10-Q 1 a2038480z10-q.txt FORM 10-Q -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-Q (MARK ONE) ~~/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934~~

FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2000 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 000-27405 ------------------------ NETZERO, INC. (Exact name of registrant as specified in its charter) DELAWARE 95-4644384 (State or other jurisdiction of (I.R.S Employer Idenificaiton No.) incorporation or organization) 2555 TOWNSGATE ROAD, WESTLAKE VILLAGE, CALIFORNIA 91361 (Address of principal executive office) (Zip Code)

(805) 418-2000 (Registrant's telephone number, including area code) NOT APPLICABLE (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 / / There were 125,233,716 shares of the registrant's common stock outstanding as of January 29, 2001. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- INDEX PART I. FINANCIAL INFORMATION Item 1. Consolidated Balance Sheets at December 31, 2000 and June 30, 2000.................................................... 3 Consolidated Statements of Operations for the three and six months ended December 31, 2000 and 1999, respectively....... 4 Consolidated Statements of Cash Flow for the six months ended December 31, 2000 and 1999............................ 5 Notes to the Consolidated Financial Statements.............. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................................................ 35 PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................... 36 Item 2. Changes in Securities and Use of Proceeds................... 36 Item 3. Defaults Upon Senior Securities............................. 36 Item 4. Submission of Matters to a Vote of Security Holders......... 36 Item 5. Other Information........................................... 37 Item 6. Exhibits and Reports on Form 8-K............................ 37 SIGNATURES............................................................. 37

In this Report, "NetZero," the "Company," "we," "us" and "our" collectively refers to NetZero, Inc. and its wholly-owned subsidiaries. 2 PART I. FINANCIAL INFORMATION NETZERO, INC. CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial statements. 3 NETZERO, INC CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

The accompanying notes are an integral part of these consolidated financial statements. 4 NETZERO, INC. CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)

The accompanying notes are an integral part of these consolidated financial statements. 5 NETZERO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. ORGANIZATION AND BUSINESS. NetZero, Inc. was incorporated in July 1997 and launched its service in October 1998. The Company is a leading provider of advertising- and commerce-supported and fee-based Internet access, offering a broad range of interactive marketing, research and measurement solutions. Through proprietary technologies, the Company offers advertisers targeting capabilities through numerous online advertising and sponsorship channels. NetZero also offers marketers, advertisers and market research organizations mass-scale, online market research through its CyberTarget division. From the inception of its service through December 2000, NetZero offered consumers free access to the Internet, free e-mail and custom navigation tools that provide "speed dial" to key sites on the Internet. Beginning in January 2001, NetZero launched a "Professional" Internet access service that allows households to pay for additional monthly Internet access beyond the free limit, which is currently set at 40 hours per month. 2. BASIS OF PRESENTATION. The consolidated financial statements are unaudited, other than the balance sheet information for the Company as of June 30, 2000 and, in the opinion of management, reflect all adjustments (consisting only of normal recurring adjustments) that are necessary for a fair presentation of the results for the periods shown. The results of operations for such periods are not necessarily indicative of the results expected for the full fiscal year or for any future period. Certain amounts in the prior year's financial statements have been reclassified to conform with the presentation of the current period. These consolidated financial statements should be read in conjunction with the audited financial statements and related notes included in the Company's Annual Report on Form 10-K for the year ended June 30, 2000 filed on September 28, 2000 with the Securities and Exchange Commission (the "SEC"). At December 31, 2000, the Company had cash, cash equivalents and short-term investments of approximately $172.6 million. The Company considers its existing cash, cash equivalents and short-term investments to be adequate to fund its operating activities, capital expenditures and other obligations for at least the next 12 months. However, in the longer term, additional capital may be needed in order to fund the Company's operations, expand marketing activities, develop new or enhance existing services or products, to respond to competitive pressures or to acquire complementary services, businesses or technologies. If the Company is not successful in generating sufficient cash flow from operations, additional capital through public or private financings, strategic relationships or other arrangements will be necessary. This additional funding might not be available on acceptable terms, or at all. Failure to raise sufficient capital when needed could have a material adverse effect on the business, results of operations and financial condition. If additional funds were raised through the issuance of equity securities, the percentage of stock owned by the then-current stockholders would be reduced. Furthermore, such equity securities might have rights, preferences or privileges senior to those of the common stockholders. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results may differ from those estimates. 6 NETZERO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 3. RECENT ACCOUNTING PRONOUNCEMENTS. In June 1998, The Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities." The statement requires the recognition of all derivatives as either assets or liabilities in the balance sheet and the measurement of those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the planned use of the derivative and the resulting designation. Because the Company does not currently hold any derivative instruments and does not engage in hedging activities, the impact of the adoption of SFAS No. 133 did not have a material impact on financial position, results of operations or cash flows. The Company was required to implement SFAS No. 133 in the first quarter of fiscal 2001. In December 1999, the SEC issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition," which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosure related to revenue recognition policies. In June 2000, the SEC issued SAB 101B, which requires implementation of SAB 101 by the Company no later than June 30, 2001. The SEC issued additional guidance in the form of its Frequently Asked Questions and Answers document in October 2000. The Company believes that the adoption of SAB 101 will not have a material impact on the Company's financial position and results of operations. In March 2000, the FASB issued FASB Interpretation ("FIN") No. 44, "Accounting for Certain Transactions Involving Stock Compensation." FIN 44 provides guidance for issues arising in applying APB 25. FIN 44 applies specifically to new awards, exchanges of awards in a business combination, modification to outstanding awards and changes in grantee status that occur on or after July 1, 2000, except for the provisions related to repricings and the definition of an employee which apply to awards issued after December 15, 1998. The application of FIN 44 has not had a material impact on the Company's financial reporting. 4. REVENUE RECOGNITION. The Company's revenues are derived principally from the sale of advertising, which includes targeted and non-targeted banner advertisements, placements and sponsorships, referrals of users to other web-sites, performance-based agreements including e-commerce arrangements and advertising messages delivered to the Company's users via e-mail. Banner advertising and sponsorship revenues are recognized in the periods in which the advertisement or sponsorship placement is displayed, based upon the lesser of impressions delivered over the total number of guaranteed impressions or ratably over the period in which the advertisement is displayed, provided that no significant Company obligations remain and collection of the related receivable is probable. The Company's obligations typically include the guarantee of a minimum number of impressions or the satisfaction of other performance criteria. Revenues from performance-based arrangements are recognized as the related performance criteria are met. Referral revenues are recognized as referrals are made to advertisers' or sponsors' web-sites, provided that no significant Company obligations remain and collection of the related receivable is probable. Barter transactions are recorded at the fair value of the goods or services provided or received, whichever is more readily determinable in the circumstances. In determining the value of the goods or services provided, the Company uses historical pricing of 7 NETZERO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 4. REVENUE RECOGNITION. (CONTINUED) comparable cash transactions. For the periods presented, revenues recognized from barter transactions were less than 1% of total net revenues. 5. LONG LIVED ASSETS. The Company identifies and records impairment losses on long-lived assets, including goodwill that is not identified with an impaired asset, when events and circumstances indicate that such assets might be impaired. Events and circumstances that may indicate that an asset is impaired include significant decreases in the market value of an asset, a change in the extent or manner in which an asset is used, shifts in technology, loss of key management or personnel, changes in the operating model or strategy and competitive forces. If events and circumstances indicate that the carrying amount of an asset may not be recoverable and the expected undiscounted future cash flow attributable to the asset is less than the carrying amount of the asset, an impairment loss equal to the excess of the asset's carrying value over its fair value is recorded. Fair value is determined based on the present value of estimated expected future cash flows using a discount rate commensurate with the risk involved, quoted market prices or appraised values, depending on the nature of the assets. To date, no such impairment has been recorded. 6. ACQUISITIONS. In December 1999, the Company acquired 100% of the outstanding capital stock and options of AimTV, Inc. ("AimTV"). AimTV has developed a patent-pending technology designed to enable advertisers to run broadcast-quality commercials over narrowband Internet connections. Pursuant to the terms of the agreement, the outstanding capital stock and options were exchanged for approximately 973,000 shares of common stock and options to purchase common stock of NetZero. The transaction has been accounted for under the purchase method and, accordingly, the results of operations of AimTV have been included in the consolidated results of the Company since the date of acquisition. The excess of the purchase price over the fair value of net liabilities acquired amounted to approximately $23.7 million. The excess purchase price is comprised of approximately $14.3 million of goodwill and $9.4 million of identifiable intangible assets both of which are being amortized over their estimated useful lives ranging from two to three years. In August 2000, the Company acquired Simpli.com. Inc. ("Simpli.com") in a stock and cash transaction. Simpli.com is a targeted marketing infrastructure and search technology company. Pursuant to the terms of the agreement, the Company issued 2.5 million shares of common stock and paid $2.6 million in cash. The transaction has been accounted for under the purchase method and, accordingly, the results of operations of Simpli.com have been included in the consolidated results of the Company since the date of acquisition. The excess of the purchase price over the fair value of net liabilities acquired amounted to approximately $23.5 million. The excess purchase price is comprised of approximately $8.7 million of goodwill, $8.4 million of deferred stock-based charges and $6.4 million of identifiable intangible assets all of which are being amortized over periods ranging from two to three years. 8 NETZERO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 6. ACQUISITIONS. (CONTINUED) In September 2000, the Company acquired RocketCash Corporation ("RocketCash") in a stock for stock transaction. RocketCash is a leading online gateway that enables consumers, particularly the rapidly growing teen market, to shop and buy securely on the Internet without a credit card. Pursuant to the terms of the agreement, the Company issued approximately 5.2 million shares of common stock and options to purchase common stock. The transaction has been accounted for under the purchase method and, accordingly, the results of operations of RocketCash have been included in the consolidated results of the Company since the date of acquisition. The excess of the purchase price over the fair value of net liabilities acquired amounted to approximately $30.2 million. The excess purchase price is comprised of approximately $18.1 million of goodwill, $9.0 million of identifiable intangible assets and $3.1 million of deferred stock-based charges all of which are being amortized over periods ranging from two to four years. As part of the acquisition of RocketCash, the Company issued 500,000 shares of its common stock in connection with a RocketCash consumer marketing program and recorded stock-based charges of approximately $2.8 million. These charges are being amortized over the fifteen-month term of the agreement. In November 2000, the Company acquired certain assets of Freeinternet.com ("Freei") for approximately $4.6 million. Assets acquired included the domain names "Freeinternet.com", "Freeinet.com" and "Freei.net", certain proprietary rights, certain fixed assets, and the rights to market NetZero's service to Freei's users. The assets acquired have been included in the consolidated balance sheet of the Company at their fair market value since the date of acquisition and are being amortized generally over a two-year period. The following summarized unaudited pro forma financial information for the six months ended December 31, 2000 and 1999 assumes that the acquisitions had occurred at the beginning of each period presented:

7. CONCENTRATION OF CREDIT RISK. At December 31, 2000 and 1999, two customers comprised approximately 21% and 18%, and one customer comprised 31%, of the accounts receivable balance, respectively. For the three months ended December 31, 2000 and 1999, three customers comprised 35%, 12% and 10% of revenues, and two customers comprised 34% and 19% of revenues, respectively. For the six months ended December 31, 2000 and 1999, two customers comprised 29% and 10% of revenues, and two customers comprised 36% and 23% of revenues, respectively. 9 NETZERO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 8. EQUITY. INITIAL PUBLIC OFFERING In September 1999, the Company completed an initial public offering in which the Company sold 11.5 million shares of its common stock, including 1.5 million shares in connection with the exercise of the underwriters' over-allotment option, at $16 per share. The proceeds to the Company from the offering, after deducting offering expenses, including underwriting discounts and commissions, were $169.3 million. Upon the closing of the offering, all of the Company's then outstanding preferred stock automatically converted into common stock on a one-for-one basis. PRIVATE PLACEMENT In April 2000, the Company completed a private placement of 11.5 million shares of the Company's common stock and realized proceeds of approximately $144 million. RESTRICTED STOCK AWARDS In July 2000, certain employees were granted restricted stock awards totaling approximately 1.5 million shares of common stock. The shares of common stock subject to such awards will vest and be issued in twelve successive equal quarterly installments beginning in August 2000. The Company has recorded deferred stock-based charges of approximately $7.8 million in connection with these awards. 9. NET LOSS PER SHARE. The Company has adopted SFAS No. 128, "Earnings per Share" ("EPS"). SFAS No. 128 requires dual presentation of basic and diluted EPS. Basic EPS represents the weighted average number of shares outstanding divided into net income(loss) during a reported period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The Company has not included potential common stock in the calculation of EPS as such inclusion would have an anti-dilutive effect. The following table sets forth the computation of basic and diluted net loss per share:

10. COMMITMENTS AND CONTINGENCIES. The Company is not currently party to any material legal proceedings. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This report on Form 10-Q contains forward-looking statements based on our current expectations, estimates and projections about our operations, industry, financial condition and liquidity. Words such as "anticipates," "expects," "intends," "plans," "believes," "may," "will" 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. Such 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 in this Form 10-Q and our Form 10-K for the year ended June 30, 2000, discuss some of the important risk factors that may affect our business, results of operations and financial condition. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. OVERVIEW We are a leading provider of free and pay Internet access services and targeted marketing solutions. We offer consumers free and pay access to the Internet, free e-mail and customizable navigation tools that provide "speed dial" to key sites on the Internet. We also offer marketers, advertisers and market research organizations mass-scale, online market research through our CyberTarget division. We incorporated in July 1997 and launched our Internet access service in October 1998. During that period, we had no revenues and our operating activities related primarily to the development of our proprietary zCast software. Since October 1998, we have focused on developing our business and building the NetZero brand. Through December 31, 2000 approximately 7.7 million users registered for our free Internet access service, of which approximately 3.9 million used our service in the month of December. Our service is available in more than 5,000 cities across North America. We offer advertisers targeting capabilities through numerous online advertising channels. We offer advertisers and commerce partners a variety of additional services to build their brands and market their products, including referring our users to partners' web-sites, enabling customer registrations and facilitating electronic commerce transactions. Our CyberTarget division offers marketers and advertisers mass-scale, online market research and measurement services. In December 1999, we acquired AimTV, which has developed a patent-pending technology to run broadcast quality television commercials over narrowband Internet connections resulting in the launch of NZTV in May 2000. In August 2000, we acquired Simpli.com, which, when fully integrated into the NetZero service is expected to enhance our targeting and personalization capabilities. In September 2000, we acquired RocketCash, which had developed a secure, flexible-currency shopping technology enabling consumers to make purchases on the Internet with or without a credit card and in December 2000 we launched the NetZero Shopping Mall, which is powered by RocketCash's proprietary technologies. All of these acquisitions have been accounted for using the purchase method of accounting. In November 2000, we acquired certain tangible and intangible assets of one of our largest competitors, Freeinternet.com, for approximately $4.6 million. The assets acquired primarily included the domain names "Freeinternet.com", "Freeinet.com" and "Freei.net", certain proprietary rights, certain fixed assets, and the rights to market the NetZero service to Freei users. 11 In January 2001, we began limiting our standard free service to a maximum of 40 hours per household per calendar month. Households desiring to exceed the 40 hour limitation are currently offered the opportunity to sign up for "NetZero Professional," a new service plan that provides households the option to pay a fee, initially set at $9.95, to allow them access to our service for the remainder of the calendar month. If these households elect not to pay a fee when they reach the 40-hour limit during a given month they will be denied access to our service for the remainder of the month, but their account will not be terminated and they can begin accessing the service for free at the beginning of the next month. We intend to launch a new service, "NZ Platinum", before the end of the March quarter. The "NZ Platinum" service is intended to offer households Internet service for a monthly fee, initially $9.95, that will be the same as NetZero's standard free service except that the 40 hour limitation will not apply and the service will feature a small toolbar without the advertising banners currently included in the ZeroPort. There can be no assurance that these new products and services will be launched and implemented as anticipated, or that these services will meet with commercial success. REVENUES We generate revenues through media fees, direct marketing agreements, referring our users to partners' web-sites, enabling customer registrations for partners, selling and licensing our services, and facilitating electronic commerce transactions. We also generate revenues through our CyberTarget division by offering marketers, advertisers and market research companies mass-scale, online market research and measurement services using our zCast technology. We recently began offering several fee-based Internet access products and services to consumers. We have only recently begun offering several of our products and services, including CyberTarget and fee-based Internet access services, and there is no assurance as to when, or if, these products or services will make a significant contribution to our revenue. We anticipate that we will receive higher advertising rates for targeted advertisements and sponsorships than for non-targeted banner advertisements. However, we have limited experience in selling and managing these types of arrangements and there can be no assurance that we will successfully sell all of the various advertising services we offer or intend to offer or that such arrangements will generate significant revenues or higher advertising rates. To date, we have sold targeted advertising based upon web-sites visited, key word searches, and users' demographic and geographic information. In addition, the growth in the user base has resulted, and may result in the future, in situations where advertising inventory capacity has increased faster than the ability to sell such inventory at desired rates. We have in the past relied on third parties to sell a portion of our banner advertisements, but intend to rely primarily on our in-house sales force in the future. The failure of the efforts of the in-house sales force to sell increased inventory at reasonable rates may materially and adversely affect operating results. In addition, success with performance-based fee arrangements may depend on our ability to effectively target users. We are still in the early stages of that process and may encounter technical and other limitations on our ability to successfully target users, including limitations associated with privacy concerns. There can be no assurance that we will adequately perform under these arrangements or that we will be able to replace such arrangements on comparable terms, if at all. The failure to generate significant relationships with advertisers or the failure to replace significant contracts when they expire could adversely affect our revenues and results of operations. Banner advertising and sponsorship revenues are recognized in the periods in which the advertisement or sponsorship placement is displayed, based upon the lesser of impressions delivered over the total number of guaranteed impressions or ratably over the period in which the advertisement is displayed, provided that no significant obligations on our part remain and collection of the related receivable is probable. Our obligations typically include the guarantee of a minimum number of 12 impressions or the satisfaction of other performance criteria. The guaranteed minimum number of impressions is generally required to be delivered over the term of the commitment. Revenues from performance-based arrangements, including click-throughs, are recognized as the related performance criteria are met. Referral revenues are recognized in the periods in which the referrals are made to advertisers' or sponsors' web-sites, provided that no significant obligations on our part remain and collection of the related receivable is probable. We generally invoice customers at the end of our performance, such as at the completion of an advertising campaign or service sponsorship. In addition, certain customers are invoiced for sponsorships and other commitments on a quarterly basis. Recently there has been a reduction in the growth of online advertising, and currently, a number of our customers hold back a significant amount of their advertising dollars spent with us until the last month of a quarter. Such practices may result in extended average days sales outstanding at the end of a fiscal quarter. Our advertising revenues are subject to the effects of seasonality. Advertisers typically purchase impressions on a forward basis. If purchasing patterns or timing of purchasing by advertisers were to change, financial condition and results of operations could be materially affected. Advertising on the Internet, particularly the products and services we offer, is a relatively new industry, and there is no assurance that the products and services we offer now or in the future will meet with commercial acceptance. In addition, competition for Internet-based advertising revenues is intense and the amount of available advertising inventory on the Internet is increasing at a significant rate. These factors are causing Internet advertising rates to decline, and it is possible that rates will continue to decline in the future. Many of the purchasers of Internet advertising have been companies with Internet-based business models. Certain of these companies have come under financial pressure and have not been able to access the capital markets to fund their operations. This trend has impacted our ability to generate revenues and could continue to do so in the future. This trend could also result in increased allowances for doubtful accounts. Due to market forces and other factors, our revenues and results of operations may fluctuate from period to period. We have experienced two consecutive quarters of decreased revenues and there can be no assurance that we will not experience decreased revenues in sequential quarters in future periods. We do not currently anticipate that inflation will have a material impact on our results of operations. We have entered into barter transactions on an extremely limited basis and, for the periods presented, barter revenue accounts for less than 1% of the our total net revenue. COST OF REVENUES Cost of revenues consists of telecommunications costs, depreciation of network equipment, occupancy costs and personnel and related expenses of our network department. We have expended significant funds on our network infrastructure. While we may expend significant additional funds on capital expenditures in the future, such expenditures may be dependent upon our expectation of user growth and usage patterns, as well as needs associated with acquired businesses and new products. Telecommunications costs for network access are expensed as incurred. Our failure to accurately forecast users' needs could result in significant overcapacity, which would adversely impact our results of operations. Conversely, under-forecasting usage could adversely impact the ability of users to receive adequate service and adversely impact our reputation and our ability to maintain or increase our user base. We have limited history in forecasting our user requirements, and there can be no assurance that we will be able to accurately forecast such requirements in the future. Based upon a recent analysis of our user behavior and activity, we determined that a relatively small percentage of our users engaged in heavy monthly usage and accounted for a disproportionately 13 high percentage of our telecommunications costs. In light of this analysis, we recently announced certain limitations on usage along with the introduction of the "NZ Professional" service, which is designed to either reduce telecommunications expense associated with heavy users or, alternatively, generate additional revenues to mitigate such expense. We have very limited history with usage limitations and fee-based services, and there can be no assurance that these limitations or the offering of new products and services to heavy users will reduce our telecommunication costs or generate additional revenues in the future. Additionally, limiting usage and the introduction of fee-based Internet access could adversely impact our reputation and our ability to maintain or increase our user base. SALES AND MARKETING Sales and marketing expenses include advertising and promotion expenses, salaries, sales commissions, employee benefits, travel and related expenses for our direct sales force, fees paid to third-party advertising sales agents and sales support functions. In the past, we have expended significant amounts on sales and marketing including a national branding campaign comprised of television, radio and print advertising, sponsorships and a variety of other promotions and due to the timing of these promotions, amounts expended have varied significantly from period to period. As a result of a number of our competitors ceasing operations over the last 90 days, we have experienced a significant increase in our user base at a very low customer acquisition cost. We are currently evaluating all of our marketing programs and may reduce our advertising and promotions expense in the near term. Marketing costs associated with increasing brand awareness and user base are expensed in the period incurred. PRODUCT DEVELOPMENT Product development costs include expenses for the development of new or improved technologies and products, including salaries and related expenses for the software engineering department, as well as costs for contracted services, facilities and equipment. We believe that a significant level of product development is necessary for the business and intend to increase, as necessary, the amount of spending to fund this activity. GENERAL AND ADMINISTRATIVE General and administrative expenses include salaries, employee benefits and expenses for executive, finance, legal, human resources and internal and customer support personnel. In addition, general and administrative expenses include fees for professional services, third-party customer support, bad debt expense, and occupancy costs. AMORTIZATION OF INTANGIBLE ASSETS Amortization of intangible assets includes amortization of goodwill, purchased technologies and other identifiable intangible assets associated with our various acquisitions. As of December 31, 2000, we had approximately $55.0 million in intangible assets recorded on our balance sheet resulting from acquisitions completed in 1999 and 2000. Decreases in the fair value of these assets could result in our recording impairment losses with respect to some or all such assets. Any such loss could adversely and materially impact our results of operations and financial condition. STOCK-BASED CHARGES In connection with the grant of stock options and restricted stock to employees, the imposition of restrictions on shares of stock held by founders, the issuance of restricted shares of stock in connection with our recent acquisitions and the issuance of warrants in connection with various marketing 14 programs, we recorded deferred stock-based charges, which are being amortized over the vesting period of the applicable shares. CONSOLIDATED RESULTS OF OPERATIONS. The following tables set forth, for the periods presented, selected unaudited consolidated statements of operations data in dollars and as a percentage of net revenues:

THREE MONTHS ENDED DECEMBER 31, 2000 COMPARED TO THE THREE MONTHS ENDED DECEMBER 31, 1999 REVENUES. Revenues for the three months ended December 31, 2000 were $16.0 million, which represented an increase of $3.8 million, or 31%, from $12.2 million for the three months ended December 31, 1999. The increase in revenues was primarily due to sales of sponsorships on the ZeroPort and increased 15 revenues from our start page agreement with LookSmart, partially offset by a reduction in revenues from our agreement with AdSmart, which ended in February 2000. Specifically, we generated approximately $5.6 million, or 35%, of our total revenues for the quarter ended December 31, 2000, from our LookSmart start page agreement. This represented an increase of approximately $1.5 million from the $4.1 million generated from our start page agreement for the quarter ended December 31, 1999, which represented approximately 34% of our total revenues for the period ended December 31, 2000. The LookSmart agreement ended in January 2001. COST OF REVENUES. Cost of revenues for the three months ended December 31, 2000 was $21.7 million, which represented an increase of $6.5 million, or 43%, from $15.2 million for the three months ended December 31, 1999. The increase was primarily attributable to increased telecommunications usage related to the growth in our user base and increased depreciation related to our internal network costs, partially offset by a reduction in telecommunications cost per user hour. During the December 2000 quarter, the Company's cost of telecommunications services purchased averaged less than $0.18 per user hour. SALES AND MARKETING. Sales and marketing expenses for the three months ended December 31, 2000 were $17.2 million, which represented an increase of $1.5 million, or 10%, from $15.7 million for the three months ended December 31, 1999. The increase was primarily due to an increase in sales personnel and related costs and an increase in stock-based charges, partially offset be a reduction in media advertising and promotion expense. Sales and marketing expenses included $1.5 million and $0.3 million of stock-based charges during the quarters ended December 31, 2000 and December 31, 1999, respectively. Stock-based charges associated with sales and marketing primarily increased as a result of warrants issued in connection with a long-term CD distribution agreement and a RocketCash marketing promotion. PRODUCT DEVELOPMENT. Product development expenses for the three months ended December 31, 2000 were $8.7 million, which represented an increase of $6.4 million, or 278%, from $2.3 million for the three months ended December 31, 1999. The increase was primarily due to increased depreciation related to equipment used in product development and testing, increased stock-based charges and the hiring of additional personnel directly by NetZero and in connection with our acquisitions of Simpli.com and RocketCash. Product Development expenses included $2.8 million and $0.1 million of stock-based charges during the quarters ended December 31, 2000 and 1999, respectively. Stock-based charges associated with product development increased primarily as a result of restricted shares that were issued in connection with the acquisition of Simpli.com. GENERAL AND ADMINISTRATIVE. General and administrative expenses for the three months ended December 31, 2000 were $8.3 million, which represented an increase of $3.4 million, or 69%, from $4.9 million for the three months ended December 31, 1999. The increase was primarily due to the hiring of additional administrative personnel, increased stock-based charges, increased customer support costs and increased occupancy costs. General and administrative expenses include $2.1 million and $1.0 million of stock-based charges during the quarters ended December 31, 2000 and 1999, respectively. The increase was primarily a result of restricted stock awards granted to employees and the issuance of restricted stock in connection with our recent acquisitions. 16 AMORTIZATION OF INTANGIBLE ASSETS. Amortization of intangible assets for the three months ended December 31, 2000 and 1999 was $6.4 million and $0.7 million, respectively. The increase was primarily the result of our acquisitions of AimTV in December 1999, Simpli.com in August 2000, RocketCash in September 2000, and certain assets of Freeinternet.com in November 2000. INTEREST INCOME AND INTEREST EXPENSE. Interest income consists of earnings on our cash and cash equivalents, short-term investments and restricted cash. Interest expense consists primarily of interest expense on capital leases and notes payable. Net interest income for the three months ended December 31, 2000 was $2.9 million, which represented an increase of $1.0 million from net interest income of $1.9 million for the three months ended December 31, 1999. The increase was primarily due to higher average cash and short-term investment balances and higher interest rates in the quarter ended December 31, 2000 compared to the quarter ended December 31, 1999. INCOME TAXES. As a result of operating losses and our inability to recognize a benefit from our deferred tax assets, we have not recorded a benefit for income taxes for the three months ended December 31, 2000 and 1999. SIX MONTHS ENDED DECEMBER 31, 2000 COMPARED TO THE SIX MONTHS ENDED DECEMBER 31, 1999 REVENUES. Revenues for the six months ended December 31, 2000 were $32.5 million, which represented an increase of $12.5 million, or 63%, from $20.0 million for the six months ended December 31, 1999. The increase was primarily attributable to revenues generated from our in-house sales force, sponsorships on the ZeroPort and our start page agreement with LookSmart, partially offset by a reduction in revenues from our agreement with AdSmart, which ended in February 2000. Specifically, we generated approximately $9.5 million, or 29%, of our total revenues for the six months ended December 31, 2000 from our LookSmart start page agreement. This represented an increase of approximately $2.4 million from the $7.1 million generated from our start page agreement for the six months ended December 31, 1999, which represented approximately 36% of our total revenues for that period. The LookSmart agreement, ended in January 2001. COST OF REVENUES. Cost of revenues for the six months ended December 31, 2000 was $39.3 million, which represented an increase of $11.9 million, or 43%, from $27.4 million for the six months ended December 31, 1999. The increase was primarily attributable to increased telecommunications usage related to the growth in our user base and increased depreciation related to our internal network costs, partially offset by a reduction in telecommunications cost per user hour. During the six months ended December 31, 2000, the Company's cost of telecommunications services purchased averaged less than $0.20 per user hour. SALES AND MARKETING. Sales and marketing expenses for the six months ended December 31, 2000 were $31.2 million, which represented an increase of $10.4 million, or 50%, from $20.8 million for the six months ended December 31, 1999. The increase was primarily due to an increase in media advertising and promotion expense, directly by NetZero and in connection with our acquisition of RocketCash, and an increase in 17 sales and marketing personnel and related costs. Sales and marketing expenses included stock-based charges of $2.6 million for the six months ended December 31, 2000 compared to $0.5 million for the six months ended December 31, 1999. Stock-based charges associated with sales and marketing primarily increased as a result of warrants issued in connection with a long-term CD distribution agreement and a RocketCash marketing promotion. PRODUCT DEVELOPMENT. Product development expenses for the six months ended December 31, 2000 were $13.6 million, which represented an increase of $9.9 million, or 268%, from $3.7 million for the six months ended December 31, 1999. The increase was primarily due to increased depreciation related to equipment used in product development and testing, increased stock-based charges, and the hiring of additional personnel directly by NetZero and in connection with our acquisitions of Simpli and RocketCash. Product development expenses included $3.5 million of stock-based charges for the six month period ended December 31, 2000 compared to $0.2 million for the six month period ended December 31, 1999. Stock-based charges associated with product development increased primarily as a result of restricted shares that were issued in connection with the acquisition of Simpli.com. GENERAL AND ADMINISTRATIVE. General and administrative expenses for the six months ended December 31, 2000 were $16.7 million, which represented an increase of $7.9 million, or 90%, from $8.8 million for the six months ended December 31, 1999. The increase was primarily due to the hiring of additional administrative personnel, increased customer support costs , increased stock-based charges and increased occupancy costs. General and Administrative expenses included $4.8 million of stock-based charges for the six-month period ended December 31, 2000 compared to $1.9 million for the six month period ended December 31, 1999. Stock-based charges associated with general and administrative expenses increased primarily as a result of restricted stock awards to employees and the issuance of restricted stock in connection with our recent acquisitions. AMORTIZATION OF INTANGIBLE ASSETS. Amortization of intangible assets for the six months ended December 31, 2000 was $10.2 million compared to $0.7 million for the six months ended December 31,2000. The increase was primarily the result of our acquisitions of AimTV in December 1999, Simpli.com in August 2000, RocketCash in September 2000, and certain assets of Freeinternet.com in November 2000. INTEREST INCOME AND INTEREST EXPENSE. Interest income consists of earnings on our cash and cash equivalents, short-term investments and restricted cash. Interest expense consists primarily of interest expense on capital leases and notes payable. Net interest income for the six months ended December 31, 2000 was $6.4 million, which represented an increase of $4.4 million from net interest income of $2.0 million for the six months ended December 31, 1999. The increase was primarily due to higher average cash and short-term investment balances, partially offset by an increase in interest expense on capital leases and notes payable. INCOME TAXES. As a result of operating losses and our inability to recognize a benefit from our deferred tax assets, we have not recorded a benefit for income taxes for the six months ended December 31, 2000 and 1999. 18 LIQUIDITY AND CAPITAL RESOURCES From the inception of our business through December 2000, our operations have been financed primarily through the sale of equity securities, cash generated from sales of our products and, to a lesser extent, equipment lease financing. At December 31, 2000 we had approximately $172.6 million in cash, cash equivalents and short-term investments and approximately $9.1 million in restricted cash. For the six months ended December 31, 2000, net cash used for operating activities was $50.0 million, consisting primarily of operating losses and increases in accounts receivable and other assets, partially offset by depreciation and amortization, stock-based charges and increases in accounts payable and accrued expenses. For the six months ended December 31, 1999, net cash used for operating activities was $39.8 million and consisted of operating losses, deposits to guarantee future obligations and increases in accounts receivable and other assets, partially offset by increases in accounts payable and accrued expenses and depreciation and amortization of stock-based charges. For the six months ended December 31, 2000, net cash used for investing activities was $50.4 million of which $39.6 million represented the net increase in short-term investments and the balance was used for acquisitions and capital expenditures. In the six months ended December 31, 1999, cash used for investing activities of $8.4 million was primarily for server network equipment, purchased software, office equipment and leasehold improvements. Net cash used for financing activities was $4.4 million for the six months ended December 31, 2000 and was primarily for payments on capital lease and notes payable obligations. In the six months ended December 31, 1999 cash provided by financing activities was $176.3 million and was principally attributable to the proceeds from our initial public offering. We have incurred significant operating losses since we began our business and we expect this trend to continue for the foreseeable future. In order to succeed we must increase our revenues while controlling our telecommunications costs, our operating expenses and our capital expenditures. Many factors will impact our ability to grow revenues including, but not limited to, the number of users who sign up for our new pay services, the growth in our user base, the dynamics of the Internet advertising market, and our ability to sell our existing products and develop new products to further monetize our users. We have invested significantly in our network infrastructure, software licenses and furniture, fixtures and equipment and we may need to make further significant investments in the future. The actual amount of capital expenditures will depend on the rate of growth in our user base, which is difficult to predict and which could change dramatically over time. Technological advances may also require us to make capital expenditures to develop or acquire new equipment or technology. We intend to use cash to fund our operating losses and a combination of cash and capital lease financing to fund our capital expenditures in a manner, which minimizes our cost of capital. However, we cannot assure you that lease financing will be available on favorable terms, if at all, in which case we would be required to use a greater portion of cash to fund our capital expenditures. We currently anticipate that our existing cash, cash equivalents and short-term investments will be sufficient to fund our operating activities, capital expenditures and other obligations for at least the next 12 months. However, we may need to raise additional capital in order to fund our operations, expand our marketing activities, develop new or enhance existing services or products to respond to competitive pressures or to acquire complementary services, businesses or technologies. If, in the future, we are not successful in generating sufficient cash flow from operations, we may need to raise additional capital through public or private financings, strategic relationships or other arrangements. This additional funding, if needed, might not be available to us on acceptable terms, or at all. Our failure to raise sufficient capital when needed could have a material adverse effect on our business, results of operations and financial condition. If additional funds were raised through the issuance of equity securities, the percentage of stock owned by the then-current stockholders would be reduced. 19 Furthermore, such equity securities might have rights, preferences or privileges senior to holders of our common stock. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities." The statement requires the recognition of all derivatives as either assets or liabilities in the balance sheet and the measurement of those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the planned use of the derivative and the resulting designation. Because the Company does not currently hold any derivative instruments and does not engage in hedging activities, the impact of the adoption of SFAS No. 133 did not have a material impact on financial position, results of operations or cash flows. The Company was required to implement SFAS No. 133 in the first quarter of fiscal 2001. In December 1999, the SEC issued Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition," which provides guidance on the recognition, presentation and disclosure of revenue in financial statements filed with the SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue and provides guidance for disclosure related to revenue recognition policies. In June 2000, the SEC issued SAB 101B, which requires implementation of SAB 101 by the Company no later than June 30, 2001. The SEC issued additional guidance in the form of its Frequently Asked Questions and Answers document in October 2000. The Company believes that the adoption of SAB 101 will not have a material impact on the Company's financial position and results of operations. In March 2000, the FASB issued FASB Interpretation ("FIN") No. 44, "Accounting for Certain Transactions Involving Stock Compensation." FIN 44 provides guidance for issues arising in applying APB 25. FIN 44 applies specifically to new awards, exchanges of awards in a business combination, modification to outstanding awards and changes in grantee status that occur on or after July 1, 2000, except for the provisions related to repricings and the definition of an employee which apply to awards issued after December 15, 1998. The application of FIN 44 has not had a material impact on the Company's financial reporting. FUTURE RESULTS OF OPERATIONS MAY VARY DUE TO CERTAIN FACTORS Our operating results may fluctuate substantially in the future as a result of a variety of factors, many of which are outside of our control, including those discussed elsewhere in this Form 10-Q. The Company may significantly increase its operating expenses and capital expenditures for a variety of reasons including, without limitation, the growth in our user base, the expansion of its sales and marketing efforts, the promotion of the NetZero brand, the enhancement of the features and functionality of our services, the development of new services and products, the integration of acquired companies, the upgrading of the internal network infrastructure, pursuit of new distribution channels and the hiring of new personnel across all levels of the organization. Expenditures in each of these categories may vary significantly from period to period. While some expenses are fixed in the short-term, total operating expenses are principally determined on the basis of anticipated growth in revenues. There are risks associated with the timing and achievement of revenue targets due to a variety of factors, and there can be no assurance that revenues will increase commensurately with expenses. We believe that expenses will significantly exceed revenues for the foreseeable future. As a result of these and other factors, operating results may vary substantially from quarter to quarter. In addition, seasonal trends could affect revenues generated. To the extent that revenues depend on the amount of usage by users, any seasonal fluctuations in Internet usage could affect revenues during such periods of fluctuation. We anticipate that the summer and year-end vacation and holiday periods will impact user traffic levels. Moreover, the rate at which new users sign up for our service 20 may be related to gifts or purchases of personal computers, which typically increase during the fourth calendar quarter because of the holiday season and may decline during other periods. As a result, new user registration may be subject to seasonality. However, because our operating history is limited, it is difficult to accurately predict these trends and plan accordingly. Since operating expenses are based on expectations of future revenues, it is possible that seasonal fluctuations could materially and adversely affect our business, results of operations and financial condition. In addition to seasonality, there are several other factors that may cause our quarter to quarter revenues to fluctuate significantly, including changes in advertising rates, fluctuations in our user count, termination of our material contracts, such as the LookSmart agreement, and the effect of short term contracts which provide significant revenues in one quarter but do not provide significant revenues in subsequent quarters. These and other factors may cause significant fluctuations in our quarter to quarter revenues. A small number of customers have accounted for, and may in the future account for, a significant portion of revenues. For the three and six months ended December 31, 2000 LookSmart accounted for 35% and 29% of our revenues, respectively. Our agreement with LookSmart, which was due to expire on February 15, 2001, was terminated by mutual agreement on January 19, 2001. LookSmart provided search functionality on our start page and on the ZeroPort, and was provided with the right to advertise third party services on our start page. While we intend to sign agreements with one or more companies to provide search functionality, we anticipate that our revenues from such arrangements will only be a small portion of the revenues that we have historically received from LookSmart. However, we are in the process of modifying our start page to create a new product which we anticipate will derive revenues from a number of third parties, although there is no assurance that we will derive the level of revenues from our revised start page that we historically derived from our previous start page which included LookSmart. If we do not generate significant revenues from our new start page, our revenues and results of operations may be adversely and materially affected. The termination of material agreements, as well as the timing of orders under material agreements, may cause significant fluctuations in our results. Our business, results of operations and financial condition will be materially and adversely affected if we are unable either to renew material agreements or to replace such agreements with similar agreements with new customers. In addition, during certain past periods we generated a significant portion of our revenues from arrangements with third party sales organizations. We no longer have any agreements in effect with third party sales organizations that we believe will result in significant revenues. We intend to focus primarily on our in-house sales organization for our advertising sales, and there is no assurance that our in-house sales organization will generate the amount of revenues necessary to support our business. 21 RISK FACTORS Before deciding to invest in our Company or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information in this report and our other filings with the SEC. 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. If any of these risks actually occur, our business, financial condition or results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you may lose all or part of your investment. WE FACE RISKS ASSOCIATED WITH OUR OPERATIONS WE CANNOT PREDICT OUR SUCCESS BECAUSE OUR BUSINESS MODEL IS UNPROVEN, AND WE HAVE OPERATED OUR BUSINESS FOR ONLY A SHORT PERIOD OF TIME. Our business model is unproven and a number of other businesses offering free Internet access have failed. Since we only began offering Internet access in October 1998, we have a limited operating history, which makes it difficult to evaluate our performance. Our business model, unlike traditional Internet service providers, does not have a measurable and predictable revenue stream from user access fees. Due to a variety of factors including deterioration in the online advertising market, we have altered our model to limit the number of hours a month a user can access our service without charge. In addition, we intend to offer a variety of products intended to provide us with additional revenues. We may make additional changes to our model in the future. There can be no assurance that our existing model will be successful or that any changes to our model will be successful. If we are not able to successfully address these risks, we will not be able to grow our business, compete effectively or achieve profitability. IF WE FAIL TO GENERATE SUFFICIENT ADVERTISING REVENUES, WE MAY NOT BE ABLE TO SUPPORT OUR OPERATIONS. Historically we have depended primarily on our ability to generate advertising revenues. Accordingly, if we fail to generate sufficient advertising revenues, we may not be able to support our operations. To date, advertising revenues have not been sufficient to support our operations. Our operating costs have continued to increase from quarter to quarter while our revenues from advertising have, from time to time, decreased from quarter to quarter. We generate revenues from a variety of different arrangements including sales of targeted and untargeted banner advertising, sponsorships, performance-based arrangements and referrals to third party web-sites. We have limited experience marketing and pricing these types of arrangements, and have limited actual experience with respect to the performance of such arrangements. As such, we do not know if we are appropriately pricing, marketing or structuring these arrangements, or whether we will perform under these arrangements to the satisfaction of the other parties. Our failure to appropriately price, market or structure these arrangements could impact our ability to enter into and perform under these arrangements, or to renew these arrangements on similar or acceptable terms. Due to a variety of factors including the deterioration of the online advertising market and the decrease in capital available to Internet companies, we have experienced a number of situations where arrangements are not renewed, are renewed at significantly lower rates or are repriced during the term of the arrangement. These factors may significantly impact our ability to enter into new arrangements with third parties, to enforce our existing arrangements and to maintain or grow our revenues. In addition, the success of some of these arrangements may depend on our ability to effectively target users based on demographic and other information. We may encounter technical and other limitations on this ability, including problems associated with the accuracy of the information provided by our users, which we do not corroborate. In light of these factors, there can be no assurance that we will be able to attract sufficient advertising revenues to support our operations. 22 In addition, competition for Internet-based advertising revenues is intense and the amount of available advertising space on the Internet is increasing at a significant rate while the demand may be declining. These factors are causing Internet advertising rates to decline, and it is possible that rates will continue to decline in the future. Also, our growth in users has resulted in, and in the future may result in, our advertising inventory growing faster than our ability to sell the inventory at reasonable rates. Many of the purchasers of Internet advertising have been companies with Internet-based business models. Many of these companies have come under financial pressure and have not been able to access the capital markets to fund their operations. This trend has adversely impacted our revenues and could impact our ability to generate revenues in the future and result in increased reserves for doubtful accounts. Many of our advertising competitors have longer operating histories, greater name recognition, larger user bases, significantly greater financial, technical, sales and marketing resources and more established relationships with advertisers than we do. These advantages may allow such competitors to respond more quickly than we can to new or emerging technologies and changes in advertiser requirements. They may also be able to devote greater resources than we can to develop, promote and sell their products and services. Such competitors may also engage in more extensive research and development, undertake more far-reaching marketing campaigns, adopt more aggressive pricing policies and make more attractive offers to existing and potential employees, strategic partners, advertisers and Web publishers. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products or services to address the needs of our prospective customers. We must also compete with television, radio, cable and print media for a share of advertisers' total advertising budgets. Advertisers may be reluctant to devote a significant portion of their advertising budget to Internet advertising if they perceive the Internet to be a limited or ineffective advertising medium. OUR MARKET SHARE AND REVENUES WOULD SUFFER IF WE WERE NOT ABLE TO COMPETE EFFECTIVELY FOR USERS WITH ESTABLISHED AND NEW PROVIDERS OF INTERNET ACCESS SERVICES. COMPETITORS Competition for users of internet access services is intense. We currently compete or expect to compete for users with the following types of companies that provide access services: - companies that provide free Internet access under their own brands, such as Juno Online Services, Inc., as well as companies that provide free Internet access co-branded with, or under the brands of, third parties; - established online service and content providers, such as America Online and The Microsoft Network; - independent national Internet service providers, such as EarthLink and Prodigy; - national long-distance carriers, such as AT&T, GTE and MCI WorldCom; - local telephone companies and regional Bell operating companies, such as Pacific Bell; - numerous regional and local commercial Internet service providers; - computer hardware and software and other technology companies, such as IBM and Microsoft; - cable operators and online cable services, such as Excite@Home; - retail companies such as K-Mart and Costco; and - nonprofit or educational Internet service providers. 23 We expect that competition for users will continue to intensify. While we have recently experienced a period of decreased competition for users of free Internet access services due to the failure of numerous free Internet access providers, there can be no assurance that we will not experience additional competition from new competitors. In addition, because we have limited the number of hours that a household may use our service free of charge, we may experience more direct competition from companies who charge for their Internet service, particularly those who charge on a discounted basis. We believe that additional competitors for Internet users, including major computer manufacturers, retail companies, and software, media and telecommunications companies, will continue to enter the Internet access market. Existing competitors have taken, and may continue to take, steps such as reducing their subscriber fees, offering promotions for access services, or bundling free access services with other product offerings. For example, both Microsoft and CompuServe have partnered with personal computer makers and consumer electronics retailers to offer consumers rebates on computer equipment when the consumer signs up for their Internet access services. We believe that increased competition has, from time to time, impacted our growth and may impact our growth in the future, resulting in increased user turnover and additional sales and marketing expenses that increase user acquisition cost. Increased competition could also result in decreased advertising revenue. Since we rely primarily on advertising revenues to support our free access model and do not charge the vast majority of our users membership fees, we may not be able to offset the effect of these increased costs, and we may not have the resources to continue to compete successfully. The ability of our competitors to acquire other Internet providers or to enter into strategic alliances or joint ventures could also put us at a significant competitive disadvantage. TELECOMMUNICATIONS SERVICES In addition, telecommunications companies with far greater resources, distribution channels and brand awareness offer, or have announced that they will offer, their own Internet access services to users. Since these companies have their own telecommunications network infrastructure, they have lower communications costs than we do. These advantages reduce the overall cost of Internet access for such companies and may significantly increase competitive pressures on us. For example, AT&T WorldNet recently began offering an Internet access service priced at $4.95 per month combined with an advertising banner window, and also announced a new program where it bundles its Internet access service with its long distance service at a discounted rate. In addition, each of our telecommunications providers supplies network access to some of our competitors, and could choose to grant those competitors preferential network access, potentially limiting our users' ability to access the Internet. If our telecommunications service providers were to decrease the levels of service or access provided to us, or if they were to terminate their relationships with us for competitive or other reasons, and we were not able to develop alternate sources of supply, we would not be able to provide Internet access to our customers, which could ultimately result in a significant loss of users and revenues. BROADBAND PROVIDERS We also face competition from companies that provide broadband Internet access, including local and long-distance telephone companies, cable television companies, electric utility companies, wireless communications companies and other Internet service providers. Most of our service is offered via dial-up modems, which are generally limited to access speeds of up to 56 kbps. Broadband technologies enable users to transmit and receive print, video, voice and data in digital form at significantly faster access speeds. We may have to develop new technologies or add broadband access services to remain competitive, which could require substantial time and expense. We cannot be certain that we will succeed in adapting our Internet access service business to compete effectively with these technologies. The telephone, cable and other companies that own broadband networks may prevent us from offering broadband Internet access through the wire and cable networks that they own. Our ability to 24 compete with telephone and cable television companies that are able to support broadband transmission may depend on future regulation to guarantee open access to their broadband networks. However, in January 1999, the Federal Communications Commission declined to take any action to mandate or otherwise regulate access by Internet service providers to broadband cable facilities at this time. We do not know whether local, state or federal regulatory agencies will take any initiatives to implement this type of regulation, and whether they will be successful in establishing their authority to do so. In addition to competing directly in the Internet access market, both cable and telephone companies are also aligning themselves with Internet service providers who would receive preferential or exclusive use of broadband local connections to users. If broadband Internet access becomes the preferred mode by which users access the Internet and we are unable to gain access to broadband networks on reasonable terms, our ability to compete could be materially and adversely affected. We are in the process of developing, and plan to implement, a strategy to deliver broadband services. There is no assurance that we will be successful in developing or implementing this strategy. It is anticipated that implementing a broadband strategy will result in significant operating costs, which could adversely impact our financial position and results of operations. IF WE FAIL TO GROW OUR USER BASE, WE MAY NOT BE ABLE TO GENERATE REVENUES, DECREASE PER-USER TELECOMMUNICATIONS COSTS OR IMPLEMENT OUR STRATEGY. If we are unable to grow our user base, we may not be able to generate revenues, decrease per-user telecommunications costs or implement our strategy. While we have, from time to time, experienced such rapid growth in our user base that we have instituted measures to limit the number of new users on our service, there is no assurance that this trend will continue in the future, especially in light of the limitations on the number of hours that a user can access our service without charge. We may find that our efforts to limit the number of users able to register for our service will adversely impact user growth in the long term. We intend to generate new users through other distribution channels, such as television, radio and print media advertising, direct marketing campaigns, and bundling, co-branding and retail distribution arrangements. However, we have limited experience with marketing our service through these channels. If these distribution channels prove more costly or less effective than anticipated, it could adversely impact our ability to grow. We would also be unable to grow our user base if a significant number of our current registered users stopped using our service. There are a variety of reasons why users would discontinue using our service, including: - Users may object to the limitation we impose on the number of hours they can use our service in a month without charge and decide to terminate their account with us in favor of a competing service; - users may decide they do not like the always-present nature of the ZeroPort or the presence of advertising on our service; - users may not like having their online activities tracked; - reliability issues, which we have experienced in the past and may experience in the future, may cause user dissatisfaction; and - our limited user support may frustrate users who have difficulty using our service. There is no assurance that we will be able to successfully address these issues and retain our existing user base. 25 OUR ADVERTISING REVENUES WILL SUFFER IF WE ARE UNABLE TO DEMONSTRATE THAT OUR REGISTERED USERS ARE ACTIVELY USING OUR SERVICE. If we are not able to demonstrate to our advertisers that our registered users are actively using our service, advertisers may choose not to advertise with us and our advertising revenues could be materially and adversely affected. Approximately 7.7 million users had registered for our service through December 31, 2000, of which approximately 3.9 million had used our service during the month of December. We believe that a number of our users have Internet access accounts with our competitors. As a result, these users may not use NetZero as their primary Internet service provider. Also, some new users use the Internet only as a novelty and do not become consistent users of Internet services and, therefore, may be less likely to continue using our service. WE MAY NOT SUCCESSFULLY DEVELOP AND MARKET NEW PRODUCTS IN A TIMELY MANNER; OUR NEW PRODUCTS MAY NOT BE ACCEPTED BY CONSUMERS OR ADVERTISERS. We have expended, and may in the future expend, significant resources developing and implementing new products. Product development involves a number of uncertainties, including unanticipated delays and expenses. New products may have technological problems or may not be accepted by our users or advertisers. There is no assurance that new products will be introduced in a timely manner or result in user satisfaction or increased revenues. If we are unable to respond in a timely manner to technological advances, we may not be able to compete effectively for users, which could cause our revenues to decrease. Several of the new products we have offered, or intend to offer, such as the NZ Platinum which provides the user with the opportunity to limit banner advertising in the ZeroPort, involve payments to us by our users. While we hope to derive additional revenues from these products, there is no assurance that our users will elect to pay for such products or that such products will provide us with any meaningful revenue. IF WE ARE UNABLE TO SUCCESSFULLY INTEGRATE ACQUISITIONS INTO OUR OPERATIONS, THEN OUR RESULTS AND FINANCIAL CONDITION MAY BE ADVERSELY AFFECTED. We have made a number of acquisitions and may continue to make acquisitions or undertake other business combinations that can complement our current or planned business activities. Such acquisitions may not be available at the times or on terms acceptable to us, or at all. In addition, acquiring a business involves many risks, including: - disruption of our ongoing business and diversion of resources and management time; - unforeseen obligations or liabilities; - difficulty assimilating the acquired operations and personnel; - risks of entering markets in which we have little or no direct prior experience; - potential impairment of relationships with employees or users as a result of changes in management; and - potential dilutive issuances of equity, large and immediate write-offs, the incurrence of debt, and amortization of goodwill or other intangible assets. There can be no assurance that we will make any further acquisitions or that we will be able to obtain additional financing for such acquisitions, if necessary. There can be no assurance that we will be able to successfully integrate the acquired businesses into our operations or that the acquired businesses will perform as expected. 26 WE MAY NOT BE ABLE TO PROVIDE INTERNET ACCESS FOR OUR USERS IF OUR TELECOMMUNICATIONS CARRIERS RAISE THEIR RATES OR IF THEY DISCONTINUE DOING BUSINESS WITH US. Our business substantially depends on the capacity, affordability, reliability and security of our telecommunications networks. Only a small number of telecommunications providers offer the network services we require. There has been significant consolidation in the telecommunications industry, and there is a significant risk that further consolidation could make us reliant on an even smaller number of providers. Certain of our telecommunications services are provided pursuant to short-term agreements that the providers can terminate or elect not to renew. As a result, any or all of our current telecommunications service providers could decide not to provide us with service at rates acceptable to us, or at all, in which event, we may not be able to provide Internet access to our users. WE MAY LOSE OUR USERS IF OUR TELECOMMUNICATIONS PROVIDERS DELIVER UNACCEPTABLE SERVICE QUALITY. If our third-party telecommunications service providers deliver unacceptable service, the quality of our Internet access service would suffer. In this event, we would likely lose users who are dissatisfied with our service. Since we do not have direct control over our telecommunications carriers' network reliability and the quality of their service, there can be no assurance that we will be able to provide consistently reliable Internet access for our users. IF TELECOMMUNICATIONS PRICES INCREASE, OUR MARGINS WOULD BE ADVERSELY IMPACTED. Our margins are highly sensitive to variations in prices for the telecommunications services we purchase. Our business could be harmed if minimum connection charges increase or become more prevalent. In addition, the availability and pricing of telecommunications services varies geographically, and we may not be able to obtain new or substitute telecommunications services in certain geographic areas on commercially reasonable terms, if at all. Legislation has been proposed from time to time that would increase the cost of doing business of many of our telecommunications providers. Any increase in their costs could result in increased prices to us. There can be no assurance that our telecommunications providers will continue to provide their services on commercially acceptable price terms, or that alternative services will be available on similar terms. OUR ABILITY TO SERVE ADVERTISEMENTS ON THE ZEROPORT COULD BE SEVERELY LIMITED IF THE SOFTWARE WE LICENSE FROM NETGRAVITY FAILS TO PERFORM OR IF WE ARE NOT ABLE TO RENEW OUR LICENSE. All of our advertisements are served using software licensed from NetGravity. While there is other software available, it would substantially disrupt our business to switch to another provider. As such, we are reliant on NetGravity and its software. Our agreement with NetGravity expires in June 2001; however we have an option to renew the agreement for an additional two-year term upon initial expiration. If NetGravity's software fails to perform as expected, or if we are not able to renew such agreement or license or internally develop similar software in the future, we may not be able to effectively display advertisements to our users. In this event, our ability to generate advertising revenues would be severely limited. In October 1999, DoubleClick, an Internet advertising provider, acquired NetGravity. Since our agreement with NetGravity does not expire until June 2001 and we have an option to renew for an additional two-year term upon initial expiration, we do not believe the acquisition will have a material effect on our contractual rights with NetGravity. OUR STOCK PRICE COULD FALL AS A RESULT OF FUTURE LOSSES AND NEGATIVE CASH FLOW. We have a significant accumulated deficit. We expect to continue to experience losses and negative cash flow. Our ability to achieve profitability or positive cash flow depends upon a number of factors, including our ability to increase revenue and reduce per-user costs. We cannot be certain that we will be able to continue to maintain or grow our revenues or that we will obtain sufficient revenues to 27 achieve profitability or positive cash flow. If we do achieve profitability, we cannot be certain that we can sustain or increase profitability on a quarterly or annual basis in the future. If we fail to do so, the market price for our common stock could suffer. OUR REVENUES WOULD SIGNIFICANTLY DECREASE IF WE LOSE KEY CUSTOMERS. A small number of customers have accounted for, and may in the future account for, a significant portion of our revenues. For example, we derived approximately 35% of our revenues for the quarter ended December 31, 2000 from our start page agreement with LookSmart. Our agreement with LookSmart, which was due to expire on February 15, 2001, was terminated by mutual agreement on January 19, 2001. LookSmart provided search functionality on our start page and on the ZeroPort, and was provided with the right to advertise third party services on our start page. While we intend to sign agreements with one or more companies to provide search functionality on our start page and on the ZeroPort, we anticipate that our revenues from such arrangements will only be a small portion of the revenues that we have historically received from LookSmart. However, we are in the process of modifying our start page to create a new product which we anticipate will derive revenues in addition to search functionality from a number of third parties, although there is no assurance that we will derive the level of revenues from our revised start page that we historically derived from LookSmart. If we do not generate signficant revenues from our new start page, our revenues may be adversely and materially impacted in the near term. The termination of material agreements, as well as the timing of orders under material agreements, may cause significant fluctuations in our quarterly results. Our business, results of operations and financial condition will be materially and adversely affected if we are unable either to renew our material agreements or to replace such agreements with similar agreements with new customers. During the year ended June 30, 2000, we generated a significant portion of our revenues from third party sales organizations. We no longer have any agreements in effect with third party sales organizations that we believe will result in significant revenues, and there is no assurance that our in-house sales organization will generate the amount of revenues necessary to support our business. OUR REPUTATION AND ABILITY TO GENERATE REVENUES WILL BE HARMED IF USER DEMAND FOR OUR SERVICE EXCEEDS OUR TELECOMMUNICATIONS AND SERVER CAPACITY. We may from time to time experience increases in our telecommunications usage which exceed our then-available telecommunications capacity and the capacity of our internal servers. As a result, users may be unable to register or log on to our service, may experience a general slow-down in their Internet access or may be disconnected from their sessions. Excessive user demand could also result in system failures of our internal server networks, which would prevent us from generating advertising revenues. Inaccessibility, interruptions or other limitations on the ability to access our service due to excessive user demand, or any failure of our servers to handle user traffic, would have a material adverse effect on our reputation and our revenues. WE WILL NOT BE ABLE TO SUPPORT INCREASED NUMBERS OF USERS IF WE ARE UNABLE TO ENHANCE OUR INTERNAL NETWORK INFRASTRUCTURE. Our internal network infrastructure is composed of a complex system of application, database, advertisement and e-mail servers. Service interruptions originating within our internal network have occurred in the past and may occur in the future, especially when usage exceeds capacity. We will need to invest in substantial financial, operational, and management resources to enhance our systems, particularly our database servers and storage capabilities, to handle a large number of users. We cannot be certain that we will be able to accomplish this on a timely basis and at a commercially reasonable cost, or at all. If we fail to do so, we will be unable to grow our business. 28 IF WE FAIL TO MANAGE OUR TELECOMMUNICATIONS CAPACITY, OUR SERVICE LEVELS MAY SUFFER OR WE MAY EXPERIENCE INCREASED PER-USER COSTS. We will have to accurately anticipate our future telecommunications capacity needs within lead-time requirements. If we fail to procure sufficient quantities of telecommunications products and services, we may be unable to provide our current and future users with acceptable service levels. We also run the risk of purchasing excessive amounts of telecommunications products and services based on incorrect projections regarding increased usage. In that event, we would be required to bear the costs of excess telecommunications capacity without commensurate increases in revenues. There can be no assurance that we will be able to effectively manage these and other aspects of our business. Our failure to do so would likely have a material adverse effect on our business, results of operations and financial condition. WE MAY NOT BE ABLE TO GROW OUR USER BASE IF WE ARE UNSUCCESSFUL IN ESTABLISHING AND MAINTAINING THE NETZERO BRAND. If we are unsuccessful in establishing or maintaining the NetZero brand, we may not be able to grow our user base. We believe that establishing and maintaining the NetZero brand is critical to retain and expand our user base. Promotion of the NetZero brand will depend on our success in providing high-quality Internet products and services. However, such success will depend, in part, on the services, products and efforts of third parties, over which we have little or no control. For instance, if our third party telecommunications service providers fail to provide quality service, our users' ability to access the Internet may be interrupted, which may adversely affect the NetZero brand. If our users and advertisers do not perceive our existing products and services as high quality, or if we introduce new products or services or enter into new business ventures that are not favorably received by our users and advertisers, then we may be unsuccessful in building brand recognition and brand loyalty in the marketplace. In addition, we may also need to devote substantial resources to create and maintain a distinct brand loyalty among our users and to promote and maintain the NetZero brand in a very competitive market. If we incur excessive expenses in promoting and maintaining our brand, our financial results could be adversely effected. WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY IF WE ARE NOT ABLE TO RESPOND TO CHANGING INDUSTRY STANDARDS. We may not be able to compete effectively if we are not able to adapt to changes in technology and industry standards, and to develop and introduce new and enhanced products and service offerings. We believe that our ability to compete successfully will also depend upon the continued compatibility of our services with products offered by various vendors. Although we intend to support emerging standards in the market for Internet access, we may not be able to conform our technology and equipment to support these new standards in a timely fashion. For instance, Sun Microsystems continues to upgrade its JAVA language and implementing new versions of JAVA may require additional memory and resources to implement. Our software uses the JAVA language extensively and we will have to modify our resources accordingly to accommodate new versions. There can be no assurance that we will be able to make such modifications, or any other modifications which may be required to adapt to new or changing standards, in a cost-effective and timely manner, or at all. WE MAY NOT BE ABLE TO DEVELOP NEW PRODUCT OR SERVICE OFFERINGS IF WE ARE UNABLE TO OBTAIN NEEDED TECHNOLOGY. We rely upon third parties to help us develop technologies that enhance our current product and service offerings. If our relationships with these third parties are impaired or terminated, then we would have to find other developers on a timely basis or develop technology completely on our own. 29 We cannot predict whether we will be able to obtain the third-party technology necessary for continued development and introduction of new and enhanced products and services. CONSUMERS MAY DECIDE NOT TO USE OUR SERVICE IF OUR TECHNOLOGY AND SERVICES BECOME OBSOLETE. Others may develop services or technologies that render our services or technology noncompetitive or obsolete. For instance, a number of companies are offering broadband and other high speed Internet access services, which allow users to access the Internet at much faster speeds than the access services we currently provide. Our ability to remain technologically competitive may require substantial expenditures and lead time. IF OUR SOFTWARE OR HARDWARE CONTAINS ERRORS, OUR BUSINESS COULD BE SERIOUSLY HARMED. The software and hardware used to operate and provide our services is complex and, accordingly, may contain undetected errors or failures. We have in the past encountered, and may in the future encounter, errors in the software or hardware used to operate and provide our services. This has resulted in, and may in the future result in, a number of adverse consequences, including: - users being disconnected from our service or being unable to access our service; - loss of data or revenue; - injury to reputation; and - diversion of development resources. We have experienced some technical and customer support issues associated with our products and software releases. These issues have resulted in users discontinuing our service and have adversely impacted our revenues. In addition, certain of our new services require us to bill the user, and we have limited experience in implementing billing services. We cannot assure you that we will not experience additional problems in the future. WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY IF WE ARE NOT ABLE TO PROTECT OUR PROPRIETARY RIGHTS. If we are not able to protect our proprietary rights, we may not be able to compete effectively. We principally rely upon patent, copyright, trade secret and contract laws to protect our proprietary technology. We cannot be certain that we have taken adequate steps to prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technologies. In addition, since we provide our Internet access software for free, we are extremely susceptible to various forms of unauthorized use of our software. These actions could adversely affect our brand name. In addition, we have recently filed lawsuits against a number of entities alleging that they are violating our proprietary rights. There is no assurance that we will prevail in any of these claims. Our attempts to enforce our proprietary rights could result in significant costs without a corresponding economic or competitive benefit. WE MAY INCUR SUBSTANTIAL COSTS AND DIVERSION OF MANAGEMENT RESOURCES IF WE INFRINGE UPON THE PROPRIETARY RIGHTS OF OTHERS. We have permission and, in some cases, licenses from each developer of the software that we use in our software. Although we do not believe that the software or the trademarks we use or any of the other elements of our business infringe on the proprietary rights of any third parties, third parties may assert claims against us for infringement of their proprietary rights and these claims may be successful. In addition, a number of third-party owners of patents have claimed to hold patents that cover various 30 forms of online transactions or online technology. As with other online service providers, patent claims could be asserted against us based upon our services or technologies. We could incur substantial costs and diversion of management resources in the defense of any claims relating to proprietary rights. Parties making these claims could secure a judgment awarding substantial damages as well as injunctive or other equitable relief that could effectively block our ability to use our products in the United States or abroad. If a third party asserts a claim relating to proprietary technology or information against us, we may seek licenses to the intellectual property from the third party. We cannot be certain, however, that third parties will extend licenses to us on commercially reasonable terms, or at all. If we fail to obtain the necessary licenses or other rights, it could materially and adversely affect our ability to operate our business. A SECURITY BREACH, VIRUS OR INAPPROPRIATE USE BY INTERNET USERS COULD DISRUPT OUR SERVICE. The future success of our business will depend on the security of our network and, in part, on the security of the network infrastructures of our third-party telecommunications service providers, over which we have no control. Computer viruses or problems caused by our users or other third parties, such as the sending of excessive volumes of unsolicited bulk e-mail or "spam", could lead to interruptions, delays, or cessation in service to our users. In addition, the sending of "spam" through our network could result in third parties asserting claims against us. There can be no assurance that we would prevail in such claims and our failure to do so could result in large judgments against us. Users or other third parties could also potentially jeopardize the security of confidential information stored in our computer systems or our users' computer systems by their inappropriate use of the Internet, including breaking into our computer network, which could cause losses to us or our users. Users or third parties may also potentially expose us to liability by "identity theft", or posing as another NetZero user. Unauthorized access by current and former employees or others could also potentially jeopardize the security of confidential information stored in our computer systems and those of our users. We expect that our users will increasingly use the Internet for commercial transactions in the future. Any network malfunction or security breach could cause these transactions to be delayed, not completed at all, or completed with compromised security. Users or others may assert claims of liability against us as a result of any failure by us to prevent these network malfunctions and security breaches, and may deter others from using our services, which could cause our business prospects to suffer. Although we intend to continue using industry-standard security measures, such measures have been circumvented in the past, and we cannot assure you that these measures will not be circumvented in the future. We also cannot assure you that the security measures of our third-party network providers will be adequate. In addition, to alleviate problems caused by computer viruses or other inappropriate uses or security breaches, we may have to interrupt, delay, or temporarily cease service to our users, which could have a material adverse effect on our revenues and could also result in inreased user turnover. OUR REVENUES COULD BE ADVERSELY AFFECTED IF PROGRAMS TO DISABLE THE ZEROPORT BECOME PREVALENT. Various software programs have been developed that specifically target the ZeroPort to disable our ability to deliver advertisements to a user. These programs attempt to blank out, or block, banner advertisements on the ZeroPort or completely delete the ZeroPort from users' computer screens. To date, such programs have not interrupted our operations or caused us to fail to meet the terms of our advertising agreements. While we believe we have been able to limit the effectiveness of such attempts, there can be no assurance that we will be able to continue to do so in the future. Widespread adoption of this type of software would seriously damage our ability to operate our business and generate revenues. 31 WE MAY NOT BE ABLE TO EXPAND OUR OPERATIONS IF WE ARE NOT ABLE TO OBTAIN ADDITIONAL EQUIPMENT FROM THIRD-PARTY HARDWARE SUPPLIERS. The expansion of our network infrastructure and Internet services in general is placing, and will continue to place, a significant demand on our suppliers. From time to time, we have experienced delayed delivery from suppliers of modems, servers, and other equipment. We may be unable to implement our planned expansion and our users may be unable to connect to our network if we are not able to obtain additional equipment in a timely manner and on commercially acceptable terms. In particular, our servers are a critical part of our infrastructure and we will need additional servers to expand our operations. We currently purchase, and expect to continue to purchase, all of our servers from Sun Microsystems. Since we do not have an agreement with Sun Microsystems regarding future server purchases, we have no assurance that Sun Microsystems will continue to supply servers to us on commercially acceptable terms, if at all. WE MAY EXPERIENCE LOSS OF DATA, DISRUPTION OF OPERATIONS, OR ERRONEOUS OVERCHARGES OR UNDERCHARGES TO ADVERTISING CUSTOMERS IF THE ORACLE SOFTWARE WE USE TO RUN OUR OPERATIONS FAILS TO OPERATE CORRECTLY. Virtually every aspect of our operations, including finance, billing, accounting, storage and retrieval of user data, and advertisement tracking, uses or interfaces with a centralized software system provided by Oracle. We have only limited experience with the operation of this system. Difficulty with the operation of, or errors, defects or malfunctions in the operation of, this system could result in loss of data, erroneous overcharges or undercharges to advertising customers or disruption of operations. OUR ABILITY TO OPERATE OUR BUSINESS COULD BE SERIOUSLY HARMED IF WE LOSE MEMBERS OF OUR SENIOR MANAGEMENT TEAM AND OTHER KEY EMPLOYEES. Our business is largely dependent on the personal efforts and abilities of our senior management and other key personnel. Any of our officers or employees can terminate his or her employment relationship at any time. The loss of these key employees or our inability to attract or retain other qualified employees could seriously harm our business and prospects. We do not carry key man life insurance on any of our employees. WE WILL NOT BE ABLE TO GROW OUR BUSINESS IF WE ARE NOT ABLE TO HIRE ADDITIONAL PERSONNEL. Our future success also depends on our ability to attract, retain and motivate highly skilled technical, managerial, editorial, merchandising, sales, marketing and user service personnel. Competition for such personnel is intense, particularly in the Internet and high technology industry. As a result, we may be unable to successfully attract, assimilate or retain qualified personnel. We may also be unable to retain the employees we currently employ or attract additional technical personnel. If we fail to retain and attract the necessary personnel, we may not be able to operate and grow our business. OUR BUSINESS COULD BE SHUT DOWN OR SEVERELY IMPACTED IF A NATURAL DISASTER OCCURS. Our operations and services depend on the extent to which our computer equipment and the telecommunications infrastructure of our third-party network providers are protected against damage from fire, earthquakes, power loss, telecommunications failures, and similar events. A significant portion of our computer equipment, including critical equipment dedicated to our Internet access services, is located at our headquarters and at facilities in Los Angeles and San Jose, California. Despite precautions taken by us and our third-party network providers, over which we have no control, a natural disaster or other unanticipated problems at our headquarters or at a network hub, or within a third-party network provider's network, could cause interruptions in the services that we provide. For example, if an earthquake damages equipment at our network operations center, we may have no means of replacing this equipment on a timely basis or at all and our service would be shut down. We 32 do not currently maintain fully redundant or back-up Internet services, backbone facilities or other fully redundant computing and telecommunications facilities. Furthermore, we do not currently have any business disruption insurance. Any prolonged disruption of our services due to system failure could result in user turnover and decreased revenues. WE MAY NOT REALIZE THE BENEFITS ASSOCIATED WITH OUR INTANGIBLE ASSETS As of December 31, 2000, we had approximately $55.0 million in intangible assets recorded on our balance sheet, which primarily includes goodwill and acquired technologies associated with our acquisitions. Decreases in the fair value of these assets could result in our recording impairment losses with respect to some or all such assets. Any such loss could adversely and materially impact our results of operations and financial condition. WE FACE RISKS RELATED TO THE INTERNET INDUSTRY WE COULD BE EXPOSED TO SIGNIFICANT LEGAL LIABILITY IF NEW CASE LAW IS DECIDED, OR NEW GOVERNMENT REGULATION IS ENACTED, REGARDING THE INTERNET AND INTERNET SERVICE PROVIDERS. The law relating to our business and operations is evolving and in a state of flux. The modification, repeal or adoption of laws or regulations may decrease the growth in the use of the Internet, affect telecommunications costs or increase the likelihood or scope of competition from regional telephone companies. These results could decrease the demand for our services or increase our cost of doing business, each of which would cause our gross margins and revenues to fall. In particular, the following risks could occur: REGULATION OF CONTENT AND ACCESS COULD LIMIT OUR ABILITY TO GENERATE REVENUES AND EXPOSE US TO LIABILITY. Prohibition and restriction of Internet content and access could dampen the growth of Internet use, decrease the acceptance of the Internet as a communications and commercial medium and expose us to liability. A variety of restrictions on content and access, primarily as they relate to children, have been enacted or proposed, including laws which would require Internet service providers to supply, at cost, filtering technologies to limit or block the ability of minors to access unsuitable materials on the Internet. Because of these content restrictions and potential liability to us for materials carried on or disseminated through our systems, we may be required to implement measures to reduce our exposure to liability. These measures may require the expenditure of substantial resources or the discontinuation of our product or service offerings that subject us to this liability. Further, we could incur substantial costs in defending against any of these claims and we may be required to pay large judgments or settlements or alter our business practices. In addition, our liability insurance may not cover potential claims relating to the Internet services we provide or may not be adequate to indemnify us for all liabilities that may be imposed on us. WE COULD BE EXPOSED TO LIABILITY ASSOCIATED WITH CHANGES IN OUR SERVICES OR THE SERVICES OF THIRD PARTIES. Our service involves the provision of Internet access services as well as a variety of other products and services offered under the NetZero brand or directly by sponsors. We and our sponsors have implemented, and may in the future implement, changes to such services. This may involve the termination of services by NetZero or its sponsors or changes to terms and conditions of services by NetZero or its sponsors. There can be no assurance that users, advertisers, sponsors or other third parties, including governmental agencies, will not assert claims against us for implementing such changes, or that any such claims would be resolved in our favor. 33 WE COULD BE EXPOSED TO LIABILITY FOR DEFAMATION, NEGLIGENCE AND INFRINGEMENT. Because users download and redistribute materials that are cached or replicated by us in connection with our Internet services, claims could be made against us for defamation, negligence, copyright or trademark infringement, or other theories based on the nature and content of such materials. While we have attempted to obtain safe harbor protection against claims of copyright infringement under the Digital Millennium Copyright Act of 1998, there can be no guarantee that we will prevail in any such claims. We also could be exposed to liability because of third-party content that may be accessible through our services, including links to web-sites maintained by our users or other third parties, or posted directly to our web-site, and subsequently retrieved by a third party through our services. It is also possible that if any third-party content provided through our services contains errors, third parties who access such material could make claims against us for losses incurred in reliance on such information. These types of claims have been successfully brought against other online service providers. In particular, copyright and trademark laws are evolving and it is uncertain how broadly the rights provided under these laws will be applied to online environments. It is impossible for us to determine who the potential rights holders may be with respect to all materials available through our services. OUR ABILITY TO SELL TARGETED ADVERTISING MAY BE LIMITED IF NEW LAWS RELATING TO USER PRIVACY ARE ENACTED. Our ability to sell targeted advertising partly depends on our ability to use personal information collected from our users. We cannot assure you that our current information collection procedures and disclosure policies will be found to be in compliance with existing or future laws or regulations. Our failure to comply with existing laws, or the adoption of new laws or regulations that require us to change the way we conduct our business, could make it cost-prohibitive to operate our business, and prevent us from pursuing our business strategies including the sale of targeted advertising. OUR MARGINS AND COSTS WOULD BE ADVERSELY AFFECTED IF OUR BUSINESS BECOMES SUBJECT TO TAXATION. The tax treatment of activities on or relating to the Internet is currently unsettled. A number of proposals have been made at the federal, state and local levels and by foreign governments that could impose taxes on the online sale of goods and services and other Internet activities. Recently, the Internet Tax Freedom Act was signed into law, placing a three-year moratorium on new state and local taxes on Internet commerce. However, there can be no assurance that future laws imposing taxes or other regulations on commerce over the Internet would not substantially impair the growth of Internet commerce and, as a result, negatively impact our margins or make it cost-prohibitive to operate our business. TELECOMMUNICATIONS REGULATION COULD MAKE IT MORE EXPENSIVE FOR US TO DO BUSINESS. Other than regulations generally applicable to all business, neither the Federal Communications Commission nor any other governmental agency currently directly regulates Internet service providers. Nevertheless, Internet-related regulatory policies are continuing to develop, and it is possible that we could be exposed to regulation in the future. We could be adversely affected if any regulatory or statutory change results in the application of access charges to Internet service providers, because this would substantially increase the cost of using the Internet. Similarly, new laws or regulations could increase costs to those entities who provide us with telecommunications services, and those changes too could substantially increase our cost of doing business. Since one of the largest components of our operating costs is telecommunications expense, any increase in such costs would have a material adverse effect on our cost of revenues and gross margins. We could also be affected by any change in the ability of our users to reach our network through a dial-up telephone call without any additional charges. 34 SEASONAL TRENDS IN INTERNET USAGE AND ADVERTISING SALES MAY NEGATIVELY AFFECT OUR BUSINESS. Seasonal trends could affect the advertising revenues we generate from operating our Internet services. To the extent that our advertising revenues depend on the amount of usage by our users, seasonal fluctuations in Internet usage could affect our advertising revenues during these periods of fluctuation. In addition, the rate at which new users sign up for our services may be lower during certain seasons and holiday periods. Because our operating history is so limited, it is difficult for us to accurately predict these trends and plan accordingly. Since our operating expenses are based on our expectations of future revenues, it is possible that seasonal fluctuations could materially and adversely affect our revenues and our operating results. IF INTERNET USAGE DOES NOT CONTINUE TO GROW, WE MAY NOT BE ABLE TO GROW OUR BUSINESS AND INCREASE OUR REVENUES. If our assumption that use of the Internet will continue to grow turns out to be incorrect, we will not be able to grow our business and increase our revenues. Substantially all of our revenues are dependent on the continued use and expansion of the Internet. Use of the Internet has grown dramatically, but we cannot assure you that usage of the Internet will continue to expand. A decrease in the demand for Internet services or a reduction in the currently anticipated growth for such services could cause our user base and our advertising revenues to decrease. OUR BRAND AND BUSINESS COULD BE ADVERSELY AFFECTED IF WE ARE NOT ABLE TO PROTECT OUR DOMAIN NAMES OR ACQUIRE OTHER RELEVANT DOMAIN NAMES. We currently hold the Web domain name relating to our brand, NetZero.com, as well as numerous other related Web domain names. Governmental agencies and their designees generally regulate the acquisition and maintenance of domain names. The regulation of domain names in the United States and in foreign countries is subject to change in the near future. As a result, we may be unable to acquire or maintain relevant domain names in the countries in which we conduct, or plan to conduct, business. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon, dilute or otherwise decrease the value of our trademarks and other proprietary rights. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK NetZero currently does not hold any derivative instruments and does not engage in hedging activities. Also, NetZero is not currently party to any transactions denominated in a foreign currency. Thus, NetZero's exposure to interest rate and foreign exchange fluctuations is minimal. 35 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are not a party to any material legal proceedings. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (d) USE OF PROCEEDS FROM SALES OF REGISTERED SECURITIES. On September 29, 1999, NetZero completed an initial public offering of its common stock, $.001 par value. The shares of common stock sold in this offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (Reg. No. 333-82827) that was declared effective by the SEC on September 23, 1999. The offering commenced on September 24, 1999. All 11.5 million shares of common stock registered under the Registration Statement (including 1.5 million shares sold pursuant to the exercise of the underwriters' over-allotment option) were sold at a price of $16 per share. The aggregate price of the offering amount registered was $184 million. In connection with the initial public offering, NetZero paid an aggregate of $12.9 million in underwriting discounts and commissions to the underwriters and paid other expenses in the amount of approximately $1.8 million. After deducting the underwriting discounts and commissions and offering expenses, NetZero received net proceeds from the offering of approximately $169.3 million. As of December 31, 2000, NetZero had used approximately $139 million of the net proceeds from the offering to fund its operating losses and capital expenditures. The balance of the proceeds will be used for general corporate purposes including additions and enhancements to the Company's server and network infrastructure, working capital, expansion of its sales and marketing capabilities and brand-name promotions. NetZero may also use a portion of its proceeds for acquisitions of complementary businesses, services or technology. Pending these uses, the net proceeds of the offering will be invested in short-term, interest-bearing, investment-grade instruments. None of the net proceeds from the offering were paid directly or indirectly to any director, officer, general partner of NetZero or their associates, persons owning 10% or more of any class of equity securities of NetZero, or an affiliate of NetZero. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The annual meeting of the Company's stockholders was held on November 16, 2000. One nominee to the Board of Directors, Robert Berglass, was elected to serve for a term expiring at the 2003 annual meeting and the appointment of PricewaterhouseCoopers LLP as independent accountants of the Company was ratified at the meeting. The results of voting for the election of Mr. Berglass were as follows: 77,105,466 votes for and 1,146,399 votes withheld. The remaining members of the Board of Directors who continued in office after the meeting and the year in which their terms expire are: (i) terms expiring in 2001: Ronald T. Burr and Jennifer S. Fonstad; and (ii) terms expiring in 2002: Mark R. Goldston, James T. Armstrong and Bill Gross. Bill Gross subsequently resigned his position on the Board of Directors on January 10, 2001. The results of the voting for the ratification of the appointment of PricewaterhouseCoopers LLP as independent accountants of the Company were as follows: 78,150,433 votes for, 95,315 votes against, and 6,117 absentations. 36 ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) None (b) None 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. NETZERO, INC. (REGISTRANT) By: /s/ CHARLES S. HILLIARD -------------------------------------- CHARLES S. HILLIARD SENIOR VICE PRESIDENT, FINANCE AND CHIEF FINANCIAL OFFICER Dated: February 14, 2001 37

NETZERO INC 10-Q