash used in changes in operating assets and liabilities is primarily a function of a decrease in our accounts payable, an increase in other non-current assets and a decrease in deferred revenues, offset by a decrease in accounts receivable, a decrease in prepaid expenses and other current assets, and an increase in other liabilities and accrued expenses relating to our restructuring accrual. Net operating cash flows for the nine month period ended September 30, 2000 were primarily attributable to the net losses, an increase in accounts receivable, and a decrease in accounts payable, other liabilities and accrued expenses, partially offset by non-cash depreciation and amortization, an increase in deferred revenues and a decrease in prepaid expenses and other current assets Net cash provided by investing activities was $36.7 million for the nine month period ended September 30, 2001 and primarily consists of a decrease in restricted cash, the redemption of marketable securities offset by purchases of property and equipment and cash paid for investments in equity method investees. Net cash used in investing activities for the nine month period ended September 30, 2000 was $45.4 million and primarily consisted of an increase of restricted cash, purchases of marketable securities, purchase of property and equipment and cash paid for investments in equity method investees, partially offset by the proceeds from the sale of property and equipment and the cash received in connection with an acquisition. 17 Net cash used in financing activities was $161,000 for the nine-month period ended September 30, 2001 and primarily consists of repayments under credit obligations offset by proceeds from the exercise of stock options. Net cash provided by financing activities was $174.5 million for the nine months ended September 30, 2000 as a result of the net proceeds from our initial public offering in February 2000 and proceeds from the exercise of stock options, partially offset by the repayment of our credit facility and a promissory note to a stockholder. As of September 30, 2001, our principal commitments consisted primarily of obligations in connection with our capital and operating leases. In 1999 and 2000, we focused significant efforts and financial resources on sales and marketing activities to build our brand, increase customer traffic to our Web site and enhance our customer loyalty. We also committed significant financial resources to the development of our Web site, transaction processing systems and network infrastructure. However, during the first quarter in 2001, we initiated a restructuring of our business and implemented a new operating plan designed to accelerate our ability to achieve positive operating cash flow. As part of the plan, we significantly reduced the size of our workforce and made further expense reductions for the business in the areas of marketing and advertising, product development and general and administrative. Our new operating plan also requires us to refine our gross margin strategy and continue to increase prices on many of our products. As a result, we expect that our sales volumes for 2001 will be significantly less than our sales volumes for 2000. On August 10, 2001, we signed a definitive merger agreement with SB Acquisition Inc., a company wholly-owned by Scott A. Blum, our founder. The merger agreement provides for us to merge with a subsidiary of SB Acquisition, after which we will continue our operations as a wholly-owned subsidiary of SB Acquisition. The merger is subject to the approval of our stockholders and to other closing conditions. If the merger is approved by our stockholders and all other conditions to closing are satisfied or waived, the merger is expected to be completed by the end of November 2001. However, because many of the closing conditions are beyond our control, there can be no assurance that the merger will be completed by the end of November 2001, if at all. If we are unable to close the merger or obtain additional financing or complete another sale or merger transaction, it is unlikely that we would be able to continue as a going concern. If the merger is completed, each outstanding share of our common stock will be canceled and converted into the right to receive $0.17 in cash from SB Acquisition. Also, in connection with the completion of the merger, the vesting of all outstanding stock options and other stock awards will accelerate and such stock options and stock awards will become exercisable. Accordingly, holders who exercise their stock options or other stock awards and pay the exercise or purchase price therefore prior to completion of the merger will receive shares of our common stock and will be entitled to receive the merger consideration. If the merger is completed, all stock options or other stock awards will be cancelled upon completion of the merger. Deferred compensation will be recorded in connection with this acceleration and other change in control benefits will be recorded under existing employee agreements. In connection with the execution of the merger agreement, we also entered into a credit agreement with a trust controlled by Mr. Blum, pursuant to which we have access to a $4.0 million line of credit and up to an additional $5.0 million to establish standby letters of credit for the benefit of our distributor and vendor partners. As of the date of this report, no amounts were outstanding under the credit agreement. We also entered into a security agreement in connection with the credit agreement, pursuant to which we granted the lender a security interest in substantially all of our assets to secure payment and performance of our obligations under the credit agreement. If the merger agreement is terminated prior to completion of the transaction, under substantially all circumstances, all outstanding debt under the line of credit and letters of credit will become immediately due and payable. In addition, if we cannot repay all of the outstanding amounts due, including commitment fees and possible termination fees, the lender may foreclose on our assets. Further, since August 30, 2001, Mr. Blum has agreed to guarantee certain obligations of ours to our credit card processors. In connection with these guarantees, we entered into reimbursement agreements and security agreements with Mr. Blum, which agreements require that we pay Mr. Blum any amounts that he pays under such guarantees and that such obligations are secured by security interests in substantially all of our assets. If we are unable to repay any of these amounts paid by Mr. Blum on our behalf, Mr. Blum may foreclose on substantially all of our assets. As of the date of this report, Mr. Blum has not paid any amounts under these guarantees. 18 We anticipate that we will spend approximately $2.5 million in expenses and other costs related to the proposed merger transaction. This amount includes financial advisory fees, legal and accounting fees, paying agent fees and expenses, printing and mailing fees, solicitation fees, SEC filing fees, and change of control severance benefits relating to existing employee agreements that may become due upon the closing of the merger. Our consolidated results have been prepared on the basis that we will continue as a going concern. However, if the merger is not successfully completed, the interim financing agreement would terminate and any amounts owed would become immediately due and we would not have sufficient working capital to continue our operations as a going concern. If we are unable to secure replacement financing or an alternative sale or merger transaction, we would be forced to discontinue our operations and liquidate the business. 19 RISK FACTORS Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and in our other filings with the SEC, including our annual report on Form 10-K, as amended. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations, or the successful completion of our merger with SB Acquisition, Inc. If any of these risks actually occur, our business, financial condition or results of operation could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment. Our new operating plan may not cause us to achieve profitability and our business would fail if we are unable to obtain additional financing In early 2001, we initiated a restructuring of our business and implemented a new operating plan designed to accelerate our ability to achieve positive operating cash flow. As part of this new operating plan, we significantly reduced the size of our workforce and made further significant expense reductions for the business in the areas of marketing and advertising, product development and general and administrative. To successfully execute against our operating plan, we must adhere to our expense reductions and work to achieve the revenue and gross margin targets incorporated as underlying assumptions to our operating plan. If we are unable to manage our operating expenses and increase our gross margins, without experiencing significant deterioration in our projected sales volumes, we will be unable to achieve positive operating cash flow. Further, we have significantly reduced our marketing and advertising budget for 2001, and we cannot guarantee that we will be able to maintain the visitor traffic levels, visitor conversion rates, customer purchase activity and the general brand awareness that we have had in the past. Our ability to achieve our annual and quarterly revenue and gross margin goals could also be negatively impacted by the softening consumer demand for technology and entertainment products, as well as the weakening general economic conditions and decreasing consumer confidence. Our new operating plan is based on assumptions made by management regarding various revenue, gross margin and operating expense items. We cannot guarantee that the assumptions that we have relied upon in developing our operating plan will be accurate, or that future events or results will conform to our expectations or assumptions. If our assumptions are inaccurate, or our expectations prove to be erroneous in light of future events, or if we are unable to maintain the support of our vendors, distributors, third party advertisers and other key corporate relationships regardless of the success of our new operating plan, we will need to raise more working capital before we achieve positive operating cash flow. Besides the financing commitments provided as a part of our merger with SB Acquisition, Inc., we currently do not have any commitments for additional financing, and we cannot be certain that additional financing will be available when and to the extent required, or that, if available, it will be on acceptable terms. If adequate funds are not available on acceptable terms, we would not be able to fund our operations and our business would fail. In light of certain perceptions regarding our financial condition, our customers, distributors and vendor partners may decide not to do business with us Due to concerns regarding our financial condition and our perceived ability to fulfill our financial and other obligations, our customers, distributors, third party advertisers, vendor partners and other corporate partners and service providers may decide not to conduct business with us, or may conduct business with us on terms that are less favorable than those customarily extended by them. For example, our distributors or credit card processors could seek to further limit our credit terms or otherwise reduce or discontinue their support of our business, forcing us to leverage our operating cash by repaying our unsecured credit lines with them or increasing the amount of our secured credit lines. Also, if our customers, vendor partners and third party advertisers choose to do less business with us, our net sales would decrease and our gross profits would be significantly impacted by reduced sales volumes, including a corresponding decrease in co-op advertising revenue, and reduced media advertising sales. 20 Our ability to continue operations, independent of a merger transaction or the receipt of additional financing, is unlikely We executed a definitive merger agreement with SB Acquisition, Inc., a company wholly-owned by Scott A. Blum, our founder. Pursuant to the terms of the merger agreement, a subsidiary of SB Acquisition will merge with and into us, and each issued and outstanding share of our common stock will be converted into the right to receive $0.17 in cash. The closing of the merger is conditioned upon the approval of our stockholders and other closing conditions. If our shareholders approve the merger and the other conditions to closing are satisfied or waived, we expect the merger to be completed before November 30, 2001. However, because many of the closing conditions are beyond our control, there can be no assurance that the merger will be completed by the end of November 2001, if at all. If we are unable to close the merger, obtain additional financing or complete another sale or merger transaction, it is unlikely that we would be able to continue as a going concern. We have encumbered substantially all of our assets in connection with our credit facility In connection with the execution of the merger agreement, we entered into a credit agreement and a security agreement with a trust owned by Scott A. Blum, pursuant to which we have access to a $4,000,000 line of credit and up to $5,000,000 to establish standby letters of credit for the benefit of our distributor and vendor partners. The security agreement grants the Blum trust a security interest in substantially all of our assets to secure payment and performance of all of our obligations under the credit agreement. In the event the merger agreement is terminated prior to completion of the transaction, under substantially all circumstances, all outstanding debt under the line of credit and letters of credit will become immediately due and payable, and we will need to obtain additional financing or complete another merger or sale transaction to repay our indebtedness in order to continue as a going concern. If we are unable to repay our indebtedness under this credit facility, the Blum trust may foreclose on substantially all of our assets. In addition, since August 30, 2001, Mr. Blum has agreed to guarantee certain obligations of ours to our credit card processors. In connection with these guarantees, we entered into reimbursement agreements and security agreements with Mr. Blum, which agreements require that we repay any amounts he pays under the guarantees and that such obligations are secured by security agreements for substantially all of our assets. If we are unable to repay any of these amounts paid by Mr. Blum on our behalf, Mr. Blum may foreclose on substantially all of our assets. Our common stock was delisted from the Nasdaq National Market On August 14, 2001, the Nasdaq National Market delisted our common stock. Our common stock is quoted and currently trading on the OTC Bulletin Board. The trading volume of our shares of our common stock may decline significantly or cease altogether, and the market price of our common stock may decline further, and you may lose some or all of your investment. We have incurred substantial losses and we may continue to incur losses for the foreseeable future We have not achieved profitability since our inception, and we incurred net losses of $97.0 million and $61.2 million for the nine month periods ended September 30, 2000 and 2001, respectively. Although we recently initiated a restructuring of our business designed, in part, to significantly reduce costs in a number of areas, we expect to continue to incur substantial costs and expenses related to: - the implementation of our business model and our pricing strategies; - brand development, marketing and other promotional activities; - the expansion of our existing product and service offerings; - the continued development and maintenance of our Web site, transaction processing systems and network infrastructure; 21 - the development of strategic relationships; and - our ability to effectively merchandise and manage our product mix. Further, because we sell many of our products at very competitive prices, we have low and sometimes negative gross margins on our product sales. Our ability to become profitable depends on, among other things: - our ability to generate and sustain net sales, consistent with the assumptions underlying our new operating plan, with improved gross margins; - our ability to maintain reasonable operating expense levels; - our ability to generate significant advertising revenue; and - our ability to provide other higher margin products and services. If we are unable to manage and reduce our operating expenses and costs, while at the same time increasing our gross margins and without experiencing a significant deterioration in our sales volumes, we will be unable to achieve positive operating cash flow. If we do not achieve positive operating cash flow in a timely manner that is consistent with our operating plan, our business could fail. In the first three quarters of 2001, our revenues decreased substantially from prior periods. As a result, we believe that we will continue to incur substantial operating losses in the near term and we may never achieve profitability. Our growth and operating results could be impaired if we are unable to meet our future capital needs Our projections of future cash needs and cash flows are subject to substantial uncertainty, and if our current cash balances and our existing credit facilities are insufficient to meet our anticipated operating cash needs, our business will fail. The factors that may impair our ability to effectively operate our business and manage our operating cash include, but are not limited to: - our ability to retain the support of our distributor and vendor partners, including but not limited to our credit card processors; - our ability to maintain other key corporate relationships; and - our ability to maintain sales volumes and gross margins consistent with our operating plan. Besides the financing commitments provided as a part of our merger with SB Acquisition, Inc., we do not have any commitments for additional financing and we cannot be certain that additional financing will be available when and to the extent required, or that, if available, it will be on acceptable terms. If adequate funds are not available on acceptable terms, we would not be able to fund our operations, and our business will fail. SOFTBANK and its affiliates control a majority of our outstanding common stock which enables them to control many significant corporate actions SOFTBANK and its affiliates own approximately 28% of our outstanding stock as of September 30, 2001. In addition, as a result of a voting trust agreement with our largest stockholder, approximately 44% of our stock outstanding as of September 30, 2001 must be voted by the trustees to mirror the voting of all shares that are not subject to the terms of the voting trust agreement on significant stockholder actions, as defined in the voting trust agreement. On routine stockholder actions, the trustees have the discretion to vote the trust shares in any manner determined by a majority of the trustees. Because SOFTBANK and its affiliates will control a majority of the shares not subject to the voting trust, they effectively control the majority of our common stock on significant corporate actions. This control by SOFTBANK and its affiliates could have a substantial impact on matters requiring the vote of the stockholders, including the decision to merge with 22 SB Acquisition, Inc. As a part of the merger with SB Acquisition, Inc., the SOFTBANK affiliates executed a voting agreement with us in which they agreed to vote their shares in favor of the merger if a majority of the holders of common stock, excluding those shares held by SOFTBANK and Scott Blum and their affiliates, vote in favor of the merger. If SOFTBANK and its affiliates are not contractually obligated to vote in favor of the merger, then SOFTBANK and its affiliates could effectively control the decision to merge, or not, with SB Acquisition, Inc. We rely on a relatively new management team and need to retain our existing personnel to effectively operate our business Our success depends, in part, upon our ability to successfully transition our new management team and to retain our existing management. Further, our business is largely dependent on the personal efforts and abilities of other members of our senior management, as well as other key personnel. In January and February 2001, we terminated the employment of approximately 104 employees, and in August 2001, we terminated approximately 50 other employees, and the retention of our remaining employees is key to our success. Any of our officers or employees can terminate their employment relationship at any time. We do not maintain key person life insurance on any member of our management team. The loss of any key employee or our inability to attract or retain other qualified employees could harm our business and results of operations. Our business may suffer as a result of our reduction in workforce In January and February 2001, we initiated a restructuring of our business and terminated the employment of approximately 104 employees, and in August 2001, we terminated approximately 50 other employees. These reductions in workforce may negatively impact our ability to conduct business and serve our customers, distributors and vendor partners in a manner comparable with past practice, which could cause our business to suffer significantly. Further, our workforce reduction and loss of key management personnel could cause concern among our distributors, vendors, third party advertisers and other critical corporate relationships. Ingram Micro's failure to supply and fulfill our computer hardware and software products could reduce our revenues and harm our business We depend on Ingram Micro, Inc. to provide the majority of our computer hardware and software products and to fulfill our customers' orders. To date, a substantial majority of our product sales revenue has been derived from computer hardware and software products acquired from Ingram Micro. We cannot guarantee that Ingram Micro will continue to supply a sufficient quantity of inventory on a timely basis to satisfy our order requirements. If Ingram Micro were to terminate or refuse to renew our distribution arrangement, we would have to purchase our computer hardware and software products from other distributors. In such event, we cannot be certain that other distributors could be effectively and efficiently integrated into our distribution systems to provide comparable fulfillment, processing and shipping services to our customers in a timely manner. In addition, in the event we do not purchase at least $350.0 million of products from Ingram Micro during the term of our agreement with them, our current pricing schedules could be revised. Our distribution agreement with Ingram Micro terminates in March 2002. Because Ingram Micro is our primary source for computer hardware and software products, we are subject to risks associated with Ingram Micro's ability to replenish its inventory in a timely manner. Our customers' orders could be significantly delayed if we need to seek other distributors to fulfill those customers' orders. In addition, our distribution agreement with Ingram Micro does not require them to set aside any amount of inventory to fulfill our orders or to give our orders priority over other resellers to whom they sell. Furthermore, some vendors may decide, for reasons outside our control, not to offer particular products for sale on the Internet. These vendors may also cause Ingram Micro not to sell products to us. Ingram Micro's delay or inability to supply our orders would substantially harm our business. Our future success also depends on our ability to provide timely and accurate order fulfillment. We depend on Ingram Micro to process and ship substantially all of the computer hardware and software products that we sell to our customers. However, we have limited control over their shipping and processing procedures. Ingram Micro's systems and 23 operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, physical and electronic break-ins, earthquakes and similar events. We do not carry sufficient business interruption insurance to compensate us for losses that could occur as a result of Ingram Micro's inability to perform for any reason. We are dependent on several third party providers to fulfill a number of our retail functions. If these parties are unwilling or unable to continue providing services to us, our business could be seriously harmed We are currently dependent on our distribution and fulfillment providers to manage inventory, process orders and distribute products to our customers in a timely manner. In addition to our contract with Ingram Micro for computer hardware and software products and for the fulfillment of our consumer electronics products, we have supply and distribution contracts with Ingram Entertainment Inc. for videos, DVDs and games, Direct Source Distributing, Inc. for our clearance products, Valley Media, Inc. for music products, and Global Trade, Inc. and DBL Distributing, Inc. for consumer electronics products. We do not have long-term agreements with any of these third parties. We purchase all of our books from the Ingram Book Company, which are shipped and processed by Ingram Fulfillment Services, Inc. We are also dependent on various supply and fulfillment partners, including Brightpoint, Inc., and various wireless service providers for the products and services offered in our wireless store. If we do not maintain our existing relationships with these providers on acceptable commercial terms, we may not be able to continue to offer a broad selection of merchandise at low prices, and customers may refuse to shop at our online store. In addition, manufacturers may decide, for reasons outside our control, not to offer particular products for sale on the Internet. If we are unable to supply products to our customers, or if other product manufacturers refuse to allow their products to be sold via the Internet, our business will suffer severely. We rely on our distributors to fulfill a number of traditional retail functions, including maintaining inventory and preparing merchandise for shipment to individual customers. In the future, our vendors may not be willing to provide these services at competitive rates. In addition, vendors may refuse to develop the communications technology necessary to support our direct shipment infrastructure. We also have no effective means to ensure that our providers will continue to perform these services to our satisfaction. Our customers could become dissatisfied and cancel their orders or decline to make future purchases if we or our providers are unable to deliver products on a timely basis. If our customers become dissatisfied with our distributors and third party service providers, our reputation and the BUY.COM brand could suffer. Our operations are also heavily dependent upon a number of other third parties for customer service and support, credit card processing, and hosting our system infrastructure and database servers. In addition, our distributors and fulfillment providers use the Federal Express Corporation, United Parcel Service and the United States Postal Service to deliver substantially all of our products. If the services of any of these third parties become unsatisfactory, our customers may experience lengthy delays in receiving their orders, and we may not be able to find a suitable replacement on a timely basis or on commercially reasonable terms. If we are not able to generate significant advertising revenue, we may not be able to achieve profitability Our future success will depend in part on the willingness of product manufacturers and other advertisers to advertise on our Web site. There is significant uncertainty about the demand for and market acceptance of Internet advertising. We cannot assure you that the market for Internet advertising will expand, become sustainable or that we will be able to continue to provide an attractive forum for advertisers. If the market for Internet advertising fails to develop or if we do not provide an attractive forum for advertisers, our business may not achieve profitability. Because our advertising revenues carry higher gross margins than our product sales, any decline in our advertising revenues would have a disproportionate impact on our overall gross margin. For example, since we expect our net sales to decrease in 2001, compared to the year ended December 31, 2000, our co-op advertising revenue should correspondingly decline, thus reducing our advertising revenue. If our advertising revenues decline, we may not be able to replace these revenues through other programs or through our product sales, and we may be unable to achieve profitability. 24 We have only been operating our online business since November 1997 and face challenges related to early stage companies in rapidly evolving markets We were founded in June 1997 and began our online operations in November 1997. You should consider our prospects in light of the risks and difficulties frequently encountered by early stage companies in the rapidly evolving online commerce market. These risks include, but are not limited to, an unpredictable business environment, the difficulty of raising working capital, the difficulty of attracting and retaining qualified management personnel and the use of our business model. To address these risks, we must, among other things: - access sufficient capital to fund the implementation of our business model; - increase our sales volumes and gross margins while limiting our operating expenses; - expand our customer base; - enhance our brand recognition; - expand our product and service offerings; - access sufficient product inventory to fulfill our customers' orders; - successfully implement our business and marketing strategy; - provide high quality customer service and order processing; - respond effectively to competitive and technological developments; and - attract and retain qualified personnel. System failures could prevent access to our online store and harm our business and results of operations Our sales would decline and we could lose existing or potential customers if they are not able to access our online store or if our online store, transaction processing systems or network infrastructure do not perform to our customers' satisfaction. Any network interruptions or problems with our Web site could: - prevent customers from accessing our online stores; - reduce our ability to fulfill orders; - reduce the number of products that we sell; - cause customer dissatisfaction; or - damage our reputation. We have experienced brief computer system interruptions in the past, and these interruptions may recur. In the future, we may need to expand and upgrade our technology, transaction processing systems and network infrastructure significantly. We may not be able to make timely upgrades to our systems and infrastructure to accommodate the number of customers visiting our Web site. Our systems and operations are also vulnerable to damage or interruption from a number of sources, including fire, flood, power loss, telecommunications failure, physical and electronic break-ins, earthquakes and other similar events. Our servers are also vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. Any substantial 25 disruption of this sort could completely impair our ability to generate revenues from our Web site. We do not presently have a formal disaster recovery plan in effect and do not carry sufficient business interruption insurance to compensate us for losses that could occur. Our business model is new and unproven, and we may not be able to achieve profitability We are subject to risks due to the unproven and evolving nature of our business model and aggressive pricing strategy. The success of our business model depends on the volume of customers that visit our Web site and purchase our products, as well as our ability to generate significant online advertising revenues. To this end, we have worked hard to build our brand name and enhance our customer loyalty by selling our products at extremely low prices and maintaining very low, and sometimes negative, gross margins on our product sales. We have implemented various strategies to improve our gross margins, including raising prices on many of the products we sell. Raising the prices on our merchandise could cause product sales to decline. If the amount of traffic to our Web site decreases due to price increases, a reduced marketing budget, a weakening demand for technology and entertainment products or otherwise, we may become less attractive to our current and potential advertisers. As a result, our margins and advertising revenues may decline. Our ability to achieve profitability also depends on our ability to effectively manage our operating costs. To this end, we have implemented a restructuring plan that requires less headcount to operate our business, less resources dedicated to the development of our system infrastructure, operating systems and other capital expenditures and a more efficient use of the resources dedicated to marketing and promoting our Web site. If we are unable to manage our operating expenses, while at the same time increasing our gross margins, and without experiencing a significant deterioration in our sales volumes, we will be unable to achieve profitability. Further, since our new operating plan requires significantly less resources focused on the operation of our business, we may not be able to achieve high levels of customer satisfaction, and consequently, we may lose existing and potential customers. Online security risks could seriously harm our business A significant barrier to e-commerce and online communications is the secure transmission of confidential information over public networks. Anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may be required to expend significant capital and other resources to protect against potential security breaches or to alleviate problems caused by any breach. We rely on licensed encryption and authentication technology to provide the security and authentication necessary for secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography, or other events or developments may result in a compromise or breach of the algorithms that we use to protect customer transaction data. In the event someone circumvents our security measures, it could seriously harm our business and reputation, and we could lose customers. Security breaches could also expose us to a risk of loss or litigation and possible liability for failing to secure confidential customer information. If sales from our computer products decline, our operating results will suffer Our operating results substantially depend on product revenue from the sale of computer hardware, software products and peripherals. To date, a substantial majority of our product sales revenues are derived from computer hardware and software products. We expect that revenue from these products will continue to represent more than a majority of our total product revenues during the next twelve months. We could experience declines in these product sales due to several factors, including, but not limited to: - a general economic slowdown or "softness" in consumer demand for technology-related products; - increased price competition from our competitors; - technological obsolescence of the computer hardware, software and peripheral products that we offer; - decisions by manufacturers of computer products to curtail or eliminate the sale of products or categories of 26 products over the Internet or by us; or If we are unable to maintain our current sales levels of computer hardware, software and peripheral products, our financial condition and results of operations would suffer. We must continue to develop and maintain the BUY.COM brand, which is costly and may not generate corresponding revenues Maintaining and strengthening the BUY.COM brand is an important factor in attracting new customers, building customer loyalty and attracting advertisers. In the past, our initiatives have involved significant expenditures. However, as part of our restructuring plan, we have significantly reduced the resources allocated to our promotional strategies. If our remaining promotional efforts are unsuccessful, we may not be able to recover these expenses or increase our revenues or margins consistent with our operating plan. Further, we also believe potential customers and advertisers are driven to our online store because of our strong brand recognition. If advertisers do not believe our Web site is an effective marketing and sales channel for their merchandise, or if customers do not perceive us as offering a desirable way to purchase merchandise, our branding efforts will suffer and we may lose customers. Our ability to build and strengthen the BUY.COM brand depends largely on: - our ability to allocate sufficient marketing dollars on our advertising and promotional efforts given our financial position; - the success of our advertising and promotional efforts; - our ability to provide our customers with a broad range of products at competitive prices with timely fulfillment; and - our ability to provide high quality customer service. Our marketing budget has been significantly reduced as a result of our effort to achieve positive operating cash flow. We cannot be certain that our reduced marketing budget will successfully drive customer acquisition or that this allocation of resources will provide additional revenues equal to this dedication of our resources. If we fail to promote and maintain our brand, or if we incur excessive expenses attempting to promote and maintain our brand, our business may suffer. Our future operating results may fluctuate and cause the price of our common stock to decline Our limited operating history and the emerging nature of the markets in which we operate make it difficult to accurately predict our future revenues. We expect that our revenues and operating results will fluctuate significantly from quarter to quarter, due to a variety of factors, many of which are beyond our control. The factors that could cause our operating results to fluctuate include, but are not limited to: - fluctuations in the amount of customer spending on the Internet; - our ability to maintain our distributor, vendor and other key corporate relationships; - our ability to maintain the operation of our specialty stores; - our ability to generate significant advertising revenues; - our ability to build and maintain customer loyalty; - the introduction of new or enhanced Web pages, services, products and strategic alliances by us and our competitors; 27 - price competition on the Internet or higher wholesale prices in general; - the success of our brand building and marketing campaigns; - our ability to effectively merchandise and manage our product mix; - increases in the cost of online or offline advertising; - unexpected increases in shipping costs or delivery times; - government regulations related to use of the Internet for commerce; - our ability to maintain, upgrade and develop our Web site, transaction processing systems and network infrastructure; - technical difficulties, system downtime, power outages or Internet brownouts; - the amount and timing of operating costs and capital expenditures relating to maintaining our business, operations and infrastructure; and - general economic conditions and economic conditions specific to the Internet and online commerce. If we do not respond to technological change, our stores could become obsolete, and we could lose customers The development of our Web site entails significant technical and business risks. To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our online stores. The Internet and the e-commerce industry are characterized by: - rapid technological change; - changes in customer requirements and preferences; - frequent new product and service introductions embodying new technologies; and - the emergence of new industry standards and practices. However, we have significantly reduced the resources dedicated to the enhancement of our network infrastructure and operating systems. If we are unable to maintain our existing systems and create a positive customer experience, our revenues may decline and our business will suffer. The evolving nature of the Internet could also render our existing online stores and systems obsolete. Our success will depend, in part, on our ability to: - license or acquire leading technologies useful in our business; - enhance our existing online stores; - maintain and enhance our network infrastructure and transaction processing systems; - develop new services and technology that address the increasingly sophisticated and varied needs of our current and prospective customers; and 28 - adapt to technological advances and emerging industry and regulatory standards and practices in a cost-effective and timely manner. Future advances in technology may not be beneficial to, or compatible with our business. Furthermore, we may not use new technologies effectively or adapt our Web site and transaction processing systems to customer requirements or emerging industry standards on a timely basis, or at all, depending on our financial condition. If we are unable to adapt to changing market conditions or user requirements in a timely manner, our stores may become obsolete and we will lose customers. We may be subject to liability for sales and other taxes We currently collect sales or other similar taxes on the shipment of goods in the States of California, Indiana, and Massachusetts. However, one or more states could seek to impose additional income tax obligations or sales tax collection obligations on out-of-state companies, such as ours, which engage in or facilitate online commerce. Any new taxes on the sale of products and services through the Internet or the income derived from these sales could substantially impair the growth of e-commerce and adversely affect our ability to become profitable. Furthermore, since our service is available over the Internet in multiple states and in foreign countries, these jurisdictions may require us to qualify to do business in these states and foreign countries. If we fail to qualify in a jurisdiction that requires us to do so, we could face liabilities for taxes and penalties. We may be unable to protect our Internet domain names, which are essential to our business Our Internet domain names are critical to our brand recognition and our overall success. We have many registered domain names relating to our brand, including BUY.COM. If we are unable to protect these domain names, our competitors could capitalize on our brand recognition. The acquisition and maintenance of domain names generally are regulated by governmental agencies and their designees. The regulation of domain names in the United States and in foreign countries has changed and is subject to further change in the future. As a result, we may be unable to acquire or maintain relevant domain names in the United States and in other countries where we conduct business. Furthermore, we may be unable to protect our domain names or prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our domain names, trademarks and other intellectual property rights. Our operating results could be impaired if we become subject to burdensome government regulations and legal uncertainties concerning the Internet Due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted with respect to the Internet, relating to: - user privacy; - pricing, usage fees and taxes; - content; - copyrights; - distribution; - characteristics and quality of products and services; and - online advertising and marketing. The adoption of any additional laws or regulations may decrease the popularity or impede the expansion of the Internet and could seriously harm our business. A decline in the popularity or growth of the Internet could decrease demand 29 for our products and services, reduce our advertising revenues and margins and increase our cost of doing business. Moreover, the applicability of existing laws to the Internet is uncertain with regard to many important issues, including property ownership, intellectual property, export of encryption technology, libel and personal privacy. The application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or the application of existing laws and regulations to the Internet and other online services, could also harm our business. If we are unable to successfully defend against pending legal actions against us, we could face substantial liabilities We are currently a party to pending legal actions against us, the outcomes of which are uncertain and could result in significant judgments against us. In March 2001, the PGA Tour filed a counterclaim against us in the federal district court in the Central District of California. The counterclaim alleges that we breached our contract with them by declaring our sponsorship agreement to be terminated, by demanding that the PGA Tour cease all uses of our trademark, by breaching the confidentiality provisions of our agreement with them and by taking action that adversely affects the goodwill of the BUY.COM Tour. The PGA Tour seeks damages in excess of $75,000 and attorneys' fees. In July and August 2001, several class action lawsuit were filed against the us in the U.S. District Court for the Southern District of New York alleging, among other things, that our prospectus failed to disclose excessive commissions earned by the underwriters of our IPO and alleging that the underwriters engaged in conduct that artificially inflated the price of our stock. The cases seek an undisclosed amount of damages. Defending against these lawsuits may involve significant expense and diversion of management's resources. Furthermore, due to the inherent uncertainties of litigation, we may not prevail in these actions. In addition, our ongoing operations may continue to subject us to significant litigation and costs in the future. For a more detailed description of these legal actions, see "Part II, Item 1, Legal Proceedings." The success of our business depends on the continued growth of the Internet as a viable commercial marketplace Our success depends upon the widespread acceptance of the Internet as a vehicle to purchase products. The e-commerce market is at an early stage of development, and demand and continued market acceptance is uncertain. We cannot predict the extent to which customers will shift their purchasing habits from traditional to online retailers. If customers or manufacturers are unwilling to use the Internet to conduct business and exchange information, our business will fail. It is possible that the Internet may not become a viable long-term commercial marketplace due to the potentially inadequate development of the necessary network infrastructure, the delayed development of enabling technologies and performance improvements and the high cost of shipping products. The commercial acceptance and use of the Internet may not continue to develop at historical rates or may not develop as quickly as we expect. In addition, concerns over security and privacy may inhibit the growth of the Internet. We face intense competition in various retail segments and some of our competitors may be better positioned to capitalize on the rapidly growing e-commerce market The e-commerce market is new, rapidly evolving and intensely competitive. Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing, technical, management and other resources than we do. Some of our competitors have and may continue to use aggressive pricing or inventory availability practices and devote substantially more resources to Web site and system development than us. We expect that competition will further intensify in the future. New technologies and the expansion of existing technologies may also increase the competitive pressure we face. Increased competition may result in reduced operating margins, loss of market share and diminished brand recognition. We believe that the primary competitive factors in the online market include brand recognition, price, product selection, ease of use, customer service, available content and value added services. We currently compete with a variety of online vendors that specialize in computer hardware and software products, as well as those who sell books, music, videos, 30 DVDs and other entertainment products, consumer electronics and wireless products and services. Moreover, all of the products we sell in our online stores are typically available from traditional retailers. Consequently, we must compete with companies in the online commerce market as well as the traditional retail industry. We would also realize significant competitive pressure if any of our distribution providers were to initiate their own retail operations. Since our distributors have access to merchandise at very low costs, they could sell products at lower prices and maintain a higher gross margin on their product sales than we can. In this event, our current and potential customers may decide to purchase directly from these distributors. Increased competition from any distributor capable of maintaining high sales volumes and acquiring product at lower prices than us could significantly reduce our market share. If we are unable to protect our trademarks and intellectual property rights, our reputation and brand could be impaired, and we could lose customers We regard our trademarks, trade secrets and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality and/or license agreements with employees, customers, providers and others to protect our proprietary rights. We cannot be certain that we have taken adequate steps to protect our proprietary rights, especially in countries where the laws may not protect our rights as fully as in the United States. In addition, third parties may infringe or misappropriate our proprietary rights, and we could be required to incur significant expenses to preserve them. We have applied for the registration of some of our trademarks and service marks in the United States and some other countries. Even if we are able to register these names, registration may not adequately protect us against infringement by others. Effective trademark, service mark, copyright and trade secret protection may not be available in every country in which our products and services are made available online. If we are not able to protect our trademarks and other intellectual property, we may experience difficulties in achieving and maintaining brand recognition and customer loyalty. Intellectual property claims against us could be costly and result in the loss of significant rights Other parties may assert infringement or unfair competition claims against us. In the past, other parties have sent us notices of claims of infringement of intellectual property rights, and we expect to receive other notices in the future. We cannot predict whether third parties will assert claims of infringement against us, or whether any past or future assertions or prosecutions will adversely affect our business. If we are forced to defend against any of these claims, whether meritless or not, we may face costly litigation and diversion of technical and management personnel. As a result of these disputes, we may have to expend significant resources to develop or acquire non-infringing property. Alternatively, we may need to pursue royalty or licensing agreements, which may not be available on acceptable terms, if at all. Our stock price may be volatile and has recently declined in a significant way The trading price of our common stock is likely to be volatile and could fluctuate widely in response to many of the following factors, some of which are beyond our control: - variations in our operating results, such as our inability to meet our estimated revenue targets; - our ability, or inability, to raise additional working capital; - announcements of technological innovations, new services or product lines by us or our competitors; - the failure to complete our merger with SB Acquisition, Inc.; - changes in our business model and operating strategies; - our ability to attract and retain members to our Board of Directors 31 - changes in expectations of our future financial performance, including financial estimates by securities analysts and investors; - changes in operating and stock price performance of other Internet and online commerce companies; - conditions or trends in the Internet industry; - additions or departures of key personnel; and - future sales of our common stock. Domestic and international stock markets often experience significant price and volume fluctuations. These fluctuations, as well as general economic and political conditions unrelated to our performance, may adversely affect the price of our common stock. From February 8, 2000 (the first day of public trading of our common stock), through September 30, 2001, the high and low sales prices for our common stock fluctuated between $27.50 and $0.08. In the past, following periods of volatility in the market price of their securities, many companies have been the subject of securities class action litigation. If we were sued in a securities class action, it could result in substantial costs and a diversion of management's attention and resources and would cause the price of our common stock to fall. A large number of shares may be sold into the public market in the near future, which may cause the market price of our common stock to decline significantly, even if our business is doing well A substantial number of shares of our common stock are eligible for resale as a result of the expiration of time restrictions imposed by law and by contract. We have also implemented an employee equity incentive program that provides for the issuance of shares of common stock to certain executives that may also be sold. Sales of such additional shares could reduce the market price of our common stock. These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK None. 32 PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On February 28, 2001, we filed suit against the PGA Tour in federal district court, Central District of California, for breach of contract based on our BUY.COM Tour sponsorship agreement with the PGA Tour. We claim that the PGA Tour entered into an agreement with another party to provide e-commerce services to them in violation of our agreement. We are seeking rescission of our agreement, a return of our sponsorship fees, including those secured by a $17,000,000 letter of credit, and additional damages. In March 2001, the PGA Tour filed a counterclaim against us in the federal district court in the Central District of California. The counterclaim alleges that we breached our contract with them by declaring our sponsorship agreement to be terminated, by demanding that the PGA Tour cease all uses of our trademark, by breaching the confidentiality provisions of our agreement with them and by taking action that adversely affects the goodwill of the BUY.COM Tour. The PGA Tour seeks damages in excess of $75,000 and attorneys' fees. Discovery is underway and a trial is set for February 2002. On July 11, 2001, a class action complaint, titled Joel Abrams v.BUY.COM, was filed against us, in addition to certain of our of officers and/or directors, and our underwriters that participated in the IPO process, alleging a violation of federal securities laws. Since July 11, 2001, several other similar class action complaints have been filed against us including: Richard Taylor v. BUY.COM (filed July 23, 2001), Robert Berkowtiz v. BUY.COM (filed July 16, 2001), Rutherford Dawson v. BUY.COM (filed August 1, 2001), Haas v. BUY.COM (filed August 15, 2001), Goodman Espstein v. BUY.COM (filed August 10, 2001), Leo and Josie Castillo v. BUY.COM (filed August 15, 2001) and Mohammad Jawed Akhtar v. BUY.COM (filed August 17, 2001). Each of the class actions were filed in the United States District Court, Southern District of New York on behalf of purchasers of Buy.com securities during the period between February 7, 2000 and December 6, 2000. The complaints allege that our prospectus was materially false and misleading because it failed to disclose, among other things, that our underwriters had solicited and received excessive and undisclosed commissions from certain investors. The lawsuits also allege that the underwriters engaged in actions that artificially inflated the price of the stock. Greg Hawkins and Mitch Hill have been named as defendants in each of these cases in connection with their capacity as former officers and/or directors of Buy.com. Mr. Hawkins and Mr. Hill have indemnification agreements with us. We believe that other similar cases may have been filed against us that are not yet known. As of the date of this report, we have not yet responded to any of these complaints and each case is in its early stages. Although we intend to defend ourselves vigorously, each of these actions could result in significant expenses and diversion of management time and other resources. Further, the outcome of the actions filed against us is uncertain. Therefore, we can give no assurance that we will prevail in these suits against us. Although we are not aware of any other material legal proceedings pending against us, we are from time to time subject to ordinary course litigation and disputes between our customers, employees and us. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (d) Use of Proceeds from Sales of Registered Securities. On February 11, 2000, we completed an initial public offering (the "Offering") of our common stock, $0.0001 par value. The shares of common stock sold in the Offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (the "Registration Statement") (Reg. No. 333-89737) that was declared effective by the SEC on February 7, 2000. All 16,100,000 shares of common stock registered under the Registration Statement (including 2,100,000 shares sold pursuant to the exercise of the Underwriters' over-allotment option) were sold at a price of $13.00 per share. After deducting the underwriting discounts and commissions and Offering expenses, we received net proceeds from the Offering of approximately $192.1 million. As of September 30, 2001, we had used all of the net proceeds from the Offering for capital expenditures associated with system upgrades and expansion, marketing activities, including our sponsorship of the buy.com Tour, repayment of certain indebtedness, investments in our joint ventures, and to fund operating losses and for working capital all as described elsewhere in this report. Except for the repayment of a $5.0 million debt to The Scott A. Blum Separate Property Trust, none of the net proceeds of the Offering were paid directly or indirectly to any director, officer, general 33 partner of our or their associates, persons owning 10% or more of any class of equity securities, or an affiliate of ours, other than in the form of wages or salaries and bonuses paid out in the ordinary course of business. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. Exhibits 2.1 Agreement and Plan of Merger dated as of August 10, 2001 by and between SB Acquisition, Inc., SB Merger Sub, Inc. and Buy.Com Inc. (1) 4.1 Voting Agreement dated August 10, 2001 by and between Buy.Com Inc. and Softbank America, Inc. and its affiliates (1) 10.1 Bridge Financing Credit Agreement dated August 10, 2001 by and between Buy.Com Inc. and the Scott A. Blum Separate Property Trust u/d/t 8/2/95 (1) 10.2 Security Agreement dated August 10, 2001 by and between Buy.Com Inc. and the Scott A. Blum Separate Property Trust u/d/t 8/2/95 (1) 10.3 Escrow Agreement dated August 10, 2001 by and between SB Acquisition Inc., Buy.Com Inc. and First American Trust (2) 10.4 Reimbursement Agreement dated as of August 30, 2001 by and between Scott A. Blum and Buy.Com Inc. (2) 10.5 Security Agreement dated as of August 30, 2001 by and between Scott A. Blum and Buy.Com Inc. (2) (1) Incorporated by reference to the Company's Current Report on Form 8-K, filed August 29, 2001. (2) Incorporated by reference to the Company's Schedule 13E-3, filed on August 31, 2001 B. Reports on Form 8-K 1. Current Report on Form 8-K, filed August 29, 2001 describing the Agreement and Plan of Merger with SB Acquisition, Inc., SB Merger Sub, Inc. and Scott A. Blum, the Voting Agreement with SoftBank America, Inc. and its affiliates, and the Bridge Financing Credit Agreement with the Scott A. Blum Separate Property Trust. 34 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BUY.COM INC. (Registrant) /s/ Robert R. Price By:__________________________________________ Robert R. Price President and Chief Financial Officer (principal financial and accounting officer) Dated: November 14, 2001 35 EXHIBIT INDEX

BUY COM INC 10-Q