**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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

 

 

**FOR THEQUARTERLY PERIOD ENDED JUNE 30, 2002**

 

**OR**

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

 

 

**FOR THETRANSITION PERIOD FROM          TO**

 

**Commissionfile number 000-24643**

 

**DIGITAL RIVER, INC.**

(Exact name of registrantas specified in its charter)

 
| **DELAWARE**                                                         |   | **41-1901640**                           |
|----------------------------------------------------------------------|--------|------------------------------------------|
| (State or other jurisdiction  of  incorporation or organization)     |   | (I.R.S. Employer  Identification Number) |
|                                                                 |   |                                     |
| **9625  WEST 76TH STREET, SUITE 150  EDEN PRAIRIE, MINNESOTA 55344** |
| (Address of principal  executive offices)                            |
|                                                                 |
| **(952)  253-1234**                                                  |
| (Registrant’s telephone  number, including area code)           |

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý No o

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practical date.

 
| COMMON STOCK, $0.01 PAR VALUE |   | 26,904,097 SHARES                  |
|-------------------------------|--------|------------------------------------|
| (Class)                       |   | Outstanding as of  August 12, 2002 |

 

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DIGITAL RIVER, INC.

 

Form 10-Q

 

Index

 
| PART  I.      |   | FINANCIAL INFORMATION                                                                                       |
|---------------|--------|-------------------------------------------------------------------------------------------------------------|
|          |   |                                                                                                        |
| Item  1.      |   | Financial Statements                                                                                        |
|          |   |                                                                                                        |
|          |   | Condensed  Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001                            |
|          |   |                                                                                                        |
|          |   | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2002 and 2001 |
|          |   |                                                                                                        |
|          |   | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 2002  and 2001           |
|          |   |                                                                                                        |
|          |   | Notes  to Condensed Consolidated Financial Statements                                                       |
|          |   |                                                                                                        |
| Item  2.      |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                 |
|          |   |                                                                                                        |
| Item  3.      |   | Qualitative  and Quantitative Disclosure about Market Risk                                                  |
|          |   |                                                                                                        |
| PART  II.     |   | OTHER INFORMATION                                                                                           |
|          |   |                                                                                                        |
| Item  1.      |   | Legal Proceedings                                                                                           |
|          |   |                                                                                                        |
| Item  4.      |   | Submission  of Matters to a Vote of Security Holders                                                        |
|          |   |                                                                                                        |
| Item  6.      |   | Exhibits and Reports  on Form 8-K                                                                           |
|          |   |                                                                                                        |
| SIGNATURES    |
|          |
| EXHIBIT INDEX |

 

2

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**PARTI.****  FINANCIAL INFORMATION**

**Item1.****  Financial Statements**

 

**DIGITALRIVER, INC.**

CONDENDSED CONSOLIDATEDBALANCE SHEETS

(in thousands, exceptshare data)

 
|                                                                                                                                |   | **June 30,  2002** |       | **December 31,  2001** |       |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|------------------------|------------|
|                                                                                                                                |   | **(unaudited)**    |       |                   |       |
| **ASSETS**                                                                                                                          |   |               | ** ** |                   | ** ** |
| CURRENT ASSETS:                                                                                                                     |   |               |       |                   |       |
| Cash and cash equivalents                                                                                                           |   | $                  | 18,710     |                   | $          | 21,677 |   |
| Short-term investments                                                                                                              |   | 13,459             |       | 9,978                  |       |
| Accounts receivable, net                                                                                                            |   | 11,079             |       | 8,719                  |       |
| Prepaid expenses and other                                                                                                          |   | 1,371              |       | 1,455                  |       |
|                                                                                                                                |   |               |       |                   |       |
| Total current assets                                                                                                                |   | 44,619             |       | 41,829                 |       |
|                                                                                                                                |   |               |       |                   |       |
| PROPERTY AND EQUIPMENT, net                                                                                                         |   | 16,226             |       | 16,146                 |       |
| GOODWILL                                                                                                                            |   | 16,206             |       | 11,273                 |       |
| CUSTOMER BASE, NONCOMPETE AGREEMENTS,  TECHNOLOGY/TRADENAME,and OTHER, net                                                          |   | 10,909             |       | 8,979                  |       |
|                                                                                                                                |   |               |       |                   |       |
|                                                                                                                                |   | $                  | 87,960     |                   | $          | 78,227 |   |
|                                                                                                                                |   |               |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                      |   |               |       |                   |       |
| CURRENT LIABILITIES:                                                                                                                |   |               |       |                   |       |
| Notes payable                                                                                                                       |   | $                  | —     |                   | $          | 2,500 |   |
| Accounts payable                                                                                                                    |   | 29,961             |       | 19,360                 |       |
| Accrued payroll                                                                                                                     |   | 2,433              |       | 2,803                  |       |
| Deferred revenue                                                                                                                    |   | 1,168              |       | 1,106                  |       |
| Other accrued liabilities                                                                                                           |   | 3,720              |       | 2,036                  |       |
|                                                                                                                                |   |               |       |                   |       |
| Total current liabilities                                                                                                           |   | 37,282             |       | 27,805                 |       |
|                                                                                                                                |   |               |       |                   |       |
| STOCKHOLDERS’ EQUITY:                                                                                                          |   |               |       |                   |       |
| Preferred Stock, $.01 par value; 5,000,000 shares  authorized; no shares issued or outstanding                                      |   | —             |       | —                 |       |
| Common Stock, $.01 par value; 60,000,000 shares  authorized; 26,879,734 and 26,462,905 shares issued and outstanding,  respectively |   | 269                |       | 265                    |       |
| Additional paid-in capital                                                                                                          |   | 157,401            |       | 153,308                |       |
| Deferred compensation                                                                                                               |   | —             |       | (37                    | )          |
| Accumulated deficit                                                                                                                 |   | (106,992           | )          | (103,114               | )          |
|                                                                                                                                |   |               |       |                   |       |
| Total stockholders’ equity                                                                                                     |   | 50,678             |       | 50,422                 |       |
|                                                                                                                                |   |               |       |                   |       |
|                                                                                                                                |   | $                  | 87,960     |                   | $          | 78,227 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS

(in thousands, except per share data; unaudited)

 
|                                                                                             |   | **Three  months ended**June 30, |   | **Six  months ended**June 30, |   |
|--------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                                                             |   | **2002**                        |   | **2001**                      |   | **2002** |   | **2001** |   |
|                                                                                             |   |                            |   |                          |   |   |   |   |   |
| REVENUE                                                                                          |   | $                               | 19,347 |                          | $      | 13,055 |   | $ | 37,417 |   | $ | 26,102 |   |
| COSTS AND EXPENSES (exclusive of depreciation and  amortization expense shown separately below): |   |                            |   |                          |   |   |   |   |   |
| Direct cost of services                                                                          |   | 556                             |   | 655                           |   | 1,171 |   | 1,212 |   |
| Network and infrastructure                                                                       |   | 2,810                           |   | 2,494                         |   | 5,522 |   | 5,458 |   |
| Sales and marketing                                                                              |   | 8,402                           |   | 6,480                         |   | 16,415 |   | 13,265 |   |
| Product research and development                                                                 |   | 3,289                           |   | 2,729                         |   | 6,563 |   | 5,198 |   |
| General and administrative                                                                       |   | 1,708                           |   | 1,005                         |   | 3,323 |   | 2,102 |   |
| Litigation and other charges                                                                     |   | —                          |   | —                        |   | 2,500 |   | — |   |
| Depreciation and amortization                                                                    |   | 1,436                           |   | 1,177                         |   | 2,810 |   | 2,297 |   |
| Amortization of goodwill and other intangibles and  acquisition related costs                    |   | 1,651                           |   | 3,839                         |   | 3,200 |   | 8,483 |   |
| Total costs and expenses                                                                         |   | 19,852                          |   | 18,379                        |   | 41,504 |   | 38,015 |   |
| LOSS FROM OPERATIONS                                                                             |   | (505                            | )      | (5,324                        | )      | (4,087 | ) | (11,913 | ) |
| INTEREST INCOME                                                                                  |   | 157                             |   | 262                           |   | 209 |   | 610 |   |
|                                                                                             |   |                            |   |                          |   |   |   |   |   |
| NET LOSS                                                                                         |   | $                               | (348   | )                             | $      | (5,062 | ) | $ | (3,878 | ) | $ | (11,303 | ) |
|                                                                                             |   |                            |   |                          |   |   |   |   |   |
| BASIC AND DILUTED NET LOSS PER SHARE                                                             |   | $                               | (0.01  | )                             | $      | (0.21 | ) | $ | (0.15 | ) | $ | (0.48 | ) |
|                                                                                             |   |                            |   |                          |   |   |   |   |   |
| BASIC AND DILUTED WEIGHTED AVERAGE COMMON SHARES  OUTSTANDING                                    |   | 26,688                          |   | 24,383                        |   | 26,569 |   | 23,432 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS

(in thousands; unaudited)

 
|                                                                                       |   | **Six months  ended****June 30,** |   |
|--------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                       |   | **2002**                          |   | **2001** |   |
|                                                                                       |   |                              |   |   |   |
| OPERATING ACTIVITIES:                                                                      |   |                              |   |   |   |
| Net loss                                                                                   |   | $                                 | (3,878 | ) | $ | (11,303 | ) |
| Adjustments to reconcile net loss to net cash provided  by (used in) operating activities: |   |                              |   |   |   |
| Amortization of goodwill and other intangibles and  acquisition related costs              |   | 3,200                             |   | 8,483 |   |
| Depreciation and amortization                                                              |   | 2,810                             |   | 2,297 |   |
| Deferred compensation expense                                                              |   | 37                                |   | 101 |   |
| Litigation and other charges                                                               |   | 2,500                             |   | — |   |
| Change in operating assets and liabilities:                                                |   |                              |   |   |   |
| Accounts receivable and prepaid expenses                                                   |   | (2,299                            | )      | (1,707 | ) |
| Accounts payable                                                                           |   | 6,860                             |   | 1,596 |   |
| Other current liabilities and deferred revenue                                             |   | (1,989                            | )      | (55 | ) |
|                                                                                       |   |                              |   |   |   |
| Net cash provided (used in) by operating activities                                        |   | 7,241                             |   | (588 | ) |
| INVESTING ACTIVITIES:                                                                      |   |                              |   |   |   |
| Sales (purchases) of investments, net                                                      |   | (3,481                            | )      | 9,000 |   |
| Cash paid for acquisitions, net of cash received                                           |   | (2,778                            | )      | (307 | ) |
| Purchases of equipment                                                                     |   | (2,636                            | )      | (3,140 | ) |
| Patent acquisition costs                                                                   |   | —                            |   | (7 | ) |
| Net cash provided by (used in) investing activities                                        |   | (8,895                            | )      | 5,546 |   |
| FINANCING ACTIVITIES:                                                                      |   |                              |   |   |   |
| Exercise of stock options and warrants                                                     |   | 807                               |   | 193 |   |
| Sales of Common Stock                                                                      |   | 380                               |   | 267 |   |
| Repurchase of Common Stock                                                                 |   | —                            |   | (225 | ) |
| Repayment of notes payable                                                                 |   | (2,500                            | )      | — |   |
| Net cash provided by (used in) financing activities                                        |   | (1,313                            | )      | 235 |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                       |   | (2,967                            | )      | 5,193 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                             |   | 21,677                            |   | 16,920 |   |
| CASH AND CASH EQUIVALENTS, end of period                                                   |   | $                                 | 18,710 |   | $ | 22,113 |   |
|                                                                                       |   |                              |   |   |   |
| SUPPLEMENTAL CASH FLOW DISCLOSURE:                                                         |   |                              |   |   |   |
| Common Stock issued in acquisitions and earn-outs                                          |   | $                                 | — |   | $ | 10,386 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

5

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**DIGITALRIVER, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. BASIS OF PRESENTATION:**

 

The unaudited condensed consolidated financial statements includedherein reflect all adjustments, consisting only of normal recurringadjustments, which in the opinion of management are necessary to fairly statethe Company’s consolidated financial position, results of operations and cashflows for the periods presented.  Thesecondensed consolidated financial statements should be read in conjunction withthe Company’s audited consolidated financial statements included in theCompany’s Form 10-K for the year ended December 31, 2001 as filed with theSecurities and Exchange Commission.  Theresults of operations for the three and six months ended June 30, 2002 are notnecessarily indicative of the results to be expected for any subsequent quarteror for the entire fiscal year ending December 31, 2002.  The December 31, 2001 balance sheet wasderived from audited financial statements, but does not include all disclosuresrequired by generally accepted accounting principles.

 

**2. PRINCIPLES OFCONSOLIDATION**

 

The condensed consolidated financial statements include the accounts ofDigital River, Inc. and its wholly owned subsidiaries. All intercompanybalances and transactions have been eliminated in consolidation.

 

**3. NET LOSS PERSHARE**

 

Basic loss per common share is computed by dividing net loss by theweighted average number of shares of common stock outstanding during the year.The computation of diluted earnings per common share is similar to thecomputation of basic loss per common share, except that the denominator isincreased for the assumed conversion of convertible securities and the exerciseof dilutive options using the treasury stock method. The weighted averageshares used in computing basic and diluted loss per share were the same in eachof the three-month and six-month periods ended June 30, 2002 and 2001. Stockoptions and warrants totaling 6,652,834 and 7,538,063 for the three and sixmonth periods ended June 30, 2002 and 2001, respectively, were excluded fromthe computation of loss per share as their effect is antidilutive.

 

**4. GOODWILL AND INTANGIBLE ASSETS**

 

In July 2001, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 141, “Business Combinations” andNo. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires allbusiness combinations initiated after June 30, 2001 to be accounted for usingthe purchase method.  Under SFAS No.142, goodwill and intangible assets with indefinite lives will no longer beamortized but are reviewed annually (or more frequently if impairmentindicators arise) for impairment.  Foracquisitions consummated by the Company subsequent to July 1, 2001, the Companyadopted the provisions of SFAS No. 141 and 142 effective July 1, 2001.  The Company has adopted the full provisionsof SFAS No. 141 and 142 during the first quarter of 2002.

 

The Company has assessed goodwill impairment using a two-step approachbased on reportable segments and reassessed any intangible assets, includinggoodwill, recorded in connection with earlier acquisitions. The Company’sassessment has indicated that there is no impairment of goodwill or otherintangibles during the first quarter of 2002.

 

6

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Upon adoption of SFAS No. 142, the Company discontinued theamortization of goodwill.  The followingtable presents a reconciliation of net loss and net loss per share adjusted forthe exclusion of goodwill amortization:

 
|                        |   | **Three  months ended****June 30,** |       | **Six months ended  June 30,** |       |
|-----------------------------|--------|-------------------------------------|------------|--------------------------------|------------|
|                        |   | **2002**                            |       | **2001**                       | ** ** | **2002** | ** ** | **2001** | ** ** |
|                        |   |                                | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Reported net loss           |   | $                                   | (348,000   | )                              | $          | (5,062,000 | ) | $ | (3,878,000 | ) | $ | (11,303,000 | ) |
| Add goodwill amortization   |   | —                              |       | 2,661,000                      |       | — |   | 4,956,000 |   |
| Adjusted net loss           |   | $                                   | (348,000   | )                              | $          | (2,401,000 | ) | $ | (3,878,000 | ) | $ | (6,347,000 | ) |
|                        |   |                                | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Reported net loss per share |   | $                                   | (0.01      | )                              | $          | (0.21 | ) | $ | (0.15 | ) | $ | (0.48 | ) |
| Add goodwill amortization   |   | —                              |       | 0.11                           |       | — |   | 0.21 |   |
| Adjusted net loss per share |   | $                                   | (0.01      | )                              | $          | (0.10 | ) | $ | (0.15 | ) | $ | (0.27 | ) |

 

The changes in the carrying amount of goodwill for the six months endedJune 30, 2002, by operating segment, are as follows:

 
|                                |   | **Software  and   Digital Commerce   Services Division** |      | **E-Business    Services Division** |   | **Total** |   |
|-------------------------------------|--------|----------------------------------------------------------|-----------|-------------------------------------|--------|-----------|--------|
|                                |   |                                                     |      |                                |   |      |   |
| Balance as of December 31, 2001     |   | $                                                        | 8,280,000 |                                | $      | 2,993,000 |   | $ | 11,273,000 |   |
| Goodwill acquired during the period |   | 298,000                                                  |      | 4,635,000                           |   | 4,933,000 |   |
| Balance as of June 30, 2002         |   | $                                                        | 8,578,000 |                                | $      | 7,628,000 |   | $ | 16,206,000 |   |

 

Informationregarding the Company’s other intangible assets is as follows:

 
|                   |   | **As of June 30, 2002** |       |
|------------------------|--------|-------------------------|------------|
|                   |   | **Carrying****amount**  |       | **Accumulated****amortization** |   | **Net** |   |
|                   |   |                    | ** ** |   | ** ** |   | ** ** |
| Customer base          |   | $                       | 14,117,000 |   | $ | 6,575,000 |   | $ | 7,542,000 |   |
| Non compete agreements |   | 3,150,000               |       | 2,111,000 |   | 1,039,000 |   |
| Technology/tradename   |   | 5,675,000               |       | 3,372,000 |   | 2,303,000 |   |
| Total                  |   | $                       | 22,942,000 |   | $ | 12,058,000 |   | $ | 10,884,000 |   |

 
|                   |   | **As of December 31, 2001** |       |
|------------------------|--------|-----------------------------|------------|
|                   |   | **Carrying****amount**      |       | **Accumulated****amortization** |   | **Net** |   |
|                   |   |                        |       |   |   |   |   |
| Customer base          |   | $                           | 9,317,000  |   | $ | 4,728,000 |   | $ | 4,589,000 |   |
| Non compete agreements |   | 3,050,000                   |       | 1,610,000 |   | 1,440,000 |   |
| Technology/tradename   |   | 5,425,000                   |       | 2,520,000 |   | 2,905,000 |   |
| Total                  |   | $                           | 17,792,000 |   | $ | 8,858,000 |   | $ | 8,934,000 |   |

 

7

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Amortization expense for the six months ended June 30, 2002 was$3,200,000.  Estimated amortizationexpense for the remaining life of the intangible assets, based on intangibleassets as of June 30, 2002, is as follows:

 

Year ending December 31,

 

| 2002 |   | $         | 5,738,000 |
|------|--------|-----------|-----------|
| 2003 |   | 4,727,000 |
| 2004 |   | 3,190,000 |
| 2005 |   | 429,000   |

 

**5. ACQUISITIONS AND EARN-OUTARRANGEMENTS**

 

In March 2002, pursuant to an Asset Purchase Agreement between theCompany and Innuity Acquisition Corp. (“IAC”), the Company purchased certainassets and assumed approximately $3,600,000 in merchant liabilities in exchangefor approximately $2,400,000 in cash. The Company will amortize intangible assets acquired, consisting ofcustomer base, non-compete agreements and technology/tradename over athree-year period.  The agreementincludes an opportunity for a cash earn-out based on revenue generated from theIAC assets during the 12-month period following the close of thetransaction.  Such amounts, if any, willbe recorded as additional goodwill.

 

In March 2002, pursuant to an Amended and Restated Asset PurchaseAgreement (the “Agreement”) between the Company and Beyond.com Corporation(“Beyond.com”), in exchange for 179,096 shares of the Company’s Common Stock,the Company purchased those assets and assumed those liabilities of Beyond.comrelated to its eStores business, which manages online stores for clients. TheCompany will amortize intangible assets acquired, consisting of customer baseand non-compete agreements, over a three-year period. The purchase was approvedby the U.S. Bankruptcy Court following Beyond.com’s filing for Chapter 11bankruptcy protection.  Immediately followingthe closing of the Agreement, the Company entered into a Post-Closing Amendmentto the Agreement with Beyond.com (the “Post-Closing Amendment”), pursuant towhich, among other things, the Company agreed to increase the number of sharesto be delivered to Beyond.com under the Agreement to 222,842, in exchange for arelease of certain potential claims by Beyond.com against the Company.  The Post-Closing Amendment is subject toapproval by the U.S. Bankruptcy Court. The Official Committee of Unsecured Creditors has objected to thePost-Closing Amendment, asserting that the increase in shares to be deliveredto Beyond.com under the Post-Closing Amendment is inadequate.  The U.S. Bankruptcy Court is currently scheduledto consider the approval of the Post-Closing Amendment on September 10,2002.  Beyond.com is also asserting thatit is entitled to additional shares with a value of $910,000 under theAgreement pursuant to provisions of the Agreement under which Beyond.com couldearn additional consideration post-closing if certain clients of Beyond.comimmediately prior to the closing maintain or establish client relationshipswith the Company following the closing. The Company disagrees that any of such shares are due to Beyond.comunder the Agreement. Of the shares issued at closing, 70,000 shares were placedin escrow to secure certain indemnification obligations contained in theagreement.  The parties have agreed that8,277 of these shares are to be returned to the Company to satisfy outstandingclaims under the escrow.  An additional13,792 of these shares are subject to additional outstanding claims and willremain in escrow pending resolution of such claims; the remaining 47,931 shareswill be released to Beyond.com.

 

The former owners of FreeMerchant.com, a company purchased by theCompany in December 2001, received earn-out payments totaling $420,000 duringthe six months ended June 30, 2002.  TheCompany recorded such amounts as additional goodwill.

 

Following is an allocation of the purchase price for the acquisitionsconsummated in the six months ended June 30, 2002:

 

| Tangible assets        |   | $          | 231,000   |   |
|------------------------|--------|------------|-----------|--------|
| Liabilities assumed    |   | (3,717,000 | )         |
| Customer base          |   | 4,800,000  |      |
| Non-compete agreements |   | 100,000    |      |
| Technology/tradename   |   | 250,000    |      |
| Goodwill               |   | 4,513,000  |      |
| Total purchase price   |   | $          | 6,177,000 |   |

 

8

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The following unaudited pro forma condensed results of operations forthe six months ended June 30, 2002 and 2001 has been prepared as if each of theacquisitions had occurred on January 1, 2001:

 

|                                 |   | **Six  months ended  June 30,** |       |
|--------------------------------------|--------|---------------------------------|------------|
|                                 |   | **2002**                        |       | **2001** |   |
|                                 |   |                            | ** ** |   | ** ** |
| Revenue                              |   | $                               | 39,406,000 |   | $ | 29,299,000 |   |
| Loss from operations                 |   | (6,596,000                      | )          | (17,418,000 | ) |
| Net loss                             |   | (7,222,000                      | )          | (17,996,000 | ) |
| Basic and diluted net loss per share |   | $                               | (0.27      | ) | $ | (0.76 | ) |

 

This financial information does not purport to represent results thatwould actually have been obtained if the transactions had been in effect onJanuary 1, 2001 or any future results that may in fact be realized.

 

**6. SEGMENT INFORMATION**

 

The Company has two operating segments, Software and Digital CommerceServices and E-Business Services, which have been identified as components ofthe Company that are reviewed regularly by management to determine resourceallocation and assess performance.  Unallocatedcorporate items consist of pending litigation and other charges, depreciation,amortization of goodwill and other intangibles and acquisition related costs,and interest income for operational results and consist of certain cash,investments and goodwill and other intangibles for total assets.  Segment information is as follows:

 
|                                   |   | **Software and   Digital Commerce   Services Division** |       | **E-Business   Services Division** |       | **Unallocated   Corporate   Items** |       | **Consolidated** |       |
|----------------------------------------|--------|---------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|------------------|------------|
| **Three  months ended June  30, 2002** |   |                                                    |       |                               |       |                                |       |             |       |
| Revenue                                |   | $                                                       | 15,104,000 |                               | $          | 4,243,000                           |       | $                | —     |   | $ | 19,347,000 |   |
| Gross profit                           |   | 12,789,000                                              |       | 3,192,000                          |       | —                              |       | 15,981,000       |       |
| Income (loss) from operations          |   | 4,610,000                                               |       | (2,028,000                         | )          | (3,087,000                          | )          | (505,000         | )          |
| Net income (loss)                      |   | 4,610,000                                               |       | (2,028,000                         | )          | (2,930,000                          | )          | (348,000         | )          |
| Total assets at June 30, 2002          |   | $                                                       | 29,913,000 |                               | $          | 16,622,000                          |       | $                | 41,425,000 |   | $ | 87,960,000 |   |
|                                   |   |                                                    |       |                               |       |                                |       |             |       |
| **Three months ended June 30, 2001**   |   |                                                    | ** ** |                               | ** ** |                                | ** ** |             | ** ** |
| Revenue                                |   | $                                                       | 9,461,000  |                               | $          | 3,594,000                           |       | $                | —     |   | $ | 13,055,000 |   |
| Gross profit                           |   | 7,367,000                                               |       | 2,539,000                          |       | —                              |       | 9,906,000        |       |
| Income (loss) from operations          |   | 1,551,000                                               |       | (1,859,000                         | )          | (5,016,000                          | )          | (5,324,000       | )          |
| Net income (loss)                      |   | 1,551,000                                               |       | (1,859,000                         | )          | (4,754,000                          | )          | (5,062,000       | )          |
| Total assets at June 30, 2001          |   | $                                                       | 18,141,000 |                               | $          | 8,277,000                           |       | $                | 44,213,000 |   | $ | 70,631,000 |   |

 

9

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|                               |   | **Software and   Digital Commerce   Services Division** |       | **E-Business   Services Division** |       | **Unallocated   Corporate   Items** |       | **Consolidated** |       |
|------------------------------------|--------|---------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|------------------|------------|
| **Six months ended June 30, 2002** |   |                                                    | ** ** |                               | ** ** |                                | ** ** |             | ** ** |
| Revenue                            |   | $                                                       | 29,801,000 |                               | $          | 7,616,000                           |       | $                | —     |   | $ | 37,417,000 |   |
| Gross profit                       |   | 25,171,000                                              |       | 5,553,000                          |       | —                              |       | 30,724,000       |       |
| Income (loss) from operations      |   | 8,985,000                                               |       | (4,562,000                         | )          | (8,510,000                          | )          | (4,087,000       | )          |
| Net income (loss)                  |   | 8,985,000                                               |       | (4,562,000                         | )          | (8,301,000                          | )          | (3,878,000       | )          |
|                               |   |                                                    |       |                               |       |                                |       |             |       |
| **Six months ended June 30, 2001** |   |                                                    | ** ** |                               | ** ** |                                | ** ** |             | ** ** |
| Revenue                            |   | $                                                       | 19,973,000 |                               | $          | 6,129,000                           |       | $                | —     |   | $ | 26,102,000 |   |
| Gross profit                       |   | 15,171,000                                              |       | 4,261,000                          |       | —                              |       | 19,432,000       |       |
| Income (loss) from operations      |   | 3,200,000                                               |       | (4,333,000                         | )          | (10,780,000                         | )          | (11,913,000      | )          |
| Net income (loss)                  |   | 3,200,000                                               |       | (4,333,000                         | )          | (10,170,000                         | )          | (11,303,000      | )          |

 

**7. RECENT ACCOUNTING PRONOUNCEMENTS**

 

In July 2001, the Financial Accounting Standards Board issued SFAS No.144, “Impairment or Disposal of Long-Lived Assets”, which is effective forfiscal years beginning after December 15, 2001. The provisions of thisstatement provide a single accounting model for impairment of long-livedassets. The Company adopted SFAS No. 144 effective January 1, 2002.  The adoption of this statement did not havea material impact on the Company’s financial position or results of operations.

 

**8. LITIGATION AND OTHER CHARGES**

 

During March 2002, the Company recorded a charge for pending litigationof $2,300,000.  This reserve wasestablished based upon developments in new and existing litigation for whichmanagement determined, in the first quarter of 2002, that payment is bothprobable and estimable.  Additionally,the Company recorded a charge of $200,000 during March 2002 in connection withits decision during the period to consolidate one of its offices.

 

10

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**Item2.****  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*The Company notes that, except forthe historical information contained herein, the matters discussed belowcontain forward-looking statements which involve known and unknown risks,uncertainties and other factors which may cause the actual results, performanceor achievements of the Company, or industry results, to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements.  TheCompany expressly disclaims any obligation to update this information orpublicly release any revision or reflect events or circumstances after the dateof this report.  Such factors include,among others:  the Company’s limitedoperating history and variability of operating results, expectation of futurelosses, risks associated with electronic software delivery, dependence on theInternet and growth in electronic commerce and Internet infrastructuredevelopment, dependence on software publishers, dependence on online retailers,system development and electronic commerce security risks, rapid technologicalchanges, competition in the electronic commerce industry, the importance ofattracting and retaining personnel, management of the company’s growth,integration of acquired companies, dependence on key employees and other riskfactors referenced in the Company’s Form 10-K for the year ended December 31,2001.*

 

**Overview**

 

The Company is a leading provider of comprehensive electronic commerceoutsourcing solutions.  The Company wasincorporated in February 1994 and commenced offering products for sale throughits clients’ Web stores in August 1996. From inception through August 1996, the Company had no sales, and itsactivities related primarily to the development of its Commerce Network Server(“CNS”) technology related to electronic commerce.  In 1996, the Company began to focus its business developmentefforts on the software industry, building its inventory of software productsthrough contracts with software publishers. In 1997, the Company began to develop software distributionrelationships through contracts with online retailers.  In late 1998, the Company began to offer itscomprehensive electronic commerce outsourcing services in the form of a transactionfee-based e-commerce service to clients outside of the software industry.  The Company currently offers more than32,000 companies the ability to cut costs and grow their businesses by usingits complete e-commerce systems and services.

 

The Company derives its revenue primarily from transaction and servicefees associated with the e-commerce services that the Company provides to itsclients.  These services include Webcommerce development and hosting, transaction processing, digital delivery, integrationto physical fulfillment, fraud screening, customer service and merchandisingand analytical marketing services.  TheCompany acts as the merchant of record on the majority of the transactionsprocessed and has contractual relationships with its clients, primarilysoftware publishers and online retailers, which obligate the Company to pay tothe client a specified percentage of each sale.  The Company retains its transaction fee and also charges forvarious service fees.  The Company alsoderives revenue from fees charged to use its software, integration, developmentand consulting services provided to its clients.  This revenue is recognized as services are performed, except forsoftware usage fee and certain integration and development fees, which arerecognized evenly over the term of the contract.

 

The Company has a limited operating history upon which investors mayevaluate its business and prospects. Since inception, the Company has incurred significant losses, and as ofJune 30, 2002, had an accumulated deficit of $106,992,000.  The Company intends to expend financial andmanagement resources on the development of additional services, sales andmarketing, technology and operations to support larger-scale operations andgreater service offerings, particularly with respect to the E-Business Servicesdivision.  Although the Company expectsto generate positive cash flow from operations in 2002, there can be noassurance that the Company’s revenue will increase or even continue at itscurrent level or that the Company will achieve or maintain profitability orgenerate cash from operations in future periods.

 

11

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The Company’s prospects must be considered in light of the risks,expenses and difficulties frequently encountered by companies in their earlystage of development, particularly companies in new and rapidly evolvingmarkets such as electronic commerce.  Toaddress these risks, the Company must, among other things, maintain existingand develop new relationships with software publishers, online retailers andE-Business Services clients, implement and successfully execute its businessand marketing strategy, continue to develop and upgrade its technology andtransaction-processing systems, provide superior customer service and orderfulfillment, respond to competitive developments, and attract, retain andmotivate qualified personnel.  There canbe no assurance that the Company will be successful in addressing such risks,and the failure to do so would have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

The Company’s current and future expense levels are based largely onits planned operations and estimates of future revenue.  Revenue and operating results generallydepend on the volume and timing of orders received, which are difficult toforecast.  The Company may be unable toadjust spending in a timely manner to compensate for any unexpected revenueshortfall.  Accordingly, any significantshortfall in revenue could have an immediate adverse effect on the Company’sbusiness, financial condition and results of operations.  The Company is also likely to continue tosee revenue in its Software and Digital Commerce Services Division fluctuate ona seasonal basis typical for the software publishing market in general.  The Company believes that its fiscal firstand fourth quarters are seasonally stronger than its second and third quartersdue to the timing of demand for tax preparation software and the holidayselling period.  In addition, it is theCompany’s belief that software publishers generally avoid new product releasesin the summer months.  In view of therapidly evolving nature of the Company’s business and its limited operatinghistory, the Company is unable to accurately forecast its revenue and believesthat period-to-period comparisons of its operating results are not necessarilymeaningful and should not be relied upon as an indication of futureperformance.

 

**Results of Operations**

 

The following table sets forth certain items from the Company’scondensed consolidated statements of operations as a percentage of totalrevenue for the periods indicated.

 
|                                                                          |   | **Three  months ended  June 30,** |       | **Six  months ended  June 30,** |       |
|-------------------------------------------------------------------------------|--------|-----------------------------------|------------|---------------------------------|------------|
|                                                                          |   | **2002**                          |       | **2001**                        |       | **2002** |   | **2001** |   |
|                                                                          |   |                              | ** ** |                            | ** ** |   | ** ** |   | ** ** |
| Revenue                                                                       |   | 100.0                             | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                            |   |                              |       |                            |       |   |   |   |   |
| Direct cost of services                                                       |   | 2.9                               |       | 5.0                             |       | 3.1 |   | 4.6 |   |
| Network and infrastructure                                                    |   | 14.5                              |       | 19.1                            |       | 14.8 |   | 20.9 |   |
| Sales and marketing                                                           |   | 43.4                              |       | 49.6                            |       | 43.9 |   | 50.8 |   |
| Product research and development                                              |   | 17.0                              |       | 20.9                            |       | 17.5 |   | 19.9 |   |
| General and administrative                                                    |   | 8.8                               |       | 7.7                             |       | 8.9 |   | 8.1 |   |
| Litigation and other charges                                                  |   | —                            |       | —                          |       | 6.7 |   | — |   |
| Depreciation and amortization                                                 |   | 7.4                               |       | 9.0                             |       | 7.5 |   | 8.8 |   |
| Amortization of goodwill and other intangibles and  acquisition related costs |   | 8.6                               |       | 29.5                            |       | 8.5 |   | 32.5 |   |
| Total operating expenses                                                      |   | 102.6                             |       | 140.8                           |       | 110.9 |   | 145.6 |   |
| Loss from operations                                                          |   | (2.6                              | )          | (40.8                           | )          | (10.9 | ) | (45.6 | ) |
| Interest income, net                                                          |   | 0.8                               |       | 2.0                             |       | 0.5 |   | 2.3 |   |
| Net loss                                                                      |   | (1.8                              | )%         | (38.8                           | )%         | (10.4 | )% | (43.3 | )% |

 

12

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***REVENUE.*** Revenue increased to $19,347,000 for thethree months ended June 30, 2002 from $13,055,000 for the same period in theprior year, an increase of $6,292,000 or 48.2%.  For the six months ended June 30, 2002, revenue totaled$37,417,000, an increase of $11,315,000 or 43.3% from revenue of $26,102,000recorded in the same period of the prior year. Revenue for the Software andDigital Commerce Services division increased to $15,104,000 for the threemonths ended June 30, 2002 from $9,461,000 for the three months ended June 30, 2001and increased to $29,801,000 for the six months ended June 30, 2002, up from$19,973,000 for the same period in 2001. The increase in the three and six-month periods primarily resulted fromgrowth in the number of the Company’s software publisher and online retailerclients, including the impact of the clients gained in the acquisition of theeStore Group of Beyond.com Corporation in March 2002, as well as increasingmarket acceptance of electronic software delivery.  In addition, results for the current year three and six-monthperiods include the impact of revenue generated by RegSoft.com, a companyacquired by the Company in August 2001. Revenue for the E-Business Services division increased to $4,243,000 forthe three months ended June 30, 2002 from $3,594,000 for the three months endedJune 30, 2001 and increased to $7,616,000 for the six months ended June 30,2002, up from $6,129,000 for the same period in 2001.  These increases primarily reflect the impact of the Company’sacquisitions of Orbit Commerce assets in September 2001, the FreeMerchant.comassets of Network Commerce in December 2001 and the CCNow assets of InnuityAcquisition Corp. in March 2002.

 

International sales represented approximately 22% of total revenue inthe three-month periods ended June 30, 2002 and 2001, and approximately 20% and14% of total revenue in the six-month periods ended June 30, 2002 and 2001,respectively.

 

***GROSS PROFIT.***Cost of revenue, which consists of directcost of services and network and infrastructure costs (both shown exclusive ofdepreciation and amortization expense), increased to $3,366,000 for the threemonths ended June 30, 2002 from $3,149,000 for the same period in the prioryear.  For the six months ended June 30,2002, cost of revenue increased to $6,693,000, up from $6,670,000 for the sameperiod in the prior year.  The increasefor the three-month period primarily resulted from increased personnel costs incustomer service to handle the additional client load along with increases ininformation systems and bandwidth costs. For the six-month period, decreases in customer service costs wereoffset by increases in information systems and bandwidth costs.  The gross profit margin for the Software andDigital Commerce Services division rose in the three and six months ended June30, 2002 to 84.7% and 84.5%, respectively, from 77.9% and 76.0% for the sameperiods of the prior year.  The grossprofit margin for the E-Business Services division increased in the three andsix months ended June 30, 2002 to 75.2% and 72.9%, respectively, compared to70.6% and 69.5% for the same periods of the prior year.  The increase in margin in both divisions isprimarily due to leveraging the Company’s infrastructure over significantlymore revenue and clients.  The Companybelieves that Internet commerce and related services could become morecompetitive in the future.  Accordingly,the Company may reduce or alter its pricing structure and policies in thefuture and any such change could reduce gross margins.

 

***SALES AND MARKETING.***Sales andmarketing expense consists primarily of personnel and related expenses,advertising and promotional expenses, credit card chargebacks and bad debtexpense, and credit card transaction fees. Sales and marketing expense increased to $8,402,000 for the three monthsended June 30, 2002 from $6,480,000 for the same period in the prior year, anincrease of $1,922,000 or 29.7%.  Forthe six months ended June 30, 2002, sales and marketing expense increased to$16,415,000 compared to $13,265,000 for the same period in the prior year, anincrease of $3,150,000 or 23.7%.  Theseincreases primarily resulted from an increase in credit card fees andchargeback costs along with an increase in personnel costs, offset by adecrease in advertising and marketing expense. Sales and marketing expense for the Software and Digital CommerceServices division increased to $5,585,000 and $11,097,000 for the three and sixmonths ended June 30, 2002, respectively, from $3,929,000 and $8,309,000 forthe same periods in the prior year. Sales and marketing expense for the E-Business Services divisionincreased to $2,817,000 and $5,318,000 for the three and six months ended June30, 2002, respectively, from $2,551,000 and $4,956,000 for the same periods inthe prior year.  As a percentage ofrevenue, sales and marketing expense was 43.4% and 43.9% in the three andsix-month periods ended June 30, 2002, respectively, compared to 49.6% and50.8% for the same periods in the prior year, primarily reflecting theCompany’s increased revenue.  TheCompany expects that sales and marketing expense will continue to increase inabsolute dollars as the Company continues to build its sales and marketinginfrastructure and develops marketing programs and as volume–drivencredit card expenses increase.  As apercentage of revenue, these expenses are expected to decrease as revenueincreases.

 

13

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***PRODUCT RESEARCHAND DEVELOPMENT.*** Product research anddevelopment expense consists primarily of personnel and related expenses andconsulting costs associated with developing and enhancing the Company’s CNS andrelated internal systems.  Productresearch and development expense increased to $3,289,000 for the three monthsended June 30, 2002 from $2,729,000 for the same period in the prior year, anincrease of $560,000 or 20.5%.  For thesix months ended June 30, 2002, product research and development expenseincreased to $6,563,000 compared to $5,198,000 for the same period in the prioryear, an increase of $1,365,000 or 26.3%. These increases primarily resulted from the discontinuance ofcapitalizing product development costs in 2002.  In the prior year three and six-month periods, the Companycapitalized product development costs related to the Company’s new platform,which totaled $460,000 and $672,000, respectively.  No product development costs were capitalized in the current yearperiods. The increase in the current year six-month period is also due toincreased personnel costs, offset by a reduction in consulting costs.  Product research and development expense forthe Software and Digital Commerce Services division increased to $1,364,000 and$2,770,000 for the three and six months ended June 30, 2002, respectively, from$978,000 and $2,005,000 for the same periods in the prior year.  Product research and development expense forthe E-Business Services division increased to $1,925,000 and $3,793,000 for thethree and six months ended June 30, 2002, respectively, from $1,751,000 and$3,193,000 for the same periods in the prior year.  As a percentage of revenue, product research and developmentexpense was 17.0% and 17.5% in the three and six-month periods ended June 30,2002, respectively, compared to 20.9% and 19.9% for the same periods in theprior year.  As a percentage of revenue,these expenses are expected to decrease further as revenue increases.

 

***GENERAL ANDADMINISTRATIVE.***Generaland administrative expense consists primarily of executive, accounting andadministrative personnel and related expenses including professional fees andinvestor relations expenses.  Generaland administrative expenses increased to $1,708,000 for the three months endedJune 30, 2002 from $1,005,000 for the same period in the prior year, anincrease of $703,000 or 70.0%.  For thesix months ended June 30, 2002, general and administrative expense increased to$3,323,000 compared to $2,102,000 for the same period in the prior year, anincrease of $1,221,000 or 58.1%.  Theseincreases resulted from an increase in legal costs related to the outstandingclaims against the Company. In addition, the Company has incurred increasedpersonnel and insurance related costs in the current year periods.  General and administrative expense for theSoftware and Digital Commerce Services division increased to $1,230,000 and$2,319,000 for the three and six months ended June 30, 2002, respectively, from$696,000 and $1,444,000 for the same periods in the prior year.  General and administrative expense for theE-Business Services division increased to $478,000 and $1,005,000 for the threeand six months ended June 30, 2002, respectively, from $309,000 and $658,000for the same periods in the prior year. As a percentage of revenue, general and administrative expense was 8.8%and 8.9% in the three and six-month periods ended June 30, 2002, respectively,compared to 7.7% and 8.1% for the same periods in the prior year, primarilyreflecting the increase in legal fees in the current year periods.  The Company expects that general andadministrative expense will increase in absolute dollars over time as theCompany defends its position related to legal claims and as it continues tobuild infrastructure to support its growth.

 

***LITIGATION ANDOTHER CHARGES.***Duringthe six months ended June 30, 2002, the Company recorded a charge for pendinglitigation of $2,300,000.  This reservewas established based upon developments in new and existing litigation forwhich management determined, in the first quarter of 2002, that payment is bothprobable and estimable.  Additionally,the Company recorded a charge of $200,000 during the six months ended June 30,2002 in connection with its decision during the period to consolidate one ofits offices.

 

***AMORTIZATION OFGOODWILL AND OTHER INTANGIBLES AND ACQUISITION RELATED COSTS.***Amortization of goodwill and otherintangibles and acquisition related costs decreased to $1,651,000 for the threemonths ended June 30, 2002 from $3,839,000 for the same period in the prioryear.  For the six months ended June 30,2002, amortization of goodwill and other intangibles and acquisition relatedcosts decreased to $3,200,000 compared to $8,483,000 for the same period in theprior year.  The decrease is primarilyrelated to the impact of the Company’s adoption of Statement of FinancialAccounting Standards No. 142, resulting in goodwill no longer being amortized(see Note 4 of Notes to Condensed Consolidated Financial Statements).  In addition, compensation based earn-outpayments totaling $1,514,000 were made in the six months ended June 30,2001.  There were no compensation basedearn-out payments in the six months ended June 30, 2002.

 

14

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***INCOME TAXES.***The Company paid no income taxes in anyreported period.  The Company hasincurred a net loss for each period since inception.  As of June 30, 2002, the Company had approximately $86,278,000 ofnet operating loss carryforwards for federal income tax purposes, which expirebeginning in 2009.  Due to theuncertainty of future profitability, a valuation allowance equal to the deferredtax asset has been recorded.  Certainchanges in ownership that resulted from the sales of common and preferred stockwill limit the future annual realization of the tax operating losscarryforwards to a specified percentage under Section 382 of the InternalRevenue Code.

 

**Liquidity and Capital Resources**

 

During the six months ended June 30, 2002, the Company’s operationsgenerated $7,241,000 of cash compared to a $588,000 use of cash for the sameperiod of the prior year.  Theimprovement is mainly due to the reduction in the net loss and improved balancesheet leverage in the current year six-month period compared to the same periodlast year.  Net cash used in investingactivities during the six months ended June 30, 2002, totaled $8,895,000.  This was comprised of investments inequipment and for acquired companies totaling $5,414,000 along with netpurchases of investments totaling $3,481,000. Net cash used in financing activities during the six months ended June30, 2002 totaled $1,313,000, comprised of the payoff of a $2,500,000 note payableoffset by cash received upon the sale of stock and the exercise of stockoptions and warrants.

 

As of June 30, 2002, the Company had $18,710,000 of cash and cashequivalents and $13,459,000 of short-term investments.  The Company’s principal commitmentsconsisted of obligations outstanding under operating leases.  Although the Company has no materialcommitments for capital expenditures, it anticipates continued capitalexpenditures consistent with its anticipated growth in operations,infrastructure and personnel.  TheCompany anticipates that it will expend approximately $12,000,000 over the next18 months on capital expenditures based on its current anticipated growthrate.  The Company further anticipatesthat it will expend approximately $16,000,000 over the next 18 months onproduct development based on its current anticipated growth rate inoperations.  The Company may also usecash to acquire or license technology, products or businesses related to theCompany’s current business.  The Companyalso anticipates that it will experience growth in its operating expenses forthe foreseeable future and that its operating expenses will be a material useof the Company’s cash resources.

 

In April 2001, the Company initiated a share repurchase program of upto $5,000,000 of its outstanding shares of Common Stock.  Repurchases will be at the Company’sdiscretion based on ongoing assessments of the capital needs of the businessand the market price of its shares.  Notime limit was set for completion of the repurchase program.  Through June 30, 2002, the Company expendedapproximately $267,000 to repurchase its shares.

 

The Company believes that existing sources of liquidity and the resultsof its operations will provide adequate cash to fund its operations for atleast the next 18 months, although the Company may seek to raise additionalcapital during that period.  In January2002, the Company filed a universal shelf registration statement with theSecurities and Exchange Commission pursuant to which the Company will bepermitted to issue up to $100,000,000 in common stock, preferred stock, debtsecurities and/or warrants.  The sale ofadditional equity or convertible securities could result in additional dilutionto the Company’s stockholders.  Therecan be no assurance that financing will be available in amounts or on termsacceptable to the Company, if at all.

 

**Recent Accounting Pronouncements**

 

In July 2001, the Financial Accounting Standards Board issued SFAS No.144, “Impairment or Disposal of Long-Lived Assets”, which is effective forfiscal years beginning after December 15, 2001. The provisions of thisstatement provide a single accounting model for impairment of long-livedassets. The Company adopted SFAS No. 144 effective January 1, 2002.  The adoption of this statement did not havea material impact on the Company’s financial position or results of operations.

 

**Item3.****  Qualitative and QuantitativeDisclosure About Market Risk**

 

The Company does not enter into financial instruments for trading orspeculative purposes and does not currently utilize derivative financialinstruments.  The operations of theCompany are conducted primarily in the United States and as such are notsubject to material foreign currency exchange rate risk.  The Company has no long-term debt.

 

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**PARTII.****  OTHER INFORMATION**

 

**Item 1.****  Legal Proceedings**

 

The Company is party to a patent infringement lawsuit filed against itand over 200 additional defendants regarding United States Patent No. 4,500,919assigned to the Massachusetts Institute of Technology. The suit was filed inApril 2002 and is pending in the U.S. District Court in the Eastern District ofTexas. The Company intends to tender the defense of the lawsuit to the clientsof the allegedly infringing products and to seek full indemnification from itsclients.  The Company has denied thepatent infringement allegations.

 

**Item4.****  Submission of Matters to a Vote ofSecurity Holders**

 

The Company’s annual meeting of stockholders was held on May 20,2002.  The stockholders were asked toconsider the election of a director nominee, Thomas F. Madison, as a directorto serve until the 2005 annual meeting of stockholders.  The proposal received 20,850,183 affirmativevotes and 191,124 votes were withheld. Timothy C. Choate, William J. Lansing and Frederic M. Seegal willcontinue in office as directors until the 2003 annual meeting ofstockholders.  Joel A. Ronning, Perry W.Steiner and J. Paul Thorin will continue in office as directors until the 2004annual meeting of stockholders.

 

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**Item6.****  Exhibits and Reports on Form 8-K**

 

(A) Exhibits

 
| **EXHIBIT  NUMBER** |   | **DESCRIPTION  OF DOCUMENTS**                                                          |
|---------------------|--------|----------------------------------------------------------------------------------------|
|                |   |                                                                                   |
| 3.1                 | (1)    | Amended and Restated Certificate of Incorporation, as amended, as  currently in effect |
| 3.2                 | (2)    | Amended and Restated Bylaws, as currently in effect                                    |
| 4.1                 | (3)    | Specimen of Common Stock Certificate                                                   |
| 11.1                | (4)    | Statement of Computation of Per Share Earnings                                         |

 

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| (1) | Filed as Exhibits 3.1 and 3.3 to the Company’s Registration Statement  on Form S-3, File No. 333-81626, filed on January 29, 2002, declared  effective on February 12, 2002, and incorporated herein by reference. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Filed as an exhibit to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2000, filed on March 27, 2001, and incorporated  herein by reference.                                             |
| (3) | Filed as an exhibit to the Company’s Registration Statement on Form  S-1, File No. 333-56787, declared effective on August 11, 1998, and  incorporated herein by reference.                                        |
| (4) | See Note 3 to Condensed Consolidated Financial Statements.                                                                                                                                                              |

 

(B) Reports on Form 8-K

 

On April 15, 2002, the Company filed a current report on Form 8-Kreporting the acquisition (the “Acquisition”) on March 31, 2002 of the assetsand liabilities of the eStore Group, a division of Beyond.com Corporation(“Beyond.com”).

 

On June 14, 2002, the Company filed a current report on Form 8-K/Aproviding, in connection with the Acquisition, certain financial statements of Beyond.com’s eStore Group.  The Company provided the audited financialstatements of the eStore Group as of and for the year ended December 31, 2000and the unaudited interim financial statements of the eStore Group for the ninemonths ended September 30, 2001 and 2000. The Company also provided a pro forma unaudited condensed consolidated balancesheet as of September 30, 2001 and pro forma unaudited condensed consolidatedstatements of operations for the nine months ended September 30, 2001 and forthe year ended December 31, 2000.

 

On June 18, 2002, the Company filed a current report on Form 8-Kannouncing that on June 13, 2002, based upon the approval of its AuditCommittee, the Company had terminated Arthur Andersen LLP and engaged Ernst& Young LLP as its as its independent accountants for the fiscal yearending December 31, 2002.

 

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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 theundersigned thereunto duly authorized.

 
| Date:  | August 14, 2002 |   | DIGITAL RIVER, INC.                                                                    |
|--------|-----------------|--------|----------------------------------------------------------------------------------------|
|   |            |   |                                                                                   |
|   |            |   |                                                                                   |
|   |            | By:    | /s/ CARTER D. HICKS                                                                    |
|   |            |   | Carter D. Hicks*Chief Financial Officer  (Principal Financial and Accounting Officer)* |

 

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EXHIBIT INDEX

 
| **EXHIBIT  NUMBER** |   | **DESCRIPTION  OF DOCUMENTS**                                                          |
|---------------------|--------|----------------------------------------------------------------------------------------|
| 3.1                 | (1)    | Amended and Restated Certificate of Incorporation, as amended, as  currently in effect |
| 3.2                 | (2)    | Amended and Restated Bylaws, as currently in effect                                    |
| 4.1                 | (3)    | Specimen of Common Stock Certificate                                                   |
| 11.1                | (4)    | Statement of Computation of Per Share Earnings                                         |

 

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| (1) | Filed as Exhibits 3.1 and 3.3 to the Company’s Registration Statement  on Form S-3, File No. 333-81626, filed on January 29, 2002, declared  effective on February 12, 2002, and incorporated herein by reference. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Filed as an exhibit to the Company’s Annual Report on Form 10-K for  the year ended December 31, 2000, filed on March 27, 2001, and incorporated  herein by reference.                                             |
| (3) | Filed as an exhibit to the Company’s Registration Statement on Form  S-1, File No. 333-56787, declared effective on August 11, 1998, and  incorporated herein by reference.                                        |
| (4) | See Note 3 to Condensed Consolidated Financial Statements.                                                                                                                                                              |

 

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