**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 SECURITIESEXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDED September 30, 2005**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

** **

**FOR THE TRANSITION PERIOD FROM        TO       **

 

**Commission file number 000-24643**

 

**DIGITAL RIVER, INC.******(Exact name of registrant as specified inits charter)

 

| **DELAWARE**                     | ** ** | **41-1901640**          |
|----------------------------------|------------|-------------------------|
| (State  or other jurisdiction of |       | (I.R.S.  Employer       |
| incorporation  or organization)  |       | Identification  Number) |

 

**9625 WEST 76TH STREET, SUITE 150EDEN 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 markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ý   No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act) Yesý   Noo

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act) Yes o   No ý

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practical date.

 

| **COMMON STOCK, $0.01 PAR VALUE** | ** ** | **35,208,759 SHARES**               |
|-----------------------------------|------------|-------------------------------------|
| (Class)                           |       | Outstanding  as of October 31, 2005 |

 

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DIGITALRIVER, INC.

 Form10-Q

Index

 

 
| PART I.       | FINANCIAL  INFORMATION                                                                                            |
|---------------|-------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                              |
| Item 1.       | Financial  Statements                                                                                             |
|          |                                                                                                              |
|          | Condensed  Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004                             |
|          |                                                                                                              |
|          | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2005 and 2004 |
|          |                                                                                                              |
|          | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2005 and 2004           |
|          |                                                                                                              |
|          | 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                                                        |
|          |                                                                                                              |
| Item  4.      | Controls  and Procedures                                                                                          |
|          |                                                                                                              |
| PART II.      | OTHER  INFORMATION                                                                                                |
|          |                                                                                                              |
| Item 1.       | Legal  Proceedings                                                                                                |
|          |                                                                                                              |
| Item 2.       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                      |
|          |                                                                                                              |
| Item 6.       | Exhibits                                                                                                          |
|          |
| SIGNATURES    |
|          |
| EXHIBIT INDEX |
|          |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

 
| ** **                                                                                                           | ** ** | **September, 30** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                           | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| **ASSETS**                                                                                                           | ** ** | ** **        | ** ** | ** **       | ** ** |
| CURRENT ASSETS:                                                                                                      |       |              |       |             |       |
| Cash and cash equivalents                                                                                            |       | $                 | 145,068    |             | $          | 127,734 |   |
| Short-term investments                                                                                               |       | 210,217           |       | 164,402          |       |
| Accounts receivable, net of allowance of $782 and $1,146                                                             |       | 25,540            |       | 21,520           |       |
| Other current assets                                                                                            |       | 5,123             |       | 3,317            |       |
| Total current assets                                                                                                 |       | 385,948           |       | 316,973          |       |
|                                                                                                                 |       |              |       |             |       |
| PROPERTY AND EQUIPMENT, NET                                                                                          |       | 18,470            |       | 17,367           |       |
| GOODWILL                                                                                                             |       | 156,515           |       | 148,086          |       |
| INTANGIBLE ASSETS, net of accumulated amortization of $34,811 and  $28,245                                           |       | 13,089            |       | 17,297           |       |
| OTHER ASSETS                                                                                                         |       | 9,637             |       | 10,113           |       |
| TOTAL ASSETS                                                                                                         |       | $                 | 583,659    |             | $          | 509,836 |   |
|                                                                                                                 |       |              |       |             |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                        | ** ** | ** **        | ** ** | ** **       | ** ** |
| CURRENT LIABILITIES:                                                                                                 |       |              |       |             |       |
| Accounts payable                                                                                                     |       | $                 | 91,983     |             | $          | 88,052 |   |
| Accrued payroll                                                                                                      |       | 7,263             |       | 5,332            |       |
| Deferred revenue                                                                                                     |       | 4,309             |       | 3,901            |       |
| Accrued acquisitions expenses                                                                                        |       | 5,297             |       | 6,720            |       |
| Other accrued liabilities                                                                                            |       | 16,903            |       | 14,221           |       |
| Total current liabilities                                                                                            |       | 125,755           |       | 118,226          |       |
|                                                                                                                 |       |              |       |             |       |
| NON-CURRENT LIABILITIES:                                                                                             |       |              |       |             |       |
| Convertible senior notes                                                                                             |       | 195,000           |       | 195,000          |       |
| Deferred tax liability                                                                                               |       | 3,245             |       | 3,841            |       |
| Total non current liabilities                                                                                        |       | 198,245           |       | 198,841          |       |
| Total liabilities                                                                                                    |       | 324,000           |       | 317,067          |       |
|                                                                                                                 |       |              |       |             |       |
| COMMITMENTS AND CONTINGENCIES                                                                                        |       |              |       |             |       |
|                                                                                                                 |       |              |       |             |       |
| 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;  35,181,798 and 33,652,149 shares issued and outstanding |       | 352               |       | 337              |       |
| Additional paid-in capital                                                                                           |       | 277,021           |       | 243,926          |       |
| Accumulated deficit                                                                                                  |       | (16,721           | )          | (51,164          | )          |
| Accumulated other comprehensive loss                                                                                 |       | (993              | )          | (330             | )          |
| Total stockholders’ equity                                                                                      |       | 259,659           |       | 192,769          |       |
| TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                                                           |       | $                 | 583,659    |             | $          | 509,836 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

3

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data; unaudited)

 
| ** **                                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                      | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                                      | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUE                                                                                         |       | $                      | 53,179     |                  | $          | 39,439 |   | $ | 158,851 |   | $ | 106,171 |   |
| COSTS AND EXPENSES (exclusive of depreciation and amortization  expense shown separately below) |       |                   |       |                  |       |   |   |   |   |
| Direct cost of services                                                                         |       | 1,050                  |       | 1,621                 |       | 3,538 |   | 3,688 |   |
| Network and infrastructure                                                                      |       | 4,983                  |       | 4,253                 |       | 14,199 |   | 11,059 |   |
| Sales and marketing                                                                             |       | 16,713                 |       | 13,338                |       | 48,829 |   | 36,213 |   |
| Product research and development                                                                |       | 5,210                  |       | 3,732                 |       | 14,796 |   | 10,301 |   |
| General and administrative                                                                      |       | 5,294                  |       | 4,045                 |       | 16,210 |   | 10,738 |   |
| Depreciation and amortization                                                                   |       | 2,308                  |       | 2,207                 |       | 6,805 |   | 5,677 |   |
| Amortization of acquisition related intangibles                                                 |       | 2,089                  |       | 2,434                 |       | 6,595 |   | 6,280 |   |
| Total costs and expenses                                                                        |       | 37,647                 |       | 31,630                |       | 110,972 |   | 83,956 |   |
|                                                                                            |       |                   |       |                  |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                          |       | 15,532                 |       | 7,809                 |       | 47,879 |   | 22,215 |   |
| OTHER INCOME/(EXPENSE), NET                                                                     |       | 1,526                  |       | 317                   |       | 3,572 |   | 281 |   |
| INCOME BEFORE INCOME TAX EXPENSE                                                                |       | $                      | 17,058     |                  | $          | 8,126 |   | $ | 51,451 |   | $ | 22,496 |   |
| Income tax expense                                                                    |       | 4,700                  |       | —                |       | 14,830 |   | — |   |
| NET INCOME                                                                                      |       | $                      | 12,358     |                  | $          | 8,126 |   | $ | 36,621 |   | $ | 22,496 |   |
|                                                                                            |       |                   |       |                  |       |   |   |   |   |
| NET INCOME PER SHARE:                                                                           |       |                   |       |                  |       |   |   |   |   |
| BASIC                                                                                           |       | $                      | 0.35       |                  | $          | 0.25 |   | $ | 1.07 |   | $ | 0.70 |   |
| DILUTED                                                                                         |       | $                      | 0.31       |                  | $          | 0.22 |   | $ | 0.92 |   | $ | 0.63 |   |
|                                                                                            |       |                   |       |                  |       |   |   |   |   |
| WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:                                                     |       |                   |       |                  |       |   |   |   |   |
| BASIC                                                                                           |       | 34,824                 |       | 32,459                |       | 34,342 |   | 32,049 |   |
| DILUTED                                                                                         |       | 41,972                 |       | 40,233                |       | 41,558 |   | 37,575 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

4

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**DIGITAL RIVER, INC.**

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands; unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **September 30,**     | ** ** |
| ** **                                                                         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| OPERATING ACTIVITES:                                                               |       |                  |       |   |   |
| Net income                                                                         |       | $                     | 36,621     |   | $ | 22,496 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                  |       |   |   |
| Amortization of acquisition related costs                                          |       | 6,595                 |       | 6,280 |   |
| Change in accounts receivable allowance                                            |       | (257                  | )          | 360 |   |
| Depreciation and amortization                                                      |       | 6,715                 |       | 5,634 |   |
| Tax benefit of stock based compensation                                            |       | 10,496                |       | — |   |
| Deferred and other income taxes                                                    |       | 3,030                 |       | — |   |
| Change in operating assets and liabilities:                                        |       |                  |       |   |   |
| Accounts receivable                                                                |       | (2,431                | )          | (2,685 | ) |
| Prepaid and other assets                                                           |       | (987                  | )          | 246 |   |
| Accounts payable                                                                   |       | 499                   |       | 23,134 |   |
| Deferred revenue                                                                   |       | 527                   |       | (164 | ) |
| Accrued payroll and other accrued liabilities                                      |       | 3,495                 |       | 2,506 |   |
| Net cash provided by operating activities                                          |       | 64,303                |       | 57,807 |   |
|                                                                               |       |                  |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                  |       |   |   |
| Purchases of investments                                                           |       | (144,509              | )          | (95,389 | ) |
| Sales of investments                                                               |       | 97,427                |       | 59,328 |   |
| Cash paid for acquisitions, net of cash received                                   |       | (9,482                | )          | (125,856 | ) |
| Purchases of property, equipment and capitalized software                          |       | (7,318                | )          | (6,125 | ) |
| Net cash used in investing activities                                              |       | (63,882               | )          | (168,042 | ) |
|                                                                               |       |                  |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                  |       |   |   |
| Principal amount on line of credit                                                 |       | —                |       | 45,000 |   |
| Repayment of principal on line of credit                                           |       | —                |       | (45,000 | ) |
| Net proceeds on issuance of 1.25% convertible senior notes due 1/1/2024            |       | —                |       | 188,398 |   |
| Exercise of stock options                                                          |       | 22,154                |       | 10,104 |   |
| Sales of common stock under employee stock purchase plan                           |       | 1,488                 |       | 904 |   |
| Repurchase of common stock                                                         |       | (3,205                | )          | — |   |
| Net cash provided by financing activities                                          |       | 20,437                |       | 199,406 |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH                                            |       | (3,524                | )          | 329 |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                          |       | 17,334                |       | 89,500 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                     |       | 127,734               |       | 101,878 |   |
| CASH AND CASH EQUIVALENTS, end of period                                           |       | $                     | 145,068    |   | $ | 191,378 |   |
| SUPPLEMENTAL DISCLOSURES:                                                          |       |                  |       |   |   |
| Cash paid for interest on Convertible Senior Notes                                 |       | $                     | 2,641      |   | $ | — |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

5

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**DIGITAL RIVER, INC.**

# **NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited)

 

**1. BASIS OF PRESENTATION**

 

Theunaudited condensed consolidated financial statements included herein reflectall adjustments, including normal recurring adjustments, which in our opinionare necessary to fairly state our consolidated financial position, results ofoperations and cash flows for the periods presented.  These condensedconsolidated financial statements should be read in conjunction with ouraudited consolidated financial statements included in our Form 10-K for theyear ended December 31, 2004 as filed with the Securities and ExchangeCommission. The results of operations for the three and ninemonths ended September 30, 2005 are not necessarily indicative of the resultsto be expected for any subsequent quarter or for the entire fiscal year endingDecember 31, 2005. The December 31, 2004 balance sheet was derived fromaudited financial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States.

 

***Summary of Significant Accounting Policies***

 

Adetailed description of our significant accounting policies can be found in ourmost recent Annual Report filed on Form 10-K for the fiscal year ended December31, 2004.

 

***ForeignCurrency Translation***

 

Foreigncurrency denominated revenue and expense transactions are remeasured to ourfunctional currency using average exchange rates for the fiscal period.  Foreign currency denominated assets andliabilities are remeasured to our functional currency using the exchange ratein effect at the respective balance sheet dates.  Any gains or losses are included in theconsolidated statement of operations within “other income (expense), net.”  The financial position and results ofoperations of our foreign subsidiaries are currently measured using localcurrency as the functional currency. Assets and liabilities are translated to their U.S. dollar equivalentsat rates in effect at the respective balance sheet dates and statements ofoperations and cash flows are translated using average exchange rates for thefiscal period.  The resulting translationadjustments are recorded as a component of stockholders’ equity.

 

***Research andDevelopment and Software Development***

 

Researchand development expenses consist primarily of development personnel andexternal contractor costs related to the development of new products andservices, enhancement of existing products and services, quality assurance andtesting.  We follow AICPA Statement ofPosition No. 98-1, “Accounting for the Costs of Computer Software Developed orObtained for Internal Use,” in accounting for internally developed software. Consistent with SOP98-1, we capitalized approximately, $0 million and $0.4 million of softwaredevelopment costs related to those efforts for the three and nine months endedSeptember 30, 2005, respectively.We did not capitalize any costs related to softwaredevelopment during the three months ended September 30, 2005 and do not expectto capitalize any such costs for the balance of 2005.  These capitalized costs are included in theinvesting activities section on our Consolidated Statement of Cash Flows.

 

 

**2. NET INCOME PER SHARE**

 

The table below setsforth the computation of basic and diluted net income per share (in thousands,except per share amounts):

 

6

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| ** **                                                                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                                                | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| EARNINGS PER SHARE — BASIC                                                                           |       |                   |       |                  |       |   |   |   |   |
| Net income — basic                                                                                   |       | $                      | 12,358     |                  | $          | 8,126 |   | $ | 36,621 |   | $ | 22,496 |   |
| Weighted average shares  outstanding — basic                                                         |       | 34,824                 |       | 32,459                |       | 34,342 |   | 32,049 |   |
| Earning per share — basic                                                                            |       | $                      | 0.35       |                  | $          | 0.25 |   | 1.07 |   | 0.70 |   |
|                                                                                                      |       |                   |       |                  |       |   |   |   |   |
| EARNINGS PER SHARE —  DILUTED                                                                        |       |                   |       |                  |       |   |   |   |   |
| Net income — basic                                                                                   |       | 12,358                 |       | 8,126                 |       | 36,621 |   | 22,496 |   |
| Exclude:  Interest expense and amortized financing

cost  of convertible senior notes, net of tax benefit |       | 501                    |       | 843                   |       | 1,470 |   | 1,080 |   |
| Net income — diluted                                                                                 |       | $                      | 12,859     |                  | $          | 8,969 |   | 38,091 |   | 23,576 |   |
| Weighted average shares  outstanding — basic                                                         |       | 34,824                 |       | 32,459                |       | 34,342 |   | 32,049 |   |
| Dilutive impact of options  outstanding                                                                   |       | 2,723                  |       | 3,349                 |       | 2,791 |   | 3,565 |   |
| Dilutive impact of  convertible senior notes                                                              |       | 4,425                  |       | 4,425                 |       | 4,425 |   | 1,961 |   |
| Diluted — weighted average  shares outstanding                                                       |       | 41,972                 |       | 40,233                |       | 41,558 |   | 37,575 |   |
| Diluted — net income per  share                                                                      |       | $                      | 0.31       |                  | $          | 0.22 |   | $ | 0.92 |   | $ | 0.63 |   |

 

Subsequent to our issuance of 1.25% convertible senior notes on June 1,2004, the Emerging Issues Task Force (EITF), Issue No. 04-08, required that theunissued shares underlying contingent convertible notes be treated as if suchshares were issued and outstanding for the purposes of calculating GAAP dilutedearnings per share.  The notes arecontingently convertible into approximately 4.4 million shares of common stockat an initial conversion price of $44.063 per share, which have been includedin our weighted average shares outstanding calculation since the date ofissuance.

 

 

**3. GOODWILL AND INTANGIBLE ASSETS**

 

We account for our goodwill in accordancewith SFAS No. 142, “Goodwill and Other Intangible Asset.”  SFAS No. 142 precludes the amortization ofgoodwill and intangible assets with indefinite lives, but these assets arereviewed annually (or more frequently if impairment indicators arise) forimpairment.

 

We complete our annual impairment test in thefourth quarter of each fiscal year, and reassess any intangible assets,including goodwill, recorded in connection with earlier acquisitions.  There was no impairment of goodwill in thethree and nine months ended September 30, 2005 and 2004.

 

7

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Informationregarding our other intangible assets is as follows (in thousands):

 
| ** **             | ** ** | **As of September 30, 2005** | ** ** |
|------------------------|------------|------------------------------|------------|
| ** **             | ** ** | **Carrying Amount**          | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **             | ** ** | **Gross**                    | ** ** | **Amortization** | ** ** | **Net** | ** ** |
|                   |       |                         |       |   |   |   |   |
| Customer relationships |       | $                            | 27,189     |   | $ | 20,054 |   | $ | 7,135 |   |
| Non-compete agreements |       | 5,137                        |       | 4,118 |   | 1,019 |   |
| Technology/tradename   |       | 15,574                       |       | 10,639 |   | 4,935 |   |
| Total                  |       | $                            | 47,900     |   | $ | 34,811 |   | $ | 13,089 |   |

 
| ** **             | ** ** | **As of December 31, 2004** | ** ** |
|------------------------|------------|-----------------------------|------------|
| ** **             | ** ** | **Carrying Amount**         | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **             | ** ** | **Gross**                   | ** ** | **Amortization** | ** ** | **Net** | ** ** |
|                   |       |                        |       |   |   |   |   |
| Customer relationships |       | $                           | 25,406     |   | $ | 14,784 |   | $ | 10,622 |   |
| Non-compete agreements |       | 5,134                       |       | 3,549 |   | 1,585 |   |
| Technology/tradename   |       | 15,002                      |       | 9,912 |   | 5,090 |   |
| Total                  |       | $                           | 45,542     |   | $ | 28,245 |   | $ | 17,297 |   |

 

Amortizationexpense for the three months ended September 30, 2005 and 2004 was $2.1 millionand $2.4 million, respectively, and $6.6 million and $6.3 million for the ninemonths ended September 30, 2005 and 2004, respectively.  Estimatedamortization expense for the remaining life of the intangible assets, based onintangible assets as of September 30, 2005, is as follows (in thousands):

 
| **Year** | ** ** | **As of September 30, 2005** | ** ** |
|----------|------------|------------------------------|------------|
| 2005     |       | 2,076                        |       |
| 2006     |       | 7,650                        |       |
| 2007     |       | 2,765                        |       |
| 2008     |       | 491                          |       |
| 2009     |       | 103                          |       |
| 2010     |       | 4                            |       |
| Total    |       | $                            | 13,089     |   |
|          |            |                              |            |  |

 

 

 

**4. STOCK BASED COMPENSATION**

 

Prior to theannual stockholders’ meeting held in May 2005, we had two stock-based employeecompensation plans, which are described more fully in Note 11 of our 2004Annual Report on Form 10-K.  At theannual stockholders’ meeting held in May 2005, stockholders approved anamendment and restatement of our 1998 Stock Option Plan that combined the 1998plan with our 1999 Stock Option Plan and gave us the flexibility to grantrestricted stock awards, restricted stock unit awards and performance shares,in addition to incentive and nonstatutory stock options, to our directors,employees, and consultants under the combined plan. We account for these plansunder the recognition and measurement principles of Accounting Principles Board(APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations.  No stock-based employeecompensation cost is reflected in net income, as all options granted underthese plans had an exercise price equal to the market value of the underlyingcommon stock on the date of the grant.

 

We have elected to apply the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” asamended by SFAS No. 148. Accordingly, we account for stock-based compensationusing the intrinsic value method prescribed in APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations. Compensation costfor stock options is measured as the excess, if any, of the fair value of ourcommon stock at the date of grant over the stock option exercise price.

 

8

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The following table illustrates the effect onnet income and net income per share if we had applied the fair valuerecognition provision of Financial Accounting Standards Board Statement No.123, “Accounting for Stock-Based Compensation,” to stock-based employeecompensation (in thousands, except per share amounts):

 
| ** **                                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                      | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                                      | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as reported                                                                         |       | $                      | 12,358     |                  | $          | 8,126 |   | $ | 36,621 |   | $ | 22,496 |   |
| Deduct: Total stock-based  compensation determined under fair value based method for all awards |       | (3,519                 | )          | (6,369                | )          | (10,100 | ) | (19,909 | ) |
| Adjusted net income, fair  value method for all stock-based awards                              |       | $                      | 8,839      |                  | $          | 1,757 |   | $ | 26,521 |   | $ | 2,587 |   |
|                                                                                            |       |                   |       |                  |       |   |   |   |   |
| Basic income per share —  as reported                                                      |       | $                      | 0.35       |                  | $          | 0.25 |   | $ | 1.07 |   | $ | 0.70 |   |
| Diluted income per share —  as reported                                                    |       | $                      | 0.31       |                  | $          | 0.22 |   | $ | 0.92 |   | $ | 0.63 |   |
| Basic income per share —  SFAS No. 123 adjusted                                            |       | $                      | 0.25       |                  | $          | 0.05 |   | $ | 0.77 |   | $ | 0.08 |   |
| Diluted income per share —  SFAS No. 123 adjusted                                          |       | $                      | 0.23       |                  | $          | 0.06 |   | $ | 0.68 |   | $ | 0.10 |   |

 

 

The fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelusing the following weighted average assumptions:

 
| ** **              | ** ** | **Nine Months Ended** | ** ** |
|-------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **September 30,**     | ** ** |
| ** **              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Risk-free interest rate |       | 4                     | %          | 4 | % |
| Expected life (years)   |       | 4                     |       | 1–3 |   |
| Volatility factor       |       | 0.93                  |       | 1.3 |   |
| Expected dividends      |       | —                |       | — |   |

 

In December 2004, the Financial AccountingStandards Board issued SFAS 123 (R), “Share-Based Payment.”  This Statement is a revision to SFAS 123, “Accountingfor Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  SFAS123(R) requires the measurement of the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award.  No compensation cost isrecognized for equity instruments for which employees do not renderservice.  We expect to adopt SFAS 123(R)effective on January 1, 2006, requiring compensation cost to be recognized asexpense for the portion of outstanding unvested awards, and any new awards madethereafter, based on the grant-date fair value of those awards.

 

We currently utilize the Black-Scholes optionpricing model to measure the fair value of stock options granted to employees.While SFAS No. 123(R) permits entities to continue to use such a model, thestandard also permits the use of a “lattice” model. We have not yet determinedwhich model we will use to measure the fair value of employee stock optionsupon the adoption of SFAS No. 123(R) effective January 1, 2006. In addition, wehave not yet determined the financial impact of adopting SFAS No. 123(R) for2006, which could be materially adverse.

 

**5. ACQUISITIONS AND EARN-OUTARRANGEMENTS**

 

InMarch 2005, we acquired certain assets and assumed certain liabilities, vendorcontracts and intellectual property of SWReg, an operating business of AtlanticCoast plc, a private limited UK company for $8.8 million in cash. SWReg is aprovider of e-commerce services for software authors. Goodwill of $8.8 millionwas recorded as a result of this acquisition. We are amortizing other intangibles assets acquired as follows: technology over three years, tradenameover five years, and customer relationships over a four-year period.  We may also makeadditional earn-out payments in cash based on achieving specific revenue anddevelopment goals over the first 12 months following the closing of theacquisition.  Such earn-out amounts, ifpaid, will be recorded as goodwill as they are considered incremental to thepurchase price.

 

9

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InNovember 2004, we acquired all of the outstanding capital stock of BlueHornetNetworks, Inc.  BlueHornet is a leadingprovider of e-mail marketing campaign management services and related customerrelationship management (CRM) tools.  Asconsideration for the acquisition, we issued a total of 160 thousand shares ofour common stock to the BlueHornet stockholders, valued at approximately $5.3million, paid off $0.7 million of BlueHornet debt obligations at closing andagreed to pay an additional $0.5 million in cash to the former BlueHornetstockholders following the transition of certain BlueHornet assets to ourfacilities in Eden Prairie, Minnesota.  Goodwill of $4.8 million was recorded asa result of this acquisition. We are amortizing other intangible assets acquired,consisting of technology/tradename, customer relationships and non-competeagreements, over a three-year period.  In addition, theformer BlueHornet stockholders may receive additional earn-out payments in cashor our common stock, at our discretion, based on BlueHornet’s operatingperformance over the first 36 months following the closing of theacquisition.  These earn-out amounts, ifpaid, will be recorded as goodwill as they are considered incremental to thepurchase price.

 

InJune 2004, we acquired substantially all of the assets and assumed certainliabilities of Fireclick, Inc., a leading provider of Web-analysis solutionsfor online retailers, providing web site owners with the tools necessary tomeasure campaign ROI, track user path analysis and enhance web site userexperience.  Under the terms of theagreement, we paid $7.5 million in cash and an additional $0.3 million in cashupon the completion of certain integration milestones.  Goodwill of $8.0 million has been recorded as aresult of this acquisition. We are amortizing other intangible assets acquired,consisting of non-compete agreements and technology/tradename, over athree-year period.The agreement also provides Fireclick the opportunity for an earn-out based onour achieving certain revenue and profitability targets attributable toFireclick over the first 36 months following the closing of theacquisition.  These earn-out amounts, ifpaid, will be recorded as goodwill as they are considered incremental to thepurchase price.

 

In April2004, we acquired element 5 AG, a privately held company based in Germany and aleading European e-commerce solution provider for software publishers.  Under the terms of the acquisition, we paid$120 million in cash to acquire all of the outstanding shares of capital stockof element 5 AG.  We also agreed to payup to an additional $2.5 million in cash based on element 5’s operatingperformance over the first 24 months following the closing of the acquisition. Goodwill of $110.8 million was recorded asa result of this acquisition. We are amortizing other intangible assetsacquired, consisting of technology/tradename, customer relationships andnon-compete agreements, over a three-year period.

 

OnJanuary 18, 2005, we entered into an agreement with senior employees of element5 AG, pursuant to which these employees agreed to cease providing services toelement 5 sixty days after the date of the agreement. We also agreed to resolvea $12 million escrow associated with our acquisition of element 5 AG by distributing$10 million to the former element 5 shareholders, and $2 million to us. Certain adjustments were also made to our earn-out obligations under the April2004 acquisition agreement.  Under the restructured earn-out, the formerelement 5 AG shareholders were paid $1.25 million on March 1, 2005 and will bepaid an additional $1.25 million on March 1, 2006.  These earn-out amounts have been recorded asadditional goodwill as they were incremental to the purchase price.  Element 5 AG was converted to Element 5 GmbHin September 2005.

 

As ofSeptember 30, 2005, our accrued acquisition cost related to the element 5restructuring plan was $2.6 million.  Thefollowing table provides detail on the activity and our remaining accrualbalance as of September 30, 2005 (in thousands):

 
| ** **                    | ** ** | **Accrual**       | ** ** | ** **        | ** ** | ** **   | ** ** | **Accrual**            | ** ** |
|-------------------------------|------------|-------------------|------------|-------------------|------------|--------------|------------|------------------------|------------|
| ** **                    | ** ** | **June 30, 2004** | ** ** | **Net Additions** | ** ** | **Payments** | ** ** | **September 30, 2005** | ** ** |
| e5 shareholder escrow         |       | $                 | 0          |              | $          | 2,500        |       | $                      | (1,250)    |   | $ | 1,250 |   |
| Employee severance costs      |       | $                 | 700        |              | $          | 2,100        |       | $                      | (1,450     | ) | $ | 1,350 |   |
| Facility consolidation  costs |       | $                 | 200        |              | $          | 100          |       | $                      | (300       | ) | $ | 0 |   |
| Total                         |       | $                 | 900        |              | $          | 4,700        |       | $                      | (3,000     | ) | $ | 2,600 |   |

 

 

Asof September 30, 2005, we believe that the maximum potential for futureearn-out payments for all prior acquisitions is approximately $2.3million.  This amount has not yet beenrecorded as goodwill.

 

TheCondensed Consolidated Financial Statements include the operating results ofeach business from the date of acquisition. The following unaudited pro forma condensed results of operations forthe three and nine months ended 

 

10

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September30, 2005 and 2004 have been prepared as if each of the acquisitions hadoccurred on January 1, 2004 (in thousands, except per share amounts):

 
| ** **                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                    | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                       |       | $                      | 53,179     |                  | $          | 40,899 |   | $ | 159,452 |   | 118,481 |   |
| Income from operations        |       | 15,532                 |       | 7,921                 |       | 48,173 |   | 20,944 |   |
| Net income                    |       | 12,358                 |       | 8,348                 |       | 36,979 |   | 21,183 |   |
|                          |       |                   |       |                  |       |   |   |   |   |
| Basic net income per share    |       | $                      | 0.35       |                  | $          | 0.26 |   | $ | 1.08 |   | $ | 0.66 |   |
| Diluted net income per  share |       | $                      | 0.31       |                  | $          | 0.23 |   | $ | 0.93 |   | $ | 0.59 |   |

 

Thisfinancial information does not purport to represent results that would actuallyhave been obtained if the transactions had been completed on January 1, 2004 orany future results that may be realized.

 

11

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**6. LONG-TERM DEBT**

 

OnJune 1, 2004 we sold and issued $175 million in aggregate principal amount of1.25% convertible senior notes due January 1, 2024, in a private, unregisteredoffering. The notes were sold at 100% of their principal amount.  The initial purchasers exercised in fulltheir option to purchase up to an additional $20 million in aggregate principalamount of the notes on June 30, 2004, which purchase transaction closed on July6, 2004. We are required to pay interest on the notes on January 1 and July 1of eachyear so long as the notes are outstanding. The notes bear interest at a rate of 1.25% and, if specified conditions aremet, are convertible into our common stock at a conversion price of $44.063 pershare.  The notes may be surrendered for conversionunder certain circumstances, including the satisfaction of a market pricecondition, such that the price of our common stock reaches a specifiedthreshold; the satisfaction of a trading price condition, such that the tradingprice of the notes falls below a specified level; the redemption of the notesby us, the occurrence of specified corporate transactions, as defined in therelated indenture; and the occurrence of a fundamental change, as defined inthe related indenture. Theinitial conversion price is equivalent to a conversion rate of approximately22.6948 shares per $1,000 of principal amount of the notes.  We will adjust the conversion price if certainevents occur, as specified in the related indenture, such as the issuance ofour common stock as a dividend or distribution or the occurrence of a stocksubdivision or combination. If a fundamental change, such as a change in ourcontrol, as defined in the related indenture, occurs on or before January 1,2009, we may also be required to purchase the notes for cash and pay anadditional make whole premium payable in our common stock upon the repurchaseor conversion of the notes in connection with the fundamental change. Holders of the notes have the right torequire us to repurchase their notes prior to maturity on January 1, 2009, 2014and 2019. We have the right to redeem the notes, under certain circumstances,on or after July 1, 2007 and prior to January 1, 2009, and we may redeem thenotes at anytime on or after January 1, 2009.

 

Aportion of the net proceeds of the offering was used to repay our seniorsecured revolving credit facility with Harris Trust and Savings Bank.  The balance will be used for generalcorporate purposes, including working capital, capital expenditures, potentialfuture acquisitions, investments, and the potential repurchase of shares of ourcommon stock.

 

Inthe third quarter of 2005 and 2004, we incurred interest expense of $0.6million and $0.6 million, respectively, on the convertible senior notes.Interest expense on the convertible senior notes for nine months ended September30, 2005 and September 30, 2004 was $1.8 million and $0.8 million,respectively.  We made interest paymentsof $1.2 million and $0 million in the third quarter of 2005 and 2004,respectively. For the nine months ended September 30, 2005 and 2004 we madeinterest payment of $2.6 million and $0.1 million, respectively.

 

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

 

*We note that, except for the historical informationcontained herein, the matters discussed below contain forward-lookingstatements that involve known and unknown risks, uncertainties and otherfactors that may cause our actual results, performance or achievements, orindustry results, to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements.  We expressly disclaim any obligation to update thisinformation or publicly release any revision or reflect events or circumstancesafter the date of this report.  Such factors include, among others: ourlimited operating history and variability of operating results, possibility offuture losses, risks associated with electronic software delivery, dependenceon the Internet 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 our growth, integration ofacquired companies, dependence on key employees and other risk factorsreferenced in our Form 10-K  for the yearended December 31, 2004.*

 

**Overview**

 

Weare a provider of comprehensive e-commerce outsourcing solutions. We wereincorporated in February 1994 and commenced offering products for salethrough our clients’ e-commerce stores in August 1996. From inceptionthrough August 1996, we had no sales, and our activities related primarilyto the development of our proprietary technology platform.  In 1996, we began to focus our businessdevelopment efforts on the software industry, building our catalog of softwareproducts through contracts with software publishers.  In 1997, we began to develop softwaredistribution relationships through contracts with online retailers. In late1998, we began to offer our comprehensive e-commerce outsourcing services inthe form of a transaction fee-based e-commerce service to clients outside ofthe software industry.  As of September30**,**2005, we were providinge-commerce services for more than 40,000 software and digital productspublishers, manufacturers, online retailers and online channel partners.  Our comprehensive platform offers sitedevelopment and hosting, order management, fraud prevention, export controls,tax management, physical and digital product fulfillment, multi-lingualcustomer service, advanced reporting and strategic marketing services.

 

Priorto January 1, 2004, we managed our physical goods clients through a division(formerly our E-Business Services Division) that was separate from our Softwareand Digital Commerce Services Division. Beginning January 1, 2004, this divisional structure was consolidated,and we announced that we will no longer report our activities as separatebusiness segments.  Nonetheless, weremain committed to serving existing and new physical goods clients.

 

Wehave approximately nine years of operating history upon which investors mayevaluate our business and prospects. Until 2003, we incurred significantoperating losses, and as of September 30, 2005, we had an accumulated deficitof $16.7 million. We intend to expend financial and management resources on thedevelopment of additional services, sales and marketing, technology and operationsto support larger-scale operations and greater service offerings. Although weexpect to generate positive cash flow from operations in 2005, there can be noassurance that our revenue will increase or even continue at its current levelor that we will maintain profitability or generate cash from operations infuture periods.

 

Ourprospects must be considered in light of the risks, expenses and difficultiesfrequently encountered by companies in new and rapidly evolving markets such ase-commerce. To address these risks, we must, among other things, attract andretain software publishers and online retailers as clients, attract and retainphysical goods clients, introduce new Web sites, online stores or services,continue to upgrade and develop our systems and infrastructure to meet emergingmarket needs and remain competitive in our service offerings, and retain andattract personnel commensurate with our business needs. There can be noassurance that we will be successful in addressing these risks, and any failureto do so could have a material adverse effect on our business, financialcondition and results of operations.

 

Ourcurrent and future expense levels are based largely on our planned operationsand estimates of future revenue. Revenue and operating results generally dependon the volume and timing of orders received, which are difficult to forecast.We may be unable to adjust spending in a timely manner to compensate for anyunexpected revenue shortfall.  Accordingly,any significant shortfall in revenue could have an immediate adverse effect onour business, financial condition and results of operations. Our quarterly andannual operating results are subject to fluctuations in demand for the productsor services offered by us or our clients, such as anti-virus software and taxpreparation software, among others.  Inparticular, sales of anti-virus software represented a significant portion ofour revenues 

 

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inrecent years, and continue to be very important to our business.  To the extent that our competitorssuccessfully introduce products or services not sold through our platform thatare competitive with products and services sold by current Digital Riverclients (including anti-virus products and services), our revenues will beadversely affected.  We are also likelyto continue to see revenue fluctuate on a seasonal basis, which is typical forthe software publishing market in general and for our existing physical goodsclients. We believe that our first and fourth quarters tend to be seasonallystronger than our second and third quarters due to the timing of demand for taxpreparation software and the holiday season selling period. In addition, webelieve that software publishers avoid new product releases in the summermonths. In view of the rapidly evolving nature of our business, we believe thatperiod-to-period comparisons of our operating results are not necessarilymeaningful and should not be relied upon as an indication of future revenue andfinancial performance.

 

 

**Results of Operations**

 

Thefollowing table sets forth certain items from our condensed consolidatedstatements of operations as a percentage of total revenue for the periodsindicated.

 
| ** **                                                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                    | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                                    | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                                                       |       | 100.0                  | %          | 100.0                 | %          | 100.0 | % | 100.0 | % |
| Cost of Revenue (exclusive  of depreciation and amortization expense shown separately below): |       |                   |       |                  |       |   |   |   |   |
| Direct cost of services                                                                       |       | 2.0                    |       | 4.1                   |       | 2.2 |   | 3.5 |   |
| Network and infrastructure                                                                    |       | 9.4                    |       | 10.8                  |       | 8.9 |   | 10.4 |   |
| Sales and marketing                                                                           |       | 31.4                   |       | 33.8                  |       | 30.7 |   | 34.1 |   |
| Product research and development                                                              |       | 9.8                    |       | 9.5                   |       | 9.3 |   | 9.7 |   |
| General and administrative                                                                    |       | 10.0                   |       | 10.2                  |       | 10.3 |   | 10.1 |   |
| Depreciation and amortization                                                                 |       | 4.3                    |       | 5.6                   |       | 4.3 |   | 5.4 |   |
| Amortization of acquisition related costs                                                     |       | 3.9                    |       | 6.2                   |       | 4.2 |   | 5.9 |   |
| Total costs and expenses                                                                      |       | 70.8                   |       | 80.2                  |       | 69.9 |   | 79.1 |   |
| Income from operations                                                                        |       | 29.2                   |       | 19.8                  |       | 30.1 |   | 20.9 |   |
| Other income/(expense),  net                                                                  |       | 2.9                    |       | 0.8                   |       | 2.3 |   | 0.3 |   |
| Income before income tax  expense                                                             |       | 32.1                   |       | 20.6                  |       | 32.4 |   | 21.2 |   |
| Income tax expense                                                                            |       | (8.9                   | )          | —                |       | (9.3 | ) | — |   |
| Net income                                                                                    |       | 23.2                   | %          | 20.6                  | %          | 23.1 | % | 21.2 | % |

 

Weacquired BlueHornet Networks, Inc. in November 2004 and SWReg in March2005.  Accordingly, our operations in thethird quarter of 2005 include the revenue and expenses of these acquiredoperations, with no corresponding revenue and expenses in the third quarter of2004.  As a result, while absolutedollars have increased in the third quarter of 2005 compared to 2004, our totalcosts and expenses declined as a percent of revenue from 80.2% for the threemonths ended September 30, 2004 to 70.8% for the three months ended September,2005 and from 79.1% for the nine months ended September 30, 2004 to 69.9% forthe nine months ended September 30, 2005.

 

***REVENUE.***Revenue increased to $53.2 million for the three months ended September 30, 2005 from $39.4 million forthe same period in the prior year, an increase of $13.7 million, or 34.8%. Forthe nine months ended September 30,2005, revenue totaled $158.9 million, an increase of $52.7 million, or 49.6%,from revenue of $106.2 million in the same period of the prior year. Theincrease was primarily attributable to higher online activity across our clientbase and growth in the number of software publishers, online retailers andinternational sites.

 

International salesrepresented approximately 39% and 29% of total revenue in the three monthperiod ended September 30, 2005 and2004, respectively, and approximately 38% and 29% of total revenue for the ninemonth period ended September 30, 2005and 2004, respectively.  We expect thatinternational sales as a percent of total sales will continue to increase on ayear-over-year basis as we continue to expand our international operations.

 

***GROSS MARGIN (Exclusive of depreciation and amortization.)***  Cost of revenue consists of direct cost ofservices and network and infrastructure costs and is comprised of direct laborcosts related to revenue and the costs to operate 

 

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and maintain ourtechnology platform, as well as customer service, site design, customerspecific development and operations functions. Such amounts are shown exclusive of any related depreciation and amortizationexpenses.  Gross margin was $47.1 millionand $141.1 million for the three and nine months ended September 30, 2005, up from $33.6 and $91.4 million for the sameperiods in the prior year.  Gross profitmargins were 88.7% and 88.8% for the three and nine months ended September 30, 2005 versus 85.1% and 86.1%for the same periods in the prior year due to greater leveraging of ourinfrastructure over more revenue and clients. We continue to believe that e-commerce and related services may becomemore competitive in the future. Accordingly, we may have to reduce our pricing or alter our pricingstructure and policies in the future and any such change could negativelyimpact gross margins.  We expect directcost of services and network and infrastructure to increase in absolute dollarsand remain relatively flat as a percent of revenue.

 

***GROSS MARGIN (Inclusive of depreciation and amortization.)***Gross margin, inclusive of depreciation and amortization, was $45.3 million and$135.7 million for the three and nine months ended September 30, 2005, up from $31.8 and $86.9 million for the sameperiods in the prior year.  Gross profitmargins, inclusive of depreciation and amortization, were 85.2% and 85.4% forthe three and nine months ended September30, 2005 and 80.7% and 81.9% for the same periods of prior year.  This inclusive presentation is an allocationof depreciation and amortization costs from that line item in our ConsolidatedStatement of Operations.  This inclusiveallocation presentation impacts neither net income, nor net income per share asreported.

 

***SALES AND MARKETING.***Sales and marketing expense consists primarily ofpersonnel and related expenses, advertising and promotional expenses, creditcard chargebacks and bad debt expense, and credit card transaction and otherpayment processing fees.  Sales and marketing expense increased to $16.7million and $48.8 million, respectively, for the three and nine months endedSeptember 30, 2005 from $13.3 million and $36.2 million for the same periods inthe prior year, an increase of $3.4 million, or 25.3%, and $12.6 million, or34.8%, respectively. The increase primarily resulted from credit card feesdirectly associated with the increase in revenue and additional sales andmarketing personnel and related expenses, partially offset by lower bad debtexpense and lower advertising expenses.  As a percentage of revenue, salesand marketing expense was 31.4% and 30.7%, respectively, in the three and ninemonths ended September 30, 2005, compared to 33.8% and 34.1%, respectively, forthe same periods in the prior year, primarily reflecting our increasedrevenue.  In the third quarter of 2005, we expanded the depth and breadthof our strategic marketing programs that we manage on behalf of our clients.These core programs include search engine optimization, affiliate and emailmarketing and site optimization. During the third quarter of 2005, we alsoincreased our marketing efforts to expand our oneNetwork affiliate program. Weexpect sales and marketing expenses to increase in absolute dollars and declineslightly as a percentage of revenue over time.

 

***PRODUCT RESEARCH ANDDEVELOPMENT.*** Productresearch and development expense consists primarily of personnel and relatedexpenses and consulting costs associated with developing and enhancing ourtechnology platform and related internal systems.  Product research and development expenseincreased to $5.2 million and $14.8 million, respectively, for the three andnine months ended September 30, 2005 from $3.7 million and $10.3 million forthe same periods in the prior year, an increase of $1.5 million, or 39.6%, and$4.5 million, or 43.6%, respectively.  The increase was primarily driven by increases in personnel-related expensesand outside consulting fees.  During thethird quarter of 2005, we continued to advance our new self-service,remote-control technology, as well as the international and e-marketingcapabilities on our next-generation e-commerce platform.  We capitalized approximately $0.0 million and$0.4 million of software development costs related to these efforts in thethree and nine months ended September 30, 2005, respectively.  Wedid not capitalize any costs related to software development during the threemonths ended September 30, 2005 anddo not expect to capitalize any such costs for the balance of 2005.  As apercentage of revenue, product research and development expense was 9.8% and9.3% in the three and nine months ended September 30, 2005, compared to 9.5%and 9.7% for the same periods in the prior year.  We expect productresearch and development costs to increase in absolute dollars and remainrelatively flat as a percentage of revenues.

 

***GENERAL AND ADMINISTRATIVE.***Generaland administrative expense consists primarily of executive, accounting andadministrative personnel and related expenses, including professional fees andinvestor relations expenses.  General and administrative expensesincreased to $5.3 million and $16.2 million, respectively, for the three andnine months ended September 30, 2005from $4.0 million and $10.7 million for the same periods in the prior year, anincrease of $1.2 million, or 30.9%, and $5.5 million, or 51.0%,respectively.  The increase resultedprimarily from wages and professional service expenses.  As a percentageof revenue, general and administrative expense was 10.0% and 10.3% for thethree and nine months ended September30, 2005, compared to 10.2% and 10.1% for the same periods in the prioryear.  We expect general and administrative expense will increase inabsolute dollars over time as we continue to build infrastructure to supportour business and comply with new governmental regulations.  As apercentage of revenue, general and administrative expense is expected todecline slightly over time.

 

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***AMORTIZATION OF ACQUISITION-RELATEDINTANGIBLES.***Amortization ofacquisition related intangibles consists of amortization of other intangibleassets recorded from our acquisitions over the last three years.  Amortization of intangible assets was $2.1million and $6.6 million, respectively, for the three and nine months ended September 30, 2005 compared to $2.4 millionand $6.3 million for the same periods in the prior year. The increase was dueto additional amortizable assets acquired throughout 2004 and the first quarterof 2005.

 

***OTHERINCOME/(EXPENSE), NET.***  Other income/(expense), net consists ofinterest income on our cash and cash equivalents and short-term investments,interest expense on debt financing obligations, currency gain or loss fromremeasured foreign transactions or assets from their native currency to theirfunctional currency, as well as gain or loss on the sale of investments.  Interest income was $2.7 million and $6.8million, respectively, for the three and nine months ended September30, 2005 compared to $1.0 million and $1.8 million for the same periods in theprior year. Interest expense on long term debt and other interest expense was$0.6 million and $1.8 million, respectively, for the three and nine monthsended September 30, 2005 compared to $0.6 million and $0.9million for the same periods in the prior year. Losses from currency remeasurement were $0.6 million and $1.4 million,respectively, for the three and nine months ended September30, 2005. Gains and losses from currency remeasurement were $0.1 million and$0.5 million for the same periods in the prior year. Gains or losses from thesale of investments were immaterial.

 

***INCOME TAXES.***** **For the three months ended September 30, 2005, we incurred taxexpense of $4.7 million of which $3.5 million related to utilization of stockoption deduction for U.S. operations and $1.2 million to foreignoperations.  The effective tax rate forthe three months ended September30, 2005 was 28%.  The effective tax ratefor the quarter included a 6% benefit related to adjustments made to incometaxes recorded in prior periods as a result of an analysis we performed in thethird quarter. The impact primarily related to additional depreciation deductionsrecorded on the tax return based on tax planning opportunities.

 

For the nine months ended September 30, 2005, we incurred tax expenseof $14.8 million of which $10.4 million related to the US operations and $4.3million to foreign operations.  The effectivetax rate for the nine months ended September 30, 2005, was 29% net of benefitof net operating loss carryforward.

 

As of September 30, 2005, wehad a net U.S. operating loss carryforward of approximately $100.1 millionresulting from disqualifying dispositions of stock options.  When the net operating loss deductionsarising from disqualifying disposition deductions are realized for financialstatement purposes, a reduction in income tax expense will not result, ratherthe benefit will be recorded as additional paid-in-capital.  The U.S. income tax net operating losscarryforward expires beginning in the year 2012.

 

As of September 30, 2005, we had foreign taxloss carryforwards of $8.1 million arising from pre-acquisition losses ofGerman subsidiary.  When thesepre-acquisition losses are realized for financial statement purposes, it willnot result in a reduction in income tax expense, but rather the benefit will berecorded as a reduction of goodwill.

 

No income tax expense was recorded for the threeand nine month period ended September 30, 2004, as we utilizedprior operating loss carryforwards arising from operations and relatedvaluation allowance resulting in a full offset of income tax expense for thequarter.  Deductions from disqualifying dispositionsof stock options are included in net operating loss carryforwards with acorresponding valuation allowance.

 

Because of the uncertainty of futurerealization, a valuation allowance equal to the net deferred tax asset has beenrecorded.  Ownership changes resultingfrom the issuance of additional equity may limit future annual realization ofthe tax net operating loss carryforward to a specified percentage of our valueunder Section 382 of the Internal Revenue Code.

 

**Off Balance Sheet Arrangements**

 

None

 

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**Liquidity and Capital Resources**

 

As of September 30,2005, we had $145.1 million of cash and cash equivalents, $210.2 million ofshort-term investments and working capital of approximately $260.2million. Significant components of our working capital are cash and cashequivalents, short term investments and short term receivables net of clientand merchant payables. Our primary source of internal liquidity is ouroperating activities.  During the ninemonths ended September 30,2005, our operations generated $64.3 million of cash compared to $57.8 millionfor the same period of the prior year.  The improvement was mainly due toan increase in net income and non-cash tax expense offset by a decrease inaccounts payable.  Net cash used in investing activities during the ninemonths ended September 30,2005 totaled $63.9 million.  This was comprised of net purchases ofinvestments of $47.1 million, cash paid for acquisitions net of cash receivedof $9.5 million, and investments in property, equipment and capitalizedsoftware of $7.3 million.  In March 2005,we acquired SWReg, an operating business of Atlantic Coast plc, a privatelimited UK company, for $8.8 million in cash.  Net cash provided by financingactivities during the nine months ended September 30,2005 totaled $20.4 million.  This wascomprised of the sale of stock through the exercise of stock options andpurchases through the employee stock purchase plan totaling $23.6 millionoffset by $3.2 million repurchases of common stock.

 

Our principalcommitments consist of interest and principal on our convertible senior notesand long-term obligations outstanding under operating leases.  Although we have no material commitments forcapital expenditures, we anticipate continued capital expenditures consistentwith our anticipated growth in operations, infrastructure, and personnel. We further anticipate that our expenditures on product development will beconsistent with our anticipated growth in operations. We also anticipate thatwe will continue to experience growth in our operating expenses for theforeseeable future and that our operating expenses will be a material use ofour cash resources.

 

**Contractual Commitments**

 
| ** **                   | ** ** | **Payment due by period (in thousands)** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **Total Amount**                         | ** ** | **Oct-Dec** | ** ** | ** ** | ** ** | ** ** | ** ** | **2010 and** | ** ** |
| **Contractual Obligations**  | ** ** | **Committed**                            | ** ** | **2005** | ** ** | **2006-2007** | ** ** | **2008-2009** | ** ** | **Thereafter** | ** ** |
| Operating Lease  Obligations |       | $6,990                                   |       | $554 |   | $4,051 |   | $2,164 |   | $221 |   |
| Convertible Senior Notes     |       | $240,094                                 |       | $0 |   | $4,875 |   | $4,875 |   | $230,344 |   |
| Total                        |       | $247,084                                 |       | $554 |   | $8,926 |   | $7,039 |   | $230,565 |   |

 

We expect to continue toevaluate and consider a wide array of potential strategic transactions,including business combinations and acquisitions of businesses, products,services and other assets as well as licenses of technology related to ourcurrent business.  At any given time, wemay be engaged in discussions or negotiations with respect to one or more suchtransactions.  Any such transactionscould have a material impact on our financial position, results of operations,or cash flows.  There is no assurancethat any such discussions or negotiations will result in the consummation ofany transaction.  The process ofintegrating any acquisition may create unforeseen challenges for ouroperational, financial and management information systems, as well asunforeseen expenditures and other risks, including diversion of management’sattention from other business concerns, the potential loss of key customers,employees and business partners, difficulties in managing facilities andemployees in different geographic areas, and difficulties in entering marketsin which we have no or limited direct prior experience and where competitors insuch markets have stronger market positions. In addition, an acquisition may cause us to assume liabilities or becomesubject to litigation.  Further, therecan be no assurance that we will realize a positive return on any acquisitionor that future acquisitions will not be dilutive to our current shareholders’percentage ownership or to earnings.  Wehave allocated significant valuation in the form of goodwill and intangiblesfor the companies we acquired in the past, which is subject to impairmenttesting on a regular basis.  If theindividual businesses do not perform as expected at the acquisition dates, wemay incur impairment charges for goodwill, accelerated amortization ofdefinite-lived intangible assets due to shortened expected lives of thoseassets, immediate write-offs and restructuring or other related expenses.

With respect to our convertible senior notes, we are required to pay intereston the notes on January 1 and July 1 of each year so long as the notes areoutstanding.  On January 3, 2005 we paid$1.4 million in interest for the period June 1 through December 31, 2004 and onJuly 1, 2005, we paid $1.2 million in interest for the period January 1 throughJune 30, 2005.  The notes bear interestat a rate of 1.25% and, if specified conditions are met, are convertible intoour common stock at a conversion price of $44.063 per share.  The notes may be surrendered for conversionunder certain circumstances, including the satisfaction of a market pricecondition, such that the price of our common stock reaches a specifiedthreshold; the satisfaction of a trading price condition, such that the trading

 

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priceof the notes falls below a specified level; the redemption of the notes by us,the occurrence of specified corporate transactions, as defined in the relatedindenture; and the occurrence of a fundamental change, as defined in therelated indenture.  The initial conversion price is equivalent toa conversion rate of approximately 22.6948 shares per $1,000 of principalamount of the notes.  We will adjust the conversion price ifcertain events occur, as specified in the related indenture, such as theissuance of our common stock as a dividend or distribution or the occurrence ofa stock subdivision or combination. In addition, contingent interest isrequired to be paid to holders if certain conditions are met. If a fundamentalchange, such as a change in our control, as defined in the related indenture,occurs on or before January 1, 2009, we may also be required to purchase thenotes for cash and pay an additional make whole premium payable in our commonstock upon the repurchase or conversion of the notes in connection with thefundamental change. Holdersof the notes have the right to require us to repurchase their notes prior tomaturity on January 1, 2009, 2014 and 2019. We have the right to redeem thenotes, under certain circumstances, on or after July 1, 2007 and prior toJanuary 1, 2009, and we may redeem the notes at anytime on or after January 1,2009.

 

We believe that existingsources of liquidity and the results of our operations will provide adequatecash to fund our operations, although we may seek to raise additional capital.In January 2002, we filed a universal shelf registration statement with the SECpursuant to which we could issue up to $100 million in common stock, preferredstock, debt securities and/or warrants.  Of this amount, approximately $45 million was utilized to issue commonstock in our July 2003 public offering, leaving approximately $55 millionavailable for future use.   In January2005, we filed a registration statement to increase our available shelfregistration amount from approximately $55 million to $255 million.  In addition, we filed an acquisition shelfregistration statement for up to approximately 1.5 million shares. Bothregistration statements were declared effective by the SEC in April 2005.  These filings were made to provide futureflexibility for acquisition and financing purposes.  The sale of additional equity or convertibledebt securities could result in additional dilution to our stockholders. Therecan be no assurances that financing will be available in amounts or on termsacceptable to us, if at all.

 

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**Item 3.  Qualitative andQuantitative Disclosure About Market Risk**

 

**Interest Rate Risk**

 

Wemaintain our portfolio of cash equivalents and short-term investments in avariety of securities, including governmentobligations and money market funds. Investments are classified asavailable-for-sale securities and carried at their market value with cumulativeunrealized gains or losses recorded as a component of accumulated othercomprehensive income/(loss) within stockholders’ equity.  As of September30, 2005, all securities held had maturities of less than three years.  A sharprise in interest rates could have an adverse impact on the market value ofcertain securities in our portfolio.  Wedo not currently hedge our interest rate exposure and do not enter intofinancial instruments for trading or speculative purposes or utilize derivativefinancial instruments.  There have beenno significant changes to our investment portfolio that would alter ourinterest rate risk for the three months ended September30, 2005.

 

**Foreign Currency Risk**

 

Our operations have historically been conducted primarilyin the United States currency and as such have not been subject to materialforeign currency exchange rate risk.   However, the growth in our internationaloperations is increasing our exposure to foreign currency fluctuations as wellas other risks typical of international operations, including, but not limitedto differing economic conditions, changes in political climate, differing taxstructures and other regulations and restrictions. Accordingly, our futureresults could be materially adversely impacted by changes in these or otherfactors.  For example, approximately halfof our subsidiary element 5’s transactions are denominated in euros orcurrencies other than the U.S. dollar. As a result, a greater proportion of our revenues and earnings are nowsubject to currency fluctuations.  Wetranslate statement of operations amounts that are denominated in foreigncurrency into U.S. dollars at the average exchange rates in each applicableperiod. To the extent the U.S. dollar weakens against foreign currencies, thetranslation of these foreign currency denominated transactions results inincreased net revenues, operating expenses and net income. Conversely, our netrevenues, operating expenses and net income will decrease when the U.S. dollarstrengthens against foreign currencies. We do not currently have a currencyhedging program to mitigate the effect of fluctuations of currency prices onour financial results.

 

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**Item 4.  Controls and Procedures**

 

(a)                      Based on their evaluation of ourdisclosure controls and procedures conducted as of September 30, 2005, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsand procedures (as defined in Rules 13a-15(e) or 15d-15(e) promulgated underthe Securities Exchange Act of 1934) are effective at the reasonable assurancelevel.

 

(b)                     This evaluation did not identifyany change in our internal control over financial reporting that occurredduring the quarter ended September 30, 2005 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

 

**Limitations on the Effectiveness ofControls**

 

Ourmanagement, including the Chief Executive Officer and Chief Financial Officer,does not expect that our disclosure controls and procedures or our internalcontrol will prevent all error and fraud. A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. Further, the design of acontrol system must reflect the fact that there are resource constraints, andthe benefits of controls must be considered relative to their costs. Because ofthe inherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within our company have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake. Additionally, controlscan be circumvented by the individual acts of some persons, by collusion of twoor more people, or by management override of the control. The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, control may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

 

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**PARTII.  OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

Beginning in August2001, we and certain of our officers and directors were named asdefendants in several class action shareholder complaints filed in the UnitedStates District Court for the Southern District of New York, now consolidatedas *In re Digital River, Inc. Initial PublicOffering Securities Litigation,* Case No. 01-CV-7355.  Similarcomplaints, referred to here as the IPO Lawsuits, were filed in the same courtagainst hundreds of other public companies, referred to here as theIssuers.  In the consolidated amended complaint against us, the plaintiffsallege that we, certain of our officers and directors and the underwriters ofour initial public offering, or IPO, violated Section 11 of the Securities Actof 1933 based on allegations that our IPO registration statement and prospectusfailed to disclose material facts regarding the compensation to be received by,and the stock allocation practices of, the IPO underwriters.  Thecomplaint also contains a claim for violation of Section 10(b) of theSecurities Exchange Act of 1934 based on allegations that this omissionconstituted a deceit on investors.  The plaintiffs seek unspecifiedmonetary damages and other relief.

 

In July 2002, we joinedin a global motion to dismiss the IPO Lawsuits filed by all of the Issuers(among others).  In October 2002, the parties agreed to toll the statuteof limitations with respect to certain of the named officers and directorsuntil September 30, 2003 and on the basis of this agreement, our officersand directors were dismissed from the lawsuit without prejudice.  InFebruary 2003, the court issued a decision denying the motion to dismiss theSection 11 claims against us and almost all of the other Issuers and denyingthe motion to dismiss the Section 10(b) claims against us and many ofthe Issuers.

 

In June2003, pursuant to the authorization of a special litigation committeeof our board of directors, we and a substantial majority of Issuersentered into a non-binding memorandum of understanding reflecting a tentativesettlement of the IPO Lawsuits. The terms of the tentative settlementprovide for, among other things, a release of the Issuers and their officersand directors from all further liability resulting from plaintiffs’ claims, andthe assignment to plaintiffs of certain potential claims that the Issuers mayhave against their IPO underwriters. The tentative settlement also providesthat, in the event that plaintiffs ultimately recover less than a guaranteedsum of $1 billion from the IPO underwriters, plaintiffs would be entitledto payment by each participating Issuer’s insurer of a pro rata share of anyshortfall in the plaintiffs’ guaranteed recovery.  In September 2003, inconnection with the tentative settlement, our officers and directors whohad entered tolling agreements with plaintiffs (described above) agreed toextend those agreements so that they would not expire prior to any settlementbeing finalized. In June 2004, we executed a final settlement agreement withthe plaintiffs consistent with the terms of the memorandum ofunderstanding.  On February 15, 2005, the Court issued a decision certifyinga class action for settlement purposes and granting preliminary approval of thesettlement, subject to modification of certain bar orders contemplated by thesettlement.  On August 31, 2005, the Court reaffirmed class certificationand preliminary approval of the modified settlement in a comprehensive Order.In addition, the Court approved the form of Notice to be sent to members of thesettlement classes, which will be published and mailed beginning November 15,2005. The Court has scheduled a Final Settlement Fairness Hearing for April 24,2006. The settlement is still subject to statutory notice requirements as wellas final judicial approval. Pending final approval of the settlement, wecontinue to believe that the claims against us, our officers and directors arewithout merit and intend to defend against them vigorously.

 

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**Item 2. Unregistered Sales of Equity Securities and Use ofProceeds**

 

In April 2005, the Boardof Directors authorized a new share repurchase program of up to $50.0 millionof our outstanding shares of common stock. This new program superseded andreplaced the $5.0 million share repurchase program adopted in 2001. In 2001, wespent $0.3 million to repurchase our shares. In May 2005 we spent $3.2 million to repurchase our shares. Under thenew program, the shares may be repurchased in the open market or in privatelynegotiated transactions. Repurchases are at our discretion based on ongoingassessments of the capital needs of the business, the market price of ourcommon stock and general market conditions. No time limit was set for thecompletion of the repurchase program.

 

During the nine monthsended September 30,2005, we repurchased a total of 136,000 shares at a weighted average price pershare of $23.57.

** **
| ** **                       | ** ** | **Total number of** | ** ** | ** **     | ** ** | ** **              | ** ** | **Approximate dollar value**  | ** ** |
|----------------------------------|------------|---------------------|------------|----------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                       | ** ** | **Total number**    | ** ** | **Average**    | ** ** | **shares purchased**    | ** ** | **of shares that may yet be** | ** ** |
| ** **                       | ** ** | **of shares**       | ** ** | **price paid** | ** ** | **as part of publicly** | ** ** | **purchased under the plan**  | ** ** |
| **Period**                       | ** ** | **purchased**       | ** ** | **per share**  | ** ** | **announced plan**      | ** ** | **(in millions)**             | ** ** |
| July 1 - July 31, 2005           |       | —              |       | —         |       | —                  |       | $                             | 46.5       |   |
| August 1 - August 31, 2005       |       | —              |       | —         |       | —                  |       | $                             | 46.5       |   |
| September 1 - September 30, 2005 |       | —              |       | —         |       | —                  |       | $                             | 46.5       |   |
| Total                            |       | —              |       |           |       | —                  |       |                          |       |

 

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**Item 6.  Exhibits**

 

(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. |
| 4.2                 |       | (1)                           |   | Form of Senior Debt Indenture. |
| 4.3                 |       | (1)                           |   | Form of Subordinated Debt Indenture. |
| 4.4                 |       |                          |   | References are made to Exhibits 3.1 and 3.2. |
| 4.5                 |       | (4)                           |   | Indenture dated as of June 1, 2004 between Digital  River, Inc. and Wells Fargo Bank, N.A. as trustee, including therein the form  of the Note. |
| 10.23               |       | (5)                           |   | Employment Agreement between Digital River, Inc. and  Joel A. Ronning. |
| 10.24               |       | (5)                           |   | Form of Amendment to Non-Qualified Stock Option  Agreement. |
| 12.1                |       |                          |   | Computation of Ratio of Earnings to Fixed Charges. |
| 31.1                |       |                          |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 31.2                |       |                          |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 32.1                |       |                          |   | Certification pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002. |
| 32.2                |       |                          |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

 

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| (1) |   | Filed as exhibits 3.1 and 3.3 and exhibits 4.5 and 4.6  to our 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 our 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 our Registration Statement on  Form S-1, File No. 333-56787, declared effective on August 11, 1998, and  incorporated herein by reference.                                                                  |
| (4) |   | Filed as exhibit 99.1 to our Current Report on Form  8-K, filed on July 13, 2004 and incorporated herein by reference.                                                                                                             |
| (5) |   | Filed as exhibits 10.23 and 10.24 to our Quarterly  Report on Form 10Q, for the quarter ended June 30, 2005 and incorporated  herein by reference.                                                                                 |

 

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SIGNATURES

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Date:  | November 9, 2005 |      | DIGITAL RIVER, INC.                            |
|--------|------------------|-----------|------------------------------------------------|
|   |             |      |                                           |
|   |             | By:  | /s/  THOMAS M. DONNELLY                        |
|   |             |      |                                           |
|   |             |      | Thomas  M. Donnelly                            |
|   |             |      | *Chief Financial Officer*                      |
|   |             |      | *(Principal Financial and Accounting Officer)* |

 

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EXHIBITINDEX

 
| **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. |
| 4.2                 |       | (1)                           |   | Form of Senior Debt Indenture. |
| 4.3                 |       | (1)                           |   | Form of Subordinated Debt Indenture. |
| 4.4                 |       |                          |   | References are made to Exhibits 3.1 and 3.2. |
| 4.5                 |       | (4)                           |   | Indenture dated as of June 1, 2004 between Digital  River, Inc. and Wells Fargo Bank, N.A. as trustee, including therein the form  of the Note. |
| 10.23               |       | (5)                           |   | Employment Agreement between Digital River, Inc. and  Joel A. Ronning. |
| 10.24               |       | (5)                           |   | Form of Amendment to Non-Qualified Stock Option  Agreement. |
| 12.1                |       |                          |   | Computation of Ratio of Earnings to Fixed Charges. |
| 31.1                |       |                          |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 31.2                |       |                          |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 32.1                |       |                          |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2                |       |                          |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

 

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| (1) |   | Filed as exhibits 3.1 and 3.3 and exhibits 4.5 and 4.6  to our 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 our 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 our Registration Statement on  Form S-1, File No. 333-56787, declared effective on August 11, 1998, and  incorporated herein by reference.                                                                  |
| (4) |   | Filed as exhibit 99.1 to our Current Report on Form  8-K, filed on July 13, 2004 and incorporated herein by reference.                                                                                                             |
| (5) |   | Filed as exhibits 10.23 and 10.24 to our Quarterly  Report on Form 10Q, for the quarter ended June 30, 2005 and incorporated  herein by reference.                                                                                 |

 

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