**As filed with the Securities and Exchange Commission on March 31, 2005**

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**FOR ANNUAL AND TRANSITION REPORTSPURSUANT TO SECTIONS 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**(MARK ONE)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2004**

**OR**

** ̈**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**FORTHE TRANSITION PERIOD FROM                    TO                    **

**CommissionFile Number: 000-50706**

**ESCHELON TELECOM, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**(State or other jurisdiction of  incorporation or organization)   | **41-1843131**(I.R.S. Employer  Identification No.) |
|-------------------------------------------------------------------------------|-----------------------------------------------------|
| **730 Second Avenue Minneapolis, MN**(Address of principal executive offices) | **55402**(Zip Code)                                 |

 

Registrant’s telephonenumber, including area code: **(612) 376-4400**

Securities Registered Pursuant to Section 12(b) ofthe Act:

**None**

Securities Registered Pursuant to Section 12(g) ofthe Act:

**CommonStock, par value $0.01 per share**

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  x    No  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will be contained, to the best of Registrant’s knowledge,in definitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K. o

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes  o    No  x

As of March 30, 2005,the number of outstanding shares of the Registrant’s Common Stock, par value$0.01 per share, was 4,758,518 shares and the number of outstanding shares ofthe Registrant’s Preferred Stock, par value $0.01 per share, was 97,526,136shares, which are convertible into 114,811,197 shares of Common Stock.

 

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**TABLE OF CONTENTS**
| **Part I**   |
|-------------------|
| Item 1.           | Business |   | 2 |   |
| Item 2.           | Properties |   | 21 |   |
| Item 3.           | Legal  Proceedings |   | 22 |   |
| Item 4.           | Submission  of Matters to a Vote of Security Holders |   | 23 |   |
| **Part II**  |
| Item 5.           | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |   | 24 |   |
| Item 6.           | Selected  Financial Data |   | 24 |   |
| Item 7.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operation  |   | 28 |   |
| Item 7A.          | Quantitative  and Qualitative Disclosures About Market Risk |   | 47 |   |
| Item 8.           | Financial  Statements and Supplementary Data |   | 48 |   |
| Item 9.           | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure      |   | 48 |   |
| Item 9A.          | Controls  and Procedures |   | 48 |   |
| Item 9B.          | Other  Information |   | 48 |   |
| **Part III** |
| Item 10.          | Directors  and Executive Officers of the Registrant |   | 49 |   |
| Item 11.          | Executive  Compensation |   | 53 |   |
| Item 12.          | Security  Ownership of Certain Beneficial Owners and Management |   | 56 |   |
| Item 13.          | Certain  Relationships and Related Transactions |   | 59 |   |
| Item 14.          | Principal  Accounting Fees and Services |   | 60 |   |
| **Part IV**  |
| Item 15.          | Exhibits,  Financial Statement Schedules |   | 61 |   |

 

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**FORWARD-LOOKING STATEMENTS**

This annual report includes forward-looking statementswithin the meaning of, and which have been made pursuant to, the U.S. PrivateSecurities Litigation Reform Act of 1995. We make “forward-looking statements”throughout this annual report. Whenever you read a statement that is not solelya statement of historical fact (such as when we state that we “may,” “will” or “planto” perform in a certain manner or that we “intend,” “believe,” “expect,” “anticipate,”“estimate” or “project” that an event will occur, or the negative thereof, andother similar statements), you should understand that our expectations may notbe correct, although we believe that they are reasonable. You should alsounderstand that our plans may change. The forward- looking informationcontained is generally located in the sections of this annual report entitled “Business”and “Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” but may be found in other locations as well. These forward-lookingstatements generally relate to our strategies, plans and objectives for futureoperations and are based upon management’s current plans and beliefs orestimates of future results or trends.

Forward-looking statements, such as those regardingmanagement’s present plans or expectations for new product offerings, capitalexpenditures, cost-saving strategies and growth are not guarantees of futureperformance. They involve risks and uncertainties relative to returnexpectations and related allocation of resources, and changing economic orcompetitive conditions, as well as the negotiation of agreements with thirdparties and the factors discussed in the section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—RiskFactors” and elsewhere herein, which could cause actual results to differ frompresent plans or expectations, and such differences could be material.Similarly, forward-looking statements regarding management’s presentexpectations for operating results and cash flow involve risks anduncertainties relative to these and other factors, such as the ability toincrease revenues and/or to achieve cost reductions and other factors discussedin the section entitled “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Risk Factors” or elsewhere herein, whichalso would cause actual results to differ from present plans. Such differencescould be material. All forward-looking statements attributable to us or by anypersons acting on our behalf are expressly qualified in their entirety by thesecautionary statements.

As such, actual results or circumstances may varymaterially from such forward-looking statements or expectations. Readers arealso cautioned not to place undue reliance on these forward-looking statementswhich speak only as of the date these statements were made. Except as requiredby law, we will not update these forward-looking statements, even if oursituation changes in the future.

 

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**PART I**

**Item 1.**                        Business.

**Overview**

Eschelon Telecom, Inc., a competitive localexchange carrier (CLEC), is headquartered in Minneapolis, Minnesota and wasincorporated in Delaware in 1996 under the name Advanced Telecommunications, Inc.On December 31, 2004, we consummated the acquisition of Advanced TelCom, Inc.,or ATI (the “ATI Acquisition”), for an aggregate purchase price of $45.5million. Unless otherwise specified, our financial results presented for 2004do not include ATI’s financial results.

We are a leading facilities-based provider ofintegrated voice and data communications services to small and medium-sizedbusinesses in 19 markets in the western United States. Our voice and dataservices, which we refer to as network services, include local dial tone, longdistance, enhanced voice features and dedicated Internet access services. Wealso sell, install and maintain business telephone and data systems andequipment, which we refer to as BTS. We provide these products and servicesindividually or in customized packages to address our customers’ need for afully-outsourced voice and data network solution. Our high quality,personalized service and customized packages are responsible for our lowmonthly customer line churn, which for 2003 and 2004 averaged 1.60% and 1.48%,respectively. As of December 31, 2004, including ATI, we haveapproximately 375,000 total access lines. For 2004, we generated consolidatedrevenue of $158.1 million.

Our network is designed to meet the voice and datacommunications needs of our customers. The Eschelon voice and data traffic isswitched through six Nortel DMS 500 voice switches and seven Nortel PassportATM switches. We have physical colocations in 125 Incumbent Local ExchangeCarrier (ILEC) central offices through which we provide voice services overunbundled network elements (loops) or integrated voice and data services overT1 lines. We also provide service via an Unbundled Network Element Platform(UNE-P), typically for multi-location customers who need additional accesslines in locations where we do not own facilities. As of December 31,2003, approximately 74% of our total access lines in service were served on ournetwork, which we refer to as on-net, compared to 81% as of December 31,2004, excluding ATI. In addition, for 2003 and for 2004, new access linesinstalled on-net represented 87% and 92%, respectively, of our total new accesslines installed.

ATI is a facilities-basedCLEC with operations primarily in 12 markets in four western states, five of whichare the same markets we are operating in and six of which are adjacent to ourmarkets. ATI has six Lucent 5ESS voice switches, one Nortel DMS 500 longdistance/local switch and eight Cisco BPX data switches and has 35 activecolocations from which it offers its services. ATI expands and strengthens ourpresence in the western United States and we expect to benefit from operatingsynergies from consolidating ATI’s operations into our business. As of December 31,2004, ATI provided service through approximately 124,000 total access lines. For2004, ATI had consolidated revenue of $59.3 million.

**Industry Overview**

According to the FederalCommunications Commission (FCC), the domestic communications service marketrepresents a $300 billion annual revenue opportunity from more than180 million switched access lines nationwide. The FCC estimates that for2002, the most recent year for which complete data is available, thecommunications services market in the states where we provided servicerepresented nearly $30 billion. Competitive service providers such as uscontinue to gain market share from the ILECs. According to the FCC, as of December 31,2003 competitive service providers served 29.6 million, or 16%, of theswitched access lines in the United States, an increase of 19% over the prioryear.

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**Our Markets**

We operate in 19 markets in the western United States.We believe that we are either the leading or second ranked competitive serviceprovider for small and medium-sized businesses in each of our markets.According to the U.S. Census Bureau, population growth from 1990 to 2000 acrossthe markets we covered averaged 27.6%, which was more than double the nationalaverage of 13.2%, and annual small and medium-sized business growth from 1997to 2001 across the markets we covered averaged 1.6%, more than triple thenational average of 0.5%. According to Kagan World Media, our markets areexpected to remain among the fastest growing markets in the United States, withan average annual population growth rate of 1.9% through 2006, compared to thenational average of 1.1%.

Ourmarkets are Minneapolis and St. Paul, MN; Denver and Boulder, CO; Phoenix, AZ;Santa Rosa, CA; Seattle, Tacoma, Everett, Bellingham, Olympia and Yakima, WA;Portland, Salem, Eugene, Bend and Medford, OR; Salt Lake City, UT; and Reno, NVand are primarily in the region in which Qwest Communications is the incumbentlocal exchange carrier. Within our markets, we have colocated in ILEC centraloffices that serve a high concentration of potential small and medium-sizedbusiness customers. As of December 31, 2004, prior to the ATI Acquisition,our facilities-based network covered approximately 70% of our defined marketthrough only 25% of the total ILEC central offices in each market. Our averageon-net penetration across our markets is approximately 12.4%. Set forth belowis key data regarding our markets prior to the ATI Acquisition.
| ** **                | ** ** | **Eschelon  On-net Access  Lines Sales  Footprint(1)** | ** ** | **Number of  Colocations** | ** ** | **Eschelon  Lines** | ** ** | **Percent  Penetration(2)** | ** ** |
|---------------------------|------------|------------------------------------------------------------------|------------|---------------------------------|------------|---------------------|------------|-----------------------------|------------|
| Minneapolis/St.  Paul, MN |       |                                                             | 233,980    |                            |       |                | 17         |                        |       | 51,349 |   |   | 21.9 | % |   |
| Denver/Boulder,  CO       |       |                                                             | 373,150    |                            |       |                | 16         |                        |       | 41,990 |   |   | 11.3 |   |   |
| Phoenix, AZ               |       |                                                             | 360,810    |                            |       |                | 14         |                        |       | 38,785 |   |   | 10.7 |   |   |
| Seattle, WA               |       |                                                             | 288,325    |                            |       |                | 13         |                        |       | 38,075 |   |   | 13.2 |   |   |
| Portland, OR              |       |                                                             | 333,750    |                            |       |                | 18         |                        |       | 30,849 |   |   | 9.2 |   |   |
| Salt Lake City,  UT       |       |                                                             | 249,445    |                            |       |                | 14         |                        |       | 23,737 |   |   | 9.5 |   |   |
| Reno, NV                  |       |                                                             | n/a        |                            |       |                | —     |                        |       | 7,691 |   |   | n/a |   |   |
| Tacoma, WA                |       |                                                             | 47,250     |                            |       |                | 3          |                        |       | 10,410 |   |   | 22.0 |   |   |
| Salem, OR                 |       |                                                             | 63,485     |                            |       |                | 3          |                        |       | 3,965 |   |   | 6.2 |   |   |
| Eugene, OR                |       |                                                             | 63,145     |                            |       |                | 3          |                        |       | 3,502 |   |   | 5.5 |   |   |
| Total                     |       |                                                             | 2,013,340  |                            |       |                | 101        |                        |       | 250,353 |   |   | 12.4 | % |   |

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(1)          The Eschelon on-netaccess lines sales footprint column shows the estimated total small and medium-sizedbusiness access lines accessible from our colocations.

(2)          The percent penetrationis defined as Eschelon lines divided by on-net access lines sales footprint.

**Products and Services**

We provide our customers a complete package of voice,data and BTS services. Within our three product lines, we provide a wide rangeof alternatives and customized service packages allowing us to reach a largernumber of potential customers and provide a comprehensive product solution. Wesell products and services at competitive prices, but focus on product qualityand customer service to attract and maintain customers.

***Voice Services***.   Weprovide customized packages of voice services to fulfill all of our customers’voice communication needs. We offer local telephone services, including basicdialtone services and vertical features, such as call forwarding, call waitingand call transfer; advanced call management capabilities such 

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as calling numberidentification, caller name identification, automatic call back and distinctiveringing; plus enhanced services such as voice mail and direct inward dialing.Our services are provided via analog and digital service platforms. We offer afull range of intra-state, inter-state and international long distance servicesand calling plans to customers who purchase our local service. Our servicesinclude “1+” outbound calling, inbound toll free service and complementaryservices such as dedicated long distance, operator and directory assistance andcalling cards.

***Data Services.  ***Ourdata service offerings are designed to provide a full range of services to ourcustomers. We offer high-speed data transmission services, such as dedicatedand broadband Internet access, and also provide and support e-mail andweb-hosting services. Our IDSL product allows us to reach customers beyond thetypical threshold of a normal DSL product. Our data services are offered attransmission speeds that range from 56Kbps to 1.54Mbps.

***Business TelephoneSystems.  ***We provide industry leading telephoneequipment systems, including complete business telephone systems and voicemessaging products. We also procure and install voice and data cable, patchpanels, routers and other network hardware. We offer customers multi-yearmaintenance agreements to maintain and upgrade their systems. Some of our keymanufacturers include Mitel, Inter-Tel, NEC and Cisco.

Thefollowing table summarizes our product and service offerings:
| Voice Services            | ** ** | ** **                 | ** ** | **Data Services**                                    | ** ** | **Business Telephone Systems** |
|---------------------------|------------|----------------------------|------------|------------------------------------------------------|------------|--------------------------------|
| Local and Long  Distance  |       | Broadband Internet Access  |       | Customer Premise Telephone Equipment and Accessories |
| Vertical Features         |       | Dedicated Internet  Access |       | Data Communications  Equipment                       |
| Advanced Call  Management |       | Dial-up Internet Access    |       | Voice Mail System  Installation                      |
| Other Enhanced  Services  |       | E-Mail                     |       | IP Phone Systems                                     |
|                      |       | Web-Hosting                |       | After Market Maintenance  and Upgrade Contracts      |

 

**Sales and Marketing**

We employ a direct sales and marketing strategy whichallows us to take a consultative approach in selling services to our customers.Our sales force is trained to focus on product differentiation, customizedpackages and superior customer service. We also offer our customers acompetitive price. We carefully manage each sales proposal within pricingparameters that ensure each new customer provides a targeted level ofprofitability. We centrally manage these pricing parameters based on anextensive cost analysis for each market. We incentivize our sales force tofocus on selling customized packages that can be serviced on-net. For 2004, 92%of our total new access lines installed were installed on-net.

As of February 28, 2005, our direct sales forceconsisted of 191 network communications specialists and 36 BTS communicationsspecialists. Our network and BTS communications specialists integrate theirefforts through a team approach created by a cross-commission structure thatincentivizes them to cross-sell products and services. For 2004, approximately65% of new BTS customers also subscribed to our network service product line.

In 2004, we launched our agent channel into threemarkets and have since added two additional markets. This agent channel reachescustomer segments that are generally not targeted by our direct sales force. Wewill continue to analyze the performance of this sales channel for strategicfit. We expect to have no more than 10% of our sales volume be attributable tothe agent channel.

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As a result of our direct sales approach, we generallyhave not spent funds on television, radio or multi-media advertising. However,we intend to increase our involvement in local community activities in each ofour markets in order to create more publicity and recognition for our company.

Backlog of customer ordershas remained at relatively low levels versus overall lines in service. As such,backlog is not material to our annual revenue and is not a meaningful measureof future revenue.

**Our Customers**

Our customers aregenerally small and medium-sized businesses with fewer than 100 employees.During 2004, we did not have any customer representing more than 10% of totalrevenue. In addition, we do not collect any reciprocal compensation and do notgenerate any wholesale carrier revenue (other than carrier access revenue) orInternet service provider revenue. Including the acquisition of ATI, we haveapproximately 56,000 business customers.

**Customer Service and Retention**

We provide our customers with superior customerservice, which is driven by a highly personalized, integrated team approach.Our 52 local customer service representatives and 20 repair service bureauassociates are supported by an additional 82 customer service professionals inour Minneapolis call center. Every new customer order is closely coordinated bya service delivery team until three days following service transition. Each newcustomer is contacted multiple times by our service delivery team during theservice initiation process to ensure accuracy and on-time delivery of servicesordered.

We segment our customer base to better serve theirspecific needs. We have six national account managers responsible formaintaining relationships with multiple location accounts and local accountmanagers responsible for single market accounts. The local and national accountmanagers coordinate service requests with our centralized call centerassociates to ensure customer satisfaction.

Our “866-Eschelon” customer service numberprovides a single contact point for customers to gain quick access to customerservice or their account manager. Our associates consistently answer more than85% of all calls within 20 seconds. Our call center is staffed by 82 highlytrained associates whose performance is closely monitored. Our centrallymanaged service platform allows us to actively track and analyze call responsetimes, trouble ticket resolution and customer satisfaction for every in-boundcall received. Our repair service bureau is staffed by 20 associates andcomplemented by our 70 field service technicians who can readily be deployed tothe customer premises. We also regularly survey our customers allowing us totrack, analyze and adjust service and processes as necessary.

We have a sophisticated network operating center, orNOC, through which we monitor our network on a 24x7 basis and are able todetect and troubleshoot network problems before our customers are aware ofthem.

Our senior director ofcustomer retention is responsible for coordinating our sales force, repairservice bureau, national and local account managers, customer serviceorganization and retention team to proactively manage customer retention. Allmembers of these groups are trained to identify at-risk customer accounts whichare then referred to our retention team for specific, personalized care. In2004, our retention team successfully retained 88% of all accounts referred tothem. Our retention team is also responsible for collecting and maintainingdetailed data on specific reasons for every disconnected line and for obtainingexit surveys from departing customers. We analyze this data on a monthly basisto better understand our customers and to implement or alter operatingprocedures to improve our operations and customer retention.

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**Network Overview and Deployment**

***Voice and DataSwitches.  ***We have deployed Nortel, Lucent Tellabsand Cisco equipment in each of our major markets (Minneapolis/St. Paul,Denver/Boulder, Portland, Salem, Eugene, Reno, Santa Rosa, Seattle, Tacoma,Olympia, Everett, Yakima, Phoenix and Salt Lake City). We use Nortel DMS andLucent 5ESS switches for local dialtone services, the Tellabs digitalcrossconnect system (DACS) for terminating, routing and aggregating on DS1/DS3transport and customer connections, and Cisco BPX and Nortel Passport ATMswitches in combination with Cisco core and edge routers for advanced dataservices. We believe the Nortel DMS 500 and Lucent 5ESS switches are reliable,proven platforms for providing local services. The Cisco BPX and NortelPassport ATM switches are highly flexible and integrate well with the Cisco IPplatforms to provide network services over common network infrastructures.

***Colocations andEdge Equipment.  ***We use Zhone Technologies, Inc.Universal Edge 9000, or UE9000, access node equipment and Lucent AnyMediaFastDigital Loop Carriers in each of the 125 ILEC central offices in which we havephysically colocated in order to provide local analog line service to ourcustomers. The UE9000 access node and AnyMediaFast enable effective delivery ofindustry standard voice service offerings. We have also deployed Zhone Sechtor300 devices in our switch rooms and various colocations and, together with theaddition of an integrated access device at customer premise locations, we areable to offer network services over a single T1 line. The UE9000, AnyMediaFastand Sechtor 300 devices are high density voice and data equipment that fit intoa single network bay, thereby reducing costly colocation space in ILEC centraloffices.

***Intra-CityTransport Deployment.  ***In select markets, we utilizeFiber Transport in a SONET Ring Configuration to connect Host Sites to ILECcolocations. In other markets, we use Leased Transport with carrier diversityfor network reliability. As customer line concentrations increase in acolocation, we are able to take advantage of carrier diversity techniques.Where Fiber Transport is not deployed, transport between our switches and ourcolocations is provided over more than one route in all cases and is purchasedfrom more than one provider in most cases. Using multiple routes and providersgives us a more robust network that maintains functionality should a transportroute incur a failure. By diversifying our high capacity circuits acrossmultiple vendors in each market, we maintain higher levels of networkreliability and lower network costs.

***Inter-City ATMBackbone Network.  ***Our Cisco BPX and Nortel PassportATM switches provide data traffic switching in our major markets. These ATMswitches are interconnected through leased long-haul transport obtained frommultiple wholesale providers. This ATM backbone carries IP data traffic betweenswitch locations. Customer access to the Internet and virtual private networkstravel over this network. ATM is a fully redundant, state-of-the-arttransmission and switching technology that carries both T1-based andDSL-based IP traffic more efficiently than traditional dedicated circuitnetworks.

***Customer Access Methods.  ***We havethe ability to serve small and medium-sized businesses in our markets by one ormore of the following methods:

·       ***T1***.   Customerswith greater than six voice lines at a single location can be served withleased high capacity connections directly from our colocation equipment to thecustomer’s location. We also offer the ability to share a single T1 connectionfor both voice and data services and to allocate the circuit capacity for voiceand data depending upon customer requirements. With this option, a customerwith as few as six total voice and data lines can take advantage of thisintegrated offering. For 2004, 57% of new access lines installed were installedon T1 circuits.

·       ***Analog UNE-loop***.   Toprovide analog voice services, we colocate our telephone access equipment inthe ILEC’s central offices and lease the ILEC’s facilities, known as unbundlednetwork elements, or UNEs, to connect customer locations to our colocationequipment. Customer locations with fewer than 10 phone lines are most likely tobe served with this method. We provide broad 

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facilities-basedcoverage by colocating in densely-populated areas so that we can access UNEsreaching approximately 70% of the estimated business access lines within ourselling areas from approximately 25% of the available ILEC central offices.

·       ***DSL***.   We providededicated connections over a pair of copper wires using DSL technology. Ourcustomers use DSL lines for data applications such as Internet access,intranets, extranets, telecommuting, e-commerce, e-mail, video conferencing andmultimedia. DSL is provided on the same copper wires as voice service or as adedicated line dependent upon customer upstream data speed requirements. DSL isnot available to all customers due to copper loop length limitations and ILECplant configurations.

·       ***UNE-P***.   We alsoprovide service via the UNE-P platform, typically to multi-location customerswho need additional access lines in locations where we do not own facilities. Asof December 31, 2004, 16% of our total access lines in service were UNE-P.

·       ***Qwest Platform Plus (QPP)***.   InJanuary 2005, we signed a three-year agreement with Qwest to purchase itsPlatform Plus product, which will replace the UNE-P platform.

·       ***Centrex Resale***.   Weresell Centrex services in the Eschelon legacy Reno market. Centrex is avalue-added business telephone service we purchase from SBC at wholesale ratesand invoice on our own bill. We serve customers having from two to40 lines at a single location with this method. In 2005, given theacquisition of ATI and the presence of a switch in the Reno market, we willconcentrate our new sales efforts on facilities-based services.

**Competition**

The communications industry is highly competitive. Webelieve we compete principally by offering superior customer service, accuratebilling, a broad set of services and competitive pricing. Our ability tocompete effectively depends upon our continued ability to maintain highquality, market-driven services at prices competitive to those charged by theILECs. Many of our current and potential competitors have financial, technical,marketing, personnel and other resources, including brand name recognition,substantially greater than ours, as well as other competitive advantages overus.

***ILECs.  ***Inour existing markets, we compete principally with Qwest. Qwest and other ILECshave long-standing relationships with their customers, have financial,technical and marketing resources substantially greater than ours, have thepotential to subsidize competitive services with revenue from a variety ofbusinesses and currently benefit from existing regulations that favor ILECsover us in some respects. As a relatively recent entrant in the communicationsservices industry, we may not achieve a major share of the market for any ofour services in our markets. While regulatory initiatives based on theTelecommunications Act, which allow competitive service providers such as us tointerconnect with Qwest’s facilities, provide increased business opportunitiesfor us, these interconnection opportunities have been, and likely will continueto be, accompanied by increased pricing flexibility for and relaxation ofregulatory oversight of Qwest and the other ILECs. Future regulatory decisionscould grant the ILECs greater pricing flexibility or other regulatory relief.These initiatives could have a material adverse effect on us.

***Competitive ServiceProviders and Other Market Entrants.  ***We also facecompetition from other competitive service providers. Consolidation andstrategic alliances within the communications industry or the development ofnew technologies could put us at a competitive disadvantage. TheTelecommunications Act radically altered the market opportunity for newcompetitive service providers. Because the Telecommunications Act requiresILECs to unbundle their networks, new competitive service providers are able torapidly enter the market by installing switches and leasing local loops.

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In addition to the new competitive service providers,ILECs and other competitors described above, we may face competition from othermarket entrants such as electric utilities, cable television companies,wireless service providers and virtual service providers using Voice overInternet Protocol (VoIP) over the public Internet or private networks. Electricutility companies have existing assets and low cost access to capital whichcould allow them to enter a market rapidly and accelerate network development.Cable television companies are entering the communications market by upgradingtheir networks with hybrid fiber coaxial lines and installing facilities toprovide fully interactive transmission of broadband voice, video and datacommunications. Wireless service providers are developing wireless technologyfor deployment in the United States, intending to provide a broadbandsubstitute for traditional wireline local telephones. Some companies aredelivering voice communications over the Internet.

***Long DistanceService.  ***The long distance communications industryhas numerous entities competing for the same customers which has historicallycreated high churn as customers frequently change long distance providers inresponse to offerings of lower rates or promotional incentives. Prices in thelong distance market have declined significantly in recent years and areexpected to continue to decline. Our primary competitors for long distanceservices are Interexchange Carriers (IXCs), ILECs and resellers. We believethat pricing levels are a principal competitive factor in providing longdistance service; however, we seek to avoid direct price competition bypackaging long distance service, local service, customer premise equipment andInternet access service together with a simple pricing plan.

***Business TelephoneSystems Sales.  ***We compete with numerous equipmentvendors and installers and communications management companies for businesstelephone systems and related services. We generally offer our products atprices consistent with other providers and differentiate our service throughour product packages and customer service.

***Data/Internet Services.  ***TheInternet services market is highly competitive, and we expect that competitionwill continue to intensify. Internet service, meaning both Internet access andon-line content services, is provided by Internet services providers, ILECs,satellite-based companies, long distance providers and cable televisioncompanies. Many of these companies provide direct access to the Internet and avariety of supporting services to businesses and individuals. In addition, manyof these companies, such as AOL and MSN, offer on-line content servicesconsisting of access to closed, proprietary information networks. Long distanceproviders, among others, are aggressively entering the Internet access markets.Long distance providers have substantial transmission capabilities,traditionally carry data to large numbers of customers and have an establishedbilling system infrastructure that permits them to add new services. Satellitecompanies are offering broadband access to the Internet from desktop PCs. Cablecompanies are providing Internet services using cable modems to customers inmajor markets. Many of these competitors have substantially greater brandrecognition and more financial, technological, marketing, personnel and otherresources than those available to us.

**Employees**

As of February 28, 2005, we had 1,139 full-timeequivalent employees. Twenty-six technicians who install and service BTS are membersof the International Brotherhood of Electrical Workers. The collectivebargaining agreement that was in effect through February 28, 2005, isstill in effect until a new contract is negotiated.

We believe that relationswith our employees, including members of the labor union, are good. We have notexperienced any work stoppage due to labor disputes.

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**Regulation**

**Overview**

We are subject to federal, state, local and foreignlaws, regulations, and orders affecting the rates, terms, and conditions ofcertain of our service offerings, our costs, and other aspects of ouroperations, including our relations with other service providers. Regulationvaries from jurisdiction to jurisdiction, and may change in response tojudicial proceedings, legislative and administrative proposals, governmentpolicies, competition, and technological developments. We cannot predict whatimpact, if any, such changes or proceedings may have on our business or resultsof operations, and we cannot guarantee that regulatory authorities will notraise material issues regarding our compliance with applicable regulations.

In general, the FCC has jurisdiction over ourfacilities and services to the extent they are used in the provision ofinterstate or international communications services. State regulatorycommissions, commonly referred to as PUCs (public utility commissions),generally have jurisdiction over facilities and services to the extent they areused in the provision of intrastate services, unless Congress or the FCC haspreempted such regulation. Local governments may regulate aspects of ourbusiness through zoning requirements, permit or right-of-way procedures, andfranchise fees. Foreign laws and regulations apply to communications thatoriginate or terminate in a foreign country. Our operations also are subject tovarious environmental, building, safety, health, and other governmental lawsand regulations. Generally, the FCC and PUCs do not regulate the Internet,video conferencing, or certain data services, although the underlyingcommunications components of such offerings may be regulated.

Federal law generallypreempts state statutes and regulations that restrict the provision ofcompetitive local, long distance and enhanced services; consequently, wegenerally are free to provide the full range of local, long distance and dataservices in every state. While this federal preemption greatly increases ourpotential for growth, it also increases the amount of competition to which wemay be subject. Enforcing federal preemption against certain state policies andprograms may be costly and may involve considerable delay.

**Federal Regulation**

The Communications Act of 1934, as amended, or theCommunications Act, grants the FCC authority to regulate interstate and foreigncommunications by wire or radio. We are regulated by the FCC as a non-dominantcarrier and are subject to less comprehensive regulation than dominantcarriers, but we remain subject to numerous requirements of the CommunicationsAct, including certain provisions of Title II, applicable to all commoncarriers, which require us to offer service upon reasonable request andpursuant to just and reasonable charges and terms, and which prohibit unjust orunreasonable discrimination in charges or terms. The FCC has authority toimpose additional requirements on non-dominant carriers.

The Telecommunications Act of 1996, or theTelecommunications Act, amended the Communications Act to eliminate manybarriers to competition in the U.S. communications industry. TheTelecommunications Act set basic standards for relationships betweencommunications service providers, including relationships between new entrantsand Regional Bell Operating Companies (RBOCs) and other ILECs. In general, theTelecommunications Act requires ILECs to provide competitors withnondiscriminatory access to and interconnection with ILEC networks, and toprovide UNEs at cost-based prices. The FCC and PUCs have adopted rules toimplement the Telecommunications Act and to encourage competition.

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***Long DistanceCompetition.  ***Section 271 of the CommunicationsAct, enacted as part of the Telecommunications Act, established a process bywhich an RBOC could obtain authority to provide long distance service in astate within its region. The process required demonstrating to the FCC that theRBOC has adhered to a 14-point competitive checklist and that grantingsuch authority would be in the public interest. On December 3, 2003, Qwestreceived FCC approval to provide in-state long distance service in the last ofthe 14 states in its region. Each of the other three RBOCs, Verizon, SBC, andBellSouth, already had received FCC approval to provide long distance servicesin each state within its respective region. Receipt of Section 271authority by the RBOCs has resulted in increased competition in certain marketsand services.

Section 272 of the Communications Act requiresthat for a period of three years after receiving Section 271 approval inany state, an RBOC must provide long-distance services through a separateaffiliate and comply with certain other structural and operational safeguards.This separate affiliate requirement expires in each state automatically, unlessthe FCC extends the three-year period. To date, the separate affiliaterequirement has expired by operation of law in several states and has not beenextended by the FCC in any state. Issues related to RBOC safeguards after thesunset of the separate affiliate requirements are the subject of a pending FCCrulemaking proceeding.

The RBOCs have a continuing obligation to comply withthe 14-point competitive checklist, and are subject to continuingoversight by the FCC and PUCs. Each RBOC must comply with state-specificPerformance Assurance Plans, or PAPs, pursuant to which an RBOC that fails toprovide access to its facilities in a timely and commercially sufficient mannermust provide to affected CLECs compensation in the form of cash or servicecredits. We have received PAP payments from Qwest in Arizona, Colorado,Minnesota, Oregon, Utah and Washington. We receive PAP payments from SBC inNevada and California. Our ability to obtain adequate interconnection andaccess to UNEs on a timely basis could be adversely affected by an RBOC’sfailure to comply with its Section 271 obligations.

***Local ServiceRegulation.  ***The Telecommunications Act required theFCC, in addition to overseeing the entry of the RBOCs into the long distancemarket, to establish national rules implementing the local competitionprovisions of the Telecommunications Act, which impose duties on all localexchange carriers, including CLECs, to provide network interconnection,reciprocal compensation, resale, number portability, and access torights-of-way. We are required to comply with these statutory obligations andthe FCC’s implementing rules.

The Telecommunications Act imposes additional dutieson ILECs, including the duty to provide access on an unbundled basis toindividual UNEs, including network facilities, features, and capabilities, onnon-discriminatory terms and cost-based rates; to allow competitors tointerconnect with their networks in a nondiscriminatory manner at anytechnically feasible point on their networks; to permit colocation ofcompetitors’ equipment at ILEC premises; and to offer their retail services forresale at wholesale rates.

***InterconnectionAgreements.  ***Pursuant to FCC rules implementingthe Telecommunications Act, we negotiate interconnection agreements with ILECsto obtain access to UNEs and services, generally on a state-by-state basis.These agreements typically have three-year terms. We currently haveinterconnection agreements in effect with Qwest for the states of Arizona,Colorado, Minnesota, Oregon, Utah and Washington, with SBC for the states ofNevada and California, and with Verizon for the states of Washington andOregon. If we enter new markets, we expect to establish interconnectionagreements with ILECs on an individual state basis. As discussed below, changesto our agreements based upon recent FCC orders ultimately will be incorporatedinto our interconnection agreements, but whether these changes will be effectedby negotiation or arbitration is uncertain.

We are in the process of renegotiating ourinterconnection agreements with Qwest for Colorado, Minnesota, and Washington.We anticipate that renegotiations will commence pursuant to statutorytimeframes in the near future for our interconnection agreements with Qwest inArizona, Oregon, and 

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Utah. We have hadexchanges with SBC for Nevada and California and with Verizon for Oregon andWashington regarding renegotiation of our interconnection agreements. If anynegotiation process does not produce, in a timely manner, an interconnectionagreement that we find acceptable, we may petition the applicable PUC toarbitrate any disputed issues. Arbitration decisions in turn may be appealed tofederal courts. We cannot predict how successful we will be in negotiatingterms critical to our provision of local network services, and we may be forcedto arbitrate certain provisions of necessary agreements. We are not a party toany current interconnection agreement arbitration proceeding. Otherinterconnection agreement arbitration proceedings before various statecommissions may result in decisions that could affect our business, but wecannot predict the extent of any such impact. As an alternative to negotiatingan interconnection agreement, we may adopt, in its entirety, another carrier’sapproved agreement. SBC has filed a complaint with the Nevada PUC against agroup of CLECs, including us, and has asked the PUC to order those CLECs toadopt an interconnection agreement amendment proposed by SBC. The PUC has notyet ruled on the complaint.

***Unbundled NetworkElements.  ***The Telecommunications Act requires ILECsto provide requesting telecommunications carriers with nondiscriminatory accessto network elements on an unbundled basis at any technically feasible point onrates, terms and conditions that are just, reasonable and non-discriminatory,in accordance with the other requirements set forth in Sections 251 and 252 ofthe Communications Act. The Telecommunications Act gives the FCC authority todetermine which network elements must be made available to requesting carrierssuch as us. For network elements that are not proprietary, the FCC is requiredto determine whether the failure to provide access to such network elementswould impair the ability of the carrier seeking access to provide the servicesit seeks to offer. The FCC has determined that most network elements arenonproprietary in nature and thus are subject to the “impair” standard. The FCC’sinitial list of ILEC network elements that are required to be unbundled on anational basis, or UNEs, was released in 1996.

When the FCC first adopted UNE rules, it indicatedthat it would reexamine the list of UNEs every three years. In December 2001,the FCC initiated its first so-called “triennial review” of those rules. In August 2003,in the Triennial Review Order, or TRO, the FCC substantially modified its rules governingaccess to UNEs. The FCC redefined the “impair” standard, concluding that a requestingcarrier is impaired when a lack of access to a UNE poses barriers to entry,including operational and economic barriers that are likely to make entry intoa market uneconomic. The FCC limited requesting carrier access to certainaspects of the loop, transport, switching and signaling/databases UNEs butcontinued to require some unbundling of these elements. In the TRO, the FCCalso determined that certain broadband elements, including fiber-to-the-home,or FTTH, loops in greenfield situations, broadband services over FTTH loops inoverbuild situations, packet switching, and the packetized portion of hybridloops, are not subject to unbundling obligations.

On March 2, 2004, the U.S. Court of Appeals forthe District of Columbia Circuit, or the D.C. Circuit, in *United States Telecom Ass’n v. FCC*, or the*USTA II* decision, vacated certainportions of the TRO and remanded to the FCC for further proceedings.Specifically, the D.C. Circuit vacated the FCC’s delegation of decision-makingauthority to state commissions and several of the FCC’s nationwide impairmentdeterminations. The D.C. Circuit also found that the FCC used a flawedmethodology when making certain impairment determinations, including thoserelating to the mass market switching and local transport network elements, andremanded those determinations to the FCC for further analysis andjustification. The D.C. Circuit affirmed the FCC’s decision to relieve theILECs from unbundling obligations with respect to broadband elements. The D.C.Circuit did not make a formal pronouncement regarding the status of the FCC’sfinding regarding enterprise market loops.

On February 4, 2005, the FCC released an Order onRemand of the TRO (the “TRRO”). The TRRO became effective on March 11,2005. The TRRO limits access to certain UNEs in specific situations in whichthe FCC considers that CLECs are not impaired without access to the UNE: First,unbundled 

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switching will beeliminated after a one-year transition period. During the transition, carrierswill pay $1 per line more for unbundled switching and may not order new lines.Second, DS1 transport UNEs will no longer be available between wire centersthat contain at least 38,000 business lines or have at least four fiber-basedcolocators. Third, DS3 transport or dark fiber UNEs will no longer be availablebetween wire centers containing at least 24,000 business lines or at leastthree fiber-based colocators. Fourth, transport UNEs between ILEC wire centersand CLEC switches will no longer be available. Fifth, DS1 UNE loops will not beavailable to any building in a wire center containing at least 60,000 businesslines and at least four fiber-based colocators. Sixth, DS3 UNE loops will notbe available to any building in a wire center containing at least 38,000 businesslines and at least four fiber-based colocators. Seventh, dark fiber UNE loopswill no longer be available. The Order provides a one-year transition periodfor DS1 and DS3 transport and loops and an 18-month transition period fordark fiber facilities. Rates for UNEs that are no longer available willincrease by 15% during the transition year, and CLECs will not be able to orderadditional UNEs along routes or to buildings that no longer qualify.

We do not lease material numbers of UNE-P lines fromeither SBC or Verizon. With respect to our UNE-P lines leased from Qwest, wehave entered into a commercial agreement referred to as Qwest’s Platform Plus (“QPP”).Under QPP, we continue to have access to unbundled switching over athree-and-one-half year period at gradually increasing rates.

We do not use DS3 UNE loops or dark fiber loops. Consequently,we are unaffected by these portions of the TRRO. However, we do use DS1 loopsand transport, DS3 transport, and a de minimis amount of dark fiber transport,and certain of our wire centers and routes will be affected by the TRRO. Ourcosts for existing UNEs affected by the TRRO will increase an estimated 15%during the year-long transition period provided by the TRRO. We will have toplace new orders for delisted UNEs as special access orders, generally atprices significantly higher than UNE rates, unless we can locate alternativesuppliers offering more favorable rates.

We have estimated our increased costs due to the TRROto be approximately $2.5 million in 2005. This includes the increased costs ofQPP, the increased cost of transitional UNEs, and the need to replace UNEs nolonger available through special access orders or through other suppliers. Weestimate our increased costs due to the TRRO for 2006 to be approximately $3.1million. Our estimates are based upon assumptions concerning market demand forour products and our ability to secure alternative suppliers of facilities incertain areas.

Shortly after adoption of the TRRO in December 2004,the ILECs petitioned the D.C. Circuit, asking it to retain jurisdiction overthe proceeding and also to adopt an expedited briefing schedule for the appealof the TRRO. The FCC and various CLECs filed responses, arguing that nointervention by the Court is necessary. On March 16, 2005, the Courtdismissed the petition without prejudice, leaving parties free to appeal theTRRO or petition the Court for a writ of mandamus with respect to the finalrules. Several CLECs have already filed appeals in various Circuit Courts, andwe anticipate that the RBOCs and their trade association, the United StatesTelephone Association, also will file appeals. We also expect both RBOCs andCLECs to file for reconsideration of the TRRO at the FCC. On March 15,2005, the FCC rejected Verizon’s Petition for Stay of the TRRO pending judicialreview. We are currently considering whether to join with other CLECs in filingfor reconsideration and/or appeal of the TRRO. We cannot predict what effects,if any, these various legal proceedings may have upon our business.

Following adoption of the TRRO, Qwest informed us thatit planned to invoke the “change of law” provisions in our interconnectionagreements. These provisions generally provide that when a party to theagreement believes that its obligations under the agreement have changed as aresult of a change in applicable law, it may request that the other party enterinto negotiations to amend the agreement, and that in the event the parties areunable to agree upon an amendment, the dispute is to be arbitrated either by aneutral arbitrator or by the relevant state commission. We have commencednegotiations with Qwest 

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regarding amendments toour interconnection agreements, but we do not know when such negotiations mightconclude or the impact on our business of an amendment to any of ourinterconnection agreements resulting from such negotiations, apart from theimpacts discussed above.

SBC and Verizon have taken the position that the TRROis immediately effective, without regard to change of law provisions in theirinterconnection agreements with us. Our position is that any changes resultingfrom the TRRO must be effected through the change of law provisions to ourinterconnection agreements. Proceedings to resolve this dispute are underway,or will soon commence, before the PUCs in Nevada, California, Washington, andOregon. We cannot predict the outcome of these proceedings.

FCC rules implementing the local competitionprovisions of the Telecommunications Act permit CLECs to lease UNEs at ratesdetermined by PUCs employing the FCC’s Total Element Long Run Incremental Cost,or TELRIC, forward-looking, cost-based pricing model. On September 15,2003, the FCC opened a proceeding reexamining the TELRIC methodology andwholesale pricing rules for communications services made available forresale by ILECs in accordance with the Telecommunications Act. This proceedingwill comprehensively re-examine whether the TELRIC pricing model producesunpredictable pricing inconsistent with appropriate economic signals; fails toadequately reflect the real-world attributes of the routing andtopography of an ILEC’s network; and creates disincentives to investment infacilities by understating forward-looking costs in pricing RBOC networkfacilities and overstating efficiency assumptions. We have participated in thisproceeding as a member of a consortium of CLECs. To date the FCC has not yetissued revised TELRIC rules. The application and effect of a revised TELRICpricing model on the communications industry generally and on certain of ourbusiness activities cannot be determined at this time.

In orders released in August 2004, the FCCextended unbundling relief to FTTH loops serving predominantly residentialmultiple dwelling units, or MDUs, and granted the same unbundling relief tofiber-to-the-curb, or FTTC, that it has applied to FTTH. We do not know whereQwest, SBC or Verizon have replaced their copper facilities with fiber or wherethey may do so in the future. Consequently, we cannot determine the impact theseorders will have upon our business. Because we serve business customers only,we do not believe these orders will substantially affect our business.

On October 27, 2004, the FCC issued an ordergranting requests by the RBOCs that the FCC forbear from enforcing theindependent unbundling requirements of Section 271 of the CommunicationsAct with regard to the broadband elements that the FCC had determined in theTRO are not subject to unbundling obligations (FTTH loops, FTTC loops, thepacketized functionality of hybrid loops, and packet switching). The FCCdeclined to address broader forbearance requests by SBC and Qwest, who hadasked the FCC to forbear from applying Section 271 requirements to anyelement that the FCC has determined no longer meets the impairment standard.Legal challenges to these orders continue.

***Colocation.  ***FCCrules generally require ILECs to permit competitors to colocate equipmentused for interconnection and/or access to UNEs. Changes to those rules, upheldin 2002 by the D.C. Circuit, allow competitors to colocate multifunctionalequipment and require ILECs to provision cross-connects between colocatedcarriers. We cannot determine the effect, if any, of future changes in the FCC’scolocation rules on our business or operations.

***IntercarrierCompensation.  ***The FCC’s intercarrier compensation rules includerules governing access charges, which govern the payments that IXCs andcommercial mobile radio service providers make to local exchange carriers tooriginate and terminate long distance calls, and reciprocal compensation rules,which generally govern the compensation between telecommunications carriers forthe transport and termination of local traffic. We purchase long distanceservice on a wholesale basis from an IXC who pays access fees to local exchangecarriers for the origination and termination of our long distancecommunications traffic. Generally, intrastate access charges are higher thaninterstate access charges. Therefore, to the degree access charges increase ora greater percentage of our long distance traffic is 

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intrastate, our costs ofproviding long distance services will increase. As a local exchange provider,we bill long distance providers access charges for the origination andtermination of those providers’ long distance calls. Accordingly, in contrastwith our long distance operations, our local exchange business benefits fromthe receipt of intrastate and interstate long distance traffic. As an entitythat collects and remits access charges, we must properly track and record thejurisdiction of our communications traffic and remit or collect access chargesaccordingly. The result of any changes to the existing regulatory scheme foraccess charges or a determination that we have been improperly recording thejurisdiction of our communications traffic could have a material adverse effecton our business.

Our costs of providing long distance services, and ourrevenues for providing local services, also are affected by changes in accesscharge rates imposed on CLECs. Pursuant to the FCC’s 2001 CLEC Access ChargeOrder, which lowered the rates that CLECs may charge long distance carriers forthe origination and termination of calls over local facilities, access rateswere reduced during Fiscal 2003 and Fiscal 2004. AT&T and Sprint haveappealed the CLEC Access Charge Order to the D.C. Circuit, arguing that the FCC’sbenchmark rates are too high.

The FCC issued the first Access Charge Reform Reportand Order in 1997. Although the FCC has since issued five further orders inthat docket, several petitions for reconsideration and clarification of the1997 Order remain pending. On December 15, 2003, the FCC issued a publicnotice requesting that the parties to such petitions file supplemental noticesidentifying any issues that were raised in the petitions and which have notbeen otherwise resolved. We cannot predict whether the FCC will further modifyits access charge rules as a result of this proceeding, or the effect thatany such changes would have on our business.

Over the last several years, the FCC has granted ILECssignificant flexibility in pricing interstate special and switched accessservices. In August 1999, the FCC granted immediate pricing flexibility tomany ILECs and established a framework for granting greater flexibility in thepricing of all interstate access services once an ILEC market satisfies certainprescribed competitive criteria. In February 2001, the D.C. Circuit upheldthe FCC’s prescribed competitive criteria. To date, the FCC has granted pricingflexibility in numerous specific markets to the RBOCs, including Qwest. Thispricing flexibility may result in Qwest lowering its prices in high trafficdensity areas, including areas where we compete or plan to compete. Weanticipate that the FCC will continue to grant ILECs greater pricingflexibility for access services if the number of actual and potentialcompetitors increases in each of these markets.

The FCC has stated that existing intercarriercompensation rules constitute transitional regimes and has promised toreform them. On March 3, 2005, the FCC released a Further Notice ofProposed Rulemaking seeking comment on a variety of proposals to replace thecurrent system of intercarrier payments, under which the compensation ratedepends on the type of traffic at issue, the type of carriers involved, and theend points of the communication, with a unified approach for access charges andreciprocal compensation. Comments have not yet been filed. Because we both makepayments to and receive payments from other carriers for the exchange of localand long distance calls, we will be affected by changes in the FCC’sintercarrier compensation rules. We cannot predict the impact that any suchchanges may have on our business.

***Detariffing.  ***Consistentwith other deregulatory measures, the FCC has largely eliminated carriers’obligations to file with the FCC tariffs containing prices, terms andconditions of service. All carriers, including us, were required to completethis detariffing process for interstate domestic commercial, orcustomer-specific, services by January 31, 2001, for consumer mass-marketservices by July 31, 2001, and for international services by January 2002.In lieu of federal tariffs, the FCC requires carriers with corporate web sitesto post information relating to the rates, terms, and conditions of services ontheir web sites. Detariffing precludes our ability to rely on filed rates,terms, and conditions as a means of providing notice to customers of prices,terms and conditions under which we offer services, and requires us instead 

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to rely on individuallynegotiated agreements with end users. We remain subject to the CommunicationsAct’s requirements that rates, terms and conditions of communications servicebe just, reasonable, and not discriminatory, and we are subject to the FCC’sjurisdiction over customer complaints regarding our communications services.

In 2002, a coalition of consumer-protection advocatesand PUCs asked the FCC to require non-dominant IXCs to give at least30 days advance written notice to their presubscribed customers of anymaterial change to the rates, terms or conditions of a carrier-customeragreement. The coalition argued that since detariffing took effect, customeragreements generally offered by large long-distance carriers reserve for thecarriers the right to unilaterally change rates, terms and conditions at anytime, thereby preventing consumers from making informed decisions regarding theterms under which they acquire service from carriers. To date, the FCC has notinstituted such a proceeding. If adopted, such requirements could constrain ourability to modify our rates, terms and conditions in response to competitivemarket pressures.

***Universal Service.  ***Section 254of the Communications Act and the FCC’s implementing rules require allcommunications carriers providing interstate or international communicationsservices to periodically contribute to the Universal Service Fund, or USF. TheUSF supports four programs administered by the Universal Service AdministrativeCompany with oversight from the FCC: (i) communications and informationservices for schools and libraries, (ii) communications and informationservices for rural health care providers, (iii) basic telephone service inregions characterized by high communications costs or low income levels, and (iv) interstatecommon line support. Periodic USF contribution requirements currently aremeasured and assessed based on the total subsidy funding needs and eachcontributor’s percentage of the total of certain interstate and internationalend user communications revenues reported to the FCC by all communicationscarriers. We measure and report our revenues in accordance with rules adoptedby the FCC. The contribution rate factors are calculated and revised quarterlyand we are billed for our contribution requirements each month based onprojected interstate and international end-user communications revenues,subject to periodic true up.

USF contributions may be passed through to consumerson an equitable and nondiscriminatory basis either as a component of the ratecharged for communications services or as a separately invoiced line item.Since April 1, 2003, communications carriers have been prohibited fromusing a separate line item on invoices to identify as a recovery of USFcontributions amounts that exceed the rate of actual USF contributions.

A proceeding pending before the FCC has the potentialto significantly alter our USF contribution obligations. The FCC is consideringchanging the basis upon which our USF contributions are determined from arevenue percentage measurement to a connection or telephone number measurement.Adoption of this proposal could have a material adverse affect on our costs,our ability to separately list USF contributions on end-user bills, and ourability to collect these fees from our customers.

The application and effect of changes to the USFcontribution requirements and similar state requirements on the communicationsindustry generally and on certain of our business activities cannot bepredicted. If our collection procedures result in over collection, we could berequired to make reimbursements of such over collection and be subject topenalty, which could have a material adverse affect on our business, financialcondition and results of operations. If a federal or state regulatory bodydetermines that we have incorrectly calculated or remitted any USFcontribution, we could be subject to the assessment and collection of past dueremittances as well as interest and penalties thereon. We do not receive anyrevenues from the USF.

***TelephoneNumbering.  ***The FCC oversees the administration andthe assignment of local telephone numbers, an important asset to voicecarriers, by NeuStar, Inc., in its capacity as North American NumberingPlan Administrator. Extensive FCC regulations govern telephone numbering, areacode 

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designation, and dialingprocedures. Since 1996, the FCC has permitted businesses and residentialcustomers to retain their telephone numbers when changing local telephonecompanies, referred to as local number portability. The availability of numberportability is important to competitive carriers like us, because customers,especially businesses, may be less likely to switch to a competitive carrier ifthey cannot retain their existing telephone numbers.

The FCC and PUCs work with industry groups andcompanies to address potential problems stemming from the depletion in certainmarkets of the pool of telephone numbers which communications service providersmake available to their customers. If a sufficient amount of telephone numbersis not available to us in a market, our operations in that market may beadversely affected or we may be unable to enter that market until sufficientnumbers become available. Consolidation among operating CLECs appears to havereduced, at least in the short term, the demand for new blocks of telephonenumbers and the risk of telephone number depletion.

***Slamming.  ***Acustomer’s choice of local or long distance communications company is encodedin the customer’s record, which is used to route the customer’s calls so thatthe customer is served and billed by the desired company. A customer may changeservice providers at any time, but the FCC and some states regulate thisprocess and require that specific procedures be followed. Slamming occurs whenthese specific procedures are not followed, such as when a customer’s serviceprovider is changed without proper authorization or as a result of fraud. TheFCC has levied substantial fines for slamming. The risk of financial damage, inthe form of fines, penalties and legal fees and costs and to businessreputation from slamming is significant. We maintain internal proceduresdesigned to ensure that our new subscribers are switched to us and billed inaccordance with federal and state regulations. Because of the volume of serviceorders that we may process, it is possible that some carrier changesinadvertently may be processed without authorization. Therefore, we cannotguarantee that we will not be subject to slamming complaints in the future.

***CommunicationsAssistance for Law Enforcement Act.  ***TheCommunications Assistance for Law Enforcement Act, or CALEA, requirescommunications providers to provide law enforcement officials with call contentand call identifying information under a valid electronic surveillance warrant,and to reserve a sufficient number of circuits for use by law enforcementofficials in executing court-authorized electronic surveillance. Because weprovide facilities-based services, we incur costs in meeting theserequirements. Noncompliance with these requirements could result in substantialfines. Although we will attempt to comply, we cannot assure that we would notbe subject to a fine in the future.

***NetworkInformation.  ***FCC rules protect the privacy ofcertain information about customers that communications carriers, including us,acquire in the course of providing communications services. Such protectedinformation, known as Customer Proprietary Network Information, or CPNI,includes information related to the quantity, technological configuration,type, destination and the amount of use of a communications service. The FCC’sinitial CPNI rules prevented a carrier from using CPNI to market certainservices without the express approval of the affected customer, referred to asan opt-in approach. In July 2002, the FCC revised its opt-in rules ina manner that limits our ability to use the CPNI of our subscribers withoutfirst engaging in extensive customer service processes and record keeping. Weuse our subscribers’ CPNI in accordance with applicable regulatoryrequirements. However, if a federal or state regulatory body determines that wehave implemented those guidelines incorrectly, we could be subject to fines orpenalties. In addition, correcting our internal customer systems and CPNIprocesses could generate significant administrative expenses.

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***Regulation ofInternet Service Providers and VoIP.  ***To date, theFCC has treated Internet service providers, or ISPs, as enhanced serviceproviders exempt from federal and state regulations governing common carriers,including the obligation to pay access charges and contribute to the USF.Nevertheless, regulations governing the disclosure of confidentialcommunications, copyright, excise tax and other requirements may apply to ourInternet access services. In addition, Congress has passed a number of laws thatconcern the Internet and Internet users. Generally, these laws limit thepotential liability of ISPs and hosting companies that do not knowingly engagein unlawful activity. We expect that Congress will consider this year a varietyof bills, some of which, if signed into law, could impose obligations on us tomonitor the Internet activities of our customers.

Where communications service providers have offeredenhanced services in addition to their communications services, the FCC andPUCs generally have exempted the enhanced service component and its associatedrevenue from legacy communications regulations. Some of the services we provideare enhanced services. Future and pending FCC and state proceedings maysignificantly affect our provision of enhanced services.

The use of the public Internet and private Internetprotocol networks to provide voice communications services, includingvoice-over-Internet protocol, or VoIP, is a relatively recent marketdevelopment. The provision of such services is largely unregulated within theUnited States. In a 1998 Report to Congress, the FCC declined to conclude thatIP telephony services constitute telecommunications services and stated that itwould undertake a subsequent examination of whether certain forms of phone-to-phoneInternet telephony are information services or telecommunications services. TheFCC indicated that, in the future, it would consider the extent to whichphone-to-phone Internet telephony providers could be consideredtelecommunications carriers such that they could be subject to regulationsgoverning traditional telephone companies. The FCC also stated that, althoughit did not have a sufficient record upon which to make a definitive ruling, therecord suggested that, to the extent that certain forms of phone-to-phone IPtelephony appear to possess the same characteristics as traditionalcommunications services and to the extent the providers of those servicesutilize circuit-switched access in the same manner as IXCs, the FCC may find itreasonable to require that IP telephony providers pay similar access charges.The FCC recognized, however, that it should consider forbearing from imposing rules thatwould apply to phone-to-phone Internet telephony providers if they wereclassified as telecommunications carriers. To date, the FCC has not imposedregulatory surcharges or traditional common carrier regulation upon providersof Internet communications services.

Several pending FCC proceedings will affect theregulatory status of Internet telephony. On February 12, 2004, the FCCadopted a notice of proposed rulemaking to address, in a comprehensive manner,the future regulation of services and applications making use of Internetprotocol, including VoIP. In the absence of federal legislation, we expect thatthrough this proceeding the FCC will resolve certain regulatory issues relatingto VoIP services and develop a regulatory framework that is unique to IPtelephony providers or that subjects VoIP providers to minimal regulatoryrequirements. We cannot predict when the FCC may take such actions. The FCC maydetermine that certain types of Internet telephony should be regulated likebasic interstate communications services, rendering VoIP calls subject to theaccess charge regime that permits local telephone companies to charge longdistance carriers for the use of the local telephone networks to originate andterminate long-distance calls, generally on a per minute basis. The FCC alsomay conclude that Internet telephony providers should contribute to the USF.The FCC’s pending review of intercarrier compensation policies (discussedabove) also may have an adverse impact on enhanced service providers.

In a series of decisions issued in 2004, the FCCclarified that the FCC, not the state PUCs, has jurisdiction to decide theregulatory status of IP-enabled services, including VoIP. Most recently, on November 12,2004, in response to a request by Vonage Holdings Corp. (Vonage), a VoIPservices provider, the FCC issued an order preempting traditional telephonecompany regulation of VoIP service 

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by the Minnesota PUC,finding that the service cannot be separated into interstate and intrastatecommunications without negating federal rules and policies. In September 2003,the Minnesota PUC issued an order requiring Vonage to comply with Minnesotalaws that regulate telephone companies. That order was appealed to the U.S.District Court for the District of Minnesota, which enjoined enforcement of theorder pending action by the FCC on Vonage’s request for preemption. Earlierthis year, the federal Court of Appeals for the Eighth Circuit upheld theinjunction.

On October 18, 2002, AT&T filed a petitionwith the FCC seeking a declaratory ruling that would prevent ILECs fromimposing traditional circuit-switched access charges on phone-to-phone IPservices. In April 2004, the FCC issued an order concluding that, undercurrent rules, AT&T’s phone-to-phone IP telephony service is atelecommunications service upon which interstate access charges may beassessed. AT&T’s service consists of an interexchange call initiated by anend user who dials 1 + the called number from a regular telephone.When the call reaches AT&T’s network, AT&T converts it into an IPformat and transports it over AT&T’s Internet backbone. AT&T then convertsthe call back from the IP format and delivers it to the called party throughlocal exchange carrier local business lines. This decision is thus limited tointerexchange service that: (1) uses ordinary customer premises equipmentwith no enhanced functionality; (2) originates and terminates on thepublic switched telephone network; and (3) undergoes no net protocolconversion and provides no enhanced functionality to end users due to theprovider’s use of IP technology. The FCC made no determination regardingretroactive application of its ruling, and stated that the decision does notpreclude it from adopting a different approach when it resolves the IP-EnabledServices or Intercarrier Compensation rulemaking proceedings.

On February 5, 2003, pulver.com filed a petitionwith the FCC seeking a declaratory ruling that its Free World Dialup service,which facilitates point-to-point broadband Internet protocol voicecommunications, is neither telecommunications nor a telecommunications serviceas these terms are defined in the Communications Act. The FCC granted thepulver.com petition on February 12, 2004, establishing that Free WorldDialup is an information service, as defined in the Communications Act. The FCClimited this finding to VoIP services that, like Free World Dialup, existsolely as an Internet application, similar to electronic mail and instantmessaging, and which do not rely on the public switched telephone network.Information services are subject to federal regulatory authority, but may notbe regulated by state authorities.

On December 23, 2003, Level 3 Communications LLCfiled a petition asking the FCC to forbear from applying interstate andintrastate access charges to VoIP communications. The FCC issued a PublicNotice in January 2004 seeking comment on the petition but has not yetissued a decision.

Other aspects of VoIP and Internet telephony services,such as regulations relating to the confidentiality of data and communications,copyright issues, taxation of services, licensing and 911 emergency access, maybe subject to federal or state regulation. For instance, in 2002 the FCCundertook an examination of whether emergency 911 requirements should beextended to packet-based networks and services. Similarly, changes in the legaland regulatory environment relating to the Internet connectivity market,including regulatory changes that affect communications costs or that mayincrease the likelihood of competition from RBOCs or other communicationscompanies could increase our costs of providing service.

***CallingCards*****.**   On February 23, 2005, the FCC foundthat AT&T Corp. unlawfully avoided paying millions of dollars of universalservice contributions and other fees related to a long-distance calling cardservice marketed by the company. The FCC rejected an assertion by AT&T thatits practice of inserting advertisements in the calling card servicetransformed it into an unregulated “information service” not subject touniversal service assessments. The advertisements are incidental to the underlyingtelecommunications service offered to the cardholder, the FCC found, and do notchange the regulatory status of the service. The FCC ordered AT&T to filerevised universal service contributions forms for the 

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entireperiod that AT&T has provided its calling card service. In its November 2004filings with the Securities and Exchange Commission, AT&T reported that ithad avoided $160 million in universal service contributions on the card since1999. The FCC also rejected AT&T’s assertion that calls made within a stateshould not be subject to intrastate access charges. AT&T said the calls areexempt because they are routed through AT&T’s out-of-state switchingplatform. The FCC generally determines the jurisdiction of a call by itsendpoints; calls that originate and terminate in the same state are consideredjurisdictionally intrastate. The FCC also initiated a rulemaking to addresscomprehensively the appropriate regulatory regime for all calling cards. Weoffer calling card services to our customers. We have taken our calling cardrevenues into account in calculating our universal service contributions and donot believe that the FCC’s determinations in the AT&T decision affects us. Wethink it is unlikely, but we cannot be certain, that the announced rulemakingwill result in any detrimental changes to our accounting treatment for thoseservices.

***Taxes andRegulatory Fees.  ***We are subject to numerous local,state and federal taxes and regulatory fees, including but not limited to athree percent federal excise tax on communications service, FCC regulatory feesand public utility commission regulatory fees. We have procedures in place toensure that we properly collect taxes and fees from our customers and remitsuch taxes and fees to the appropriate entity pursuant to applicable law and/orregulation. If our collection procedures prove to be insufficient or if ataxing or regulatory authority determines that our remittances were inadequate,we could be required to make additional payments, which could have a materialadverse effect on our business.

On July 2, 2004, theInternal Revenue Service issued an advance notice of proposed rulemaking askingfor public comment on expanding the current three percent excise tax to newcommunications services, such as VoIP and other IP-based services,applications, and technologies, to reflect changes in technology. The commentperiod expired September 30, 2004. We cannot predict the outcome of thisproceeding on our business.

**State Regulation**

The Communications Act maintains the authority ofindividual states to impose their own regulation of rates, terms and conditionsof intrastate services, so long as such regulation is not inconsistent with therequirements of federal law or has not been preempted. Because we providecommunications services that originate and terminate within individual states,including both local service and in-state long distance toll calls, we aresubject to the jurisdiction of the PUC and other regulators in each state inwhich we provide such services. For instance, we must obtain a Certificate ofPublic Convenience and Necessity, or CPCN, or similar authorization before wemay commence the provision of communications services in a state. We haveobtained CPCNs to provide facilities-based or resold competitive local andinterexchange service in Arizona, Colorado, Minnesota, Nevada, Oregon, Utah andWashington. We recently received authorization to provide local and longdistance telephone service in Texas and California. There can be no guarantee thatwe will receive authorizations we may seek in other states in the future. Asour local service business expands, we may offer additional intrastate servicesand may become subject to additional state regulations.

In addition to requiring certification, stateregulatory authorities may impose tariff and filing requirements andobligations to contribute to state universal service and other funds. Statecommissions also have jurisdiction to approve negotiated rates, and toestablish rates through arbitration, for interconnection, including rates forUNEs. Changes in rates for UNEs could have a material adverse effect on ourbusiness.

We also are subject to state laws and regulationsregarding slamming, cramming, and other consumer protection and disclosureregulations. These rules could substantially increase the cost of doingbusiness in any particular state. State commissions have issued or proposedsubstantial fines against CLECs for 

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slamming or cramming. Therisk of financial damage, in the form of fines, penalties and legal fees andcosts and to business reputation from slamming is significant. A slammingcomplaint before a state commission could generate substantial litigationexpenses. In addition, state law enforcement authorities may use their consumerprotection authority against us if we fail to meet applicable state lawrequirements.

States also retain the right to sanction a serviceprovider or to revoke certification if a service provider violates relevantlaws or regulations. If any regulatory agency were to conclude that we are orwere providing intrastate services without the appropriate authority, theagency could initiate enforcement actions, which could include the impositionof fines, a requirement to disgorge revenues, or refusal to grant regulatoryauthority necessary for the future provision of intrastate services.

We may be subject to requirements in some states toobtain prior approval for, or notify the state commission of, any transfers ofcontrol, sales of assets, corporate reorganizations, issuance of stock or debtinstruments and related transactions. Although we believe such authorizationscould be obtained in due course, there can be no assurance that statecommissions would grant us authority to complete any of these transactions, orthat such authority would be granted on a timely basis.

Rates for intrastate switched access services, whichwe provide to long-distance companies to originate and terminate in-state tollcalls, are subject to the jurisdiction of the state in which the calloriginated and/or terminated. Such regulation by states could have a materialadverse affect on our revenues and business opportunities within that state.PUCs also regulate the rates ILECs charge for interconnection of networkelements with, and resale of, services by competitors. In response to theUSTA II decision and the FCC’s ongoing TRO proceedings, some statecommissions have continued proceedings to address issues affecting the rates,terms and conditions of intrastate services while other states suspended orterminated their proceedings. Any such proceedings may affect the rates, terms,and conditions contained in our interconnection agreements. The pricing, termsand conditions under which the ILEC in each of the states in which we currentlyoperate offers such services may preclude our ability to offer a competitivelyviable and profitable product within these and other states on a going forwardbasis.

State governments and regulators may attempt to assertjurisdiction over the provision of intrastate IP communications services.Various state regulatory authorities already have initiated proceedings toexamine the regulatory status of Internet telephony services. While most PUCshave not indicated an intention to impose traditional communications regulatoryrequirements on IP telephony, some PUCs have issued rulings that may beinterpreted differently. For instance, a state court in Colorado has ruled thatthe use of the Internet to provide certain intrastate services does not exemptan entity from paying intrastate access charges. Prior to imposing regulatoryburdens on VoIP providers, however, the Colorado PUC opened a docket toinvestigate whether it has jurisdiction to regulate VoIP services. Any suchstate proceedings will be affected by the FCC’s IP Telephony rulemakingproceeding, in which the FCC is considering the extent to which conflictingstate regulation of IP telephony is preempted.

State legislatures andstate PUCs also regulate, to varying degrees, the terms and conditions upon whichour competitors conduct their retail businesses. In general, state regulationof RBOC retail offerings is greater than the level of regulation applicable toCLECs. Qwest, SBC and Verizon either have obtained or are actively seeking somelevel of deregulation, either through amendment of state law or throughproceedings before state PUCs. We cannot predict whether these efforts willmaterially affect our business.

**Local Regulation**

In some municipalitieswhere we have installed facilities, we are required to pay license or franchisefees based on a percentage of our revenue generated from within the municipalboundaries. We cannot guarantee that fees will remain at their current levelsfollowing the expiration of existing franchises or that other local jurisdictionswill not impose similar fees.

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**Other Domestic Regulation**

We are subject to a variety of federal, state, andlocal environmental, safety and health laws, and regulations governing matterssuch as the generation, storage, handling, use, and transportation of hazardousmaterials, the emission and discharge of hazardous materials into theatmosphere, the emission of electromagnetic radiation, the protection ofwetlands, historic sites, and endangered species and the health and safety ofemployees. We also may be subject to laws requiring the investigation andcleanup of contamination at sites it owns or operates or at third-party wastedisposal sites. Such laws often impose liability even if the owner or operatordid not know of, or was not responsible for, the contamination.

We operate numerous sitesin connection with our operations. We are not aware of any liability or allegedliability at any operated sites or third-party waste disposal sites that wouldbe expected to have a material adverse effect on us. Although we monitor ourcompliance with environmental, safety and health laws and regulations, wecannot give assurances that it has been or will be in complete compliance withthese laws and regulations. We may be subject to fines or other sanctions byfederal, state and local governmental authorities if we fail to obtain requiredpermits or violate applicable laws and regulations.

**Available Information**

Copies of our AnnualReport on Form 10-K, Quarterly Reports on Form 10-Q, Current Reportson 8-K, and amendments to those reports filed or furnished to theSecurities Exchange Commission pursuant to Section 13(a) or 15(d) ofthe Securities Exchange Act of 1934 are available free of charge through ourwebsite (*www.eschelon.com*) as soon as reasonably practicableafter we electronically file the material with, or furnish it to, theSecurities Exchange Commission.

**Item 2.**                        Properties.

We are headquartered in Minneapolis, Minnesota andconduct our principal operations in Minnesota, Washington, Oregon, Colorado,Arizona, Utah, Nevada and California.

We donot own any of our facilities. The table below lists our leased facilities asof February 28, 2005.
| **Location**                    | ** ** | ** **             | ** ** | **Lease Expiration** | ** ** | **Square   Footage** | ** ** | **Purpose**            | ** ** |
|---------------------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|------------------------|------------|
| Minneapolis, MN                 |       | November 30, 2012 |       |                 | 95,037     |                 |       | Main Office            |       |
| Minneapolis, MN                 |       | April 15, 2009    |       |                 | 17,342     |                 |       | Switch Facility/NOC    |       |
| Minneapolis, MN                 |       | June 30, 2005     |       |                 | 4,887      |                 |       | Data Switch Facility   |       |
| Golden Valley, MN               |       | January 31, 2007  |       |                 | 33,246     |                 |       | Office/Warehouse       |       |
| Phoenix, AZ                     |       | May 15, 2010      |       |                 | 5,545      |                 |       | Switch Facility        |       |
| Phoenix, AZ                     |       | February 1, 2009  |       |                 | 9,391      |                 |       | Office                 |       |
| Santa Rosa, CA                  |       | April 30, 2014    |       |                 | 8,278      |                 |       | Switch Facility/NOC    |       |
| Santa Rosa, CA                  |       | August 1, 2007    |       |                 | 10,500     |                 |       | Office                 |       |
| Denver, CO                      |       | January 31, 2011  |       |                 | 6,000      |                 |       | Switch Facility        |       |
| Wheatridge, CO                  |       | June 15, 2005     |       |                 | 9,000      |                 |       | Office/Warehouse       |       |
| Wheatridge, CO                  |       | November 30, 2006 |       |                 | 9,514      |                 |       | Office/Warehouse       |       |
| Greenwood Village, CO |       | January 31, 2009  |       |                 | 3,965      |                 |       | Office                 |       |
| Reno, NV                        |       | July 31, 2006     |       |                 | 1,443      |                 |       | Office                 |       |
| Reno, NV                        |       | June 1, 2011      |       |                 | 6,053      |                 |       | Switch Facility        |       |
| Reno, NV                        |       | July 31, 2009     |       |                 | 8,778      |                 |       | Switch Facility/Office |       |
| Portland, OR                    |       | February 28, 2006 |       |                 | 9,760      |                 |       | Switch Facility        |       |
| Portland, OR                    |       | December 31, 2009 |       |                 | 7,028      |                 |       | Switch Facility        |       |
| Portland, OR                    |       | June 30, 2008     |       |                 | 15,033     |                 |       | Office/Warehouse       |       |
| Salem, OR                       |       | May 14, 2005(1)   |       |                 | 1,800      |                 |       | Office                 |       |

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| Salem, OR          |   | April 30, 2009     |   |   | 7,997  |   |   | Switch Facility        |   |
|--------------------|--------|-------------------------|--------|--------|--------|--------|--------|------------------------|--------|
| Salem, OR          |   | April 30, 2005(2)  |   |   | 30,000 |   |   | Office                 |   |
| Salem, OR          |   | April 30, 2006     |   |   | 13,695 |   |   | Office                 |   |
| Eugene, OR         |   | December 31, 2006  |   |   | 1,950  |   |   | Office                 |   |
| Salt Lake City, UT |   | January 31, 2010   |   |   | 6,744  |   |   | Switch Facility        |   |
| Murray, UT         |   | May 14, 2005       |   |   | 7,855  |   |   | Office                 |   |
| Murray, UT         |   | June 14, 2005      |   |   | 1,229  |   |   | Office                 |   |
| Murray, UT         |   | June 14, 2005      |   |   | 1,363  |   |   | Warehouse              |   |
| Yakima, WA         |   | September 30, 2014 |   |   | 5,750  |   |   | Switch Facility/Office |   |
| Everett, WA        |   | September 15, 2010 |   |   | 16,000 |   |   | Switch Facility/Office |   |
| Seattle, WA        |   | December 31, 2009  |   |   | 12,645 |   |   | Switch Facility        |   |
| Tukwila, WA        |   | August 31, 2009    |   |   | 18,803 |   |   | Office/Warehouse       |   |
| Tacoma, WA         |   | January 31, 2009   |   |   | 11,373 |   |   | Switch Facility/Office |   |
| Tacoma, WA         |   | July 31, 2009      |   |   | 3,332  |   |   | Office                 |   |

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(1)*         *Willnot be renewed.

(2)*         *Whenthis lease expires, it will be replaced with the next lease listed.

We believe that thefacilities used in our operations are suitable for their respective uses andadequate to meet our current needs. We are taking steps to consolidate ordownsize office and switch facilities where we have overlap as a result of theATI Acquisition.

**Item 3.**                        LegalProceedings.

Global Crossing Bandwidth, Inc., our provider oflong distance services, filed a suit against us in February 2005 in thefederal district court for the Western District of New York. The suit allegesthat we owe approximately $8.4 million in unpaid pre-subscribed inter-exchangecarrier charges (“PICC”). We believe that we have a strong defense to GlobalCrossing’s claim for PICC charges and we intend to vigorously defend againstthe suit. We are unable to predict the outcome of this litigation and GlobalCrossing’s actions during the litigation process.

On August 2, 2004, a Nevada state court entered ajudgment against us for intentionally interfering with a former salesperson’seconomic relationship with his new employer in the amount of $376,000 pluscosts. We had reason to believe the former employee was violating hisnon-solicitation agreement with us. On August 30, 2004, we appealed thejudgment because, among other reasons, the jury was not instructed to considerwhether we were justified in informing the new employer of the agreement and ourintent to enforce it. We recently settled this case, agreeing to pay a total of$300,000 in three annual installments.

In October 2004, a former employee filed a suitagainst us in federal district court in Minnesota alleging that in terminatinghis employment we violated the federal Age Discrimination in Employment Act andthe Minnesota Human Rights Act. We rejected an offer from the plaintiff tosettle his claims in return for a payment of $250,000, because we do notbelieve his claims have any merit. We intend to vigorously defend against theseclaims, but we cannot predict the outcome of the lawsuit.

We are a party to several complaint proceedingsagainst Qwest filed with the Arizona, Colorado, Minnesota and Washington PUCsand two federal court lawsuits involving Qwest. The Minnesota PUC ordered Qwestto pay us $500,000 as a refund of overcharges related to enhanced extendedloops and we received the refund. The Federal District Court in Minnesotarecently denied Qwest’s appeal of the Minnesota PUC’s UNE Cost Order. Qwestthen appealed to the Federal Court of Appeals. If Qwest is successful, our UNErates in Minnesota could increase. We have appealed the unfavorable decision bythe 

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Minnesota PUC regardingour request for a refund from Qwest for overcharges for our Minnesotacollocations. The Minnesota PUC, the Colorado PUC, and the Arizona CorporationCommission recently granted, and the Washington PUC denied in part and grantedin part, our complaints regarding retroactive application of certain favorableUNE rates. Qwest has not appealed these decisions.

We have reached a settlement with Qwest that resolvesthe following matters on mutually acceptable terms: our appeal of theunfavorable decision by the Minnesota PUC for Qwest’s withholding of Direct Measuresof Quality, or DMOQ, billing credits from us; our appeal of the WashingtonState District Court decision upholding the PUC’s decision that denied in partour complaint regarding retroactive application of certain favorable UNE rates;and our lawsuit against Qwest in the United States District Court, WesternDistrict of Washington regarding the financial harm we have suffered as aresult of Qwest’s violations of our interconnection agreements by failing toprovide accurate records relating to interstate and intrastate long distancecalls, failing to develop an unbundled network platform and failing to make DSLavailable for resale.

Investigations are ongoing in Arizona, Oregon andColorado relating to the alleged failure of Qwest and several CLECs, includingus, to submit interconnection agreements for approval by state regulatoryagencies. We cannot predict the outcome of the Arizona, Colorado or Oregoninvestigations or the effect that any corresponding regulatory actions may haveon our business. A similar investigation by the Minnesota PUC resulted in nodirect penalties against us while the Washington Commission approved asettlement under which we paid $25,000 and provided testimony in return fordismissal of the case against us.

The Minnesota Department of Commerce has filed acomplaint with the Minnesota PUC concerning agreements that CLECs, includingus, have with certain interexchange carriers for pricing access services. Theyhave asserted that the agreements are unlawfully discriminatory and required tobe filed. We cannot predict the outcome of this proceeding or its effect on ourbusiness.

We have disputed the amount of a bond that we arerequired to post with the Arizona Corporation Commission. The ArizonaCorporation Commission recently ruled to reduce our bond to $235,000 ratherthan the $400,000 bond currently posted. However, future proceedings couldresult in a substantial increase in the bond, depending on Commission decisionson its policies concerning bond requirements.

We cannot predict theoutcome of any of these proceedings or their effect on our business. We areparty from time to time to other ordinary course disputes which we do notbelieve to be material.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

On October 12, 2004, the holders of the holdersof greater than (1) 60% of the issued and outstanding shares of Series APreferred Stock and (2) a majority of all of the issued and outstandingcapital stock of the Company on an as converted and combined basis, acting bywritten consent, approved the acquisition of ATI. Notice of the written consentwas provided to the non-consenting stockholders in accordance with Delaware law.

On December 23, 2004, the holders of the holdersof greater than (1) 60% of the issued and outstanding shares of Series APreferred Stock and (2) a majority of all of the issued and outstandingcapital stock of the Company on an as converted and combined basis, acting bywritten consent, approved the adoption of the Company’s Sixth Amended andRestated Certificate of Incorporation and approved the Series B financingtransaction. Notice of the written consent was provided to the non-consentingstockholders in accordance with Delaware law.

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**Part II**

**Item 5.**                        Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities.

Ourcommon stock is not publicly traded. As of December 31, 2004, there were164 holders of record of our common stock. See Item 12, Security Ownership ofCertain Beneficial Owners and Management, for a discussion of the ownership ofour company. We have not declared any cash dividends on our common stock and donot intend to pay cash dividends for the foreseeable future. Our outstandingnotes restrict our ability to pay dividends on our capital stock.

**EquityCompensation Plan Information**
| ** **                                                  | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities remaining available   for future issuance under equity  compensation plans (excluding securities  reflected in the first column)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       |                                                                                                                                                 | 10,105,574 |                                                                                                        |       |                                                                                                                                                                                                                                      | $          | 0.06 |   |   |   | 983,067 |   |   |
| Equity  compensation plans not approved by security holders |       |                                                                                                                                                 | —     |                                                                                                        |       |                                                                                                                                                                                                                                      | —     |   |   |   | — |   |   |
| Total                                                       |       |                                                                                                                                                 | 10,105,574 |                                                                                                        |       |                                                                                                                                                                                                                                      | $          | 0.06 |   |   |   | 983,067 |   |   |

 

Upon the exercise of options, 160,575 common shareswere issued in 2004. The proceeds were used for general corporate purposes. In May 2004,140,365 common shares, valued at $0.10 per share, were issued to certainmembers of our Board of Directors as compensation for service on our Board ofDirectors. These transactions were exempt under Rule 701 of Section 4(2) ofthe Securities Act.

In November 2004,Eschelon Operating Company (a wholly owned subsidiary) issued $65 millionprincipal amount at maturity of 8 3/8% Senior Second Secured Notes due 2010 ata discount resulting in a 14% yield. Jefferies & Company, Inc.was the joint book-running manager for the transaction. The notes were pricedat 79.000% of the principal amount and the gross proceeds were $51.350 million.We offered these notes to qualified institutional buyers as defined in Rule 144Aunder the Securities Act, to persons outside the United States under RegulationS of the Securities Act and to a limited number of institutional accreditedinvestors within the meaning of Rule 501 (a) (1), (2), (3) or (7) ofthe Securities Act. Subsequent to the end of the period covered by this Report,we engaged in an exchange offer with the holders of the notes whereby the noteswere exchanged for a like principal amount of registered 8 3/8% Senior SecondSecured Notes due 2010 which was completed on March 24, 2005. On December 30,2004, our equity sponsors purchased 20.0 million shares of new convertiblepreferred stock for net cash proceeds of $15.0 million pursuant to Section 4(2) ofthe Securities Act. We used $45.5 million of the proceeds from our offerings tocomplete the ATI Acquisition, $5.1 million to redeem 6,780,541 shares of our Series Aconvertible preferred stock held by NTFC Capital Corporation, $3.7 million topay fees related to our notes offering and $12.1 million for general corporatepurposes.

**Item 6.**                        SelectedFinancial Data.

Thefollowing tables set forth our selected consolidated financial and other datafor the periods indicated. The selected consolidated financial data as of December 31,2003 and 2004 and for the years ended December 31, 2002, 2003 and 2004have been derived from the audited consolidated financial statements and notesto consolidated financial statements included elsewhere in this report. Theselected consolidated financial data as of December 31, 2000, 2001 and2002 and for the years ended December 31, 

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2000 and 2001 were derived from the auditedconsolidated financial statements and notes to consolidated financialstatements not included herein. The following financial information isqualified by reference to and should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe consolidated financial statements and notes to consolidated financialstatements included elsewhere in this report. Results for 2004 exclude the resultsof ATI except for the Balance Sheet Data. All dollar amounts are in thousandsof dollars, except per share amounts.
| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2000**                                   | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Statements of operations data:**                                                |       |                                       |       |   |   |   |   |   |   |   |   |
| Revenue:                                                                          |       |                                       |       |   |   |   |   |   |   |   |   |
| Network services                                                                  |       | $                                          | 36,111     |   | $ | 72,773 |   | $ | 96,209 |   | $ | 115,482 |   | $ | 131,780 |   |
| BTS                                                                               |       | 24,330                                     |       | 25,837 |   | 25,659 |   | 25,614 |   | 26,316 |   |
| Total revenue                                                                     |       | 60,441                                     |       | 98,610 |   | 121,868 |   | 141,096 |   | 158,096 |   |
| Cost of revenue:                                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Network services                                                                  |       | 25,769                                     |       | 40,320 |   | 39,493 |   | 45,037 |   | 47,354 |   |
| BTS                                                                               |       | 15,048                                     |       | 16,190 |   | 16,053 |   | 15,784 |   | 15,979 |   |
| Total cost of revenue                                                             |       | 40,817                                     |       | 56,510 |   | 55,546 |   | 60,821 |   | 63,333 |   |
| Gross profit:                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |
| Network services                                                                  |       | 10,342                                     |       | 32,453 |   | 56,716 |   | 70,445 |   | 84,426 |   |
| BTS                                                                               |       | 9,282                                      |       | 9,647 |   | 9,606 |   | 9,830 |   | 10,337 |   |
| Total gross profit                                                                |       | 19,624                                     |       | 42,100 |   | 66,322 |   | 80,275 |   | 94,763 |   |
| Operating expenses:                                                               |       |                                       |       |   |   |   |   |   |   |   |   |
| Sales, general and administrative                                                 |       | 54,660                                     |       | 55,960 |   | 68,920 |   | 66,252 |   | 69,255 |   |
| Depreciation and amortization                                                     |       | 9,061                                      |       | 28,307 |   | 25,261 |   | 30,099 |   | 31,105 |   |
| Total operating expenses                                                          |       | 63,721                                     |       | 84,267 |   | 94,181 |   | 96,351 |   | 100,360 |   |
| Operating loss                                                                    |       | (44,097                                    | )          | (42,167 | ) | (27,859 | ) | (16,076 | ) | (5,597 | ) |
| Other income  (expense)(1)                                                        |       | (8,547                                     | )          | (11,535 | ) | 48,052 |   | (1,102 | ) | 6,712 |   |
| Income (loss) before income taxes(1)                                              |       | (52,644                                    | )          | (53,702 | ) | 20,193 |   | (17,178 | ) | 1,115 |   |
| Income taxes                                                                      |       | —                                     |       | (14 | ) | (50 | ) | (28 | ) | (4 | ) |
| Net income (loss)(1)                                                              |       | (52,644                                    | )          | (53,716 | ) | 20,143 |   | (17,206 | ) | 1,111 |   |
| Less preferred  stock dividends and premium paid on redemption of preferred stock |       | (7,741                                     | )          | (9,890 | ) | (2,701 | ) | (3,426 | ) | (4,292 | ) |
| Net income (loss) applicable to common stockholders                               |       | $                                          | (60,385    | ) | $ | (63,606 | ) | $ | 17,442 |   | $ | (20,632 | ) | $ | (3,181 | ) |
| Per share amounts (basic and diluted):  Net income (loss)                         |       | $                                          | (41.43     | ) | $ | (39.75 | ) | $ | 10.90 |   | $ | (5.21 | ) | $ | (0.82 | ) |
| **Other  financial data:**                                                        |       |                                       |       |   |   |   |   |   |   |   |   |
| Capital  expenditures(2)                                                          |       | $                                          | 87,436     |   | $ | 38,684 |   | $ | 23,175 |   | $ | 26,466 |   | $ | 30,771 |   |
| Cash flows  provided by (used in) operating activities                       |       | (31,519                                    | )          | (37,116 | ) | (2,888 | ) | 16,688 |   | 25,393 |   |
| Cash flows  provided by (used in) investing activities                       |       | (85,622                                    | )          | (36,468 | ) | (23,020 | ) | (25,008 | ) | (78,334 | ) |
| Cash flows provided by  (used in) financing activities                       |       | 139,829                                    |       | 30,471 |   | 31,593 |   | (2,807 | ) | 70,770 |   |

 

25

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| ** **                                          | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2000**                                                                              | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Operating data:**                                 |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Voice access  lines in service(3)                   |       | 65,117                                                                                |       | 98,922 |   | 133,908 |   | 156,165 |   | 173,492 |   |
| Data access lines  in service(3)                    |       | 5,191                                                                                 |       | 12,217 |   | 24,657 |   | 50,256 |   | 76,861 |   |
| Total access lines in service(3)                    |       | 70,308                                                                                |       | 111,139 |   | 158,565 |   | 206,421 |   | 250,353 |   |
| Markets in  operation                               |       | 12                                                                                    |       | 12 |   | 12 |   | 12 |   | 12 |   |
| Percent of new  access lines installed on-net       |       | 22                                                                                    | %          | 61 | % | 77 | % | 87 | % | 92 | % |
| Percent of total  access lines on-net               |       | 31                                                                                    | %          | 50 | % | 63 | % | 74 | % | 81 | % |
| Average monthly  churn(4)                           |       | 1.63                                                                                  | %          | 2.01 | % | 1.87 | % | 1.60 | % | 1.48 | % |
| Total full-time equivalent employees                |       | 833                                                                                   |       | 934 |   | 918 |   | 888 |   | 924 |   |
| Quota-carrying  network services sales people  |       | 183                                                                                   |       | 176 |   | 164 |   | 139 |   | 167 |   |
| Quota-carrying  BTS sales people                    |       | 40                                                                                    |       | 47 |   | 35 |   | 36 |   | 33 |   |
| Total  quota-carrying sales people                  |       | 223                                                                                   |       | 223 |   | 199 |   | 175 |   | 200 |   |

 
| ** **                                                                 | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                 | ** ** | **2000**                              | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Balance sheet data:**                                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents, restricted cash and available-for-sale securities |       | $                                     | 57,161     |   | $ | 14,048 |   | $ | 19,733 |   | $ | 8,606 |   | $ | 33,351 |   |
| Property and  equipment, net                                               |       | 81,532                                |       | 95,719 |   | 91,296 |   | 86,777 |   | 102,849 |   |
| Total assets                                                               |       | 193,013                               |       | 170,370 |   | 169,133 |   | 153,721 |   | 237,119 |   |
| Total debt,  including current portion                                     |       | 107,837                               |       | 140,321 |   | 88,625 |   | 87,822 |   | 142,231 |   |
| Net debt(5)                                                                |       | 50,676                                |       | 126,273 |   | 68,892 |   | 79,216 |   | 108,880 |   |
| Total stockholders’  equity (deficit)                                 |       | 55,880                                |       | 3,332 |   | 15,542 |   | (5,071 | ) | (8,180 | ) |
|                                                                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)*         *In June 2002, we entered into anegotiated debt restructuring, which included the reduction of outstanding debtunder our senior secured credit facility from $139,293 to $57,062. In therestructuring, certain lenders with outstanding principal and interest due of$65,778 chose to receive $12,229 in cash to cancel all liabilities, as a resultof which we recorded a pre-tax gain of $53,549. In accordance with SFAS No. 15,“Accounting by Debtors and Creditors for Troubled Debt Restructurings,” aportion of the reduction in the amount outstanding could not be immediatelyrecognized as a gain, but instead would be recognized as a reduction tointerest expense over the term of the new credit facility. As of December 31,2003, $21,871 of excess carrying value had yet to be recognized as a reductionin interest expense. In March 2004, we paid off our senior secured creditfacility resulting in a pretax gain of $18,195, which represented the remainingexcess carrying value as of the payoff date.

(2)*         *Capital expenditures are the sum total ofpurchases of property and equipment including equipment purchased under acapital lease and cash paid for customer installation costs.

(3)*         *Each access line and access lineequivalent is equal to one 64 kilobit customer line that is active and beingbilled. Unused capacity on T1 circuits is not included in our line count.

(4)*         *Average monthly churn is the total accesslines disconnected for the month as a percentage of total access lines in serviceat the end of the month.

(5)*         *Net debt consists of total debt lesscash, cash equivalents, restricted cash and available-for-sale securities.

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**SelectedQuarterly Financial Data (Unaudited. In thousands, except per shareinformation)**
| ** **                                | ** ** | **2004**                                           | ** ** |
|-------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | **For the Three Months Ended** | ** ** |
| ** **                                | ** ** | **March 31**                                  | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** | **Total Year** | ** ** |
| Total revenue                             |       | $                                                  | 38,196     |   | $ | 39,151 |   |   | $ | 40,562 |   |   |   | $ | 40,187 |   |   | $ | 158,096 |   |
| Total gross  profit                       |       | 22,768                                             |       | 23,741 |   |   | 24,521 |   |   |   | 23,733 |   |   | 94,763 |   |
| Income (loss)  before income taxes        |       | 14,283                                             |       | (3,377 | ) |   | (4,325 | ) |   |   | (5,466 | ) |   | 1,115 |   |
| Net income (loss)                         |       | 14,283                                             |       | (3,377 | ) |   | (4,329 | ) |   |   | (5,466 | ) |   | 1,111 |   |
| Net income (loss)  per share—basic   |       | 3.70                                               |       | (1.09 | ) |   | (1.30 | ) |   |   | (1.56 | ) |   | (0.82 | ) |
| Net income (loss) per  share—diluted |       | 0.19                                               |       | (1.09 | ) |   | (1.30 | ) |   |   | (1.56 | ) |   | (0.82 | ) |
|                                           |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                | ** ** | **2003**                                           | ** ** |
|-------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | **For the Three Months Ended** | ** ** |
| ** **                                | ** ** | **March 31**                                  | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** | **Total Year** | ** ** |
| Total revenue                             |       | $                                                  | 31,914     |   | $ | 35,405 |   |   | $ | 36,573 |   |   |   | $ | 37,204 |   |   | $ | 141,096 |   |
| Total gross  profit                       |       | 17,882                                             |       | 20,032 |   |   | 20,567 |   |   |   | 21,794 |   |   | 80,275 |   |
| Income (loss)  before income taxes        |       | (5,624                                             | )          | (4,601 | ) |   | (3,687 | ) |   |   | (3,266 | ) |   | (17,178 | ) |
| Net income (loss)                         |       | (5,624                                             | )          | (4,601 | ) |   | (3,715 | ) |   |   | (3,266 | ) |   | (17,206 | ) |
| Net income (loss)  per share—basic   |       | (2.70                                              | )          | (1.76 | ) |   | (1.43 | ) |   |   | (1.27 | ) |   | (5.21 | ) |
| Net income (loss) per  share—diluted |       | (2.70                                              | )          | (1.76 | ) |   | (1.43 | ) |   |   | (1.27 | ) |   | (5.21 | ) |
|                                           |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

27

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Conditionand Results of Operations.

*The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with the “SelectedFinancial Data” and the Consolidated Financial Statements and Notes toConsolidated Financial Statements included elsewhere in this annual report.Certain information contained in the discussion and analysis set forth belowand elsewhere in this annual report, including information with respect to ourplans and strategy for our business and related financing, includesforward-looking statements that involve risk and uncertainties. In evaluatingsuch statements, you should specifically consider the various factorsidentified in this prospectus that could cause results to differ materiallyfrom those expressed in such forward-looking statements, including matters setforth in the section entitled “Risk Factors.”*

**Overview**

We are a leading facilities-based provider ofintegrated voice and data communications services to small and medium-sizedbusinesses in 19 markets in the western United States. Our voice and dataservices, which we refer to as network services, include local dial tone, longdistance, enhanced voice features and dedicated Internet access services. Wealso sell, install and maintain business telephone and data systems andequipment, which we call BTS. We provide these products and servicesindividually or in customized packages to address our customers’ need for a fully-outsourcedvoice and data network solution.

Early in our developmentwe expanded into new markets generally through acquisitions of BTS companiesthat we have augmented with our network services capabilities. In 1996, weacquired Cady Communications, an established Minneapolis business telephonesystems company and expanded the business with network capability throughCentrex resale. We expanded into the Denver, Portland, Seattle and Salt LakeCity markets through similar acquisitions of BTS companies between 1996 and2001. On December 31, 2004, we closed on the ATI Acquisition adding apresence in California. The following discussion of results of operations doesnot incorporate any of ATI’s financial results. While we continue to evaluatestrategic acquisitions, our focus remains on growing market share in ourexisting markets and increasing profitability.

**KeyComponents of Results of Operations**

***Revenue.  ***Networkservices revenue consists primarily of local dial tone, long distance, accesscharges, and data service. Revenue from local telephone service consists ofcharges for basic local service, including dedicated T1 access, andcustom-calling features such as call waiting and call forwarding. Revenue fromlong distance service consists of per-minute-of-use charges for a full range oftraditional switched and dedicated long distance, toll-free calling,international, calling card and operator services. Revenue from data servicesconsists primarily of monthly usage fees for dedicated Internet accessservices.

Network services revenue is recognized in the monththe services are used. In the case of local service revenue, local servicescharges are billed in advance but accrued for and recognized on a proratedbasis based on length of service in any given month. Long distance and accesscharges are billed in arrears but accrued based on monthly average usage. We donot receive any revenues from reciprocal compensation due to our bill-and-keeparrangement with Qwest nor do we have any wholesale revenue other than accessrevenue. For the year ended December 31, 2004, carrier access revenuerepresented 7.7% of our total revenue.

BTS revenue consists of revenue from both the sale oftelephone equipment and the servicing of telephone equipment systems. Telephoneequipment revenue is recognized upon delivery and acceptance by the customer.Service revenue is recognized upon completion of service or, in the case of maintenanceagreements, is spread equally over the life of the maintenance contract.

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***Cost of revenue.  ***Our networkservices cost of revenue consists primarily of the cost of operating andmaintaining our network facilities. The network components for ourfacilities-based business include the cost of:

·       leasinglocal loops and digital T1 lines which connect our customers to our network;

·       leasinghigh capacity digital lines that interconnect our network with ILECs;

·       leasinghigh capacity digital lines that connect our switching equipment to ourcolocations;

·       leasingspace in ILEC central offices for colocating our equipment;

·       signalingsystem network connectivity; and

·       leasingour ATM backbone network.

The costs to lease local loops, digital T1 lines andhigh capacity digital interoffice facilities from the ILECs varies by carrierand by state and are regulated under federal and state laws. In virtually allareas, we lease local loops, T1 lines and interoffice capacity from the ILECs.We lease interoffice facilities from carriers other than the ILEC wherepossible in order to lower costs and improve network redundancy. However, inmost cases, the ILEC is the only source for local loops and T1 lines. We alsopurchase, on a wholesale or negotiated basis, UNE-P and customized networkelement packages, or UNE-E, from Qwest and Centrex services from SBC CommunicationsInc. The rates for UNE-P and Centrex are regulated and established by thevarious state corporation or utility commissions. The rates for QPP, whichreplaces UNE-P in 2005, were commercially negotiated and agreed to for threeyears. As of December 31, 2004 and 2003, excluding ATI, we had 38,735 and43,107 UNE-P access lines in service, respectively. As of December 31,2004 and 2003, excluding ATI, we had 7,691 and 8,493 Centrex access lines inservice, respectively. The rates for UNE-E were negotiated with Qwest under theterms of a five-year contract that expires December 31, 2005. As of December 31,2004 and 2003, excluding ATI, we had 1,666 and 1,934 UNE-E access lines inservice, respectively.

We have entered into wholesale purchasing agreements withlong distance and other service providers. Some of these agreements alsocontain termination penalties and/or minimum usage volume commitments. In theevent we fail to meet minimum volume commitments, we may be obligated to payunderutilization charges. We do not anticipate having to pay anyunderutilization charges in the foreseeable future.

We carefully review all of our vendor invoices andfrequently dispute inaccurate or inappropriate charges. Our single largestvendor is Qwest, to whom we paid $25.8 million for the year ended December 31,2003 and $29.2 million for the year ended December 31, 2004. Wefrequently pay only undisputed amounts on vendor invoices in order to payproper amounts owed. We use significant estimates to determine the level of successin dispute resolution and consider past historical experience, basis ofdispute, financial status and current relationship with vendors and aging ofprior disputes in quantifying our estimates.

We account for all of our network depreciation in depreciationand amortization expense and do not have any depreciation expense in cost ofrevenue.

Our most significant BTS costs of revenue are theequipment purchased from manufacturers and labor for service and equipmentinstallation. To take advantage of volume purchase discounts, we purchaseequipment primarily from three manufacturers. For all BTS installations ourpolicy is to require a 30% deposit before ordering the equipment so our risk ofexcess inventory or inventory obsolescence is low. BTS cost of revenue alsoincludes salaries and benefits of field technicians as well as vehicle andincidental expenses associated with equipment installation, maintenance andservice provisioning.

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***Sales, General andAdministrative.  ***Sales, general and administrativeexpenses are comprised primarily of salaries and benefits, bonuses,commissions, occupancy costs, sales and marketing expenses, bad debt, billingand professional services.

Determining our allowance for doubtful accounts receivablerequires significant estimates. We consider two primary factors in determiningthe proper level of the allowance, including historical collections experienceand the aging of the accounts receivable portfolio. We perform a rigorouscredit review process on each new customer that involves reviewing the customer’scurrent service provider bill and payment history, matching customers with theNational Telecommunications Data Exchange database for delinquent customersand, in some cases, requesting credit reviews through Dun and Bradstreet. For2002, 2003 and 2004, our bad debt expense as a percentage of revenue was 3.7%,0.4%, and 0.5%, respectively.

***Depreciation andAmortization.  ***Our depreciation and amortizationcurrently includes depreciation for network related voice and data equipment,back office systems, furniture, fixtures, leasehold improvements, officeequipment and computers. All internal costs directly related to the expansionof our network and operating and support systems, including salaries of certainemployees, are capitalized and depreciated over the lives of the switches orsystems, as the case may be. Capitalized customer installation costs areamortized over the approximate average life of a customer. Detailed annual timestudies are used to determine labor capitalization. These time studies arebased on employee time sheets for those engaged in capitalizable activities.

As described inNote 1 to the Consolidated Financial Statements, in 2002 we adoptedStatement of Financial Accounting Standards (SFAS) No. 142, “Goodwill andIntangible Assets.” SFAS No. 142 provides that goodwill and intangibleassets that have indefinite useful lives not be amortized but rather be testedat least annually for impairment.

**Results of Operations**

The followingtables set forth financial data as a percentage of total revenue for the yearsended December 31, 2002, 2003 and 2004.
| ** **                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Consolidated  financial data:**                    |       |                                       |       |   |   |   |   |
| Revenue:                                             |       |                                       |       |   |   |   |   |
| Network services                                     |       | 78.9                                       | %          | 81.8 | % | 83.4 | % |
| BTS                                                  |       | 21.1                                       | %          | 18.2 | % | 16.6 | % |
| Total revenue                                        |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
| Cost of revenue                                      |       | 45.6                                       | %          | 43.1 | % | 40.1 | % |
| Total gross profit                                   |       | 54.4                                       | %          | 56.9 | % | 59.9 | % |
| Operating  expenses:                                 |       |                                       |       |   |   |   |   |
| Sales, general and administrative                    |       | 56.6                                       | %          | 47.0 | % | 43.8 | % |
| Depreciation and amortization                        |       | 20.7                                       | %          | 21.3 | % | 19.7 | % |
| Total operating expenses                             |       | 77.3                                       | %          | 68.3 | % | 63.5 | % |
| Operating loss                                       |       | (22.9                                      | )%         | (11.4 | )% | (3.6 | )% |
| Net income (loss)                                    |       | 16.5                                       | %          | (12.2 | )% | 0.7 | % |
| Net income (loss)  applicable to common stockholders |       | 14.3                                       | %          | (14.6 | )% | (2.0 | )% |

 

30

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Thefollowing table sets forth the cost of revenue and the gross profit aspercentages of the related revenue for the periods indicated.
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cost of network  services revenue           |       | 41.0                                       | %          | 39.0 | % | 35.9 | % |
| Cost of BTS  revenue                        |       | 62.6                                       | %          | 61.6 | % | 60.7 | % |
| Gross profit from  network services revenue |       | 59.0                                       | %          | 61.0 | % | 64.1 | % |
| Gross profit from BTS  revenue              |       | 37.4                                       | %          | 38.4 | % | 39.3 | % |

 

**YearEnded December 31, 2004 Compared to Year Ended December 31, 2003**

***Revenue.  ***Revenuefor the years ended December 31, 2003 and 2004 is as follows:
| ** **                 | ** ** | **Year Ended December 31,**                                       | ** ** | ** **                                                                       | ** ** |
|----------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **      2003      ** | ** ** | **      2004      ** | ** ** | **% Change** | ** ** |
| Revenue (in  millions):    |       |                                                                             |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Voice and data services    |       |                                                                             | $          | 84.7                                                                             |       |   |   | $ | 98.4 |   |   |   | 16.1 | % |   |
| Long distance              |       |                                                                             | 18.7       |                                                                             |       |   | 21.2 |   |   |   | 13.7 |   |   |
| Access                     |       |                                                                             | 12.1       |                                                                             |       |   | 12.2 |   |   |   | 0.8 |   |   |
| Total network services     |       |                                                                             | 115.5      |                                                                             |       |   | 131.8 |   |   |   | 14.1 |   |   |
| Business telephone systems |       |                                                                             | 25.6       |                                                                             |       |   | 26.3 |   |   |   | 2.7 |   |   |
| Total revenue              |       |                                                                             | $          | 141.1                                                                            |       |   |   | $ | 158.1 |   |   |   | 12.0 | % |   |

 

**Network Services.  **Networkservices revenue was $131.8 million for the year ended December 31,2004, an increase of 14.1% from $115.5 million for the year ended December 31,2003. The increase in revenue was primarily due to an increase in the averagenumber of voice and data access lines in service. Over the past 12 monthsthe number of voice lines increased by 11.1% to 173,492 lines at December 31,2004, and the number of data lines increased by 52.9% to 76,861 lines at December 31,2004. The growth in access lines was partially offset by declines inpre-subscribed interexchange carrier charge (PICC) revenue, access revenue perminute of use and a decline in data revenue per line. The decline in PICCrevenue was due to our recently announced dispute with Global Crossing. As aresult of that dispute, we elected not to record approximately $0.3 million permonth of PICC revenue beginning in November of 2004. Access revenue perminute of use declined as a result of the scheduled FCC reduction of interstaterate levels. Data revenue per line declined due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets. We expect all of the above trends in linegrowth, PICC revenue, access rates and data revenue per line to continue forthe foreseeable future. As we continue to grow, our size and customer linechurn will begin to limit our access line growth rate on both an absolute and apercentage basis unless we increase our sales force and expand our geographicterritory.

**BTS.  **BTS revenue was$26.3 million for the year ended December 31, 2004, an increase of2.7% from $25.6 million for the year ended December 31, 2003 due to ahigher level of new system sales in 2004. We cannot predict future trends incapital spending by small and medium-sized business customers.

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***Cost of Revenue.  ***Cost of revenuefor the years ended December 31, 2003 and 2004 is as follows:
| ** **                      | ** ** | **Year Ended December 31,**                                       | ** ** | ** **                                                                       | ** ** |
|---------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **      2003      ** | ** ** | **      2004      ** | ** ** | **% Change** | ** ** |
| Cost of revenue  (in millions): |       |                                                                             |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Network services                |       |                                                                             | $          | 45.0                                                                             |       |   |   | $ | 47.3 |   |   |   | 5.1 | % |   |
| Business telephone systems      |       |                                                                             | 15.8       |                                                                             |       |   | 16.0 |   |   |   | 1.2 |   |   |
| Total cost of  revenue          |       |                                                                             | $          | 60.8                                                                             |       |   |   | $ | 63.3 |   |   |   | 4.1 | % |   |

 

**Network Services.  **Networkservices cost of revenue was $47.3 million for the year ended December 31,2004, an increase of 5.1% from $45.0 million for the year ended December 31,2003. This increase is due to our growth in access lines. As a percentage ofrelated revenue, network services cost of revenue for 2004 declined to 35.9%from 39.0% for 2003. This improvement was due to the increase in our percentageof access lines on-net to 81% as of December 31, 2004 from 74% as of December 31,2003.

**BTS.  **BTS cost of revenuewas $15.8 million and $16.0 million for the years ended December 31,2003 and 2004, respectively. As a percentage of related revenue, BTS cost ofrevenue for the year ended December 31, 2004 decreased to 60.7% from 61.6%for the year ended December 31, 2003, due to better labor utilization. Wedo not expect future improvements in BTS cost of revenue as a percentage ofrelated revenue unless we are able to significantly increase BTS revenue andtherefore achieve greater volume discounts or economies of scale in ourworkforce.

***Gross Profit.  ***Gross profit forthe years ended December 31, 2003 and 2004 is as follows:
| ** **                   | ** ** | **Year Ended December 31,**                                       | ** ** | ** **                                                                       | ** ** |
|------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                   | ** ** | **      2003      ** | ** ** | **      2004      ** | ** ** | **% Change** | ** ** |
| Gross profit (in  millions): |       |                                                                             |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Network services             |       |                                                                             | $          | 70.5                                                                             |       |   |   | $ | 84.5 |   |   |   | 19.8 | % |   |
| Business telephone systems   |       |                                                                             | 9.8        |                                                                             |       |   | 10.3 |   |   |   | 5.1 |   |   |
| Total gross  profit          |       |                                                                             | $          | 80.3                                                                             |       |   |   | $ | 94.8 |   |   |   | 18.0 | % |   |

 

The increase in gross profit for the years ended December 31,2004 from 2003 is due to the increase in revenue described above.

***Sales, General andAdministrative.  ***Sales, general and administrativeexpenses were $69.3 million for the year ended December 31, 2004, anincrease of 4.5% from $66.3 million for the year ended December 31,2003. The increase is primarily due to higher payroll, legal and operating taxand assessment expenses. As a percentage of revenue, sales, general andadministrative expenses for the year ended December 31, 2004 declined to43.8% from 47.0% for the year ended December 31, 2003 due to the improvedefficiency of our existing operations resulting from our fixed cost structuresupporting a higher level of revenue. Sales, general and administrativeexpenses dollars will increase in 2005 due to the ATI acquisition, but weexpect that as a percentage of revenue we will continue to see improvements.

***Depreciation andAmortization.  ***Depreciation and amortization expensewas $31.1 million for the year ended December 31, 2004, an increaseof 3.3% from $30.1 million for the year ended December 31, 2003. Thisincrease was primarily due to our network growth and associated capitalexpenditures. As a percentage of revenue, depreciation and amortizationdecreased to 19.7% for the year ended December 31, 2004 from 21.3% for theyear ended December 31, 2003. Depreciation and amortization expense willincrease in 2005 due to the ATI acquisition.

***Interest.  ***Interestexpense was $11.5 million for the year ended December 31, 2004, anincrease of 553.1% from $1.8 million for the year ended December 31, 2003.This increase was primarily due to 

32

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interest expense on oursenior second secured notes issued in 2004. In 2005, interest expense willincrease from 2004 as a result of a full year of interest expense on a higheroutstanding note balance.

***Gain onExtinguishment of Debt.  ***Net income for the yearended December 31, 2004 included a gain on extinguishment of debt of$18.2 million. The gain on the extinguishment of debt was the result ofpaying off our bank facility. In June 2002, we restructured our bankfacility and because the future cash flows could not be calculated withcertainty, the gain was deferred. As a result of the repayment, the excesscarrying value of $20.9 million and debt issuance costs of$2.7 million resulted in the $18.2 million gain on extinguishment ofdebt.

***Net Income (Loss).  ***Net incomefor the year ended December 31, 2004 was $1.1 million compared to a netloss for the year ended December 31, 2003 of $17.2 million. The net incomein 2004 was primarily due to the gain on extinguishment of debt and theimprovement in gross profit discussed above which were partially offset byincreased interest expense discussed above.

**YearEnded December 31, 2003 Compared to Year Ended December 31, 2002**

***Revenue****.  *Revenue for the years ended December 31, 2002and 2003 is as follows:
| ** **                  | ** ** | **Year Ended December 31,**                                       | ** ** | ** **                                                                       | ** ** |
|-----------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **      2002      ** | ** ** | **      2003      ** | ** ** | **% Change** | ** ** |
| Revenue (in millions):      |       |                                                                             |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Voice and data services     |       |                                                                             | $          | 67.5                                                                             |       |   |   | $ | 84.7 |   |   |   | 25.4 | % |   |
| Long distance               |       |                                                                             | 16.6       |                                                                             |       |   | 18.7 |   |   |   | 12.5 |   |   |
| Access                      |       |                                                                             | 12.1       |                                                                             |       |   | 12.1 |   |   |   | 0.4 |   |   |
| Total network services      |       |                                                                             | 96.2       |                                                                             |       |   | 115.5 |   |   |   | 20.0 |   |   |
| Business telephone  systems |       |                                                                             | 25.7       |                                                                             |       |   | 25.6 |   |   |   | (0.2 | ) |   |
| Total revenue               |       |                                                                             | $          | 121.9                                                                            |       |   |   | $ | 141.1 |   |   |   | 15.8 | % |   |

 

**Network Services.  **Networkservices revenue was $115.5 million for the year ended December 31,2003, an increase of 20.0% from $96.2 million for the year ended December 31,2002. The increase in revenue was primarily due to an increase in the averagenumber of voice and data access lines in service. During the year ended December 31,2003, the number of voice lines increased by 16.6% to 156,165 lines at December 31,2003 and the number of data lines increased by 103.8% to 50,256 lines at December 31,2003. The growth in access lines was partially offset by declines in longdistance and access revenue per minute of use and a decline in data revenue perline. Due to continued high levels of competition, long distance revenue perminute of use declined. Access revenue per minute of use declined as a resultof the scheduled FCC reduction of interstate rate levels. Data revenue per linedeclined due to a combination of customers purchasing more bandwidth atdiscounted prices and general pricing pressures for data services in our markets

**BTS.  **BTSrevenue was $25.6 million for the year ended December 31, 2003,essentially equal to the $25.7 million for the year ended December 31,2002 due to continuing constrained spending on capital improvements by businesscustomers. We cannot predict future trends in capital spending by small andmedium-sized business.

***Cost of Revenue.  ***Cost of revenuefor the years ended December 31, 2002 and 2003 is as follows:
| ** **                      | ** ** | **Year Ended December 31,**                                       | ** ** | ** **                                                                       | ** ** |
|---------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **      2002      ** | ** ** | **      2003      ** | ** ** | **% Change** | ** ** |
| Cost of revenue  (in millions): |       |                                                                             |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Network services                |       |                                                                             | $          | 39.5                                                                             |       |   |   | $ | 45.0 |   |   |   | 14.0 | % |   |
| Business telephone systems      |       |                                                                             | 16.1       |                                                                             |       |   | 15.8 |   |   |   | (1.7 | ) |   |
| Total cost of  revenue          |       |                                                                             | $          | 55.6                                                                             |       |   |   | $ | 60.8 |   |   |   | 9.5 | % |   |

 

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**NetworkServices.  **Network services cost of revenue was$45.0 million for the year ended December 31, 2003, an increase of14.0% from $39.5 million for the year ended December 31, 2002. Thisincrease is due to our growth in access lines. As a percentage of relatedrevenue, network services cost of revenue for the year ended December 31,2003 declined to 39.0% from 41.0% for the year ended December 31, 2002.This improvement was due to the increase in our percentage of access lineson-net to 74% as of December 31, 2003 from 63% as of December 31,2002. We also improved our gross margin through the migration of approximately6,000 lines from UNE-E to UNE-P. UNE-P is less expensive than UNE-E on a peraccess line basis. We expect our cost of revenue as a percentage of revenue toimprove as we continue to increase our percentage of lines on-net, although weexpect future gains will be modest as we already have a high percentage oflines on-net.

**BTS.  **BTScost of revenue was $15.8 million for the year ended December 31,2003, a decrease of 1.7% from $16.1 million for the year ended December 31,2002. This decrease was due to a reduction in materials cost. As a percentageof related revenue, BTS cost of revenue for the year ended December 31,2003 declined to 61.6% from 62.6% for the year ended December 31, 2002. Wedo not expect future improvements in BTS cost of revenue as a percentage ofrelated revenue unless we are able to significantly increase BTS revenue andtherefore achieve greater volume discounts or economies of scale in ourworkforce.

***Gross Profit.  ***Gross profit forthe years ended December 31, 2002 and 2003 is as follows:
| ** **                   | ** ** | **Year Ended December 31,**                                       | ** ** | ** **                                                                       | ** ** |
|------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                   | ** ** | **      2002      ** | ** ** | **      2003      ** | ** ** | **% Change** | ** ** |
| Gross profit (in  millions): |       |                                                                             |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Network services             |       |                                                                             | $          | 56.7                                                                             |       |   |   | $ | 70.5 |   |   |   | 24.2 | % |   |
| Business telephone systems   |       |                                                                             | 9.6        |                                                                             |       |   | 9.8 |   |   |   | 2.3 |   |   |
| Total gross  profit          |       |                                                                             | $          | 66.3                                                                             |       |   |   | $ | 80.3 |   |   |   | 21.0 | % |   |

 

The increase in grossprofit for the year ended December 31, 2003 from the year ended December 31,2002 is due to the increase in revenue discussed above.

***Sales, General and Administrative.  ***Sales,general and administrative expenses were $66.3 million for the year ended December 31,2003, a decrease of 3.9% from $68.9 million for the year ended December 31,2002. This decrease was primarily due to a reduction in bad debt expense to$0.5 million for the year ended December 31, 2003 compared to$4.5 million for the year ended December 31, 2002. Bad debt expensefor the year ended December 31, 2002 was unusually high because we wroteoff receivables for delinquent customers and also increased our allowance fordoubtful accounts to $2.0 million because of economic conditions. We alsorecorded a bad debt write-off of $1.1 million of access receivablesrelated to bankruptcy filings by two large carrier access customers. In theyear ended December 31, 2003, we subsequently reduced our allowance fordoubtful accounts to $0.7 million because of the improvement in thequality of our accounts receivable. As a percentage of revenue, sales, generaland administrative expenses for the year ended December 31, 2003 declinedto 47.0% from 56.6% for the year ended December 31, 2002 due to ourreduction in bad debt expense and the improved efficiency of our existingoperations resulting from our fixed cost structure supporting a higher level ofrevenue. We expect this trend to continue as we add more access lines with onlymodest increases in our employee base.

***Depreciation and Amortization.  ***Depreciationand amortization expense was $30.1 million for the year ended December 31,2003, an increase of 19.2% from $25.3 million for the year ended December 31,2002. This increase was primarily due to our network growth and associatedcapital expenditures. As a percentage of revenue, depreciation and amortizationincreased to 21.3% for the year ended December 31, 2003 from 20.7% for theyear ended December 31, 2002.

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***Interest.  ***Interest expense was$1.8 million for the year ended December 31, 2003, a decrease of69.4% from $5.7 million for the year ended December 31, 2002. Thisdecrease was due to the impact of a full year of SFAS No. 15 combined witha reduction in average long-term debt outstanding.

***Gain on Debt Restructuring.  ***Netincome for the year ended December 31, 2002 included a gain on debtrestructuring. In June 2002, we completed a debt restructuring describedin Note 4 to Consolidated Financial Statements. As part of the debtrestructuring, we recorded a gain of $53.5 million.

***Net Income (Loss).  ***The net lossfor the year ended December 31, 2003 was $17.2 million compared to netincome for the year ended December 31, 2002 of $20.1 million. Net incomein 2002 was primarily due to the gain on debt restructuring which was partiallyoffset by a lower gross profit as discussed above.

**Liquidity and Capital Resources**

***Principal Liquidity Requirements.  ***Ournotes payable balance at December 31, 2004, was $137.8 million. Interestpayments on the notes are required on each March 15 and September 15 the notesare outstanding. On March 15, 2005 we were able to pay the $5.8 million cashinterest from existing cash on hand and expect to be able to pay the September15, 2005 cash interest of $6.9 million from cash generated from operations andcash on hand.

***Cash and Cash Equivalents.  ***Cashand cash equivalents was $26.4 million at December 31, 2004, which is anincrease of $17.8 million from December 31, 2003. This increase is primarilyattributable to the net proceeds from the issuance of senior second securednotes and the issuance of Series B convertible preferred stock, after therepayment of our senior secured bank facility, the completion of the ATIAcquisition, the redemption of Series A convertible preferred stock and thepayment of fees related to all of the aforementioned transactions.

***Available-for-Sale Securities***.   In2004, we began investing in available-for-sale securities. The balance at December31, 2004, was $6.2 million and represented investments in municipal and UnitedStates government debt securities with maturities of more than three months butless than one year. The securities represent additional liquidity for us.

***Financings.  ***We have funded growthand migration to our facilities-based model through a series of privateplacements of equity and debt funding. We were initially funded withinvestments totaling $16.5 million from a group of investors led byStolberg, Meehan and Scano II, L.P. In 1999 and early 2000, we raised$55.9 million in additional capital from a group of investors led by BainCapital Fund VI, LP to fund our facilities-based, multi-market business plan.In 2000, we raised an additional $53.5 million of equity to further fundour build-out plan. As a result of decreases in carrier access revenue and datapricing and a shift in our expectations for future carrier access revenue anddata pricing, in June 2002, we completed a negotiated recapitalization. Inthe recapitalization, we reduced our total debt from approximately$139.3 million to $57.1 million. Our senior secured credit facilitywas amended, resulting in a fixed annual interest rate of 8.0% through June 2005and a floating interest rate of LIBOR plus 4.75% thereafter. We also reset ouramortization schedule extending the maturity of our debt to 2009. We alsoreceived $50.2 million of gross proceeds from the issuance of preferredstock to existing investors and a creditor. In March 2004, we completed anoffering of $100.0 million of 8 3/8% senior second secured notes due 2010at a discount resulting in gross proceeds of $84.8 million. We used theproceeds from our offering to retire bank debt, pay fees related to theoffering and provide additional liquidity to our company. After repayment ofour senior secured bank facility and fees related to the issuance of the notes,we received incremental cash of approximately $13.2 million. In November 2004,we completed our offering of $65.0 million of 8 3/8% senior second securednotes due 2010 at a discount resulting in gross proceeds of $51.4 million. On December 30,2004, our equity sponsors purchased 20.0 million shares of new convertiblepreferred stock for net cash proceeds of $15.0 million. We used theproceeds from our offerings to complete our acquisition of ATI for $45.5million, net of cash received, to redeem 6,780,541 shares of our Series Aconvertible preferred stock for $5.1 million and to pay fees related to thenotes offering.

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***Cash Flows Providedby (Used in) Operating Activities.  ***Cash provided byoperating activities was $25.4 million for 2004 compared to cash providedby operating activities of $16.7 million for 2003. Our improvement in cashprovided by operating activities was primarily due to our growth in grossprofit accompanied by a smaller increase in our operating expenses. Workingcapital improved primarily through improvement in our accounts receivablecollections and our accounts payable days outstanding. Average accountsreceivable days sales outstanding improved from 36.2 for 2003 to 30.0 for 2004.Average accounts payable days outstanding increased to 79.4 in 2004 from 71.2in 2003. We do not expect further improvement in our accounts receivable oraccounts payable days outstanding in the future.

Cash used in operating activities was $2.9 million for2002. Our improvement in cash provided by operating activities from 2002 to2003 was primarily due to our growth in gross profit accompanied by a smallerincrease in our operating expenses. However, we also generated $2.9 million inincremental working capital cash primarily through improvement in our accountsreceivable collections and an increase in our accounts payable daysoutstanding. Net cash provided by operating activities was primarily used tofund our investing activities of $25.0 million in 2003.

***Cash Flows Used inInvesting Activities.  ***Cash used in investingactivities was $78.3 million for 2004 compared to $25.0 million for2003 and $23.0 million for 2002. The increase in cash used in investingactivities from 2003 to 2004 was primarily due to the acquisition of ATI on December 31,2004. In 2004 we also used cash to invest in marketable securities withmaturity dates of six months or less. In 2003 and 2002, all of our cash used ininvesting activities was for the maintenance and expansion of our network andback office systems and customer installation.

***Cash Flows Provided by (Used in)Financing Activities*.**   Cash provided by financingactivities was $70.8 million for 2004. The net proceeds from the issuance ofthe senior second secured notes in March 2004 generated approximately $13.2million, which is net of a $1.6 million prepayment penalty mentioned previously.The net cash proceeds from the issuance of senior second secured notes inNovember 2004 and the Series B preferred stock issuance generated approximately$57.5 million after payment of debt issuance costs and the redemption of SeriesA preferred stock. We also used cash for payments on capital lease obligations.For 2003, net cash used in financing activities was $2.8 million, primarily forpayments on capital lease obligations. We generated $31.6 million fromfinancing activities for 2002. In 2002, cash provided by financing activitieswas primarily the result of the issuance of our Series A convertible preferredstock.

***Capital Requirements.  ***We expectto spend approximately $44.6 million on capital expenditures in 2005,approximately $4.1 million of which will be to integrate ATI into ouroperations. We believe that our existing cash, cash equivalents and short-terminvestments will be sufficient to fund our operations and we do not currentlyanticipate the need to raise additional financing to fund capital expendituresor operations for at least the next 12 months.

**Income Taxes**

We account for incometaxes under the liability method in accordance with SFAS No. 109, *Accounting for Income Taxes*. Deferred taxliabilities are recognized for temporary differences that will result intaxable amounts in future years. Deferred tax assets are recognized fordeductible temporary differences and tax operating loss and tax creditcarryforwards. Deferred tax assets and liabilities are measured using the enactedtax rates expected to apply to taxable income in the periods in which thedeferred tax asset or liability is expected to be realized or settled. Weassess the likelihood that deferred tax assets will be recovered from futuretaxable income and we record a valuation allowance to reduce the deferred taxassets to the amounts we believe will be realizable. We concluded that a fullvaluation allowance against the deferred tax assets was appropriate.

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**Contractual Obligations**
| ** **                   | ** ** | **Total**                            | ** ** | ** Less Than   One Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | ** More Than   Five Years** | ** ** |
|------------------------------|------------|--------------------------------------|------------|-----------------------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------------------------------|------------|
| ** **                   | ** ** | **(Dollars in thousands)** | ** ** |
| Notes payable                |       | $                                    | 239,884    |                                          |       | $                  | 12,700     |               |       | $                                               | 27,638     |   | $ | 33,314 |   |   | $ | 166,232 |   |   |
| Capital lease  obligations   |       | 5,349                                |       |                                          | 2,128      |               |       | 3,033              |       | 188                                             |       |   | — |   |   |
| Operating lease  obligations |       | 35,133                               |       |                                          | 6,855      |               |       | 12,219             |       | 10,037                                          |       |   | 6,022 |   |   |
| Purchase obligations         |       | 73,355                               |       |                                          | 1,338      |               |       | 2,253              |       | 291                                             |       |   | 69,453 |   |   |
|                              |            |                                      |            |                                               |            |                    |            |                    |            |                                                 |            |  |  |  |  |  |  |  |  |  |

 

The contractual obligationfor notes payable includes related interest payments and assumes all notes areoutstanding prior to the date of mandatory redemption and also assumes thenotes are not otherwise required to be redeemed in a greater amount.

**Applicationof Critical Accounting Policies**

Our discussion of the financial condition and resultsof operations are based upon the consolidated financial statements, which havebeen prepared in conformity with accounting principles generally accepted inthe United States. The preparation of our financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, revenues and expenses, and related disclosure of anycontingent assets and liabilities at the date of the financial statements.Management regularly reviews its estimates and assumptions, which are based onhistorical factors and other factors that are believed to be relevant under thecircumstances. Actual results may differ from these estimates under differentassumptions, estimates or conditions.

Critical accountingpolicies are defined as those that are reflective of significant judgments anduncertainties, and potentially result in materially different results underdifferent assumptions and conditions. See Note 1 of the Notes to ConsolidatedFinancial Statements for additional disclosure of the application of these andother accounting policies.

***Revenue Recognition***

Revenues from networkservices are recognized in the period in which subscribers use the relatedservices. Revenues from equipment sales and related installation charges arerecognized upon delivery, completion of the installation of the relatedequipment, and acceptance by the customer, at which point legal title passes tothe customer. Revenues for carrier interconnection and access are recognized inthe period in which the service is provided.

***Accounts Receivableand Allowance for Doubtful Accounts***

Accounts receivable areinitially recorded at fair value upon the sale of products or services tocustomers. Significant estimates are required in determining the allowance fordoubtful accounts receivable. We consider two primary factors in determiningthe proper level of allowance, including historical collections experience andthe aging of the accounts receivable portfolio. The allowance for doubtfulaccounts requirements are based on the best facts available to us and are reevaluatedand adjusted as additional information is received. We have a credit policywhich helps minimize credit risk. We believe this risk is limited due to thelarge number and diversity of clients which comprise our customer base.

***Valuation of Goodwill and Other Intangible Assets***

Goodwill is tested at least annually for impairment atthe reporting unit level. If the undiscounted future cash flows of a reportingunit are less than the carrying amount, an impairment charge is recognized. Inaccordance with SFAS No. 142, *Goodwilland Other Intangible Assets*, management completed its annual 

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impairment test in thefourth quarter of 2003 and 2004 and determined that goodwill had not beenimpaired.

Intangibles consist of debt issuance costs, customerinstallation costs, and non-compete agreements. In 2003, and 2004, debtissuance costs were incurred in connection with the issuance of notes payable.These costs are being amortized over the term of the facility. The customerinstallation costs are being amortized over a period of 48 months, whichapproximates the average life of a customer contract. Non-competeagreement costs represent costs associated with various agreements we haveentered into with existing management of the companies we have acquired. Thesecosts are being amortized over the terms of the agreements.

We review all long-livedassets for impairment in accordance with SFAS No. 144, *Accounting for the Impairment and Disposal ofLong-Lived Assets*. Under SFAS No. 144, impairment losses arerecorded on long-lived assets used in operations when events and circumstancesindicate the assets might be impaired and the undiscounted cash flows estimatedto be generated by those assets are less than the carrying amounts of thoseassets.

***Income Taxes***

We account for incometaxes under the liability method in accordance with SFAS No. 109, *Accounting for Income Taxes*. Deferred taxliabilities are recognized for temporary differences that will result intaxable amounts in future years. Deferred tax assets are recognized fordeductible temporary differences and tax operating loss and tax creditcarryforwards. Deferred tax assets and liabilities are measured using theenacted tax rates expected to apply to taxable income in the periods in whichthe deferred tax asset or liability is expected to be realized or settled. Weassess the likelihood that our deferred tax assets will be recovered fromfuture taxable income and record a valuation allowance to reduce our deferredtax assets to the amounts we believe to be realizable. We concluded that a fullvaluation allowance against our deferred tax assets was appropriate.

**New AccountingPronouncements**

In May 2003, theFinancial Accounting Standards Board issued SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of Both Liabilities andEquity.” SFAS No. 150 requires that certain financial instruments, whichunder previous guidance were accounted for as equity, must now be accounted foras liabilities. The financial instruments affected include mandatorilyredeemable stock, certain financial instruments that require or may require theissuer to buy back some of its shares in exchange for cash or other assets andcertain obligations that can be settled with shares of stock. SFAS No. 150is effective for all financial instruments entered into or modified after May 31,2003, and otherwise is effective the beginning of the first interim periodafter June 15, 2003. The adoption of SFAS No. 150 did not have amaterial impact on our financial statements and did not require us toreclassify our Series A convertible preferred stock to a liability as theshares are contingently redeemable.

In December 2004, theFinancial Accounting Standards Board issued SFAS No. 123R, *Share-Based Payment: an amendment of FASB Statement No. 123and FASB Statement No. 95*, which requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values. Prior to SFAS No. 123R,only certain pro forma disclosures of fair value were required. SFAS 123R mustbe adopted no later than July 1, 2005 for calendar quarter companies. Weexpect to adopt SFAS 123R on July 1, 2005.

SFAS 123R permitscompanies to adopt one of two methods: (1) A “modified prospective” methodin which compensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123R for all share-based payments granted after theeffective date and (b) based on the requirements of SFAS 123 for allawards granted to employees prior to the effective date of SFAS 123R 

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thatremain unvested on the effective date or (2) A “modified retrospective”method which includes the requirements of the modified prospective methoddescribed above, but also permits entities to restate based on the amountspreviously recognized under FAS 123 for purposes of pro forma disclosureseither (a) all prior periods presented or (b) prior interim periodsof the year of adoption. We are currently in the process of evaluating the twooption valuation methods and the potential impact on the financial statements.

**RISK FACTORS**

**Risks Related toOur Industry**

***Thecommunications industry is subject to government regulation, and changes incurrent or future regulations could have a material adverse effect on ourbusiness, operating results and financial condition and restrict the manner inwhich we operate our business.  ***We are subject tovarying degrees of federal, state and local regulation. Pursuant to theCommunications Act of 1934, as amended, or the Communications Act, the FCCexercises jurisdiction over us with respect to interstate and internationalservices. We must comply with various federal regulations, such as the duty tocontribute to universal service and other subsidies. Failure to comply withfederal reporting and regulatory requirements may result in fines or otherpenalties, including loss of authority to provide services.

State regulatorycommissions exercise jurisdiction over us to the extent we provide intrastateservices. We are required to obtain regulatory authorization and/or filetariffs with regulators in most of the states in which we operate. Constructinga network and selling telephone equipment is also subject to numerous localregulations such as building codes and licensing. Such regulations may vary bycity and county. In some states, we are required to obtain state contractorlicenses. If we do not obtain such required licenses, we may be subject tofines and other penalties. Future regulatory provisions may be less favorableto competitive service providers and more favorable to the incumbent localexchange carriers, or ILECs.

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Both federal and stateregulators require us to pay various fees and assessments, file periodicreports and comply with various rules regarding the contents of our bills,protection of subscriber privacy, service quality and similar consumerprotection matters on an ongoing basis.

We cannot assure you thatthe FCC or state regulators will grant us any required regulatory authorizationor refrain from taking action against us if we are found to have providedservices without obtaining the necessary authorizations, or to have violatedother requirements of their rules and orders. Delays in receiving requiredregulatory approvals or the enactment of new adverse regulation or regulatoryrequirements may slow our growth and have a material adverse effect upon us. Noassurance can be given that changes in current or future regulations adopted bythe FCC or state regulators, or other legislative, administrative or judicialinitiatives relating to the communications industry, would not have a materialadverse effect on our business, operating results and financial condition.

***Deregulation of thecommunications industry involves uncertainties, and the resolution of theseuncertainties could have a material adverse affect on our business.*  **TheTelecommunications Act of 1996, or the Telecommunications Act, remains subjectto judicial review and ongoing proceedings before the FCC and state regulators,including proceedings relating to interconnection pricing, access to andpricing for unbundled network elements, and other issues that could result insignificant changes to the business conditions in the communications industry.It is difficult to predict the effects, if any, such proceedings may have on usand our operations, and we cannot assure you that any such changes will nothave a material adverse effect upon us. A brief summary of current legal andregulatory developments is discussed in the section entitled “Regulation.”

**RisksRelated to the ATI Acquisition**

***We may not be able to successfully integrate ATI into ourbusiness.  ***We consummated the acquisition of ATI on December 31,2004. There can be no assurance that we will be able to integrate andconsolidate ATI into our ongoing business and operations according tomanagement’s plan. This process will require substantial management, financialand other resources and may pose risks with respect to production, customerservice and market share. It may also require regulatory approvals for someaspects which we cannot assure will be obtained. While we believe that we havesufficient financial and management resources to complete the integration ofATI, there can be no assurance in this regard or that we will not experiencedifficulties with customers, personnel or others resulting from theintegration. In addition, although we believe that the ATI acquisition willenhance our competitive position and business prospects, there can be noassurance that such benefits will be fully realized or that the integration ofATI into our business and operations will ultimately be successful.

As we adapt to the currenttelecom environment and begin to integrate ATI, we may be required to makeoperational changes, including consolidating certain operations, closingcertain facilities, or amending or terminating existing contractualrelationships, in order to improve our future profitability. However, there canbe no assurance as to the cost required to effect those operational changes,their effectiveness, or the timing or amount of any cost savings that areactually realized as a result of such changes. Management is continuing toassess our overall organization and cost structures and may, as a result ofthis ongoing process, develop future initiatives to increase operating andadministrative efficiency and enhance profitability. If we are unable toeffectively and efficiently integrate ATI into our business and operations, ourbusiness, financial condition, results of operations and cash flows may suffer.

**Risks Related toOur Business**

***We have a history of operating losses, and we may not beprofitable in the future.  ***We have incurredsignificant operating and net losses in the past and expect to continue toincur losses in the future. For the year ended December 31, 2003, we hadan operating loss of $16.1 million, a net loss of $17.2 million andan accumulated deficit of $125.2 million. For the year ended December 31,2004, we had an operating loss of 

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$5.6 million, netincome of $1.1 million and an accumulated deficit of $124.1 million. The netincome for the year ended December 31, 2004 is primarily the result of again on extinguishment of debt of $18.2 million. We expect our operating lossesto continue for the foreseeable future. We cannot assure you that our revenueswill grow or that we will achieve profitability in the future.

***If we do not maintain effective working relationships withthe ILECs, our business will be adversely affected.  ***Ourfacilities-based strategy allows us to control much of our network, but we alsodepend on our ability to interconnect with ILECs and to lease from them certainessential network elements, thereby decreasing our capital and operating costs.ILECs are required by federal and state law to unbundle and make availablethese network elements and services at cost-based rates. We obtain access tothese network elements and services under terms established in interconnectionagreements that we have entered into with certain ILECs. Like many competitivecarriers, we have experienced difficulties in working with the ILECs withrespect to obtaining information about network facilities, ordering networkelements and services, interconnecting with ILEC networks and settlingfinancial disputes. These difficulties can impair our ability to provide localservice to customers on a timely and competitive basis. Federal law requiredthat the Regional Bell Operating Companies, or RBOCs, cooperate withcompetitive carriers and meet statutory requirements for opening their localmarkets to competition before they could receive permission to providein-region long distance services. Now that each RBOC has met those requirementsand received authorization to provide long distance services throughout itsrespective operating region, it may have less incentive to properly maintainthe information, ordering and interconnection interfaces that we rely on and mayotherwise fail to cooperate with us regarding service provisioning issues.

The RBOCs have been finedby both federal and state authorities for their failure to comply with the lawsand regulations that support local competition. We believe these fines have notsubstantially reduced the use of such anticompetitive practices and thatillegal and anticompetitive activity will continue to occur in most of ourmarkets. We consistently undertake legal actions to oppose theseanticompetitive actions and enforce our legal right of access to ILECfacilities. Nevertheless, regulatory and judicial remedies frequently do notpreclude further anticompetitive behavior and rarely compensate us for ourdamages and legal expenses. Moreover, if an ILEC refuses to cooperate orotherwise fails to support our business needs in retaliation for our efforts toenforce our legal rights or for any other reason, including labor shortages,work stoppages or disruption caused by mergers, other organizationalchanges or terrorist attacks, our ability to offer local services on a timelyand cost-effective basis will be materially harmed.

We have also experienceddifficulties with receiving payments due to us for services that we provide toILECs and long distance service providers. These balances due to us can bematerial. We generally have been able to reach mutually acceptable settlementsto collect overdue and disputed payments, but there can be no assurance that wewill be able to do so in the future. Our inability to continue to timelyreceive payments and to create settlement agreements with other carriers couldhave a material adverse effect on us. In addition, certain of ourinterconnection agreements allow the ILEC to increase our security depositobligations. If an ILEC makes an enforceable demand for an increased securitydeposit, we could have less cash available for other expenses, which could havea material adverse effect on our business.

Our ability to continue toobtain favorable interconnection, unbundling, service provisioning and pricingterms, and the time and expense involved in negotiating interconnectionagreements and amendments, can be adversely affected by ongoing legal andregulatory activity. Many of our existing interconnection agreements providethat one or both parties may be entitled to demand renegotiation of particularprovisions or of the entire agreement based on intervening changes in lawresulting from ongoing legal and regulatory activity. We are in the process ofrenegotiating the terms of certain of our interconnection agreements. We cannotbe certain that we will be able to successfully renegotiate any such agreementon terms favorable to us. Any limitation on the availability of unbundlednetwork elements, especially unbundled local loops, network interface devicesor interoffice transmission facilities resulting from federal or stateregulatory activity could increase our costs and otherwise have a materialadverse 

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impacton our business. A brief summary of current legal and regulatory developmentsis discussed in the section entitled “Regulation.”

***Wedepend on a limited number of third party service providers for long distanceand other services, and if any such third party service providers were toexperience significant interruptions in their business operations, or were tootherwise cease to provide such services to us, our operations could bematerially and adversely affected.  ***We depend on alimited number of third party service providers for long distance and otherservices. If any of these third party providers were to experience significantinterruptions in their business operations, terminate their agreements with us,or fail to perform the services required under the terms of our agreements withthem, our ability to provide services to our customers could be materially andadversely affected for a period of time that we cannot predict. There can be noassurance that we would be able to timely locate alternative providers of suchservices, or that we could do so at economical rates.

***The communications market inwhich we operate is highly competitive, and we may not be able to competeeffectively against companies that have significantly greater resources than wedo, which could cause us to lose customers and impede our ability to attractnew customers.***   The communication industry is highlycompetitive and is affected by the introduction of new services by, and themarket activities of, major industry participants.

Ineach of our markets we compete principally with the ILEC serving that area. Wehave not achieved, and do not expect to achieve, a major share of the marketfor any of the communications services we offer. Current and potential largecompetitors in each market have the following advantages over us:

·        long-standing relationships and brandrecognition with customers;

·        financial, technical,marketing, personnel and other resources substantially greater than ours;

·        morefunds to deploy communications services that compete with ours;

·        largernetworks; and

·        benefitsfrom existing regulations that favor the ILECs.

We also face, and expectto continue to face, competition in the local market from other current andpotential market entrants, including other competitive local carriers, wirelesscarriers, resellers, competitive access providers, cable television companies,electric utility companies, microwave carriers and private networks built bylarge end users. In addition, the development of new technologies could giverise to significant new competitors in the local market.

In the long distance communicationsmarket we face competition from large carriers such as AT&T, MCI andSprint, the RBOCs, wireless carriers and many smaller long distance carriers.

We also face competitionfrom companies offering local and long distance data and voice services overthe Internet.

In the Internet servicesmarket there are limited barriers to entry and our competitors in this marketinclude Internet service providers, other communications companies, onlineservice providers, cable companies and Internet software providers.

***The regulation of access chargesinvolves uncertainties, and the resolution of these uncertainties couldadversely affect our business.***   As a competitivelocal exchange carrier, we are allowed to earn access charges by connecting ourvoice services customers with interexchange carriers, or IXCs, such asAT&T, MCI and Sprint. When a network service voice customer of oursoriginates or receives a long distance call, we are entitled to compensationfrom the IXC for the cost we incur in originating or terminating the longdistance call. We have tariffs filed with the FCC for interstate accessservices and with each state where we provide intrastate access services. Ourrates can be higher than those charged by some larger local exchange carriersthat have many more customers and, consequently, lower per-unit costs. Future 

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regulatoryproceedings, both at the FCC and in individual states where we operate, couldresult in a decrease in our access charges. Such reductions could have amaterial adverse effect on us.

The FCC has indicated thatits current carrier compensation rules are transitional measures thatshould be replaced by mid-2005 by a bill-and-keep or other alternativecompensation arrangement. Because we receive payments from other carriers forthe exchange of long distance calls, we will be affected by any changes to theFCC’s intercarrier compensation rules. We cannot predict the impact that anysuch changes would have on our business.

The FCC has granted toILECs and RBOCs, including Qwest, significant flexibility in pricing interstatespecial access services. This pricing flexibility may result in Qwest loweringits prices in high traffic density areas, including areas where we compete. Weanticipate that the FCC will continue to grant to ILECs greater pricingflexibility for access services if the number of actual and potentialcompetitors increases in each of these markets, potentially forcing us toreduce our prices or withdraw from certain markets. We provide a more detaileddiscussion of current legal and regulatory developments affecting accesscharges and intercarrier compensation issues in the section entitled “Regulation.”

***Thelevel of our outstanding total debt may adversely affect our financial healthand prevent us from fulfilling our financial obligations.***   Asof December 31, 2004, we had approximately $137.8 million of totalindebtedness outstanding, excluding capital lease obligations. Our indebtednesscould significantly affect our business and our ability to fulfill ourfinancial obligations. For example, a high level of indebtedness could:

·        makeit more difficult for us to satisfy our current and future debt obligations;

·        limitour ability to borrow additional funds or obtain other forms of financing;

·        increaseour vulnerability to general adverse economic and industry conditions;

·        limitour ability to fund working capital, capital expenditures and other generalcorporate requirements out of future operating cash flows or with additionaldebt or equity financing;

·        limitour flexibility in planning for, or reacting to, changes in our business or ourindustry;

·        placeus at a disadvantage to competitors with less debt; and

·        makeus vulnerable to interest rate fluctuations, if we incur any indebtedness thatbears interest at variable rates.

***Our outstanding notes contain restrictive and financial covenants thatlimit our operating flexibility, and we may obtain a credit facility in thefuture that may include similar or additional restrictions.***   Our outstanding notes contain covenantsthat, among other things, restrict our ability to take specific actions, evenif we believe them to be in our best interest. In addition, we may obtain acredit facility in the future which may include similar or additionalcovenants. These covenants may include restrictions on our ability to:

·        incuradditional indebtedness;

·        paydividends or distributions on, or redeem or repurchase, capital stock;

·        createliens with respect to our assets;

·        makeinvestments, loans or advances;

·        prepayspecified indebtedness;

·        enterinto transactions with affiliates;

·        merge,consolidate, reorganize or sell our assets; and

·        engagein any business other than activities related or complementary tocommunications.

In addition, a futurecredit facility may impose financial covenants that require us to comply withspecified financial ratios and tests, including minimum quarterly EBITDA,senior debt to total 

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capitalization,maximum capital expenditures, maximum leverage ratios and minimum interestcoverage ratios. We cannot assure you that we will be able to meet theserequirements or satisfy these covenants in the future. If we fail to do so, ourdebts could become immediately payable at a time when we are unable to paythem. This could adversely affect our ability to carry out our business planand would have a negative effect on our financial condition.

***If we are unable to retain and attract management and keypersonnel, we may not be able to execute our business plan.  ***Webelieve that our success is due, in part, to our experienced management team,including Mr. Richard A. Smith, our president and chief executive officer.Losing the services of one or more members of our management team couldadversely affect our business and our expansion efforts, and possibly preventus from further improving our operational, financial and information managementsystems and controls. As we continue to grow, we will need to retain and hirequalified sales, marketing, administrative, operating and technical personnel,and to train and manage new personnel.

We believe that there area limited number of persons with experience comparable to the experience of themembers of our management team. Our ability to implement our business plan isdependent on our ability to retain and hire a large number of qualified newemployees each year. If we are unable to hire sufficient qualified personnel,our customers could experience inadequate customer service and delays in theinstallation and maintenance of access lines.

***If we choose to grow by expanding to new markets and/or bymaking acquisitions, we would face additional risks.  ***Althoughwe believe the proceeds from the notes together with our cash resources on handwill fund our current operations, we may need additional funding if we chooseto expand our geographic service area or to make acquisitions.

The actual amount andtiming of our future capital requirements may differ from our currentestimates. Competitive developments, changes in technology, changes in theregulatory environment and other events may cause us to alter the currentlyestimated amount and timing of our expenditures.

These and other factorsmay also cause our actual revenues and costs to differ from what we currentlyanticipate, which could affect the amount and timing of our additionalfinancing needs.

Sources of additionalfinancing may include the private or public sale of equity or debt securities,commercial bank debt financing, vendor financing or lease financing. If we meetour funding needs through debt financing, our interest and debt serviceobligations will increase, and we may become subject to restrictive covenantsthat could impair our ability to implement our business plan. We cannot assureyou that any additional financing we may need will be available to us onfavorable terms or at all.

Rapid growth would place asignificant strain on our management, operational, financial and informationmanagement systems and controls, personnel and other resources. We cannotassure you that we will successfully implement the operational and financialinformation management systems and controls that we anticipate would benecessary to support rapid growth and to manage a competitive business in anevolving industry. Any failure to implement and improve these systems andcontrols and to maintain our other resources at a pace consistent with industrychanges and the growth of our business could cause customers to switch to othercompetitive service providers, which would have a material adverse effect onus.

***Our failure to successfully integrate other businesses weacquire may raise our costs and reduce our revenue.  ***Aspart of our business strategy, we may seek to expand through investments in orthe acquisition of other businesses that we believe are complementary to ourbusiness. Although we regularly engage in discussions relating to potentialacquisitions, we are unable to predict whether any acquisitions will actuallyoccur. If we acquire companies, networks or other complementary assets, we willbe subject to the risks generally associated with acquisitions. These risksinclude, among others:

·        theacquired companies may not provide us with all the benefits that we expect;

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·        thetransactions with, and subsequent integration of, the acquired companies maydisrupt our ongoing business operations and strain our resources andmanagement;

·        itmay be difficult to successfully integrate the acquired businesses with ouroperations;

·        ourrelationships with employees or customers may be impaired; and

·        itmay not be possible to maintain uniform standards, controls, procedures andpolicies across the acquired companies.

Our ability to completeacquisitions will depend, in part, on our ability to finance the acquisitions,including the costs of acquisition and integration. Our ability may beconstrained by our cash flow, the level of our indebtedness at the time,restrictive covenants in the agreements governing our indebtedness, conditionsin the securities markets and other factors, many of which are not within ourcontrol. If we proceed with one or more acquisitions in which the considerationconsists of cash, we may use a substantial portion of our available cash tocomplete the acquisitions. If we finance one or more acquisitions with theproceeds of indebtedness, our interest expense and debt service requirementscould increase materially. The financial impact of acquisitions couldmaterially affect our business and could cause substantial fluctuations in ourquarterly and yearly operating results.

***We are dependent on effective billing, customer service andinformation systems.  ***Sophisticated back officeinformation and processing systems are vital to our ability to control andmonitor costs, provide outstanding customer service, bill and servicecustomers, initiate, implement and track customer orders and achieve operatingefficiencies. We have purchased and implemented our essential informationsystems consisting of our billing system, our sales order entry system, ourcustomer provisioning system, our electronic bonding system, our mediationsystem and our switch information systems. The integration of these systems is challengingbecause all of these systems were developed by different vendors and must becoordinated through custom software and integration processes. Our sales, linecount and other core operating and financial data are generated by thesesystems and the accuracy of this data depends on the quality of manual entryand system integration. Although we have completed some systems integration,the upgrading of these systems and the integration of updated systems isongoing. In addition, we may experience negative adjustments to our financialand operating data if we encounter difficulties in these projects. We cannotassure you that any such adjustments arising out of our systems integrationefforts will not have a material adverse effect in the future. If we are unableto effectively upgrade and integrate our operations and financial systems, ourcustomers could experience delays in connection of service, billing issuesand/or lower levels of customer service.

***Declining prices for communications services could reduceour revenue and profitability.  ***Long distance priceshave decreased substantially in recent years and are expected to continue todecline in the future. In addition, the long distance industry has historicallyexperienced high customer churn, as customers frequently change their chosenlong distance providers in response to lower rates or promotional incentives bycompetitors. Prices for network services have also been decreasing. If thistrend continues, revenue from our network services and other service offeringsmay be subject to significant price pressure.

***The communications industry isundergoing rapid technological changes, and new technologies may be superior tothe technologies we use.***   Our failure to anticipateand keep up with such changes could adversely affect our business. Thecommunications industry is subject to rapid and significant changes intechnology and in customer requirements and preferences. We have developed ourbusiness based, in part, on traditional telephone technology. Subsequenttechnological developments may reduce the competitiveness of our network andrequire expensive unbudgeted upgrades or additional communications productsthat could be time consuming to integrate into our business and could cause usto lose customers and impede our ability to attract new customers. We may berequired to select one technology over another at a time when it might beimpossible to predict with any certainty which technology will prove to be moreeconomic, efficient or capable of attracting customers. In addition, even if weutilize new technologies, such as voice-

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over-Internetprotocol, or VoIP, we may not be able to implement them as effectively as othercompanies with more experience with those new technologies.

***A network failure could cause delays or interruptions ofservice, which could cause us to lose customers and revenue.  ***Oursuccess requires that our network provide competitive reliability, capacity andsecurity. Some of the risks to our network and infrastructure include:

·        physicaldamage to access lines;

·        powersurges or outages;

·        capacitylimitations;

·        softwaredefects;

·        lackof adequate redundancy;

·        breachesof security; and

·        otherdisruptions beyond our control.

Such disruptions may causeinterruptions in service or reduced capacity for customers, any of which couldcause us to lose customers.

***We continue to monitor ournetwork from a performance and cost perspective and as a result, our networkoptimization routines may have an adverse effect on our customers.***   Ourengineering and operations organizations continually monitor and analyze theutilization of our network. As a result, they may develop projects to modify oreliminate network circuits that are underutilized. This ongoing process mayresult in limited network outages for a subset of our customers, adverselyaffecting our relationship with them and may increase our customer disputes andmonthly churn.

***Some of our employees are unionized, and we could face workdisruptions due to strikes, slowdowns or other labor disputes.  ***Asmall percentage of our employees are members of the International Brotherhoodof Electrical Workers. Although our management believes that its relationshipwith our union employees is good, we cannot promise that we will neverexperience a labor disruption. Such disruptions could occur in response to ouractions but could also be due to the actions of other union employers.Significant labor disruptions could adversely affect our ability to provideacceptable levels of service to our customers, which could result in customerdissatisfaction and a loss of business.

***Terrorist attacks and other actsof violence or war may affect the markets in which we operate, our operationsand our profitability.***   Terrorist attacks, such asthe attacks that occurred in New York and Washington, D.C. on September 11,2001, and subsequent worldwide terrorist actions may negatively affect ouroperations. We cannot assure you that there will not be further terroristattacks that impact our employees, network facilities or support systems.Certain losses resulting from these types of events are uninsurable and othersare not likely to be covered by our insurance.

Terrorist attacks maydirectly impact our business operations through damage or harm to ouremployees, network facilities or support systems, increased security costs orthe general curtailment of voice or data traffic. Any of these events couldresult in increased volatility in or damage to our business and the UnitedStates financial markets and economies.

**Item7A.**                Quantitativeand Qualitative Disclosure About Market Risk.

We are not exposed tomarket risks from changes in foreign currency exchange rates or commodityprices. We do not hold any derivative financial instruments nor do we hold anysecurities for trading or speculative purposes.

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We are exposed to changesin interest rates on our investments in cash equivalents and short-terminvestments. All of our investments have maturities of six months or less whichreduces our exposure to long-term interest rate changes. Interest income for theyear ended December 31, 2004 was $0.1 million, therefore not exposing usto any meaningful interest income risk had rates dropped. Excluding capitalleases, we had approximately $137.8 million in senior second secured notesoutstanding as of December 31, 2004. These notes are at a fixed interestrate and are therefore not exposed to any interest rate risk.

**Item 8.**                        FinancialStatements and Supplementary Data.

Our Consolidated FinancialStatements and the report of our independent registered public accounting firmare included in this Annual Report on Form 10-K beginning on page F-1.The index to this report and the financial statements is included in Item 15.

**Item 9.**                        Changes Inand Disagreements with Accountants on Accounting and Financial Disclosure.

None.

**Item 9A.**                Controls andProcedures.

***Evaluation of Disclosure Controls and Procedures***

Our management, under thedirection and with the participation of Richard A. Smith, our President andChief Executive Officer, and Geoffrey M. Boyd, our Chief Financial Officer,performed an evaluation of the design and operation of our disclosure controlsand procedures (as defined in Rule 13a-15 under the Securities ExchangeAct of 1934). Based on that evaluation, Messers. Smith and Boyd concluded thatas of December 31, 2004, our disclosure controls and procedures areeffective.

***Changes in Internal Control Over Financial Reporting***

During the quarter ended December 31,2004, there have been no significant changes in our internal controls overfinancial reporting that materially affected, or are reasonably likely tomaterially affect, our reported financial results.

**Item 9B.**               Other Information.

None.

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**Part III**

**Item 10.**                 Directors andExecutive Officers of the Registrant.

Our executive officers and directors and their agesand years of service as of December 31, 2004 are as follows:
| **Name**                     | ** ** | ** ** | ** ** | **Age** | ** ** | **Years of  Service**                                         | ** ** | **Position(s)** |
|------------------------------|------------|------------|------------|---------|------------|---------------------------------------------------------------|------------|-----------------|
| *Executive  Officers:*       |       |       |       |    |       |                                                          |
| Clifford D. Williams         |       | 57         |       | 8       |       | Chairman of the Board and Founder                             |
| Richard A. Smith             |       | 54         |       | 6       |       | Director,  President and Chief Executive Officer              |
| Geoffrey M. Boyd             |       | 37         |       | 4       |       | Chief Financial  Officer                                      |
| Robert E. Pickens            |       | 44         |       | 8       |       | Executive Vice  President, Marketing                          |
| David A. Kunde               |       | 45         |       | 5       |       | Executive Vice  President, Engineering and Network Operations |
| Arlin B. Goldberg            |       | 48         |       | 8       |       | Executive Vice President,  Information Technology             |
| J. Jeffery Oxley             |       | 50         |       | 5       |       | Executive Vice  President, Law and Policy                     |
| Steven K. Wachter            |       | 43         |       | 5       |       | Executive Vice  President, Sales                              |
| *Non-Management Directors:*  |       |       |       |    |       |                                                          |
| James P. TenBroek(1)(2)      |       | 43         |       | 4       |       | Director                                                      |
| Marvin C. Moses(3)           |       | 60         |       | 5       |       | Director                                                      |
| Mark E. Nunnelly(1)          |       | 46         |       | 5       |       | Director                                                      |
| Ian K. Loring(3)(2)          |       | 38         |       | 3       |       | Director                                                      |
| Peter M. Van  Genderen(1)(2) |       | 39         |       | 7       |       | Director                                                      |

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(1)          Member of theCompensation Committee.

(2)          Member of the SteeringCommittee.

(3)          Member of the Audit Committee.

***Executive Officers***

**Clifford D. Williams**is our founder, and has served as chairman of the board since July 1996.He also served as our chief executive officer from July 1996 to August 2003and as president from July 1996 to April 2000. From September 1995to July 1996, Mr. Williams was raising capital for the formation ofthe Company. From March 1992 to September 1995, Mr. Williams waspresident and chief executive officer of Enhanced Telemanagement Incorporated,an integrated communications provider that offered a full line ofcommunications products and services to small businesses in Minnesota,Washington, Oregon, Illinois and Ohio. From 1971 to 1991, Mr. Williamsheld a variety of senior management positions in the cable television industry,leading to vice president and general manager for RogersCommunications Inc. in Minneapolis.

**Richard A. Smith**has served as our chief executive officer since August 2003, as presidentsince April 2000 and as a member of the board of directors since July 2000.He also served as our chief financial officer from October 1998 to April 2000and as chief operating officer from March 1999 to July 2003. From1972 to 1998, Mr. Smith held various positions at Frontier, includingcontroller, chief information officer, president of Frontier InformationTechnologies, vice president of Midwest Telephone Operations, network plantoperations director, director of business development and vice president offinancial management.

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**Geoffrey M. Boyd**has served as our chief financial officer since March 2000. From November 1998to March 2000, Mr. Boyd was chief financial officer of LogixCommunications Enterprises, Inc. From September 1997 to November 1998,Mr. Boyd was director of mergers and acquisitions and strategic planningfor Dobson Communications Corporation, the parent company of Logix. From August 1996to September 1997 he was a vice president at MLC Industries, Inc., acompany that has managed several cellular and paging companies. From January 1996to September 1996, Mr. Boyd worked at a start-up cellular acquisitioncompany. From November 1994 to December 1995, he served as a vicepresident at Shawmut Bank.

**Robert E. Pickens**has served as our executive vice president of marketing since April 1996.Prior to that, from July 1995 to March 1996, Mr. Pickens servedas general manager of local services and operations for Frontier. From June 1990to June 1995, Mr. Pickens served as marketing manager and marketingdirector for ETI.

**David A. Kunde** hasserved as our executive vice president of engineering and network operationssince July 2001. Prior to that, from May 1999, he was our vicepresident of operations and technology planning. From 1994 until May 1999,Mr. Kunde held the positions of vice president of network engineering and directorof network engineering and operations at Citizens Communications. From 1986 to1994, Mr. Kunde held a variety of positions with Frontier.

**Arlin B. Goldberg**has served as our executive vice president of information technology since October 1996.Previously, from July 1995 to October 1996, Mr. Goldberg was thedirector of information services at Frontier, and from February 1993 to July 1995Mr. Goldberg was the director of information services at ETI.

**Steven K. Wachter**has served as our executive vice president of sales since August 1999.Prior to joining us, Mr. Wachter served in a variety of capacities atAmeritech Corporation since October 1994, including director of businesssales for Wisconsin, East Region GM/director of small business marketplace,general manager/director of premises sales, and director of sales programming.

**J.Jeffery Oxley** has served as our executive vice president oflaw and policy since May 2003. Since joining us in September 1999, hehas also served as our vice president, general counsel and director ofregulatory affairs. Prior to joining us, from September 1995 to September 1999,Mr. Oxley served as assistant attorney general for the State of Minnesota.

***Non-Management Directors***

**Marvin C. Moses** hasserved as a member of the board of directors since January 1999. He ispresently on the advisory board of the University of Illinois Center forEntrepreneurial Development, which he joined in 2004. Mr. Moses is aprivate investor and has acted as a communications consultant from 1996 to thepresent. From 1988 to 1996, Mr. Moses served as executive vice presidentand chief financial officer of ALC Communications/Frontier. Mr. Moses wasthe senior vice president and chief financial officer at Cable &Wireless Communications US operations from 1982 to 1988.

**Mark E. Nunnelly**has served as a member of the board of directors since September 1999. Mr. Nunnellyis a managing director at Bain Capital, a leading global private investmentfirm based in Boston. Prior to joining Bain Capital in 1990, Mr. Nunnellywas a partner of Bain & Company. Mr. Nunnelly serves on the boardof directors of a number of companies and non-profit organizations, includingHoughton-Mifflin Company, Domino’s Pizza, Warner Music and DoubleClick.

**Peter M. Van Genderen**has served as a member of the board of directors since December 1997. Mr. VanGenderen is a partner with Stolberg Equity Partners, which he joined in 1996.From 1990 to 1995, he was employed by UniLink Software, Inc. where heserved as its general manager. Previously, Mr. Van Genderen worked incorporate finance at Bankers Trust Company, where he was responsible for 

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structuring acquisitionand merchant banking transactions. Mr. Van Genderen’s other directorshipsinclude Alpine Access, Inc. and Central Security Group, Inc.

**James P. TenBroek**has served as a member of the board of directors since November 2000. Mr. TenBroekis a managing director at Wind Point Partners. Prior to joining Wind Point in1997, Mr. TenBroek was an investment professional at GTCR, Inc. andpreviously had been an engineering manager at Hewlett-Packard Company and aconsultant with the Boston Consulting Group. Mr. TenBroek serves on theboards of directors of LDMI Telecommunications, Inc., Network Telephone, Inc.,V-SPAN, Inc. and U.S. Security Associates, Inc.

**IanK. Loring** has served as a member of the board of directorssince August 2001. Mr. Loring has been a managing director of BainCapital, Inc. since 1999. Prior to joining Bain, Mr. Loring was avice president with Berkshire Partners.

**Board Committees**

Our by-laws provide that our board of directors maydesignate one or more board committees. We currently have an audit committee, acompensation committee and a steering committee.

Our audit committeecomprises Messers. Moses and Loring and performs the following functions:

·        recommendsto our board of directors the independent auditors to conduct the annual auditof our books and records;

·        reviewsthe proposed scope and results of the audit;

·        approvesthe audit fees to be paid;

·        reviewsaccounting and financial controls with the independent public accountants andour financial and accounting staff; and

·        reviewsand approves transactions between us and our directors, officers andaffiliates.

Mr. Moses is an audit committee financial expertand is an independent director.

Our compensationcommittee comprises Messers. Nunnelly, Van Genderen and TenBroek andperforms the following functions:

·        reviewsand recommends approval by the board for compensation and benefit plans;

·        establishesand reviews general compensation policies with the objective to attract andretain superior talent, to reward individual performance and to achieve ourfinancial goals;

·        administersour stock option plans and grants; and

·        evaluatesand assesses executive performance.

Our steeringcommittee comprises Messers. Van Genderen, Loring and TenBroek andperforms the following functions:

·        evaluatesmerger and acquisition opportunities;

·        evaluatesfinancing options and opportunities; and

·        evaluatesbusiness plans, strategies and tactics.

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**Section 16(a)Beneficial Ownership Reporting Compliance**

During fiscal year 2004, the following reportingpersons had late Form 3 filings:

BainCapital Fund VI, L.P.

GeoffreyM. Boyd

RobertE. Pickens

DavidA. Kunde

ArlinB. Goldberg

J.Jeffrey Oxley

StevenK. Wachter

PeterM. Van Genderen

AnthonyJ. Cassara

MarvinC. Moses

CliffordD. Williams

RichardA. Smith

MarkE. Nunnelly

JamesA. TenBroek

IanK. Loring

StolbergParners LP

Wind Point Partners IV,L.P.

**Code of Ethics**

We adopted a Code of Ethics that applies to allemployees, our executive officers and directors. Our Code of Ethics is filed asan exhibit to this annual report. It is also available on our website at *www.eschelon.com.*

We intend to satisfy thedisclosure requirement under Item 5.05 of Form 8-K regarding an amendmentto, or waiver from, a provision of this Code of Ethics by posting suchinformation on our website at the address specified above.

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**Item11.**                 ExecutiveCompensation.

Thefollowing table summarizes the compensation earned by our chief executiveofficer and the other four most highly paid executive officers whose totalsalary and bonus exceeded $100,000 for 2004. We refer to these individuals asour named executive officers.

**SummaryCompensation Table**
| ** **                                   | ** ** | **Annual Compensation** | ** ** | **Long-Term  Compensation Awards** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|-----------------------------------------|------------|
| **Name and  Principal Position**   | ** ** | ** **                   | ** ** | **Year**                                | ** ** | **Salary** | ** ** | **Bonus** | ** ** | **Restricted  Stock Awards** | ** ** | **Shares  Underlying Options** | ** ** |
| Clifford D. Williams(1)                      |       | 2004                         |       | $                                       | 330,335    |   | $ | 243,071 |   |   | $ | — |   |   |   | 50,000 |   |   |
| *Chairman  of the Board*                     |       | 2003                         |       | 285,441                                 |       | 30,873 |   |   | — |   |   |   | 2,755,786 |   |   |
|                                         |       | 2002                         |       | 267,825                                 |       | 160,710 |   |   | — |   |   |   |   |   |   |
| Richard A. Smith(2)                          |       | 2004                         |       | 311,697                                 |       | 261,863 |   |   | — |   |   |   | 150,000 |   |   |
| *President  and Chief Executive Officer*     |       | 2003                         |       | 239,993                                 |       | 75,544 |   |   | — |   |   |   | 2,483,337 |   |   |
|                                         |       | 2002                         |       | 220,473                                 |       | 255,225 |   |   | — |   |   |   |   |   |   |
| Geoffrey M. Boyd                             |       | 2004                         |       | 197,886                                 |       | 94,812 |   |   | — |   |   |   | 25,000 |   |   |
| *Chief  Financial Officer*                   |       | 2003                         |       | 181,502                                 |       | 13,401 |   |   | 13,500 |   |   |   | 342,754 |   |   |
|                                         |       | 2002                         |       | 178,414                                 |       | 80,285 |   |   | — |   |   |   |   |   |   |
| David A. Kunde                               |       | 2004                         |       | 186,787                                 |       | 70,560 |   |   | — |   |   |   | 25,000 |   |   |
| *Executive  Vice President, Engineering and* |       | 2003                         |       | 183,451                                 |       | 9,837 |   |   | 13,166 |   |   |   | 202,243 |   |   |
| *Network  Operations*                        |       | 2002                         |       | 175,135                                 |       | 52,540 |   |   | — |   |   |   |   |   |   |
| Steven K. Wachter                            |       | 2004                         |       | 187,952                                 |       | 70,284 |   |   | — |   |   |   | 15,000 |   |   |
| *Executive  Vice President, Sales*           |       | 2003                         |       | 166,350                                 |       | 9,168 |   |   | 8,093 |   |   |   | 141,110 |   |   |
|                                         |       | 2002                         |       | 152,100                                 |       | 45,630 |   |   | — |   |   |   |   |   |   |
|                                              |            |                              |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Prior to August 14,2003, Mr. Williams served as chief executive officer.

(2)*         *Mr. Smith became chief executiveofficer on August 14, 2003.

**Option Grants**

The table below containsinformation concerning the grant of options to purchase shares of our commonstock to each of the named executive officers during 2004. All options weregranted at or above fair market value as determined by the board of directorson the date of grant.

**Option Grants inLast Fiscal Year**
| ** **           | ** ** | **Individual Grants** | ** ** | ** **                | ** ** | ** **          | ** ** | ** **       | ** ** |
|----------------------|------------|----------------------------|------------|---------------------------|------------|---------------------|------------|------------------|------------|
| ** **           | ** ** | ** **                 | ** ** | **Percent of ** | ** ** | ** **          | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **           | ** ** | **Number of**         | ** ** | **Total**                 | ** ** | ** **          | ** ** | ** **       | ** ** | **Potential Realizable** | ** ** |
| ** **           | ** ** | **Securities**             | ** ** | **Options**               | ** ** | ** **          | ** ** | ** **       | ** ** | **Value at Assumed** | ** ** |
| ** **           | ** ** | **Underlying**             | ** ** | **Granted to**       | ** ** | **Exercise **  | ** ** | ** **       | ** ** | **Annual Rates of Stock Price** | ** ** |
| ** **           | ** ** | **Options**                | ** ** | **Employees**             | ** ** | **Price **     | ** ** | **Expiration**   | ** ** | **Appreciation for Option Term(3)** | ** ** |
| **Name**             | ** ** | ** **                 | ** ** | **Granted**               | ** ** | **in 2004(1)** | ** ** | **($/Share)(2)** | ** ** | **Date** | ** ** | **          **5%           | ** ** | **          10%          ** | ** ** |
| Clifford D. Williams |       |                       | 50,000     |                      |       |                | 3.6        | %                |       |   | $ | 0.10 |   |   | 5/20/2014 |   |   | $ | 3,144 |   |   |   | $ | 7,969 |   |   |
| Richard A. Smith     |       |                       | 150,000    |                      |       |                | 10.9       | %                |       |   | $ | 0.10 |   |   | 5/20/2014 |   |   | 9,433 |   |   |   | 23,906 |   |   |
| Geoffrey M. Boyd     |       |                       | 25,000     |                      |       |                | 1.8        | %                |       |   | $ | 0.10 |   |   | 5/20/2014 |   |   | 1,572 |   |   |   | 3,984 |   |   |
| David A. Kunde       |       |                       | —     |                      |       |                | —     |             |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| Steven K. Wachter    |       |                       | 15,000     |                      |       |                | 1.1        | %                |       |   | $ | 0.10 |   |   | 5/20/2014 |   |   | 943 |   |   |   | 2,391 |   |   |
|                      |            |                            |            |                           |            |                     |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)*         *The percentage of total options grantedto employees is based on an aggregate of 1,376,384 shares subject to optionsgranted to our employees in 2004.

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(2)*         *The exercise price per share reflects thefair market value of the common stock at the time of issuance.

(3)*         *The options have ten-year terms, subjectto earlier termination upon death, disability or termination of employment. Thepotential realizable value is calculated based on the term of the option at thetime of grant. Stock price appreciation of 5% and 10% is assumed pursuant to rules promulgatedby the SEC and does not represent our prediction of our stock priceperformance. The potential realizable values at 5% and 10% appreciation arecalculated by assuming that the exercise price on the date of grant representsthe fair value of a share of common stock on that date, that the valueappreciates annually at the indicated rate for the entire term of the optionand that the option is exercised at the exercise price and sold on the last dayof its term at the appreciated price.

**Year-End Options**

The following table showsinformation the exercisable and unexercisable stock options held as of December 31,2004 by each named executive officer.

**2004 Year-EndOptions**
| ** **            | ** ** | **Number of  Unexercised Options at  December 31, 2004(1)** | ** ** |
|-----------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **            | ** ** | **Exercisable**                                                                      | ** ** | **Unexercisable** | ** ** |
| Clifford D.  Williams |       | 1,489,353                                                                            |       |   | 1,316,433 |   |   |
| Richard A. Smith      |       | 1,482,536                                                                            |       |   | 1,150,801 |   |   |
| Geoffrey M. Boyd      |       | 142,101                                                                              |       |   | 225,653 |   |   |
| David A. Kunde        |       | 80,896                                                                               |       |   | 121,347 |   |   |
| Steven K. Wachter     |       | 59,443                                                                               |       |   | 96,667 |   |   |

----

(1)          Excludesrestricted stock awards.

**CompensationCommittee Interlocks and Insider Participation**

The members of our compensationcommittee are Messrs. Nunnelly, Van Genderen and TenBroek. None of ourexecutive officers has served as a member of a compensation committee (or othercommittee serving an equivalent function) of any other entity whose executiveofficers serve as a director of our company or member of our compensationcommittee.

**Compensation of Directors**

In February 2003,five of our current and former directors received shares of our restrictedcommon stock, valued at $0.05 per share, as compensation for service on ourboard of directors for the years 2002 and 2003, as follows: Marvin C. Mosesreceived 410,653 shares; Anthony J. Cassara, a former director who resigned in December 2004,received 25,100 shares; Peter M. Van Genderen received 16,753 shares; Alan J.Glazer, a former director who resigned in March 2004, received 5,100shares and Tanksukh V. Ganatra, a former director who resigned in December 2002,received 34,000 shares. In addition, Mr. Glazer received $33,000 in cashconsideration for services provided during 2003. In May 2004, two of ourcurrent and former directors received shares of our common stock, valued at$0.10 per share, as compensation for service on our board of directors for theyear 2004, as follows: Anthony J. Cassara, a former director who resignedin December 2004, received 63,802 shares; and Marvin C. Mosesreceived 76,563 shares. We also reimburse our directors for reasonable expensesthey incur to attend board and committee meetings.

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**BoardCompensation Committee Report on Executive Compensation**

**COMPENSATION COMMITTEE REPORT ONEXECUTIVE COMPENSATIONfor the Year Ended December 31, 2004Date of Report: March 30, 2005**

The Compensation Committee of the board of directorsconsists entirely of non-employee directors. The Compensation Committee isresponsible for setting and administering the policies that govern annualexecutive salaries, bonuses and stock ownership programs. The Committeeannually evaluates the performance, and determines the compensation, of theChief Executive Officer and the other executive officers of the Company basedupon a mix of the achievement of corporate goals, individual performance andcomparison with other companies in our industry.

The Compensation Committee’s goals with respect toexecutive officers, including the Chief Executive Officer, are to providecompensation sufficient to attract, motivate and retain executives ofoutstanding ability and potential, and to establish and maintain an appropriaterelationship between executive compensation and the creation of shareholdervalue. When determining adjustments to an individual’s compensation package,the Compensation Committee evaluates the importance to stockholders of thatperson’s continued service. The compensation programs for our executivesestablished by the Compensation Committee consist of three elements tied to theforegoing objectives: base salary, annual cash bonus, and stock-based equityincentives achieved primarily through participation in our stock option plans. Ourcompensation philosophy is to be competitive with comparable and directlycompetitive companies in order to attract, retain, and motivate highlyqualified employees. To this end, we have adjusted the mix of the compensationcomponents from year to year according to the Company’s performance.

BASE SALARY.   Salaries for 2004 were set based onthe foregoing factors and after review of industry comparables. The Company’sphilosophy is to maintain executive base salary at a competitive levelsufficient to recruit individuals possessing the skills and values necessary toachieve the Company’s vision and mission over the long term. Each individual’sbase salary is determined by the Compensation Committee after considering avariety of factors that make up market value and prospective value to theCompany, including the knowledge, experience and accomplishments of theindividual, the individual’s level of responsibility, and the typicalcompensation levels for individuals with similar credentials. The CompensationCommittee may, considering the advice of Company management, change the salaryof an individual on the basis of its judgment for any reason, including theperformance of the individual or the Company, changes in responsibility andchanges in the market for executives with similar credentials. Determinationsof appropriate base salary levels and other compensation elements are generallymade through consideration of a variety of industry studies and surveys as wellas by monitoring developments in the Company’s industry.

CASH BONUS.   Bonuses are awarded foraccomplishments during the past year. Bonuses are determined by theCompensation Committee, with advice from Company management, based upon anestablished Company bonus plan that compares Company financial performanceagainst a Board-approved budget. The annual bonuses earned by each of the namedexecutive officers for the past three years are shown above, in the SummaryCompensation Table.

STOCK OPTIONS.   Stock options are a fundamentalelement in the Company’s compensation program because they emphasize long-termcompany performance, as measured by creation of stockholder value, and foster acommonality of interest between stockholders and employees. Options aregenerally granted to all regular full-time and part-time employees, andparticularly to key employees likely to contribute significantly to the Company.In determining the size of an option grant to an executive officer, theCompensation Committee considers competitive factors, changes in responsibilityand the executive 

55

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officer’s achievement ofindividual pre-established goals. Such options are granted at 100% of the fairmarket value on the date of grant. The Company generally awards options toofficers at regular intervals, but other awards may be made as well. Some ofthe Company’s option plans provide for option grants to members of the board. Optionsgranted to employees generally vest over periods ranging from three to fiveyears after grant. The number of stock options granted to each of the namedexecutive officers in 2004, and the value of these awards, are shown above, inthe table entitled Option Grants in Last Fiscal Year.

CHIEF EXECUTIVE COMPENSATION.   The base salaryand annual bonus paid to Mr. Smith for 2004 is shown in the SummaryCompensation Table included above. Mr. Smith’s base salary as our ChiefExecutive Officer is based upon his business experience, individual performanceand the salary levels paid to chief executive officers of similarly sizedcompanies in our industry. Mr. Smith was also granted options to purchaseour stock, as shown in the table entitled Option Grants in Last Fiscal Year. Indetermining Mr. Smith’s compensation, the Compensation Committeeconsidered the factors described above, as well as the following additionalfactors: (1) his role in leading the company to strong financial results; (2) hisleadership in driving and managing growth initiatives and building organicgrowth capability; (3) his actions to ensure that the company continues tohave strong relationships with its suppliers and vendors, as well as itscustomers and employees; and (4) his leadership in improving the company’sculture and diversity.

COMPENSATION DEDUCTION LIMIT.   The CompensationCommittee has considered the $1 million limit for federal income taxpurposes on deductible executive compensation that is not performance based,and believes all executive compensation expenses will be deductible by theCompany for the foreseeable future.

Thisreport on executive compensation for 2004 is provided by the undersignedmembers of the Compensation Committee of the Board of Directors.
|        | Mark E. Nunnelly      |
|--------|-----------------------|
|   | James P. TenBroek     |
|   | Peter M. Van Genderen |

 

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

The following tablesets forth certain information regarding beneficial ownership of our commonstock as of February 28, 2005, by:

·       eachperson known by us to beneficially own more than 5% of our outstanding capitalstock;

·       eachof our directors and named executive officers; and

·       alldirectors and executive officers as a group.

Unless otherwise indicated, the address for eachstockholder listed is c/o Eschelon Telecom, Inc., 730 Second Avenue, Suite 900,Minneapolis, Minnesota 55402. Except as otherwise indicated, each of thepersons named in this table has sole voting and investment power with respectto all the shares indicated.

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Shareownership in each case includes shares issuable upon exercise of outstandingoptions and warrants that are exercisable within 60 days of February 28,2005, as described in the footnotes below.
| Beneficial Owner                                             | ** ** | ** ** | ** ** | **Number of Shares  of Common Stock  Beneficially Owned** | ** ** | **Percentage of Shares  Beneficially Owned(1)** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| Bain Capital Fund VI, L.P.(2)                                     |       |       | 41,706,763 |                                                                               |       |                                                           | 40.77      | % |   |
| Two Copley Place, 7th Floor  Boston, MA 02116                     |       |       |       |                                                                               |       |                                                           |       |   |   |
| Wind Point  Partners IV, L.P.(3)                                  |       |       | 33,329,602 |                                                                               |       |                                                           | 32.58      | % |   |
| One Towne Square,  Suite 780  Southfield, MI 48076           |       |       |       |                                                                               |       |                                                           |       |   |   |
| Stolberg Partners, L.P.(4)                                        |       |       | 15,667,675 |                                                                               |       |                                                           | 15.32      | % |   |
| 370-17th Street, Suite 4240  Denver, CO 80202                |       |       |       |                                                                               |       |                                                           |       |   |   |
| Clifford D.  Williams(6)                                          |       |       | 1,947,093  |                                                                               |       |                                                           | 1.87       | % |   |
| Richard A. Smith(7)                                               |       |       | 1,753,439  |                                                                               |       |                                                           | 1.69       | % |   |
| Geoffrey M.  Boyd(8)                                              |       |       | 473,652    |                                                                               |       |                                                           | *          |   |   |
| Steven K. Wachter(9)                                              |       |       | 244,532    |                                                                               |       |                                                           | *          |   |   |
| David A.  Kunde(10)                                               |       |       | 379,674    |                                                                               |       |                                                           | *          |   |   |
| Marvin C. Moses(11)                                               |       |       | 687,216    |                                                                               |       |                                                           | *          |   |   |
| James P.  TenBroek(3)(12)                                         |       |       | 33,329,602 |                                                                               |       |                                                           | 32.59      | % |   |
| Mark E. Nunnelly(2)(13)                                           |       |       | 41,706,763 |                                                                               |       |                                                           | 40.77      | % |   |
| Ian K.  Loring(2)(14)                                             |       |       | 41,706,763 |                                                                               |       |                                                           | 40.77      | % |   |
| Peter M. Van Genderen(4)(15)                                      |       |       | 15,684,428 |                                                                               |       |                                                           | 15.33      | % |   |
| All executive officers  and directors as a group (13 members)(16) |       |       | 96,900,638 |                                                                               |       |                                                           | 90.96      | % |   |

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****                   *Less than 1%.

(1)          The percentage of sharesbeneficially owned was determined based on a fraction. The numerator of suchfraction is the sum of (a) the number of outstanding shares of preferredand/or common stock (including restricted common stock issued but not yet fullyvested) beneficially owned by such owner and (b) the number of shares ofcommon stock issuable upon exercise of options and warrants beneficially ownedby such owner and which are exercisable within 60 days of February 28,2005. The denominator of such fraction is the sum of (a) the aggregatenumber of shares of preferred and common stock outstanding on February 28,2005 (which was 102,300,344 total shares) plus (b) the aggregate number ofshares of common stock issuable upon exercise of options and warrantsbeneficially owned by such owner and which are exercisable within 60 daysof February 28, 2005.

(2)          Includes 4,494,471shares of stock owned by BCIP Associates II, 1,683,732 shares of stock owned byBCIP Associates II-C, 732,804 shares of stock owned by BCIP Trust AssociatesII, 649,392 shares of stock owned by BCIP Associates II-B and 986,687 shares ofstock owned by BCIP Trust Associates II-B, 108,034 shares of stock ownedby PEP Investments PTY Ltd., 16,843 shares of stock owned by Sankaty HighYield Asset Partners, L.P., 413,216 shares of stock owned by Randolf StreetPartners IV, L.P., and 416,932 shares of stock owned by RGIP, LLC,affiliates of Bain Capital Fund VI, L.P. Bain Capital Fund VI, L.P. disclaimsbeneficial interest in those shares except to the extent of its pecuniaryinterest in each entity.

(3)          Includes 122,074 sharesof stock owned by Wind Point Associates IV, L.P. and 241,662 shares of stockowned by Wind Point Executive Advisor Partners, L.P., affiliates of Wind PointPartners IV, L.P. Wind Point Partners IV, L.P. disclaims beneficial interest inthose shares except to the extent of its pecuniary interest in each entity.

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(4)          Includes 5,920,397shares owned by SMS II-A, L.P. and 2,282,858 shares of stock owned by Stolberg,Meehan & Scano II, L.P., affiliates of Stolberg Partners, L.P., 2,783shares of stock owned by 780 Partners, a Wisconsin general partnership, anaffiliate of Stolberg Partners, L.P., 1,877 shares of stock owned by LarryWalker, an affiliate of Stolberg Partners, L.P., 1,766 shares of stock owned byLawrence Freeborg, an affiliate of Stolberg Partners, L.P., 905 shares of stockowned by Nottingham & Spirk, an affiliate of Stolberg Partners, L.P.and 905 shares of stock owned by Gary Snyder, an affiliate of StolbergPartners, L.P. Stolberg Partners, L.P. disclaims beneficial interest in thoseshares except to the extent of its pecuniary interest in each entity.

(5)          Pursuant to an agreemententered into with NTFC Capital Corporation, we redeemed the 6,780,541 shares ofour Series A Convertible Preferred Stock held by NTFC Capital Corporationfor a purchase price of approximately $5.1 million on December 30,2004. See the section entitled “The Transactions.”

(6)          Includes 1,914,196shares of common stock issuable upon exercise of vested options and 32,897shares of common stock beneficially owned by the C&M Family Limited Partnership.Mr. Williams shares voting and dispositive control over those sharesbeneficially owned by the C&M Family Limited Partnership and disclaimsbeneficial interest in those shares except to the extent of his pecuniaryinterest.

(7)          Includes 1,753,439 sharesof common stock issuable upon exercise of vested options.

(8)          Includes 203,652 sharesof common stock issuable upon exercise of vested options and 270,000 shares ofrestricted common stock issued but not yet fully vested.

(9)          Includes 82,665 sharesof common stock issuable upon exercise of vested options and 161,867 shares ofrestricted common stock issued but not yet fully vested.

(10)   Includes 116,345 shares ofcommon stock issuable upon exercise of vested options and 263,329 shares ofrestricted common stock issued but not yet fully vested.

(11)   Includes 410,653 shares ofrestricted stock issuable once fully vested, 176,563 shares of stock and100,000 shares of stock beneficially owned by the Moses Family LimitedPartnership. Mr. Moses, a director, shares voting and dispositive controlover those shares beneficially owned by the Moses Family Limited Partnershipand disclaims beneficial interest in those shares except to the extent of hispecuniary interest. The address of Mr. Moses is P.O. Box 6506, SnowmassVillage, CO 81615.

(12)   Includes 33,329,602 shares ofstock beneficially owned by Wind Point Partners IV, L.P. Mr. TenBroek, adirector, is a managing director of Wind Point Partners IV, L.P. Mr. TenBroekshares voting and dispositive control over shares beneficially owned by WindPoint Partners IV, L.P. and disclaims beneficial interest in those sharesexcept to the extent of his pecuniary interest. Mr. Ten Broek’s address isc/o Wind Point Partners, One Towne Square, Suite 780, Southfield, MI 48076

(13)   Includes 41,706,763 shares ofstock beneficially owned by Bain Capital Fund VI, L.P. Mr. Nunnelly, adirector, is a managing director of Bain Capital Fund VI, L.P. Mr. Nunnellyshares voting and dispositive control over shares beneficially owned by BainCapital Fund VI, L.P. and disclaims beneficial interest in those shares exceptto the extent of his pecuniary interest. Mr. Nunnelly’s address is c/oBain Capital Fund VI, L.P., Two Copley Place, 7th Floor, Boston, MA02116

(14)   Includes 41,706,763 shares ofstock beneficially owned by Bain Capital Fund VI, L.P. Mr. Loring, adirector, is a managing director of Bain Capital Fund VI, L.P. Mr. Nunnellyshares voting and dispositive control over shares beneficially owned by BainCapital Fund VI, L.P. and disclaims beneficial interest in those shares exceptto the extent of his pecuniary interest. Mr. Loring’s address is c/o BainCapital Fund VI, L.P., Two Copley Place, 7th Floor, Boston, MA02116.

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(15)   Includes 16,753 shares ofrestricted common stock issued but not yet fully vested and 15,667,675 sharesof stock beneficially owned by Stolberg Partners, L.P. and by Stolberg, Meehan &Scano II, L.P., an affiliate of Stolberg Partners, L.P. Mr. Van Genderen,a director, is a principal of Stolberg Partners, L.P. and Stolberg, Meehan &Scano II, L.P. and shares voting and dispositive control over the shares theyhold to the extent of his pecuniary interest. The address of Mr. VanGenderen is c/o Stolberg Partners, L.P. 370-17th Street, Suite 4240,Denver, CO 80202.

(16)   The aggregate number of optionsexercisable within 60 days of February 28, 2005, for all executiveofficers and directors is 4,229,710.

**Item 13.**                 CertainRelationships and Related Transactions.

**Issuances of Securities**

*Compensation ofDirectors.*

In May 2004,the following common shares, valued at $0.10 per share, were issued ascompensation for service on our board of directors:
| **Name of Director** | ** ** | ** ** | ** ** | **Number of  Shares Acquired** | ** ** |
|--------------------------------|------------|------------|------------|------------------------------------------|------------|
| Marvin C. Moses                |       |       | 76,563     |                                     |       |
| Anthony J. Cassara             |       |       | 63,802     |                                     |       |

 

*Saleof Series B Convertible Preferred Stock.  *Inconnection with the ATI Acquisition and to provide operating cash, we issued atotal of 20,000,000 shares of Series B Convertible Preferred Stock at aprice of $0.75 per share on December 30, 2004 to the following of ourprincipal stockholders:
| **Name of Stockholder** | ** ** | ** **             | ** ** | **Date of Purchase** | ** ** | **Number of  Preferred Shares** | ** ** |
|-----------------------------------|------------|------------------------|------------|--------------------------------|------------|-------------------------------------------|------------|
| Bain Capital Fund  VI, L.P.(1)    |       | December 30, 2004 |       |                           | 9,821,104  |                                      |       |
| Wind Point  Partners IV, L.P.(2)  |       | December 30, 2004 |       |                           | 7,920,816  |                                      |       |
| SMS II-A, L.P.(3)                 |       | December 30, 2004 |       |                           | 1,200,000  |                                      |       |

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(1)          Includes affiliated Bainentities

(2)          Includes affiliated WindPoint entities

(3)          Includes affiliatedStolberg entities

**Advisory Agreement**

In March 2004, weentered into an advisory agreement with Bain Capital, Wind Point Partners andStolberg Equity Partners, three of our principal stockholders, under which weagreed to pay each of them $50,000 per year for consulting and advisoryservices.

**Employment Agreements**

We have executed employment agreements with thefollowing of our named executive officers:

Mr. Smith serves as our president and chiefexecutive officer. His annual base salary is $339,775 and he is eligible toreceive an annual performance-based bonus up to 120% of his base salary,determined at the discretion of the board of directors or compensationcommittee. In the event of a change in control of our company, Mr. Smithcould receive a payment of up to $1,750,000 in exchange for his transfer to usof all of his stock options. The amount of payment is based on the return ofBain Capital, Wind Point Partners and Stolberg Equity Partners.

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Mr. Boyd serves as our chief financial officer.He receives a base salary of $195,225 per year and he is eligible to receive anannual performance-based bonus up to 75% of his annual base salary, determinedat the discretion of the board of directors or compensation committee.

Mr. Kunde serves as our executive vice presidentof engineering and network operations. He receives a base salary of $181,317and he is eligible to receive an annual performance-based bonus up to 75% ofhis annual base salary, determined at the discretion of the board of directorsor compensation committee.

Mr. Wachter serves asour executive vice president of sales. He receives a base salary of $183,872and he is eligible to receive an annual performance-based bonus up to 75% ofhis annual base salary, determined at the discretion of the board of directorsor compensation committee.

**Item 14.**                 PrincipalAccounting Fees and Services.

Thefollowing table is a summary of the fees billed to Eschelon Telecom, Inc.by Ernst & Young LLP for professional services rendered for the fiscalyears ended December 31, 2003 and December 31, 2004:
| **Type of Fee** | ** ** | ** ** | ** ** | ** Fiscal 2003 ** | ** ** | ** Fiscal 2004 ** | ** ** |
|---------------------------|------------|------------|------------|----------------------------------|------------|----------------------------------|------------|
| Audit Fees                |       |       | $          | 107,500                          |       |                             |       | $ | 354,734 |   |   |
| Audit-Related  Fees       |       |       | 9,500      |                             |       |                             | 18,500     |   |   |
| Tax Fees                  |       |       | 130,421    |                             |       |                             | 103,430    |   |   |
| Other Fees                |       |       | —     |                             |       |                             | —     |   |   |

 

*Audit-Related Fees.  *Audit-relatedfees are for assurance services for our 401(k) employee benefit plan.

*Tax Fees.  *Taxfees are for tax compliance services related to our federal and state incometax returns.

**AuditCommittee Pre-Approval Policies and Procedures.**

The Audit Committee pre-approves all audit andnon-audit services provided by the independent auditors and will not engage theindependent auditors to perform non-audit services prohibited by law orregulation. The Committee may delegate pre-approval authority to a member ofthe Audit Committee. The decisions of any Committee member to whom pre-approvalauthority is delegated must be presented to the full Committee at its nextscheduled meeting. All fees for 2003 and 2004 were approved by the Committee.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedules.
| **(a)** | **Documents filed as part of the report:**                                                                                                                                         |
|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (1)     | Schedule II—Valuation of Qualifying Accounts and  Reserves. All other supplemental schedules are omitted because of the absence  of conditions under which they are required. |   |
| (2)     | Report  of Independent Registered Public Accounting Firm                                                                                                                           | F-2 |
|    | Consolidated  Balance Sheets as of December 31, 2003 and 2004                                                                                                                 | F-3 |
|    | Consolidated  Statements of Operations for the years ended December 31, 2002, 2003 and  2004                                                                                  | F-4 |
|    | Consolidated  Statements of Stockholders’ Equity (Deficit) for the years ended  December 31, 2002, 2003 and 2004                                                         | F-5 |
|    | Consolidated  Statements of Cash Flows for the years ended December 31, 2002, 2003 and  2004                                                                                  | F-6 |
|    | Notes  to Consolidated Financial Statements                                                                                                                                        | F-7 |
| (3)     | Exhibits                                                                                                                                                                           |
| **(b)** | **Exhibits:**                                                                                                                                                                      |
|         |                                                                                                                                                                                    |  |  |

                                                

Thefollowing exhibits are filed or incorporated by reference as stated below:
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **Description** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1              |       | Sixth Amended and Restated Certificate of  Incorporation of Eschelon Telecom, Inc. filed on December 29, 2004.                                                                                                                                                                                                                                                                                                                                                                               |
| 3.2*             |       | By-Laws of Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 4.1*             |       | Fourth Amended and Restated Stockholders Agreement  dated June 27, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.1.2            |       | Amendment No. 1 to Fourth Amended and Restated  Stockholders Agreement dated December 23, 2004 (relating to  Exhibit 4.1)                                                                                                                                                                                                                                                                                                                                                               |
| 4.2*             |       | Eschelon Telecom, Inc. 2002 Stock Incentive  Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 4.3*             |       | Form of Incentive Stock Option Grant Agreement  Under the Eschelon Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.4*             |       | Form of Nonstatutory Stock Option Grant  Agreement Under the Eschelon Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                               |
| 4.5*             |       | Form of Restricted Stock Grant Agreement Under  the Eschelon Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.6**            |       | Indenture dated March 17, 2004 by and among Eschelon  Operating Company; Eschelon Telecom, Inc.; Eschelon Telecom of  Minnesota, Inc.; Eschelon Telecom of Washington, Inc.; Eschelon  Telecom of Colorado, Inc.; Eschelon Telecom of Nevada, Inc.;  Eschelon Telecom of Utah, Inc.; Eschelon Telecom of Oregon, Inc.;  Eschelon Telecom of Arizona, Inc.; and The Bank of New York Trust  Company, N.A.                                                  |
| 4.7**            |       | Registration Rights Agreement dated March 17,  2004 by and among Jefferies & Company, Inc.; Wachovia Capital  Markets LLC; Eschelon Operating Company; Eschelon Telecom, Inc.;  Eschelon Telecom of Minnesota, Inc.; Eschelon Telecom of  Washington, Inc.; Eschelon Telecom of Colorado, Inc.; Eschelon  Telecom of Nevada, Inc.; Eschelon Telecom of Utah, Inc.; Eschelon  Telecom of Oregon, Inc.; and Eschelon Telecom of Arizona, Inc. |
| 4.8**            |       | Security Agreement dated March 17, 2004 by and  among Eschelon Operating Company; Eschelon Telecom, Inc.; Eschelon  Telecom of Minnesota, Inc.; Eschelon Telecom of Washington, Inc.;  Eschelon Telecom of Colorado, Inc.; Eschelon Telecom of Nevada, Inc.;  Eschelon Telecom of Utah, Inc.; Eschelon Telecom of Oregon, Inc.;  Eschelon Telecom of Arizona, Inc.; and The Bank of New York Trust  Company, N.A. (as Collateral Agent.)                  |

61

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| 4.9**   |   | Trademark Security Agreement dated March 17,  2004 by and among Eschelon Operating Company; Eschelon Telecom, Inc.;  and The Bank of New York Trust Company, N.A. (as Collateral Agent.)                                                                                                                                                                                                                                                                          |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.10**  |   | Form of Initial 8 3/8% Senior Second Secured  Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.11**  |   | Form of Guarantee of Initial 8 3/8% Senior  Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.12**  |   | Form of Exchange 8 3/8% Senior Second Secured  Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.13**  |   | Form of Guarantee of Exchange 8 3/8% Senior  Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.14+   |   | Registration Rights Agreement dated  November 29, 2004 by and among Jefferies & Company, Inc.;  Eschelon Operating Company; Eschelon Telecom, Inc.; Eschelon Telecom of  Minnesota, Inc.; Eschelon Telecom of Washington, Inc.; Eschelon  Telecom of Colorado, Inc.; Eschelon Telecom of Nevada, Inc.;  Eschelon Telecom of Utah, Inc.; Eschelon Telecom of Oregon, Inc.;  and Eschelon Telecom of Arizona, Inc. |
| 4.15+   |   | Supplemental Indenture dated November 29, 2004  by and among Eschelon Operating Company, the guarantors party thereto and The  Bank of New York Trust Company, N.A., as Trustee.                                                                                                                                                                                                                                                                                  |
| 4.16+   |   | Supplemental Indenture dated December 31, 2004  by and among Eschelon Operating Company, the guarantors party thereto and The  Bank of New York Trust Company, N.A., as Trustee.                                                                                                                                                                                                                                                                                  |
| 4.17+   |   | Supplemental Indenture dated January 20, 2005  by and among Eschelon Operating Company, the guarantors party thereto and The  Bank of New York Trust Company, N.A., as trustee.                                                                                                                                                                                                                                                                                        |
| 4.18    |   | Redemption Agreement as of October 13, 2004, by  and between NTFC Capital Corporation and Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                                                  |
| 10.1*   |   | Change-in-Control Severance Pay and Employment  Agreement dated November 22, 2002 by and between Eschelon  Telecom, Inc. and Richard A. Smith.                                                                                                                                                                                                                                                                                                                    |
| 10.2*   |   | Employment Offer Letter dated March 7, 2000  from Eschelon Telecom, Inc. to Geoffrey M. Boyd.                                                                                                                                                                                                                                                                                                                                                                     |
| 10.2.1* |   | Severance Pay Letter Agreement dated November 14,  2002 by and between Eschelon Telecom, Inc. and Geoffrey M. Boyd.                                                                                                                                                                                                                                                                                                                                               |
| 10.3*   |   | Change-in-Control Severance Pay Agreement dated  April 21, 1999 by and between Advanced Telecommunications, Inc. and  David A. Kunde.                                                                                                                                                                                                                                                                                                                             |
| 10.4*   |   | Employment Offer Letter dated July 19, 1999  from Eschelon Telecom, Inc. to Steven K. Wachter.                                                                                                                                                                                                                                                                                                                                                                    |
| 10.5*   |   | Stock Restriction Agreement dated February 7,  2003 between Eschelon Telecom, Inc. and Marvin C. Moses.                                                                                                                                                                                                                                                                                                                                                           |
| 10.6*   |   | Stock Restriction Agreement dated February 7,  2003 between Eschelon Telecom, Inc. and Anthony J. Cassara.                                                                                                                                                                                                                                                                                                                                                        |
| 10.7*   |   | Stock Restriction Agreement dated February 7,  2003 between Eschelon Telecom, Inc. and Peter M. Van Genderen.                                                                                                                                                                                                                                                                                                                                                     |
| 10.8*   |   | Carrier Global Services Agreement dated  July 28, 2000 by and between MCI WorldCom Communications, Inc. and  Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                          |
| 10.8.1* |   | First Amendment dated June 20, 2001 to Carrier  Global Services Agreement dated July 28, 2000 by and between MCI  WorldCom Communications, Inc. and Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                              |
| 10.8.2* |   | Second Amendment dated April 8, 2002 to Carrier  Global Services Agreement dated July 28, 2000 by and between MCI  WorldCom Communications, Inc. and Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                             |
| 10.8.3* |   | Third Amendment dated April 1, 2003 to Carrier  Global Services Agreement dated July 28, 2000 by and between MCI WorldCom  Communications, Inc. and Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                              |
| 10.8.4* |   | WorldCom Internet Dedicated Service Agreement and  Service Order Form dated June 12, 2003.                                                                                                                                                                                                                                                                                                                                                                        |

62

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| 10.8.5*  |   | WorldCom Internet Dedicated Service Agreement and  Service Order Form dated January 23, 2004.                                                                                  |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8.6*  |   | WorldCom Internet Dedicated T3 Price-Protected  Agreement dated July 26, 2001.                                                                                                      |
| 10.8.7*  |   | WorldCom Wholesale Dedicated Internet Pricing Sheet                                                                                                                                      |
| 10.9*    |   | Carrier Service Agreement dated August 25, 2000  between Global Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                                                       |
| 10.9.1*  |   | Amendment #1 dated November 10, 2000 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.         |
| 10.9.2*  |   | Amendment #2 dated January 2, 2001 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.           |
| 10.9.3*  |   | Amendment #3 dated June 25, 2001 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.             |
| 10.9.4*  |   | Amendment #4 dated July 17, 2001 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.             |
| 10.9.5*  |   | Amendment #5 dated April 25, 2002 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.            |
| 10.9.6*  |   | Amendment #6 dated July 12, 2002 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.             |
| 10.9.7*  |   | Amendment #7 dated March 26, 2004 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.            |
| 10.10*   |   | Advisory Agreement dated March 15, 2004 among  Eschelon Telecom, Inc.; Bain Capital Investors, LLC; Wind Point Advisor,  L.L.C.; and Stolberg, Meehan & Scano, L.L.C. |
| 10.11*   |   | Lease of Office Space by and between St. Paul  Properties, Inc. and Eschelon Telecom, Inc. dated as of  November 18, 2003.                                                |
| 10.12*   |   | Lease Agreement by and between Timeshare  Systems, Inc. and Advanced Telecommunications, Inc. dated  March 3, 1999.                                                       |
| 10.13*   |   | Lease For Storage dated July 30, 1996 by and  between T.H.S. Northstar Associates Limited Partnership and  Fishnet.com, Inc.                                                   |
| 10.13.1* |   | First Amendment dated March 10, 1998 of Lease  for Storage dated July 30, 1996 by and between T.H.S. Northstar  Associates Limited Partnership and Fishnet.com, Inc.      |
| 10.13.2* |   | Second Amendment dated March 27, 1998 of Lease  for Storage dated July 30, 1996 by and between T.H.S. Northstar  Associates Limited Partnership and Fishnet.com, Inc.     |
| 10.13.3* |   | Third Amendment dated April 30, 1999 of Lease  for Storage dated July 30, 1996 by and between T.H.S. Northstar  Associates Limited Partnership and Fishnet.com, Inc.      |
| 10.13.4* |   | Fourth Amendment dated October 3, 2000 of Lease  for Storage dated July 30, 1996 by and between T.H.S. Northstar  Associates Limited Partnership and Fishnet.com, Inc.    |
| 10.13.5* |   | Lease For Storage dated March 6, 2000 by and  between T.H.S. Northstar Associates Limited Partnership and  Fishnet.com, Inc.                                                   |
| 10.13.6* |   | Lease For Storage dated July 11, 1999 by and  between T.H.S. Northstar Associates Limited Partnership and  Fishnet.com, Inc.                                                   |
| 10.14*   |   | Lease Agreement by and between Duke Realty Limited  Partnership and Cady Communications, Inc. dated May 21, 1999.                                                              |
| 10.15*   |   | Lease Agreement between Seattle Telecom LLC and  Advanced Telecommunications, Inc. dated December 20, 1999.                                                                    |
| 10.16*   |   | Office Lease by and between Parkside Salt Lake  Corporation and Advanced Telecommunications, Inc. dated  December 28, 1999.                                                    |
| 10.17*   |   | Lease by and between Denver Place Associates Limited  Partnership and Eschelon Telecom of Colorado, Inc. dated  October 24, 2000.                                              |

63

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| 10.18*    |   | Office Lease by and between SOFI-IV SIM Office  Investors II, Limited Partnership and Advanced Telecommunications, Inc.  dated December 19, 1999.                            |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18.1*  |   | First Amendment dated March 17, 2003 to Lease  by and between SOFI-IV SIM Office Investors II, Limited Partnership and  Eschelon Telecom, Inc. dated December 19, 1999. |
| 10.19*    |   | Lease by and between Alco Investment Company and  Advanced Telecommunications, Inc. dated November 19, 1999.                                                                 |
| 10.20+    |   | Stock Purchase Agreement dated October 13,  2004, by and between Eschelon Telecom, Inc. and Advanced TelCom  Group, Inc.                                                |
| 10.20.1   |   | Amendment to Stock Purchase Agreement dated as of  December 30, 2004 (related to Exhibit 10.20)                                                                              |
| 10.21+    |   | Asset Purchase Agreement dated October 13, 2004  by and between GE Business Productivity Solutions, Inc. and Eschelon  Telecom, Inc.                                    |
| 10.22++   |   | Lease Agreement – Commercial Premises by and between  Avista Communications of Washington and Yesterday’s Village, Inc. dated  September 30, 1999.                           |
| 10.22.1++ |   | Amended Lease Agreement by and between Advanced  TelCom, Inc. and Yesterday’s Village, Inc. dated March 27, 2003.                                                                 |
| 10.22.2++ |   | Amendment to Lease Agreement by and between Advanced  TelCom, Inc. and Yesterday’s Village, Inc. dated 2004.                                                                      |
| 10.23++   |   | Lease by and between U.S. National Bank of Oregon  and Shared Communications Services, Inc. dated March 1, 1996.                                                                       |
| 10.23.1++ |   | Lease Extension and Assignment Agreement by and  between U.S. Bank, N.A., Shared Communications Services, Inc. and Advanced  TelCom, Inc. dated June 6, 2001.                          |
| 10.24++   |   | Lease Agreement by and between Hartmann Limited  Partnership & William Ludwig Hartman Marital Trust and Advanced TelCom,  Inc. dated August 18, 2000.                              |
| 10.25++   |   | Lease Agreement by and between Advanced TelCom  Group, Inc. and 200 South Virginia Investments, LLC dated July 16, 1999.                                                               |
| 10.25.1++ |   | First Amendment to Lease by and between Advanced  TelCom Group, Inc. and 200 South Virginia Investments, LLC dated January 10,  1999.                                                  |
| 10.25.2++ |   | Second Amendment to Lease by and between Advanced  TelCom Group, Inc. and 200 South Virginia Investments, LLC dated August 1,  2001.                                                   |
| 10.25.3++ |   | Third Amendment to Lease by and between Advanced  TelCom Group, Inc. and 200 South Virginia Investments, LLC dated April 1,  2004.                                                     |
| 10.25.4++ |   | Fourth Amendment to Lease by and between Advanced  TelCom, Inc. and 200 South Virginia Investments, LLC dated September 2004.                                                          |
| 10.26++   |   | Triple-Net Lease Agreement by and between Sunwest  Properties II, LLC and Eschelon Telecom, Inc. dated March 11, 2005.                                                                 |
| 10.27++   |   | Standard Industrial/Commercial Single-Tenant Lease –  Net by and between Courthouse Square, LLC and Advanced TelCom Group, Inc.  dated January 29, 1999.                          |
| 10.27.1++ |   | First Amendment to Lease by and between Courthouse  Square, LLC and Advanced TelCom Group, Inc. dated August 12, 1999.                                                                 |
| 10.27.2++ |   | Second Amendment to Lease by and between Kayares  International, LLC and Advanced TelCom Group, Inc. dated November 1, 2002.                                                           |
| 10.28++   |   | Lease by and between WVB Holdings, LLC and Advanced  TelCom, Inc. dated June 10, 2004.                                                                                                 |
| 10.29++   |   | Office Building Lease by and between Shaub  Properties, Inc. and Advance TelCom Group, Inc. dated March 7, 2000.                                                                       |
| 10.30++   |   | Office Lease by and between Retro, LLC and Advanced  TelCom Group, Inc. dated January 19, 1999.                                                                                        |

64

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| 10.30.1++ |   | Lease Modification Agreement by and between Retro,  LLC and Advanced TelCom Group, Inc. dated April 23, 1999.               |
|-----------|--------|-----------------------------------------------------------------------------------------------------------------------------|
| 14.1      |   | Code of Ethics                                                                                                              |
| 21.1+     |   | Subsidiaries of Eschelon Telecom, Inc.                                                                                 |
| 31.1      |   | Certification by Richard A. Smith, Chief Executive  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2      |   | Certification by Geoffrey M. Boyd, Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1      |   | Certification by Richard A. Smith, Chief Executive  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2      |   | Certification by Geoffrey M. Boyd, Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

----

*                    Incorporatedherein by reference to Eschelon Telecom, Inc. Registration Statement on Form 10,No. 000-50706.

**             Incorporated hereinby reference to Eschelon Operating Company Registration Statement on Form S-4,No. 333-114437.

+                Incorporatedherein by reference to Eschelon Operating Company Registration Statement on Form S-4,No. 333-122292.

++  To be filedby amendment.

65

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on March 31, 2005.
|        | ESCHELON TELECOM, INC. |
|--------|------------------------|
|   | By                     | /s/ RICHARD A. SMITH |
|   | Name:                  | Richard A. Smith |
|   | Title:                 | *President, Chief Executive Officer and Director* |

 

Eachperson whose signature appears below constitutes and appoints Richard A. Smith,Geoffrey M. Boyd and J. Jeffrey Oxley and each of them, his true and lawfulattorney-in-fact and agent, with full power and substitution andresubstitution, for him and in his name, place and stead, in any and allcapacities, to sign any and all amendments to this annual report on Form 10-Kand to file the same, with all exhibits thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorney-in-fact and agent full power and authority to do and performeach and every act and thing requisite and necessary to be done in and aboutthe premises, as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming all that said attorney-in-fact, agent,or his substitute may lawfully do or cause to be done by virtue hereof. Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed by the following persons in the capacities and on the datesindicated.
|                            | **Signature** | ** **                                        | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------|---------------|---------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  RICHARD A. SMITH      |          | President, Chief  Executive Officer and Director  |       | March 31, 2005 |
| Richard A. Smith           |          | (Principal Executive Officer)                     |       |                |
| /s/  GEOFFREY M. BOYD      |          | Chief Financial Officer  (Principal Financial and |       | March 31, 2005 |
| Geoffrey M. Boyd           |          | Accounting Officer)                               |       |                |
| /s/  CLIFFORD D. WILLIAMS  |          | Chairman of the Board                             |       | March 31, 2005 |
| Clifford D.  Williams      |          |                                              |       |                |
| /s/  MARVIN C. MOSES       |          | Director                                          |       | March 31, 2005 |
| Marvin C. Moses            |          |                                              |       |                |
| /s/  PETER M. VAN GENDEREN |          | Director                                          |       | March 31, 2005 |
| Peter M. Van  Genderen     |          |                                              |       |                |
| /s/  MARK E. NUNNELLY      |          | Director                                          |       | March 31, 2005 |
| Mark E. Nunnelly           |          |                                              |       |                |
| /s/  JAMES P. TENBROEK     |          | Director                                          |       | March 31, 2005 |
| James P. TenBroek          |          |                                              |       |                |
| /s/  IAN K. LORING         |          | Director                                          |       | March 31, 2005 |
| Ian K. Loring              |          |                                              |       |                |

 

66

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**EschelonTelecom, Inc.Schedule II—Valuation and Qualifying AccountsYears Ended December 31, 2002, 2003 and 2004(Dollars in thousands)**
| ** **                                   | ** ** | **Balance at  Beginning of  Year** | ** ** | **Additions  Charged to  Costs and  Expenses** | ** ** | **Less  Deductions** | ** ** | **Balance Acquired  Through  Acquisition on  December 31, 2004** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| Allowance for Doubtful  Accounts Receivable: |       |                                         |       |                                                     |       |                 |       |                                                                                 |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| 2002                                         |       |                                         | $          | 3,736                                                    |       |                 |       | $                                                                                    | 4,893      |                                       |       |   | $ | (6,611 | ) |   |   | — |   |   |   | $ | 2,018 |   |   |
| 2003                                         |       |                                         | 2,018      |                                                     |       |                 | 1,033      |                                                                                 |       |                                       | (2,311     | ) |   |   | — |   |   |   | 739 |   |   |
| 2004                                         |       |                                         | 739        |                                                     |       |                 | 1,567      |                                                                                 |       |                                       | (1,894     | ) |   |   | 405 |   |   |   | 817 |   |   |
|                                              |            |                                              |            |                                                          |            |                      |            |                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

67

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CONSOLIDATEDFINANCIAL STATEMENTS

EschelonTelecom, Inc.

Years Ended December 31, 2002, 2003 and 2004

 

----

 

**Eschelon Telecom, Inc.Consolidated Financial StatementsYears Ended December 31, 2002, 2003 and 2004**

**Index**
| Report of Independent  Registered Public Accounting Firm        | F-2    |
|-----------------------------------------------------------------|--------|
| Audited  Consolidated Financial Statements                      |   |
| Consolidated Balance Sheets                                     | F-3    |
| Consolidated Statements of  Operations                          | F-4    |
| Consolidated Statements of  Stockholders’ Equity (Deficit) | F-5    |
| Consolidated Statements of  Cash Flows                          | F-6    |
| Notes  to Consolidated Financial Statements                     | F-7    |

 

F-1

----

 

**Report of Independent Registered Public AccountingFirm**

TheBoard of Directors

Eschelon Telecom, Inc.

We have audited the accompanying consolidated balancesheets of Eschelon Telecom, Inc. as of December 31, 2003 and 2004,and the related consolidated statements of operations, stockholders’ equity(deficit), and cash flows for each of the three years in the period ended December 31,2004. Our audits also included the financial statement schedule listed in theIndex at Item 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged toperform an audit of the Company’s internal control over financial reporting*.* Our audits included considerationof internal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Eschelon Telecom, Inc.at December 31, 2003 and 2004, and the consolidated results of itsoperations and its cash flows for each of the three years in the period ended December 31,2004, in conformity with United States generally accepted accounting principles.Also, in our opinion, the related financial statement schedule, when consideredin relation to the basic consolidated financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP

March 4,2005

Minneapolis, Minnesota

F-2

----

**Eschelon Telecom, Inc.Consolidated Balance Sheets(In Thousands)**
| ** **                                                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2003**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                                                                   |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                    |       | $                     | 8,606      | ** ** | **$** | **26,435** | ** ** |
| Restricted cash                                                                                                                                                                                              |       | —                | ** ** | **722** | ** ** |
| Available-for-sale  securities                                                                                                                                                                               |       | —                | ** ** | **6,194** | ** ** |
| Accounts receivable, net  of allowance for doubtful accounts of $739 and $817, respectively                                                                                                             |       | 13,537                | ** ** | **18,941** | ** ** |
| Other receivables                                                                                                                                                                                            |       | 2,097                 | ** ** | **2,976** | ** ** |
| Inventories                                                                                                                                                                                                  |       | 3,169                 | ** ** | **2,873** | ** ** |
| Prepaid expenses                                                                                                                                                                                             |       | 2,046                 | ** ** | **2,410** | ** ** |
| Total current  assets                                                                                                                                                                                        |       | 29,455                | ** ** | **60,551** | ** ** |
| Property and equipment,  net                                                                                                                                                                                 |       | 86,777                | ** ** | **102,849** | ** ** |
| Other assets                                                                                                                                                                                                 |       | 1,269                 | ** ** | **1,985** | ** ** |
| Goodwill                                                                                                                                                                                                     |       | 7,168                 | ** ** | **38,776** | ** ** |
| Intangible assets,  net                                                                                                                                                                                      |       | 29,052                | ** ** | **32,958** | ** ** |
| Total assets                                                                                                                                                                                                 |       | $                     | 153,721    | ** ** | **$** | **237,119** | ** ** |
| **Liabilities and stockholders’ deficit**                                                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                             |       | $                     | 4,582      | ** ** | **$** | **8,375** | ** ** |
| Accrued telecommunication  costs                                                                                                                                                                             |       | 6,939                 | ** ** | **7,616** | ** ** |
| Accrued office rent                                                                                                                                                                                          |       | 396                   | ** ** | **2,336** | ** ** |
| Accrued interest expense                                                                                                                                                                                     |       | —                | ** ** | **4,070** | ** ** |
| Other accrued expenses                                                                                                                                                                                       |       | 2,844                 | ** ** | **5,998** | ** ** |
| Deferred revenue                                                                                                                                                                                             |       | 3,000                 | ** ** | **7,300** | ** ** |
| Accrued compensation  expenses                                                                                                                                                                               |       | 4,261                 | ** ** | **3,588** | ** ** |
| Capital lease  obligations, current maturities                                                                                                                                                               |       | 1,020                 | ** ** | **1,629** | ** ** |
| Total current  liabilities                                                                                                                                                                                   |       | 23,042                | ** ** | **40,912** | ** ** |
| Long-term liabilities:                                                                                                                                                                                       | ** ** | ** **            | ** ** | ** ** | ** ** |
| Other long-term  liabilities                                                                                                                                                                                 |       | —                | ** ** | **630** | ** ** |
| Capital lease  obligations, less current maturities                                                                                                                                                          |       | 576                   | ** ** | **2,824** | ** ** |
| Notes payable                                                                                                                                                                                                |       | 86,226                | ** ** | **137,778** | ** ** |
| Total liabilities                                                                                                                                                                                            |       | 109,844               | ** ** | **182,144** | ** ** |
| Series A  convertible preferred stock, $0.01 par value per share; 100,000,000 shares  authorized; issued and outstanding shares—84,306,677 shares in 2003 and  77,526,136 shares in 2004 |       | 48,948                | ** ** | **48,155** | ** ** |
| Series B  convertible preferred stock, $0.01 par value per share; 25,000,000 shares  authorized; 20,000,000 shares issued and outstanding in 2004                                                       |       | —                | ** ** | **15,000** | ** ** |
| Stockholders’ deficit:                                                                                                                                                                                  | ** ** | ** **            | ** ** | ** ** | ** ** |
| Common stock, $0.01 par  value per share; 200,000,000 shares authorized; issued and outstanding shares—4,457,579  shares in 2003 and 4,758,518 shares in 2004                                           |       | 45                    | ** ** | **48** | ** ** |
| Additional paid-in  capital                                                                                                                                                                                  |       | 120,105               | ** ** | **115,832** | ** ** |
| Accumulated other  comprehensive income                                                                                                                                                                      |       | —                | ** ** | **30** | ** ** |
| Accumulated deficit                                                                                                                                                                                          |       | (125,167              | )          | **(124,056** | **)** |
| Deferred compensation                                                                                                                                                                                        |       | (54                   | )          | **(34** | **)** |
| Total  stockholders’ deficit                                                                                                                                                                            |       | (5,071                | )          | **(8,180** | **)** |
| Total liabilities  and stockholders’ deficit                                                                                                                                                            |       | $                     | 153,721    | ** ** | **$** | **237,119** | ** ** |

 

See accompanying notes.

F-3

----

**Eschelon Telecom, Inc.Consolidated Statements ofOperations(Dollars in Thousands, Except per Share Amounts)**
| ** **                                                                        | ** ** | **Year Ended December 31,**                                                                                       | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **          2002          ** | ** ** | **          2003          ** | ** ** | **          2004          ** | ** ** |
| Revenue:                                                                          | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Network services                                                                  |       |                                                                                                                             | $          | 96,209 | ** ** |   |   | $ | 115,482 | ** ** |   |   | **$** | **131,780** | ** ** |   |
| BTS                                                                               |       |                                                                                                                             | 25,659     | ** ** |   |   | 25,614 | ** ** |   |   | **26,316** | ** ** |   |
|                                                                              |       |                                                                                                                             | 121,868    | ** ** |   |   | 141,096 | ** ** |   |   | **158,096** | ** ** |   |
| Cost of revenue:                                                                  | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Network services                                                                  |       |                                                                                                                             | 39,493     | ** ** |   |   | 45,037 | ** ** |   |   | **47,354** | ** ** |   |
| BTS                                                                               |       |                                                                                                                             | 16,053     | ** ** |   |   | 15,784 | ** ** |   |   | **15,979** | ** ** |   |
|                                                                              |       |                                                                                                                             | 55,546     | ** ** |   |   | 60,821 | ** ** |   |   | **63,333** | ** ** |   |
| Gross profit:                                                                     | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Network services                                                                  |       |                                                                                                                             | 56,716     | ** ** |   |   | 70,445 | ** ** |   |   | **84,426** | ** ** |   |
| BTS                                                                               |       |                                                                                                                             | 9,606      | ** ** |   |   | 9,830 | ** ** |   |   | **10,337** | ** ** |   |
|                                                                              |       |                                                                                                                             | 66,322     | ** ** |   |   | 80,275 | ** ** |   |   | **94,763** | ** ** |   |
| Operating  expenses:                                                              | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| General and administrative                                                        |       |                                                                                                                             | 42,660     | ** ** |   |   | 39,297 | ** ** |   |   | **41,755** | ** ** |   |
| Sales and marketing                                                               |       |                                                                                                                             | 26,260     | ** ** |   |   | 26,955 | ** ** |   |   | **27,500** | ** ** |   |
| Depreciation and amortization                                                     |       |                                                                                                                             | 25,261     | ** ** |   |   | 30,099 | ** ** |   |   | **31,105** | ** ** |   |
| Operating loss                                                                    |       |                                                                                                                             | (27,859    | **)** |   |   | (16,076 | **)** |   |   | **(5,597** | **)** |   |
| Other income (expense):                                                           | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Interest income                                                                   |       |                                                                                                                             | 379        | ** ** |   |   | 168 | ** ** |   |   | **124** | ** ** |   |
| Interest expense                                                                  |       |                                                                                                                             | (5,729     | **)** |   |   | (1,754 | **)** |   |   | **(11,452** | **)** |   |
| Gain on extinguishment of debt                                                    |       |                                                                                                                             | 53,549     | ** ** |   |   | — | ** ** |   |   | **18,195** | ** ** |   |
| Other income (expense)                                                            |       |                                                                                                                             | (147       | **)** |   |   | 484 | ** ** |   |   | **(155** | **)** |   |
| Income (loss)  before income taxes                                                |       |                                                                                                                             | 20,193     | ** ** |   |   | (17,178 | **)** |   |   | **1,115** | ** ** |   |
| Income taxes                                                                      |       |                                                                                                                             | (50        | **)** |   |   | (28 | **)** |   |   | **(4** | **)** |   |
| Net income (loss)                                                                 |       |                                                                                                                             | 20,143     | ** ** |   |   | (17,206 | **)** |   |   | **1,111** | ** ** |   |
| Less preferred  stock dividends and premium paid on redemption of preferred stock |       |                                                                                                                             | (2,701     | **)** |   |   | (3,426 | **)** |   |   | **(4,292** | **)** |   |
| Net income (loss)  applicable to common stockholders                              |       |                                                                                                                             | $          | 17,442 | ** ** |   |   | $ | (20,632 | **)** |   |   | **$** | **(3,181** | **)** |   |
| Per share amounts (basic and diluted):                                            | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income (loss)                                                                 |       |                                                                                                                             | $          | 10.90 | ** ** |   |   | $ | (5.21 | **)** |   |   | **$** | **(0.82** | **)** |   |
| Weighted average number of shares outstanding:                                    | ** ** |                                                                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Basic and diluted                                                                 |       |                                                                                                                             | 1,599,950  | ** ** |   |   | 3,962,842 | ** ** |   |   | **3,893,907** | ** ** |   |

 

See accompanying notes.

F-4

----

 

**Eschelon Telecom, Inc.Consolidated Statements ofStockholders’ Equity (Deficit)(Dollars in Thousands)**
| ** **                                                                    | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | ** Additional   Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** **    | **Deferred** | ** ** | ** **  | ** **         |
|-------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|-------------------------------------|------------|---------------------------------------|------------|-----------------|---------------|--------------|------------|-------------|--------------------|
| ** **                                                                    | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                          | ** ** | **Amount**                            | ** ** | **Capital**     | ** **    | **Income**   | ** ** | **Deficit** | ** **         | **Compensation** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2001                                            |       | 27,509,342               |       |                  | $ 275 |                                |       | 3,054,658                             |       |            | $ 30     |         |       |        | $ 130,845     | ** ** |   |   | $ 372 |   |   |   | $ (128,104 | ) |   |   | $ (86 | ) |   | $ 3,332 |   |
| Corporate  restructuring and cancellation of stock warrants and stock options |       | (27,509,342              | )          |                  | (275       | )                                   |       | (1,454,658                            | )          |            | (14           | )            |       |        | 90                 | ** ** |   |   | — |   |   |   | — | ** ** |   |   | 70 | ** ** |   | (129 | ) |
| Accumulated  dividends in connection with preferred stock                     |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | (2,701             | ) |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | (2,701 | ) |
| Fees associated  with preferred stock offering                                |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | (4,747             | ) |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | (4,747 | ) |
| Forfeiture of  common stock after corporate restructuring                     |       | —                   |       |                  | —     |                                |       | (9,960                                | )          |            | —        |         |       |        | —             | ** ** |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | — |   |
| Change in fair  value of interest rate swap                                   |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | —             | ** ** |   |   | 38 |   |   |   | — | ** ** |   |   | — | ** ** |   | 38 |   |
| Termination of  interest rate swap agreement                                  |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | —             | ** ** |   |   | (410 | ) |   |   | — | ** ** |   |   | — | ** ** |   | (410 | ) |
| Amortization of  deferred compensation                                        |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | —             | ** ** |   |   | — |   |   |   | — | ** ** |   |   | 16 | ** ** |   | 16 |   |
| Net income for the  year                                                      |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | —             | ** ** |   |   | — |   |   |   | 20,143 | ** ** |   |   | — | ** ** |   | 20,143 |   |
| Balance at  December 31, 2002                                            |       | —                   |       |                  | —     |                                |       | 1,590,040                             |       |            | 16            |         |       |        | 123,487            | ** ** |   |   | — |   |   |   | (107,961 | ) |   |   | — | ** ** |   | 15,542 |   |
| Forfeiture of  common stock after corporate restructuring                     |       | —                   |       |                  | —     |                                |       | (893                                  | )          |            | —        |         |       |        | —             | ** ** |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | — |   |
| Accumulated  dividends in connection with preferred stock                     |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | (3,426             | ) |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | (3,426 | ) |
| Fees associated  with 2002 sale of preferred stock                            |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | (70                | ) |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | (70 | ) |
| Issuance of  restricted common stock                                          |       | —                   |       |                  | —     |                                |       | 2,484,979                             |       |            | 25            |         |       |        | 99                 | ** ** |   |   | — |   |   |   | — | ** ** |   |   | (124 | ) |   | — |   |
| Stock options  exercised                                                      |       | —                   |       |                  | —     |                                |       | 383,452                               |       |            | 4             |         |       |        | 15                 | ** ** |   |   | — |   |   |   | — | ** ** |   |   | — | ** ** |   | 19 |   |
| Amortization of  deferred compensation                                        |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | —             | ** ** |   |   | — |   |   |   | — | ** ** |   |   | 70 | ** ** |   | 70 |   |
| Net loss for the  year                                                        |       | —                   |       |                  | —     |                                |       | —                                |       |            | —        |         |       |        | —             | ** ** |   |   | — |   |   |   | (17,206 | ) |   |   | — | ** ** |   | (17,206 | ) |
| Balance at  December 31, 2003                                            |       | —                   |       |                  | —     |                                |       | 4,457,578                             |       |            | 45            |         |       |        | 120,105            | ** ** |   |   | — |   |   |   | (125,167 | ) |   |   | (54 | ) |   | (5,071 | ) |
| Accumulated  dividends in connection with preferred stock                     | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **—**                            | ** ** | ** **      | **—**    |         | ** ** | ** **  | **(3,435**         | **)** | ** ** | ** ** | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **(3,435** | **)** |
| Series A  convertible preferred stock redemption                         | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **—**                            | ** ** | ** **      | **—**    |         | ** ** | ** **  | **(857**           | **)** | ** ** | ** ** | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **(857** | **)** |
| Issuance of  restricted common stock                                          | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **140,365**                           | ** ** | ** **      | **1**         |         | ** ** | ** **  | **13**             | ** ** | ** ** | ** ** | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **14** | ** ** |
| Stock options  exercised                                                      | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **160,575**                           | ** ** | ** **      | **2**         |         | ** ** | ** **  | **6**              | ** ** | ** ** | ** ** | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **8** | ** ** |
| Unrealized gain on  investments                                               | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **—**                            | ** ** | ** **      | **—**    |         | ** ** | ** **  | **—**         | ** ** | ** ** | ** ** | **30** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **30** | ** ** |
| Amortization of  deferred compensation                                        | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **—**                            | ** ** | ** **      | **—**    |         | ** ** | ** **  | **—**         | ** ** | ** ** | ** ** | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **20** | ** ** | ** ** | **20** | ** ** |
| Net income for the  year                                                      | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **—**                            | ** ** | ** **      | **—**    |         | ** ** | ** **  | **—**         | ** ** | ** ** | ** ** | **—** |   | ** ** | ** ** | **1,111** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **1,111** | ** ** |
| Balance at  December 31, 2004                                            | ** ** | **—**               | ** ** | ** **            | **—** |                                | ** ** | **4,758,518**                         | ** ** | ** **      | **$ 48** |         | ** ** | ** **  | **$ 115,832** | ** ** | ** ** | ** ** | **$  30** |   | ** ** | ** ** | **$ (124,056** | **)** | ** ** | ** ** | **$ (34** | **)** | ** ** | **$ (8,180** | **)** |

 

See accompanying notes.

F-5

 

----

**Eschelon Telecom, Inc.Consolidated Statements ofCash Flows(In Thousands)**
| ** **                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| **Operating activities**                                                                            | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                   |       | $                                          | 20,143     |   | $ | (17,206 | ) | **$** | **1,111** | ** ** |
| Adjustments to reconcile  net income (loss) to net cash (used in) provided by operating activities: | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Depreciation and amortization expense                                                               |       | 25,261                                     |       | 30,099 | ** ** | **31,105** | ** ** |
| Provision for bad debt expense                                                                      |       | 4,510                                      |       | 500 | ** ** | **721** | ** ** |
| Noncash interest expense                                                                            |       | 1,289                                      |       | 1,302 | ** ** | **2,339** | ** ** |
| Value of stock issued to management and directors                                                   |       | —                                     |       | 70 | ** ** | **34** | ** ** |
| Cancellation of warrants, options, and unamortized  note discount                                   |       | 3,030                                      |       | — | ** ** | **—** | ** ** |
| Loss (gain) on write-off and sales of assets                                                        |       | 148                                        |       | (484 | ) | **162** | ** ** |
| Gain on extinguishment of debt                                                                      |       | (53,549                                    | )          | — | ** ** | **(18,195** | **)** |
| Gain on sales of marketable securities                                                              |       | —                                     |       | — | ** ** | **(7** | **)** |
| Changes  in operating assets and liabilities:                                                       | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Restricted cash                                                                                     |       | —                                     |       | — | ** ** | **(722** | **)** |
| Accounts receivable                                                                                 |       | (2,240                                     | )          | (1,520 | ) | **658** | ** ** |
| Other receivables                                                                                   |       | 2,431                                      |       | 904 | ** ** | **(546** | **)** |
| Inventories                                                                                         |       | (218                                       | )          | (393 | ) | **296** | ** ** |
| Prepaid expenses and other assets                                                                   |       | (697                                       | )          | (219 | ) | **(209** | **)** |
| Accounts payable and accrued expenses                                                               |       | (2,848                                     | )          | 3,450 | ** ** | **8,984** | ** ** |
| Deferred revenue                                                                                    |       | (137                                       | )          | (397 | ) | **878** | ** ** |
| Accrued compensation expenses                                                                       |       | (11                                        | )          | 582 | ** ** | **(1,216** | **)** |
| Net cash (used in) provided by operating activities                                                 |       | (2,888                                     | )          | 16,688 | ** ** | **25,393** | ** ** |
| **Investing  activities**                                                                           | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchase of subsidiaries, net of cash acquired                                                      |       | —                                     |       | — | ** ** | **(45,495** | **)** |
| Purchases of available-for-sale securities                                                          |       | —                                     |       | — | ** ** | **(8,198** | **)** |
| Proceeds from sales of available-for-sale securities                                                |       | —                                     |       | — | ** ** | **2,041** | ** ** |
| Purchases of property and equipment                                                                 |       | (12,569                                    | )          | (13,367 | ) | **(15,414** | **)** |
| Cash paid for customer installation costs                                                           |       | (10,541                                    | )          | (11,669 | ) | **(11,293** | **)** |
| Proceeds from sale of assets                                                                        |       | 90                                         |       | 28 | ** ** | **25** | ** ** |
| Net cash used in investing activities                                                               |       | (23,020                                    | )          | (25,008 | ) | **(78,334** | **)** |
| **Financing  activities**                                                                           | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from issuance of notes payable                                                             |       | 1,432                                      |       | — | ** ** | **136,163** | ** ** |
| Payments made on bank debt and capital lease  obligations                                           |       | (14,886                                    | )          | (2,697 | ) | **(66,948** | **)** |
| Proceeds from (fees associated with) issuance of  preferred stock                                   |       | 36,696                                     |       | (70 | ) | **15,000** | ** ** |
| Payment on redemption of preferred stock                                                            |       | —                                     |       | — | ** ** | **(5,085** | **)** |
| Proceeds from issuance of common stock                                                              |       | —                                     |       | 19 | ** ** | **8** | ** ** |
| Cash received in connection with debt extinguishment                                                |       | 8,785                                      |       | — | ** ** | **—** | ** ** |
| Increase in debt issuance costs                                                                     |       | (434                                       | )          | (59 | ) | **(8,368** | **)** |
| Net cash provided by (used in) financing activities                                                 |       | 31,593                                     |       | (2,807 | ) | **70,770** | ** ** |
| Net increase (decrease) in cash and cash equivalents                                                |       | 5,685                                      |       | (11,127 | ) | **17,829** | ** ** |
| Cash and cash equivalents at beginning of year                                                      |       | 14,048                                     |       | 19,733 | ** ** | **8,606** | ** ** |
| Cash and cash equivalents at end of year                                                            |       | $                                          | 19,733     |   | $ | 8,606 | ** ** | **$** | **26,435** | ** ** |
| **Supplemental cash flow information**                                                              | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                              |       | $                                          | 1,411      |   | $ | 452 | ** ** | **$** | **9,114** | ** ** |
| **Supplemental noncash activities**                                                                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment purchases under capital leases                                                            |       | $                                          | 65         |   | $ | 1,430 | ** ** | **$** | **4,064** | ** ** |
| Value of common stock issued to management and  certain members of the board of directors      |       | $                                          | —     |   | $ | 124 | ** ** | **$** | **14** | ** ** |
| Value of preferred  stock issued in connection with debt extinguishment                             |       | $                                          | 1,378      |   | $ | — |   | $ | — |   |

 

See accompanying notes.

F-6

----

**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Dollars in Thousands, Except per Share Amounts)**

**1.**   Summary of Significant AccountingPolicies

**Organization**

Eschelon Telecom, Inc. (the Company) is afacilities-based provider of integrated voice and data communications servicesto small and medium-sized businesses in 12 markets in the western United States.As a result of the ATI acquisition (see Note 2), the Company will operate in 19markets in the western United States in 2005.

The Company offersthe following products and services:

·       ***Local Business Telephone Service****—*Local access lines including traditional business lines,direct dial trunks, and analog and digital access; local service enhancedfeatures including hunting, forwarding, transferring, voice messaging, callerID, call waiting, three-way calling, and call hold.

·       ***Long Distance Services****—*Outbound services, inbound services includingtoll-free services, calling cards, and operator services.

·       ***Data Services****—*High-speeddata transmission services, such as dedicated and broadband Internet access,and e-mail and web-hosting services.

·       ***BTSProducts and Services****—*Productsinclude telephone transmission products, data transmission products, and voicemessaging products; services include system configurations, maintenanceagreements, and technical service and repair.

**Principles of Consolidation**

The consolidated financialstatements include the accounts of the Company and its wholly ownedsubsidiaries. All intercompany balances and transactions have been eliminatedin consolidation.

**Cash and Cash Equivalents**

The Company considers allhighly liquid investments with maturities of three months or less at the timeof purchase to be cash equivalents. Cash equivalents are carried at cost whichapproximates market value. On December 31, 2003 and 2004, the Company hadinvestments in securities of $3,145 and $17,051, respectively, which areincluded in cash and cash equivalents.

**Restricted Cash**

In August 2004, a Nevada state court entered ajudgment against the Company for intentionally interfering with a formersalesperson’s economic relationship with his new employer in the amount of $376plus costs. The Company had reason to believe the former employee was violatinghis non-solicitation agreement with the Company. The Company appealed thejudgment because, among other reasons, the jury was not instructed to considerwhether the Company was justified in informing the new employer of theagreement and the intent to enforce it. During the appeal process, the Companyis required to hold an amount equal to one-half times the pending judgment,plus accrued interest, as restricted cash.

F-7

----

**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**1.**   Summary ofSignificant Accounting Policies (Continued)

In addition, included inrestricted cash is $75 for collateral on bank credit cards, $50 for a municipalletter of credit with the city of Tacoma, Washington and $20 for a municipalletter of credit with the city of Olympia, Washington.

**Available-for-Sale Securities**

Short-term investments arecomprised of municipal and United States government debt securities withmaturities of more than three months but less than one year. In accordance withStatement of Financial Accounting Standards (SFAS) No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*, and based on the Company’s intentions regarding theseinstruments, all investments in debt securities are classified asavailable-for-sale and accounted for at fair value. Fair value is determined byquoted market prices, with unrealized gains and losses reported as a separatecomponent of stockholders’ equity (deficit). The Company uses the specificidentification of securities sold method to recognize realized gains and lossesin earnings.

**Property and Equipment**

Propertyand equipment, including leasehold improvements, are stated at cost.Depreciation is provided using the straight-line method over the estimateduseful lives of the assets as follows:
| Vehicles                        |   | 5 years        |   |
|---------------------------------|--------|----------------|--------|
| Office furniture  and equipment |   | 5–7 years |   |
| Computer  equipment             |   | 5 years        |   |
| Computer software               |   | 3 years        |   |
| Switching and  data equipment   |   | 12 years       |   |
| Switching and data  software    |   | 5 years        |   |

 

Leasehold improvements are amortized over the shorterof the related lease term or the estimated useful life of the asset.

All internal costs directly related to theconstruction of the switches and operating and support systems, includingcompensation of certain employees, are capitalized.

F-8

----

**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**1.**   Summary ofSignificant Accounting Policies (Continued)

Property and equipmentconsist of the following:
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2003**              | ** ** | **2004** | ** ** |
| Vehicles                                   |       | $                     | 39         | ** ** | **$** | **590** | ** ** |
| Office furniture  and equipment            |       | 13,243                | ** ** | **16,746** | ** ** |
| Computer  equipment and software           |       | 30,264                | ** ** | **34,534** | ** ** |
| Leasehold  improvements                    |       | 16,931                | ** ** | **19,504** | ** ** |
| Switching and  data equipment and software |       | 76,751                | ** ** | **99,736** | ** ** |
|                                       | ** ** | 137,228               | ** ** | **171,110** | ** ** |
| Less accumulated  depreciation             |       | (50,451               | )          | **(68,261** | **)** |
|                                       | ** ** | $                     | 86,777     | ** ** | **$** | **102,849** | ** ** |

 

**Goodwilland Other Intangible Assets**

Goodwill is tested at least annually for impairment atthe reporting unit level. If the undiscounted future cash flows of a reportingunit are less than the carrying amount, an impairment charge is recognized. Inaccordance with SFAS No. 142, *Goodwilland Other Intangible Assets*, management completed its annualimpairment test in the fourth quarter of 2003 and 2004 and determined thatgoodwill had not been impaired.

Intangibles consist of debt issuance costs, customerinstallation costs, and non-compete agreements. In 2003, and 2004, debtissuance costs were incurred in connection with the issuance of notes payable.These costs are being amortized over the term of the facility. The customerinstallation costs are being amortized over a period of 48 months, whichapproximates the average life of a customer contract. Non-compete agreementcosts represent costs associated with various agreements the Company hasentered into with existing management of the companies they have acquired.These costs are being amortized over the terms of the agreements.

Intangibleassets consist of the following:
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2003**              | ** ** | **2004** | ** ** |
| Customer  installation costs   |       | $                     | 52,794     | ** ** | **$** | **64,087** | ** ** |
| Debt issuance  costs           |       | 5,833                 | ** ** | **8,368** | ** ** |
| Non-compete  agreements        |       | 15                    | ** ** | **15** | ** ** |
|                           |       | 58,642                | ** ** | **72,470** | ** ** |
| Less accumulated  amortization |       | (29,590               | )          | **(39,512** | **)** |
|                           |       | $                     | 29,052     | ** ** | **$** | **32,958** | ** ** |

 

The Company reviews all long-lived assets forimpairment in accordance with SFAS No. 144, *Accounting for the Impairment and Disposal of Long-Lived Assets*.Under SFAS No. 144, impairment losses are recorded on long-lived assetsused in operations when events and circumstances indicate the assets might beimpaired and the undiscounted cash flows estimated to be generated by thoseassets are less than the carrying amounts of those assets.

F-9

----

**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**1.**   Summary ofSignificant Accounting Policies (Continued)

Total amortization expensewas $10,402, $12,131 and $14,759 for the years ended December 31, 2002,2003 and 2004, respectively. Estimated amortization expense for each of thefive succeeding fiscal years based on current intangible assets is expected to be$16,502, $12,864, $11,247, $9,151 and $8,463, respectively.

**Revenue Recognition**

Revenues from networkservices are recognized in the period in which subscribers use the relatedservices. Revenues from equipment sales and related installation charges arerecognized upon delivery, completion of the installation of the relatedequipment, and acceptance by the customer, at which point legal title passes tothe customer. Revenues for carrier interconnection and access are recognized inthe period in which the service is provided.

**Advertising Costs**

Advertising costs areexpensed as incurred. For the years ended December 31, 2002, 2003 and2004, the Company had advertising expense of $869, $479 and $464, respectively.

**AccountsReceivable and Allowance for Doubtful Accounts**

Accounts receivable areinitially recorded at fair value upon the sale of products or services tocustomers. Significant estimates are required in determining the allowance fordoubtful accounts receivable. The Company considers two primary factors indetermining the proper level of allowance, including historical collectionsexperience and the aging of the accounts receivable portfolio. The allowancefor doubtful accounts requirements are based on the best facts available to theCompany and are reevaluated and adjusted as additional information is received.The Company has a credit policy which helps minimize credit risk.

**Use of Estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results could differ from those estimates.

**AccumulatedOther Comprehensive Income**

Accumulated other comprehensive income representsunrealized gains on available-for-sale securities, net of tax. Accumulatedother comprehensive income is presented in the consolidated statements ofstockholders’ equity (deficit).

F-10

----

**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**1.**   Summaryof Significant Accounting Policies (Continued)

The components ofaccumulated other comprehensive income are as follows:
| Balance,  December 31, 2003                     |   | $  | — |   |
|------------------------------------------------------|--------|----|--------|--------|
| Net unrealized gain  (loss) on financial instruments |   | 30 |   |
| Balance, December 31, 2004                      |   | $  | 30     |   |

 

**Income Taxes**

The Company accounts forincome taxes under the liability method in accordance with SFAS No. 109, *Accounting for Income Taxes*. Deferred taxliabilities are recognized for temporary differences that will result intaxable amounts in future years. Deferred tax assets are recognized fordeductible temporary differences and tax operating loss and tax creditcarryforwards. Deferred tax assets and liabilities are measured using theenacted tax rates expected to apply to taxable income in the periods in whichthe deferred tax asset or liability is expected to be realized or settled. TheCompany assesses the likelihood that its deferred tax assets will be recoveredfrom future taxable income and the Company records a valuation allowance toreduce its deferred tax assets to the amounts it believes to be realizable. TheCompany has concluded that a full valuation allowance against its deferred taxassets was appropriate.

**Stock-Based Compensation**

The Company accounts for its stock-based employeecompensation under the recognition and measurement principles of AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations. UnderAPB No. 25, when the exercise price of stock options equals the marketprice of the underlying stock on the date of grant, no compensation expense isrecognized in the consolidated statements of operations.

The Company adopted the disclosure provisions of SFAS No. 148,*Accounting for Stock-Based Compensation.*SFASNo. 148 requires disclosure of how stock compensation expense would becomputed under SFAS No. 123, *Accountingfor Stock-Based Compensation*, using the fair value method.

The following tableillustrates the effect on net income (loss) per share if the Company hadapplied the fair value recognition provision of SFAS No. 123 tostock-based employee compensation:
| ** **                                                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net income (loss) applicable to common stockholders  as reported                                            |       | $                                          | 17,442     |   | $ | (20,632 | ) | **$** | **(3,181** | **)** |
| Add: Stock-based employee compensation expense  included in reported net loss, net of related tax effects        |       | —                                     |       | 70 | ** ** | **20** | ** ** |
| Deduct: Total stock-based employee compensation  expense determined under fair value-based method for all awards |       | (290                                       | )          | (133 | ) | **(45** | **)** |
| Pro forma net income (loss) applicable to common  stockholders                                                   |       | $                                          | 17,152     |   | $ | (20,695 | ) | **$** | **(3,206** | **)** |
| Net income (loss) per share:                                                                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic and diluted—as  reported                                                                              |       | $                                          | 10.90      |   | $ | (5.21 | ) | **$** | **(0.82** | **)** |
| Basic and diluted—pro  forma                                                                                |       | 10.72                                      |       | (5.22 | ) | **(0.82** | **)** |

 

F-11

----

**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**1.**   Summary ofSignificant Accounting Policies (Continued)

The fair value of theseoptions was estimated at the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions:
| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| Expected dividend  yield         |       | —                                     |       | — | ** ** | **—** | ** ** |
| Expected stock  price volatility |       | 25                                         | %          | 25 | % | **25** | **%** |
| Risk-free  interest rate         |       | 4.00                                       | %          | 3.25 | % | **3.88** | **%** |
| Expected life of options         |       | 5 years                                    |       | 5 years | ** ** | **5 years** | ** ** |

 

The Black-Scholes optionvaluation model was developed for use in estimating the fair value of tradedoptions which have no vesting restrictions and are fully transferable. Inaddition, option valuation models require the input of highly subjectiveassumptions. Because the Company’s employee stock options have characteristicssignificantly different from those of traded options and because changes in thesubjective input assumptions can materially affect the fair value estimate, inmanagement’s opinion, the existing models do not necessarily provide a reliablesingle measure of the fair value of its employee stock options.

**New Accounting Pronouncements**

In December 2004, the Financial AccountingStandards Board issued SFAS No. 123R, *Share-BasedPayment: an amendment of FASB Statement No. 123 and FASB Statement No. 95*,which requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values. Prior to SFAS No. 123R, only certain pro forma disclosures offair value were required. SFAS 123R must be adopted no later than July 1,2005 for calendar quarter companies. The Company expects to adopt SFAS 123R on July 1,2005.

SFAS 123R permitscompanies to adopt one of two methods:  (1) A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements of SFAS123R for all share-based payments granted after the effective date and (b) basedon the requirements of SFAS 123 for all awards granted to employees prior tothe effective date of SFAS 123R that remain unvested on the effective date or (2) A“modified retrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under FAS 123 for purposes of pro formadisclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. The Company is currently in theprocess of evaluating the two option valuation methods and the potential impacton the financial statements.

**2.**   Acquisition

On October 13, 2004 the Company entered into anagreement to purchase all of the outstanding common stock of Advanced TelCom, Inc.(ATI) for $45,495, net of cash acquired. The transaction closed on December 31,2004. The closing of this transaction gives the Company a leading marketposition among competitive local exchange carriers within the PacificNorthwest, acquiring more than 18,000 business customers that utilizeapproximately 124,000 access lines. The Company expects to benefit from operatingsynergies from consolidating ATI’s operations into its existing business.

F-12

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**2.**   Acquisition(Continued)

The following tablesummarizes the estimated fair values of the assets acquired and liabilitiesassumed at the date of acquisition:
| Cash                       |   | $      | 321    |   |
|----------------------------|--------|--------|--------|--------|
| Other current  assets      |   | 7,987  |   |
| Property and  equipment    |   | 15,389 |   |
| Goodwill                   |   | 31,608 |   |
| Total assets  acquired     |   | 55,305 |   |
| Current liabilities        |   | 6,741  |   |
| Long-term  liabilities     |   | 217    |   |
| Acquisition  reserve       |   | 2,531  |   |
| Total liabilities  assumed |   | 9,489  |   |
| Net assets  acquired       |   | $      | 45,816 |   |

 

The Company allocated the purchase price on a preliminarybasis using the information then available. The allocation of the purchaseprice to the assets and liabilities will be finalized within the next 12 months.Upon completion of the final purchase price allocation, an additional portionof the excess purchase price may be allocated to certain intangibles that areseparable from goodwill or arise from contractual or legal rights. The Companyaccrued $2,531 in acquisition related expenses, which included severancebenefits, relocation costs and contract termination fees. As of December 31,2004, none of the acquisition related expenses have been paid.

The following unauditedpro forma financial information was prepared in accordance with SFAS No. 141,*Business Combinations*, andassumes the acquisition had occurred at the beginning of the periods presented.The unaudited pro forma information is provided for informational purposes only.These pro forma results are based upon the respective historical financialstatements of the respective companies, and do not incorporate, nor do theyassume, any benefits from cost savings or synergies of operations of thecombined company. The pro forma results of operations do not necessarilyreflect the results that would have occurred had the acquisition occurred atthe beginning of the periods presented or the results which may occur in thefuture.

Thepro forma combined results are as follows:
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2003**                                   | ** ** | **2004** | ** ** |
| Revenue                                    |       | $                                          | 180,542    | ** ** | **$** | **217,387** | ** ** |
| Net loss                                   |       | (19,673                                    | )          | **(1,559** | **)** |
| Net loss per share—basic  and diluted |       | (6.06                                      | )          | **(1.73** | **)** |
|                                            |            |                                            |            |  |  |  |  |

 

ATI’s consolidatedfinancial information included in the 2003 pro forma results represents theperiod from May 15, 2003 (the date on which ATI emerged from bankruptcy)through December 31, 2003.

F-13

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**3.**   Investments

As of December 31,2004, available-for-sale securities consist of the following:
| ** **                          | ** ** | **Cost Basis** | ** ** | **Unrealized  Holding  Gains** | ** ** | **Fair Value** | ** ** |
|-------------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------|------------|
| U.S. government agencies            |       |                | $          | 2,300                          |       |                |       | $ | 11 |   |   |   | $ | 2,311 |   |   |
| Corporate obligations               |       |                | 3,864      |                           |       |                | 19         |   |   |   | 3,883 |   |   |
| Total available-for-sale securities |       |                | $          | 6,164                          |       |                |       | $ | 30 |   |   |   | $ | 6,194 |   |   |

 

All debt securities as of December 31,2004, have maturities of six months or less.

**4.**   NotesPayable

In 1999, EschelonOperating Company, a subsidiary of the Company, entered into a credit agreement(subsequently amended in 2000 and 2001) with NTFC Capital Corporation (NTFC)and certain other lenders (collectively with NTFC, the lenders) and GeneralElectric Capital Corporation (GECC), providing a credit facility in theaggregate principal amount of $145,000 (the Credit Agreement).

In June 2002, the Company entered into anExchange Agreement with the lenders on its Credit Agreement. Under the terms ofthe Exchange Agreement, the Company’s lenders were given three options torestructure the debt under the Credit Agreement. Lenders who chose the firstoption received cash in the amount of $0.19 per dollar of outstanding principalin repayment in full of all liabilities owed to such lenders under the CreditAgreement. Lenders who chose the second option entered into new notes with aprincipal amount of approximately $0.38 per dollar of the previouslyoutstanding principal amount, with new payment terms and interest rates andreceived shares of Series A Preferred Stock in exchange of all liabilitiesowed to such lenders under the Credit Agreement. Lenders who chose the thirdoption entered into new notes in the same principal amount but with new paymentterms and interest rates and agreed to cancel a warrant for the purchase of734,897 shares of Common Stock in exchange of all liabilities owed to suchlenders under the Credit Agreement.

In accordance with SFAS No. 15, *Accounting by Debtors and Creditors for Troubled DebtRestructurings*, the Exchange Agreement transaction was accounted foras a troubled debt restructuring. The Company recognized a pretax gain of$53,549 from the debt restructuring and recorded $28,481 of excess carryingvalue over the face amount of the remaining principal due, which would reduceinterest expense over the term of the new notes utilizing the effectiveinterest rate method. The Company was not able to recognize the $28,481 as again because the interest to be incurred on the new notes was calculated viaeither a Base Rate of LIBOR, plus an applicable margin, not allowing the futurecash flows to be calculated with certainty. The Company recorded a gain on thisportion of the restructuring once the maximum future payments on the new noteswere certain to be less than the original carrying amount. In addition, certainlenders received 6,780,541 shares of Series A Convertible Preferred Stockwith a fair value of $3,444 in the Exchange Agreement.

For the years ended December 31, 2002, 2003 and2004, the Company recognized, as a reduction to interest expense, $2,140,$4,470 and $998, respectively, of the excess carrying value.

F-14

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**4.**   Notes Payable (Continued)

As of December 31, 2003, the notes had a carryingvalue of $86,226, including $21,871 of excess carrying value. The maturity dateof the loans under the amended Credit Agreement was June 30, 2009. Theterms of the amended Credit Agreement did not require repayment of any outstandingprincipal until June 30, 2005, at which time the Company was required tomake quarterly payments of varying amounts through June 30, 2009. Duringthe first 36 months of the term of the amended Credit Agreement, the Companywas obligated to pay interest quarterly on the outstanding loan balance at theinitial interest rate of 8% per year. The Company had the option ofcapitalizing such accrued interest into the outstanding balance during this36-month period. The Company capitalized $4,932 and $861 of interest expensefor the years ended December 31, 2003 and 2004, respectively. The amendedCredit Agreement allowed for prepayments of outstanding amounts and containedcertain restrictive covenants. At December 31, 2003, the Company was incompliance with these covenants.

In March 2004, the Company completed an offeringof $100,000 of 83¤8%senior second secured notes (“notes”) due 2010 at a discount resulting in a 12%yield. Proceeds from the offering were used to retire the Credit Agreement witha principal balance of $65,421 and provide additional liquidity to the Company.The repayment of the Credit Agreement resulted in the Company recording $18,195as a gain on extinguishment of debt, which represented $20,873 of excesscarrying value less the write-off of $2,678 of debt issuance costs associatedwith the 2002 Exchange Agreement.

In November 2004, the Company completed anoffering of $65,000 of 83¤8%senior second secured notes (“notes”) due 2010 at a discount resulting in a 14%yield. Proceeds from the offering were used to finance the acquisition ofAdvanced TelCom, Inc.

The notes will mature on March 15, 2010, andaccrue interest at an annual rate of 83¤8% withinterest payments made on a semiannual basis on each March 15 and September 15.On or after March 15, 2007, the Company may redeem some or all of thenotes at the following redemption prices, expressed as percentages of theiraccreted value, plus accrued and unpaid interest, if any, to the date of redemption:1) on or after March 15, 2007, at 106%; 2) on or after March 15,2008 at 103%; and 3) on or after March 15, 2009 at 100%. Prior to March 15,2007, up to 35% of the aggregate principal amount at maturity of the notes maybe redeemed at the Company’s option with the net proceeds of certain equityofferings at 112.000% of their accreted value, plus accrued and unpaidinterest, if any, to the date of redemption, provided that, following suchredemption, at least 65% of the aggregate principal amount at maturity of thenotes originally issued remains outstanding. In addition, the Company may, atits option upon a change of control, redeem all, but not less than all, of thenotes at any time prior to March 15, 2007, at 112.000% of their accretedvalue, plus accrued and unpaid interest, if any, to the redemption date. On September 15,2009, if any notes are outstanding, the Company will be required to redeem 3.5%of each then outstanding note’s aggregate accreted value, or the MandatoryPrincipal Redemption Amount, at a redemption price of 100% of the accretedvalue of the portion of notes so redeemed; provided, that the Company shallsimultaneously be required to redeem an additional portion of each note to theextent required to prevent such note from being treated as an Applicable HighYield Discount Obligation within the meaning of Section 163(i)(1) ofthe Internal Revenue Code of 1986, as amended. The Mandatory PrincipalRedemption Amount represents, with respect to each note, an amountapproximately equal to (i) the excess of the accreted value of theoutstanding notes over the original issue price thereof less (ii) an 

F-15

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**4.**   Notes Payable(Continued)

amount equal to one year’ssimple uncompounded interest on the aggregate original issue price of suchoutstanding notes at a rate per annum equal to the yield to maturity on theoutstanding notes.

Thecarrying value of the notes is comprised of the following as of December 31:
| ** **                                       | ** ** | **2003** | ** ** | **2004**    | ** ** |
|--------------------------------------------------|------------|----------|------------|-------------|------------|
| Principal amount  due                            |       | $        | 64,355     | ** **  | **$**      | **165,000** | ** ** |
| Excess carrying  value over principal amount due |       | 21,871   | ** ** | **—**  | ** ** |
| Discount on notes  payable                       |       | —   | ** ** | **(27,222** | **)**      |
|                                             | ** ** | $        | 86,226     | ** **  | **$**      | **137,778** | ** ** |

 

The accreted value ofnotes payable as of December 31 of the following years is:
| 2005 |   | $       | 141,731 |   |
|------|--------|---------|---------|--------|
| 2006 |   | 146,204 |    |
| 2007 |   | 151,280 |    |
| 2008 |   | 157,040 |    |
| 2009 |   | 163,578 |    |
| 2010 |   | 165,000 |    |

 

The carrying amount, netof the excess carrying value resulting from the troubled debt restructuring, ofthe Company’s debt instruments in the consolidated balance sheets at December 31,2003 approximates fair value. The carrying amount, net of discount, of theCompany’s debt instruments in the consolidated balance sheets at December 31,2004 approximates fair value.

**5.**   Commitments and Contingencies

In April 2003,the Company entered into a five-year agreement with MCI to purchasecolocation/LIS transport services. The agreement requires that the Companymaintain monthly minimums as follows:
| April 2004—March 2005 |   | $ | 84/month |   |
|--------------------------------------|--------|---|----------|--------|
| April 2005—March 2006 |   | $ | 88/month |   |
| April 2006—March 2007 |   | $ | 93/month |   |
| April 2007—March 2008 |   | $ | 97/month |   |

 

The Company will pay an underutilization charge forany amounts billed under the monthly minimum.

In 2000, the Company entered into an amendment of anearlier Master Purchase and Services agreement with Nortel Networks, Inc.(Nortel Networks). Under the amendment, the Company committed to purchaseand/or license $100,000 of Nortel Networks’ equipment or services. However, theCompany is confident that, due to Nortel Networks’ discontinuance of certainproduct lines contemplated in the Amended Master Purchase and Servicesagreement, neither party will be held to the conditions of the contract.

F-16

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**5.**   Commitments andContingencies (Continued)

In August 2000, the Company entered into aten-year agreement with Global Crossing to purchase a total of $100,000 ofservices. In connection with this agreement the Company paid approximately$6,791, $8,273 and $9,344 in 2002, 2003 and 2004, respectively. The agreementdoes not contain monthly minimums, however a penalty is assessed for earlytermination upon change in control. Upon change in control, the earlytermination penalty fee is $5,000.

On October 13, 2004,the Company entered into an agreement with GE Business Productivity Solutions, Inc.(GE BPS), a Georgia corporation and wholly owned subsidiary of General ElectricCapital Corporation (GECC), pursuant to which the Company agreed to purchasesubstantially all of the operating assets of GE BPS (the GE BPS Acquisition)and assume certain liabilities, for a purchase price of $100. Due to theextensive regulatory approvals required to close the GE BPS Acquisition, theCompany cannot currently estimate the closing date, however the Company expectsthe GE BPS transaction to close in the first half of 2005. GE BPS is anon-facility based reseller serving primarily residential customers in almostall 50 states. Consummation of the GE BPS Acquisition is subject to customaryconditions, including the receipt of required regulatory approvals.

**Legal Proceedings**

In August 2004, a Nevada state court entered ajudgment against the Company for intentionally interfering with a formersalesperson’s economic relationship with his new employer in the amount of $376plus costs. The Company had reason to believe the former employee was violatinghis non-solicitation agreement with the Company. The Company appealed thejudgment because, among other reasons, the jury was not instructed to considerwhether the Company was justified in informing the new employer of theagreement and the Company’s intent to enforce it. The Company settled this casein January 2005, agreeing to pay a total of $300 over three annualinstallments.

In October 2004, a former employee filed a suitagainst the Company in federal district court in Minnesota alleging that interminating his employment the Company violated the federal Age Discriminationin Employment Act and the Minnesota Human Rights Act. The Company rejected anoffer from the plaintiff to settle his claims in return for a payment of $250because the Company does not believe his claims have any merit. The Companyintends to vigorously defend against these claims, but cannot predict theoutcome of the lawsuit.

Global Crossing Bandwidth, Inc., the Company’sprovider of long distance services, filed a suit against the Company in February 2005in the federal district court for the Western District of New York. The suitalleges that the Company owes $8,377 in unpaid pre-subscribed inter-exchangecarrier charges (“PICC”). The Company believes it has a strong defense toGlobal Crossing’s claim for PICC charges and the Company intends to vigorouslydefend against the suit. The Company cannot predict the outcome of thislitigation.

The Company is a party to several complaintproceedings against Qwest filed with the Arizona, Colorado, Minnesota andWashington PUCs and two federal court lawsuits involving Qwest. The MinnesotaPUC ordered Qwest to pay the Company $500 as a refund of overcharges related toenhanced extended loops and the Company received the refund. The FederalDistrict Court in Minnesota recently denied Qwest’s appeal of the Minnesota PUC’sUNE Cost Order. Qwest then appealed to the Federal 

F-17

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**5.**   Commitments andContingencies (Continued)

Court ofAppeals. If Qwest is successful, the Company’s UNE rates in Minnesota couldincrease. The Company has appealed the unfavorable decision by the MinnesotaPUC regarding the Company’s request for a refund from Qwest for overcharges forthe Company’s Minnesota collocations. The Minnesota PUC, the Colorado PUC, andthe Arizona Corporation Commission recently granted, and the Washington PUCdenied in part and granted in part, the Company’s complaints regarding retroactiveapplication of certain favorable UNE rates. Qwest has not appealed thesedecisions.

The Company has reached asettlement with Qwest that resolves the following matters on mutuallyacceptable terms: the Company’s appeal of the unfavorable decision by theMinnesota PUC for Qwest’s withholding of Direct Measures of Quality, or DMOQ,billing credits from the Company; the Company’s appeal of the Washington StateDistrict Court decision upholding the PUC’s decision that denied in part theCompany’s complaint regarding retroactive application of certain favorable UNErates; and the Company’s lawsuit against Qwest in the United States DistrictCourt, Western District of Washington regarding the financial harm the Companyhas suffered as a result of Qwest’s violations of the Company’s interconnectionagreements by failing to provide accurate records relating to interstate andintrastate long distance calls, failing to develop an unbundled networkplatform and failing to make DSL available for resale.

Investigations are ongoingin Arizona, Oregon and Colorado relating to the alleged failure of Qwest andseveral CLECs, including the Company, to submit interconnection agreements forapproval by state regulatory agencies. The Company cannot predict the outcomeof the Arizona, Colorado or Oregon investigations or the effect that anycorresponding regulatory actions may have on its business. A similarinvestigation by the Minnesota PUC resulted in no direct penalties against theCompany, while the Washington Commission approved a settlement under which theCompany paid $25 and provided testimony in return for dismissal of the caseagainst the Company.

The Minnesota Departmentof Commerce has filed a complaint with the Minnesota PUC concerning agreementsthat CLECs, including the Company, have with certain interexchange carriers forpricing access services. The Minnesota Department of Commerce has asserted thatthe agreements are unlawfully discriminatory and required to be filed. TheCompany cannot predict the outcome of this proceeding or its effect on theCompany’s business.

The Company has disputedthe amount of a bond that the Company is required to post with the ArizonaCorporation Commission. The Arizona Corporation Commission recently ruled toreduce the Company’s bond to $235 rather than the $400 bond currently posted. However,future proceedings could result in a substantial increase in the bond,depending on Commission decisions on its policies concerning bond requirements.

The Company cannot predictthe outcome of any of these proceedings or their effect on its business. TheCompany is party from time to time to other ordinary course matters notbelieved to be material.

**6.**   Operating and Capital Leases

The Company leases officespace under operating leases. The office leases generally require a base rentplus amounts covering operating expenses and property tax. Rent expense for theyears ended December 31, 2002, 2003, and 2004 was $5,837, $6,007, and$5,087, respectively.

F-18

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**6.**   Operating and Capital Leases(Continued)

Futureminimum lease payments under operating leases with a term in excess of one yearas of December 31, 2004 are as follows:
| 2005       |   | $     | 6,855  |   |
|------------|--------|-------|--------|--------|
| 2006       |   | 6,542 |   |
| 2007       |   | 5,677 |   |
| 2008       |   | 5,500 |   |
| 2009       |   | 4,537 |   |
| Thereafter |   | 6,022 |   |
|       |   | $     | 35,133 |   |

 

TheCompany also leases certain furniture and equipment under capital leases. Thecost of furniture and equipment in the accompanying balance sheets includes thefollowing amounts under capital leases:
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2003**              | ** ** | **2004** | ** ** |
| Cost                           |       | $                     | 9,897      | ** ** | **$** | **6,020** | ** ** |
| Less accumulated  depreciation |       | (5,062                | )          | **(782** | **)** |
|                           | ** ** | $                     | 4,835      | ** ** | **$** | **5,238** | ** ** |

 

Future minimum leasepayments required under capital leases together with the present value of thenet future minimum lease payments at December 31, 2004 are as follows:
| 2005                                               |   | $      | 2,128  |   |
|----------------------------------------------------|--------|--------|--------|--------|
| 2006                                               |   | 1,726  |   |
| 2007                                               |   | 1,307  |   |
| 2008                                               |   | 180    |   |
| 2009                                               |   | 8      |   |
| Total minimum  lease payments                      |   | 5,349  |   |
| Less amount  representing interest                 |   | (896   | )      |
| Present value of  net minimum payments             |   | 4,453  |   |
| Less current  portion                              |   | (1,629 | )      |
| Capital lease  obligations, net of current portion |   | $      | 2,824  |   |

 

**7.**   Benefit Contribution Plan

The Company has a definedcontribution salary deferral plan covering substantially all employees under Section 401(k) ofthe Internal Revenue Code. The Company contributes an amount equal to 45 centsfor each dollar contributed by each employee up to a maximum of 6% of eachemployee’s compensation. The Company recognized expense for contributions tothe plan of $706, $602 and $764 in 2002, 2003 and 2004, respectively.

F-19

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**8.   Capital Stock**

In June 2002, the Company completed a corporaterestructuring, pursuant to which the Company restructured its Credit Agreement(see Note 4); reclassified each share of the Company’s outstanding Common Stockinto 0.0010754995720 shares of common stock; converted all outstanding sharesof the Company’s Series A, B, C, and D preferred stock into common stockat prescribed conversion prices; issued 68,907,245 shares of its newlyauthorized Series A Convertible Preferred Stock, resulting in proceeds of$35,000; issued 6,780,541 shares of its newly authorized Series AConvertible Preferred Stock with a fair value of $3,444 to a lender asdescribed in Note 4; and issued 2,712,216 of its newly authorized Series AConvertible Preferred Stock with a fair value of $1,378 in exchange for notespreviously outstanding.

In November and December 2002, the Companyissued 5,906,675 shares of its newly authorized Series A ConvertiblePreferred Stock, resulting in proceeds of $3,000.

In December 2004, in connection with the ATIacquisition, the Company redeemed 6,780,541 shares of its Series AConvertible Preferred Stock held by a lender for $5,085.

In December 2004, the Company issued 20,000,000shares of its newly authorized Series B Convertible Preferred Stock,resulting in proceeds of $15,000.

Under the terms of the Series A and Series BConvertible Preferred Stock (collectively, Preferred Stock), the holders areentitled to receive, when and if declared by the Board of Directors, cumulativedividends on each share of Preferred Stock at the rate of 8% per year whichshall accrue daily and, to the extent not paid, shall accumulate quarterly inarrears. At December 31, 2003 and 2004, dividends in arrears are $6,127and $8,777, respectively.

The shares of Series A Convertible PreferredStock, plus all accrued and unpaid dividends at the time of conversion, areconvertible at any time, at the option of the holder, into shares of theCompany’s common stock at the then applicable conversion price; the initialconversion price is $0.5079 per share. The shares of Series B ConvertiblePreferred Stock, plus all accrued and unpaid dividends at the time ofconversion, are convertible at any time, at the option of the holder, intoshares of the Company’s common stock at the then applicable conversion price;the initial conversion price is $0.75 per share. The conversion price for eachof the Series A Convertible Preferred Stock and the Series BConvertible Preferred Stock is subject to adjustment in the event of certainevents, such as dilutive issuances of additional securities. The PreferredStock will automatically convert into common stock in the event of an initialpublic offering raising at least $50,000. The Preferred Stock may be automaticallyconverted upon the consent of the holders of at least 60% of the thenoutstanding shares of Preferred Stock.

The shares of Preferred Stock will be redeemed in June 2012,if the shares have not previously been redeemed or converted. The Company mayredeem all of the Preferred Stock upon the effectiveness of an initial publicoffering. The redemption price of the Preferred Stock will be the greater of (i) theapplicable original issue price plus all accrued and unpaid dividends or (ii) thefair market value of the shares of common stock, as determined by the Board ofDirectors, that would be received upon conversion of (a) the PreferredStock, and (b) any accrued and unpaid dividends on the Preferred Stock.

Upon a change of control, the holders of 60% of thethen outstanding shares of the Preferred Stock may require the Company toredeem all of or a portion of the Preferred Stock at a price equal to (1) the

F-20

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**8.**   Capital Stock(Continued)

redemption price;provided, however, that if the change of control occurs before the fifthanniversary of the Series A Convertible Preferred Stock, then theredemption price for the shares of Series A Convertible Preferred Stockshall be the liquidation preference (as described below).

In the event of theCompany’s liquidation, the holders of the Preferred Stock will receive anydistribution of corporate assets before any distributions are made to a juniorclass of equity. The amount to be distributed to the holders of Series AConvertible Preferred Stock will be the greater of (i) two times the Series Aoriginal issue price plus all accrued and unpaid dividends thereupon (whetheror not yet accumulated) as of the date of distribution and (ii) the fairmarket value of the shares of the Company’s common stock after taking intoaccount the pari passu rights on liquidation of the Series B ConvertiblePreferred Stock, as determined by the Board of Directors, that would bereceived upon (1) conversion of the Series A Convertible PreferredStock, (2) any accrued and unpaid dividends thereupon and, (3) if theliquidation is prior to the fifth anniversary of the date of issuance of the Series AConvertible Preferred Stock, all additional dividends that would have beenaccrued thereupon through the fifth anniversary date. The amount to bedistributed to the holders of Series B Convertible Preferred Stock will bethe greater of (i) the Series B original issue price plus all accruedand unpaid dividends thereupon (whether of not yet accumulated) as of the dateof distribution and (ii) the fair market value of the shares of theCompany’s common stock, after taking into account the pari passu rights onliquidation of the Series A Convertible Preferred Stock, as determined bythe Board of Directors, that would be received upon (1) conversion of the Series BConvertible Preferred Stock and (2) any accrued and unpaid dividendsthereupon.

**Stock Options**

The Board of Directors approved the Eschelon Telecom, Inc.Stock Option Plan of 1996 (the 1996 Plan). The 1996 Plan provided for theissuance of incentive and nonqualified stock options to key management staff.Under the 1996 Plan, the exercise price of options granted was determined bythe Board of Directors, providing that incentive stock options were granted atexercise prices equal to the fair market value of the Company’s stock on thedate of grant. A total of 6,680,000 shares of the Company’s common stock werereserved for issuance under the 1996 Plan.

In June 2002, the Company completed a corporaterestructuring, pursuant to which the Company terminated the 1996 Plan,including the cancellation of all unexercised options outstanding under the1996 Plan.

In November 2002, the Board of Directors approvedthe Eschelon Telecom, Inc. Stock Option Plan of 2002 (the 2002 Plan). Atotal of 14,117,647 shares of the Company’s common stock have been reserved forissuance under the 2002 Plan. At December 31, 2002, the Company did nothave any options outstanding.

F-21

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**8.**   Capital Stock(Continued)

The following tablesummarizes the options to purchase shares of the Company’s common stock underthe Eschelon Telecom, Inc. Stock Option Plans of 1996 and 2002:
| ** **                         | ** ** | **Shares  Available for  Grant** | ** ** | **Plan  Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| Balance at  December 31, 2001 |       | 1,009,020                             |       | 5,433,980                      |       |                                       | $          | 5.13 |   |   |
| Additional shares reserved         |       | 14,117,647                            |       | —                         |       |                                       | —     |   |   |
| Canceled                           |       | (1,009,020                            | )          | (5,433,980                     | )          |                                       | 5.13       |   |   |
| Balance at  December 31, 2002 |       | 14,117,647                            |       | —                         |       |                                       | —     |   |   |
| Options granted                    |       | (10,643,804                           | )          | 10,643,804                     |       |                                       | 0.05       |   |   |
| Restricted stock granted           |       | (2,484,979                            | )          | —                         |       |                                       | 0.05       |   |   |
| Canceled                           |       | 883,867                               |       | (883,867                       | )          |                                       | 0.05       |   |   |
| Exercised                          |       | —                                |       | (383,452                       | )          |                                       | 0.05       |   |   |
| Balance at  December 31, 2003 |       | 1,872,731                             |       | 9,376,485                      |       |                                       | 0.05       |   |   |
| Options granted                    |       | (1,376,384                            | )          | 1,376,384                      |       |                                       | 0.10       |   |   |
| Canceled                           |       | 486,720                               |       | (486,720                       | )          |                                       | 0.06       |   |   |
| Exercised                          |       | —                                |       | (160,575                       | )          |                                       | 0.05       |   |   |
| Balance at  December 31, 2004 |       | 983,067                               |       | 10,105,574                     |       |                                       | $0.06      |   |   |

 

The following tablecontains details of the stock options outstanding as of December 31, 2004:
| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted-Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $0.00 - $0.05                               |       | 8,718,360                    |       |                         | 8.1 years  |   |   |   | $ | 0.05 |   |   | 5,071,174 |   |   | $ | 0.05 |   |   |
| $0.06 - $0.10                               |       | 1,387,214                    |       |                         | 9.2 years  |   |   |   | $ | 0.10 |   |   | 269,456 |   |   | $ | 0.10 |   |   |
|                                        |       | 10,105,574                   |       |                         | 8.2 years  |   |   |   | $ | 0.06 |   |   | 5,340,630 |   |   | $ | 0.05 |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Restricted CommonStock**

In February 2003, theCompany granted 2,484,979 shares of restricted common stock to certaindirectors and members of management. The fair value per share of thisrestricted stock was $0.05. The Company records compensation expense as therestrictions are removed from the stock. At December 31, 2003, 1,399,902shares had vested resulting in total compensation expense related to restrictedcommon stock of $70. At December 31, 2004, an additional 405,968 shareshad vested resulting in compensation expense of $20.

**9.   Income Taxes**

As of December 31, 2004, the Company had $134,000of net operating loss (NOL) carryforwards. The NOL carryforwards begin toexpire in the year 2019. Should the Company incur a change in ownership in thefuture, Section 382 of the United States Internal Revenue Code may limitthe amount of cumulative NOLs available to offset future income.

F-22

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**Eschelon Telecom, Inc. Notes to Consolidated Financial Statements (Continued) (Dollars in Thousands, Except per Share Amounts)**

**9.**   Income Taxes(Continued)

Components of the deferredtax asset at December 31, 2003 and 2004 are as follows:
| ** **                      | ** ** | **2003**   | ** ** | **2004**    | ** ** |
|---------------------------------|------------|------------|------------|-------------|------------|
| Deferred tax assets:            |       |       |       |        |       |
| Net operating loss carryforward |       | $          | 52,490     | ** **  | **$**      | **53,096** | ** ** |
| Bad debts                       |       | 296        | ** ** | **157**     | ** ** |
| Compensation accruals           |       | 423        | ** ** | **—**  | ** ** |
| Inventory obsolescence          |       | 104        | ** ** | **91**      | ** ** |
| Other temporary differences     |       | 111        | ** ** | **134**     | ** ** |
|                            | ** ** | 53,424     | ** ** | **53,478**  | ** ** |
| Deferred tax  liabilities:      | ** ** | ** ** | ** ** | ** **  | ** ** |
| Depreciation                    |       | (8,663     | )          | **(7,416**  | **)**      |
| Other                           |       | —     | ** ** | **(11**     | **)**      |
|                            | ** ** | 44,761     | ** ** | **46,051**  | ** ** |
| Valuation  allowance            |       | (44,761    | )          | **(46,051** | **)**      |
| Net deferred tax asset          |       | $          | —     | ** **  | **$**      | **—** | ** ** |

 

Income tax expense for theyear ended December 31, 2004, is comprised of state taxes. Thereconciliation between the statutory federal income tax rate and the effectiverate is as follows:
| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004** | ** ** |
| Federal statutory  tax rate         |       | 35.00                                      | %          | 35.00 | % | **34.00** | **%** |
| State taxes                         |       | 5.25                                       |       | 5.16 | ** ** | **0.25** | ** ** |
| Permanent  differences              |       | —                                     |       | — | ** ** | **2.74** | ** ** |
| Utilization of  valuation allowance |       | (40.00                                     | )          | (40.00 | ) | **(36.61** | **)** |
| Effective tax rate                  |       | 0.25                                       | %          | 0.16 | % | **0.38** | **%** |

 

F-23

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