**As filed with the Securities and Exchange Commission on March 17, 2006**

**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 THE SECURITIES EXCHANGE ACTOF 1934 

**FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934 

**FOR THE TRANSITION PERIODFROM                    TO                    **

**Commission File Number: 000-50706**

**ESCHELON TELECOM, INC.**

(Exact name of registrantas specified in its charter)

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

 

Registrant’s telephone number, 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:**Common Stock, par value $0.01 per share**

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o     No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o     No x

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

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendments to the Form 10-K. x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

| Large accelerated  filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes o     No x

Asof February 28, 2006, the number of outstanding shares of the registrant’sCommon Stock, par value $0.01 per share, was 14,721,287 shares.

**DOCUMENTS INCORPORATED BYREFERENCE**

Aportion of the information required by Part III of the Form 10-Kis incorporated by reference from portions of our definitive proxy statementfor our 2006 Annual Meeting of Stockholders to be filed with the Securities andExchange Commission.

 

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**TABLE OF CONTENTS**

| ** ** |   | **Part I**                                                                                                     |   |   |
|------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.    |   | Business                                                                                                            |   | 4      |
| Item 1A.   |   | Risk  Factors                                                                                                       |   | 24     |
| Item 1B.   |   | Unresolved Staff  Comments                                                                                          |   | 33     |
| Item 2.    |   | Properties                                                                                                          |   | 34     |
| Item 3.    |   | Legal Proceedings                                                                                                   |   | 34     |
| Item 4.    |   | Submission of  Matters to a Vote of Security Holders                                                                |   | 35     |
| ** ** |   | **Part II**                                                                                                    |   |   |
| Item 5.    |   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   | 36     |
| Item 6.    |   | Selected Financial  Data                                                                                            |   | 37     |
| Item 7.    |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operation                     |   | 41     |
| Item 7A.   |   | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   | 54     |
| Item 8.    |   | Financial  Statements and Supplementary Data                                                                        |   | 54     |
| Item 9.    |   | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                               |   | 54     |
| Item 9A.   |   | Controls and Procedures                                                                                             |   | 54     |
| Item 9B.   |   | Other Information                                                                                                   |   | 54     |
| ** ** |   | **Part III**                                                                                                   |   |   |
| Item 10.   |   | Directors and  Executive Officers of the Registrant                                                                 |   | 55     |
| Item 11.   |   | Executive  Compensation                                                                                             |   | 55     |
| Item 12.   |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   | 55     |
| Item 13.   |   | Certain  Relationships and Related Transactions                                                                     |   | 55     |
| Item 14.   |   | Principal  Accounting Fees and Services                                                                             |   | 55     |
| ** ** |   | **Part IV**                                                                                                    |   |   |
| Item 15.   |   | Exhibits,  Financial Statement Schedules                                                                            |   | 56     |

 

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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 “Risk Factors” andelsewhere herein, which could cause actual results to differ from present plansor expectations, and such differences could be material. Similarly,forward-looking statements regarding management’s present expectations foroperating results and cash flow involve risks and uncertainties relative tothese and other factors, such as the ability to increase revenues and/or toachieve cost reductions and other factors discussed in the section entitled “RiskFactors” or elsewhere herein, which also would cause actual results to differfrom present plans. Such differences could be material. All forward-lookingstatements attributable to us or by any persons acting on our behalf areexpressly qualified in their entirety by these cautionary 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 statements,which speak only as of the date these statements were made. Except as requiredby law, we may 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. (“we” or “the Company”) isa competitive local exchange carrier (“CLEC”), headquartered in Minneapolis,Minnesota. The Company was incorporated in Delaware in 1996 under the nameAdvanced Telecommunications, Inc. We are a leading facilities-basedprovider of integrated voice and data communications services to small andmedium-sized businesses in 19 markets in the western United States. Our voiceand data services, which we refer to as network services, include local dialtone, long distance, enhanced voice features and Internet access services. Wealso sell, install and maintain business telephone and data systems andequipment, which we refer to as business telephone systems (“BTS”). We providethese products and services individually or in customized packages to addressour customers’ need for a fully-outsourced voice and data network solution. Webelieve that our high quality, personalized service and customized packagescontribute to our low monthly customer line churn, which for 2004 and 2005averaged 1.48% and 1.34%, respectively. As of December 31, 2005, weprovided service through approximately 415,000 total access lines. For 2005, wegenerated consolidated revenue of $227.7 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, six Lucent 5ESS voiceswitches, six Cisco BPX data switches and seven Nortel Passport ATM switches.We have physical colocations in 127 incumbent local exchange carrier (“ILEC”)central offices through which we provide voice services over unbundled networkelements (“loops”) or integrated voice and data services over T1 lines. We alsoprovide service via commercial agreements, formally known as Unbundled NetworkElement Platform (“UNE-P”), typically for multi-location customers who needadditional access lines in locations where we do not own facilities. As of December 31,2004, approximately 81% of our total access lines in service were served on ournetwork, which we refer to as “on-net”, compared to 86% as of December 31,2005. In addition, for 2004 and for 2005, new access lines installed on-netrepresented 92% and 97%, respectively, of our total new access lines installed.

We acquired Advanced TelCom, Inc. (“ATI”) on December 31,2004 for an aggregate purchase price of $45.5 million. ATI was also afacilities-based CLEC with operations primarily in 12 markets in four westernstates. Eschelon was already operating in five of ATI’s markets and six wereadjacent to our markets. ATI expanded and strengthened our presence in thewestern United States and we believe that we have benefited from operatingsynergies from consolidating ATI’s operations into our business.

On January 27, 2006,we announced that a definitive agreement had been signed to acquire OregonTelecom, Inc. (“OTI”), a privately-held competitive services providerbased in Salem, Oregon. We will pay approximately $20 million in cash toacquire OTI. The acquisition is expected to close early in the second quarterof 2006.

**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 provide servicerepresents nearly $30 billion. Competitive service providers such as uscontinue to gain market share from the Regional Bell Operating Companies (“RBOCs”).According to the FCC, as of December 31, 2005 CLECs served32.9 million, or 18.5%, of the switched access lines in the United States,an increase of 11.1% over the prior year.

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**Our Markets**

We operate in 19 markets in the western United States.According to the U.S. Census Bureau, population growth from 1990 to 2000 acrossour markets averaged 27.6%, which was more than double the national average of13.2%, and annual small and medium-sized business growth from 1997 to 2001across our markets averaged 1.6%, more than triple the national average of0.5%. According to Kagan World Media, our markets are expected to remain amongthe fastest growing markets in the United States, with an average annualpopulation growth rate of 1.9% through 2006, compared to the national averageof 1.1%.

Our markets areMinneapolis 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, NV, and areprimarily in the region in which Qwest Communications is the incumbent localexchange carrier. Within our markets, we have colocated in RBOC central officesthat serve a high concentration of potential small and medium-sized businesscustomers. As of December 31, 2005, our facilities-based network coveredapproximately 70% of our defined market through only 25% of the total RBOCcentral offices in each market.

**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 basicdial tone services and vertical features such as call forwarding, call waitingand call transfer; advanced call management capabilities such 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 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 we also provide and support e-mail andweb-hosting services. Our IDSL product allows us to reach customers beyond thetypical distance threshold of a normal DSL product. Our data services areoffered at transmission speeds that range from 56Kbps to 6Mbps.

***Business TelephoneSystems.***   We provide telephone equipmentsystems and voice messaging products. We also procure and install voice anddata cable, patch panels, routers and other network hardware. We offercustomers multi-year maintenance agreements to maintain and upgrade their systems.Some of our key manufacturers include Mitel, Inter-Tel, NEC, Cisco and Adtran.

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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 Systems                                     |       |
| 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 provide incentives to our salesforce to focus on selling customized packages that can be serviced on-net. For2005, 97% of our total new access lines installed were installed on-net.

As of December 31, 2005, our direct sales forceconsisted of 204 network communications specialists and 39 BTS communicationsspecialists. Our network and BTS communications specialists integrate theirefforts through a team approach created by a cross-commission structure thatprovides incentives for them to cross-sell products and services.

In 2004, we began using third party agents to sell ourservices and systems to complement the sales of our direct sales force. Thisagent channel reaches customer segments that are generally not targeted by ourdirect sales force. We initially launched our agent channel into three markets.During 2005, we expanded the agent channel into our Utah, Oregon and Washingtonmarkets. We will continue to analyze the performance of this sales channel forstrategic fit. We expect that no more than 10% of our sales volume will beattributable to the agent channel.

As a result of our directsales approach, we generally have not spent funds on television, radio ormulti-media advertising. However, we intend to increase our involvement inlocal community activities in each of our markets in order to create morepublicity and recognition for our company.

**Our Customers**

Our customers are generallysmall and medium-sized businesses with fewer than 100 employees and cross avariety of industries including professional services, communications,technology and heavy industry. During 2005, we did not have any customerrepresenting more than 2% of our total revenue. We do not generate anywholesale carrier revenue (other than carrier access and reciprocalcompensation revenue) or wholesale Internet service provider revenue. Wecurrently serve over 50,000 customers.

**Customer Service and Retention**

We provide our customers with superior customerservice, which is driven by a highly personalized, integrated team approach.Our local customer service representatives and repair service bureau associatesare supported by customer service professionals in our Minneapolis call center.Every new customer order is closely coordinated by a service delivery teamuntil three days following service transition. Each new 

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customer is contactedmultiple times by our service delivery team during the service initiation processto ensure accuracy and on-time delivery of services ordered.

We segment our customer base to better serve theirspecific needs. We have national account managers responsible for maintainingrelationships with multiple location accounts and local account managersresponsible for single market accounts. The local and national account managerscoordinate service requests with our centralized call center associates toensure 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 trainedassociates whose performance is closely monitored. Our centrally managedservice platform allows us to actively track and analyze call response times,trouble ticket resolution and customer satisfaction for every in-bound callreceived. Our centralized repair service bureau is complemented by our fieldservice technicians who can readily be deployed to the customer premises. Wealso regularly survey our customers allowing us to track, analyze and adjustservice and processes as necessary.

We have a centralized network operating center throughwhich we monitor our network on a 24x7 basis and are able to detect andtroubleshoot many types of network problems before our customers are aware ofthem.

Our senior director of customer retention isresponsible for coordinating our sales force, repair service bureau, nationaland local account managers, customer service organization and retention team toproactively manage customer retention. All members of these groups are trainedto identify at-risk customer accounts, which are then referred to our retentionteam for specific, personalized care. We analyze our survey, performance andchurn data on a monthly basis to better understand our customers and toimplement or alter operating procedures to improve our operations and customerretention.

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 indicatorof potential future revenue.

**Network Overview and Deployment**

We have constructed our network around owned switchingand collocation equipment. Our network is a system of switches and equipmentcolocated in RBOC central offices or carrier hotels that are interconnectedusing primarily leased transport and then linked to customers’ premises usingleased loops. In almost all cases, we purchase the last mile connection fromthe RBOC. In addition, with the acquisition of ATI, we acquired active (i.e.,working or “lit”) fiber transport connecting ATI’s switches and colocations ina number of ATI’s markets.

***Voice and DataSwitches.***   We have deployed Nortel, Lucent,Tellabs and Cisco equipment in each of our major markets. We use Nortel DMS andLucent 5ESS switches for local dial tone 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.

***ColocationEquipment.***   We use Zhone Technologies, Inc.Universal Edge 9000, or UE9000, access node equipment and Lucent AnyMediaFastDigital Loop Carriers in each of the 127 RBOC 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 

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offerings. We have alsodeployed Verilink Sechtor 300 devices in our switch rooms and variouscolocations and, together with the addition of an integrated access device atcustomer premise locations, we are able to offer network voice and dataservices over a single T1 line. In select colocations, we also use Nokia’sDSLAMs in order to provide on-net DSL services. The UE9000, AnyMediaFast,Sechtor 300 and Nokia devices are high density voice and data equipment thatfit into a single network bay, thereby reducing costly colocation space in RBOCcentral offices.

***Intra-CityTransport Deployment.******  ***In select markets, we utilizefiber transport in a SONET ring configuration to connect host sites to RBOCcolocations. 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 is not deployed, transport between our switches and our colocationsis provided over more than one route in all cases and is purchased from morethan one provider in most cases. Using multiple routes and providers gives us amore robust network that maintains functionality should a transport route incura failure. By diversifying our high capacity circuits across multiple vendorsin each market, we maintain higher levels of network reliability and lowernetwork costs.

***Inter-City ATMBackbone Network.***   Our Cisco BPX and NortelPassport ATM switches provide data traffic switching in our major markets.These ATM switches are interconnected through leased long-haul transportobtained from multiple wholesale providers. This ATM backbone carries IP datatraffic between switch locations. Customer access to the Internet and virtualprivate networks travel over this network. ATM is a fully redundant,state-of-the-art transmission and switching technology that carries both T1-basedand DSL-based IP traffic more efficiently than traditional dedicated circuitnetworks.

***Customer Access Methods.***   Wehave the ability to serve small and medium-sized businesses in our markets byone or more of the following methods:

·       ***T1***.   Largercustomers can be served with leased high capacity connections directly from ourcolocation equipment to the customer’s location. We also offer the ability toshare a single T1 connection for both voice and data services and to allocatethe circuit capacity for voice and data depending upon customer requirements. For2005, 55% of new access lines installed were installed on T1 circuits.

·       ***Analog UNE-loop***.   Toprovide analog voice services, we colocate our telephone access equipment inthe RBOC’s central offices and lease the RBOC’s facilities, known as unbundlednetwork elements, or UNEs, to connect customer locations to our colocationequipment. Smaller customers are most likely to be served with this method. Weprovide broad facilities-based coverage by colocating in densely-populatedareas so that we can access unbundled network elements reaching approximately70% of the estimated business access lines within our selling areas fromapproximately 25% of the available RBOC central offices.

·       ***DSL******.  ***Weprovide dedicated connections to certain customers using conventional “twistedpair” copper wire employing DSL technology. Our customers use DSL lines fordata applications such as Internet access, intranets, extranets, telecommuting,e-commerce, e-mail, video conferencing and multimedia. DSL is provided on thesame copper wires as voice service or as a dedicated line dependent uponcustomer situations. DSL is not available to all customers due to copper looplength limitations and RBOC plant configurations.

·       ***ILEC Commercial Agreements***.   InJanuary 2005, we signed a three-year agreement with Qwest to purchase itsPlatform Plus product, which replaced the UNE-P platform. In June 2005, wealso signed a three-year agreement with Verizon to purchase its WholesaleAdvantage product, which replaced the UNE-P platform in Verizon operatingregions.

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·       ***Centrex Resale***.   Weresell Centrex services in the Eschelon legacy Reno market. Centrex is avalue-added business telephone service we purchase from AT&T at wholesalerates and invoice on our own bills.

**Competition**

The communications industry is highly competitive. Ourability to compete effectively depends upon our continued ability to maintainhigh quality, market-driven services at prices competitive to those charged bythe RBOCs. Many of our current and potential competitors have financial,technical, marketing, personnel and other resources, including brand namerecognition, substantially greater than ours, as well as other competitiveadvantages over us.

***RBOCs.***   Inour existing markets, we compete principally with Qwest. Qwest and other RBOCshave 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 RBOCsover 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. While regulatory initiatives based on the Telecommunications Act,which allow competitive service providers such as us to interconnect with Qwest’sfacilities, provide increased business opportunities for us, these interconnectionopportunities have been, and likely will continue to be, accompanied byincreased pricing flexibility for and relaxation of regulatory oversight ofQwest and the other RBOCs. Future regulatory decisions could grant the RBOCsgreater pricing flexibility or other regulatory relief. These initiatives couldhave a material adverse effect on us.

***Competitive ServiceProviders and Other Market Entrants.***   We alsoface competition 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 requiresRBOCs to unbundle their network services, new competitive service providers areable to rapidly enter the market by installing switches and leasing localloops.

In addition to the new competitive service providers,RBOCs and other competitors described above, we may face competition from othermarket entrants such as cable television companies, wireless service providersand virtual service providers using Voice over Internet Protocol (VoIP) overthe public Internet or private networks. Electric utility companies haveexisting assets and low cost access to capital which could allow them to entera market and accelerate network development. Cable television companies areentering the communications market by upgrading their networks with hybridfiber coaxial lines and installing facilities to provide fully interactivetransmission of broadband voice, video and data communications. Wireless serviceproviders are developing wireless technology for deployment in the UnitedStates, intending to provide a broadband substitute for traditional wirelinelocal telephones. Some companies are delivering voice communications over theInternet.

***Long DistanceService.***   The long distance communicationsindustry has numerous entities competing for the same customers which hashistorically created high churn as customers frequently change long distanceproviders in response to offerings of lower rates or promotional incentives.Prices in the long distance market have declined significantly in recent yearsand are expected to continue to decline. Our primary competitors for longdistance services are interexchange carriers, RBOCs 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 and Internet access servicetogether with a simple pricing plan.

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***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, RBOCs,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. 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.

***Business Telephone Systems Sales.***   Wecompete with numerous equipment vendors and installers and communicationsmanagement companies for business telephone systems and related services. Wegenerally offer our products at prices consistent with other providers anddifferentiate our service through our product packages and customer service.

**Employees**

As of February 28, 2006, we had 1,094 full-timeequivalent employees. Twenty-seven field service technicians are members of theInternational Brotherhood of Electrical Workers (IBEW). A new collectivebargaining agreement was signed in 2005 with the IBEW and is in effect through February 29,2008.

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

**Executive Officers**

Ourexecutive officers and directors as of December 31, 2005 are as follows:

| **Name**                    | ** ** | ** ** | ** ** | **Age** | ** ** | **Start of  Service** | ** ** | **Position(s)** | ** ** |
|-----------------------------|------------|------------|------------|---------|------------|----------------------------|------------|-----------------|------------|
| *Executive  Officers:*      |       |       |       |    |       |                       |       |            |       |   |   |
| Clifford D. Williams        |       |       | 58         |    |       |                       | 1996       |            |       | Chairman of the Board and Founder |   |
| Richard A. Smith            |       |       | 55         |    |       |                       | 1998       |            |       | Director,  President and Chief Executive Officer |   |
| Geoffrey M. Boyd            |       |       | 38         |    |       |                       | 2000       |            |       | Chief  Financial Officer |   |
| Robert E. Pickens           |       |       | 45         |    |       |                       | 1996       |            |       | Executive  Vice President, Marketing |   |
| David A. Kunde              |       |       | 46         |    |       |                       | 1999       |            |       | Executive  Vice President, Engineering   and Network Operations |   |
| Arlin B. Goldberg           |       |       | 49         |    |       |                       | 1996       |            |       | Executive  Vice President, Information Technology |   |
| J. Jeffery Oxley            |       |       | 51         |    |       |                       | 1999       |            |       | Executive  Vice President, Law and Policy |   |
| Steven K. Wachter           |       |       | 44         |    |       |                       | 1999       |            |       | Executive  Vice President, Sales |   |
| *Non-Management Directors:* |       |       |       |    |       |                       |       |            |       |   |   |
| James P. TenBroek           |       |       | 44         |    |       |                       | 2000       |            |       | Director |   |
| Marvin C. Moses             |       |       | 61         |    |       |                       | 1999       |            |       | Director |   |
| Mark E. Nunnelly            |       |       | 47         |    |       |                       | 1999       |            |       | Director |   |
| Ian K. Loring               |       |       | 39         |    |       |                       | 2001       |            |       | Director |   |
| Louis L. Massaro            |       |       | 59         |    |       |                       | 2005       |            |       | Director |   |

 

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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 telecommunications serviceproviders. Regulation varies from jurisdiction to jurisdiction, and may changein response to judicial proceedings, legislative and administrative proposals,government policies, competition, and technological developments. We cannotpredict what impact, if any, such changes or proceedings may have on ourbusiness or results of operations, and we cannot guarantee that regulatoryauthorities will not raise material issues regarding our compliance withapplicable 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 andforeign communications by wire or radio. We are regulated by the FCC as anon-dominant carrier and are subject to less comprehensive regulation thandominant carriers, but we remain subject to numerous requirements of theCommunications Act, including certain provisions of Title II, applicable to allcommon carriers, 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 RBOCs. In general, the Telecommunications Act requires RBOCs to providecompetitors with nondiscriminatory access to and interconnection with RBOCnetworks, and to provide UNEs at cost-based prices. The FCC and PUCs haveadopted rules to implement the Telecommunications Act and to encouragecompetition.

***Long DistanceCompetition.***   Section 271 of theCommunications Act, enacted as part of the Telecommunications Act, establisheda process by which an RBOC could obtain authority to provide long distanceservice in a state within its region. The process required demonstrating to theFCC that the 

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RBOC has adhered to a 14-pointcompetitive checklist and that granting such authority would be in the publicinterest. All of the RBOCs have received FCC approval to provide in-state longdistance service within their respective regions. Receipt of Section 271authority by the RBOCs has resulted in increased competition in certain marketsand services.

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 AT&Tin Nevada 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.

Under Section 272 of the Communications Act, theRBOCs are also required to provide in-region inter-LATA services throughseparate affiliates and subject to certain other safeguards. The Section 272requirements, other than the obligation not to discriminate against otherproviders requesting service, are subject to a statutory sunset three yearsafter an RBOC is authorized under Section 271 to provide in-regioninter-LATA services in a given state, unless the FCC extends the three yearperiod by rule or order. In the eight states in which we operate, the RBOC’sSection 272 requirements have sunset for AT&T in California, and forQwest in Colorado, Utah, and Washington. For Qwest, the Section 272requirements in the remainder of the states in which it operates will sunset bythe end of 2006. The sunset of Section 272 requirements could make iteasier for the RBOCs to engage in discrimination, which would adversely affectour ability to compete. In addition, if the FCC granted the RBOCs permission tocease complying with dominant carrier regulations even when they provide localand inter-LATA services on an integrated basis (that is, without structuralseparation), that also could make it harder to detect discrimination and thusadversely affect our ability to compete.

***InterconnectionAgreements.***   Pursuant to FCC rules implementingthe Telecommunications Act, we negotiate interconnection agreements with RBOCsto 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 AT&T for the statesof Nevada and California, and with Verizon for the states of Washington andOregon. If we enter new markets, we expect to establish interconnectionagreements with RBOCs 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 affectedby negotiation or arbitration is uncertain.

We are in the process of renegotiating ourinterconnection agreements with Qwest for Arizona, Colorado, Minnesota, Oregon,Utah, and Washington. We have had discussions with AT&T for Nevada andCalifornia and with Verizon for Oregon and Washington regarding renegotiationof our interconnection agreements. If any negotiation process does not produce,in a timely manner, an interconnection agreement that we find acceptable, wemay petition the applicable PUC to arbitrate any disputed issues. Arbitrationdecisions in turn may be appealed to federal courts. We cannot predict howsuccessful we will be in negotiating terms critical to our provision of localnetwork services, and we may be forced to arbitrate certain provisions ofnecessary agreements. We are not a party to any current interconnectionagreement arbitration proceeding. Other interconnection agreement arbitrationproceedings before various state commissions may result in decisions that couldaffect our business, but we cannot predict the extent of any such impact. As analternative to negotiating an interconnection agreement, we may adopt, in itsentirety, another carrier’s approved agreement.

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***Unbundled NetworkElements.***   The Telecommunications Actrequires RBOCs to provide requesting telecommunications carriers withnondiscriminatory access to network elements on an unbundled basis at anytechnically feasible point on rates, terms and conditions that are just,reasonable and non-discriminatory, in accordance with the other requirementsset forth in Sections 251 and 252 of the Telecommunications Act. TheTelecommunications Act gives the FCC authority to determine which networkelements must be made available to requesting carriers such as us. The FCC isrequired to determine whether the failure to provide access to such networkelements would impair the ability of the carrier seeking access to provide theservices it seeks to offer. Based on this standard, the FCC developed aninitial list of RBOC network elements that must be unbundled on a nationalbasis, or UNEs, in 1996.

Those initial rules were set aside by the U.S.Supreme Court and the FCC subsequently developed revised unbundling rules,which also were set aside on appeal. In August 2003, in the TriennialReview Order, or TRO, the FCC substantially modified its rules governingaccess to UNEs. The FCC redefined the “impair” standard, concluding that arequesting carrier is impaired when a lack of access to a UNE poses barriers toentry, including operational and economic barriers that are likely to makeentry into a market uneconomic. The FCC limited requesting carrier access tocertain aspects of the loop, transport, switching and signaling/databases UNEsbut continued 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 D.C. Circuit vacated certain portions of the TRO and remanded to the FCCfor further proceedings. Specifically, the D.C. Circuit vacated the FCC’sdelegation of decision-making authority to state commissions and several of theFCC’s nationwide impairment determinations. The D.C. Circuit also found thatthe FCC used a flawed methodology when making certain impairment determinations,including those relating to the mass market switching and local transportnetwork elements, and remanded those determinations to the FCC for furtheranalysis and justification. The D.C. Circuit affirmed the FCC’s decision torelieve the RBOCs from unbundling obligations with respect to broadbandelements. The D.C. Circuit did not make a formal pronouncement regarding thestatus of the FCC’s finding regarding enterprise market loops.

In December 2004, the FCC adopted 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 switching will be eliminated after a one-year transition period.During the transition, carriers will pay $1 per line more for unbundledswitching and may not order new lines. Second, DS1 transport UNEs will nolonger be available between wire centers that contain at least 38,000 businesslines or have at least four fiber-based colocators. Third, DS3 transport ordark fiber UNEs will no longer be available between wire centers containing atleast 24,000 business lines or at least three fiber-based colocators. Fourth,transport UNEs between RBOC wire centers and CLEC switches will no longer beavailable. Fifth, DS1 UNE loops will not be available to any building in a wirecenter containing at least 60,000 business lines and at least four fiber-basedcolocators. Sixth, DS3 UNE loops will not be available to any building in awire center containing at least 38,000 business lines and at least fourfiber-based colocators. Seventh, dark fiber UNE loops will no longer beavailable. The Order provides a one-year transition period for DS1 and DS3transport and loops and an 18-month transition period for dark fiberfacilities. Rates for UNEs that are no longer available will increase by 15%during the transition year, and CLECs will not be able to order additional UNEsalong routes or to buildings that no longer qualify.

We did not lease material numbers of UNE-P lines fromeither AT&T or Verizon in 2005. With respect to our UNE-P lines leased fromQwest, we have converted them to an equivalent product under a commercialagreement referred to as Qwest’s Platform Plus (“QPP”). Under QPP, we continueto have access to unbundled switching over a three-and-one-half year period atgradually increasing rates. We have 

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also entered into acommercial agreement with Verizon, referred to as the Wholesale AdvantageAgreement, under which we continue to have access to unbundled switching fromVerizon 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 *deminimis* amount of dark fiber transport, and certain of our wirecenters and routes will be affected by the TRRO. Our costs for existing UNEsaffected by the TRRO will increase an estimated 15% during the year-longtransition period provided by the TRRO. Delisted UNEs may have to be replacedwith special access, generally at prices significantly higher than UNE rates,unless we can locate alternative suppliers offering more favorable rates.

We have estimated our increased costs due to the TRROto be approximately $2.3 million in 2006. This includes the increased costs ofQPP, the increased cost of transitional UNEs, and the need to replace delistedUNEs. Our estimates are based upon assumptions concerning market demand for ourproducts and our ability to secure alternative suppliers of facilities incertain areas.

The TRRO has been appealed by RBOCs (which argue thatthe TRRO continues to require unbundled access to more network elements thanthe law permits) as well as CLECs (which argue that the FCC did not order asufficient degree of unbundling). Those appeals have been consolidated andtransferred to the U.S. Court of Appeals for the D.C. Circuit. Briefs in theconsolidated appeals have been filed and oral argument on the appeals has beenset for March 21, 2006. RBOC and CLEC parties also have filed petitionswith the FCC seeking reconsideration of the TRRO. Comments and replies havebeen filed in those proceedings. No decision by the FCC on the reconsiderationpetitions is expected until after a decision is issued by the DC Circuit on theappeals. Eschelon is a party to the appeals and reconsideration petitions thathave been filed, but cannot predict the outcome either of the appeals or thepetitions for reconsideration.

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 regarding amendments to our interconnection agreements,but we do not know when such negotiations might conclude or the impact on ourbusiness of an amendment to any of our interconnection agreements resultingfrom such negotiations, apart from the impacts discussed above.

AT&T and Verizon have taken the position that theTRRO is immediately effective, without regard to change of law provisions intheir interconnection agreements with us. Our position is that any changesresulting from the TRRO must be effected through the change of law provisionsto our interconnection agreements. Proceedings to resolve this dispute arenearing completion before the PUCs in Nevada, California and Washington. Wecannot predict the outcome of these proceedings nor their impact upon Eschelon.

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 RBOCs 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 and topography ofan RBOC’s network; and creates disincentives to 

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investment in facilitiesby understating forward-looking costs in pricing RBOC network facilities andoverstating efficiency assumptions. We have participated in this proceeding asa member of a consortium of CLECs. To date the FCC has not yet issued revisedTELRIC rules. The application and effect of a revised TELRIC pricing model onthe communications industry generally and on certain of our business activitiescannot 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, AT&T or Verizon have replaced their copper facilities with fiber orwhere they may do so in the future. Consequently, we cannot determine theimpact these orders will have upon our business. Because we serve businesscustomers only, we do not believe these orders will substantially affect ourbusiness.

On October 27, 2004, the FCC issued an ordergranting requests by the RBOCs that the FCC forbear from enforcing the independentunbundling requirements of Section 271 of the Communications Act withregard to the broadband elements that the FCC had determined in the TRO are notsubject to unbundling obligations (FTTH loops, FTTC loops, the packetizedfunctionality of hybrid loops, and packet switching). The FCC declined toaddress broader forbearance requests by AT&T and Qwest, who had asked theFCC to forbear from applying Section 271 requirements to any element thatthe FCC has determined no longer meets the impairment standard. Legalchallenges to these orders continue. Several state proceedings on this issueare ongoing. We cannot predict the outcome of these proceedings or the effectof such rulings on our business.

On September 23, 2005, the FCC released an orderthat largely deregulates “wireline broadband Internet access service.” The FCCrefers to “wireline broadband Internet access service” as a service that usesexisting or future wireline facilities of the telephone network to providesubscribers with access to the Internet, including by means of both xDSL andnext generation fiber-to-the-premises services. This decision by the FCCfollows the decision by the United States Supreme Court in the *Brand X* case, issued June 27, 2005,in which the Court held that cable systems are not legally required to leaseaccess to competing providers of Internet access service. Consistent with theFCC’s previous classification of cable modem service as an information service,the FCC’s decision in this order classifies broadband Internet access serviceas an information service because it intertwines transmission service withinformation processing and is not, therefore, a “pure” transmission servicesuch as frame relay or ATM, which remain classified as telecommunicationsservices. Under the terms of the Order, the FCC requires that existingtransmission arrangements between broadband Internet access service providersand their customers be made available for a one year period from the effectivedate of the Order. This Order does not affect CLECs’ ability to obtain UNEs,but does relieve the RBOCs of any duty to offer DSL transmission servicessubject to regulatory oversight. Internet service providers and our tradeassociation have sought judicial review of this order in the U.S. Court ofAppeals for the Third Circuit. Our QPP agreement with Qwest, which runs throughmid-2008, provides us the ability to resell Qwest’s DSL product. As aresult, we expect no immediate adverse impact from the FCC’s Wireline BroadbandOrder.

On September 16, 2005, the FCC partially grantedQwest’s petition seeking forbearance from the application of the FCC’s dominantcarrier regulation of interstate services, and Section 251(c) requirementsthroughout the Omaha MSA. The FCC granted Qwest the requested relief in nine (9) ofits twenty-four (24) Omaha central offices where it determined that competitionfrom intermodal (cable) service providers was “extensive.” Although the FCCrequired that Qwest continue to make UNEs available throughout Omaha, in the nine(9) specified central offices, Qwest may do so at non-TELRIC rates. TheFCC did not grant Qwest the requested relief regarding its colocation andinterconnection obligations. Both CLECs and Qwest have sought judicial reviewof this order in the U.S. Court of Appeals for the D.C. Circuit. We do notoperate in the Omaha MSA, and cannot predict whether 

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future such petitions willbe filed for markets in which we do operate, nor can we predict what would bethe outcome of any such petitions.

On December 20, 2004, Verizon filed a Petitionfor Forbearance from the application of the FCC’s *Computer II* and Title II requirements to Verizon’s Broadbandservice offerings. If granted, Verizon’s petition would permit it to offer DSL,ATM, Frame Relay and T-1 services on a non-common carrier basis, freefrom unbundling and TELRIC pricing requirements. Verizon’s petition also asksthat the FCC forbear from applying these requirements to broadband servicesprovided by other RBOCs. To date, the FCC has not acted on Verizon’s petition,and has extended to March 19, 2006, the deadline for action by theCommission, in the absence of which Verizon’s petition will be deemed granted. Asa practical matter, the FCC’s deregulation of RBOC DSL services as a result ofits order in the Wireline Broadband proceeding granted Verizon, and the otherRBOCs, some of the relief Verizon’s forbearance petition seeks. We cannotpredict the effect, if any, of further unbundling and pricing relief that wouldresult from the possible grant of Verizon’s petition, or whether the FCC wouldin fact extend to all RBOCs any relief it might grant to Verizon.

***Colocation.***   FCCrules generally require RBOCs 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 RBOCs 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.

***CPNI.******  ***FCCrules protect the privacy of certain information about customers thatcommunications carriers, including us, acquire in the course of providingcommunications services. Such protected information, known as CustomerProprietary Network Information, or CPNI, includes information related to thequantity, technological configuration, type, destination and the amount of useof a communications service. The FCC’s initial CPNI rules initiallyprevented a carrier from using CPNI to market certain services without theexpress approval of the affected customer, referred to as an opt-in approach.In July 2002, the FCC revised its opt-in rules in a manner thatlimits our ability to use the CPNI of our subscribers without first engaging inextensive customer service processes and record keeping. We use oursubscribers’ CPNI in accordance with applicable regulatory requirements.However, if a federal or state regulatory body determines that we haveimplemented those guidelines incorrectly, we could be subject to fines orpenalties. In addition, correcting our internal customer systems and CPNIprocesses could generate significant administrative expenses.

On January 30, 2006, the FCC released a publicnotice requiring all telecommunications carriers, including wireline andwireless carriers, to submit a compliance certificate regarding maintenance ofinternal records related to the FCC’s customer proprietary network information(CPNI) rules. Coincident with the issuance of its public notice, the FCCannounced that it had begun enforcement proceedings against carriers thatallegedly failed to comply with the FCC’s CPNI rules. To date, we are unawareof any material noncompliance on our part with the FCC’s CPNI rules, or ourrecord-keeping and reporting, and have received no notice of any enforcementproceeding directed at us. We cannot predict the outcome of any enforcementproceeding in this regard, or its effect on our business.

On February 14, 2006, the FCC released a Noticeof Proposed Rulemaking seeking comment on possible modifications to its CPNIrules. New CPNI requirements could impose additional administrative burdens andcosts on us. We cannot predict the outcome of the FCC’s ongoing review of itsCPNI rules.

***IntercarrierCompensation.***   The FCC’s intercarriercompensation rules include rules governing access charges, whichgovern the payments that IXCs and commercial mobile radio service providersmake to local exchange carriers to originate and terminate long distance calls,and reciprocal compensation rules, which generally govern the compensationbetween telecommunications carriers for the transport and termination of localtraffic. We purchase long distance service on a wholesale basis from an IXC whopays 

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access fees to localexchange carriers 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 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 have appealedthe CLEC Access Charge Order to the D.C. Circuit, arguing that the FCC’sbenchmark rates are too high.

Over the last several years, the FCC has granted RBOCssignificant flexibility in pricing interstate special and switched accessservices. In August 1999, the FCC granted immediate pricing flexibility tomany RBOCs and established a framework for granting greater flexibility in thepricing of all interstate access services once an RBOC 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 RBOCs 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. Because we both make payments to and receive paymentsfrom other carriers for the exchange of local and long distance calls, we willbe affected by changes in the FCC’s intercarrier compensation rules. We cannotpredict the impact that any such changes 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 torely on individually negotiated agreements with end users. We remain subject tothe Communications Act’s requirements that rates, terms and conditions ofcommunications service be just, reasonable, and not discriminatory, and we aresubject to the FCC’s jurisdiction over customer complaints regarding ourcommunications services.

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***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 several programs administered by the Universal ServiceAdministrative Company with oversight from the FCC, including: (i) communicationsand information services for schools and libraries, (ii) communicationsand information services for rural health care providers, (iii) basictelephone service in regions characterized by high communications costs, (iv) basictelephone services for low-income consumers, and (v) interstate accesssupport. Based on the total funding needs for these programs, the FCCdetermines a contribution factor, which it applies to each contributor’sinterstate and international end user communications revenues. We measure andreport our revenues in accordance with rules adopted by the FCC. Thecontribution rate factors are calculated and revised quarterly and we arebilled for our contribution requirements each month based on projectedinterstate and international end-user communications revenues, subject toperiodic true up.

USF contributions may bepassed through to consumers on an equitable and nondiscriminatory basis eitheras a component of the rate charged for communications services or as aseparately invoiced line item. Since April 1, 2003, communicationscarriers have been prohibited from using a separate line item on invoices toidentify as a recovery of USF contributions amounts that exceed the rate ofactual USF contributions.

A proceeding pendingbefore the FCC has the potential to significantly alter our USF contributionobligations. The FCC is considering changing the basis upon which our USFcontributions are determined from a revenue percentage measurement to aconnection or telephone number measurement. Adoption of this proposal couldhave a material adverse affect on our costs, our ability to separately list USFcontributions on end-user bills, and our ability to collect these fees from ourcustomers.

The application and effectof changes to the USF contribution requirements and similar state requirementson the communications industry generally and on certain of our businessactivities cannot be predicted. If our collection procedures result in overcollection, we could be required to make reimbursements of such over collectionand be subject to penalty, which could have a material adverse affect on ourbusiness, financial condition and results of operations. If a federal or stateregulatory body determines that we have incorrectly calculated or remitted anyUSF contribution, we could be subject to the assessment and collection of pastdue remittances as well as interest and penalties thereon.

***Telephone Numbering.***   TheFCC oversees the administration and the assignment of local telephone numbers,an important asset to voice carriers, by NeuStar, Inc., in its capacity asNorth American Numbering Plan Administrator. Extensive FCC regulations governtelephone numbering, area code designation, and dialing procedures. Since 1996,the FCC has permitted businesses and residential customers to retain theirtelephone numbers when changing local telephone companies, referred to as localnumber portability. The availability of number portability is important tocompetitive carriers like us, because customers, especially businesses, may beless likely to switch to a competitive carrier if they cannot retain theirexisting telephone numbers.

***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 changes inadvertentlymay be processed without 

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authorization.Therefore, we cannot guarantee that we will not be subject to slammingcomplaints in the future.

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

In August 2005, theFCC extended CALEA obligations to facilities-based providers of broadbandInternet access service and to interconnected VoIP services. As a broadbandInternet access provider, we will be subject to these new requirements oncethey take effect. The current compliance deadline is set for April 2007,although the FCC is considering requests from industry participants to grantadditional time. Several parties have appealed the FCC’s order extending newrequirements in the U.S. Court of Appeals for the D.C. Circuit. Unless thedecision is overturned on appeal, we could face increased compliance costs,which are uncertain in nature because the specific assistance-capabilityrequirements for providers of broadband Internet access service have not yetbeen established.

***Regulation of Internet Service Providers and VoIP.******  ***To date, theFCC has treated Internet service providers, or ISPs, as enhanced serviceproviders, which are generally exempt from federal and state regulationsgoverning common carriers. Nevertheless, regulations governing the disclosureof confidential communications, copyright, excise tax and other requirementsmay apply to our Internet access services. In addition, the FCC released aNotice of Proposed Rulemaking in September 2005 seeking comment on a broadarray of consumer protection regulations for broadband Internet access services,including rules regarding the protection of CPNI, slamming, truth inbilling, network outage reporting, service discontinuance notices, andrate-averaging requirements. We cannot predict whether the FCC will adopt new rules regulatingbroadband Internet access services and, if it does so, how such rules wouldaffect us, except that new obligations could increase the costs of providingDSL service.

Moreover, Congress haspassed a number of laws that concern the Internet and Internet users.Generally, these laws limit the potential liability of ISPs and hostingcompanies that do not knowingly engage in unlawful activity. We expect thatCongress will consider this year a variety of bills, some of which, if signedinto law, could impose obligations on us to monitor the Internet activities ofour customers.

The use of the publicInternet and private Internet protocol networks to provide voice communicationsservices, including voice-over-Internet protocol, or VoIP, is a relativelyrecent market development. The provision of such services until recently waslargely unregulated within the United States. To date, the FCC has not imposedregulatory surcharges or most forms of traditional common carrier regulationupon providers of Internet communications services. But the FCC has imposedobligations on providers of two-way interconnected VoIP services to provideE911 service, and it has extended CALEA obligations to such VoIP providers. Bothdecisions have been appealed in the U.S. Court of Appeals for the D.C. Circuit,although the E911 regulations have already taken effect. To the extent that wechoose to provide interconnected VoIP services, we will bear costs as a resultof these mandates.

Several additional pendingFCC proceedings will affect the regulatory status of Internet telephony. On February 12,2004, the FCC adopted a notice of proposed rulemaking to address, in acomprehensive manner, the future regulation of services and applications makinguse of Internet protocol, including VoIP. In the absence of federallegislation, we expect that through this proceeding the FCC will resolvecertain 

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regulatoryissues relating to VoIP services and develop a regulatory framework that isunique to IP telephony providers or that subjects VoIP providers to minimal regulatoryrequirements. We cannot predict when, or if, the FCC may take such actions. TheFCC may determine that certain types of Internet telephony should be regulatedlike basic interstate communications services, rendering VoIP calls subject tothe access 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 decisionsissued in 2004, the FCC clarified that the FCC, not the state PUCs, hasjurisdiction to decide the regulatory status of IP-enabled services, includingVoIP. Most recently, on November 12, 2004, in response to a request byVonage Holdings Corp. (Vonage), a VoIP services provider, the FCC issued anorder preempting traditional telephone company regulation of VoIP service bythe Minnesota PUC, finding that the service cannot be separated into interstateand intrastate communications without negating federal rules and policies.In September 2003, the Minnesota PUC issued an order requiring Vonage tocomply with Minnesota laws that regulate telephone companies. That order wasappealed to the U.S. District Court for the District of Minnesota, whichenjoined enforcement of the order pending action by the FCC on Vonage’s requestfor preemption. Earlier this year, the U.S. Court of Appeals for the EighthCircuit upheld the injunction, and that court also is reviewing the merits ofthe FCC order that preempted the Minnesota PUC’s regulations as applied to VoIPproviders.

On October 18, 2002,AT&T filed a petition with the FCC seeking a declaratory ruling that wouldprevent RBOCs from imposing traditional circuit-switched access charges onphone-to-phone IP services. In April 2004, the FCC issued an order concludingthat, under current 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 thenconverts the call back from the IP format and delivers it to the called partythrough local exchange carrier local business lines. This decision is thuslimited to interexchange service that: (1) uses ordinary customer premisesequipment with no enhanced functionality; (2) originates and terminates onthe public 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.

Other aspects of VoIP andInternet telephony services, such as regulations relating to theconfidentiality of data and communications, copyright issues, taxation ofservices, and licensing, may be subject to federal or state regulation.Similarly, changes in the legal and regulatory environment relating to theInternet connectivity market, including regulatory changes that affectcommunications costs or that may increase the likelihood of competition fromRBOCs or other communications companies could increase our costs of providingservice.

***Taxes and Regulatory Fees.***   Weare subject to numerous local, state and federal taxes and regulatory fees,including but not limited to a three percent federal excise tax oncommunications service, FCC regulatory fees and public utility commissionregulatory fees. We have procedures in place to ensure that we properly collecttaxes and fees from our customers and remit such taxes and fees to theappropriate entity pursuant to applicable law and/or regulation. If ourcollection procedures prove to be insufficient or if a taxing or regulatoryauthority determines that our remittances were inadequate, we could be requiredto make additional payments, which could have a material adverse effect on ourbusiness.

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***Legislation.******  ***Congress isconsidering various measures that would overhaul telecom laws in the UnitedStates. Bills introduced in the House of Representatives and the Senate addressa wide variety of issues, including the regulation of broadband and VoIPservices, network neutrality requirements, video franchising procedures, andmunicipal broadband services, among others. The prospects and timing of anypotential legislation remain unclear, and as such, we cannot predict theoutcome of any such legislation upon our business.

***RBOC-IXC Mergers.****  *On October 31, 2005, the FCCunanimously approved orders clearing the SBC-AT&T and Verizon-MCI mergerswith relatively limited conditions in certain areas, including minimaldivestitures and no reduction in special access rates. Although the Departmentof Justice, in its consent decrees approving the mergers concluded that themergers would reduce competition in certain markets for special access,primarily for business customers, it concluded that there was no basis forimposing remedies in the mass market or Internet backbone market, and furtherconcluded there was no problem in the overall structure of the resulting marketthat would justify imposing restrictions on the companies’ dealings with eachother. Rather than requiring them to divest lines and other facilities,however, it opted instead for the lighter remedy of requiring them to sell ordivest, at market rates, ten-year leases for loops into certain buildings alongwith leases for dark fiber transport necessary to connect the loops to the facilityof the purchaser of the lease. The end result is that Verizon must sell darkfiber leases to 350 buildings and SBC to 383 buildings. The FCC’s conditionstook the form of voluntary conditions offered by the merging parties, asfollows: 1) SBC and Verizon agreed to freeze certain high-capacity specialaccess rates for existing in-region AT&T and MCI customers for 30 months,and to refrain from providing themselves, their affiliates, or each other withspecial access services not generally available to other competitors. AsEschelon’s reliance on special access is minimal, we do not expect theseconditions to affect us positively or negatively. In addition, as ouroperations in the Verizon and SBC regions are minimal, we do not expect to seea significant impact as a result of the UNE rate freezes they each agreed tofor a two year period from the merger closing date. On the closing of themerger, SBC renamed itself AT&T.

In March 2006,AT&T and Bell South announced they had reached an agreement to merge. Thistransaction will be subject to significant review by the FCC and the Departmentof Justice as well as by many state PUCs. We cannot predict whether the mergerwill be approved, and if so, what conditions may be placed upon the parties. Consequently,we cannot predict the effect of the merger upon our business.

**State Regulation**

The Communications Actmaintains the authority of individual states to impose their own regulation ofrates, terms and conditions of intrastate services, so long as such regulationis not inconsistent with the requirements of federal law or has not beenpreempted. Because we provide communications services that originate andterminate within individual states, including both local service and in-statelong distance toll calls, we are subject to the jurisdiction of the PUC andother regulators in each state in which we provide such services. For instance,we must obtain a Certificate of Public Convenience and Necessity, or CPCN, orsimilar authorization before we may commence the provision of communicationsservices in a state. We have obtained CPCNs to provide facilities-based orresold competitive local and interexchange service in California, Arizona,Colorado, Idaho, Minnesota, Nevada, New Mexico, New York, Oregon, Utah andWashington. There can be no guarantee that we will receive authorizations wemay seek in other states in the future. As our local service business expands,we may offer additional intrastate services and may become subject toadditional state regulations.

In addition to requiringcertification, state regulatory authorities may impose tariff and filingrequirements and obligations to contribute to state universal service and otherfunds. State commissions also have jurisdiction to approve negotiated rates,and to establish rates through arbitration, for 

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interconnection,including rates for UNEs. Changes in rates for UNEs could have a materialadverse effect on our business.

We also are subject tostate laws and regulations regarding slamming, cramming, and other consumerprotection and disclosure regulations. These rules could substantiallyincrease the cost of doing business in any particular state. State commissionshave issued or proposed substantial fines against CLECs for slamming orcramming. The risk of financial damage, in the form of fines, penalties andlegal fees and costs and to business reputation from slamming is significant. Aslamming complaint before a state commission could generate substantiallitigation expenses. In addition, state law enforcement authorities may usetheir consumer protection authority against us if we fail to meet applicablestate law requirements.

States also retain theright to sanction a service provider or to revoke certification if a serviceprovider violates relevant laws or regulations. If any regulatory agency wereto conclude that we are or were providing intrastate services without theappropriate authority, the agency could initiate enforcement actions, whichcould include the imposition of fines, a requirement to disgorge revenues, orrefusal to grant regulatory authority necessary for the future provision ofintrastate services.

We may be subject torequirements in some states to obtain prior approval for, or notify the statecommission of, any transfers of control, sales of assets, corporatereorganizations, issuance of stock or debt instruments and relatedtransactions. Although we believe such authorizations could be obtained in duecourse, there can be no assurance that state commissions would grant usauthority to complete any of these transactions, or that such authority wouldbe granted on a timely basis.

Rates for intrastateswitched access services, which we provide to long-distance companies tooriginate and terminate in-state toll calls, are subject to the jurisdiction ofthe state in which the call originated and/or terminated. Such regulation bystates could have a material adverse affect on our revenues and businessopportunities within that state. PUCs also regulate the rates RBOCs charge forinterconnection, access to network elements, and resale of services bycompetitors. In response to the USTA II decision and the FCC’s ongoing TROproceedings, some state commissions have continued proceedings to addressissues affecting the rates, terms and conditions of intrastate services whileother states suspended or terminated their proceedings. The states of Colorado,Minnesota and Arizona may initiate cost cases to reprice UNEs and to establishrates for wholesale services that are no longer required to be provided as UNEsunder the FCC’s TRRO orders. Any such proceedings may affect the rates, terms,and conditions contained in our interconnection agreements or in otherwholesale agreements with RBOCs. We cannot predict the outcome of theseproceedings. The pricing, terms and conditions under which the RBOC in each ofthe states in which we currently operate offers such services may preclude orreduce our ability to offer a competitively viable and profitable productwithin these and other states on a going forward basis.

State regulators establishand enforce wholesale service quality standards that RBOCs must meet inproviding network elements to CLECs like Eschelon. These plans sometimesrequire payments from the RBOCs to the CLECs if quality standards are not met. In2005, the Minnesota Supreme Court ruled that the Minnesota Commission had theauthority to establish wholesale service quality standards but that it did nothave the legal authority to impose requirements that Qwest make payments toCLECs for Qwest’s failure to comply with those standards. This decision leavesthe only payments in Minnesota from Qwest to CLECs for poor wholesale servicequality those payments due under Qwest’s Minnesota PAP. The Minnesota PAPpayments to Eschelon are less than they would have been under the MinnesotaCommission’s plan. Qwest accordingly has less financial incentive to providegood wholesale service and the service quality we experience in Minnesota coulddecline. Qwest and other RBOCs are asking various other state commissions wherewe operate to modify the state wholesale quality plans in ways that wouldreduce or eliminate certain wholesale quality standards. The ColoradoCommission has recently changed Qwest’s performance standards in that state anda proceeding has recently commenced in Nevada to change AT&T’s performancestandards. Changes in performance standards could result in reduced 

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paymentsand a diminution of the service quality we receive. We cannot predict how statecommissions will respond to such requests, nor the ultimate impact of suchdecisions on the Company.

State governments andregulators may attempt to assert jurisdiction over the provision of intrastateIP communications services. Various state regulatory authorities already haveinitiated proceedings to examine the regulatory status of Internet telephonyservices. While most PUCs have not indicated an intention to impose traditionalcommunications regulatory requirements on IP telephony, some PUCs have issuedrulings that may be interpreted differently. For instance, a state court inColorado has ruled that the use of the Internet to provide certain intrastateservices does not exempt an entity from paying intrastate access charges. Priorto imposing regulatory burdens on VoIP providers, however, the Colorado PUCopened a docket to investigate whether it has jurisdiction to regulate VoIPservices. Any such state proceedings will be affected by the FCC’s IP-EnabledServices rulemaking proceeding, in which the FCC is considering the extent towhich conflicting state regulation of IP telephony is preempted.

State legislatures andstate PUCs also regulate, to varying degrees, the terms and conditions uponwhich our competitors conduct their retail businesses. In general, stateregulation of RBOC retail offerings is greater than the level of regulationapplicable to CLECs. Qwest, AT&T and Verizon either have obtained or areactively seeking some level of increased pricing flexibility or deregulation,either through amendment of state law or through proceedings before state PUCs.Such increased pricing flexibility could have an adverse effect on ourcompetitive position in those states because it could allow the RBOCs to reduceretail rates to customers while wholesale rates that we pay to Qwest stay thesame or increase. We cannot predict whether these efforts will materiallyaffect 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 localjurisdictions will not impose similar fees.

**Other DomesticRegulation**

We are subject to avariety of federal, state, and local environmental, safety and health laws, andregulations governing matters such as the generation, storage, handling, use,and transportation of hazardous materials, the emission and discharge ofhazardous materials into the atmosphere, the emission of electromagneticradiation, the protection of wetlands, historic sites, and endangered speciesand the health and safety of employees. We also may be subject to lawsrequiring the investigation and cleanup of contamination at sites it owns oroperates or at third-party waste disposal sites. Such laws often imposeliability even if the owner or operator did not know of, or was not responsiblefor, 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.

**AvailableInformation**

Copies of our AnnualReports on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K, and amendments to those reports filedor furnished to the Securities Exchange Commission pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934 are available free of chargethrough our website (www.eschelon.com) as soon as reasonably practicable afterwe electronically file the material with, or furnish it to, the SecuritiesExchange Commission.

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**Item 1A.**                RiskFactors.

**Risks Related to Our Industry**

***The communicationsindustry is subject to government regulation, and changes in current or futureregulations could have a material adverse effect on our business, operatingresults and financial condition and restrict the manner in which we operate ourbusiness.***   We are subject to varying degrees offederal, state and local regulation. Pursuant to the Communications Act, asamended, or the Telecommunications Act, the FCC exercises jurisdiction over uswith respect to interstate and international services. We must comply withvarious federal regulations, such as the duty to contribute to universalservice and other subsidies. Failure to comply with federal reporting andregulatory requirements may result in fines or other penalties, including lossof authority to provide services.

The FCC’s recent Triennial Review Order, or TRO, andits Triennial Review Remand Order, or TRRO, has reduced our ability to obtainunbundled network elements, or UNEs, and certain combinations of UNEs inseveral ways and have affected our operations. We may no longer purchase theunbundled network element platform, or UNE-P, for new customers and all UNE-Paccess terminates in March 2006. Because of this, we entered into acommercial agreement with Qwest and Verizon to purchase substitute UNE-Pproducts at higher rates and have converted all of our UNE-P lines to these newproducts. We may also no longer be able to purchase DS1 UNE loops in four wirecenters in the Qwest territory. In addition, we have only limited or no accessto DS1 and DS3 transport on certain interoffice routes. Finally, we cannotpurchase UNE transport between our switches and Qwest switches. In theseinstances where we lose access to UNEs, we must either find alternativesuppliers or purchase substitute circuits from the RBOC as special access,which would increase our costs.

State regulatory commissions also exercisejurisdiction over us to the extent we provide intrastate services. We arerequired to obtain regulatory authorization and/or file tariffs with regulatorsin all of the states in which we operate. We have obtained the necessarycertifications to provide service, but each commission retains the authority torevoke our certificate if that commission determines we have violated anycondition of our certification or if it finds that doing so would be in thepublic interest. While we believe we are in compliance with regulatoryrequirements, our interpretation of our obligations may differ from those ofregulatory authorities.

Both federal and state regulators require us to payvarious fees and assessments, file periodic reports and comply with various rules regardingthe contents of our bills, protection of subscriber privacy, service qualityand similar consumer protection matters on an ongoing basis. If we fail tocomply with these requirements, we may be subject to fines or potentially beasked to show cause as to why our certificate of authority to provide serviceshould not be revoked.

***The communications market in which we operate ishighly competitive, and we may not be able to compete effectively againstcompanies that have significantly greater resources than we do, which couldcause us to lose customers and impede our ability to attract new customers.***   The communications industry ishighly competitive and is affected by the introduction of new services andsystems by, and the market activities of, major industry participants. In eachof our markets we compete principally with the RBOC serving that area. Therecent mergers of SBC with AT&T and MCI, Inc. with Verizon may causethese risks to intensify. We have not achieved, and do not expect to achieve, amajor share of the local access lines for any of the communications servicesand systems we offer. Current and potential large competitors in each markethave the following advantages over us:

·       long-standingrelationships and strong reputation with customers;

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

·       morefunds to deploy communications services and systems that compete with ours;

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·       largernetworks; and

·       benefitsfrom existing regulations that favor the RBOCs.

We also face, and expect to continue to face,competition in our markets from other current and potential market entrants,including other competitive communications services providers, competitivelocal carriers, wireless carriers, resellers, competitive access providers,cable television companies, electric utility companies, microwave carriers andprivate networks built by large end users. Increasingly, we are subject tocompetition in the Internet services market from communications companies,online service providers, cable companies and Internet telephone and otherIP-based service providers, such as 8 x 8, Inc., Net2Phone, Inc.,pulver.com, Inc. and Vonage Holdings Corp. The Internet services providersare currently subject to substantially less regulation than competitive andtraditional local telephone companies and are exempt from a number of taxes andregulatory charges that we are required to pay. In addition, the development ofnew technologies could give rise to significant new competitors in the localmarket.

In the long distance communications market, we facecompetition from large carriers such as AT&T, Verizon and Sprint, theRBOCs, wireless carriers, many smaller long distance carriers and IP-basedservice providers. Long distance prices have decreased substantially in recentyears and are expected to continue to decline in the future as a result ofincreased competition. If this trend continues, we anticipate that revenue fromour network services and other service offerings will likely be subject tosignificant price pressure, which could have a material adverse effect on ourbusiness, results of operations and financial condition.

***Changes in currentor future regulations in the local and long distance industries may hurt ourbusiness and results of operations and restrict the manner in which we operateour business.***   If current or future regulationschange, we cannot assure you that the FCC or state regulators will grant us anyrequired regulatory authorization or refrain from taking action against us ifwe are found to have provided services without obtaining the necessaryauthorizations, or to have violated other requirements of their rules andorders. Delays in receiving required regulatory approvals or the enactment ofnew adverse regulation or regulatory requirements may slow our growth and havea material adverse effect upon our business, results of operations andfinancial condition. We cannot assure you that changes in current or futureregulations adopted by the FCC or state regulators, or other legislative,administrative or judicial initiatives relating to the communications industry,would not be less favorable to competitive communications services providersand more favorable to RBOCs and thus have a material adverse effect on ourbusiness, results of operations and financial condition.

***The communicationsindustry faces significant regulatory uncertainties and the resolution of theseuncertainties could hurt our business, results of operations and financialcondition.***   TheTelecommunications Act requires, among other things, that RBOCs provide accessto their networks to us; however, this act remains subject to judicial reviewand ongoing proceedings before the FCC and state regulators, includingproceedings relating to interconnection pricing, access to and pricing forunbundled network elements and other issues that could result in significantchanges to our business and business conditions in the communications industrygenerally. We must lease unbundled network elements from RBOCs at cost-basedrates to serve our customers and to connect our telecommunications equipment. Weprovide our customers with telecommunications services through telephone linesor “loops” we lease from RBOCs. We pay RBOCs to maintain and repair these loops.We also purchase other unbundled network elements from RBOCs, such as transportbetween RBOC switches. Recent decisions by the FCC have eliminated or reducedour access to some unbundled network elements and increased the rates that wepay for such elements. This has required us to enter into commercial agreementswith the RBOCs to obtain the elements at increased prices. Our business wouldbe substantially impaired if the FCC, the courts, state commissions or theCongress eliminated our access to these elements or substantially increased therates at 

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which we pay for access. TheTRRO, the most recent FCC order governing our access to network elements, isbeing appealed and judicial review could result in significant changes to theorder. Other proceedings are underway that could potentially further limit ouraccess to UNEs. The FCC has initiated a proceeding that may result inincreasing the rates we pay for network elements. A number of states also haveproceedings and legislative proposals pending to re-examine and possiblyincrease our network element rates. In addition, several important federallegislators have announced their intention to substantially revise theCommunications Act. We cannot predict the outcome of these proceedings or theeffects, if any, that these proposals may have on our business and operations. Abrief summary of legal and regulatory developments is discussed in more detailin the section entitled “Regulation.”

***The financial difficulties faced by others in ourindustry could adversely affect our public image and our financial results.******  ***Manycompetitive communications services providers, long distance carriers and othercommunications providers have experienced substantial financial difficultiesover the past few years. To the extent that carriers in financial difficultiespurchase access services from us, we may not be paid in full or at all forservices we have rendered. Further, the perception of instability of companiesin our industry may diminish our ability to obtain further capital and mayadversely affect the willingness of potential customers to purchase theircommunications services from us.

**Risks Related to Acquisitions**

***We may not be ableto successfully integrate acquired companies into our business.***   During2005, we completed the acquisition of ATI, which closed on December 31,2004. While we believe that this acquisition was successfully integrated intothe legacy Eschelon operation, there can be no assurance that we will be ableto integrate and consolidate subsequent acquisitions into our ongoing businessand operations according to management’s plan. As noted in Item 1. Business,Eschelon announced the signing of a definitive agreement to purchase OTI on January 27,2006. While we believe that we have sufficient financial and managementresources to complete the integration of OTI, there can be no assurance in thisregard or that we will not experience difficulties with customers, personnel orothers resulting from the integration. This process will require management,financial and other resources and may pose risks with respect to production,customer service and market share. It may also require regulatory approvals forsome aspects which we cannot assure will be obtained. In addition, although webelieve that the OTI acquisition will enhance our competitive position andbusiness prospects, there can be no assurance that such benefits will be fullyrealized or that the integration of OTI into our business and operations willultimately be successful.

As we adapt to the current telecom environment andbegin to integrate OTI, we may be required to make operational changes,including consolidating certain operations, closing certain facilities, oramending or terminating existing contractual relationships, in order to improveour future profitability. However, there can be no assurance as to the costrequired to effect those operational changes, their effectiveness, or thetiming or amount of any cost savings that are actually realized as a result ofsuch changes. Management is continuing to assess our overall organization andcost structures and may, as a result of this ongoing process, develop futureinitiatives to increase operating and administrative efficiency and enhanceprofitability. If we are unable to effectively and efficiently integrate OTIinto our business and operations, our business, financial condition, results ofoperations and cash flows may suffer.

We will continue to look for opportunities that fitour acquisition filters, in terms of price, services and footprint. There canbe no assurance that future acquisitions will be successfully integrated orwill not result in significant disruption to on-going operations.

If we acquireanother business, we may face difficulties, including:

·       integratingthat business’ personnel, services, products or technologies into ouroperations;

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·       retainingkey personnel of the acquired business;

·       failingto adequately identify or assess liabilities of that business;

·       failureof that business to achieve the forecasts we used to determine the purchaseprice; and

·       divertingour management’s attention from the normal daily operation of our business.

These difficulties could disrupt our ongoing businessand increase our expenses.

Inaddition, our ability to complete acquisitions will depend, in part, on ourability to finance the acquisitions, including the costs of acquisition andintegration. Our ability may be constrained by our cash flow, the level of ourindebtedness at the time, restrictive covenants in the agreements governing ourindebtedness, conditions in the securities markets and other factors, many ofwhich are not within our control. If we proceed with one or more acquisitionsin which the consideration consists of cash, we may use a substantial portionof our available cash to complete the acquisitions. If we finance one or moreacquisitions with the proceeds of indebtedness, our interest expense and debtservice requirements could increase materially. The financial impact ofacquisitions could materially affect our business and could cause substantialfluctuations in our quarterly and yearly operating results.

**Risks Related to Our Business**

***We have a historyof operating losses, and we may not be profitable in the future.******  ***We haveincurred significant operating and net losses in the past and expect tocontinue to incur losses in the future. For the year ended December 31,2003, we had an operating loss of $16.1 million, a net loss of$17.2 million and an accumulated deficit of $125.2 million. For theyear ended December 31, 2004, we had an operating loss of $5.6 million,net income of $1.1 million and an accumulated deficit of $124.1 million. Thenet income for the year ended December 31, 2004 was primarily the resultof a gain on extinguishment of debt of $18.2 million. For the year ended December 31,2005, we had an operating loss of $4.3 million, a net loss of $31.0 million andan accumulated deficit of $155.0 million. We cannot assure you that ourrevenues will continue to grow or that we will achieve profitability in thefuture.

***If the RBOCs withwhom we have interconnection agreements engage in anticompetitive practices,our business will be adversely affected.***   Ourbusiness depends on our ability to interconnect with RBOC networks and to leasefrom them certain essential network elements. We obtain access to these networkelements and services under terms established in interconnection agreementsthat we have entered into with Qwest, AT&T and Verizon. Like manycompetitive communications services providers, from time to time, we haveexperienced difficulties in working with the RBOCs with respect to obtaininginformation about network facilities, ordering network elements and services,interconnecting with RBOC networks and settling financial disputes. Thesedifficulties can impair our ability to provide local service to customers on atimely and competitive basis. The Telecommunications Act of 1996, or theTelecommunications Act, required RBOCs to cooperate with competitivecommunication services providers and meet statutory requirements for openingtheir local markets to competition before they could receive permission toprovide in-region long distance services. Now that each RBOC has met thoserequirements and received authorization to provide long distance servicesthroughout its respective operating region, it may have less incentive toproperly maintain the information, ordering and interconnection interfaces thatwe rely on and may otherwise fail to cooperate with us regarding serviceprovisioning issues.

The RBOCs, including Qwest, AT&T and Verizon, havebeen fined by or have agreed to make voluntary payments in connection withconsent decrees to both federal and state authorities for their failure tocomply with the laws and regulations that support local competition. We believethese fines and payments may not substantially reduce the use ofanticompetitive practices and illegal and anticompetitive activity may continueto occur in most of our markets. While we consistently undertake legal actionsto oppose these anticompetitive actions and enforce our legal right of accessto RBOC facilities, regulatory 

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and judicial remediesfrequently do not preclude further anticompetitive behavior and rarelycompensate us for our damages and legal expenses. If an RBOC refuses tocooperate or otherwise fails to support our business needs in retaliation forour efforts to enforce our legal rights or for any other reason, includinglabor shortages, work stoppages, cost-cutting initiatives or disruption causedby mergers, other organizational changes or terrorist attacks, our ability tooffer services on a timely and cost-effective basis will be materially andadversely affected.

***Our ability toprovide our services and systems at competitive prices is dependent on ourability to negotiate and enforce favorable interconnection agreements.***   Ourability to continue to obtain favorable interconnection, unbundling, serviceprovisioning and pricing terms, and the time and expense involved in negotiatinginterconnection agreements and amendments, can be adversely affected by ongoinglegal and regulatory activity. All of our existing interconnection agreementsprovide either that a party is entitled to demand renegotiation of particularprovisions or of the entire agreement based on intervening changes in lawresulting from ongoing legal and regulatory activity, or that a change of lawis immediately effective in the agreement and set out a dispute resolutionprocess if the parties do not agree upon the change of law. The initial termsof all of our interconnection agreements with the RBOCs have expired; however,each agreement with Qwest and AT&T contains an “evergreen” provision thatallows the agreement to continue in effect until a new agreement is in place. OurVerizon agreements are subject to termination on 60 day’s notice. If we were toreceive a termination notice from Verizon, we could initiate an arbitrationproceeding at the relevant state commission before the expiration of the noticeperiod and our existing agreement would remain in effect until the commissionapproved a new agreement. We are in the process of renegotiating the terms ofour interconnection agreements with Qwest, AT&T and Verizon. We cannotassure you that we will be able to successfully renegotiate the agreements onterms favorable to us. In addition to negotiation and arbitration, the Actgives us the right to opt into any other carrier’s interconnection agreement,provided the agreement is still in effect and provided that we adopt the entireagreement. Any limitation on our ability to colocate telecommunicationsequipment in RBOC central offices, or on the terms and conditions forinterconnecting our network to the RBOCs’ networks, or on the availability ofunbundled network elements, especially unbundled local loops or interofficetransmission facilities, resulting from our failure to negotiate favorableinterconnection agreements or resulting from federal or state regulatoryactivity, could increase our costs and otherwise have a material adverse impacton our business, results of operations and financial condition.

The FCC has granted Qwest, AT&T, and Verizonsignificant flexibility in pricing interstate special access services. Thispricing flexibility may result in RBOCs raising their prices. To the extent weare forced to purchase special access circuits because equivalent facilitiesare no longer available at cost-based rates as unbundled network elements underour interconnection agreements, our costs may significantly increase. Weprovide a more detailed discussion of current legal and regulatory developmentsaffecting access charges and intercarrier compensation issues in the sectionentitled “Regulation.”

***The regulation ofaccess charges involves uncertainties, and the resolution of theseuncertainties could adversely affect our business, results of operations andfinancial condition.***   As a facilities-basedcompetitive communications services provider, we earn access charges byconnecting our voice services customers with long distance carriers such asAT&T, Verizon and Sprint Corp. When a network service voice customer ofours originates or receives a long distance call, we are entitled tocompensation from these carriers for the cost we incur in originating orterminating the long distance call. In 2005, access charges accounted for $13.3million, or 5.8% of our total revenue. We have tariffs filed with the FCC forinterstate access services and with most states where we provide intrastateaccess services. Our rates can be higher than those charged by some largerlocal exchange carriers that have many more customers and, consequently, lowerper-unit costs. In the past, we have experienced difficulty in collectingaccess fees due to us from some carriers. We cannot guarantee that we will beable to successfully resolve future rate disputes with all carriers. Futureregulatory proceedings, both at the FCC and in individual states where weoperate, could 

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result in decreasing ouraccess charges. Such reductions could have a material adverse effect on ourbusiness, results of operations and financial condition.

The FCC has commenced a proceeding to revise itscompensation rules regarding carrier access charges. Because we receivepayments from long distance carriers for the calls their customers make thataccess our network facilities, we will be affected by any changes to the FCC’scompensation rules. We cannot predict the impact that any such changes wouldhave on our business.

***Difficulties we mayexperience with the RBOCs and long distance providers over payment issues mayhurt our financial performance.***   Wehave experienced difficulties with receiving payments due to us for servicesthat we provide to RBOCs and long distance service providers. These balancesdue to us can be material. We generally have been able to reach mutuallyacceptable settlements to collect overdue and disputed payments, but we cannotassure you that we will be able to do so in the future. If we are unable tocontinue to timely receive payments and to create settlement agreements withother carriers, our business, results of operations and financial condition maybe materially adversely affected. In addition, certain of our interconnectionagreements allow the RBOCs to decrease order processing, disconnect customersand increase our security deposit obligations for delinquent payments. Forexample, interconnection agreement provisions required by Qwest provide that,in addition to late payment charges, Qwest may discontinue order processing ifwe fail to pay within 30 days of the payment due date, disconnect customers ifwe fail to pay within 60 days after the payment due date, and require a depositif we pay late three times during a 12 month period. The deposit may be up tothe estimated total monthly charges for an average two-month period within thefirst three months from the date of delinquency. If an RBOC makes anenforceable demand for an increased security deposit, we could have less cashavailable for other expenses, which could have a material adverse effect on ourbusiness, results of operations and financial condition.

***The level of our outstanding total debt may adverselyaffect our financial health and prevent us from fulfilling our financialobligations.***   As of December 31, 2005, wehad approximately $92.1 million of total indebtedness outstanding, excludingcapital lease obligations. Our indebtedness could significantly affect ourbusiness and our ability to fulfill our financial obligations. For example, ahigh 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 covenantsthat limit our operating flexibility.******  ***The indenturegoverning our outstanding 83¤8%senior second secured notes due 2010 contains covenants that, among otherthings, limit our ability to take specific actions, even if we believe them tobe in our best interest. In addition, we may obtain a credit facility in thefuture which may include similar or additional covenants. These covenants mayinclude restrictions on our ability to:

·       incuradditional indebtedness;

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

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·       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 totelecommunications, voice, data or video services.

In addition, a future credit facility may imposefinancial covenants that require us to comply with specified financial ratiosand tests, including minimum quarterly EBITDA, senior debt to totalcapitalization, maximum capital expenditures, maximum leverage ratios andminimum interest coverage ratios. We cannot assure you that we will be able tomeet these requirements or satisfy these covenants in the future. If we fail todo so, our debts could become immediately payable at a time when we are unableto pay them. This could adversely affect our ability to carry out our businessplan and would have a negative effect on our financial condition.

***If we are unable toretain and attract management and key personnel, we may not be able to executeour business plan.******  ***We believe that our success isdue, in part, to our experienced management team, including Mr. Richard A.Smith, our president and chief executive officer. Losing the services of one ormore members of our management team could adversely affect our business and ourexpansion efforts, and possibly prevent us from further improving ouroperational, financial and information management systems and controls. As wecontinue to grow, we will need to retain and hire qualified sales, marketing,administrative, operating and technical personnel, and to train and manage newpersonnel.

We believe that there are a limited number of personswith experience comparable to the experience of the members of our managementteam. Our ability to implement our business plan is dependent on our ability toretain and hire a large number of qualified new employees each year. If we areunable to hire sufficient qualified personnel, our customers could experienceinadequate customer service and delays in the installation and maintenance ofaccess lines.

***If we choose togrow by expanding to new markets and/or by making acquisitions, we would faceadditional risks.******  ***Although we believe cashresources on hand will be sufficient to fund our current operations, we mayneed to seek additional funding by issuing new debt or equity, if we choose toexpand our geographic service area or to make acquisitions.

The actual amount and timing of our future capitalrequirements may differ from our current estimates. Competitive developments,changes in technology, changes in the regulatory environment and other eventsmay cause us to alter the currently estimated amount and timing of ourexpenditures.

These and other factors may also cause our actualrevenues and costs to differ from what we currently anticipate, which couldaffect the amount and timing of our additional financing needs.

Sources of additional financing may include theprivate or public sale of equity or debt securities, commercial bank debtfinancing, vendor financing or lease financing. If we meet our funding needsthrough debt financing, our interest and debt service obligations willincrease, and we may become subject to restrictive covenants that could impairour ability to implement our business plan. We cannot assure you that anyadditional financing we may need will be available to us on favorable terms orat all.

Rapid growth could place a significant strain on ourmanagement, operational, financial and information management systems andcontrols, personnel and other resources. We cannot assure you that we willsuccessfully implement the operational and financial information managementsystems and 

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controls that weanticipate would be necessary to support rapid growth and to manage acompetitive business in an evolving industry. Any failure to implement andimprove these systems and controls and to maintain our other resources at apace consistent with industry changes and the growth of our business couldcause customers to switch to other competitive service providers, which wouldhave a material adverse effect on us.

***We are dependent oneffective billing, customer service and information systems.******  ***Sophisticatedback office information and processing systems are vital to our ability tocontrol and monitor costs, provide outstanding customer service, bill andservice customers, initiate, implement and track customer orders and achieveoperating efficiencies. We have purchased and implemented our essentialinformation systems consisting of our billing system, our sales order entrysystem, our customer provisioning system, our electronic bonding system, ourmediation system and our switch information systems. The integration of thesesystems is challenging because all of these systems were developed by differentvendors and must be coordinated through custom software and integrationprocesses. Our sales, line count and other core operating and financial dataare generated by these systems and the accuracy of this data depends on thequality of manual entry and system integration. Although we have completed somesystems integration, the upgrading of these systems and the integration ofupdated systems is ongoing. In addition, we may experience negative adjustmentsto our financial and operating data if we encounter difficulties in theseprojects. We cannot assure you that any such adjustments arising out of oursystems integration efforts will not have a material adverse effect in thefuture. If we are unable to effectively upgrade and integrate our operationsand financial systems, our customers could experience delays in connection ofservice, billing issues and/or lower levels of customer service.

***Declining pricesfor communications services could reduce our revenue and profitability.******  ***Prices fornetwork services have decreased 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. This trend may continue.

***We depend on alimited number of third party service providers for long distance and otherservices, and if any of these providers were to experience significantinterruptions in its business operations, or were to otherwise cease to providesuch services to us, our business could be materially and adversely affected.***   We depend on a limited numberof third party service providers for long distance, data and other services. Ifany of these third party providers were to experience significant interruptionsin their business operations, terminate their agreements with us or fail toperform the services or meet the standards of quality required under the termsof our agreements with them, our ability to provide these services to ourcustomers would be materially and adversely affected for a period of time thatwe cannot predict. If we have to migrate the provision of these services to analternative provider, we cannot assure you that we would be able to timelylocate alternative providers of such services, that we could migrate suchservices in a short period of time without significant customer disruption soas to avoid a material loss of customers or business, or that we could do so ateconomical rates. If we are unable to locate such alternative providers we mayneed to seek an alternative that could be costly and disrupt our service or wewould lose our transport capacity.

***The communicationsindustry is undergoing rapid technological changes, and new technologies may besuperior to the technologies we use. Our failure to anticipate and keep up withsuch changes could have a material adverse effect on our business, results ofoperations and financial condition.***   Thecommunications industry is subject to rapid and significant changes intechnology and in customer requirements and preferences. If we fail toanticipate and keep up with such changes we could lose market share which couldreduce our revenue. We have developed our business based, in part, ontraditional telephone technology. Subsequent technological developments mayreduce the competitiveness of our network and require expensive unanticipatedupgrades or additional communications products that could be time consuming tointegrate into our business and could cause us to lose customers and impede ourability to attract new customers. 

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We may be required toselect one technology over another at a time when it might be impossible topredict with any certainty which technology will prove to be more economic,efficient or capable of attracting customers. In addition, even if we utilizenew technologies, such as VoIP, we may not be able to implement them aseffectively as other companies with more experience with those new technologies.Technological advancements and manufacturing economies of scale could make VoIPservices delivered over the Internet cost effective to deploy and of sufficientquality to be acceptable to business customers.

***A network failure could cause delays or interruptionsof service, which could cause us to lose customers and revenue.******  ***Our successrequires 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 redundancy;

·       breachesof security; and

·       otherdisruptions beyond our control.

Such disruptions may cause interruptions in service orreduced capacity for customers, any of which could cause us to lose customers.

***We continue tomonitor our network from a performance and cost perspective and as a result,our network optimization 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.

***We will be requiredto report the effectiveness of the internal controls over financial reportingof our business in our annual report on Form 10-K for 2006.***   Section 404 of the Sarbanes-Oxley Act of 2002and the rules of the Securities and Exchange Commission promulgatedthereunder require our annual reports to contain a report of management’sassessment of the effectiveness of internal controls over financial reportingand an attestation of our independent registered public accounting firm as tothat management report. Our first management internal controls report, as wellas our first auditor attestation of that report, will be required to beincluded commencing with our annual report on Form 10-K for 2006.The evaluation of our systems and the documentation of such systems that wewill need to comply with Section 404 will be both costly andtime-consuming. We have recently begun the work necessary to comply with Section 404and cannot estimate at this time how long this process will take nor how muchadditional expense we will incur in completing the process. In addition, if weare unable to conclude that our internal controls over financial reporting iseffective as of December 31, 2006 (or if our auditors are unable to attestthat our management’s report are fairly stated or they are unable to express anopinion on our management’s assessment or on the effectiveness of the internalcontrols), we could lose investor confidence in the accuracy and completenessof our financial reports, which could, in turn, have an adverse effect on ourstock price.

***Some of ouremployees are unionized, and we could face work disruptions due to strikes,slowdowns or other labor disputes.******  ***A smallpercentage of our employees are members of the International Brotherhood ofElectrical Workers. Although our management believes that our relationship withour union employees is good, we cannot promise that we will never experience alabor disruption. Such disruptions could occur in 

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response to our actionsbut could also be due to the actions of other union employers. Significantlabor disruptions could adversely affect our ability to provide acceptablelevels of service to our customers, which could result in customerdissatisfaction and a loss of business.

***Terrorist attacksand other acts of violence or war may affect the markets in which we operate,our operations and our profitability.***   Terroristattacks, such as the 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 terrorist attacksthat impact our employees, network facilities or support systems. Certainlosses resulting from these types of events are uninsurable and others are notlikely 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.

**Item 1B. Unresolved Staff Comments.**

None.

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**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, 2006.

| **Location**                    | ** ** | ** **               | ** ** | **Lease Expiration** | ** ** | **Square  Footage**     | ** ** | **Purpose** | ** ** |
|---------------------------------|------------|--------------------------|------------|---------------------------|------------|-------------------------|------------|-------------|------------|
| Minneapolis, MN                 |       | May 31,  2013       |       | 118,174                   |       | Main  Office            |       |
| Minneapolis, MN                 |       | April 15,  2009     |       | 17,342                    |       | Switch  Facility/NOC    |       |
| Minneapolis, MN                 |       | June 30,  2010      |       | 3,348                     |       | Data  Switch Facility   |       |
| Golden Valley, MN               |       | February 28,  2012  |       | 33,246                    |       | Office/Warehouse        |       |
| Phoenix, AZ                     |       | May 15,  2010       |       | 7,468                     |       | Switch  Facility/Office |       |
| Phoenix, AZ                     |       | February 1,  2009   |       | 9,391                     |       | Office                  |       |
| Santa Rosa, CA                  |       | April 30,  2014     |       | 8,278                     |       | Switch  Facility        |       |
| Santa Rosa, CA                  |       | August 1,  2007     |       | 4,230                     |       | Office                  |       |
| Denver, CO                      |       | January 31,  2011   |       | 6,000                     |       | Switch  Facility        |       |
| Wheatridge, CO                  |       | November 30,  2006  |       | 18,514                    |       | 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/Office |       |
| Reno, NV                        |       | July 31,  2009      |       | 8,778                     |       | Switch  Facility/Office |       |
| Portland, OR                    |       | December 31,  2009  |       | 7,028                     |       | Switch  Facility        |       |
| Portland, OR                    |       | June 30,  2008      |       | 15,033                    |       | Office/Warehouse        |       |
| Salem, OR                       |       | April 30,  2009     |       | 7,997                     |       | Switch  Facility/Office |       |
| Salem, OR                       |       | April 30,  2006(1)  |       | 13,695                    |       | Office                  |       |
| Salem, OR                       |       | July 31,  2007      |       | 5,000                     |       | Storage                 |       |
| Eugene, OR                      |       | December 31,  2006  |       | 1,950                     |       | Office                  |       |
| Salt Lake City,  UT             |       | January 31,  2010   |       | 18,669                    |       | Switch  Facility/Office |       |
| 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  |       |

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(1)          Will not be renewed.

We believe that thefacilities used in our operations are suitable for their respective uses andadequate to meet our current needs. We continue to take steps to consolidate ordownsize office and switch facilities where we have overlap as a result of theATI acquisition and expect that process to be complete by April 30, 2006.

**Item 3.**                        LegalProceedings.

In November of 2004, a former employee filed asuit against us in federal district court in Minnesota alleging thattermination of her employment violated the federal Civil Rights Act and theFamily Medical Leave Act (“FMLA”), claiming $225.0 thousand in damages. We arevigorously defending against these claims and have filed a summary judgmentmotion as to all claims.  We cannotpredict the outcome of the lawsuit.

The 8th Circuit Court of Appeals has denied Qwest’sappeal of the Federal District Court’s Order upholding the Minnesota PUC’s UNECost Order. This means that the rates set by the Minnesota 

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Commission for UNEs willremain in place unless and until the matter is overturned by the U.S. SupremeCourt or new rates are set by the Commission.

The Minnesota Department of Commerce filed a complaintwith the Minnesota PUC concerning agreements that CLECs, including us, havewith certain interexchange carriers for pricing access services. They assertedthat the agreements are unlawfully discriminatory and are required to be filed.The matter has been settled and new access rates were filed with the MinnesotaPUC.

A lawsuit is pending against us and others by a formercustomer in Utah state court. The suit alleges damages of $1.0 million regardingalleged improper assignment of an “800” number. We are vigorously defendingthis claim and believe it to be without merit, but we cannot predict theoutcome of the lawsuit. The discovery phase and period for making dispositivemotions in the case have concluded. We anticipate that the court will dismissthe case due to the plaintiff’s failure to pursue it.

In March 2005, we settled several lawsuitsagainst Qwest on mutually acceptable terms. As a result of the settlementagreement, our suit against Qwest in the United States District Court, WesternDistrict of Washington regarding access, the development of an unbundlednetwork element platform, and failing to make DSL available for resale wasdismissed and we agreed to withdraw our appeal in the United States DistrictCourt, District of Minnesota of the unfavorable decision of the Minnesota PUCdenying us service quality credits.

On June 21, 2005, we settled the lawsuit broughtagainst us by Global Crossing. The parties agreed to release each other from allclaims related to the dispute and to amend their agreement. The settlementagreement provided for us to pay Global Crossing $5.0 million and for GlobalCrossing to credit our future bills for approximately $564 thousand over thefollowing six months.

Under the terms of the Global Crossing settlement, theCarrier Services Agreement between the parties, which had provided that GlobalCrossing was our exclusive provider of voice and data services, subject tocertain exceptions, and that we had a purchase commitment of $100.0 million,was amended to shorten the term of the agreement to July 1, 2006, toeliminate the exclusivity, purchase commitment and shortfall provisions and toprovide that Global Crossing will be our preferred provider for Internettransit and long haul data private line needs.

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 that we do notbelieve to be material.

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

None.

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**Part II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

On August 2, 2005, we completed a 0.0738-for-onereverse stock split affecting all outstanding shares of common stock.

We consummated an initial public offering of ourcommon stock on August 9, 2005. Our common stock trades on the NASDAQNational Market under the symbol “ESCH”.

The high and low pricesduring the two quarters since trading began are as follows:

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2005**       |       |     |       |    |       |
| Third quarter  |       | 14.14    |       | 11.63   |       |
| Fourth quarter |       | 14.25    |       | 11.50   |       |

 

On February 28, 2006, there were 190 holders ofrecord of our common stock. See Item 12, Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters, for adiscussion of the ownership of our company. We have not declared any cashdividends on our common stock and do not intend to pay cash dividends for theforeseeable future. Our outstanding notes restrict our ability to pay dividendson our capital stock.

Upon the exercise of options, 78,457 common shareswere issued in 2005. The proceeds were used for general corporate purposes. In March 2005,8,856 restricted common shares, valued at $2.71 per share, were issued to amember of our Board of Directors as compensation for service on our Board ofDirectors. In July 2005, 494 restricted common shares, valued at $6.77 pershare, were issued to a former member of our Board of Directors as compensationfor 494 shares of unvested restricted common stock that was forfeited whenmembership on our Board of Directors ended. These transactions were exemptunder Rule 701 of Section 4(2) of the Securities Act.

As a result of the initial public offering of commonstock on August 9, 2005, all of our then-outstanding shares of convertiblepreferred stock and accumulated dividends were automatically converted tocommon stock.

On September 15, 2005, we redeemed $50.630million accreted value ($57.750 million principal amount) of our 8 3/8% seniorsecond secured notes due March 15, 2010 at a redemption price of 112% ofthe accreted value. Proceeds from the initial public offering of common stockwere used to redeem the notes.

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**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 31,2004 and 2005 and for the years ended December 31, 2003, 2004 and 2005have 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, 2001, 2002 and2003 and for the years ended December 31, 2001 and 2002 were derived fromthe audited consolidated financial statements and notes to consolidatedfinancial statements not included herein. The following financial informationis qualified 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 theresults of ATI except for the Balance Sheet Data. All dollar amounts are inthousands of dollars, except per share amounts.

| ** **                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2001**                                   | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| **Statements of operations data:**                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Revenue:                                                                             |       |                                       |       |   |   |   |   |   |   |   |   |
| Network services                                                                     |       | $                                          | 72,773     |   | $ | 96,209 |   | $ | 115,482 |   | $ | 131,780 |   | $ | 201,835 |   |
| BTS                                                                                  |       | 25,837                                     |       | 25,659 |   | 25,614 |   | 26,316 |   | 25,908 |   |
| Total revenue                                                                        |       | 98,610                                     |       | 121,868 |   | 141,096 |   | 158,096 |   | 227,743 |   |
| Cost of revenue:                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |
| Network services                                                                     |       | 40,320                                     |       | 39,493 |   | 45,037 |   | 47,354 |   | 85,914 |   |
| BTS                                                                                  |       | 16,190                                     |       | 16,053 |   | 15,784 |   | 15,979 |   | 16,139 |   |
| Total cost of revenue                                                                |       | 56,510                                     |       | 55,546 |   | 60,821 |   | 63,333 |   | 102,053 |   |
| Gross profit:                                                                        |       |                                       |       |   |   |   |   |   |   |   |   |
| Network services                                                                     |       | 32,453                                     |       | 56,716 |   | 70,445 |   | 84,426 |   | 115,921 |   |
| BTS                                                                                  |       | 9,647                                      |       | 9,606 |   | 9,830 |   | 10,337 |   | 9,769 |   |
| Total gross profit                                                                   |       | 42,100                                     |       | 66,322 |   | 80,275 |   | 94,763 |   | 125,690 |   |
| Operating expenses:                                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Sales, general and  administrative                                                   |       | 55,960                                     |       | 68,920 |   | 66,252 |   | 69,255 |   | 90,310 |   |
| Depreciation and  amortization                                                       |       | 28,307                                     |       | 25,261 |   | 30,099 |   | 31,105 |   | 39,653 |   |
| Total operating expenses                                                             |       | 84,267                                     |       | 94,181 |   | 96,351 |   | 100,360 |   | 129,963 |   |
| Operating loss                                                                       |       | (42,167                                    | )          | (27,859 | ) | (16,076 | ) | (5,597 | ) | (4,273 | ) |
| Other income  (expense)(1)                                                           |       | (11,535                                    | )          | 48,052 |   | (1,102 | ) | 6,712 |   | (27,369 | ) |
| Income (loss) before  income taxes(1)                                                |       | (53,702                                    | )          | 20,193 |   | (17,178 | ) | 1,115 |   | (31,642 | ) |
| Income taxes                                                                         |       | (14                                        | )          | (50 | ) | (28 | ) | (4 | ) | (4 | ) |
| Net income (loss) from  continuing operations(1)                                     |       | (53,716                                    | )          | 20,143 |   | (17,206 | ) | 1,111 |   | (31,646 | ) |
| Income from discontinued  operation, net of tax                                      |       | —                                     |       | — |   | — |   | — |   | 329 |   |
| Gain on sale of  discontinued operation, net of tax                                  |       | —                                     |       | — |   | — |   | — |   | 326 |   |
| Net income (loss)(1)                                                                 |       | (53,716                                    | )          | 20,143 |   | (17,206 | ) | 1,111 |   | (30,991 | ) |
| Less preferred stock  dividends and premium paid on repurchase of preferred stock(2) |       | (9,890                                     | )          | (2,701 | ) | (3,426 | ) | (4,292 | ) | — |   |
| Net income (loss)  applicable to common stockholders                                 |       | $                                          | (63,606    | ) | $ | 17,442 |   | $ | (20,632 | ) | $ | (3,181 | ) | $ | (30,991 | ) |

 

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| ** **                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2001**                                   | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| **Statements of operations data (continued):**         |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic income (loss) per common share:                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations               |       | $                                          | (538.57    | ) | $ | 147.68 |   | $ | (70.59 | ) | $ | (11.11 | ) | $ | (5.32 | ) |
| Income from discontinued operations                    |       | —                                     |       | — |   | — |   | — |   | 0.11 |   |
| Net income (loss)                                      |       | $                                          | (538.57    | ) | $ | 147.68 |   | $ | (70.59 | ) | $ | (11.11 | ) | $ | (5.21 | ) |
| Diluted income (loss)  per common share:               |       |                                       |       |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations              |       | $                                          | (538.57    | ) | $ | 5.83 |   | $ | (70.59 | ) | $ | (11.11 | ) | $ | (5.32 | ) |
| Income from discontinued  operations                   |       | —                                     |       | — |   | — |   | — |   | 0.11 |   |
| Net income (loss)                                      |       | $                                          | (538.57    | ) | $ | 5.83 |   | $ | (70.59 | ) | $ | (11.11 | ) | $ | (5.21 | ) |
| **Other  financial data:**                             |       |                                       |       |   |   |   |   |   |   |   |   |
| Capital expenditures(3)                                |       | $                                          | 38,684     |   | $ | 23,175 |   | $ | 26,466 |   | $ | 30,771 |   | $ | 35,905 |   |
| Cash flows provided by  (used in) operating activities |       | (37,116                                    | )          | (2,888 | ) | 16,688 |   | 25,393 |   | 14,754 |   |
| Cash flows provided by  (used in) investing activities |       | (36,468                                    | )          | (23,020 | ) | (25,008 | ) | (78,334 | ) | (30,967 | ) |
| Cash flows provided by (used in) financing  activities |       | 30,471                                     |       | 31,593 |   | (2,807 | ) | 70,770 |   | 15,570 |   |

 

| ** **                                    | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2001**                                                                              | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| **Operating  data:**                          |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Voice access lines in  service(4)             |       | 98,922                                                                                |       | 133,908 |   | 156,165 |   | 173,492 |   | 270,662 |   |
| Data access lines in  service(4)              |       | 12,217                                                                                |       | 24,657 |   | 50,256 |   | 76,861 |   | 144,790 |   |
| Total access lines in  service(4)             |       | 111,139                                                                               |       | 158,565 |   | 206,421 |   | 250,353 |   | 415,452 |   |
| Markets in operation                          |       | 12                                                                                    |       | 12 |   | 12 |   | 12 |   | 19 |   |
| Percent of new access  lines installed on-net |       | 61                                                                                    | %          | 77 | % | 87 | % | 92 | % | 97 | % |
| Percent of total access  lines on-net         |       | 50                                                                                    | %          | 63 | % | 74 | % | 81 | % | 86 | % |
| Average monthly churn(5)                      |       | 2.01                                                                                  | %          | 1.87 | % | 1.60 | % | 1.48 | % | 1.34 | % |
| Total full-time  equivalent employees         |       | 934                                                                                   |       | 918 |   | 888 |   | 924 |   | 1,118 |   |
| Quota-carrying network  services sales people |       | 176                                                                                   |       | 164 |   | 139 |   | 167 |   | 204 |   |
| Quota-carrying BTS sales  people              |       | 47                                                                                    |       | 35 |   | 36 |   | 33 |   | 39 |   |
| Total quota-carrying sales  people            |       | 223                                                                                   |       | 199 |   | 175 |   | 200 |   | 243 |   |

 

| ** **                                                                 | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                 | ** ** | **2001**                              | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| **Balance sheet data:**                                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents,  restricted cash and available-for-sale securities |       | $                                     | 14,048     |   | $ | 19,733 |   | $ | 8,606 |   | $ | 33,351 |   | $ | 31,818 |   |
| Property and equipment,  net                                               |       | 95,719                                |       | 91,296 |   | 86,777 |   | 102,849 |   | 126,452 |   |
| Total assets                                                               |       | 170,370                               |       | 169,133 |   | 153,721 |   | 237,119 |   | 231,546 |   |
| Total debt, including  current portion                                     |       | 140,321                               |       | 88,625 |   | 87,822 |   | 142,231 |   | 97,519 |   |
| Net debt(6)                                                                |       | 126,273                               |       | 68,892 |   | 79,216 |   | 108,880 |   | 65,701 |   |
| Total stockholders’  equity (deficit)                                 |       | 3,332                                 |       | 15,542 |   | (5,071 | ) | (8,180 | ) | 92,253 |   |
|                                                                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          In June 2002, weentered into a negotiated debt restructuring, which included the reduction ofoutstanding debt under our senior secured credit facility from $139,293 to$57,062. In the 

38

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restructuring, certainlenders with outstanding principal and interest due of $65,778 chose to receive$12,229 in cash to cancel all liabilities, as a result of which we recorded apre-tax gain of $53,549. In accordance with SFAS No. 15, Accounting by Debtors and Creditors forTroubled Debt Restructurings, a portion of the reduction in the amountoutstanding could not be immediately recognized as a gain, but instead would berecognized as a reduction to interest expense over the term of the new creditfacility. As of December 31, 2003, $21,871 of excess carrying value hadyet to be recognized as a reduction in interest expense. In March 2004, wepaid off our senior secured credit facility, which resulted in a pretax gain of$18,195, for the remaining excess carrying value as of the payoff date.

In September 2005, we redeemed $50,630 accretedvalue ($57,750 principal amount) of our 8 3/8% senior second secured notes due March 15,2010 at a redemption price of 112% of the accreted value. The $6,076accreted-value premium was recorded as interest expense. In addition, we wroteoff a proportionate amount of the associated debt issuance costs and recorded$2,579 as interest expense.

(2)          In December 2004,in connection with our acquisition of ATI, we repurchased 6,780,541 shares ofour series A convertible preferred stock for $5,085.

(3)          Capital expenditures arethe sum total of purchases of property and equipment including equipmentpurchased under a capital lease, cash paid for customer installation costs andinternal capitalized labor.

(4)          Each access line andaccess line equivalent is equal to one 64-kilobit customer line that isactive and being billed. Unused capacity on T1 circuits is not included in ourline count.

(5)          Average monthly churn isthe total access line service disconnections for the month as a percentage oftotal access lines in service at the end of the month.

(6)          Net debt consists oftotal debt less cash, cash equivalents, restricted cash and available-for-salesecurities.

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**SelectedQuarterly Financial Data (Unaudited. In thousands, except per shareinformation)**

| ** **                                          | ** ** | **2005**                                           | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                          | ** ** | **For the Three Months Ended** | ** ** |
| ** **                                          | ** ** | **March 31**                                  | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** | **Total Year** | ** ** |
| Total revenue                                       |       |                                               | $          | 54,533 |   |   | $ | 56,921 |   |   | $ | 57,912 |   |   |   | $ | 58,377 |   |   | $ | 227,743 |   |
| Total gross profit                                  |       |                                               | 30,902     |   |   | 27,829 |   |   | 33,118 |   |   |   | 33,841 |   |   | 125,690 |   |
| Income (loss) before  income taxes(1)               |       |                                               | (4,768     | ) |   | (8,754 | ) |   | (12,913 | ) |   |   | (5,207 | ) |   | (31,642 | ) |
| Net income (loss)(1)                                |       |                                               | (4,768     | ) |   | (8,643 | ) |   | (12,453 | ) |   |   | (5,127 | ) |   | (30,991 | ) |
| Net income (loss) per  share—basic and diluted |       |                                               | (18.70     | ) |   | (26.32 | ) |   | (1.49 | ) |   |   | (0.35 | ) |   | (5.21 | ) |
|                                                     |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                | ** ** | **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(1)     |       |                                               | 14,283     |   |   | (3,377 | ) |   | (4,325 | ) |   |   | (5,466 | ) |   | 1,115 |   |
| Net income (loss)(1)                      |       |                                               | 14,283     |   |   | (3,377 | ) |   | (4,329 | ) |   |   | (5,466 | ) |   | 1,111 |   |
| Net income (loss) per  share—basic   |       |                                               | 50.13      |   |   | (14.74 | ) |   | (17.62 | ) |   |   | (21.14 | ) |   | (11.11 | ) |
| Net income (loss) per  share—diluted |       |                                               | 2.57       |   |   | (14.74 | ) |   | (17.62 | ) |   |   | (21.14 | ) |   | (11.11 | ) |
|                                           |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          In June 2002, weentered into a negotiated debt restructuring, which included the reduction ofoutstanding debt under our senior secured credit facility from $139,293 to$57,062. In the restructuring, certain lenders with outstanding principal andinterest due of $65,778 chose to receive $12,229 in cash to cancel allliabilities, as a result of which we recorded a pre-tax gain of $53,549. Inaccordance with SFAS No. 15, *Accountingby Debtors and Creditors for Troubled Debt Restructurings*, a portionof the reduction in the amount outstanding could not be immediately recognizedas a gain, but instead would be recognized as a reduction to interest expenseover the term of the new credit facility. As of December 31, 2003, $21,871of excess carrying value had yet to be recognized as a reduction in interestexpense. In March 2004, we paid off our senior secured credit facility,which resulted in a pretax gain of $18,195, for the remaining excess carryingvalue as of the payoff date.

In September 2005, we redeemed $50,630 accretedvalue ($57,750 principal amount) of our 8 3/8% senior second secured notes dueMarch 15, 2010 at a redemption price of 112% of the accreted value. The$6,076 accreted-value premium was recorded as interest expense. In addition, wewrote off a proportionate amount of the associated debt issuance costs andrecorded $2,579 as interest expense.

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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 annual report 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 services and business telephone systems in 19 marketsin the western United States. As a facilities-based competitive communicationsservices provider, we provide services to our customers primarily through ourown network of telecommunications switches and related equipment and primarilyleased telecommunications lines, or transport. We target the small andmedium-sized business segment and currently serve over 50,000 customers,primarily within the local service territory of Qwest.

Early in our development, we expanded into new marketsgenerally through acquisitions of companies that we augmented with our networkservices capabilities. We were founded in 1996 and shortly thereafter, wemerged with Cady Communications, a business telephone systems company based inMinnesota, and began offering local and long distance voice services. In 1997and 1998, we acquired three additional business telephone systems companies andlaunched voice services in five additional markets, including Denver, Phoenix,Portland, Salt Lake City and Seattle. In December 1999, we activated ourfirst switch. In January 2000, we acquired an Internet service providerand began providing advanced data services. In March 2000 we beganproviding voice and data services over our network, which began our transitionto a facilities-based competitive communications services provider. In January 2001,we acquired a business telephone systems company in Salt Lake City. On December 31,2004, we consummated our eighth acquisition, ATI, whereby we enhanced ourpresence in Washington, Oregon and Nevada and entered California.

We measure our operational performance using a varietyof indicators including revenue growth, the percentage of our revenue thatcomes from customers that we serve on-switch, gross margin percentage,operating expenses as a percentage of revenue and access line churn rates. Wemonitor key operating and customer service metrics to improve customer service,maintain the quality of our network and reduce costs.

The telecommunicationsindustry is highly competitive. We believe we compete principally by offeringsuperior customer service, accurate billing, a broad set of services andsystems and competitive pricing. We compete with the RBOCs, other competitivecommunications services providers, and long distance and data service providers.While wireless providers are competing with us, we do not believe they are acompetitive threat in the market nor are they likely to be in the near future,because of the different service standards that business customers require.

**KeyComponents of Results of Operations**

***Revenue.***   Networkservices revenue consists primarily of local dial tone, switched access lines,long distance, access charges, and data service. Revenue from local telephoneservice consists of charges for basic local service, including dedicated T1access, and custom-calling features such as call waiting and call forwarding.Revenue from long distance service consists of per-minute-of-use charges for afull range of traditional switched and dedicated long distance, toll-freecalling, international, calling card and operator 

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services. Carrier accessrevenue consists primarily of usage charges that we bill long distance carriersto originate and terminate calls to and from our customers. In addition, insome of our markets we currently charge other local exchange carriers andwireless carriers usage charges to originate and terminate local and wirelesscalls to and from certain customers (otherwise known as reciprocal compensation).Revenue from data services consists primarily of monthly usage fees forInternet access services. We typically commit our customers to contractsranging from one to three years and provide discounts for longer terms. Networkservices revenue comprised 88.6% of our total revenue for the year ended December 31,2005, and represents a predominantly recurring revenue stream.

Monthly recurring network services revenue isrecognized in the month the services are used. In the case of local servicerevenue, monthly recurring local services charges are billed in advance butaccrued for and recognized on a prorated basis based on length of service inany given month. Non-recurring revenues associated with line installations arerecognized over the average life of the customers. Long distance and accesscharges are billed in arrears but accrued based on monthly average usage. Priorto 2005, we had not historically received any revenues from reciprocalcompensation due to our bill-and-keep arrangement with Qwest. With theacquisition of ATI, which was not under a bill-and-keep arrangement with theRBOCs, and our recent negotiated reciprocal compensation agreements with a fewwireless carriers, we recorded approximately $0.5 million of reciprocalcompensation revenue in 2005. We do not have any wholesale revenue other thanaccess revenue and this reciprocal compensation mentioned above.

Business telephone systems revenue consists of revenuefrom the sale of telephone equipment and the servicing of telephone equipmentsystems. Telephone equipment revenue is recognized upon delivery, completion ofthe installation and acceptance by the customer. Business telephone servicerevenue is recognized upon completion of service or, in the case of maintenanceagreements, is spread equally over the life of the maintenance contract, whichtypically ranges from one to two years.

***Cost of revenue.***   Ournetwork services cost of revenue consists primarily of the cost of operatingour network facilities. The network components for our facilities-basedbusiness include the cost of:

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

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

·       leasinghigh capacity digital lines that interconnect our network with the RBOCs;

·       leasingspace, power and terminal connections in the RBOC central offices forcolocating our equipment;

·       signalingsystem network connectivity;

·       leasingour ATM long-haul Internet backbone network; and

·       Internettransit and peering, which is the cost of delivering Internet traffic from ourcustomers to the public Internet.

The costs to lease local loops, digital T1 lines andhigh capacity digital interoffice transport facilities from the RBOCs varies bycarrier and by state and are regulated under federal and state laws. Invirtually all areas, we lease local loops, T1 lines and interoffice transportcapacity from the RBOCs. We lease interoffice facilities from carriers otherthan the RBOCs where possible in order to lower costs and improve networkredundancy; however, in most cases, the RBOCs are our only source for localloops and T1 lines. Historically we purchased, on a wholesale or negotiatedbasis, unbundled network elements platform, or UNE-P, from Qwest, AT&T andVerizon, and customized network element packages, or UNE-E, from Qwest. We alsopurchase, on a wholesale or negotiated basis, Centrex services, which areservices for the portion of the public telephone switch that is dedicated to acustomer, from AT&T. The rates for UNE-P and Centrex were regulated andestablished by the various state corporation or utility 

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commissions. We enteredinto agreements with Qwest and Verizon for UNE-P replacement products in 2005. Asof December 31, 2005, we had approximately 50,000 access lines in servicethat were formerly categorized as UNE-P access lines and are now provided undercommercial agreements. The Qwest UNE-E agreement was terminated with theadoption of Qwest’s commercial UNE-P replacement product, QPP, and all QwestUNE-E lines were moved to QPP on January 1, 2005. We believe we will incurhigher costs in 2006 to obtain access to certain elements of telecommunicationsplatforms as a result of the Triennial Review Remand Order.

Our network services cost of revenue also includes thefees we pay for long distance, data and other services. We have entered intolong-term wholesale purchasing agreements for these services. Some of theagreements contain significant termination penalties and/or minimum usagevolume commitments. In the event we fail to meet minimum volume commitments, wemay be obligated to pay underutilization charges. We do not anticipate havingto pay any underutilization charges in the foreseeable future.

We carefully review all of our vendor invoices andfrequently dispute inaccurate or inappropriate charges. In cases where wedispute certain charges, we frequently pay only undisputed amounts on vendorinvoices in order to pay proper amounts owed. Our single largest vendor isQwest. We use estimates to determine the level of success in dispute resolutionand consider past historical experience, basis of dispute, financial status andcurrent relationship with vendors and aging of prior disputes in quantifyingour estimates.

We account for all of our network depreciation indepreciation and amortization expense and do not have any depreciation expensein cost of revenue.

Our most significant business telephone systems costsof revenue are the equipment purchased from manufacturers and labor for serviceinstallation. To take advantage of volume purchase discounts, we purchaseequipment primarily from three manufacturers pursuant to master purchaseagreements we have with these manufacturers. For all business telephone systemsinstallations, our policy is to require a 30% deposit before ordering theequipment so our risk of excess inventory or inventory obsolescence is low.Business telephone systems cost of revenue also includes salaries and benefitsof field technicians as well as vehicle and incidental expenses associated withequipment installation, maintenance and service provisioning.

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

Determining our allowance for doubtful accountsreceivable requires significant estimates. We consider two primary factors indetermining the proper level of the allowance, including historical collectionsexperience and the aging of the accounts receivable portfolio. We perform acredit 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. For2003, 2004 and 2005, our bad debt expense as a percentage of revenue was 0.4%,0.5%, and 0.5%, respectively.

***Depreciation andAmortization.***   Our depreciation andamortization expense currently includes depreciation for network related voiceand data equipment, back office systems, furniture, fixtures, leaseholdimprovements, office equipment and computers. All internal costs directlyrelated to the expansion of our network and operating and support systems,including salaries of certain employees, are capitalized and depreciated overthe lives of the switches or systems, as the case may be. Capitalized customerinstallation costs are amortized over the approximate average life of acustomer, which is currently 48 months. Detailed time studies are used todetermine labor capitalization. These time studies are based on employee timesheets for those engaged in capitalizable activities.

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**Results of Operations**

Thefollowing tables set forth financial data as a percentage of total revenue forthe years ended December 31, 2003, 2004 and 2005.

| ** **                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                          | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| **Consolidated financial data:**                    |       |                                       |       |   |   |   |   |
| Revenue:                                            |       |                                       |       |   |   |   |   |
| Network services                                    |       | 81.8                                       | %          | 83.4 | % | 88.6 | % |
| BTS                                                 |       | 18.2                                       | %          | 16.6 | % | 11.4 | % |
| Total revenue                                       |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
| Cost of revenue                                     |       | 43.1                                       | %          | 40.1 | % | 44.8 | % |
| Total gross profit                                  |       | 56.9                                       | %          | 59.9 | % | 55.2 | % |
| Operating expenses:                                 |       |                                       |       |   |   |   |   |
| Sales, general and administrative                   |       | 47.0                                       | %          | 43.8 | % | 39.7 | % |
| Depreciation and amortization                       |       | 21.3                                       | %          | 19.7 | % | 17.4 | % |
| Total operating expenses                            |       | 68.3                                       | %          | 63.5 | % | 57.1 | % |
| Operating loss                                      |       | (11.4                                      | )%         | (3.6 | )% | (1.9 | )% |
| Net income (loss)                                   |       | (12.2                                      | )%         | 0.7 | % | (13.6 | )% |
| Net income (loss) applicable to common stockholders |       | (14.6                                      | )%         | (2.0 | )% | (13.6 | )% |

 

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,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cost of network  services revenue           |       | 39.0                                       | %          | 35.9 | % | 42.6 | % |
| Cost of BTS  revenue                        |       | 61.6                                       | %          | 60.7 | % | 62.3 | % |
| Gross profit from  network services revenue |       | 61.0                                       | %          | 64.1 | % | 57.4 | % |
| Gross profit from BTS  revenue              |       | 38.4                                       | %          | 39.3 | % | 37.7 | % |

 

**YearEnded December 31, 2005 Compared to Year Ended December 31, 2004**

***Revenue.***   Revenuefor the years ended December 31, 2004 and 2005 is as follows:

| ** **              | ** ** | **Year Ended December 31,**                                 | ** ** | ** **                                                                       | ** ** |
|-------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **              | ** ** | **      2004     ** | ** ** | **      2005      ** | ** ** | **% Change** | ** ** |
| Revenue (in  millions): |       |                                                                       |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Voice and data services |       |                                                                       | $          | 98.4                                                                             |       |   |   | $ | 153.9 |   |   |   | 56.6 | % |   |
| Long distance           |       |                                                                       | 21.2       |                                                                             |       |   | 34.6 |   |   |   | 63.0 |   |   |
| Access                  |       |                                                                       | 12.2       |                                                                             |       |   | 13.3 |   |   |   | 8.8 |   |   |
| Total network services  |       |                                                                       | 131.8      |                                                                             |       |   | 201.8 |   |   |   | 53.2 |   |   |
| BTS                     |       |                                                                       | 26.3       |                                                                             |       |   | 25.9 |   |   |   | (1.6 | ) |   |
| Total revenue           |       |                                                                       | $          | 158.1                                                                            |       |   |   | $ | 227.7 |   |   |   | 44.1 | % |   |

 

**NetworkServices.****  **Networkservices revenue was $201.8 million for the year ended December 31,2005, an increase of 53.2% from $131.8 million for the year ended December 31,2004. The increase in 

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revenue is primarily dueto the inclusion of ATI, which was acquired on December 31, 2004, and, toa lesser extent, an increase in the average number of voice and data accesslines in service. Over the past 12 months the number of voice linesincreased by 56.0% to 270,662 lines at December 31, 2005, and the numberof data lines increased by 88.4% to 144,790 lines at December 31, 2005.The growth in revenue associated with access line growth was partially offsetby declines in pre-subscribed interexchange carrier charge (PICC) revenue,access revenue per minute of use and a decline in data revenue per line. Thedecline in PICC revenue was related to our dispute with Global Crossing, whichwas resolved in June 2005. As a result of that dispute, we did not recordapproximately $0.3 million per month of PICC revenue beginning in November of2004. Access revenue per minute of use declined as a result of the scheduledFCC reduction of interstate rate levels in June 2004. Data revenue perline declined due to a combination of customers purchasing more bandwidth atdiscounted prices and general pricing pressures for data services in ourmarkets. We expect all of the above trends in PICC revenue, access revenue anddata revenue per line to continue for the foreseeable future. We expect a 10-15basis point increase in customer line churn in the first quarter of 2006related to the ATI system integration work in addition to normal seasonalitythat we typically see between the fourth and first quarters of each year. Thisincrease will most likely negatively impact our line growth in the firstquarter by one to two thousand lines. However, we believe any increase incustomer line churn will be temporary in nature based on current customerservice statistics. We expect to return to historical churn levels in thesecond quarter of 2006.

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 extend our networkfootprint.

**BTS.****  **BTS revenue was $25.9 million for the year endedDecember 31, 2005, a decrease of 1.6% from $26.3 million for the yearended December 31, 2004 due to a one-time revenue adjustment of$0.5 million made in 2005. We cannot predict future trends in capitalspending by small and medium-sized business customers.

***Cost of Revenue.******  ***Cost ofrevenue for the years ended December 31, 2004 and 2005 is as follows:

| ** **                      | ** ** | **Year Ended December 31,**                                 | ** ** | ** **                                                                       | ** ** |
|---------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **      2004     ** | ** ** | **      2005      ** | ** ** | **% Change** | ** ** |
| Cost of revenue  (in millions): |       |                                                                       |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Network services                |       |                                                                       | $          | 47.3                                                                             |       |   |   | $ | 85.9 |   |   |   | 81.4 | % |   |
| BTS                             |       |                                                                       | 16.0       |                                                                             |       |   | 16.1 |   |   |   | 1.0 |   |   |
| Total cost of revenue           |       |                                                                       | $          | 63.3                                                                             |       |   |   | $ | 102.0 |   |   |   | 61.1 | % |   |

 

**NetworkServices.****  **Networkservices cost of revenue was $85.9 million for the year ended December 31,2005, an increase of 81.4% from $47.3 million for the year ended December 31,2004. This increase is primarily due to the inclusion of ATI, which wasacquired on December 31, 2004, and recording approximately $4.7 million incosts related to the settlement with Global Crossing in June 2005. As apercentage of related revenue, network services cost of revenue for 2005increased to 42.6% from 35.9% for 2004. This increase was primarily due to theGlobal Crossing settlement impact and the inclusion of ATI.

**BTS.****  **BTS cost of revenue was $16.0 million and$16.1 million for the years ended December 31, 2004 and 2005,respectively. As a percentage of related revenue, BTS cost of revenue for theyear ended December 31, 2005 increased to 62.3% from 60.7% for the yearended December 31, 2004, primarily due to the one-time revenue adjustmentdiscussed above. We do not expect future improvements in BTS cost of revenue asa percentage of related revenue unless we are able to significantly increase BTSrevenue and therefore achieve greater volume discounts or economies of scale inour workforce.

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***Gross Profit.******  ***Gross profitfor the years ended December 31, 2004 and 2005 is as follows:

| ** **                   | ** ** | **Year Ended December 31,**                                 | ** ** | ** **                                                                       | ** ** |
|------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                   | ** ** | **      2004     ** | ** ** | **      2005      ** | ** ** | **% Change** | ** ** |
| Gross profit (in  millions): |       |                                                                       |       |                                                                             |       |   |   |   |   |   |   |   |   |
| Network services             |       |                                                                       | $          | 84.5                                                                             |       |   |   | $ | 115.9 |   |   |   | 37.3 | % |   |
| BTS                          |       |                                                                       | 10.3       |                                                                             |       |   | 9.8 |   |   |   | (5.5 | ) |   |
| Total gross profit           |       |                                                                       | $          | 94.8                                                                             |       |   |   | $ | 125.7 |   |   |   | 32.6 | % |   |

 

The increase in gross profit for the year ended December 31,2005 from 2004 is due to the increase in revenue described above.

***Sales, General andAdministrative.******  ***Sales, general and administrativeexpenses were $90.3 million for the year ended December 31, 2005, anincrease of 30.4% from $69.3 million for the year ended December 31,2004. The increase is primarily due to the inclusion of ATI, including$0.6 million of expenses related to integrating ATI’s operation into ours.As a percentage of revenue, sales, general and administrative expenses for theyear ended December 31, 2005 declined to 39.7% from 43.8% for the yearended December 31, 2004 due to the improved efficiency of our existingoperations resulting from our fixed cost structure supporting a higher level ofrevenue.

***Depreciation andAmortization.******  ***Depreciation and amortization expensewas $39.7 million for the year ended December 31, 2005, an increaseof 27.5% from $31.1 million for the year ended December 31, 2004.This increase was primarily due to the inclusion of ATI and, to a lesserextent, our network growth and associated capital expenditures. As a result offinalizing our purchase price allocation for ATI, we recorded a one-time$4.3 million adjustment to depreciation and amortization in the fourthquarter of 2005. As a percentage of revenue, depreciation and amortizationdecreased to 17.4% for the year ended December 31, 2005 from 19.7% for theyear ended December 31, 2004.

***Interest.******  ***Interestexpense was $28.1 million for the year ended December 31, 2005, anincrease of 145.6% from $11.5 million for the year ended December 31,2004. In September 2005, we redeemed $50.6 million accreted value ($57.8million principal amount) of our 8 3/8% senior second secured notes due 2010 ata redemption price of 112% of the accreted value. The $6.1 millionaccreted-value premium was recorded as interest expense. In addition, we wroteoff a proportionate amount of the associated debt issuance costs and recorded$2.6 million as interest expense. The remaining increase is primarily theresult of a full year of interest expense on a higher outstanding note balance.

***Gain onExtinguishment of Debt.******  ***Net income forthe year ended December 31, 2004 included a gain on extinguishment of debtof $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 loss forthe year ended December 31, 2005 was $31.0 million compared to net incomefor the year ended December 31, 2004 of $1.1 million. In 2004, we recordedan $18.2 million gain on extinguishment of debt, whereas in 2005 we recordedboth a debt charge-off of $8.7 million and additional depreciation andamortization expense of $4.3 million as mentioned previously.

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**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 |   |   |
| BTS                     |       |                                                                             | 25.6       |                                                                             |       |   | 26.3 |   |   |   | 2.7 |   |   |
| Total revenue           |       |                                                                             | $          | 141.1                                                                            |       |   |   | $ | 158.1 |   |   |   | 12.0 | % |   |

 

**NetworkServices.****  **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. From 2003, the number ofvoice lines increased by 11.1% to 173,492 lines at December 31, 2004, andthe 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 in PICCrevenue, access revenue per minute of use and a decline in data revenue perline. The decline in PICC revenue was related to our dispute with GlobalCrossing. As a result of that dispute, we elected not to record approximately$0.3 million per month of PICC revenue beginning in November of 2004.Access revenue per minute of use declined as a result of the scheduled FCCreduction of interstate rate levels. Data revenue per line declined due to acombination of customers purchasing more bandwidth at discounted prices andgeneral pricing pressures for data services in our markets.

**BTS.****  **BTS revenue was $26.3 million for the year endedDecember 31, 2004, an increase of 2.7% from $25.6 million for the yearended December 31, 2003 due to a higher level of new system sales in 2004.

***Cost of Revenue.******  ***Cost ofrevenue for 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 | % |   |
| BTS                             |       |                                                                             | 15.8       |                                                                             |       |   | 16.0 |   |   |   | 1.2 |   |   |
| Total cost of  revenue          |       |                                                                             | $          | 60.8                                                                             |       |   |   | $ | 63.3 |   |   |   | 4.1 | % |   |

 

**NetworkServices.****  **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 revenue was $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 of revenue for theyear ended December 31, 2004 decreased to 60.7% from 61.6% for the yearended December 31, 2003, due to better labor utilization.

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***Gross Profit.******  ***Gross profitfor the 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 | % |   |
| BTS                          |       |                                                                             | 9.8        |                                                                             |       |   | 10.3 |   |   |   | 5.1 |   |   |
| Total gross profit           |       |                                                                             | $          | 80.3                                                                             |       |   |   | $ | 94.8 |   |   |   | 18.0 | % |   |

 

The increase in gross profit for the year endedDecember 31, 2004 from 2003 is due to the increase in revenue describedabove.

***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.

***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 capital expenditures.As a percentage of revenue, depreciation and amortization decreased to 19.7%for the year ended December 31, 2004 from 21.3% for the year endedDecember 31, 2003.

***Interest.******  ***Interestexpense was $11.5 million for the year ended December 31, 2004, an increaseof 553.1% from $1.8 million for the year ended December 31, 2003.This increase was primarily due to interest expense on our senior secondsecured notes issued in 2004.

***Gain onExtinguishment of Debt.******  ***Net income forthe year ended December 31, 2004 included a gain on extinguishment of debtof $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 income forthe year ended December 31, 2004 was $1.1 million compared to a net lossfor the year ended December 31, 2003 of $17.2 million. The net income in2004 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.

**Liquidityand Capital Resources**

***Principal Sourcesand Uses of Liquidity.******  ***Our principalsources of liquidity are cash from operations and our cash and cash equivalentsand available-for-sale securities. Our principal liquidity requirements consistof debt service, capital expenditures and working capital.

***Cash and CashEquivalents; Available-for-Sale Securities.******  ***Cash and cash equivalentswas $26.1 million at December 31, 2005, which is a decrease of $0.3million from December 31, 2004. In 2004, we began investing inavailable-for-sale securities. The balance at December 31, 2004 and 2005was $6.2 million and $4.8 million, respectively and in each case representsinvestments in municipal and United States 

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government debt securitieswith maturities of more than three months but less than one year. Thesecurities represent additional liquidity for us.

***Financings.******  ***In March 2004, wecompleted an offering of $100.0 million of 8 3/8% senior second securednotes due 2010 at a discount resulting in gross proceeds of $84.8 million.We used the proceeds from our offering to retire bank debt, pay fees related tothe offering and provide additional liquidity to our company. After repaymentof our senior secured bank facility and fees related to the issuance of thenotes, we received incremental cash of approximately $13.2 million. InNovember 2004, we completed our offering of $65.0 million of 8 3/8%senior second secured notes due 2010 at a discount resulting in gross proceedsof $51.4 million. On December 30, 2004, our equity sponsors purchased20.0 million shares of new convertible preferred stock for net cashproceeds of $15.0 million. We used the proceeds from our offerings tocomplete our acquisition of ATI for $45.5 million, to redeem 6,780,541 sharesof our Series A convertible preferred stock for $5.1 million and to payfees related to the notes offering. On August 9, 2005, we consummated aninitial public offering of 5,357,143 of our common stock at $14.00 per share.Net proceeds from the offering, after deducting underwriting discounts andcommissions, were $69.8 million. Proceeds were used to redeem $50.6 million accretedvalue ($57.8 million principal amount) of our 8 3/8% senior second securednotes due 2010; to pay a $6.1 million premium due upon redemption of the notes;and to pay $2.7 million of fees and expenses associated with the offering.

***Cash Flows Providedby Operating Activities.******  ***Cash providedby operating activities was $14.8 million for 2005 compared to cashprovided by operating activities of $25.4 million for 2004. The decreasein cash provided by operating activities was due to an $11.7 millionincrease in cash interest payments. During 2005, we paid $6.1 millionrelated to the redemption of 35% of our senior second secured notes due 2010 and$5.6 million related to additional interest payments as a result of our$65.0 million senior second secured notes due 2010 issued onNovember 29, 2004.

Cash provided by operating activities was $25.4million for 2004 compared to cash provided by operating activities of $16.7million for 2003. Our improvement in cash provided by operating activities wasprimarily due to our growth in gross profit accompanied by a smaller increasein our operating expenses. Working capital improved primarily throughimprovement in our accounts receivable collections and our accounts payabledays outstanding.

***Cash Flows Used inInvesting Activities.******  ***Cash used in investing activitieswas $31.0 million for 2005 compared to $78.3 million for 2004 and$25.0 million for 2003. The decrease in cash used in investing activities from2004 to 2005 was primarily due to 2004 activity including the acquisition ofATI on December 31, 2004. Also, the activity related to available-for-salesecurities was a net use of cash in 2004 of $6.2 million versus $1.8 million ofnet cash provided in 2005. Cash used for investing in the maintenance andexpansion of our network and back office systems and customer installationincreased $6.1 million in 2005 versus 2004. The increase in cash used ininvesting activities from 2003 to 2004 was primarily due to the acquisition ofATI on December 31, 2004. In 2004 we also used cash to invest inavailable-for-sale securities with maturity dates of six months or less. In2003, all of our cash used in investing activities was for the maintenance andexpansion of our network and back office systems and customer installation.

***Cash Flows Providedby (Used in) Financing Activities.******  ***Cash providedby financing activities was $15.6 million for 2005. The proceeds from ourinitial public offering of our common stock, after deducting underwritingdiscounts and commissions, were $69.8 million. Proceeds were used to redeem$50.6 million accreted value ($49.2 million book value; $57.8 principal amount)of our 8 3/8% senior second secured notes due 2010; to pay a $6.1 millionpremium due upon redemption of the notes, which is included in interestexpense; and to pay $2.7 million of fees and expenses associated with theoffering. We also used cash for payments on capital lease obligations. Cashprovided by financing activities was $70.8 million for 2004. The netproceeds from the issuance of the senior second secured notes in March 2004generated approximately $13.2 million, which is net of a $1.6 millionprepayment penalty mentioned previously. The 

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net cash proceeds from theissuance of senior second secured notes in November 2004 and theSeries B preferred stock issuance generated approximately $57.5 millionafter payment of debt issuance costs and the redemption of Series Apreferred stock. We also used cash for payments on capital lease obligations.For 2003, net cash used in financing activities was $2.8 million, primarilyfor payments on capital lease obligations.

***OutstandingIndebtedness.******  ***As of December 31, 2005, we had$97.5 million in outstanding indebtedness, consisting of $92.1 million 83¤8%senior second secured notes due 2010, and $5.4 million in capital leaseobligations. Interest payments on the notes are required on each March 15and September 15 the notes are outstanding. We expect to be able to pay theSeptember 15, 2006 cash interest payment of $4.5 million from acombination of cash generated from operations and cash on hand.

The notes will mature on March 15, 2010, andaccrue interest at an annual rate of 8 3/8% with cash interest payments made ona semiannual basis on each March 15 and September 15. On or after March 15,2007 we may redeem some or all of the notes at declining redemption prices,plus accrued and unpaid cash interest, beginning at 106%.

In addition, if any notes are outstanding on September 15,2009, we will be required to redeem 3.5% of each then outstanding note’s accretedvalue at a redemption price of 100% of the accreted value of the portion of thenotes so redeemed, as well as an additional portion of each note to the extentrequired to prevent that note from being treated as an “applicable high yielddiscount obligation” within the meaning of Section 163(i)(1) of theInternal Revenue Code of 1986, as amended.

The indenture for the notes requires us and oursubsidiaries to comply with certain restrictive covenants, includinglimitations and restrictions, subject to certain baskets and carveouts, on theability of our subsidiaries to pay dividends or distributions, redeem orrepurchase equity securities, incur debt, make investments or sell assets andstock of subsidiaries, enter into affiliate transactions, incur liens andsecurity interests, merge, consolidate or sell all or substantially all of ourassets, make loans to us or any other restricted subsidiary or enter into anybusiness other than certain permitted businesses. Also, in the event of achange of control as defined in the indenture, we would be required to offer torepurchase all of the outstanding notes at a price equal to 101% of theirthen-current accreted value.

The notes and theguarantees are secured by a second priority lien on substantially of our existingand future property and assets other than:

·       Capitalstock and other securities;

·       realproperty leases;

·       propertyor assets owned by any foreign subsidiary; and

·       anyproperty in which a lien may not be granted.

***CapitalRequirements.******  ***We expect to spend between $40.0 and$43.0 million on capital expenditures in 2006. In addition, we expect to closeon our acquisition of OTI in the second quarter of 2006, for which we will payapproximately $20.0 million. We plan to raise at least $20.0 million of additionalfinancing prior to closing on our acquisition of OTI.

Based on our current level of operations andanticipated growth, however, we believe that our existing cash, cashequivalents and short-term investments will be sufficient to fund our operations.Other than the additional financing planned in connection with the OTIacquisition, we do not currently anticipate the need to raise additionalfinancing to fund capital expenditures or operations for at least the next 12months.

Any future acquisitions orother significant unplanned costs or cash requirements may require that weraise additional funds through the issuance of debt or equity. We cannot assureyou that such financing will 

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beavailable on terms acceptable to us or our stockholders, or at all. Insufficientfunds may require us to alter our business plan or take other actions thatcould have a material adverse effect on our business, results of operations andfinancial condition. If issuing equity securities raises additional funds,substantial dilution to existing stockholder may result.

**ContractualObligations**

| ** **                   | ** ** | **Total**                            | ** ** | **Less Than  One Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More Than  Five Years** | ** ** |
|------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|--------------------|------------|--------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **(Dollars in thousands)** | ** ** |
| Notes payable                |       | $                                    | 147,448    |                              |       | $                  | 8,982      |               |       | $                                   | 17,964     |   | $ | 120,502 |   |   | $ | — |   |   |
| Capital lease  obligations   |       | 6,294                                |       |                              | 3,011      |               |       | 3,256              |       | 27                                  |       |   | — |   |   |
| Operating lease  obligations |       | 24,133                               |       |                              | 4,929      |               |       | 9,187              |       | 5,745                               |       |   | 4,272 |   |   |
| Purchase  obligations        |       | 2,544                                |       |                              | 1,101      |               |       | 1,443              |       | —                              |       |   | — |   |   |
|                              |            |                                      |            |                                   |            |                    |            |                    |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

The contractual obligationfor notes payable includes related interest payments and assumes all notes currentlyoutstanding are outstanding prior to the date of mandatory redemption and alsoassumes the notes 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.

***Accounts Receivable and Allowance for DoubtfulAccounts***

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 is based on the best facts available to us and is reevaluated andadjusted as additional information is received. We have a credit policy thathelps minimize credit risk. We believe this risk is limited due to the largenumber and diversity of clients that 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 annualimpairment test in the fourth quarter of 2004 and 2005 and determined thatgoodwill had not been impaired.

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Intangibles consist ofdebt issuance costs, customer installation costs, customer relationships,developed technology, and non-compete agreements. In 2004 and 2005, debtissuance costs were incurred in connection with the issuance of notes payable.These costs are being amortized over the term of the respective debtobligation. The customer installation costs are being amortized over a periodof 48 months, which approximates the average life of a customer contract. Asa result of finalizing our purchase price allocation with ATI, we recorded $3.8million for customer relationships and $0.1 million for developed technology.Customer relationships and developed technology are being amortized over fourand three years, respectively. Non-compete agreement costs represent costsassociated with a non-compete agreement with a former employee. These costs arebeing amortized over the term of the agreement.

***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.

***Revenue***

Network services revenue consists primarily of localdial tone, switched access lines, long distance, access charges and dataservice. Revenue from local telephone service consists of charges for basiclocal service, including dedicated T1 access, and custom-calling features suchas call waiting and call forwarding. Revenue from long distance serviceconsists of monthly recurring and per-minute-of-use charges for a full range oftraditional switched and dedicated long distance, toll-free calling,international, calling card and operator services. Carrier access revenueconsists primarily of usage charges that we bill long distance carriers tooriginate and terminate calls to and from our customers. Revenue from dataservices consists primarily of monthly usage fees for Internet access services.

Monthly recurring network services revenue isrecognized in the month the services are used. In the case of local servicerevenue, monthly recurring local services charges are billed in advance butaccrued for and recognized on a prorated basis based on length of service inany given month.

Non-recurring revenues from the installation ofnetwork services are recognized over the average life of the customers.

Long distance and access charges are billed in arrearsbut accrued based on monthly average usage. We base our estimates of monthlyaverage usage on historical experience and periodically review our estimates toensure ongoing accuracy of the usage estimates. Historically, our actualexperience has not differed significantly from our estimates.

Business telephone systemsrevenue consists of revenue from the sale of telephone equipment and theservicing of telephone equipment systems. Telephone equipment revenue isrecognized upon delivery, completion of the installation and acceptance by thecustomer. Business telephone service revenue is recognized upon completion ofservice or, in the case of maintenance agreements, is spread equally over thelife of the maintenance contract, which typically ranges from one to two years.

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***Cost of Revenue***

We carefully review all of our vendor invoices andfrequently dispute inaccurate or inappropriate charges. In cases where wedispute certain charges, we frequently pay only undisputed amounts on vendorinvoices in order to pay the proper amounts owed. We record costs net ofdisputed amounts based on our expected outcome of disputes that are initiated. Weuse significant estimates to determine the level of success in disputeresolution and consider past historical experience, basis of dispute, financialstatus of the vendor and current relationship with the vendor and aging ofprior disputes in quantifying our estimates. Disputes are common in ourindustry and we believe our treatment of disputes is consistent with industrypractice.

We believe our cost ofrevenue accrual is sufficient to cover all outstanding disputes that we maylose. In addition, we accrue for expected costs that have not yet been invoicedand we believe our cost of revenue accrual is sufficient to cover these costsas well.

**NewAccounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, *Inventory Costs*. This statement requires that abnormalamounts of idle facility expense, freight, handling costs and spoilage berecognized as current-period charges. This statement also requires that fixedproduction overhead be allocated to inventory costs incurred by us beginning infiscal 2006. We do not expect the adoption of this statement will have amaterial impact on our consolidated financial statements.

In December 2004, as amended on April 14,2005, the FASB 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 the beginningof the first fiscal year beginning after June 15, 2005. We adopted SFAS123R on January 1, 2006.

We will use the modified prospective method in whichcompensation 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 thatremain unvested on the effective date. We are evaluating the potential impacton the financial statements.

In December 2004, the FASB issued SFAS No. 153,*Exchanges of Nonmonetary Assets*. SFASNo. 153 addresses the measurement of exchange of nonmonetary assets. SFAS No. 153eliminates the exception from fair value measurement for nonmonetary exchangesof similar productive assets in paragraph 21(b) of APB Opinion No. 29,*Accounting for Nonmonetary Transactions*,and replaces it with an exception for exchanges that do not have commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS No. 153 is effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005. We will adopt the provisions of SFAS No. 153 on January 1, 2006.The adoption of this statement will not have a material impact on ourconsolidated financial statements.

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*. SFASNo. 154 replaces Accounting Principles Board Opinion No. 20, *Accounting Changes*, and FASB Statement No. 3,*Reporting Accounting Changes in InterimFinancial Statements*, and requires the direct effects of accountingprinciple changes to be retrospectively applied. The existing guidance withrespect to accounting estimate changes and corrections of errors is carriedforward in SFAS No. 154. SFAS No. 154 is effective for accountingchanges and corrections of errors made in fiscal years beginning after December 15,2005.

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**Item 7A.**                Quantitativeand Qualitative Disclosure About Market Risk.

We are not exposed to market risks from changes inforeign currency exchange rates or commodity prices. We do not hold anyderivative financial instruments nor do we hold any securities for trading orspeculative purposes.

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 forthe year ended December 31, 2005 was $0.7 million, therefore not exposingus to any meaningful interest income risk had rates dropped. Excluding capitalleases, we had approximately $92.1 million in senior second secured notesoutstanding as of December 31, 2005. 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.**                        ChangesIn and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

**Item 9A.**                Controlsand Procedures.

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

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our reportsunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our principal executive officer and principal financialofficer, as appropriate, to allow timely decisions regarding requireddisclosure. In designing and evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

As required by SEC Rule 13a-15(b),an evaluation was performed under the supervision and with the participation ofour management, including our principal executive officer and our principalfinancial officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) as of the endof the period covered by this report. Based upon that evaluation, ourmanagement, including our principal executive officer and our principalfinancial officer, concluded that the design and operation of these disclosurecontrols and procedures were effective at the reasonable assurance level.

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

During the quarter ended December 31,2005, there have been no significant changes in our internal controls overfinancial reporting that materially affected, or are reasonably likely tomaterially affect, our internal controls over financial reporting.

**Item 9B.**               OtherInformation.

None.

54

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**Part III**

**Item 10.**                 Directorsand Executive Officers of the Registrant.

The disclosure under part I of Item 1 of this Form 10-Kentitled “Executive Officers” is incorporated by reference into this Item 10.

The sections entitled “Election of Directors,” “TheBoard of Directors and Committees” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our definitive proxy statement for our 2006Annual Meeting of Stockholders, which will be filed with the SEC (the “ProxyStatement”), are incorporated in this Form 10-K by reference.

We adopted a Code of Ethics that applies to allemployees, our executive officers and directors. Our Code of Ethics isavailable on our website at www.eschelon.com.

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

**Item 11.**                 ExecutiveCompensation.

The sections of the ProxyStatement entitled “The Board of Directors and Committees,” “ExecutiveCompensation,” “Employment and Change of Control Agreements,” “Report of theCompensation Committee on Executive Compensation” and “Compensation CommitteeInterlocks and Insider Participation” are incorporated in this Form 10-Kby reference.

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

The section of the ProxyStatement entitled “Security Ownership of Certain Beneficial Owners and Management”is incorporated by reference into this Form 10-K.

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

The section of the ProxyStatement entitled “Certain Relationships and Related Transactions” isincorporated by reference into this Form 10-K.

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

The section of the Proxy Statement entitled “Ratificationof Independent Registered Public Accounting Firm” is incorporated by referenceinto this Form 10-K.

55

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**PART IV**

**Item 15.   Exhibits, Financial StatementSchedules.**

**(a) Documentsfiled as part of the report:**

(1)          Report of IndependentRegistered Public Accounting Firm

Consolidated Balance Sheets as of December 31,2004 and 2005

Consolidated Statements of Operations for the yearsended December 31, 2003, 2004 and 2005

Consolidated Statements of Stockholders’ Equity(Deficit) for the years ended December 31, 2003, 2004 and 2005

Consolidated Statements of Cash Flows for the yearsended December 31, 2003, 2004 and 2005

Notes to Consolidated Financial Statements

(2)          Schedule II—Valuation ofQualifying Accounts and Reserves

Report of Independent Registered Public AccountingFirm

(3)          Exhibits

**(b) Exhibits:**

Thefollowing exhibits are filed or incorporated by reference as stated below:
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **Description** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1(2)          |       | Seventh Amended and Restated Certificate of  Incorporation of Eschelon Telecom, Inc. filed on July 8, 2005.                                                                                                                                                                                                                                                                                                                                                                                  |
| 3.2(2)          |       | Form of Amended and Restated Bylaws of Eschelon  Telecom, Inc. filed on July 8, 2005.                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.1*            |       | Fourth Amended and Restated Stockholders Agreement  dated June 27, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.1.2(1)        |       | 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. |

 

56

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| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **Description** |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 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.) |
| 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(1)         |       | Redemption Agreement as of October 13, 2004, by  and between NTFC Capital Corporation and Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                                                            |
| 10.1(4)         |       | Employment Agreement dated May 23, 2005 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.                                                                                                                                                                                                                                                                                                                                                        |
| 10.2.2(3)       |       | Amendment dated April 11, 2005 to Employement  Offer Letter dated March 7, 2000 from Eschelon Telecom, Inc. to  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 Advanced Telecommunications, Inc. to Steven K. Wachter.                                                                                                                                                                                                                                                                                                                                                                   |
| 10.5*           |       | Stock Restriction Agreement dated February 7,  2003 between Eschelon Telecom, Inc. and Marvin C. Moses.                                                                                                                                                                                                                                                                                                                                                                     |
| 10.6*^          |       | Carrier Global Services Agreement dated  July 28, 2000 by and between MCI WorldCom Communications, Inc. and  Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                                    |
| 10.6.1*^        |       | 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.                                                                                                                                                                                                                                                                                        |

 

57

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| Exhibit  Number | ** ** | ** **                                                                                                                                                                                      | ** ** | **Description** |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.6.2*^        |       | 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. |
| 10.6.3*^        |       | 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.  |
| 10.6.4*^        |       | WorldCom Internet Dedicated Service Agreement and  Service Order Form dated June 12, 2003.                                                                                            |
| 10.6.5*^        |       | WorldCom Internet Dedicated Service Agreement and  Service Order Form dated January 23, 2004.                                                                                         |
| 10.6.6*^        |       | WorldCom Internet Dedicated T3 Price-Protected  Agreement dated July 26, 2001.                                                                                                             |
| 10.6.7*^        |       | WorldCom Wholesale Dedicated Internet Pricing Sheet                                                                                                                                             |
| 10.7*^          |       | Carrier Service Agreement dated August 25, 2000  between Global Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                                                              |
| 10.7.1*^        |       | Amendment #1 dated November 10, 2000 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                |
| 10.7.2*^        |       | Amendment #2 dated January 2, 2001 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                  |
| 10.7.3*^        |       | Amendment #3 dated June 25, 2001 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                    |
| 10.7.4*^        |       | Amendment #4 dated July 17, 2001 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                    |
| 10.7.5*         |       | Amendment #5 dated April 25, 2002 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                   |
| 10.7.6*^        |       | Amendment #6 dated July 12, 2002 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                    |
| 10.7.7*^        |       | Amendment #7 dated March 26, 2004 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                   |
| 10.7.8(5)^      |       | Amendment #8 dated September 14, 2004 to  Carrier Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.               |
| 10.7.9(2)^^     |       | Amendment #9 dated July 1, 2005 to Carrier  Service Agreement dated August 25, 2000 between Global Crossing  Bandwidth, Inc. and Eschelon Telecom, Inc.                     |
| 10.11*          |       | Lease of Office Space by and between St. Paul  Properties, Inc. and Eschelon Telecom, Inc. dated as of  November 18, 2003.                                                       |
| 10.11.1         |       | Amendment of Lease dated December 29, 2005 of  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.           |

 

58

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| Exhibit  Number | ** ** | ** **                                                                                                                                                                             | ** ** | **Description** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 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.                                                 |
| 10.13.7         |       | Fifth Amendment dated January 9, 2006 of Lease  For Storage dated July 30, 1996 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.                                                            |
| 10.14.1         |       | Amendment dated February 15, 2006 of 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.                                                  |
| 10.16.1         |       | Amendment dated April 28, 2005 to 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.                                            |
| 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. |
| 10.18.2         |       | Second Amendment dated July 18, 2005 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(5)        |       | Lease Agreement by and between Hartmann Limited  Partnership & William Ludwig Hartmann Marital Trust and Advanced  TelCom, Inc. dated August 18, 2000.              |
| 10.23(5)        |       | Lease Agreement by and between Advanced  TelCom, Inc. and 200 South Virginia Investments, LLC dated July 16,  1999.                                                          |
| 10.23.1(5)      |       | First Amendment to Lease Agreement by and between  Advanced TelCom, Inc. and 200 South Virginia Investments, LLC dated  January 6, 1999.                                     |
| 10.23.2(5)      |       | Second Amendment to Lease Agreement by and between  Advanced TelCom, Inc. and 200 South Virginia Investments, LLC dated  August 1, 2001.                                     |
| 10.23.3(5)      |       | Third Amendment to Lease Agreement by and between  Advanced TelCom, Inc. and 200 South Virginia Investments, LLC dated  April 1, 2004.                                       |
| 10.23.4(5)      |       | Fourth Amendment to Lease Agreement by and between Advanced  TelCom, Inc. and 200 South Virginia Investments, LLC dated  September 2004.                                     |
| 10.24(5)        |       | Triple-Net Lease Agreement by and between Sunwest  Properties II, LLC and Eschelon Telecom, Inc. dated March 11, 2005.                                                       |
| 10.25(5)        |       | Standard Industrial/Commercial Single-Tenant  Lease—Net by and between Courthouse Square, LLC and Advanced TelCom  Group, Inc. dated January 29, 1999.                  |

 

59

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| Exhibit  Number | ** ** | ** **                                                                                                                                                                   | ** ** | **Description** |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.25.1(5)      |       | First Amendment to Lease by and between Courthouse  Square, LLC and Advanced TelCom Group, Inc. dated August 12, 1999.                                             |
| 10.25.2(5)      |       | Second Amendment to Lease by and between Kayares  International, LLC and Advanced TelCom Group, Inc. dated  November 1, 2002.                                      |
| 10.26(5)        |       | Lease by and between WVB Holdings, LLC and Advanced  TelCom, Inc. dated June 10, 2004.                                                                             |
| 10.27(5)        |       | Office Building Lease by and between Shaub  Properties, Inc. and Advanced TelCom Group, Inc. dated  March 7, 2000.                                            |
| 10.28(5)        |       | Office Lease by and between Retro, LLC and Advanced  TelCom Group, Inc. dated January 19, 1999.                                                                    |
| 10.28.1(5)      |       | Lease Modification Agreement by and between Retro,  LLC and Advanced TelCom Group, Inc. dated April 23, 1999.                                                      |
| 10.29(2)        |       | Form of Indemnification Agreement entered into  between Eschelon Telecom, Inc. and its directors and officers.                                                     |
| 10.30(5)        |       | Lease Agreement-Commercial Premises by and between  Avista Communications of Washington and Yesterday’s Village, Inc. dated  September 30, 1999.              |
| 10.30.1(5)      |       | Amended Lease Agreement by and between Advanced  TelCom, Inc. and Yesterday’s Village, Inc. dated March 27,  2003.                                       |
| 10.30.2(5)      |       | Amendment to Lease Agreement by and between Advanced  TelCom, Inc. and Yesterday’s Village, Inc. dated 2004.                                                  |
| 10.31(5)        |       | Lease by and between U.S. National Bank of Oregon  and Shared Communications Services, Inc. dated March 1, 1996.                                                   |
| 10.31.1(5)      |       | 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. |
| 14.1(1)         |       | Eschelon Telecom, Inc. Code of Ethics and  Business Conduct                                                                                                             |
| 21.1+           |       | Subsidiaries of Eschelon Telecom, Inc.                                                                                                                                  |
| 23.1            |       | Consent of Ernst & Young LLP                                                                                                                                        |
| 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 as filed with the Commission on April 26, 2004.

**                                       Incorporatedherein by reference to Eschelon Operating Company Registration Statement on Form S-4,No. 333-114437 as filed with the Commission on April 13, 2004.

+                                          Incorporatedherein by reference to Eschelon Operating Company Registration Statement on Form S-4,No. 333-122292 as filed with the Commission on January 25,2005.

^                                        Portionsof this Exhibit were omitted and have been filed separately with theSecretary of the Commission pursuant to the Company’s Application RequestingConfidential Treatment under Rule 24b-2 of the Exchange Act, filedon April 26, 2004, as amended on July 7, 2005.

60

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^^                           Portionsof this Exhibit were omitted and have been filed separately with theSecretary of the Commission pursuant to the Company’s Application RequestingConfidential Treatment under Rule 406 of the Securities Act, filed on July 7,2005.

(1)                                    Incorporatedherein by reference to Eschelon Telecom, Inc. Annual Report on Form 10-Kas filed with the Commission on March 31, 2005.

(2)                                    Incorporatedherein by reference to Eschelon Telecom, Inc. Registration Statement on Form S-1/A,No. 333-124703 as filed with the Commission on July 8, 2005.

(3)                                    Incorporatedherein by reference to Eschelon Telecom, Inc. Current Report on Form 8-Kas filed with the Commission on April 18, 2005.

(4)                                    Incorporatedherein by reference to Eschelon Telecom, Inc. Current Report on Form 8-Kas filed with the Commission on May 27, 2005.

(5)                                    Incorporatedherein by reference to Eschelon Telecom, Inc. Registration Statement on Form S-1,No. 333-124703 as filed with the Commission on May 6, 2005.

61

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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 15, 2006.

|   | ESCHELON TELECOM, INC. |
|--------|------------------------|
|   | By                     | /s/ RICHARD A. SMITH |
|   | Name:                  | Richard A. Smith |
|   | Title:                 | *President, Chief Executive Officer and Director* |

 

Each person whosesignature appears below constitutes and appoints Richard A. Smith, Geoffrey M.Boyd and J. Jeffery 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 |       |                |
| Richard A. Smith         |          | (Principal Executive Officer)                   |       | March 17, 2006 |
| /s/ GEOFFREY M. BOYD     |          | Chief Financial Officer                         |       |                |
| Geoffrey M. Boyd         |          | (Principal Financial and Accounting Officer)    |       | March 17, 2006 |
| /s/ CLIFFORD D. WILLIAMS |          | Chairman of the Board                           |       |                |
| Clifford D. Williams     |          |                                            |       | March 17, 2006 |
| /s/ MARVIN C. MOSES      |          | Director                                        |       |                |
| Marvin C. Moses          |          |                                            |       | March 17, 2006 |
| /s/ LOUIS L. MASSARO     |          | Director                                        |       |                |
| Louis L. Massaro         |          |                                            |       | March 17, 2006 |
| /s/ MARK E. NUNNELLY     |          | Director                                        |       |                |
| Mark E. Nunnelly         |          |                                            |       | March 17, 2006 |
| /s/ JAMES P. TENBROEK    |          | Director                                        |       |                |
| James P. TenBroek        |          |                                            |       | March 17, 2006 |
| /s/ IAN K. LORING        |          | Director                                        |       |                |
| Ian K. Loring            |          |                                            |       | March 17, 2006 |

 

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**Eschelon Telecom, Inc.**

**Schedule II—Valuation and Qualifying Accounts**

**Years Ended December 31, 2003, 2004 and 2005**

**(Dollars inthousands)**

| ** **                                   | ** ** | **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: |       |                                         |       |                                                     |       |                 |       |                                                                                 |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| 2003                                         |       |                                         | $          | 2,018                                                    |       |                 |       | $                                                                                    | 1,033      |                                   |       |   | $ | (2,312 | ) |   |   | $ | — |   |   |   | $ | 739 |   |   |
| 2004                                         |       |                                         | 739        |                                                     |       |                 | 1,567      |                                                                                 |       |                                   | (1,894     | ) |   |   | 405 |   |   |   | 817 |   |   |
| 2005                                         |       |                                         | 817        |                                                     |       |                 | 2,338      |                                                                                 |       |                                   | (2,663     | ) |   |   | — |   |   |   | 492 |   |   |
|                                              |            |                                              |            |                                                          |            |                      |            |                                                                                      |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **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** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| Valuation Allowance for  Deferred Income Tax Assets: |       |                                         |       |                                                     |       |                 |       |                                                                                 |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| 2003                                                 |       |                                         | $          | 38,482                                                   |       |                 |       | $                                                                                    | 6,279      |                                   |       |   | $ | — |   |   |   | $ | — |   |   |   | $ | 44,761 |   |   |
| 2004                                                 |       |                                         | 44,761     |                                                     |       |                 | 1,378      |                                                                                 |       |                                   | —     |   |   |   | — |   |   |   | 46,139 |   |   |
| 2005                                                 |       |                                         | 46,139     |                                                     |       |                 | 11,661     |                                                                                 |       |                                   | —     |   |   |   | — |   |   |   | 57,800 |   |   |
|                                                      |            |                                              |            |                                                          |            |                      |            |                                                                                      |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

63

----

CONSOLIDATEDFINANCIAL STATEMENTS

EschelonTelecom, Inc.

Years Ended December 31, 2003, 2004 and 2005

----

**EschelonTelecom, Inc.Consolidated Financial StatementsYears Ended December 31, 2003, 2004 and 2005**

**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**

The Board of DirectorsEschelon Telecom, Inc.

We have audited the accompanying consolidated balancesheets of Eschelon Telecom, Inc. as of December 31, 2004 and 2005,and the related consolidated statements of operations, stockholders’ equity(deficit), and cash flows for each of the three years in the period ended December 31,2005. 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 to perform an audit of the Company’s internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofEschelon Telecom, Inc. at December 31, 2004 and 2005, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2005, in conformity with UnitedStates generally accepted accounting principles. Also, in our opinion, therelated financial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.
|                        |        |
|------------------------|--------|
| February 17, 2006 |   |
| Minneapolis, Minnesota |   |

 

F-2

----

**Eschelon Telecom, Inc.Consolidated Balance Sheets(Dollars in Thousands, Except per Share Amounts)**

| ** **                                                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                  | ** ** | **2004**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                                                  |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                             |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                   |       | $                     | 26,435     | ** ** | **$** | **26,062** | ** ** |
| Restricted cash                                                                                                                                                                                             |       | 722                   | ** ** | **996** | ** ** |
| Available-for-sale securities                                                                                                                                                                               |       | 6,194                 | ** ** | **4,760** | ** ** |
| Accounts receivable, net of allowance for doubtful  accounts of $817 and $492, respectively                                                                                                                 |       | 18,941                | ** ** | **22,996** | ** ** |
| Other receivables                                                                                                                                                                                           |       | 2,976                 | ** ** | **3,052** | ** ** |
| Inventories                                                                                                                                                                                                 |       | 2,873                 | ** ** | **2,927** | ** ** |
| Prepaid expenses                                                                                                                                                                                            |       | 2,410                 | ** ** | **2,294** | ** ** |
| Total current assets                                                                                                                                                                                        |       | 60,551                | ** ** | **63,087** | ** ** |
| Property and equipment, net                                                                                                                                                                                 |       | 102,849               | ** ** | **126,452** | ** ** |
| Other assets                                                                                                                                                                                                |       | 1,985                 | ** ** | **1,506** | ** ** |
| Goodwill                                                                                                                                                                                                    |       | 38,776                | ** ** | **7,168** | ** ** |
| Intangible assets, net                                                                                                                                                                                      |       | 32,958                | ** ** | **33,333** | ** ** |
| Total assets                                                                                                                                                                                                |       | $                     | 237,119    | ** ** | **$** | **231,546** | ** ** |
| **Liabilities  and stockholders’ equity (deficit)**                                                                                                                                                    |       |                  | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                        |       |                  | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                            |       | $                     | 13,801     | ** ** | **$** | **16,400** | ** ** |
| Accrued telecommunication costs                                                                                                                                                                             |       | 2,190                 | ** ** | **4,227** | ** ** |
| Accrued office rent                                                                                                                                                                                         |       | 2,336                 | ** ** | **2,035** | ** ** |
| Accrued interest expense                                                                                                                                                                                    |       | 4,070                 | ** ** | **2,646** | ** ** |
| Other accrued expenses                                                                                                                                                                                      |       | 5,998                 | ** ** | **5,485** | ** ** |
| Deferred revenue                                                                                                                                                                                            |       | 7,300                 | ** ** | **7,921** | ** ** |
| Accrued compensation expenses                                                                                                                                                                               |       | 3,588                 | ** ** | **2,809** | ** ** |
| Capital lease obligations, current maturities                                                                                                                                                               |       | 1,629                 | ** ** | **2,430** | ** ** |
| Total current liabilities                                                                                                                                                                                   |       | 40,912                | ** ** | **43,953** | ** ** |
| Long-term  liabilities:                                                                                                                                                                                     |       |                  | ** ** | ** ** | ** ** |
| Other long-term liabilities                                                                                                                                                                                 |       | 630                   | ** ** | **251** | ** ** |
| Capital lease obligations, less current maturities                                                                                                                                                          |       | 2,824                 | ** ** | **2,964** | ** ** |
| Notes payable                                                                                                                                                                                               |       | 137,778               | ** ** | **92,125** | ** ** |
| Total liabilities                                                                                                                                                                                           |       | 182,144               | ** ** | **139,293** | ** ** |
| Series A convertible preferred stock, $0.01 par  value per share; 100,000,000 shares authorized and 77,526,136 shares issued  and outstanding on December 31, 2004                                |       | 48,155                | ** ** | **—** | ** ** |
| Series B convertible preferred stock, $0.01 par  value per share; 25,000,000 shares authorized and 20,000,000 shares  issued and outstanding on December 31, 2004                            |       | 15,000                | ** ** | **—** | ** ** |
| Stockholders’ equity (deficit):                                                                                                                                                                        |       |                  | ** ** | ** ** | ** ** |
| Common stock, $0.01 par value per share; 200,000,000  shares authorized; issued and outstanding shares—351,134 shares on  December 31, 2004 and 14,634,279 shares on December 31, 2005  |       | 4                     | ** ** | **146** | ** ** |
| Additional paid-in capital                                                                                                                                                                                  |       | 115,876               | ** ** | **248,199** | ** ** |
| Accumulated other comprehensive income                                                                                                                                                                      |       | 30                    | ** ** | **56** | ** ** |
| Accumulated deficit                                                                                                                                                                                         |       | (124,056              | )          | **(155,047** | **)** |
| Deferred compensation                                                                                                                                                                                       |       | (34                   | )          | **(1,101** | **)** |
| Total stockholders’ equity (deficit)                                                                                                                                                                   |       | (8,180                | )          | **92,253** | ** ** |
| Total liabilities  and stockholders’ equity (deficit)                                                                                                                                                  |       | $                     | 237,119    | ** ** | **$** | **231,546** | ** ** |

 

See accompanying notes.

F-3

----

**EschelonTelecom, Inc.Consolidated Statements of Operations(Dollars in Thousands, Except per Share Amounts)**

| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenue:                                                                          | ** ** | ** **                                 |       |   | ** ** | ** ** | ** ** |
| Network services                                                                  |       | $                                          | 115,482    |   | $ | 131,780 | ** ** | **$** | **201,835** | ** ** |
| Business telephone systems                                                        |       | 25,614                                     |       | 26,316 | ** ** | **25,908** | ** ** |
|                                                                              |       | 141,096                                    |       | 158,096 | ** ** | **227,743** | ** ** |
| Cost of revenue:                                                                  |       |                                       |       |   | ** ** | ** ** | ** ** |
| Network services (exclusive of depreciation and  amortization)                    |       | 45,037                                     |       | 47,354 | ** ** | **85,914** | ** ** |
| Business telephone systems                                                        |       | 15,784                                     |       | 15,979 | ** ** | **16,139** | ** ** |
|                                                                              |       | 60,821                                     |       | 63,333 | ** ** | **102,053** | ** ** |
| Gross profit:                                                                     |       |                                       |       |   | ** ** | ** ** | ** ** |
| Network services                                                                  |       | 70,445                                     |       | 84,426 | ** ** | **115,921** | ** ** |
| Business telephone systems                                                        |       | 9,830                                      |       | 10,337 | ** ** | **9,769** | ** ** |
|                                                                              |       | 80,275                                     |       | 94,763 | ** ** | **125,690** | ** ** |
| Operating  expenses:                                                              |       |                                       |       |   | ** ** | ** ** | ** ** |
| General and administrative                                                        |       | 39,297                                     |       | 41,755 | ** ** | **56,431** | ** ** |
| Sales and marketing                                                               |       | 26,955                                     |       | 27,500 | ** ** | **33,879** | ** ** |
| Depreciation and amortization                                                     |       | 30,099                                     |       | 31,105 | ** ** | **39,653** | ** ** |
| Operating loss                                                                    |       | (16,076                                    | )          | (5,597 | ) | **(4,273** | **)** |
| Other income  (expense):                                                          |       |                                       |       |   | ** ** | ** ** | ** ** |
| Interest income                                                                   |       | 168                                        |       | 124 | ** ** | **691** | ** ** |
| Interest expense                                                                  |       | (1,754                                     | )          | (11,452 | ) | **(28,125** | **)** |
| Gain on extinguishment of debt                                                    |       | —                                     |       | 18,195 | ** ** | **—** | ** ** |
| Other income (expense)                                                            |       | 484                                        |       | (155 | ) | **65** | ** ** |
| Income (loss)  before income taxes                                                |       | (17,178                                    | )          | 1,115 | ** ** | **(31,642** | **)** |
| Income taxes                                                                      |       | (28                                        | )          | (4 | ) | **(4** | **)** |
| Net income (loss)  from continuing operations                                     |       | (17,206                                    | )          | 1,111 | ** ** | **(31,646** | **)** |
| Income from discontinued operation, net of tax                                    |       | —                                     |       | — | ** ** | **329** | ** ** |
| Gain on sale of discontinued operation, net of tax                                |       | —                                     |       | — | ** ** | **326** | ** ** |
| Net income (loss)                                                                 |       | (17,206                                    | )          | 1,111 | ** ** | **(30,991** | **)** |
| Less preferred  stock dividends and premium paid on repurchase of preferred stock |       | (3,426                                     | )          | (4,292 | ) | — |   |
| Net income (loss)  applicable to common stockholders                              |       | $                                          | (20,632    | ) | $ | (3,181 | ) | **$** | **(30,991** | **)** |
| Basic and diluted  income (loss) per share:                                       |       |                                       |       |   | ** ** | ** ** | ** ** |
| Continuing operations                                                             |       | $                                          | (70.59     | ) | $ | (11.11 | ) | **$** | **(5.32** | **)** |
| Discontinued operation                                                            |       | —                                     |       | — | ** ** | **0.11** | ** ** |
| Net income (loss)                                                                 |       | $                                          | (70.59     | ) | $ | (11.11 | ) | **$** | **(5.21** | **)** |
| Weighted average  shares outstanding:                                             |       |                                       |       |   | ** ** | ** ** | ** ** |
| Basic and diluted                                                                 |       | 292,481                                    |       | 287,393 | ** ** | **5,949,310** | ** ** |

 

See accompanying notes.

F-4

----

**EschelonTelecom, Inc.Consolidated Statements of Stockholders’ Equity (Deficit)(Dollars in Thousands)**

| ** **                                                | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Deferred** | ** **  | ** **       | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|--------------|-------------|------------------|------------|
| ** **                                                | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Income**      | ** ** | **Deficit**  | ** **  | **Compensation** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2002                        |       | 117,307               |       |                    | $          | 1                                     |       |            |       | $            | 123,502     |             |       |   | $ | — |   |   |   | $ | (107,961 | ) |   |   | $ | — |   |   | $ | 15,542 |   |
| Forfeiture of  common stock after corporate restructuring |       | (63                   | )          |                    | —     |                                  |       |            | —     |         |        |             | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| 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                      |       | 183,399               |       |                    | 2          |                                  |       |            | 122        |         |        |             | —     |   |   |   | — |   |   |   | (124 | ) |   | — |   |
| Stock options  exercised                                  |       | 28,290                |       |                    | —     |                                  |       |            | 19         |         |        |             | —     |   |   |   | — |   |   |   | — |   |   | 19 |   |
| Amortization of  deferred compensation                    |       | —                |       |                    | —     |                                  |       |            | —     |         |        |             | —     |   |   |   | — |   |   |   | 70 |   |   | 70 |   |
| Net loss for the  year                                    |       | —                |       |                    | —     |                                  |       |            | —     |         |        |             | —     |   |   |   | (17,206 | ) |   |   | — |   |   | (17,206 | ) |
| Balance at  December 31, 2003                        |       | 328,933               |       |                    | 3          |                                  |       |            | 120,147    |         |        |             | —     |   |   |   | (125,167 | ) |   |   | (54 | ) |   | (5,071 | ) |
| Accumulated  dividends in connection with preferred stock |       | —                |       |                    | —     |                                  |       |            | (3,435     | )            |        |             | —     |   |   |   | — |   |   |   | — |   |   | (3,435 | ) |
| Series A  convertible preferred stock repurchase     |       | —                |       |                    | —     |                                  |       |            | (857       | )            |        |             | —     |   |   |   | — |   |   |   | — |   |   | (857 | ) |
| Issuance of  restricted common stock                      |       | 10,358                |       |                    | —     |                                  |       |            | 14         |         |        |             | —     |   |   |   | — |   |   |   | — |   |   | 14 |   |
| Stock options  exercised                                  |       | 11,843                |       |                    | 1          |                                  |       |            | 7          |         |        |             | —     |   |   |   | — |   |   |   | — |   |   | 8 |   |
| Unrealized gain on  available-for-sale securities         |       | —                |       |                    | —     |                                  |       |            | —     |         |        |             | 30         |   |   |   | — |   |   |   | — |   |   | 30 |   |
| Amortization of  deferred compensation                    |       | —                |       |                    | —     |                                  |       |            | —     |         |        |             | —     |   |   |   | — |   |   |   | 20 |   |   | 20 |   |
| Net income for the  year                                  |       | —                |       |                    | —     |                                  |       |            | —     |         |        |             | —     |   |   |   | 1,111 |   |   |   | — |   |   | 1,111 |   |
| Balance at  December 31, 2004                        |       | 351,134               |       |                    | 4          |                                  |       |            | 115,876    |         |        |             | 30         |   |   |   | (124,056 | ) |   |   | (34 | ) |   | (8,180 | ) |
| Accumulated  dividends in connection with preferred stock | ** ** | **—**            | ** ** | ** **              | **—** |                                  | ** ** | ** **      | **(2,648** | **)**        | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **(2,648** | **)** |
| Issuance of  restricted common stock                      | ** ** | **9,350**             | ** ** | ** **              | **—** |                                  | ** ** | ** **      | **27**     | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **27** | ** ** |
| Stock options  exercised                                  | ** ** | **78,457**            | ** ** | ** **              | **1**      |                                  | ** ** | ** **      | **59**     | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **60** | ** ** |
| Restricted stock  forfeited                               | ** ** | **(494**              | **)**      | ** **              | **—** |                                  | ** ** | ** **      | **—** | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **—** | ** ** |
| Deferred  compensation related to stock options granted   | ** ** | **—**            | ** ** | ** **              | **—** |                                  | ** ** | ** **      | **2,003**  | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **(2,003** | **)** | ** ** | **—** | ** ** |
| Amortization of  deferred compensation                    | ** ** | **—**            | ** ** | ** **              | **—** |                                  | ** ** | ** **      | **—** | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **936** | ** ** | ** ** | **936** | ** ** |
| Unrealized gain on  available-for-sale securities         | ** ** | **—**            | ** ** | ** **              | **—** |                                  | ** ** | ** **      | **—** | ** **   | ** **  | ** **       | **26**     |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **26** | ** ** |
| Convert preferred  stock to common stock                  | ** ** | **8,838,689**         | ** ** | ** **              | **88**     |                                  | ** ** | ** **      | **65,869** | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **65,957** | ** ** |
| Sale of common  stock, net of fees                        | ** ** | **5,357,143**         | ** ** | ** **              | **53**     |                                  | ** ** | ** **      | **67,013** | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **—** | ** ** | ** ** | ** ** | **—** | ** ** | ** ** | **67,066** | ** ** |
| Net loss for the  year                                    | ** ** | **—**            | ** ** | ** **              | **—** |                                  | ** ** | ** **      | **—** | ** **   | ** **  | ** **       | **—** |   | ** ** | ** ** | **(30,991** | **)** | ** ** | ** ** | **—** | ** ** | ** ** | **(30,991** | **)** |
| Balance at  December 31, 2005                        | ** ** | **14,634,279**        | ** ** | ** **              | **$**      | **146**                               |       | ** **      | ** ** | **$**        | **248,199** | ** **       | ** ** | ** ** | **$** | **56** |   | ** ** | ** ** | **$** | **(155,047** | **)** | ** ** | ** ** | **$** | **(1,101** | **)** | ** ** | **$** | **92,253** | ** ** |

 

See accompanyingnotes.

F-5

 

----

**EschelonTelecom, Inc.Consolidated Statements of Cash Flows(In Thousands)**

| ** **                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| **Operating  activities**                                                                 | ** ** | ** **                                 |       |   | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $                                          | (17,206    | ) | $ | 1,111 | ** ** | **$** | **(30,991** | **)** |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                       |       |   | ** ** | ** ** | ** ** |
| Depreciation and amortization expense                                                     |       | 30,099                                     |       | 31,105 | ** ** | **39,653** | ** ** |
| Provision for bad debt expense                                                            |       | 500                                        |       | 721 | ** ** | **1,090** | ** ** |
| Noncash interest expense                                                                  |       | 1,302                                      |       | 2,339 | ** ** | **7,288** | ** ** |
| Value of stock issued to management and directors                                         |       | 70                                         |       | 34 | ** ** | **963** | ** ** |
| Loss (gain) on write-off and sales of assets                                              |       | (484                                       | )          | 162 | ** ** | **260** | ** ** |
| Gain on extinguishment of debt                                                            |       | —                                     |       | (18,195 | ) | **—** | ** ** |
| Gain on sales of available-for-sale securities                                            |       | —                                     |       | (7 | ) | **(326** | **)** |
| Gain on sale of discontinued operation                                                    |       | —                                     |       | — | ** ** | **(326** | **)** |
| Changes in operating assets and liabilities:                                              |       |                                       |       |   | ** ** | ** ** | ** ** |
| Restricted cash                                                                           |       | —                                     |       | (722 | ) | **(274** | **)** |
| Accounts receivable                                                                       |       | (1,520                                     | )          | 658 | ** ** | **(5,145** | **)** |
| Other receivables                                                                         |       | 904                                        |       | (546 | ) | **(76** | **)** |
| Inventories                                                                               |       | (393                                       | )          | 296 | ** ** | **(54** | **)** |
| Prepaid expenses and other assets                                                         |       | (219                                       | )          | (209 | ) | **495** | ** ** |
| Discontinued assets held for sale, net of liabilities                                     |       | —                                     |       | — | ** ** | **222** | ** ** |
| Accounts payable and accrued expenses                                                     |       | 3,450                                      |       | 8,984 | ** ** | **2,133** | ** ** |
| Deferred revenue                                                                          |       | (397                                       | )          | 878 | ** ** | **621** | ** ** |
| Accrued compensation expenses                                                             |       | 582                                        |       | (1,216 | ) | **(779** | **)** |
| Net cash provided  by operating activities                                                |       | 16,688                                     |       | 25,393 | ** ** | **14,754** | ** ** |
| **Investing activities**                                                                  |       |                                       |       |   | ** ** | ** ** | ** ** |
| Purchase of  subsidiaries, net of cash acquired                                           |       | —                                     |       | (45,495 | ) | **(48** | **)** |
| Purchase of assets  held for sale, net of liabilities                                     |       | —                                     |       | — | ** ** | **(216** | **)** |
| Purchases of  available-for-sale securities                                               |       | —                                     |       | (8,198 | ) | **(30,526** | **)** |
| Proceeds from  sales of available-for-sale securities                                     |       | —                                     |       | 2,041 | ** ** | **32,312** | ** ** |
| Purchases of  property and equipment                                                      |       | (13,367                                    | )          | (15,414 | ) | **(19,227** | **)** |
| Cash paid for  customer installation costs                                                |       | (11,669                                    | )          | (11,293 | ) | **(13,551** | **)** |
| Proceeds from sale  of assets                                                             |       | 28                                         |       | 25 | ** ** | **239** | ** ** |
| Proceeds from sale  of discontinued operation, net of fees                                |       | —                                     |       | — | ** ** | **320** | ** ** |
| Net cash used in  investing activities                                                    |       | (25,008                                    | )          | (78,334 | ) | **(30,481** | **)** |
| **Financing activities**                                                                  |       |                                       |       |   | ** ** | ** ** | ** ** |
| Proceeds from  issuance of notes payable                                                  |       | —                                     |       | 136,163 | ** ** | **—** | ** ** |
| Payments made on notes  and capital lease obligations                                     |       | (2,697                                     | )          | (66,948 | ) | **(51,362** | **)** |
| Proceeds from  (fees associated with) issuance of preferred stock                         |       | (70                                        | )          | 15,000 | ** ** | **154** | ** ** |
| Payment on repurchase  of preferred stock                                                 |       | —                                     |       | (5,085 | ) | **—** | ** ** |
| Proceeds from  issuance of common stock, net of fees                                      |       | 19                                         |       | 8 | ** ** | **67,126** | ** ** |
| Increase in debt  issuance costs                                                          |       | (59                                        | )          | (8,368 | ) | **(348** | **)** |
| Net cash provided  by (used in) financing activities                                      |       | (2,807                                     | )          | 70,770 | ** ** | **15,570** | ** ** |
| Net increase (decrease) in cash and cash equivalents                                      |       | (11,127                                    | )          | 17,829 | ** ** | **(373** | **)** |
| Cash and cash  equivalents at beginning of year                                           |       | 19,733                                     |       | 8,606 | ** ** | **26,435** | ** ** |
| Cash and cash  equivalents at end of year                                                 |       | $                                          | 8,606      |   | $ | 26,435 | ** ** | **$** | **26,062** | ** ** |
| **Supplemental cash flow information**                                                    |       |                                       |       |   | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                    |       | $                                          | 452        |   | $ | 9,114 | ** ** | **$** | **20,837** | ** ** |
| **Supplemental noncash activities**                                                       |       |                                       |       |   | ** ** | ** ** | ** ** |
| Equipment  purchases under capital leases                                                 |       | $                                          | 1,430      |   | $ | 4,064 | ** ** | **$** | **3,127** | ** ** |
| Value of common stock issued to management and  certain members of the board of directors |       | $                                          | 124        |   | $ | 14 | ** ** | **$** | **27** | ** ** |

 

See accompanying notes.

F-6

----

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

**1.   Summary of Significant Accounting Policies**

**Organization**

Eschelon Telecom, Inc. (the Company) is a competitivelocal exchange carrier, headquartered in Minneapolis, Minnesota. The Companywas incorporated in Delaware in 1996 under the name AdvancedTelecommunications, Inc. The Company is a facilities-based provider ofintegrated voice and data communications services to small and medium-sizedbusinesses in 19 markets in the western United States. The Company offers voiceand data services, which are referred to as network services. The Company alsosells, installs and maintains business telephone and data systems and equipmentreferred to as business telephone systems.

The Company offers thefollowing products and services:

| **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 Systems                                   |
| Other Enhanced Services  |       | E-Mail                     |       | IP Phone Systems                                     |
|                     |       | Web-Hosting                |       | After Market Maintenance  and Upgrade Contracts      |

 

**Principles of Consolidation**

The consolidated financialstatements include the accounts of the Company and its wholly owned subsidiaries.All intercompany balances and transactions have been eliminated inconsolidation.

**Reclassifications**

Certain prior year itemshave been reclassified to conform to current year presentation.

**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, 2004 and 2005, the Company had investmentsin securities of $17,051 and $21,728, respectively, which are included in cashand cash equivalents.

**Restricted Cash**

In August 2004, a Nevadastate court entered a judgment against the Company in the amount of $376 pluscosts. The Company appealed the judgment and was required to hold $577 asrestricted cash. Also in 2004, the Company held $75 for collateral on bankcredit cards and $70 for performance bonds as restricted cash.

F-7

----

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

**1.**   Summary of Significant Accounting Policies (Continued)

In January 2005, theCompany settled the Nevada state court judgment agreeing to pay a total of $300in three annual installments starting in January 2005. As part of the agreementthe Company is required to hold the remaining installments in restricted cash.As a result, the Company reduced the amount held in restricted cash from $577to $200.

In 2005, the Companyincreased the amount held in restricted cash for performance bonds from $70 to$720 as a result of the ATI acquisition. Also in 2005, the Company reduced theamount held in restricted cash for collateral on bank credit cards from $75 to$55. Restricted cash also includes $6 for interest earned on balances held.

**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 of Significant Accounting Policies (Continued)

Property and equipmentconsists of the following:

| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Vehicles                                   |       | $                     | 590        | ** ** | **$** | **1,375** | ** ** |
| Office furniture  and equipment            |       | 16,746                | ** ** | **18,229** | ** ** |
| Computer equipment  and software           |       | 34,534                | ** ** | **41,897** | ** ** |
| Leasehold  improvements                    |       | 19,504                | ** ** | **23,765** | ** ** |
| Switching and data  equipment and software |       | 99,736                | ** ** | **134,661** | ** ** |
|                                       |       | 171,110               | ** ** | **219,927** | ** ** |
| Less accumulated  depreciation             |       | (68,261               | )          | **(93,475** | **)** |
|                                       |       | $                     | 102,849    | ** ** | **$** | **126,452** | ** ** |

 

Total depreciation expensewas $19,270, 18,684 and 25,565 for the years ended December 31, 2003, 2004and 2005, respectively.

The Company reviews alllong-lived assets 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.

**Goodwilland Other Intangible Assets**

Goodwill is tested at least annually for impairment atthe reporting unit level. If the implied fair value of a reporting unit is lessthan the carrying amount, an impairment charge is recognized. In accordancewith SFAS No. 142, *Goodwill and OtherIntangible Assets*, management completed its annual impairment testin the fourth quarter of 2004 and 2005 and determined that goodwill had notbeen impaired.

On September 15, 2005, the Company redeemed 35% ofits outstanding 8 3/8% senior second secured notes due March 15, 2010. Inconnection with the redemption, the Company wrote off a proportionate amount ofthe associated debt issuance costs resulting in a net decrease to intangibleassets and a corresponding increase to interest expense of $2,579.

The following tablerepresents other intangible assets by category and accumulated amortization asof December 31, 2005 and 2004:

| ** **                   | ** ** | **Gross**    | ** ** | ** **      | ** ** | ** **       | ** ** | **Estimated**       | ** ** |
|------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|---------------------|------------|
| ** **                   | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** **       | ** ** | **Life Range** | ** ** |
| **2005**                     | ** ** | ** **   | ** ** | **Amount**      | ** ** | **Amortization** | ** ** | **Net**             | ** ** | **(in Years)** | ** ** |
| Customer  installation costs |       |         | $          | 77,650          |       |             |       | $                   | 52,034     |   |   | $ | 25,616 |   |   | 4 |   |   |
| Debt issuance  costs         |       |         | 5,666      |            |       |             | 1,077      |                |       | 4,589 |   |   | 7 |   |   |
| Customer  relationships      |       |         | 3,820      |            |       |             | 955        |                |       | 2,865 |   |   | 4 |   |   |
| Non-compete  agreements      |       |         | 300        |            |       |             | 100        |                |       | 200 |   |   | 3 |   |   |
| Developed  technology        |       |         | 94         |            |       |             | 31         |                |       | 63 |   |   | 3 |   |   |
| Total                        |       |         | 87,530     |            |       |             | 54,197     |                |       | 33,333 |   |   | 4 | (1) |   |
|                              |            |              |            |                 |            |                  |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |

 

F-9

----

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

**1.**   Summary of Significant Accounting Policies (Continued)

| ** **                   | ** ** | **Gross**    | ** ** | ** **      | ** ** | ** **       | ** ** | **Estimated**       | ** ** |
|------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|---------------------|------------|
| ** **                   | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | ** **       | ** ** | **Life Range** | ** ** |
| **2004**                     | ** ** | ** **   | ** ** | **Amount**      | ** ** | **Amortization** | ** ** | **Net**             | ** ** | **(in Years)** | ** ** |
| Customer  installation costs |       | $            | 64,087     |            |       | $                | 39,019     |                |       | $ | 25,068 |   |   | 4 |   |   |
| Debt issuance  costs         |       | 8,368        |       |            | 476        |             |       | 7,890               |       |   | 7 |   |   |
| Non-compete  agreements      |       | 15           |       |            | 15         |             |       | —              |       |   | 5 |   |   |
| Total                        |       | 72,470       |       |            | 39,512     |             |       | 32,958              |       |   | 4 | (1) |   |
|                              |            |              |            |                 |            |                  |            |                     |            |  |  |  |  |  |  |  |  |  |

----

(1)   Weightedaverage life.

Total amortization expensewas $11,667, $13,076 and $15,153 for the years ended December 31, 2003,2004 and 2005, respectively. Estimated amortization expense for each of thefive succeeding fiscal years based on current intangible assets is expected tobe $12,363, $10,045, $6,978, $2,978 and $969, 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.

**Cost of Revenue**

The Company carefullyreviews all vendor invoices and frequently disputes inaccurate or inappropriatecharges. In cases where the Company disputes certain charges, only undisputedamounts on vendor invoices are paid in order to pay the proper amounts owed.The Company records costs net of disputed amounts based on the expected outcomeof disputes that are initiated. The Company uses significant estimates todetermine the level of success in dispute resolution and considers pasthistorical experience, basis of dispute, financial status of the vendor andcurrent relationship with the vendor and aging of prior disputes in quantifyingestimates.

**Deferred Revenue**

Deferred revenue consists of voice and data servicesthat are billed in advance and recorded as a liability for services provided inthe future, maintenance contracts related to servicing business telephonesystems and estimated warranty costs associated with business telephonesystems.

Deferred revenue relatedto voice and data services is recognized over the average customer life.Deferred revenue related to maintenance contracts is recognized over the lifeof the contract. Deferred revenue related to estimated warranty costs isrecognized over the warranty period, which typically ranges from one to two years.

**Advertising Costs**

Advertising costs areexpensed as incurred. For the years ended December 31, 2003, 2004 and2005, the Company had advertising expense of $479, $464 and $589, respectively.

F-10

----

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

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

**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 is based on the best facts available to the Company andis reevaluated and adjusted as additional information is received.

**Use of Estimates**

The preparation of financialstatements in conformity with United States generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying notes. Actualresults 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).

Thecomponents of accumulated other comprehensive income are as follows:

| Balance,  December 31, 2003                     |   | $  | — |   |
|------------------------------------------------------|--------|----|--------|--------|
| Net unrealized  gain (loss) on financial instruments |   | 30 |   |
| Balance,  December 31, 2004                     |   | 30 |   |
| Net unrealized gain  (loss) on financial instruments |   | 26 |   |
| Balance,  December 31, 2005                     |   | $  | 56     |   |

 

**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.

**Net Income (Loss) Per Share**

Basic earnings per shareis computed based on the weighted average number of common shares outstanding.Diluted earnings per share is computed based on the weighted average number ofcommon 

F-11

----

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

**1.**   Summary of Significant Accounting Policies (Continued)

sharesoutstanding adjusted by the number of additional shares that would have beenoutstanding had the potentially dilutive common shares been issued. Potentiallydilutive shares of common stock include unexercised stock options and unvestedrestricted stock grants. The Company does not have any potentially dilutiveshares because net losses were reported in all periods presented.

**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.*SFAS No. 148 requires disclosure of how stock compensation expense wouldbe computed under SFAS No. 123, *Accountingfor Stock-Based Compensation*, using the fair value method.

Thefollowing table illustrates the effect on net income (loss) per share if theCompany had applied the fair value recognition provision of SFAS No. 123to stock-based employee compensation:

| ** **                                                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net loss  applicable to common stockholders as reported                                                           |       | $                                          | (20,632    | ) | $ | (3,181 | ) | **$** | **(30,991** | **)** |
| Add: Stock-based  employee compensation expense included in reported net loss, net of related  tax effects        |       | 70                                         |       | 20 | ** ** | **963** | ** ** |
| Deduct: Total  stock-based employee compensation expense determined under fair value-based  method for all awards |       | (133                                       | )          | (45 | ) | **(1,303** | **)** |
| Pro forma net  loss applicable to common stockholders                                                             |       | $                                          | (20,695    | ) | $ | (3,206 | ) | **$** | **(31,331** | **)** |
| Net income (loss) per  share:                                                                                     |       |                                       |       |   | ** ** | ** ** | ** ** |
| Basic and diluted—as reported                                                                                |       | $                                          | (70.59     | ) | $ | (11.11 | ) | **$** | **(5.21** | **)** |
| Basic and  diluted—pro forma                                                                                 |       | (70.73                                     | )          | (11.11 | ) | **(5.27** | **)** |

 

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,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Expected dividend  yield         |       | —                                     |       | — | ** ** | **—** | ** ** |
| Expected stock  price volatility |       | 25                                         | %          | 25 | % | **25** | **%** |
| Risk-free  interest rate         |       | 3.25                                       | %          | 3.88 | % | **4.45** | **%** |
| Expected life of options         |       | 5 years                                    |       | 5 years | ** ** | **5 years** | ** ** |

 

**New Accounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 151, *Inventory Costs*. This statement requires that abnormalamounts of idle facility expense, freight, handling 

F-12

----

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

**1.**   Summary of Significant AccountingPolicies (Continued)

costs and spoilage berecognized as current-period charges. This statement also requires that fixedproduction overhead be allocated to inventory costs beginning in fiscal 2006.The Company does not expect that the adoption of this statement will have amaterial impact on its consolidated financial statements.

In December 2004, as amended on April 14,2005, the FASB 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 the beginningof the first fiscal year beginning after June 15, 2005. The Company adoptedSFAS 123R on January 1, 2006.

The Company will use the 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 thatremain unvested on the effective date. The Company is evaluating the potentialimpact on its financial statements.

In December 2004, the FASB issued SFAS No. 153,*Exchanges of Nonmonetary Assets*.SFAS No. 153 addresses the measurement of exchange of nonmonetary assets.SFAS No. 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets in paragraph 21(b) ofAPB Opinion No. 29, *Accounting forNonmonetary Transactions*, and replaces it with an exception forexchanges that do not have commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS No. 153is effective for nonmonetary asset exchanges occurring in fiscal periodsbeginning after June 15, 2005. The Company will adopt the provisions ofSFAS No. 153 on January 1, 2006. The adoption of this statement willnot have a material impact on the Company’s consolidated financial statements.

In May 2005, the FASBissued SFAS No. 154, *Accounting Changesand Error Corrections*. SFAS No. 154 replaces AccountingPrinciples Board Opinion No. 20, *AccountingChanges*, and FASB Statement No. 3, *Reporting Accounting Changes in Interim Financial Statements*,and requires the direct effects of accounting principle changes to beretrospectively applied. The existing guidance with respect to accountingestimate changes and corrections of errors is carried forward in SFAS No. 154.SFAS No. 154 is effective for accounting changes and corrections of errorsmade in fiscal years beginning after December 15, 2005.

**2.   Acquisitions**

*Advanced TelCom, Inc.*

On October 13, 2004 the Company entered into anagreement to purchase all of the outstanding common stock of Advanced TelCom, Inc.(ATI) for $45,543, 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 fromoperating synergies from consolidating ATI’s operations into its existingbusiness.

F-13

----

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

**2.**   Acquisitions (Continued)

The following tablesummarizes the fair values of the assets acquired and liabilities assumed atthe date of acquisition:

| Cash                       |   | $      | 321    |   |
|----------------------------|--------|--------|--------|--------|
| Other current  assets      |   | 7,958  |   |
| Property and  equipment    |   | 42,729 |   |
| Other assets               |   | 29     |   |
| Other intangible  assets   |   | 3,913  |   |
| Total assets  acquired     |   | 54,950 |   |
| Current  liabilities       |   | 6,741  |   |
| Long-term  liabilities     |   | 217    |   |
| Acquisition  reserve       |   | 2,128  |   |
| Total liabilities  assumed |   | 9,086  |   |
| Net assets acquired        |   | $      | 45,864 |   |

 

On December 31, 2004, the Company allocated thepurchase price on a preliminary basis using the information then available.During the fourth quarter of 2005, the company completed an independentvaluation. Upon the completion of the independent valuation, the Companyadjusted its preliminary purchase price allocation by increasing the fair valueassigned to fixed assets and other intangible assets by $27,340 and $3,913respectively with a corresponding $31,253 reduction to goodwill. As a result ofincreasing the fair values associated with fixed asset and other intangibleassets the Company recorded additional depreciation expense and amortizationexpense of $4,285 in the fourth quarter of 2005. On December 31, 2004, theCompany accrued $2,531 in acquisition related expenses, which included severancebenefits, relocation costs and contract termination fees. During the fourthquarter of 2005 the Company finalized its liabilities incurred in connectionwith the acquisition and recorded an adjustment to decrease the recordedliabilities by $403, which was recorded as a reduction to goodwill. As of December 31,2005, $375 of the acquisition related expenses have yet to be paid.

The following unaudited pro forma financialinformation was prepared in accordance with SFAS No. 141, *Business Combinations*, and assumes theacquisition had occurred at the beginning of the periods presented. Theunaudited 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 of continuing operations are as follows:

| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2003**                                   | ** ** | **2004** | ** ** |
| Revenue                                    |       | $                                          | 180,542    | ** ** | $ | 217,187 |   |
| Net loss                                   |       | (19,673                                    | )          | (1,559 | ) |
| Net loss per share—basic  and diluted |       | (6.06                                      | )          | (1.73 | ) |
|                                            |            |                                            |            |  |  |  |  |

 

F-14

----

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

**2.**   Acquisitions(Continued)

ATI’s consolidated financial information included inthe 2003 pro forma results represents the period from May 15, 2003 (thedate on which ATI emerged from bankruptcy) through December 31, 2003.

*General ElectricBusiness Productivity Solutions*

On October 13, 2004 the Company entered into anagreement with General Electric Capital Corporation to purchase substantiallyall other assets of General Electric Business Productivity Solutions, Inc.(GE BPS) for $100. The transaction closed on March 31, 2005 and was beaccounted for as a discontinued operation. GE BPS constitutes a group of assetsthat can be clearly distinguished operationally and for financial reportingpurposes from the rest of the Company. Management has determined that the groupof assets does not fit the Company’s future business model and committed tosell the net assets with an original carrying value of $216, which approximatedthe fair value less cost to sell the group of assets. At March 31, 2005the Company determined that the plan of sale criteria in SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, had been met and classified the assets andliabilities accordingly on the balance sheet.

On October 1, 2005,the Company sold its discontinued operation for $320, net of sales costsincurred. The sale resulted in gain of $326 and is presented in theconsolidated statement of operations.

**3.   Investments**

AtDecember 31, 2005, available-for-sale securities consist of the following:

| ** **                           | ** ** | **Cost Basis** | ** ** | **Unrealized  Holding  Gains** | ** ** | **Fair Value** | ** ** |
|--------------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------|------------|
| U.S. government  agencies            |       |                | $          | 1,961                          |       |                |       | $ | 26 |   |   |   | $ | 1,987 |   |   |
| Corporate  obligations               |       |                | 2,743      |                           |       |                | 30         |   |   |   | 2,773 |   |   |
| Total available-for-sale  securities |       |                | $          | 4,704                          |       |                |       | $ | 56 |   |   |   | $ | 4,760 |   |   |

 

AtDecember 31, 2004, available-for-sale securities consists of thefollowing:

| ** **                           | ** ** | **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 ofDecember 31, 2004 and 2005, have maturities of six months or less.

**4.   Notes Payable**

In June 2002, the Company entered into anegotiated debt restructuring, which included the reduction of outstanding debtunder its 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 the Company recorded a pre-tax gain of $53,549. In accordance 

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)

with SFAS No. 15, *Accounting by Debtors and Creditors for Troubled DebtRestructurings*, a portion of the reduction in the amount outstandingcould not be immediately recognized as a gain, but instead would be recognizedas a reduction to interest expense over the term of the new credit facility. Asof December 31, 2003, $21,871 of excess carrying value had yet to berecognized as a reduction in interest expense. For the years ended December 31,2003 and 2004, the Company recognized, as a reduction to interest expense,$4,470 and $998, respectively, of the excess carrying value.

In March 2004, the Company completed an offeringof $100,000 of 8 3/8% senior second secured notes (“notes”) due 2010 at adiscount resulting in a 12% yield. Proceeds from the offering were used toretire the Credit Agreement with a principal balance of $65,421 and provideadditional liquidity to the Company. The repayment of the Credit Agreementresulted in the Company recording $18,195 as a gain on extinguishment of debt,which represented $20,873 of excess carrying value less the write-off of $2,678of debt issuance costs associated with the 2002 Exchange Agreement.

In November 2004, the Company completed anoffering of $65,000 of 8 3/8% senior second secured notes (“notes”) due 2010 ata discount resulting in a 14% yield. Proceeds from the offering were used tofinance the acquisition of Advanced TelCom, Inc.

The notes will mature on March 15, 2010, andaccrue interest at an annual rate of 8 3/8% with interest payments made on asemiannual basis on each March 15 and September 15. On or after March 15,2007, the Company may redeem some or all of the notes at the followingredemption prices, expressed as percentages of their accreted value, plusaccrued 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 aggregateprincipal amount at maturity of the notes may be redeemed at the Company’soption with the net proceeds of certain equity offerings at 112.000% of theiraccreted value, plus accrued and unpaid interest, if any, to the date ofredemption, provided that, following such redemption, at least 65% of theaggregate principal amount at maturity of the notes originally issued remainsoutstanding. In addition, the Company may, at its option upon a change ofcontrol, redeem all, but not less than all, of the notes at any time prior to March 15,2007, at 112.000% of their accreted value, plus accrued and unpaid interest, ifany, to the redemption date. On September 15, 2009, if any notes areoutstanding, the Company will be required to redeem 3.5% of each thenoutstanding note’s aggregate accreted value, or the Mandatory PrincipalRedemption Amount, at a redemption price of 100% of the accreted value of theportion of notes so redeemed; provided, that the Company shall simultaneouslybe required to redeem an additional portion of each note to the extent requiredto prevent such note from being treated as an Applicable High Yield DiscountObligation within the meaning of Section 163(i)(1) of the InternalRevenue Code of 1986, as amended. The Mandatory Principal Redemption Amountrepresents, with respect to each note, an amount approximately equal to (i) theexcess of the accreted value of the outstanding notes over the original issueprice thereof less (ii) an amount equal to one year’s simple uncompoundedinterest on the aggregate original issue price of such outstanding notes at arate per annum equal to the yield to maturity on the outstanding notes.

On September 15, 2005, the Company redeemed$50,630 accreted value ($57,750 principal amount) of the Company’s 8 3/8%senior second secured notes due March 15, 2010 at a redemption price of112% of the accreted value. The $6,076 accreted-value premium was recorded asinterest expense. Proceeds from 

F-16

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

**4.**   Notes Payable (Continued)

the Company’s initialpublic offering of the Company common stock (see Note 8) were used to redeemthe notes.

The carrying value of thenotes is comprised of the following as of December 31:

| ** **                 | ** ** | **2004** | ** ** | **2005**    | ** ** |
|----------------------------|------------|----------|------------|-------------|------------|
| Principal amount  due      |       | $        | 165,000    | ** **  | **$**      | **107,250** | ** ** |
| Discount on notes  payable |       | (27,222  | )          | **(15,125** | **)**      |
|                       |       | $        | 137,778    | ** **  | **$**      | **92,125** | ** ** |

 

Theaccreted value of notes payable as of December 31 of the following yearsis:

| 2006                |   | $       | 95,033 |   |
|---------------------|--------|---------|--------|--------|
| 2007                |   | 98,332  |   |
| 2008                |   | 102,076 |   |
| 2009                |   | 106,326 |   |
| March 15, 2010 |   | 107,250 |   |

 

The carrying amount, netof discount, of the Company’s debt instruments in the consolidated balancesheets at December 31, 2004 and 2005 approximates fair value.

**5.   Commitments andContingencies**

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 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 Companyentered into an amendment of an earlier Master Purchase and Services agreementwith Nortel Networks, Inc. (Nortel Networks). Under the amendment, theCompany committed to purchase and/or license $100,000 of Nortel Networks’equipment or services. However, the Company is confident that, due to NortelNetworks’ discontinuance of certain product lines contemplated in the AmendedMaster Purchase and Services agreement, neither party will be held to theconditions of the contract.

**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 

F-17

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

**5.**   Commitments and Contingencies(Continued)

jury wasnot instructed to consider whether the Company was justified in informing thenew employer of the agreement and the Company’s intent to enforce it. TheCompany settled this case in January 2005, agreeing to pay a total of $300over three annual installments.

In November of 2004, a former employee filed a suitagainst the Company in federal district court in Minnesota alleging thattermination of her employment violated the federal Civil Rights Act and theFamily Medical Leave Act, claiming $225 in damages. The Company is vigorouslydefending against these claims and filed a summary judgment motion as to allclaims.

A lawsuit is pending against the Company and others bya former customer in Utah state court. The suit alleges damages of $1,000regarding alleged improper assignment of an “800” number. The Company isvigorously defending this claim and believes it to be without merit. Thediscovery phase and period for making dispositive motions in the case haveconcluded.

In June 2005, the Company settled the lawsuitbrought against us by Global Crossing. The parties agreed to release each otherfrom all claims related to the dispute and to amend their agreement. Thesettlement agreement provided for the Company to pay Global Crossing $5,000 andfor Global Crossing to credit the Company’s future bills for approximately $564over the following six months. Under the terms of the Global Crossingsettlement, the Carrier Services Agreement between the parties, which hadprovided that Global Crossing was the Company’s exclusive provider of voice anddata services, subject to certain exceptions, and that the Company had apurchase commitment of $100,000, was amended to shorten the term of theagreement to July 1, 2006, to eliminate the exclusivity, purchasecommitment and shortfall provisions and to provide that Global Crossing will bethe Company’s preferred provider for Internet transit and long haul dataprivate line needs.

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 not believeto be material.

**6.   Operating andCapital Leases**

The Company leases office space under operatingleases. The office leases generally require a base rent plus amounts coveringoperating expenses and property tax. Rent expense for the years endedDecember 31, 2003, 2004, and 2005 was $6,007, $5,087, and $7,468,respectively.

F-18

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

**6.**   Operatingand Capital Leases (Continued)

Futureminimum lease payments under operating leases with a term in excess of one yearas of December 31, 2005 are as follows:

| 2006       |   | $     | 4,929  |   |
|------------|--------|-------|--------|--------|
| 2007       |   | 4,661 |   |
| 2008       |   | 4,526 |   |
| 2009       |   | 3,590 |   |
| 2010       |   | 2,155 |   |
| Thereafter |   | 4,272 |   |
|       |   | $     | 24,133 |   |

 

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,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Cost                           |       | $                     | 6,020      | ** ** | **$** | **9,207** | ** ** |
| Less accumulated  depreciation |       | (782                  | )          | **(2,507** | **)** |
|                           |       | $                     | 5,238      | ** ** | **$** | **6,700** | ** ** |

 

Future minimum leasepayments required under capital leases together with the present value of thenet future minimum lease payments at December 31, 2005 are as follows:

| 2006                                               |   | $      | 3,011  |   |
|----------------------------------------------------|--------|--------|--------|--------|
| 2007                                               |   | 2,592  |   |
| 2008                                               |   | 664    |   |
| 2009                                               |   | 27     |   |
| Total minimum  lease payments                      |   | 6,294  |   |
| Less amount  representing interest                 |   | (900   | )      |
| Present value of  net minimum payments             |   | 5,394  |   |
| Less current  portion                              |   | (2,430 | )      |
| Capital lease  obligations, net of current portion |   | $      | 2,964  |   |

 

**7.   BenefitContribution 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 $602, $764 and $962 in 2003, 2004 and 2005, 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**

**Initial Public Offering**

On August 9, 2005,the Company consummated an initial public offering of 5,357,143 of the Company’scommon stock at $14.00 per share. Net proceeds from the offering, afterdeducting underwriting discounts and commissions, were $69,750. Proceeds wereused to redeem $50,630 accreted value ($57,750 principal amount) of the Company’s83¤8%senior second secured notes due March 15, 2010; to pay a $6,076 premiumdue upon redemption of the notes; and to pay $2,684 of fees and expensesassociated with the offering.

**Preferred Stock**

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, 2004, dividends in arrears were $8,777.

As a result of the Company’s initial public offeringof common stock on August 9, 2005, all of the Company’s then-outstandingshares of convertible preferred stock and accumulated dividends wereautomatically converted to common stock.

After the conversion, theCompany has 125,000,000 of undesignated preferred shares authorized and noshares of preferred stock outstanding.

**Stock Options**

In November 2002, the Board of Directors approvedthe Eschelon Telecom, Inc. Stock Option Plan of 2002 (the 2002 Plan). The2002 Plan provides for the issuance of incentive and nonqualified stock optionsto key management staff. Under the 2002 Plan, the exercise price of optionsgranted is determined by the Board of Directors, providing that incentive stockoptions are granted at exercise prices equal to the fair market value of theCompany’s stock on the date of grant and the options are exercisable for aperiod not to exceed ten years from date of grant. Options are typicallysubject to vesting over four years, with 20% of the award vested on the grantdate, and 20% of the award vesting on each subsequent anniversary of the grantdate. A total of 1,632,414 shares of the Company’s common stock have beenreserved for issuance under the 2002 Plan.

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)

The following tablesummarizes the options to purchase shares of the Company’s common stock underthe Eschelon Telecom, Inc. Stock Option Plan of 2002:

| ** **                         | ** ** | **Shares   Available for  Grant** | ** ** | **Plan   Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|
| Balance at  December 31, 2002 |       |                                        | 1,041,966  |                                 |       |                                       | —     |   |   |   | $ | 0.68 |   |   |
| Options granted                    |       |                                        | (786,294   | )                                    |       |                                       | 786,294    |   |   |   | 0.68 |   |   |
| Restricted stock granted           |       |                                        | (183,399   | )                                    |       |                                       | —     |   |   |   | 0.68 |   |   |
| Canceled                           |       |                                        | 65,120     |                                 |       |                                       | (65,120    | ) |   |   | 0.68 |   |   |
| Exercised                          |       |                                        | —     |                                 |       |                                       | (28,290    | ) |   |   | 0.68 |   |   |
| Balance at  December 31, 2003 |       |                                        | 137,393    |                                 |       |                                       | 692,884    |   |   |   | 0.68 |   |   |
| Options granted                    |       |                                        | (101,984   | )                                    |       |                                       | 101,984    |   |   |   | 1.35 |   |   |
| Canceled                           |       |                                        | 35,921     |                                 |       |                                       | (35,921    | ) |   |   | 0.83 |   |   |
| Exercised                          |       |                                        | —     |                                 |       |                                       | (11,843    | ) |   |   | 0.69 |   |   |
| Balance at  December 31, 2004 |       |                                        | 71,330     |                                 |       |                                       | 747,104    |   |   |   | 0.77 |   |   |
| Additional shares  reserved        |       |                                        | 590,448    |                                 |       |                                       | —     |   |   |   | — |   |   |
| Options granted                    |       |                                        | (533,536   | )                                    |       |                                       | 533,536    |   |   |   | 8.24 |   |   |
| Restricted stock  forfeited        |       |                                        | 494        |                                 |       |                                       | —     |   |   |   | 0.68 |   |   |
| Restricted stock granted           |       |                                        | (9,350     | )                                    |       |                                       | —     |   |   |   | 2.92 |   |   |
| Canceled                           |       |                                        | 34,693     |                                 |       |                                       | (34,693    | ) |   |   | 3.18 |   |   |
| Exercised                          |       |                                        | —     |                                 |       |                                       | (78,457    | ) |   |   | 0.76 |   |   |
| Balance at  December 31, 2005 |       |                                        | 154,079    |                                 |       |                                       | 1,167,490  |   |   |   | $ | 4.12 |   |   |

 

The following tablecontains details of the stock options outstanding as of December 31, 2005:

| ** **                                  | ** ** | **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 - $10.84                              |       |                         | 962,162    |                                                         |       |   | 7.85 years |   |   |   | $ | 2.38 |   |   |   | 521,144 |   |   |   | $ | 1.66 |   |   |
| $10.85 - $21.68                             |       |                         | 205,328    |                                                         |       |   | 9.56 years |   |   |   | $ | 12.24 |   |   |   | 41,261 |   |   |   | $ | 12.23 |   |   |
|                                        |       |                         | 1,167,490  |                                                         |       |   | 8.15 years |   |   |   | $ | 4.12 |   |   |   | 562,405 |   |   |   | $ | 2.43 |   |   |

 

**Restricted CommonStock**

In 2003, the Companygranted 183,399 shares of restricted common stock to certain directors andmembers of management. The Company records compensation expense as therestrictions are removed from the stock. In 2005, the Company granted 9,350shares of restricted common stock to certain directors. Total compensationexpense related to restricted common stock for the years ended December 31,2003, 2004 and 2005 was $70, $20 and $39, respectively.

F-21

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

**9.   Income Taxes**

As of December 31, 2005, the Company had $176,780of 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.

Components of the deferredtax asset at December 31, 2004 and 2005 are as follows:

| ** **                      | ** ** | **2004** | ** ** | **2005**    | ** ** |
|---------------------------------|------------|----------|------------|-------------|------------|
| Deferred tax  assets:           |       |     |       |        |       |
| Net operating loss carryforward |       | $        | 53,033     | ** **  | **$**      | **69,179** | ** ** |
| Bad debts                       |       | 157      | ** ** | **186**     | ** ** |
| Compensation accruals           | ** ** | —   | ** ** | **174**     | ** ** |
| Inventory obsolescence          |       | 91       | ** ** | **104**     | ** ** |
| Other temporary differences     |       | 121      | ** ** | **437**     | ** ** |
|                            |       | 53,402   | ** ** | **70,080**  | ** ** |
| Deferred tax  liabilities:      |       |     | ** ** | ** **  | ** ** |
| Depreciation                    |       | (7,252   | )          | **(12,259** | **)**      |
| Other                           |       | (11      | )          | **(21**     | **)**      |
|                            |       | 46,139   | ** ** | **57,800**  | ** ** |
| Valuation  allowance            |       | (46,139  | )          | **(57,800** | **)**      |
| Net deferred tax asset          |       | $        | —     | ** **  | **$**      | **—** | ** ** |

 

Incometax expense for the year ended December 31, 2005, is comprised of federaltaxes. The reconciliation between the statutory federal income tax rate and theeffective rate is as follows:

| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Federal statutory  tax rate         |       | 35.00                                      | %          | 34.00 | % | **34.00** | **%** |
| State taxes                         |       | 5.16                                       |       | 0.25 | ** ** | **—** | ** ** |
| Permanent  differences              |       | —                                     |       | 2.74 | ** ** | **(0.01** | **)** |
| Utilization of  valuation allowance |       | (40.00                                     | )          | (36.61 | ) | **(34.00** | **)** |
| Effective tax rate                  |       | 0.16                                       | %          | 0.38 | % | **(0.01** | **)%** |

 

**10.**   CondensedConsolidating Financial Information

The 83¤8% seniorsecond secured notes due 2010 issued by Eschelon Operating Company are fullyand unconditionally guaranteed jointly and severally by the Company and allexisting subsidiaries and the indenture governing the notes requires that anyfuture subsidiaries that are organized in the United States must also guaranteethe notes on the same basis.

Additional information regarding the 83¤8%senior second secured notes due 2010 is included in Note 4, Notes Payable.

F-22

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

**10.**   CondensedConsolidating Financial Information (Continued)

The following tablespresent condensed consolidating balance sheets for the years ended December 31,2004 and 2005 and condensed consolidating statements of operations for theyears ended December 31, 2003, 2004 and 2005.

**CondensedConsolidating Balance SheetsAs of December 31, 2004**

| ** **                                                | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                                |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Current assets:                                           |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                                |       |                   | $          | 26,332        |       |             | $          | —           |       |             | $          | 103 |   |   |   | $ | — |   |   |   | $ | 26,435 |   |   |
| Restricted cash                                           |       |                   | 722        |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 722 |   |   |
| Available-for-sale  securities                            |       |                   | 6,194      |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 6,194 |   |   |
| Accounts receivable                                       |       |                   | —     |          |       | —           |       |             | 18,941     |             |       |   | — |   |   |   | 18,941 |   |   |
| Other receivables                                         |       |                   | —     |          |       | —           |       |             | 2,976      |             |       |   | — |   |   |   | 2,976 |   |   |
| Inventories                                               |       |                   | —     |          |       | —           |       |             | 2,873      |             |       |   | — |   |   |   | 2,873 |   |   |
| Prepaid expenses                                          |       |                   | 1,227      |          |       | —           |       |             | 1,183      |             |       |   | — |   |   |   | 2,410 |   |   |
| Total current assets                                      |       |                   | 34,475     |          |       | —           |       |             | 26,076     |             |       |   | — |   |   |   | 60,551 |   |   |
| Property and equipment,  net                              |       |                   | 82,550     |          |       | —           |       |             | 20,299     |             |       |   | — |   |   |   | 102,849 |   |   |
| Investment in affiliates                                  |       |                   | 58,998     |          |       | —           |       |             | —     |             |       |   | (58,998 | ) |   |   | — |   |   |
| Other assets                                              |       |                   | 1,042      |          |       | —           |       |             | 943        |             |       |   | — |   |   |   | 1,985 |   |   |
| Goodwill                                                  |       |                   | —     |          |       | —           |       |             | 38,776     |             |       |   | — |   |   |   | 38,776 |   |   |
| Intangible assets, net                                    |       |                   | 12,548     |          |       | 7,890            |       |             | 12,520     |             |       |   | — |   |   |   | 32,958 |   |   |
| Total assets                                              |       |                   | $          | 189,613       |       |             | $          | 7,890            |       |             | $          | 98,614 |   |   |   | $ | (58,998 | ) |   |   | $ | 237,119 |   |   |
| **Liabilities  and stockholders’ equity (deficit)**  |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |
| Current liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Accounts payable                                          |       |                   | $          | 4,314         |       |             | $          | —           |       |             | $          | 9,487 |   |   |   | $ | — |   |   |   | $ | 13,801 |   |   |
| Accrued  telecommunication costs                     |       |                   | —     |          |       | —           |       |             | 2,190      |             |       |   | — |   |   |   | 2,190 |   |   |
| Accrued office rent                                       |       |                   | 1,722      |          |       | —           |       |             | 614        |             |       |   | — |   |   |   | 2,336 |   |   |
| Accrued interest expense                                  |       |                   | —     |          |       | 4,069            |       |             | 1          |             |       |   | — |   |   |   | 4,070 |   |   |
| Other accrued expenses                                    |       |                   | 489        |          |       | —           |       |             | 5,509      |             |       |   | — |   |   |   | 5,998 |   |   |
| Deferred revenue                                          |       |                   | —     |          |       | —           |       |             | 7,300      |             |       |   | — |   |   |   | 7,300 |   |   |
| Accrued compensation  expenses                            |       |                   | 2,172      |          |       | —           |       |             | 1,416      |             |       |   | — |   |   |   | 3,588 |   |   |
| Capital lease  obligation, current maturities             |       |                   | 1,526      |          |       | —           |       |             | 103        |             |       |   | — |   |   |   | 1,629 |   |   |
| Total current  liabilities                                |       |                   | 10,223     |          |       | 4,069            |       |             | 26,620     |             |       |   | — |   |   |   | 40,912 |   |   |
| Long-term liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Other long-term  liabilities                              |       |                   | 76         |          |       | —           |       |             | 554        |             |       |   | — |   |   |   | 630 |   |   |
| Capital lease  obligation, less current maturities        |       |                   | 2,607      |          |       | —           |       |             | 217        |             |       |   | — |   |   |   | 2,824 |   |   |
| Notes payable                                             |       |                   | —     |          |       | 137,778          |       |             | —     |             |       |   | — |   |   |   | 137,778 |   |   |
| Due to (from) affiliates                                  |       |                   | 227,721    |          |       | (174,370         | )          |             | (53,351    | )                |       |   | — |   |   |   | — |   |   |
| Total liabilities                                         |       |                   | 240,627    |          |       | (32,523          | )          |             | (25,960    | )                |       |   | — |   |   |   | 182,144 |   |   |
| Convertible preferred  stock                              |       |                   | 63,155     |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 63,155 |   |   |
| Stockholders’ equity  (deficit)                      |       |                   | (114,169   | )             |       | 40,413           |       |             | 124,574    |             |       |   | (58,998 | ) |   |   | (8,180 | ) |   |
| Total liabilities and stockholders’ equity (deficit) |       |                   | $          | 189,613       |       |             | $          | 7,890            |       |             | $          | 98,614 |   |   |   | $ | (58,998 | ) |   |   | $ | 237,119 |   |   |

 

F-23

----

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

**10.**   Condensed Consolidating Financial Information (Continued)

**CondensedConsolidating Balance SheetsAs of December 31, 2005**

| ** **                                                | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                                |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Current assets:                                           |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                                |       |                   | $          | 25,070        |       |             | $          | —           |       |             | $          | 992 |   |   |   | $ | — |   |   |   | $ | 26,062 |   |   |
| Restricted cash                                           |       |                   | 996        |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 996 |   |   |
| Available-for-sale  securities                            |       |                   | 4,760      |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 4,760 |   |   |
| Accounts receivable                                       |       |                   | —     |          |       | —           |       |             | 22,996     |             |       |   | — |   |   |   | 22,996 |   |   |
| Other receivables                                         |       |                   | —     |          |       | —           |       |             | 3,052      |             |       |   | — |   |   |   | 3,052 |   |   |
| Inventories                                               |       |                   | —     |          |       | —           |       |             | 2,927      |             |       |   | — |   |   |   | 2,927 |   |   |
| Prepaid expenses                                          |       |                   | 1,149      |          |       | —           |       |             | 1,145      |             |       |   | — |   |   |   | 2,294 |   |   |
| Total current assets                                      |       |                   | 31,975     |          |       | —           |       |             | 31,112     |             |       |   | — |   |   |   | 63,087 |   |   |
| Property and equipment,  net                              |       |                   | 82,840     |          |       | —           |       |             | 43,612     |             |       |   | — |   |   |   | 126,452 |   |   |
| Investment in affiliates                                  |       |                   | 59,046     |          |       | —           |       |             | —     |             |       |   | (59,046 | ) |   |   | — |   |   |
| Other assets                                              |       |                   | 507        |          |       | —           |       |             | 999        |             |       |   | — |   |   |   | 1,506 |   |   |
| Goodwill                                                  |       |                   | —     |          |       | —           |       |             | 7,168      |             |       |   | — |   |   |   | 7,168 |   |   |
| Intangible assets, net                                    |       |                   | 13,695     |          |       | 4,588            |       |             | 15,050     |             |       |   | — |   |   |   | 33,333 |   |   |
| Total assets                                              |       |                   | $          | 188,063       |       |             | $          | 4,588            |       |             | $          | 97,941 |   |   |   | $ | (59,046 | ) |   |   | $ | 231,546 |   |   |
| **Liabilities and stockholders’ equity (deficit)**   |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |
| Current liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Accounts payable                                          |       |                   | $          | 14,602        |       |             | $          | —           |       |             | $          | 1,798 |   |   |   | $ | — |   |   |   | $ | 16,400 |   |   |
| Accrued  telecommunication   costs                        |       |                   | —     |          |       | —           |       |             | 4,227      |             |       |   | — |   |   |   | 4,227 |   |   |
| Accrued office rent                                       |       |                   | 1,485      |          |       | —           |       |             | 550        |             |       |   | — |   |   |   | 2,035 |   |   |
| Accrued interest expense                                  |       |                   | —     |          |       | 2,645            |       |             | 1          |             |       |   | — |   |   |   | 2,646 |   |   |
| Other accrued expenses                                    |       |                   | 944        |          |       | —           |       |             | 4,541      |             |       |   | — |   |   |   | 5,485 |   |   |
| Deferred revenue                                          |       |                   | —     |          |       | —           |       |             | 7,921      |             |       |   | — |   |   |   | 7,921 |   |   |
| Accrued compensation  expenses                            |       |                   | 1,623      |          |       | —           |       |             | 1,186      |             |       |   | — |   |   |   | 2,809 |   |   |
| Capital lease  obligation, current maturities             |       |                   | 2,320      |          |       | —           |       |             | 110        |             |       |   | — |   |   |   | 2,430 |   |   |
| Total current  liabilities                                |       |                   | 20,974     |          |       | 2,645            |       |             | 20,334     |             |       |   | — |   |   |   | 43,953 |   |   |
| Long-term liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Other long-term  liabilities                              |       |                   | 251        |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 251 |   |   |
| Capital lease  obligation, less current maturities        |       |                   | 2,857      |          |       | —           |       |             | 107        |             |       |   | — |   |   |   | 2,964 |   |   |
| Notes payable                                             |       |                   | —     |          |       | 92,125           |       |             | —     |             |       |   | — |   |   |   | 92,125 |   |   |
| Due to (from) affiliates                                  |       |                   | 214,773    |          |       | (107,148         | )          |             | (107,625   | )                |       |   | — |   |   |   | — |   |   |
| Total liabilities                                         |       |                   | 238,855    |          |       | (12,378          | )          |             | (87,184    | )                |       |   | — |   |   |   | 139,293 |   |   |
| Convertible preferred  stock                              |       |                   | —     |          |       | —           |       |             | —     |             |       |   | — |   |   |   | — |   |   |
| Stockholders’ equity  (deficit)                      |       |                   | (50,792    | )             |       | 16,966           |       |             | 185,125    |             |       |   | (59,046 | ) |   |   | 92,253 |   |   |
| Total liabilities and stockholders’ equity (deficit) |       |                   | $          | 188,063       |       |             | $          | 4,588            |       |             | $          | 97,941 |   |   |   | $ | (59,046 | ) |   |   | $ | 231,546 |   |   |

 

F-24

----

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

**10.**   Condensed Consolidating Financial Information (Continued)

**CondensedConsolidating Statement of OperationsFor the Year Ended December 31, 2003**

| ** **                         | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                         | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                         | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| Revenue:                           |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                   |       |                   | $          | —        |       |             |       | $                | —     |   |   |   | $ | 115,482 |   |   |   | $ | 115,482 |   |   |
| Business telephone systems         |       |                   | —     |          |       |             | —     |             |       |   | 25,614 |   |   |   | 25,614 |   |   |
|                               |       |                   | —     |          |       |             | —     |             |       |   | 141,096 |   |   |   | 141,096 |   |   |
| Cost of revenue:                   |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                   |       |                   | —     |          |       |             | —     |             |       |   | 45,037 |   |   |   | 45,037 |   |   |
| Business telephone systems         |       |                   | —     |          |       |             | —     |             |       |   | 15,784 |   |   |   | 15,784 |   |   |
|                               |       |                   | —     |          |       |             | —     |             |       |   | 60,821 |   |   |   | 60,821 |   |   |
| Gross profit:                      |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                   |       |                   | —     |          |       |             | —     |             |       |   | 70,445 |   |   |   | 70,445 |   |   |
| Business telephone systems         |       |                   | —     |          |       |             | —     |             |       |   | 9,830 |   |   |   | 9,830 |   |   |
|                               |       |                   | —     |          |       |             | —     |             |       |   | 80,275 |   |   |   | 80,275 |   |   |
| Operating expenses:                |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Sales, general and administrative  |       |                   | 35,274     |          |       |             | —     |             |       |   | 30,978 |   |   |   | 66,252 |   |   |
| Depreciation and amortization      |       |                   | 16,785     |          |       |             | —     |             |       |   | 13,314 |   |   |   | 30,099 |   |   |
| Total operating  expenses          |       |                   | 52,059     |          |       |             | —     |             |       |   | 44,292 |   |   |   | 96,351 |   |   |
| Operating income  (loss)           |       |                   | (52,059    | )             |       |             | —     |             |       |   | 35,983 |   |   |   | (16,076 | ) |   |
| Other income  (expense)            |       |                   | (669       | )             |       |             | (440       | )                |       |   | 7 |   |   |   | (1,102 | ) |   |
| Income (loss)  before income taxes |       |                   | (52,728    | )             |       |             | (440       | )                |       |   | 35,990 |   |   |   | (17,178 | ) |   |
| Income taxes                       |       |                   | (28        | )             |       |             | —     |             |       |   | — |   |   |   | (28 | ) |   |
| Net income (loss)                  |       |                   | $          | (52,756       | )          |             |       | $                | (440       | ) |   |   | $ | 35,990 |   |   |   | $ | (17,206 | ) |   |

 

F-25

----

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

**10.**   Condensed Consolidating Financial Information (Continued)

**CondensedConsolidating Statement of OperationsFor the Year Ended December 31, 2004**

| ** **                         | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                         | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                         | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| Revenue:                           |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                   |       |                   | $          | —        |       |             |       | $                | —     |   |   |   | $ | 131,780 |   |   |   | $ | 131,780 |   |   |
| Business telephone systems         |       |                   | —     |          |       |             | —     |             |       |   | 26,316 |   |   |   | 26,316 |   |   |
|                               |       |                   | —     |          |       |             | —     |             |       |   | 158,096 |   |   |   | 158,096 |   |   |
| Cost of revenue:                   |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                   |       |                   | —     |          |       |             | —     |             |       |   | 47,354 |   |   |   | 47,354 |   |   |
| Business telephone systems         |       |                   | —     |          |       |             | —     |             |       |   | 15,979 |   |   |   | 15,979 |   |   |
|                               |       |                   | —     |          |       |             | —     |             |       |   | 63,333 |   |   |   | 63,333 |   |   |
| Gross profit:                      |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                   |       |                   | —     |          |       |             | —     |             |       |   | 84,426 |   |   |   | 84,426 |   |   |
| Business telephone systems         |       |                   | —     |          |       |             | —     |             |       |   | 10,337 |   |   |   | 10,337 |   |   |
|                               |       |                   | —     |          |       |             | —     |             |       |   | 94,763 |   |   |   | 94,763 |   |   |
| Operating expenses:                |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Sales, general and administrative  |       |                   | 37,400     |          |       |             | —     |             |       |   | 31,855 |   |   |   | 69,255 |   |   |
| Depreciation and amortization      |       |                   | 20,734     |          |       |             | —     |             |       |   | 10,371 |   |   |   | 31,105 |   |   |
| Total operating  expenses          |       |                   | 58,134     |          |       |             | —     |             |       |   | 42,226 |   |   |   | 100,360 |   |   |
| Operating income  (loss)           |       |                   | (58,134    | )             |       |             | —     |             |       |   | 52,537 |   |   |   | (5,597 | ) |   |
| Other income  (expense)            |       |                   | (1,079     | )             |       |             | 7,811      |             |       |   | (20 | ) |   |   | 6,712 |   |   |
| Income (loss)  before income taxes |       |                   | (59,213    | )             |       |             | 7,811      |             |       |   | 52,517 |   |   |   | 1,115 |   |   |
| Income taxes                       |       |                   | (4         | )             |       |             | —     |             |       |   | — |   |   |   | (4 | ) |   |
| Net income (loss)                  |       |                   | $          | (59,217       | )          |             |       | $                | 7,811      |   |   |   | $ | 52,517 |   |   |   | $ | 1,111 |   |   |

 

F-26

----

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

**10.**   Condensed Consolidating Financial Information (Continued)

**CondensedConsolidating Statement of OperationsFor the Year Ended December 31, 2005**

| ** **                                       | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                       | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| Revenue:                                         |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Network services                                 |       |                   | $          | —        |       |             | $          | —           |       |   | $ | 201,835 |   |   |   | $ | 201,835 |   |   |
| Business telephone systems                       |       |                   | —     |          |       | —           |       |             | 25,908     |   |   |   | 25,908 |   |   |
|                                             |       |                   | —     |          |       | —           |       |             | 227,743    |   |   |   | 227,743 |   |   |
| Cost of revenue:                                 |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Network services                                 |       |                   | —     |          |       | —           |       |             | 85,914     |   |   |   | 85,914 |   |   |
| Business telephone systems                       |       |                   | —     |          |       | —           |       |             | 16,139     |   |   |   | 16,139 |   |   |
|                                             |       |                   | —     |          |       | —           |       |             | 102,053    |   |   |   | 102,053 |   |   |
| Gross profit:                                    |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Network services                                 |       |                   | —     |          |       | —           |       |             | 115,921    |   |   |   | 115,921 |   |   |
| Business telephone systems                       |       |                   | —     |          |       | —           |       |             | 9,769      |   |   |   | 9,769 |   |   |
|                                             |       |                   | —     |          |       | —           |       |             | 125,690    |   |   |   | 125,690 |   |   |
| Operating expenses:                              |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Sales, general and administrative                |       |                   | 42,551     |          |       | —           |       |             | 47,759     |   |   |   | 90,310 |   |   |
| Depreciation and amortization                    |       |                   | 22,160     |          |       | —           |       |             | 17,493     |   |   |   | 39,653 |   |   |
| Total operating  expenses                        |       |                   | 64,711     |          |       | —           |       |             | 65,252     |   |   |   | 129,963 |   |   |
| Operating income  (loss)                         |       |                   | (64,711    | )             |       | —           |       |             | 60,438     |   |   |   | (4,273 | ) |   |
| Other income  (expense)                          |       |                   | (3,988     | )             |       | (23,447          | )          |             | 66         |   |   |   | (27,369 | ) |   |
| Income (loss)  before income taxes               |       |                   | (68,699    | )             |       | (23,447          | )          |             | 60,504     |   |   |   | (31,642 | ) |   |
| Income taxes                                     |       |                   | (4         | )             |       | —           |       |             | —     |   |   |   | (4 | ) |   |
| Net income (loss)  before discontinued operation |       |                   | (68,703    | )             |       | (23,447          | )          |             | 60,504     |   |   |   | (31,646 | ) |   |
| Income from  discontinued operation, net of tax  |       |                   | —     |          |       | —           |       |             | 655        |   |   |   | 655 |   |   |
| Net income (loss)                                |       |                   | $          | (68,703       | )          |             | $          | (23,447          | )          |   | $ | 61,159 |   |   |   | $ | (30,991 | ) |   |

 

**11. Reverse Stock Split**

The Company completed a0.0738-for-one reverse stock split affecting all outstanding shares ofcommon stock on August 2, 2005. All share and per share data have beenadjusted to reflect the stock split.

**12. Subsequent Events**

In January 2006, the Company signed a definitiveagreement to acquire Oregon Telecom, Inc., a privately-held competitiveservices provider based in Salem, Oregon. The Company will pay $20,000 in cashto acquire Oregon Telecom. The transaction is expected to close early in thesecond quarter of 2006.

F-27

----