**As filed with the Securities and Exchange Commission on March 12, 2007**

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

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

**(MARK ONE)**

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

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2006**

**OR**

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

**FORTHE TRANSITION PERIOD FROM                    TO                    **

**CommissionFile Number: 000-50706**

**ESCHELONTELECOM, INC.**

(Exact name of registrant as 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 toSection 12(b) of the Act: 

| Title of each class                          | ** ** | **Name of each exchange on which registered** |
|----------------------------------------------|------------|-----------------------------------------------|
| **Common Stock, par value $0.01  per share** | ** ** | **The NASDAQ Global Market**                  |

 

Securities Registered Pursuant to Section 12(g) of the Act:

**None**

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

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

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendments tothe Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

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

 

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

As of June 30, 2006, theaggregate market value of the common stock held by non-affiliates of theregistrant was $160,416,737 based on a closing price of $15.47 on The NASDAQGlobal Market on such date.

As of February 28, 2007, thenumber of outstanding shares of the registrant’s Common Stock, par value $0.01per share, was 18,065,141 shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

A portion of the informationrequired by Part III of the Form 10-K is incorporated byreference from portions of our definitive proxy statement for our 2007 AnnualMeeting of Stockholders to be filed with the Securities and ExchangeCommission.

 

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**TABLE OF CONTENTS**

**Part I**

| Item 1.  |   | Business                                             |   | 4  |   |
|----------|--------|------------------------------------------------------|--------|----|--------|
| Item 1A. |   | Risk Factors                                         |   | 19 |   |
| Item 1B. |   | Unresolved Staff Comments                            |   | 27 |   |
| Item 2.  |   | Properties                                           |   | 28 |   |
| Item 3.  |   | Legal Proceedings                                    |   | 28 |   |
| Item 4.  |   | Submission of Matters to a Vote of  Security Holders |   | 28 |   |

 

**Part II**

| Item 5.  |   | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities |   | 29 |   |
|----------|--------|--------------------------------------------------------------------------------------------------------------------|--------|----|--------|
| Item 6.  |   | Selected Financial Data                                                                                            |   | 30 |   |
| Item 7.  |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operation                         |   | 33 |   |
| Item 7A. |   | Quantitative and Qualitative Disclosures  About Market Risk                                                        |   | 43 |   |
| Item 8.  |   | Financial Statements and Supplementary Data                                                                        |   | 44 |   |
| Item 9.  |   | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                              |   | 44 |   |
| Item 9A. |   | Controls and Procedures                                                                                            |   | 44 |   |
| Item 9B. |   | Other Information                                                                                                  |   | 46 |   |

 

**Part III**

| Item 10. |   | Directors, Executive Officers and Corporate  Governance                                         |   | 47 |   |
|----------|--------|-------------------------------------------------------------------------------------------------|--------|----|--------|
| Item 11. |   | Executive Compensation                                                                          |   | 47 |   |
| Item 12. |   | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters |   | 47 |   |
| Item 13. |   | Certain Relationships and Related  Transactions, and Director Independence                      |   | 47 |   |
| Item 14. |   | Principal Accounting Fees and Services                                                          |   | 47 |   |

 

**Part IV**

| Item 15. |   | Exhibits, Financial Statement Schedules |   | 48 |   |
|----------|--------|-----------------------------------------|--------|----|--------|

 

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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 originally incorporated in Minnesota in 1996 underthe name Advanced Telecommunications, Inc. and subsequently its state ofincorporation was changed to Delaware. We are a leading facilities-basedprovider of integrated voice and data communications services to small andmedium-sized businesses in 45 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 and equipment,which we refer to as business telephone systems (“BTS”). We provide theseproducts and services individually or in customized packages to address ourcustomers’ 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 2006 and 2005averaged 1.28% and 1.34%, respectively. As of December 31, 2006, weprovided service through approximately 598,000 total access lines. For the yearended December 31, 2006, we generated consolidated revenue of $274.5million.

Our network is designed to meet the voice and datacommunications needs of our customers. The Eschelon voice and data traffic isswitched through eight Nortel DMS 500 voice switches, seven Lucent 5ESS voiceswitches, 10 Nortel Passport ATM switches and a Cisco IP network. We havephysical colocations in 150 unique 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 31,2006, approximately 85% of our total access lines in service were served on ournetwork, which we refer to as “on-net”. In addition, for 2006, new access linesinstalled on-net represented 95% of our total new access lines installed.

On April 1, 2006, we acquired Oregon Telecom, Inc.(“OTI”) a privately-heldcompetitive services provider based in Salem, Oregon for $20.3 million. Theacquisition expands our market presence in the Pacific Northwest. On October 1,2006, we completed the acquisition of OneEighty Communications, Inc. (“OneEighty”), acompetitive services provider based in Billings, Montana for $10.2 million. Theacquisition of OneEighty establishes a market presence in Montana. On November 1,2006, we completed the acquisition of Mountain Telecommunications, Inc. (“MTI”),a competitive services provider based in Tempe, Arizona for $37.3 million. MTIprovides services in Phoenix, Tucson and markets throughout the state ofArizona expanding our market presence in Arizona. We also have signed anagreement with Tel West Communications, LLC (“TelWest”) whereby we wouldacquire their access lines for $500 per line as we migrated them to our network.We expect to acquire and migrate approximately 11,000 lines from TelWest by March 31,2007.

On February 19, 2007, weannounced that a definitive agreement had been signed to acquire UnitedCommunications, Inc. (“UNICOM”), a privately-held competitive servicesprovider based in Bend, Oregon. We will pay approximately $13.9 million toacquire UNICOM. The acquisition is expected to close in the second quarter of2007.

**Industry Overview**

For 2006, IDC, an independentindustry research firm, estimated telecommunications spending by businesscustomers would be $330 billion. This spending level is expected to grow toapproximately $340 billion by 2009. The compound average growth rate of dataservices from 2005 to 2009 is expected to be 12.8%, while the rate for voiceservices over the same period is forecasted to decline 2.2%. In 2005, accordingto the Federal Communications Commission (“FCC”), there were 178.2 millionswitched access lines in service to end-users and competitive local exchangecarriers served over 34.1 million lines of those lines.

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**Our Markets**

We operate in 45 markets in thestates of Arizona, California, Colorado, Minnesota, Montana, Nevada, Oregon,Utah and Washington. According to the U.S. Census Bureau, the states where weprovide service are among the fastest growing in terms of population in thenation. All of our states are among the top 25 fastest growing states, withNevada and Arizona ranking as the two fastest growing states in the country. From2000 to 2006, it is estimated that the population in our states grew 9.5%,which is significantly faster than the national average of 6.4%.

**Products and Services**

We provide our customers a complete package of voice,data and BTS products and services. Within our three product lines, we providea wide range of alternatives and customized service packages allowing us toreach a large number of potential customers and provide a comprehensive productsolution. We sell products and services at competitive prices, but focus onproduct quality and 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. Ourservices are provided via analog and digital service platforms. We offer a fullrange of intra-state, inter-state and international long distance services andcalling plans to customers. Our services include “1+” outbound calling, inboundtoll free service and associated services such as dedicated long distance,operator and directory assistance and calling cards.

***Data Services.******  ***Our dataofferings are designed to provide a full range of services to our customers. Weoffer high-speed data transmission services, such as dedicated, broadbandInternet access and DSL, and we also provide and support e-mail and web-hostingservices. Our IDSL product allows us to reach customers beyond the typicaldistance threshold of a normal DSL product. Our data services are offered attransmission speeds that range from 56Kbps to 6Mbps.

***Business Telephone Systems.******  ***We providetelephone equipment systems and voice messaging products. We also procure andinstall voice and data cable, patch panels, routers and other network hardware.We offer customers multi-year maintenance agreements to maintain and upgradetheir systems. Some of our key manufacturers include Mitel, Inter-Tel, NEC,Cisco and Adtran.

The following table summarizesour product and service offerings:

| **Voice Services**                | ** ** | **Data Services**                                 | ** ** | **Business Telephone Systems**                        |
|-----------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------|
| Local Analog and Digital Services |       | Dial-Up, Dedicated and Broadband Internet  Access |       | Customer Premise Telephone Equipment and  Accessories |
| Vertical Features                 |       | Point to Point Services                           |       | Data Communications Equipment                         |
| Long Distance                     |       | SPAM Filtering                                    |       | 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 and competitive analysis for each market. We provide incentivesto our sales force to focus on selling customized packages that can be servicedon-net. For 2006, 98% of our total access lines sold were on-net.

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As of December 31, 2006, our direct sales forceconsisted of 265 network communications specialists and 42 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 alsosell our services and systems to complement the sales of our direct sales force.This agent channel reaches customer segments that are generally not availableto our direct sales force. In 2006 our agent channel accounted forapproximately 12% of our access lines sold.

As a result of our direct salesstrategy, we generally have not spent funds on television, radio or multi-mediaadvertising. However, we intend to continue our involvement in local communityactivities in each of our markets in order to create more publicity and namerecognition for our company.

**Our Customers**

Our customers are generally smalland medium-sized businesses with fewer than 100 employees and cross a varietyof industries including professional services, communications, technology andheavy industry. During 2006, we did not have any end-user customer representingmore than 1% of our total revenue. We do not generate a significant amount ofwholesale carrier revenue (other than carrier access and reciprocalcompensation revenue) or wholesale Internet service provider revenue. Wecurrently serve over 60,000 customers.

**Customer Service and Retention**

We provide our customers with superior customerservice, which is driven by a highly personalized, integrated team approach. Ourlocal customer service representatives and repair service bureau associates aresupported by customer service professionals in our markets and in our callcenters. Each new customer is contacted multiple times by our service deliveryteam during the service initiation process to ensure accuracy and on-timedelivery of services ordered.

We segment our customer base to better serve theirspecific needs. We have national account managers responsible for maintainingrelationships with large and multiple location accounts and local accountmanagers responsible for single market accounts. The local and national accountmanagers coordinate service requests with our call center associates to ensurecustomer satisfaction.

Our “866-Eschelon” customer service numberprovides a single contact point for customers to gain quick access to customer serviceor their account manager. Our associates consistently answer calls within 20seconds. Our call centers are staffed by trained associates whose performanceis closely monitored. Our centrally managed service platform allows us toactively track and analyze call response times, trouble ticket resolution andcustomer satisfaction for every in-bound call received. Our centralized repairservice bureau is complemented by our field service technicians who can readilybe deployed to the customer premises. We also regularly survey our customersallowing us to track, analyze and adjust service 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.

Due to our sales force expansionand recently acquired TelWest lines, our installation backlog has increased. Weexpect backlog to return to our targeted level over the next 3-4 months.

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**Network Overview and Deployment**

We have constructed our network around owned switchingand colocation equipment. Our network is a system of switches and equipment colocatedin Regional Bell Operating Companies (“RBOC”) central offices or carrier hotelsthat are interconnected using company operated fiber rings and leasedtransport, which is then linked to customers’ premises using leased loops. Inalmost all cases, we purchase the last mile connection from the RBOC.

***Voice and Data Switches.******  ***We havedeployed Nortel, Lucent, Tellabs and Cisco equipment in each of our majormarkets. We use Nortel DMS and Lucent 5ESS switches for local dial toneservices, the Tellabs digital crossconnect system (DACS) for terminating,routing and aggregating on DS1/DS3 transport and customer connections, andNortel Passport ATM switches in combination with Cisco core and edge routersfor advanced data services. We believe the Nortel DMS 500 and Lucent 5ESSswitches are reliable, proven platforms for providing local services. TheNortel Passport ATM switches are highly flexible and integrate well with theCisco IP platforms to provide network services over common networkinfrastructures.

***Colocation Equipment.******  ***We use ZhoneTechnologies, Inc. Universal Edge 9000, or UE9000, access node equipmentand Lucent AnyMediaFast Digital Loop Carriers in each of the 150 unique RBOCcentral offices in which we have physically colocated in order to provide localanalog line service to our customers. The UE9000 access node and AnyMediaFastenable effective delivery of industry standard voice service offerings. We havealso deployed Adtran 4303 and Verso Sechtor 300 devices in our switch rooms andvarious colocations and, together with the addition of an integrated accessdevice at customer premise locations, we are able to offer network voice anddata services over a single T1 line. In select colocations, we also use Nokia’sDSLAMs in order to provide on-net DSL services. The UE9000, AnyMediaFast,Adtran 4303, Sechtor 300 and Nokia devices are high density voice and dataequipment that fit into a single network bay, thereby reducing costlycolocation space required in RBOC central offices.

***Intra-City TransportDeployment.******  ***We utilize fiber transport in a SONETring configuration to connect host sites to RBOC colocations. We also useleased transport with carrier diversity for network reliability. As customerline concentrations increase in a colocation, we are able to take advantage ofcarrier diversity techniques. Where fiber is not deployed, transport betweenour switches and our colocations is provided over more than one route in allcases and is purchased from more than one provider in most cases. Usingmultiple routes and providers gives us a more robust network that maintainsfunctionality should a transport route incur a failure. By diversifying ourhigh capacity circuits across multiple vendors in each market, we maintainhigher levels of network reliability and lower network costs.

***Inter-City BackboneNetwork.******  ***Our Cisco routers and Nortel PassportATM switches provide data traffic switching in our major markets. These devicesare interconnected through leased long-haul transport obtained from multiplewholesale providers. This backbone carries IP data traffic between switchlocations. Customer access to the Internet and virtual private networks travelover this network. We utilize redundant, state-of-the-art transmission andswitching technology that carries both T1-based and DSL-based IP trafficmore efficiently than traditional dedicated circuit networks.

***Customer Access Methods.******  ***We have theability to serve small and medium-sized businesses in our markets by one ormore 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. For2006, 72% 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 the majority ofthe estimated business access lines within our selling areas.

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·       ***DSL***.   We providededicated connections to certain customers using conventional “twisted pair”copper wire employing DSL technology. Our customers use DSL lines for dataapplications 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***.   Wehave commercial agreements in place that replace UNE-P platform in both theQwest and Verizon territories in which we operate.

·       ***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.******  ***In ourexisting markets, we compete principally with Qwest. Qwest and other RBOCs havelong-standing relationships with their customers, have financial, technical andmarketing resources substantially greater than ours, have the potential tosubsidize competitive services with revenue from a variety of businesses, andcurrently benefit from existing regulations that favor RBOCs over us in somerespects. As a relatively recent entrant in the communications services industry,we may not achieve a major share of the market for any of our services. Whileregulatory initiatives based on the Telecommunications Act of 1996, or (“theTelecom Act”), which allow competitive service providers such as us tointerconnect with Qwest’s facilities, provide increased business opportunitiesfor us, these interconnection opportunities have been, and likely will continueto be, accompanied by increased pricing flexibility for and relaxation ofregulatory oversight of Qwest and the other RBOCs. Future regulatory decisionscould grant the RBOCs greater pricing flexibility or other regulatory relief. Theseinitiatives could have a material adverse effect on us.

***Competitive ServiceProviders and Other Market Entrants.******  ***We also facecompetition from other competitive service providers. Consolidation andstrategic alliances within the communications industry or the development ofnew technologies could put us at a competitive disadvantage. The Telecom Actradically altered the market opportunity for new competitive service providers.Because the Telecom Act requires RBOCs to unbundle their network services, newcompetitive service providers are able to rapidly enter the market byinstalling switches and leasing local loops.

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. Wirelessservice providers are developing wireless technology for deployment in theUnited States, intending to provide a broadband substitute for traditionalwireline local telephones. Some companies are delivering voice communicationsover the Internet.

***Long Distance Service.******  ***The long distancecommunications industry has numerous entities competing for the same customerswhich has historically created high churn as customers frequently change longdistance providers in response to offerings of lower rates or promotionalincentives. Prices in the long distance market have declined significantly inrecent years and are expected to continue to decline. Our primary competitorsfor long distance services are interexchange carriers, RBOCs and resellers. Webelieve that pricing levels are a principal competitive factor in providinglong distance 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.******  ***The Internetservices market is highly competitive, and we expect that competition willcontinue 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.******  ***We competewith numerous equipment vendors and installers and communications managementcompanies for business telephone systems and related services. We generallyoffer our products at prices consistent with other providers and differentiateour service through our product packages and customer service.

**Employees**

As of February 28, 2007, we had 1,390 full-timeequivalent employees. Twenty-seven field service technicians are members of theInternational Brotherhood of Electrical Workers (IBEW). A collective bargainingagreement with the IBEW is in effect through February 29, 2008.

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

**Executive Officers**

Our executive officers anddirectors as of December 31, 2006 are as follows:

| **Name**                    | ** ** | ** ** | ** ** | **Age**  | ** ** | **Start of  Service**                                              | ** ** | **Position(s)** |
|-----------------------------|------------|------------|------------|----------|------------|--------------------------------------------------------------------|------------|-----------------|
| *Executive Officers:*       | * *   | * *   | * *   | * * | * *   | * *                                                           |
| Clifford D.  Williams       |       | 59         |       | 1996     |       | Chairman of the Board and Founder                                  |
| Richard A.  Smith           |       | 56         |       | 1998     |       | Director, President and Chief Executive  Officer                   |
| Geoffrey M.  Boyd           |       | 39         |       | 2000     |       | Chief Financial Officer                                            |
| Robert E.  Pickens          |       | 46         |       | 1996     |       | Chief Operating Officer                                            |
| David A.  Kunde             |       | 47         |       | 1999     |       | Executive Vice President, Engineering and  Network Operations |
| Arlin B.  Goldberg          |       | 50         |       | 1996     |       | Executive Vice President, Information  Technology                  |
| J. Jeffery  Oxley           |       | 52         |       | 1999     |       | Executive Vice President, Law and Policy                           |
| Steven K.  Wachter          |       | 45         |       | 1999     |       | Executive Vice President, Sales                                    |
| William D.  Markert         |       | 42         |       | 1999     |       | Executive Vice President, Network Financial  Management            |
| *Non-Management Directors:* |       |       |       |     |       |                                                               |
| James P.  TenBroek          |       | 45         |       | 2000     |       | Director                                                           |
| Marvin C.  Moses            |       | 62         |       | 1999     |       | Director                                                           |
| Mark E.  Nunnelly           |       | 48         |       | 1999     |       | Director                                                           |
| Ian K. Loring               |       | 40         |       | 2001     |       | Director                                                           |
| Louis L. Massaro            |       | 60         |       | 2005     |       | Director                                                           |

 

**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 our 

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business or results ofoperations, and we cannot guarantee that regulatory authorities will not raisematerial issues regarding our compliance with applicable regulations.

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

Federal law generally preemptsstate statutes and regulations that restrict the provision of competitivelocal, long distance and enhanced services; consequently, we generally are freeto provide the full range of local, long distance and data services in everystate. While this federal preemption greatly increases our potential forgrowth, it also increases the amount of competition to which we may be subject.Enforcing federal preemption against certain state policies and programs may becostly 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 Telecom Act amended the Communications Act toeliminate many barriers to competition in the U.S. communications industry. TheTelecom Act set basic standards for relationships between communicationsservice providers, including relationships between new entrants and RBOCs. Ingeneral, the Telecom Act requires RBOCs to provide competitors withnondiscriminatory access to and interconnection with RBOC networks, and toprovide UNEs at cost-based prices. The FCC and PUCs have adopted rules toimplement the Telecom Act and to encourage competition.

***Long Distance Competition.******  ***Section 271of the Communications Act, enacted as part of the Telecom Act, established aprocess 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 RBOC has adhered to a 14-point competitive checklist andthat granting such authority would be in the public interest. All of the RBOCshave received FCC approval to provide in-state long distance service withintheir respective regions. Receipt of Section 271 authority by the RBOCshas resulted in increased competition in certain markets and 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 all the states in which we operate, the RBOC’sSection 272 requirements have sunset. The sunset of Section 272requirements could make it easier for the RBOCs to engage in 

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discrimination, which wouldadversely affect our ability to compete. In addition, if the FCC granted theRBOCs permission to cease complying with dominant carrier regulations even whenthey provide local and inter-LATA services on an integrated basis (that is,without structural separation), that also could make it harder to detectdiscrimination and thus adversely affect our ability to compete.

***Interconnection Agreements.******  ***Pursuant toFCC rules implementing the Telecom Act, we negotiate interconnectionagreements with RBOCs to obtain access to UNEs and services, generally on astate-by-state basis. We currently have interconnection agreements in effectwith Qwest for the states of Arizona, Colorado, Minnesota, Montana, Oregon,Utah and Washington, with AT&T for the states of Nevada and California, andwith Verizon for the states of Washington and Oregon. If we enter new markets,we expect to establish interconnection agreements with RBOCs on an individualstate basis. As discussed below, changes to our agreements based upon recentFCC orders ultimately will be incorporated into our interconnection agreements,but whether these changes will be affected by negotiation or arbitration isuncertain.

Interconnection agreements typically have three-yearterms. At the end of the term the parties can terminate the agreement or, ifeither party so requests, the agreement goes into an “evergreen” status whereit is still in effect until a new agreement is reached. All of ourinterconnection agreements are in evergreen status. We are in the process ofarbitrating our interconnection agreements with Qwest for Arizona, Colorado,Minnesota, Oregon, Utah, and Washington and we are in negotiations with Qwestover our interconnection agreement in Montana. State Commission arbitrationdecisions in turn may be appealed to federal courts. Neither AT&T in Nevadaand California, nor Verizon in Oregon and Washington, has sought to terminateour interconnection agreements or commence negotiations to develop newagreements. We also have the right to opt into any interconnection agreementthat is in effect but not in evergreen status between an RBOC and anothercompetitive local service provider or to adopt State Commission reviewedstandard agreements called “SGATs” or Statements of Generally Available Termsand Conditions. We cannot predict how successful we will be in arbitrating ornegotiating terms critical to our provision of local network services. Otherinterconnection agreement arbitration proceedings before various statecommissions may result in decisions that could affect our business, but wecannot predict the extent of any such impact.

***Unbundled NetworkElements.******  ***The Telecom Act requires RBOCs toprovide requesting telecommunications carriers with nondiscriminatory access tonetwork elements on an unbundled basis at any technically feasible point onrates, terms and conditions that are just, reasonable and non-discriminatory,in accordance with the other requirements set forth in Sections 251 and 252 ofthe Telecom Act. The Telecom Act gives the FCC authority to determine whichnetwork elements must be made available to requesting carriers such as us. TheFCC is required to determine whether the failure to provide access to suchnetwork elements would impair the ability of the carrier seeking access toprovide the services it seeks to offer. Based on this standard, the FCCdeveloped an initial list of RBOC network elements that must be unbundled on anational basis, or UNEs, in 1996.

Those initial rules have been re-examined severaltimes by the FCC as appellate courts directed the FCC to revisit its unbundlingdecisions. The prolonged litigation concerning UNE rules concluded, atleast for the time being, when the D.C. Circuit Court of Appeals upheld theFCC’s revised rules in June 2006. Comparing the list of UNEsavailable to CLECs in 1999 with the list CLECs currently has access to, revealsthat the FCC at the direction of the Courts, has significantly reduced UNEavailability. CLECs no longer have access to UNE-P, the Unbundled NetworkElement Platform, an offering which combined switching, loop, and transportfacilities, and they face restrictions as to where high capacity loops andtransport are available as UNEs. In general terms, the FCC restricted orlimited access to loop and transport UNEs only in wire centers with highconcentrations of business lines, reasoning that either competitivealternatives were either actually available in these areas or that competitorscould economically deploy such facilities there. The FCC also determined thatcertain broadband elements, including fiber-to-the-home, or FTTH, loops ingreenfield situations, broadband services over FTTH loops in overbuildsituations, packet switching, and the packetized portion of hybrid loops, arenot subject to unbundling obligations. In large part, we have adapted to thesechanges in UNE availability by entering into commercial agreements which provideidentical facilities, albeit at a higher price. Further adaptation would benecessary in the event ILECs determined to retire copper facilities which wecurrently obtain as UNEs. Consequently, Eschelon together with a number ofother CLECs, has petitioned the FCC to prevent widespread retirement of copperfacilities. We cannot predict the outcome of this proceeding nor can we predictwhen and where ILECs might decide to replace their copper infrastructure withfiber.

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Changes in UNE rules must be incorporated intointerconnection agreements. We have completed this effort with respect to ouragreements with AT&T in California and Nevada. Our interconnectionagreement arbitrations/negotiations with Qwest will incorporate these changeswhen concluded. Revisions to our interconnection agreements with Verizon inOregon and Washington are substantially complete and await only statecommission action to take effect.

FCC rules implementing the local competitionprovisions of the Telecom Act permit CLECs to lease UNEs at rates determined byPUCs employing the FCC’s Total Element Long Run Incremental Cost, or TELRIC,forward-looking, cost-based pricing model. On September 15, 2003, the FCCopened a proceeding reexamining the TELRIC methodology and wholesale pricing rules forcommunications services made available for resale by RBOCs in accordance withthe Telecom Act. This proceeding will comprehensively re-examine whether theTELRIC pricing model produces unpredictable pricing inconsistent withappropriate economic signals; fails to adequately reflect the real-worldattributes of the routing and topography of an RBOC’s network; and createsdisincentives to investment in facilities by understating forward-looking costsin pricing RBOC network facilities and overstating efficiency assumptions. Wehave participated in this proceeding as a member of a consortium of CLECs. Todate the FCC has not yet issued revised TELRIC rules. The application andeffect of a revised TELRIC pricing model on the communications industrygenerally and on certain of our business activities cannot be determined atthis time.

In August 2005, the FCC released an order thatlargely deregulated “wireline broadband Internet access service” by determiningthat it was an information service rather than a telecommunications service. TheFCC refers to “wireline broadband Internet access service” as a service thatuses existing 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 Order did not affect CLECs’ability to obtain UNEs, but it did relieve the RBOCs of any duty to offer DSLtransmission services subject to their competitors. We have been able to enterinto commercial agreements to resell Qwest DSL through March, 2009. We cannotguarantee that Qwest will extend these agreements or offer comparable terms andconditions when our current agreements expire.

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 ofits 24 Omaha central offices where it determined that competition fromintermodal (cable) service providers was “extensive.”  Although the FCC required that Qwest continueto make UNEs available throughout Omaha, in the nine specified central offices,Qwest may do so at non-TELRIC rates. The FCC did not grant Qwest the requestedrelief regarding its colocation and interconnection obligations. Both CLECs andQwest have sought judicial review of this order in the U.S. Court of Appealsfor the D.C. Circuit. On December 28, 2006, the FCC granted ACS similarrelief from unbundling obligations in five wire centers in Anchorage, Alaska. OnSeptember 6, 2006, Verizon filed six separate petitions requesting relieffrom unbundling in six major eastern cities. On January 24, 2007, Qwestfiled a similar petition for Terry, Montana. We do not operate in any of theseareas and we cannot predict whether future such petitions will be filed formarkets in which we do operate, nor can we predict what would be the outcome ofany such petitions. We are not aware of wire centers in any metropolitan areain which we currently offer or plan to offer service that would meet thestandard for UNE elimination applied in the Qwest and ACS proceedings. Dependingon the future levels of facilities-based deployment in the markets at issue,however, such forbearance petitions could eventually reduce our access to UNEfacilities.

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. Verizon subsequently filed a “clarification” of its originalpetition. Verizon’s petition was deemed granted when the FCC failed to act uponit, raising the question of whether the FCC granted Verizon’s original petitionwhich sought wide relief from unbundling for all broadband services or whetherVerizon’s subsequent clarification of its petition was granted. Verizon’sclarification suggested that only packet-based and optical transport servicesand not Time Dimension Multiplex (TDM) services would receive relief fromunbundling and TELRIC pricing requirements. AT&T and Qwest have filedpetitions requesting to receive the relief that Verizon received. The grant offorbearance is being appealed. The FCC has not acted upon these petitions yet. 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 have notexperienced any significant adverse impact to date. We cannot predict theeffect, if any, of further unbundling and pricing relief that would result fromthe possible grant of AT&T’s and Qwest’s petitions.

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***Colocation.******  ***FCC rules generallyrequire RBOCs to permit competitors to colocate equipment used forinterconnection and/or access to UNEs. Changes to those rules, upheld in 2002by the D.C. Circuit, allow competitors to colocate multifunctional equipmentand require RBOCs to provision cross-connects between colocated carriers. Wecannot determine the effect, if any, of future changes in the FCC’s colocation rules onour business or operations.

***CPNI.******  ***FCC rules protectthe privacy of certain information about customers that communicationscarriers, including us, acquire in the course of providing communicationsservices. Such protected information, known as Customer Proprietary NetworkInformation, or CPNI, includes information related to the quantity,technological configuration, type, destination and the amount of use of acommunications service. The FCC’s initial CPNI rules initially prevented acarrier from using CPNI to market certain services without the express approvalof the affected customer, referred to as an opt-in approach. In July 2002,the FCC revised its opt-in rules in a manner that limits our ability touse the CPNI of our subscribers without first engaging in extensive customerservice processes and record keeping. We believe that we use our subscribers’ CPNIin accordance with applicable regulatory requirements. However, if a federal orstate regulatory body determines that we have implemented those guidelinesincorrectly, we could be subject to fines or penalties. In addition, correctingour internal customer systems and CPNI processes could generate significantadministrative 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 that allegedlyfailed to comply with the FCC’s CPNI rules. To date, we are unaware of anymaterial 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. Reports indicate that the FCC is preparing to release an order settingout new requirements. These requirements could impose significant compliancecosts on us.

***Intercarrier Compensation.******  ***The FCC’sintercarrier compensation rules include rules governing accesscharges, which govern the payments that IXCs and commercial mobile radioservice providers make to local exchange carriers to originate and terminatelong distance calls, and reciprocal compensation rules, which generally governthe compensation between telecommunications carriers for the transport andtermination of local traffic. We purchase long distance service on a wholesalebasis from several IXCs who pay access fees to local exchange carriers for theorigination and termination of our long distance communications traffic. Generally,intrastate access charges are higher than interstate access charges. Therefore,to the degree access charges increase or a greater percentage of our longdistance traffic is intrastate, our costs of providing long distance serviceswill increase. As a local exchange provider, we bill long distance providersaccess charges for the origination and termination of those providers’ longdistance calls. Accordingly, in contrast with our long distance operations, ourlocal exchange business benefits from the receipt of intrastate and interstatelong distance traffic. As an entity that collects and remits access charges, wemust properly track and record the jurisdiction of our communications trafficand remit or collect access charges accordingly. The result of any changes tothe existing regulatory scheme for access charges or a determination that wehave been improperly recording the jurisdiction of our communications trafficcould have a material adverse effect on 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. CLECs must now mirror RBOCinterstate rates.

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 make payments 

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to and receive payments from othercarriers for the exchange of local and long distance calls, we will be affectedby changes in the FCC’s intercarrier compensation rules. In July 2006, agroup of carriers including AT&T and many small rural companies proposed acomprehensive plan to reform the access system. Called “The Missoula Plan,” theproposed reforms would likely result in reducing our access revenues andincreasing our network costs. The FCC may decide to adopt all, part or none ofthe Missoula Plan or indeed any of the other proposals that have been made inthe proceeding. We cannot predict the impact that any changes the FCC maydecide to implement may have on our business.

One of the issues before the FCC in its intercarriercompensation docket concerns the treatment of VoIP traffic. Certain carrierswho send us VoIP traffic for termination contend that because such traffic isan “enhanced service,” it should not be subject to access charges as is thecase with circuit switched long distance traffic, but should instead be treatedas local traffic and be subject to significantly lower rates for call termination than traditional longdistance traffic.  We cannot predict whenthe FCC will decide this question or how it will decide it. If the FCCdetermines that VoIP traffic should be exempt from access charges and the VoIPplatform is widely adopted, our access revenues will decline.

***Special Access.******  ***Over the last several years,the FCC has granted RBOCs significant flexibility in pricing interstate specialand switched access services. In August 1999, the FCC granted immediatepricing flexibility to many RBOCs and established a framework for grantinggreater flexibility in the pricing of all interstate access services once anRBOC market satisfies certain prescribed competitive criteria. In February 2001,the D.C. Circuit upheld the FCC’s prescribed competitive criteria. To date, theFCC has granted pricing flexibility in numerous specific markets to the RBOCs,including Qwest. This pricing flexibility may result in Qwest lowering itsprices in high traffic density areas, including areas where we compete or planto compete. On the other hand, Qwest could also use its pricing flexibility toincrease rates as it last did in 2004. We anticipate that the FCC will continueto grant RBOCs greater pricing flexibility for access services if the number ofactual and potential competitors increases in each of these markets.

***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) communications and informationservices for schools and libraries, (ii) communications and informationservices for rural health care providers, (iii) basic telephone service inregions characterized by high communications costs, (iv) basic telephoneservices for low-income consumers, and (v) interstate access support. Basedon the total funding needs for these programs, the FCC determines acontribution factor, which it applies to each contributor’s interstate andinternational end user communications revenues. We measure and report ourrevenues in accordance with rules adopted by the FCC. The contributionrate factors are calculated and revised quarterly and we are billed for ourcontribution requirements each month based on projected interstate andinternational end-user communications revenues, subject to periodic true up. USFcontributions may be passed through to consumers on an equitable andnondiscriminatory basis either as a component of the rate charged forcommunications services or as a separately invoiced line item.

The FCC has recently expanded the obligation tocontribute to the USF fund to include VoIP providers who were previously exempt.The FCC is also considering changing the basis upon which our USF contributionsare determined from a revenue percentage measurement to a connection ortelephone number measurement. Adoption of this proposal could have a materialadverse affect on our costs, our ability to separately list USF contributionson end-user bills, and our ability to collect these fees from our customers. Congressis also currently considering legislation that would potentially affect our USFobligations.

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

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

***Communications Assistancefor 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. Becausewe 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, the FCC extended CALEAobligations to facilities-based providers of broadband Internet access serviceand to interconnected VoIP services and the order was later upheld on appeal. Asa broadband Internet access provider, we will be subject to these newrequirements once they take effect. The current compliance deadline is set for May 2007.We notified the FCC in February of 2007 that we intend to be compliantwith its CALEA requirements. Several parties have appealed the FCC’s orderextending new requirements in the U.S. Court of Appeals for the D.C. Circuit. Asa result of these new obligations, 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.

***Deregulation of BroadbandFacilities and Regulation of Internet Access and VoIP Services.******  ***To date, theFCC has treated Internet service providers, or ISPs, as information serviceproviders, which are generally exempt from federal and state regulationsgoverning common carriers. In June 2005, the U.S. Supreme Court upheld theFCC’s finding that broadband cable modem service is an information service.Consequently, cable modem operators are not required to provide other Internetservice providers, including us, with access to their cable broadband lines. Asmentioned above, in August 2005, the FCC found that wireline broadbandservice, including DSL internet access by facilities-based telephone companiesis an information service, which the companies are not required to makeavailable to competitors, including us. In November 2006, the FCC issued anorder classifying Broadband over Power Line Internet access service aninformation services as well, similarly removing the requirement that suchcompanies make those line available to competitors, including us.

Notwithstanding these rulings limiting our access tobroadband facilities, the FCC is also considering regulations governing thedisclosure of confidential communications, copyright, excise tax and otherrequirements that may apply to our Internet access services. In addition, theFCC released a Notice of Proposed Rulemaking in September 2005 seekingcomment on a broad array of consumer protection regulations for broadbandInternet access services, including rules regarding the protection ofCPNI, slamming, truth in billing, network outage reporting, servicediscontinuance notices, and rate-averaging requirements. Consequently, ourregulatory obligations vis a vis our Internet access services may increase. Wecannot predict our costs of compliance and we may be subject to penalties inthe event we fail to comply with such new rules.

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Moreover, Congress has passed a number of laws thatconcern the Internet and Internet users. Generally, these laws limit thepotential liability of ISPs and hosting companies that do not knowingly engagein unlawful activity. We expect that Congress will consider this year a varietyof bills, some of which, if signed into law, could impose obligations on us tomonitor the Internet activities of our customers.

The use of the public Internet and private Internetprotocol networks to provide voice communications services, includingvoice-over-Internet protocol, or VoIP, is a relatively recent marketdevelopment. The provision of such services until recently was largelyunregulated within the United States. To date, the FCC has not imposed mostforms of traditional common carrier regulation upon providers of Internetcommunications services. But the FCC has imposed obligations on providers oftwo-way interconnected VoIP services to provide E911 service, to comply withCALEA and to contribute to the federal universal service support mechanisms. Tothe extent that we choose to provide interconnected VoIP services, we will bearthose costs as a result of these mandates.

Several additional pending FCCproceedings 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 regulatory issues relating to VoIP services and develop a regulatoryframework that is unique to IP telephony providers or that subjects VoIPproviders to minimal regulatory requirements. We cannot predict when, or if,the FCC may take such actions. The FCC may determine that certain types ofInternet telephony should be regulated like basic interstate communicationsservices, rendering VoIP calls subject to the access charge regime that permitslocal telephone companies to charge long distance carriers for the use of thelocal telephone networks to originate and terminate long-distance calls,generally on a per minute basis. The FCC’s pending review of intercarriercompensation policies (discussed above) also may have an adverse impact onenhanced service providers.

In June, 2006, the FCC determinedthat all “interconnected” VOIP services are required to contribute a percentageof interstate gross revenues to USF. This ruling has been appealed, but remainsin effect pending the appeal. Other aspects of VoIP and Internet telephonyservices, such as regulations relating to the confidentiality of data andcommunications, copyright issues, taxation of services, and licensing, may besubject to federal or state regulation. While the Company currently does notprovide interconnected VoIP services, we are planning to do so and consequentlywill be affected by these regulations. Similarly, changes in the legal andregulatory environment relating to the Internet connectivity market, includingregulatory changes that affect communications costs or that may increase thelikelihood of competition from RBOCs or other communications companies couldincrease our costs of providing service.

Broadband Internet-related andVoIP services are the subject of evolving policies. It is possible suchservices could be subject to additional regulation in the future. The effect ofsuch regulations on our business could be substantial, but we cannot predictwhat rules will ultimately apply or their impact on our business.

***Taxes and Regulatory Fees.******  ***We are subjectto numerous local, state and federal taxes and regulatory fees, FCC regulatoryfees and public utility commission regulatory fees. We have procedures in placeto ensure that we properly collect taxes and fees from our customers and remitsuch taxes and fees to the appropriate entity pursuant to applicable law and/orregulation. If our collection procedures prove to be insufficient or if ataxing or regulatory authority determines that our remittances were inadequate,we could be required to make additional payments, which could have a materialadverse effect on our business.

***Legislation.******  ***In recentsessions, Congress has considered various measures that would overhaul telecomlaws in the United States. Bills introduced in the House of Representatives andthe Senate have addressed a wide variety of issues, including the regulation ofbroadband and VoIP services, network neutrality requirements, universalservice, video franchising procedures, and municipal broadband services, amongothers. The prospects and timing of any potential legislation remain unclear,and as such, we cannot predict the outcome of any such legislation upon ourbusiness.

***RBOC-IXC Mergers.******  ***In October 2005,the FCC approved orders clearing the SBC-AT&T and Verizon-MCI mergers withrelatively limited conditions in certain areas, including minimal divestituresand no reduction in special access rates. SBC and Verizon volunteered to sellor divest, at market rates, ten-year leases for loops into certain buildingsalong with leases for dark fiber transport necessary to connect the loops tothe facility of the purchaser of the lease. SBC and Verizon also agreed tofreeze certain high-capacity special access rates for existing in-regionAT&T and MCI customers for 30 months, and to refrain from providingthemselves, their affiliates, or each other with special 

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access services notgenerally available to other competitors. As our reliance on special access isminimal, we do not expect these conditions to affect us positively ornegatively. In addition, as our operations in the Verizon and SBC regions areminimal, we do not expect to see a significant impact as a result of the UNErate freezes they each agreed to for a two year period from the merger closingdate. On the closing of the merger, SBC renamed itself AT&T.

On December 29, 2006, theFCC approved the AT&T and Bell South merger. AT&T agreed to a number ofconditions that will remain in effect throughout the entire AT&T-Bell Southterritory for up to 42 months. These conditions included following netneutrality provisions, freezing certain and reducing other special accessrates, freezing UNE rates, recalculating competitive figures for implementingthe TRRO, and agreeing not to alter the status of any loop or transport UNE viaforbearance or other petitions. In addition, AT&T will expand its broadbandofferings to all residences and divest itself of 31 buildings in the Bell Southregion by selling fiber IRUs. We anticipate little material benefit from theseconditions or harm from the merger itself because of our limited operations inAT&T’s territory.

**State Regulation**

The Communications Act maintains the authority ofindividual states to impose their own regulation of rates, terms and conditionsof intrastate services, so long as such regulation is not inconsistent with therequirements of federal law or has not been preempted. Because we providecommunications services that originate and terminate within individual states,including both local service and in-state long distance toll calls, we aresubject to the jurisdiction of the PUC and other regulators in each state inwhich we provide such services. For instance, we must obtain a Certificate of PublicConvenience and Necessity, or CPCN, or similar authorization before we maycommence the provision of communications services in a state. We have obtainedCPCNs to provide facilities-based or resold competitive local and interexchangeservice in California, Arizona, Colorado, Idaho, Minnesota, Montana, Nevada,New Mexico, New York, Oregon, Utah and Washington. There can be no guaranteethat we will receive authorizations we may seek in other states in the future. Asour local service business expands, we may offer additional intrastate servicesand may become subject to additional state regulations.

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

We also are subject to state laws and regulationsregarding slamming, cramming, and other consumer protection and disclosureregulations. These rules could substantially increase the cost of doingbusiness in any particular state. State commissions have issued or proposedsubstantial fines against CLECs for slamming or cramming. The risk of financialdamage, in the form of fines, penalties and legal fees and costs and tobusiness reputation from slamming is significant. A slamming complaint before astate commission could generate substantial litigation expenses. In addition,state law enforcement authorities may use their consumer protection authorityagainst us if we fail to meet applicable state law requirements.

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

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

Rates for intrastate switched access services, whichwe provide to long-distance companies to originate and terminate in-state tollcalls, are subject to the jurisdiction of the state in which the calloriginated and/or terminated. Such regulation by states could have a materialadverse affect on our revenues and business opportunities within that state. PUCsalso regulate the rates RBOCs charge for interconnection, access to networkelements, and resale of services by competitors. In response to FCC’s TRROproceedings, some state commissions have continued 

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proceedings to address issuesaffecting the rates, terms and conditions of intrastate services while otherstates suspended or terminated their proceedings. The states of Colorado andMinnesota have initiated cost cases to add new UNE rates and reprice other UNEs.Any such proceedings may affect the rates, terms, and conditions contained inour interconnection agreements or in other wholesale agreements with RBOCs. Wecannot predict the outcome of these proceedings. The pricing, terms andconditions under which the RBOC in each of the states in which we currentlyoperate offers such services may preclude or reduce our ability to offer acompetitively viable and profitable product within these and other states on agoing forward basis.

State regulators establish and enforce wholesaleservice quality standards that RBOCs must meet in providing network elements toCLECs like Eschelon. These plans, called Performance Assurance Plans, sometimesrequire payments from the RBOCs to the CLECs if quality standards are not met. Aregion-wide review of Qwest’s Performance Assurance Plan is currently underway.In addition, the Nevada Commissions has recently revised AT&T’s wholesaleperformance standards in Nevada. The RBOCs are seeking changes in performancestandards that will reduce the payments made to CLECs under the PerformanceAssurance Plans. If such changes are adopted, we will experience reducedpayments and could also experience a diminution of the wholesale servicequality we receive. We cannot predict how state commissions will respond tosuch requests, nor the ultimate impact of such decisions on the Company.

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

State legislatures and state PUCsalso regulate, to varying degrees, the terms and conditions upon which ourcompetitors conduct their retail businesses. In general, state regulation ofRBOC retail offerings is greater than the level of regulation applicable toCLECs. Qwest, AT&T and Verizon either have obtained or are actively seekingsome level of increased pricing flexibility or deregulation, either through amendmentof state law or through proceedings before state PUCs. Such increased pricingflexibility could have an adverse effect on our competitive position in thosestates because it could allow the RBOCs to reduce retail rates to customerswhile wholesale rates that we pay to Qwest stay the same or increase. We cannotpredict whether these efforts will materially affect our business.

**Local Regulation**

In some municipalities where wehave installed facilities, we are required to pay license or franchise fees basedon a percentage of our revenue generated from within the municipal boundaries. Wecannot guarantee that fees will remain at their current levels following theexpiration of existing franchises or that other local jurisdictions will notimpose similar fees.

**Other Domestic Regulation**

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

We operate numerous sites inconnection 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, we 

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cannot giveassurances that it has been or will be in complete compliance with these lawsand regulations. We may be subject to fines or other sanctions by federal,state and local governmental authorities if we fail to obtain required permitsor violate applicable laws and regulations.

**Available Information**

Copies of our Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K,and amendments to those reports filed or furnished to the Securities ExchangeCommission pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934 are available free of charge through our website(www.eschelon.com) as soon as reasonably practicable after we electronicallyfile the material with, or furnish it to, the Securities Exchange Commission.

**Item 1A.**             RiskFactors.

**Risks Related to Our Industry**

***The communicationsindustry faces significant regulatory uncertainties and the resolution of theseuncertainties could hurt our business, results of operations and financialcondition.***   TheTelecom Act requires, among other things, that RBOCs provide access to theirnetworks to us; however, this act remains subject to judicial review andongoing proceedings before the FCC and state regulators, including proceedingsrelating to interconnection pricing, access to and pricing for unbundlednetwork elements and other issues that could result in significant changes toour business and business conditions in the communications industry generally.We must lease unbundled network elements from RBOCs at cost-based rates toserve our customers and to connect our telecommunications equipment. We provideour customers with telecommunications services through telephone lines or“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 which we pay for access. Although no legislation affecting us wasenacted in the last session of Congress, both the House and the Senateconsidered bills containing provisions that could have adversely affected ouraccess to UNEs at cost based rates. We face the risk of similar provisionsbeing incorporated into future telecommunications bills. The D.C. Circuit Courthas upheld the FCC’s Triennial Review Remand Order, or TRRO. The TRRO reducedour ability to obtain unbundled network elements, or UNEs and consequentlyaffected our operations and increased our costs for certain network elements.Where we have lost access to UNEs, we have either been able to obtainreplacement circuits from other providers or we have purchased circuits fromthe RBOCs as special access or private line service, generally at higher pricesthan UNEs. In addition, the FCC has permitted the RBOCs to detariff their DSLofferings. While we have been able to obtain commercial agreements to resellDSL, our wholesale rates may increase. Other proceedings are underway thatcould potentially further limit our access to UNEs. The Telecom Act gave theFCC the authority for forbearance from enforcing regulatory provisions,including unbundling requirements. The FCC has recently granted Qwest and ACSrelief from unbundling obligations in certain wire centers in Omaha, Nebraska(Qwest) and Anchorage, Alaska (ACS). There is also a petition pending beforeFCC in which Verizon seeks similar relief from unbundling in a number of majoreast coast markets. While the FCC’s actions in these forbearance proceedings donot affect us currently, our access to UNEs could be limited by futureforbearance proceedings. In future orders, the FCC could eliminate unbundlingobligations in markets in which we operate, which would adversely impact ouroperations and increase our costs. The FCC has initiated proceedings that mayresult in increasing the rates we pay for network elements or reducing therates we charge long distance companies to originate and terminate their calls.A number of states also have proceedings and legislative proposals pending tore-examine and possibly increase our network element rates. We cannot predictthe outcome of these proceedings or the effects, if any, that these proposalsmay have on our business and operations. A summary of legal and regulatorydevelopments is discussed in more detail in the section entitled “Regulation.”

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***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 Telecom Act, as amended,the FCC exercises jurisdiction over us with respect to interstate andinternational services. We must comply with various federal regulations, suchas the duty to contribute to universal service and other subsidies. Failure tocomply with federal reporting and regulatory requirements may result in finesor other penalties, including loss of authority to provide services.

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 be askedto show cause as to why our certificate of authority to provide service shouldnot be revoked.

***The communications marketin which we operate is highly competitive, and we may not be able to competeeffectively against companies that have significantly greater resources than wedo, which could cause us to lose customers and impede our ability to attractnew customers.***   The communications industry is highly competitive and isaffected by the introduction of new services and systems by, and the marketactivities of, major industry participants. In each of our markets we competeprincipally with the RBOC serving that area. The recent mergers of SBC withAT&T, MCI, Inc. with Verizon, and AT&T with Bell South, 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;

·       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.

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***Changes in current orfuture 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 financial difficultiesfaced by others in our industry could adversely affect our public image and ourfinancial results.******  ***Many competitive communicationsservices providers, long distance carriers and other communications providershave experienced substantial financial difficulties over the past few years. Tothe extent that carriers in financial difficulties purchase access servicesfrom us, we may not be paid in full or at all for services we have rendered. Further,the perception of instability of companies in our industry may diminish ourability to obtain further capital and may adversely affect the willingness ofpotential customers to purchase their communications services from us.

**Risks Related to Acquisitions**

***We may not be able tosuccessfully integrate acquired companies into our business and we may have toincur additional indebtedness.***   During2006, we completed the acquisition of OTI, OneEighty and MTI and we acquiredmuch of the Washington state customer base of TelWest, and in the secondquarter of 2007, we expect to complete the acquisition of UNICOM. While webelieve that these acquisitions will be successfully integrated into ouroperations, there can be no assurance that we will be able to integrate andconsolidate these or subsequent acquisitions into our ongoing business andoperations according to management’s plan. While we believe that we havesufficient financial and management resources to complete the integration ofthese acquisitions, there can be no assurance in this regard or that we willnot experience difficulties with customers, personnel or others resulting fromthe integration. This process will require management, financial and otherresources and may pose risks with respect to production, customer service andmarket share. It may also require regulatory approvals for some aspects whichwe cannot assure will be obtained. In addition, although we believe that theseacquisitions will enhance our competitive position and business prospects,there can be no assurance that such benefits will be fully realized or that theintegration of these acquisitions into our business and operations willultimately be successful.

As we adapt to the current telecom environment andcomplete the integration of OTI, OneEighty, MTI, UNICOM and the migration ofTelWest’s lines, we may be required to make operational changes, includingconsolidating certain operations, closing certain facilities, or amending orterminating existing contractual relationships, in order to improve our futureprofitability. However, there can be no assurance as to the cost required toeffect those operational changes, their effectiveness, or the timing or amountof any cost savings that are actually realized as a result of such changes. Managementis continuing to assess our overall organization and cost structures and may,as a result of this ongoing process, develop future initiatives to increaseoperating and administrative efficiency and enhance profitability. If we areunable to effectively and efficiently integrate these acquisitions into ourbusiness and operations, our business, financial condition, results ofoperations and cash flows may suffer.

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

If we acquire anotherbusiness, we may face difficulties, including:

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

·       retainingkey personnel of the acquired business;

·       failingto adequately identify or assess liabilities of that business;

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·       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.

In addition,our ability to complete acquisitions will depend, in part, on our ability tofinance the acquisitions, including the costs of acquisition and integration. Ourability may be constrained by our cash flow, the level of our indebtedness atthe time, restrictive covenants in the agreements governing our indebtedness,conditions in the securities markets and other factors, many of which are not withinour control. If we proceed with one or more acquisitions in which theconsideration consists of cash, we may use a substantial portion of ouravailable 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 history of netlosses, and we may not be profitable in the future.******  ***We haveincurred net losses in the past and may continue to incur losses in the future.For the year ended December 31, 2006, we had a net loss of $2.8 millionand an accumulated deficit of $157.8 million. For the year ended December 31,2005, we had a net loss of $31.0 million and an accumulated deficit of $155.0million. For the year ended December 31, 2004, we had net income of $1.1million and an accumulated deficit of $124.1 million. The net income for theyear ended December 31, 2004 was primarily the result of a gain onextinguishment of debt of $18.2 million. We cannot assure you that our revenueswill continue to grow or that we will achieve profitability in the future.

***If the RBOCs with whom wehave interconnection agreements engage in anticompetitive practices, ourbusiness 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 Telecom Act required RBOCs to cooperate withcompetitive communication services providers and meet statutory requirementsfor opening their local markets to competition before they could receivepermission to provide in-region long distance services. Now that each RBOC hasmet those requirements and received authorization to provide long distanceservices throughout its respective operating region, they may have lessincentive to properly maintain the information, ordering and interconnectioninterfaces that we rely on and may otherwise fail to cooperate with usregarding service provisioning 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 and judicial remedies frequently do not precludefurther anticompetitive behavior and rarely fully compensate us for our damagesand legal expenses. If an RBOC refuses to cooperate or otherwise fails tosupport our business needs in retaliation for our efforts to enforce our legalrights or for any other reason, including labor shortages, work stoppages,cost-cutting initiatives or disruption caused by mergers, other organizationalchanges or terrorist attacks, our ability to offer services on a timely andcost-effective basis will be materially and adversely affected.

***Our ability to provide ourservices and systems at competitive prices is dependent on our ability tonegotiate and enforce favorable interconnection agreements.***   Ourability to continue to obtain favorable interconnection, unbundling, serviceprovisioning and pricing terms, and the time and expense involved innegotiating interconnection agreements and amendments, can be adverselyaffected by ongoing legal and regulatory activity. All of our existinginterconnection agreements provide either that a party is entitled to demandrenegotiation 

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of particular provisions or of the entire agreementbased on intervening changes in law resulting from ongoing legal and regulatoryactivity, or that a change of law is immediately effective in the agreement andset out a dispute resolution process if the parties do not agree upon thechange of law. The initial terms of all of our interconnection agreements withthe RBOCs have expired. Our interconnection agreements with Qwest, AT&T andVerizon are in “evergreen,” a provision that allows the agreement to continuein effect until a new agreement is in place. We are in the process ofnegotiating our Montana interconnection agreement and arbitrating the remainingdisputed provisions of our proposed interconnection agreements within Arizona,Colorado, Minnesota, Oregon, Utah and Washington. We are operating under ourAT&T and Verizon agreements in evergreen and neither party has notified theother of an intent to terminate the existing agreements or commencenegotiations on new agreements. We cannot assure you that we will be able tosuccessfully renegotiate the agreements on terms favorable to us. In additionto negotiation and arbitration, the Telecom Act gives us the right to opt intoany other carrier’s interconnection agreement, provided the agreement is stillin effect and provided that we adopt the entire agreement. Any limitation onour ability to colocate telecommunications equipment in RBOC central offices,or on the terms and conditions for interconnecting our network to the RBOCs’networks, or on the availability of unbundled network elements, especiallyunbundled local loops or interoffice transmission facilities, resulting fromour failure to negotiate favorable interconnection agreements or resulting fromfederal or state regulatory activity, could increase our costs and otherwisehave a material adverse impact on our business, results of operations andfinancial 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, and although bothAT&T and Verizon have agreed to freeze or reduce special access rates inorder to gain approval of their recent mergers, Qwest is under no obligation tofreeze or reduce its special access rates. To the extent we are forced topurchase special access circuits because equivalent facilities are no longeravailable at cost-based rates as unbundled network elements under ourinterconnection agreements, our costs may significantly increase.  We provide a more detailed discussion ofcurrent legal and regulatory developments affecting access charges andintercarrier compensation issues in the section entitled “Regulation.”

***The regulation of accesscharges involves uncertainties, and the resolution of these uncertainties couldadversely affect our business, results of operations and financial condition.***   Asa facilities-based competitive communications services provider, we earn accesscharges by connecting our voice services customers with long distance carrierssuch as AT&T, Verizon and Sprint Corp. When a network service voicecustomer of ours originates or receives a long distance call, we are entitledto compensation from these carriers for the cost we incur in originating orterminating the long distance call. In 2006, access charges accounted for $16.8million, or 6.1% 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 result in decreasing our access charges. Such reductions couldhave a material adverse effect on our business, results of operations andfinancial condition.

The FCC has commenced a proceeding to revise itscompensation rules regarding carrier access charges as has the MinnesotaPublic Utilities Commission. Because we receive payments from long distancecarriers for the calls their customers make that access our network facilities,we will be affected by any changes to the FCC’s or Minnesota’s compensationrules. We cannot predict the impact that any such changes would have on ourbusiness.

***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 mutually acceptablesettlements to collect overdue and disputed payments, but we cannot assure youthat we will be able to do so in the future. If we are unable to continue totimely receive payments and to create settlement agreements with othercarriers, our business, results of operations and financial condition may bematerially 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 

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customers if we fail to pay within 60 days after thepayment due date, and require a deposit if we pay late three times during a 12month period. The deposit may be up to the estimated total monthly charges foran average two-month period within the first three months from the date ofdelinquency. If an RBOC makes an enforceable demand for an increased securitydeposit, we could have less cash available for other expenses, which could havea material adverse effect on our business, results of operations and financialcondition.

***The level of our outstanding total debt may adverselyaffect our financial health and prevent us from fulfilling our financialobligations.***   As of December 31, 2006, wehad approximately $147.7 million of total indebtedness outstanding. Ourindebtedness could significantly affect our business and our ability to fulfillour financial obligations. For example, a high level of indebtedness could:

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

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

·       increaseour vulnerability to general adverse economic and industry conditions;

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

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

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

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

***Our outstanding notes contain restrictive covenantsthat limit our operating flexibility.******  ***The indenturegoverning our outstanding 8 3/8% senior second secured notes due 2010 containscovenants that, among other things, limit our ability to take specific actions,even if we believe them to be in our best interest. In addition, we may obtaina credit facility in the future which may include similar or additionalcovenants. These covenants may include restrictions on our ability to:

·       incuradditional indebtedness;

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

·       createliens with respect to our assets;

·       makeinvestments, loans or advances;

·       prepayspecified indebtedness;

·       enterinto transactions with affiliates;

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

·       engagein any business other than activities related or complementary 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.

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***If we are unable to retainand attract management and key personnel, we may not be able to execute ourbusiness plan.******  ***We believe that our success is due, inpart, to our experienced management team, including Mr. Richard A. Smith,our president and chief executive officer. Losing the services of one or moremembers 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 new personnel.

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 to grow byexpanding 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 controls that we anticipate would be necessary to support rapidgrowth and to manage a competitive business in an evolving industry. Anyfailure to implement and improve these systems and controls and to maintain ourother resources at a pace consistent with industry changes and the growth ofour business could cause customers to switch to other competitive serviceproviders, which would have 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 prices for communicationsservices 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 chosen 

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long distance providers in response to lower rates orpromotional incentives by competitors. These trends may continue.

***We depend on a limitednumber of third party service providers for long distance and other services,and if any of these providers were to experience significant interruptions inits business operations, or were to otherwise cease to provide such services tous, 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. We may be required to select one technologyover another at a time when it might be impossible to predict with anycertainty which technology will prove to be more economic, efficient or capableof attracting customers. In addition, even if we utilize new technologies, suchas VoIP, we may not be able to implement them as effectively as other companieswith more experience with those new technologies. Technological advancementsand manufacturing economies of scale could make VoIP services delivered overthe Internet cost effective to deploy and of sufficient quality to beacceptable 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 to monitor ournetwork from a performance and cost perspective and as a result, our networkoptimization routines may have an adverse effect on our customers.***   Ourengineering and operations organizations continually monitor and analyze theutilization of our network. As a result, they may develop projects to modify oreliminate network circuits that are underutilized. This ongoing process mayresult in limited network outages for a subset of our customers, adverselyaffecting our relationship with them and may increase our customer disputes andmonthly churn.

26

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***Some of our employees areunionized, and we could face work disruptions due to strikes, slowdowns orother labor disputes.******  ***Twenty-seven of our employees aremembers of the International Brotherhood of Electrical Workers. Although ourmanagement believes that our relationship with our union employees is good, wecannot promise that we will never experience a labor disruption. Suchdisruptions could occur in response to our actions but could also be due to theactions of other union employers. Significant labor disruptions could adverselyaffect our ability to provide acceptable levels of service to our customers,which could result in customer dissatisfaction and a loss of business.

***Terrorist attacks andother acts of violence or war may affect the markets in which we operate, ouroperations 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 may directlyimpact our business operations through damage or harm to our employees, networkfacilities or support systems, increased security costs or the generalcurtailment of voice or data traffic. Any of these events could result inincreased volatility in or damage to our business and the United Statesfinancial markets and economy.

**Item 1B.**             UnresolvedStaff Comments.

None.

27

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**Item 2.**                     Properties.

We are headquartered inMinneapolis, Minnesota and conduct our principal operations in Arizona,California, Colorado, Minnesota, Montana, Nevada, Oregon, Utah and Washington.

We do not ownany of our facilities. The table below lists our leased facilities as of February 28,2007.

| **Location**                    | ** ** | **Lease Expiration** | ** ** | **Square  Footage** | ** ** | **Purpose**            | ** ** |
|---------------------------------|------------|---------------------------|------------|---------------------|------------|------------------------|------------|
| Peoria, AZ                      |       | January 31,  2011    |       | 6,104               |       | Office                 |       |
| Phoenix, AZ                     |       | May 15, 2010         |       | 7,468               |       | Switch Facility/Office |       |
| Phoenix, AZ                     |       | February 1, 2009     |       | 9,391               |       | Office                 |       |
| Mesa, AZ                        |       | July 31, 2011        |       | 4,480               |       | Office                 |       |
| Tempe, AZ                       |       | February 28, 2010    |       | 9,527               |       | Switch Facility/Office |       |
| Tempe, AZ                       |       | March 31, 2007(1)    |       | 9,223               |       | Office                 |       |
| Santa Rosa, CA                  |       | April 30, 2014       |       | 5,250               |       | Switch Facility        |       |
| Santa Rosa, CA                  |       | August 1, 2007       |       | 4,230               |       | Office                 |       |
| Denver, CO                      |       | January 31, 2011     |       | 6,000               |       | Switch Facility        |       |
| Denver, CO                      |       | April 30, 2012       |       | 36,000              |       | Office/Warehouse       |       |
| Greenwood Village, CO |       | January 31, 2009     |       | 3,965               |       | Office                 |       |
| Minneapolis, MN                 |       | May 31, 2013         |       | 118,174             |       | Main Office            |       |
| Minneapolis, MN                 |       | March 31, 2009       |       | 17,342              |       | Switch Facility/Office |       |
| Minneapolis, MN                 |       | June 30, 2010        |       | 3,348               |       | Data Switch Facility   |       |
| Minneapolis, MN                 |       | November 30, 2012    |       | 143                 |       | Storage                |       |
| Golden Valley, MN               |       | February 28, 2012    |       | 33,246              |       | Office/Warehouse       |       |
| Billings, MT                    |       | June 30, 2011        |       | 4,300               |       | Switch Facility        |       |
| Billings, MT                    |       | June 30, 2009        |       | 4,600               |       | Office                 |       |
| Bozeman, MT                     |       | May 31, 2007         |       | 1,282               |       | Office                 |       |
| Reno, NV                        |       | June 1, 2011         |       | 6,053               |       | Office                 |       |
| Reno, NV                        |       | July 31, 2009        |       | 8,778               |       | Switch Facility/Office |       |
| Portland, OR                    |       | December 31, 2009    |       | 7,028               |       | Switch Facility        |       |
| Portland, OR                    |       | September 30, 2011   |       | 6,217               |       | Warehouse              |       |
| Tigard, OR                      |       | June 30, 2008        |       | 15,033              |       | Office/Warehouse       |       |
| Salem, OR                       |       | April 30, 2009       |       | 7,997               |       | Switch Facility/Office |       |
| Salem, OR                       |       | July 31, 2007        |       | 5,000               |       | Storage                |       |
| Salem, OR                       |       | February 17, 2010    |       | 14,548              |       | Office                 |       |
| Eugene, OR                      |       | October 31, 2011     |       | 4,964               |       | Office                 |       |
| Bend, OR                        |       | July 31, 2007        |       | 1,966               |       | Office                 |       |
| Medford, OR                     |       | June 30, 2008        |       | 1,568               |       | Office                 |       |
| Salt Lake City, UT              |       | July 14, 2012        |       | 22,069              |       | 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, 2012      |       | 30,503              |       | Office/Warehouse       |       |
| Tacoma, WA                      |       | January 31, 2009     |       | 11,373              |       | Switch Facility/Office |       |
| Bellingham, WA                  |       | December 31, 2007    |       | 800                 |       | Office                 |       |
| Cody, WY                        |       | March 31, 2007(1)    |       | 324                 |       | Office                 |       |

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(1)*            *Willnot be renewed.

We believe that the facilities used in our operationsare suitable for their respective uses and adequate to meet our current needs.

**Item 3.**                     LegalProceedings.

We are party from time to time to ordinary coursedisputes that we do not believe to be material.

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

None.

28

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**Part II**

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

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

The following table sets forth the high and low pricesduring the periods indicated since trading began:

| ** **     | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------|------------|------------|------------|------------|------------|
| **2006**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| First quarter  |       | 15.87      |       | 11.63      |       |
| Second quarter |       | 17.18      |       | 15.02      |       |
| Third quarter  |       | 17.04      |       | 13.72      |       |
| Fourth quarter |       | 19.94      |       | 16.68      |       |
| **2005**       |       |       |       |       |       |
| Third quarter  |       | 14.14      |       | 11.63      |       |
| Fourth quarter |       | 14.25      |       | 11.50      |       |

 

As of March 8, 2007, the closing price of ourcommon stock was $24.97 per share.

On February 28, 2007, therewere 230 holders of record of our common stock. See Item 12, Security Ownershipof Certain Beneficial Owners and Management and Related Stockholder Matters,for a discussion of the ownership of our company. We have not declared any cashdividends on our common stock. Our outstanding notes restrict our ability topay dividends on our capital stock.

29

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**Item 6.**                     SelectedFinancial Data.

The followingtables set forth our selected consolidated financial and other data for theperiods indicated. The selected consolidated financial data as of December 31,2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004have been derived from the audited consolidated financial statements and notesto consolidated financial statements included elsewhere in this report. Theselected consolidated financial data as of December 31, 2004, 2003 and2002 and for the years ended December 31, 2003 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 Advanced TelCom, Inc. (“ATI”) except for the Balance Sheet Data.All dollar amounts are in thousands of dollars, except per share amounts.
|                                                                                      | ** ** | ***Year Ended December 31,*** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Statements  of operations data:**                                                  | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenue:                                                                             |       |                                         |       |   |   |   |   |   |   |   |   |
| Network services                                                                     |       | $                                            | 244,702    |   | $ | 201,835 |   | $ | 131,780 |   | $ | 115,482 |   | $ | 96,209 |   |
| BTS                                                                                  |       | 29,824                                       |       | 25,908 |   | 26,316 |   | 25,614 |   | 25,659 |   |
| Total revenue                                                                        |       | 274,526                                      |       | 227,743 |   | 158,096 |   | 141,096 |   | 121,868 |   |
| Cost and expenses:                                                                   |       |                                         |       |   |   |   |   |   |   |   |   |
| Network service expenses (excluding depreciation and amortization)                   |       | 98,664                                       |       | 85,914 |   | 47,354 |   | 45,037 |   | 39,493 |   |
| BTS cost of revenue                                                                  |       | 18,427                                       |       | 16,139 |   | 15,979 |   | 15,784 |   | 16,053 |   |
| Sales, general and administrative                                                    |       | 103,569                                      |       | 90,310 |   | 69,255 |   | 66,252 |   | 68,920 |   |
| Depreciation and amortization                                                        |       | 42,247                                       |       | 39,653 |   | 31,105 |   | 30,099 |   | 25,261 |   |
| Operating income (loss)                                                              |       | 11,619                                       |       | (4,273 | ) | (5,597 | ) | (16,076 | ) | (27,859 | ) |
| Other income (expense)(1)                                                            |       | (14,399                                      | )          | (27,369 | ) | 6,712 |   | (1,102 | ) | 48,052 |   |
| Income (loss) before income taxes(1)                                                 |       | (2,780                                       | )          | (31,642 | ) | 1,115 |   | (17,178 | ) | 20,193 |   |
| Income taxes                                                                         |       | —                             |       | (4 | ) | (4 | ) | (28 | ) | (50 | ) |
| Net income (loss) from continuing operations(1)                                      |       | (2,780                                       | )          | (31,646 | ) | 1,111 |   | (17,206 | ) | 20,143 |   |
| Income from discontinued operation, net of tax                                       |       | —                                       |       | 329 |   | — |   | — |   | — |   |
| Gain on sale of discontinued operation, net of tax                                   |       | —                                       |       | 326 |   | — |   | — |   | — |   |
| Net income (loss)(1)                                                                 |       | (2,780                                       | )          | (30,991 | ) | 1,111 |   | (17,206 | ) | 20,143 |   |
| Less preferred stock dividends and premium paid on repurchase of  preferred stock(2) |       | —                                       |       | — |   | (4,292 | ) | (3,426 | ) | (2,701 | ) |
| Net income (loss) applicable to common stockholders                                  |       | $                                            | (2,780     | ) | $ | (30,991 | ) | $ | (3,181 | ) | $ | (20,632 | ) | $ | 17,442 |   |
| Basic income (loss) per  common share:                                               |       |                                         |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                             |       | $                                            | (0.17      | ) | $ | (5.32 | ) | $ | (11.11 | ) | $ | (70.59 | ) | $ | 147.68 |   |
| Income from discontinued operation                                                   |       | —                                       |       | 0.11 |   | — |   | — |   | — |   |
| Net income (loss)                                                                    |       | $                                            | (0.17      | ) | $ | (5.21 | ) | $ | (11.11 | ) | $ | (70.59 | ) | $ | 147.68 |   |
| Diluted income (loss) per  common share:                                             |       |                                         |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                             |       | $                                            | (0.17      | ) | $ | (5.32 | ) | $ | (11.11 | ) | $ | (70.59 | ) | $ | 5.83 |   |
| Income from discontinued operation                                                   |       | —                                       |       | 0.11 |   | — |   | — |   | — |   |
| Net income (loss)                                                                    |       | $                                            | (0.17      | ) | $ | (5.21 | ) | $ | (11.11 | ) | $ | (70.59 | ) | $ | 5.83 |   |
| **Other financial data:**                                                            |       |                                         |       |   |   |   |   |   |   |   |   |
| Capital expenditures(3)                                                              |       | $                                            | 54,658     |   | $ | 35,905 |   | $ | 30,771 |   | $ | 26,466 |   | $ | 23,175 |   |
| Cash flows provided by (used in) operating activities                                |       | 45,953                                       |       | 15,028 |   | 26,115 |   | 16,688 |   | (2,888 | ) |
| Cash flows provided by (used in) investing activities                                |       | (132,756                                     | )          | (30,971 | ) | (79,056 | ) | (25,008 | ) | (23,020 | ) |
| Cash flows provided by (used  in) financing activities                               |       | 81,887                                       |       | 15,570 |   | 70,770 |   | (2,807 | ) | 31,593 |   |

 

30

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| ** **                                    | ** ** | ***As of and for the Year Ended December 31,*** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| **Operating  data:**                          | ** ** | **2006**                                                                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Voice access lines in service(4)              |       | 363,375                                                                                 |       | 270,662 |   | 173,492 |   | 156,165 |   | 133,908 |   |
| Data access lines in service(4)               |       | 234,954                                                                                 |       | 144,790 |   | 76,861 |   | 50,256 |   | 24,657 |   |
| Total access lines in service(4)              |       | 598,329                                                                                 |       | 415,452 |   | 250,353 |   | 206,421 |   | 158,565 |   |
| Markets in operation                          |       | 45                                                                                      |       | 19 |   | 12 |   | 12 |   | 12 |   |
| Percent of new access lines installed  on-net |       | 95                                                                                      | %          | 97 | % | 92 | % | 87 | % | 77 | % |
| Percent of total access lines on-net          |       | 85                                                                                      | %          | 86 | % | 81 | % | 74 | % | 63 | % |
| Average monthly churn(5)                      |       | 1.28                                                                                    | %          | 1.34 | % | 1.48 | % | 1.60 | % | 1.87 | % |
| Total full-time equivalent employees          |       | 1,385                                                                                   |       | 1,118 |   | 924 |   | 888 |   | 918 |   |
| Quota-carrying network services sales  people |       | 265                                                                                     |       | 204 |   | 167 |   | 139 |   | 164 |   |
| Quota-carrying BTS sales people               |       | 42                                                                                      |       | 39 |   | 33 |   | 36 |   | 35 |   |
| Total quota-carrying sales people             |       | 307                                                                                     |       | 243 |   | 200 |   | 175 |   | 199 |   |

 

| ** **                                                                 | ** ** | ***As of December 31,*** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| **Balance  sheet data:**                                                   | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash, cash equivalents, restricted cash and  available-for-sale securities |       | $                                       | 39,467     |   | $ | 31,818 |   | $ | 33,351 |   | $ | 8,606 |   | $ | 19,733 |   |
| Property and equipment, net                                                |       | 145,785                                 |       | 126,452 |   | 102,849 |   | 86,777 |   | 91,296 |   |
| Total assets                                                               |       | 330,521                                 |       | 231,546 |   | 237,119 |   | 153,721 |   | 169,133 |   |
| Total debt, including current portion                                      |       | 147,736                                 |       | 97,519 |   | 142,231 |   | 87,822 |   | 88,625 |   |
| Net debt(6)                                                                |       | 108,269                                 |       | 65,701 |   | 108,880 |   | 79,216 |   | 68,892 |   |
| Total stockholders’ equity (deficit)                                  |       | 131,450                                 |       | 92,253 |   | (8,180 | ) | (5,071 | ) | 15,542 |   |
|                                                                            |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)*            *InJune 2002, we entered into a negotiated debt restructuring, which includedthe reduction of outstanding debt under our senior secured credit facility from$139,293 to $57,062. In the restructuring, certain lenders with outstandingprincipal and interest due of $65,778 chose to receive $12,229 in cash tocancel all liabilities, as a result of which we recorded a pre-tax gain of$53,549. In accordance 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.

                         InSeptember 2005, we redeemed $50,630 accreted value ($57,750 principalamount) of our 8 3/8% senior second secured notes due March 15, 2010 at aredemption price of 112% of the accreted value. The $6,076 accreted-valuepremium was recorded as interest expense. In addition, we wrote off aproportionate amount of the associated debt issuance costs and recorded $2,579as interest expense.

(2)*            *InDecember 2004, in connection with our acquisition of ATI, we repurchased6,780,541 shares of our series A convertible preferred stock for $5,085.

(3)*            *Capitalexpenditures are the sum total of purchases of property and equipment includingequipment purchased under a capital lease, cash paid for customer installationcosts and internal capitalized labor.

(4)*            *Eachaccess line and access line equivalent is equal to one 64-kilobitcustomer line that is active and being billed. Unused capacity on T1 circuitsis not included in our line count.

(5)*            *Averagemonthly churn is the total access line service disconnections for the month asa percentage of total access lines in service at the end of the month.

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

31

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

| ** **                               | ** ** | ***2006***                       | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | ***For the Three Months Ended*** | ** ** |
| ** **                               | ** ** | **March 31**                | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** | **Total Year** | ** ** |
| Total revenue                            |       |                             | $          | 59,726 |   |   |   | $ | 68,250 |   |   |   | $ | 69,806 |   |   |   | $ | 76,744 |   |   |   | $ | 274,526 |   |   |
| Income (loss) before income taxes        |       |                             | (1,583     | ) |   |   | (599 | ) |   |   | (608 | ) |   |   | 10 |   |   |   | (2,780 | ) |   |
| Net income (loss)                        |       |                             | (1,583     | ) |   |   | (599 | ) |   |   | (608 | ) |   |   | 10 |   |   |   | (2,780 | ) |   |
| Net income (loss) per share—basic   |       |                             | (0.11      | ) |   |   | (0.04 | ) |   |   | (0.03 | ) |   |   | 0.00 |   |   |   | (0.17 | ) |   |
| Net income (loss) per share—diluted |       |                             | (0.11      | ) |   |   | (0.04 | ) |   |   | (0.03 | ) |   |   | 0.00 |   |   |   | (0.17 | ) |   |

 

| ** **                               | ** ** | ***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 |   |   |
| 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   |       |                             | (18.70     | ) |   |   | (26.32 | ) |   |   | (1.49 | ) |   |   | (0.35 | ) |   |   | (5.21 | ) |   |
| Net income (loss) per share—diluted |       |                             | (18.70     | ) |   |   | (26.32 | ) |   |   | (1.49 | ) |   |   | (0.35 | ) |   |   | (5.21 | ) |   |

 

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(1)*            *InSeptember 2005, we redeemed $50,630 accreted value ($57,750 principalamount) of our 8 3/8% senior second secured notes due March 15, 2010 at aredemption price of 112% of the accreted value. The $6,076 accreted-valuepremium was recorded as interest expense. In addition, we wrote off aproportionate amount of the associated debt issuance costs and recorded $2,579as interest expense.

                         2005includes $4,748 in costs related to the settlement with Global Crossing in June 2005,which is described in our Form 10-K filed with the SEC on March 17,2006.

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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 45 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 60,000 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. In December 2004,we acquired ATI, whereby we enhanced our presence in Washington, Oregon andNevada and entered California. During 2006, we acquired OTI, OneEighty and MTI,which enhanced our market presence in Oregon and Arizona and gave us a marketpresence in Montana.

In February 2007, we announced that we signed adefinitive agreement to acquire UNICOM. UNICOM is headquartered in Bend, Oregon.The acquisition is expected to close in the second quarter of 2007 and willenhance our presence in Oregon.

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, costs and expenses as apercentage of revenue and access line churn rates. We monitor key operating andcustomer service metrics to improve customer service, maintain the quality ofour network and reduce costs.

The telecommunications industryis highly competitive. We believe we compete principally by offering superiorcustomer service, accurate billing, a broad set of services and systems andcompetitive pricing. We compete with the RBOCs, other competitivecommunications services providers, and long distance and data service providers.While wireless and cable providers are competing with us, we do not believethey are a significant competitive threat in the markets we serve nor are theylikely to be in the near future, because of the different service standardsthat business customers require.

**Key Components of Results of Operations**

***Revenue.******  ***Networkservices revenue consists primarily of local telephone service, long distanceservice, carrier access charges, and data and Internet access services. Revenuefrom local telephone service consists of charges for basic local dial-toneservice, including dedicated T1 access, and custom-calling features such ascall waiting and call forwarding. Revenue from long distance service consistsof flat rated and per-minute-of-use charges for a full range of traditionalswitched and dedicated long distance, toll-free calling, international calling,calling card and operator services. Carrier access revenue consists primarilyof usage charges that we bill long distance carriers to originate and terminatecalls to and from our customers. In addition, in some of our markets wecurrently charge other local exchange carriers and wireless carriers usagecharges to originate and terminate local and wireless calls to and from 

33

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certain customers (otherwise known as reciprocalcompensation). Revenue from data and Internet access services consistsprimarily of monthly usage fees for DSL and T1 circuits and Internet accessservices. We typically commit our customers to contracts ranging from one tothree years and provide discounts for longer terms. Network services revenue comprised89.1% of our total revenue for the year ended December 31, 2006, andrepresents a predominantly recurring revenue stream.

Monthly recurring network services revenue isrecognized in the month the services are used. In the case of local service revenue,monthly recurring local services charges are billed in advance but accrued forand recognized on a prorated basis based on length of service in any givenmonth. Non-recurring revenues associated with line installations are recognizedover the average life of the customers. Long distance and carrier access usagecharges 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 theacquisitions of ATI, OneEighty and MTI, which were not under a bill-and-keeparrangement with the RBOCs, and our negotiated reciprocal compensationagreements with a few wireless carriers, we recorded approximately $0.9 millionof reciprocal compensation revenue in 2006. We do not have any significantwholesale carrier revenue or wholesale Internet service provider revenue otherthan carrier access revenue and this reciprocal compensation.

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.

***Network Services Expense.******  ***Our networkservices expense consists primarily of the cost of operating our networkfacilities. The network components for our facilities-based business includethe 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 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 vary bycarrier and by state and in many cases are regulated under federal and statelaws. In virtually all areas, we lease local loops, T1 lines and interofficetransport capacity from the RBOCs. We lease interoffice facilities fromcarriers other than the RBOCs where possible in order to lower costs andimprove network redundancy; however, in some cases, the RBOCs are our onlysource for local loops and T1 lines. Historically we purchased unbundlednetwork elements platform, or UNE-P, from Qwest and Verizon, and customizednetwork element packages, or UNE-E, from Qwest. We also purchase, on a resalebasis, Centrex services, which are services for the portion of the public telephoneswitch that is dedicated to a customer, from AT&T. The rates for UNE-P andCentrex were regulated and established by the various state corporation orutility commissions. We entered into agreements with Qwest and Verizon forUNE-P replacement products in 2005. As of December 31, 2006, we hadapproximately 85,000 access lines in service that were formerly categorized asUNE-P access lines and are now provided under commercial agreements. The QwestUNE-E agreement was terminated with the adoption of Qwest’s commercial UNE-Preplacement product, QPP, and all Qwest UNE-E lines were moved to QPP on January 1,2005. We have incurred higher costs in 2006 to obtain access to certainelements of telecommunications platforms as a result of the TRRO. We will continueto migrate QPP lines to our switches as resources permit to help mitigate theincreased costs.

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Our network services expense also includes the fees wepay for long distance, data and other services. We have entered into wholesalepurchasing agreements for these services. Some of the agreements containsignificant termination penalties and/or minimum usage volume commitments. Inthe event we fail to meet minimum volume commitments, we may be obligated topay underutilization charges. We do not anticipate having to pay anyunderutilization charges in the foreseeable future.

We carefully review all of our vendor invoices andfrequently dispute inaccurate or inappropriate charges. 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 network services expense.

***Business Telephone SystemsCost of Revenue.******  ***Ourmost significant business telephone systems costs of revenue are the equipmentpurchased from manufacturers and labor for service installation. To takeadvantage of volume purchase discounts, we purchase equipment primarily fromthree manufacturers pursuant to master purchase agreements we have with thesemanufacturers. For all business telephone systems installations, our policy isto require a 30% deposit before ordering the equipment so our risk of excessinventory or inventory obsolescence is low. Business telephone systems cost ofrevenue also includes salaries and benefits of field technicians as well asvehicle and incidental expenses associated with equipment installation,maintenance and service provisioning.

***Sales, General andAdministrative.******  ***Sales, general and administrativeexpenses are comprised primarily of employee compensation and benefits,commissions, occupancy costs, bad debt, operating taxes, billing expense andprofessional 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. For2006, 2005 and 2004, our bad debt expense as a percentage of revenue was 0.7 %,0.5%, and 0.5%, respectively.

***Depreciation and Amortization.******  ***Ourdepreciation and amortization expense includes depreciation for network relatedvoice and 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 periods approximating the average life ofcustomers. Detailed time studies are used to determine labor capitalization. Thesetime studies are based on employee time sheets for those engaged incapitalizable activities.

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**Results of Operations**

The followingtable sets forth financial data as a percentage of total revenue for the yearsended December 31, 2006, 2005 and 2004.

| ** **                                                          | ** ** | ***Year Ended December 31,*** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Consolidated  financial data:**                                   | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                            |       |                                         |       |   |   |   |   |
| Network services                                                    |       | 89.1                                         | %          | 88.6 | % | 83.4 | % |
| BTS                                                                 |       | 10.9                                         | %          | 11.4 | % | 16.6 | % |
| Total revenue                                                       |       | 100.0                                        | %          | 100.0 | % | 100.0 | % |
| Costs and expenses:                                                 |       |                                         |       |   |   |   |   |
| Network services expense (excluding  depreciation and amortization) |       | 35.9                                         | %          | 37.7 | % | 30.0 | % |
| Business telephone systems cost of revenue                          |       | 6.7                                          | %          | 7.1 | % | 10.1 | % |
| Sales, general and administrative                                   |       | 37.8                                         | %          | 39.7 | % | 43.8 | % |
| Depreciation and amortization                                       |       | 15.4                                         | %          | 17.4 | % | 19.7 | % |
| Operating income (loss)                                             |       | 4.2                                          | %          | (1.9 | )% | (3.6 | )% |
| Net income (loss)                                                   |       | (1.0                                         | )%         | (13.6 | )% | 0.7 | % |
| Net income (loss) applicable to common  stockholders                |       | (1.0                                         | )%         | (13.6 | )% | (2.0 | )% |

 

The following table sets forthnetwork services expense (excluding depreciation and amortization) and businesstelephone systems cost of revenue as percentages of the related revenue for theperiods indicated.

| ** **                                                          | ** ** | ***Year Ended December 31,*** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Network services expense (excluding  depreciation and amortization) |       |                                         | 40.3       | % |   |   | 42.6 | % |   |   | 35.9 | % |   |
| BTS cost of revenue                                                 |       |                                         | 61.8       | % |   |   | 62.3 | % |   |   | 60.7 | % |   |

 

**Year Ended December 31, 2006 Compared toYear Ended December 31, 2005**

***Revenue.******  ***Revenue forthe years ended December 31, 2006 and 2005 is as follows:
| ** **              | ** ** | ***Year Ended  December 31,*** | ** ** | **%  Change** | ** ** |
|-------------------------|------------|------------------------------------------|------------|---------------|------------|
| ** **              | ** ** | **2006**                                 | ** ** | **2005**      | ** ** | ** ** |
| Revenue (in millions):  |       |                                     |       |          |       |   |   |   |   |
| Voice and data services |       | $                                        | 186.3      |          | $          | 153.9 |   |   | 21.0 | % |   |
| Long distance           |       | 41.6                                     |       | 34.6          |       |   | 20.3 |   |   |
| Access                  |       | 16.8                                     |       | 13.3          |       |   | 26.7 |   |   |
| Total network services  |       | 244.7                                    |       | 201.8         |       |   | 21.2 |   |   |
| BTS                     |       | 29.8                                     |       | 25.9          |       |   | 15.1 |   |   |
| Total revenue           |       | $                                        | 274.5      |          | $          | 227.7 |   |   | 20.5 | % |   |

 

***Network Services.*****  **Networkservices revenue was $244.7 million for the year ended December 31,2006, an increase of 21.2% from $201.8 million for the year ended December 31,2005. The increase in revenue is primarily due to the inclusion of OTI, whichwas acquired on April 1, 2006, OneEighty, which was acquired on October 1,2006, MTI, which was acquired on November 1, 2006, and organic line growth.During the 12 months of 2006, the number of voice lines in serviceincreased by 34.3% to 363,375 lines at December 31, 2006, and the numberof data lines in service increased by 62.3% to 234,954 lines at December 31,2006. The revenue growth associated with access line growth was partiallyoffset by a decline in data revenue per line due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets. We increased our network sales force to 265associates at December 31, 2006, from 204 associates at December 31,2005. We expect to increase the network sales force by an additional 60associates throughout 2007. We expect this increase in sales associates willfavorably impact our lines in service and revenue over the next year.

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***BTS.*****  **BTSrevenue was $29.8 million for the year ended December 31, 2006, anincrease of 15.1% from $25.9 million for the year ended December 31, 2005.The increase in BTS revenue was primarily the result of increases in newsystems sales and revenue from change orders.

***Network Services Expenses(Excluding Depreciation and Amortization).******  ***Network services expenseswere $98.7 million for the year ended December 31, 2006, an increaseof 14.8% from $85.9 million for the year ended December 31, 2005. 2005includes $4.7 million in costs related to the settlement with Global Crossingin June 2005, which is described in our Form 10-K filed withthe SEC on March 17, 2006. 2006 includes network expenses associated withOTI, which was acquired on April 1, 2006, OneEighty, which was acquired onOctober 1, 2006 and MTI, which was acquired on November 1, 2006. Wecontinue to experience improvements in network services expense relative to thegrowth in network services revenue due to several factors, including 1) ourcontinued focus on selling high margin T1-based products, 2) networkgrooming and optimization projects to lower monthly network cost, and 3)efficiencies associated with the integration of our acquired companies. Theseimprovements were partially offset by the inclusion of OTI and higher costsassociated with TRRO. OTI’s network services expenses are a higher percentageof revenue than ours because they are not facilities based. We plan to migratea portion of OTI’s lines to our network over the next 24 months in order tolower costs.  As a percentage of relatedrevenue, network services expenses for 2006 decreased to 40.3% from 42.6% for2005. This decrease was primarily due to the Global Crossing settlement impactin 2005.

***BTS Cost of Revenue.******  ***BTS cost of revenue was$18.4 million and $16.1 million for the years ended December 31,2006 and 2005, respectively. The increase in BTS cost of revenue is due to theincrease in materials expense to support the higher level of revenue. As apercentage of related revenue, BTS cost of revenue for the year ended December 31,2006 decreased to 61.8% from 62.3% for the year ended December 31, 2005. Wedo not expect future improvements in BTS cost of revenue as a percentage ofrelated revenue unless we are able to significantly increase BTS new systemssales and therefore achieve greater volume discounts or economies of scale inour workforce.

***Sales, General andAdministrative.******  ***Sales, general and administrativeexpenses were $103.6 million for the year ended December 31, 2006, anincrease of 14.7% from $90.3 million for the year ended December 31,2005. The increase is primarily due to the inclusion of OTI, OneEighty and MTI,and an increase in costs associated with the sales force expansion. As apercentage of revenue, sales, general and administrative expenses for the yearended December 31, 2006 declined to 37.7% from 39.7% for the year ended December 31,2005 due to the improved efficiency of our existing operations resulting fromour fixed cost structure supporting a higher level of revenue. Our sales,general and administrative expenses are largely fixed as they are driven by the1,385 associates that were employed at December 31, 2006. We expectexpenses as a percentage of revenue to continue to decline due to continuedefficiency improvements and synergies related to acquisitions.

***Depreciation andAmortization.******  ***Depreciation and amortization expensewas $42.2 million for the year ended December 31, 2006, an increaseof 6.5% from $39.7 million for the year ended December 31, 2005. Thisincrease was primarily due to the amortization related to the $5.8 million ofintangible assets purchased in the OTI acquisition and from the depreciation onthe $54.7 million of capital expenditures over the past 12 months. As apercentage of revenue, depreciation and amortization decreased to 15.4% for theyear ended December 31, 2006 from 17.4% for the year ended December 31,2005.

***Interest.******  ***Interestexpense was $17.5 million for the year ended December 31, 2006, a decreaseof 37.7% from $28.1 million for the year ended December 31, 2005. Thedecrease was primarily due to 2005 including $10.2 million of interest expenserelated to the partial redemption of our notes in September. The decrease wasalso due to lower interest expense as a result of having a lower averageoutstanding debt balance for 2006 compared to 2005.

***Net Loss.******  ***Net loss forthe year ended December 31, 2006 was $2.8 million compared to a net lossfor the year ended December 31, 2005 of $31.0 million. This improvement isprimarily due to the increase in revenue, lower interest expense and theimprovements in costs and expenses as a percentage of revenue.

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**Year Ended December 31, 2005 Compared toYear Ended December 31, 2004**

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

 

***Network Services.*****  **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 revenue is primarily due to the inclusion of ATI, whichwas acquired on December 31, 2004, and, to a lesser extent, an increase inthe average number of voice and data access lines in service. From December 31,2004 to December 31, 2005, the number of voice lines increased by 56.0% to270,662 lines at December 31, 2005, and the number of data lines increasedby 88.4% to 144,790 lines at December 31, 2005. The growth in revenueassociated with access line growth was partially offset by declines inpre-subscribed interexchange carrier charge (PICC) revenue, access revenue perminute of use and a decline in data revenue per line. The decline in PICCrevenue was related to our dispute with Global Crossing, which was resolved in June 2005.As a result of that dispute, we stopped recording approximately $0.3 millionper month of PICC revenue beginning in November of 2004. Access revenueper minute of use declined as a result of the scheduled FCC reduction ofinterstate rate levels in June 2004. Data revenue per line declined due toa combination of customers purchasing more bandwidth at discounted prices andgeneral pricing pressures for data services in our markets.

***BTS.*****  **BTSrevenue was $25.9 million for the year ended December 31, 2005, adecrease of 1.6% from $26.3 million for the year ended December 31, 2004due to a one-time revenue adjustment of $0.5 million made in 2005.

***Network Services Expenses(Excluding Depreciation and Amortization).******  ***Network services expenseswere $85.9 million for the year ended December 31, 2005, an increaseof 81.4% from $47.3 million for the year ended December 31, 2004. Thisincrease is primarily due to the inclusion of ATI, which was acquired on December 31,2004, and recording approximately $4.7 million in costs related to thesettlement with Global Crossing in June 2005. As a percentage of relatedrevenue, network services expenses for 2005 increased to 42.6% from 35.9% for2004. This increase was primarily due to the Global Crossing settlement impactand the inclusion of ATI.

***BTS Cost of Revenue.******  ***BTS cost of revenue was$16.1 million and $16.0 million for the years ended December 31,2005 and 2004, respectively. As a percentage of related revenue, BTS cost ofrevenue for the year ended December 31, 2005 increased to 62.3% from 60.7%for the year ended December 31, 2004, primarily due to the one-timerevenue adjustment discussed 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. As a percentage ofrevenue, sales, general and administrative expenses for the year ended December 31,2005 declined to 39.7% from 43.8% for the year ended December 31, 2004 dueto the improved efficiency of our existing operations resulting from our fixedcost structure supporting a higher level of revenue.

***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. Thisincrease was primarily due to the inclusion of ATI and, to a lesser extent, ournetwork growth and associated capital expenditures. As a result of finalizingour purchase price allocation for ATI, we recorded a one-time $4.3 millionadjustment to depreciation and amortization in the fourth quarter of 2005. As apercentage of revenue, depreciation 

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and amortization decreased to 17.4% for the year endedDecember 31, 2005 from 19.7% for the year 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 March 15,2010 at a 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 on Extinguishment ofDebt.******  ***Net income for the year ended December 31,2004 included a gain on extinguishment of debt of $18.2 million. The gainon the extinguishment of debt was the result of paying off our bank facility. InJune 2002, we restructured our bank facility and because the future cashflows could not be calculated with certainty, the gain was deferred. As aresult of the repayment, the excess carrying value of $20.9 million anddebt issuance costs of $2.7 million resulted in the $18.2 milliongain on extinguishment of debt.

***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 and additional depreciation and amortization expense asmentioned previously.

**Liquidity and Capital Resources**

***Principal Sources and Usesof Liquidity.******  ***Our principal sources of liquidity arecash from operations and our cash and cash equivalents and available-for-salesecurities. Our principal liquidity requirements consist of debt service,capital expenditures and working capital.

***Cash and Cash Equivalents.******  ***Cash and cashequivalents was $21.1 million at December 31, 2006, compared to $26.1million at December 31, 2005.

***Available-for-SaleSecurities.******  ***Short-terminvestments are comprised of municipal and United States government debtsecurities with maturities of more than three months but less than one year andauction rate securities. The balance at December 31, 2006 and 2005 was$17.1 million and $4.8 million, respectively. The securities representadditional liquidity for us.

***Financings.******  ***OnMarch 29, 2006, we completed a $48.0 million tack-on offering of oursenior second secured notes at a discount resulting in a 9.92% yield. Afterdeducting fees and expenses associated with the offering, our net proceeds were$44.3 million. Our acquisition of OTI on April 1, 2006, was financed with$20.3 million of the net proceeds from the offering. Our acquisition ofOneEighty on October 1, 2006, was financed with $10.2 million of the netproceeds from the offering. Our acquisition of MTI on November 1, 2006 waspartially financed with the remaining proceeds of $13.8 million.

On May 19, 2006, we completed an offering of2,550,000 shares of our common stock, $0.01 par value per share, at $15.70 pershare. After deducting fees and expenses related to the offering, we receivednet proceeds of $40.0 million. Our acquisition of MTI on November 1, 2006was partially financed with $23.5 million of the proceeds from the offering. Weexpect that the remaining proceeds will be used to fund potential futureacquisitions or for general corporate purposes.

***Cash Provided by OperatingActivities.******  ***Cash provided by operating activitieswas $46.0 million for 2006 compared to cash provided by operatingactivities of $15.0 million for 2005. The increase was primarily due torevenue growth and the related improvement of our cash operating costs and expensesas a percent of revenue. The increase is also due to lower cash interestexpense. During 2005, we paid $6.1 million related to the redemption of 35% ofour senior second secured notes.

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Cash provided by operating activities was$15.0 million for 2005 compared to cash provided by operating activitiesof $26.1 million for 2004. The decrease in cash provided by operatingactivities was due to an $11.7 million increase in cash interest payments. During2005, we paid $6.1 million related to the redemption of 35% of our seniorsecond secured notes and $5.6 million related to additional interest paymentsas a result of our $65.0 million senior second secured notes issued on November 29,2004.

***Cash Used in InvestingActivities.******  ***Cash used in investing activities was$132.8 million for 2006 compared to $31.0 million for 2005 and $79.1million for 2004. The increase in cash used in investing activities from 2005to 2006 was due in part to the acquisitions of OTI, OneEighty and MTI during2006. The increase was also due to increased investments in available-for-salesecurities and property and equipment, and cash paid for customer installationcosts. The decrease in cash used in investing activities from 2004 to 2005 wasprimarily due to 2004 activity including the acquisition of ATI on December 31,2004. Also, net cash provided in 2005 related to available-for-sale securitieswas $1.8 million versus a net use of cash in 2004 of $6.2 million. Cash used forinvesting in the maintenance and expansion of our network and back officesystems and customer installation increased $6.1 million in 2005 versus 2004.

***Cash Provided by FinancingActivities.******  ***Cash provided by financing activitieswas $81.9 million for 2006 compared to $15.6 million for 2005. In 2006, theissuance of senior second secured notes in March 2006 generated $45.6million of proceeds and the issuance of common stock in May 2006 generated$40.4 million of proceeds.

Cash provided by financing activities was $15.6million for 2005. The proceeds from our initial public offering of our commonstock in August 2005, after deducting underwriting discounts andcommissions, were $69.8 million. Proceeds were used to redeem $50.6 millionaccreted value ($49.2 million book value; $57.8 principal amount) of our 8 3/8%senior second secured notes due March 15, 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.

Cash provided by financing activities was$70.8 million for 2004. The net proceeds from the issuance of the seniorsecond secured notes in March 2004 generated approximately$13.2 million. The net cash proceeds from the issuance of senior secondsecured notes in November 2004 and the Series B preferred stockissuance generated approximately $57.5 million after payment of debt issuancecosts and the redemption of Series A preferred stock. We also used cashfor payments on capital lease obligations.

***Outstanding Indebtedness.******  ***As of December 31,2006, we had $147.7 million in outstanding indebtedness, consisting of $141.0million 8 3/8% senior second secured notes due 2010, $5.3 million in capitallease obligations, and $1.4 million for a loan assumed through the acquisitionof MTI. Interest payments on the notes are required on each March 15 and September 15the notes are outstanding. We expect to be able to pay the March 15, 2007and September 15, 2007 cash interest payments from a combination of cashgenerated from operations and cash on hand.

The notes will mature on March 15, 2010, andaccrue interest at an annual rate of 83¤8% with cashinterest payments made on a semiannual basis on each March 15 and September 15.On or after March 15, 2007 we may redeem some or all of the notes atdeclining redemption prices, plus accrued and unpaid cash interest, beginningat 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’saccreted value at a redemption price of 100% of the accreted value of theportion of the notes so redeemed, as well as an additional portion of each noteto the extent required to prevent that note from being treated as an “applicablehigh yield discount obligation” within the meaning of Section 163(i)(1) ofthe Internal 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.

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The notes and theguarantees are secured by a second priority lien on substantially of ourexisting and 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.

***Capital Requirements.******  ***We expect tospend between $54.0 and $58.0 million on capital expenditures in 2007. Inaddition, we expect to close on our acquisition of UNICOM in the second quarterof 2007, for which we will pay approximately $13.9 million. We intend tofinance the acquisition of UNICOM with debt.

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 ouroperations. Other than the additional financing planned in connection with theUNICOM acquisition, 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 or othersignificant unplanned costs or cash requirements may require that we raiseadditional funds through the issuance of debt or equity. We cannot assure youthat such financing will be available on terms acceptable to us or ourstockholders, or at all. Insufficient funds may require us to alter our businessplan or take other actions that could have a material adverse effect on ourbusiness, results of operations and financial condition. If we elect to issueequity securities to raise additional funds, substantial dilution to existingstockholder may result.

**Off-Balance Sheet Arrangements**

We have no off-balance sheetarrangements that have or are reasonably likely to have a current or futurematerial effect on our financial condition, results of operations, liquidity,capital expenditures or capital resources.

**ContractualObligations**

| ** **                  | ** ** | **Total**                            | ** ** | **Less Than  One Year** | ** ** | **1-3 Years** | ** ** | ** 3-5 Years** | ** ** | **More Than  Five Years** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|--------------------|------------|--------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **(Dollars in thousands)** | ** ** |
| Notes payable               |       | $                                    | 200,437    |                              |       | $                  | 13,002     |                     |       |                                | $          | 31,345 |   |   |   | $ | 156,090 |   |   |   | $ | — |   |   |
| Capital lease obligations   |       | 6,102                                |       |                              | 3,622      |               |       |                     | 2,205      |                                |       |   | 275 |   |   |   | — |   |   |
| Operating lease obligations |       | 27,254                               |       |                              | 6,067      |               |       |                     | 11,255     |                                |       |   | 6,868 |   |   |   | 3,064 |   |   |
| Fiber ring payable          |       | 2,792                                |       |                              | 270        |               |       |                     | 463        |                                |       |   | 276 |   |   |   | 1,783 |   |   |
| Purchase obligations        |       | 1,443                                |       |                              | 1,152      |               |       |                     | 291        |                                |       |   | — |   |   |   | — |   |   |
|                             |            |                                      |            |                                   |            |                    |            |                          |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The contractual obligation fornotes payable includes related interest payments and assumes all notescurrently outstanding are outstanding prior to the date of mandatory redemptionand also assumes the notes are not otherwise required to be redeemed in agreater amount.

**Application of Critical Accounting Policies**

Our discussion of the financial condition and resultsof operations is based upon our 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. Managementregularly reviews its estimates and assumptions, which are based on historicalfactors and other factors that are believed to be relevant under thecircumstances. Actual results may differ from these estimates under differentassumptions, estimates or conditions.

41

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Critical accounting policies aredefined 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 are initiallyrecorded at fair value upon the sale of products or services to customers. Significantestimates are required in determining the allowance for doubtful accountsreceivable. We consider two primary factors in determining the proper level ofallowance, including historical collections experience and the aging of theaccounts receivable portfolio. The allowance for doubtful accounts is based onthe best facts available to us and is reevaluated and adjusted as additionalinformation is received. We have a credit policy that helps minimize credit risk.We believe this risk is limited due to the large number and diversity ofclients that comprise our customer base.

***Valuation of Goodwill***

Goodwill is tested annually forimpairment at the reporting unit level. If the undiscounted anticipated futurecash flows of a reporting unit are less than the carrying amount, an impairmentcharge is recognized. In accordance with Statement of Financial AccountingStandards (SFAS) No. 142, *Goodwill andOther Intangible Assets*, management completed its annual impairment testin the fourth quarter of 2006 and 2005 and determined that goodwill had notbeen impaired.

***Income Taxes***

We account for income taxes underthe 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***

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 periods that approximate the average lifeof 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.

***Network Expense***

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 

42

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that are initiated. We usesignificant estimates to determine the level of success in dispute resolutionand consider past historical experience, basis of dispute, financial status ofthe vendor and current relationship with the vendor and aging of prior disputesin quantifying our estimates. Disputes are common in our industry and webelieve our treatment of disputes is consistent with industry practice.

We believe our network expenseaccrual is sufficient to cover all outstanding disputes that we may lose. Inaddition, we accrue for expected costs that have not yet been invoiced and webelieve our network expense accrual is sufficient to cover these costs as well.

***Share-Based Compensation***

Effective January 1, 2006, we adopted theprovisions of SFAS No. 123(R), *Shared-Based Payment*,which requires the measurement and recognition of compensation expense for allshare-based payment awards to employees and directors based on estimated fairvalues. Prior to the adoption of SFAS No. 123(R), we accounted for ourstock-based compensation under the recognition and measurement principles ofAccounting Principles Board Opinion No. 25 (APB No. 25), *Accounting for Stock Issued to Employees,*and relatedinterpretations.

We adopted SFAS No. 123(R) using themodified prospective transition method and the straight-line attribution methodfor recognizing compensation expense. Under the modified prospective transitionmethod, compensation expense recognized during the year ended December 31,2006, included:  (a) the proratedportion of compensation expense for all share-based awards granted prior to January 1,2006, but not yet vested, based on the grant date fair value estimated inaccordance with the original provisions of SFAS No. 123, and (b) theprorated portion of compensation expense for all share-based awards grantedsubsequent to adoption of SFAS No. 123(R), based on the grant date fairvalue estimated in accordance with the provisions of SFAS No. 123(R). Inaccordance with the modified prospective transition method, our consolidatedfinancial statements for periods prior to the adoption of SFAS No. 123(R) havenot been restated to reflect the impact of the provisions of SFAS No. 123(R).

We used the Black-Scholes option-pricingmodel (“Black-Scholes Model”) for the purposes of determining the estimatedfair value of our share-based payment awards at the date of grant. TheBlack-Scholes Model requires certain assumptions that involve judgment. Ourshare-based awards have characteristics significantly different from publiclytraded options, and because changes in the input assumptions can materiallyaffect the fair value estimate, the existing pricing models may not provide areliable single measure of the fair value of our share-based payment awards. Wewill continue to assess the assumptions and methodologies used to calculateestimated fair value of share-based compensation.

**Recent Accounting Pronouncements**

In June 2006, the Financial Accounting StandardsBoard (FASB) issued FASB Interpretation No. 48 (FIN 48), *Accounting for Uncertainty in Income Taxes*. FIN 48 clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109*,*and prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. We have determined the adoption of FIN 48will not have a material impact on our consolidated financial statements.

In September 2006, the FASBissued SFAS No. 157, *Fair Value Measurements*.The standard provides guidance for using fair value to measure assets andliabilities. The standard clarifies the principle that fair value should bebased on the assumptions market participants would use when pricing the assetor liability and establishes a fair value hierarchy that prioritizes theinformation used to develop those assumptions. Under the standard, fair valuemeasurements would be separately disclosed by level within the fair valuehierarchy. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007 and interim periods withinthose fiscal years. We have not yet determined the impact, if any, that theadoption of SFAS No. 157 will have on our consolidated financialstatements.

**Item 7A. Quantitative and QualitativeDisclosure 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.

43

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We are exposed to changes ininterest rates on our investments in cash equivalents and available-for-salesecurities. Interest income for the year ended December 31, 2006 was $3.2million, therefore not exposing us to any meaningful interest income risk hadrates dropped. We had $141.0 million in senior second secured notesoutstanding as of December 31, 2006. These notes are at a fixed interestrate and are therefore not exposed to any interest rate risk.

**Item 8. Financial Statements andSupplementary Data.**

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

**Item 9. Changes In and Disagreements withAccountants on Accounting and Financial Disclosure.**

None.

**Item 9A. Controls and Procedures.**

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

We have established disclosure controls and proceduresto ensure that information required to be disclosed in our reports under theSecurities Exchange Act of 1934, as amended, is recorded, processed, summarizedand reported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to our Board of Directorsand senior management, including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

Based on their evaluation as of December 31,2006, the principal executive officer and principal financial officer of theCompany have concluded that the design and operation of our disclosure controlsand procedures were effective to ensure information required to be disclosed inthis Form 10-K was processed, recorded, summarized and reportedwithin the time periods specified in the rules and instructions for the Form 10-K.

***Management’s Report on Internal Control Over FinancialReporting***

Management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(f). The Company’s internalcontrol over financial reporting includes those policies and procedures that (i) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the Company arebeing made only in accordance with authorizations of management and directorsof the Company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the Company’s assets that could have a material effect on the financialstatements.

Internal control over financial reporting is designedto provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements prepared for externalpurposes in accordance with generally accepted accounting principles. Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also**,**projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

Under the supervision and with the participation ofmanagement, including our principal executive officer and principal financialofficer, we conducted an evaluation of the effectiveness of our internal controlover financial reporting based on the framework in *Internal Control—Integrated Framework*issued by theCommittee of Sponsoring 

44

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Organizations of the TreadwayCommission. Based on our evaluation under the framework in *Internal Control—Integrated Framework,*managementconcluded that our internal control over financial reporting was effective asof December 31, 2006.

During the fourth quarter of 2006, we acquiredOneEighty Communications, Inc. (OneEighty) and Mountain Telecommunications, Inc.(MTI) in a purchase business combination. In reliance on guidance contained ina “Frequently Asked Questions” interpretive release issued by the staff of theSEC’s Office of Chief Accountant and Division of Corporation Finance in June 2004(and revised on October 6, 2004), we determined to exclude both OneEightyand MTI from the scope of our assessment of our internal control over financialreporting as of December 31, 2006. The total assets of OneEighty and MTI,excluding goodwill, were 1.6% and 3.7%, respectively, of our consolidated totalassets as of December 31, 2006. The total revenues of OneEighty and MTIwere 0.7% and 1.3%, respectively, of our total consolidated revenues for theyear ended December 31, 2006.

Management’s assessment of theeffectiveness of our internal control over financial reporting as of December 31,2006 has been given an unqualified audit opinion on the Company’s 2006financial statements by Ernst & Young LLP, an independent registeredpublic accounting firm, as stated in their attestation report which is includedherein.

***Changes in Internal Controls***

During the fourth quarter of 2006, we acquiredOneEighty and MTI in a purchase business combination. There have been noother significant changes in our internal control over financial reporting orin factors affecting internal control over financial reporting during thefiscal year ended December 31, 2006, that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

***Report of Independent Registered Public AccountingFirm***

The Board of Directors and ShareownersEschelon Telecom, Inc.

We have audited management’sassessment, included in the accompanying Management’s Annual Report on InternalControl Over Financial Reporting, that Eschelon Telecom, Inc. maintainedeffective internal control over financial reporting as of December 31,2006, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(the COSO criteria). Eschelon Telecom, Inc.’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining an understandingof internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls 

45

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may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

As indicated in the accompanying Management’s Reporton Internal Control over Financial Reporting, management’s assessment of andconclusion on the effectiveness of internal control over financial reportingdid not include the internal controls of OneEighty Communications, Inc.and Mountain Telecommunications, Inc, which are included in the December 31,2006 consolidated results of Eschelon Telecom, Inc. and constituteapproximately 1.6% and 3.7%, respectively, of the total assets at December 31,2006, excluding goodwill, and 0.7% and 1.3%, respectively, of the totalrevenues for the year then ended. Our audit of the internal control overfinancial reporting of Eschelon Telecom, Inc. also did not include anevaluation of the internal control over financial reporting of OneEightyCommunications, Inc. and Mountain Telecommunications, Inc.

In our opinion, management’s assessment that EschelonTelecom, Inc. maintained effective internal control over financialreporting as of December 31, 2006, is fairly stated, in all materialrespects, based on the COSO criteria. Also, in our opinion, Eschelon Telecom, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on the COSO criteria**.**

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Eschelon Telecom, Inc.as of December 31, 2006 and 2005, and the related consolidated statementsof operations, stockholders’ equity (deficit) and cash flows for each of thethree years in the period ended December 31, 2006, and our report dated March 8,2007 expressed an unqualified opinion thereon.

Ernst &Young LLP

March 8, 2007Minneapolis, Minnesota

**Item 9B. Other Information.**

None.

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**Part III**

**Item 10.**             Directors,Executive Officers and Corporate Governance.

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) Beneficial OwnershipReporting Compliance” in our definitive proxy statement for our 2007 AnnualMeeting of Stockholders (the “Proxy Statement”), which will be filed with theSEC within 120 days after December 31, 2006 are incorporated in this Form 10-Kby 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 by reference in this Form 10-Kfrom our Proxy Statement, which will be filed with the SEC.

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

The sections of the ProxyStatement entitled “Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters” and “Approval of the Amendment tothe 2002 Plan” are incorporated by reference in this Form 10-K fromour Proxy Statement, which will be filed with the SEC.

**Item 13.**             CertainRelationships and Related Transactions, and Director Independence.

The section of the ProxyStatement entitled “Certain Relationships and Related Transactions, andDirector Independence” is incorporated by reference in this Form 10-Kfrom our Proxy Statement, which will be filed with the SEC.

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

The section of the Proxy Statement entitled “Ratificationof Independent Registered Public Accounting Firm” is incorporated by referencein this Form 10-K from our Proxy Statement, which will be filed withthe SEC.

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**PART IV**

**Item 15.**             Exhibits,Financial Statement Schedules.

**(a) Documents filed as part of thereport:**

(1)            Report of IndependentRegistered Public Accounting Firm

Consolidated Balance Sheets as of December 31,2006 and 2005

Consolidated Statements of Operations for the yearsended December 31, 2006, 2005 and 2004

Consolidated Statements of Stockholders’ Equity(Deficit) for the years ended December 31, 2006, 2005 and 2004

Consolidated Statements of Cash Flows for the yearsended December 31, 2006, 2005 and 2004

Notes to ConsolidatedFinancial Statements

(2)            Schedule II—Valuationof Qualifying Accounts and Reserves

Such schedule should beread in conjunction with the consolidated financial statements. All othersupplemental schedules are omitted because of the absence of conditions underwhich they are required.

(3)            Exhibits

**(b) Exhibits:**

The following exhibits are filed or incorporated byreference as stated below:
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **Description** |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1(2)          |       | Seventh Amended and Restated Certificate of  Incorporation of Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                                                                                                               |
| 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. |
| 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 83¤8%  Senior Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 4.11**          |       | Form of Guarantee of Initial 83¤8%  Senior Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.12**          |       | Form of Exchange 83¤8%  Senior Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 4.13**          |       | Form of  Guarantee of Exchange 83¤8%  Senior Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

48

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| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Description** |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 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(7)         |       | Supplemental Indenture dated March 27,  2006, between Eschelon Operating Company, the various Guarantors and Bank of  New York Trust Company, N.A., as trustee.                                                                                                                                                                                                                                                                                                        |
| 4.19(8)         |       | Supplemental Indenture dated March 28,  2006, between Eschelon Operating Company, the various Guarantors and Bank of  New York Trust Company, N.A., as trustee.                                                                                                                                                                                                                                                                                                        |
| 4.20(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  Employment Offer Letter dated March 7, 2000 from Eschelon  Telecom, Inc. to Geoffrey M. Boyd.                                                                                                                                                                                                                                                                                                                        |
| 10.2.3          |       | Amendment dated February 19, 2007 to  Employment 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.                                                                                                                                                                                                                                                                              |
| 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.                                                                                                                                                                                                                                                                                           |

49

----

 
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                   | ** ** | **Description** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 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.                  |
| 10.7.10         |       | Amendment #10  dated August 15, 2005 to Carrier Service Agreement dated August 25,  2000 between Global Crossing Bandwidth, Inc. and Eschelon  Telecom, Inc.             |
| 10.7.11         |       | Amendment #11 dated December 2, 2005  to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.             |
| 10.7.12         |       | Amendment #12 dated February 1, 2006  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(6)      |       | 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.        |
| 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(6)      |       | 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(6)      |       | 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(6)      |       | Amendment dated April 28, 2005 to  Office Lease by and between Parkside Salt Lake Corporation and Advanced  Telecommunications, Inc. dated December 28, 1999.                 |
| 10.16.2         |       | Amendment dated October 5, 2006 to  Office Lease by and between EOS Acquisition I, LLC and Eschelon  Telecom, 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(6)      |       | 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.                    |

 

50

----

 
| Exhibit  Number | ** ** | ** **                                                                                                                                                                           | ** ** | **Description** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 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.                |
| 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.         |
| 10.32           |       | Lease Agreement by and between Bruce E.  Lee/Table Butte Cattle Company and OneEighty Communications, Inc. dated  November 20, 1998.                                       |
| 10.33           |       | Industrial Lease by and between Hardy  Commerce Center, LLC and Prism Arizona Operations, LLC dated  September 24, 1999.                                                        |
| 10.33.1         |       | Amendment dated October 24, 2003 by  and between Desert Vista, LLC and Mountain Telecommunications, Inc. to  Industrial Lease dated September 24, 1999.               |
| 10.34           |       | Right to Use Agreement dated  December 6, 2002 by and between Mountain Telecommunications, Inc.  and the Salt River Pima-Maricopa Indian Community.                        |
| 10.35           |       | Qwest Regional Commitment Program  Acknowledgement for Eschelon Telecom, Inc. dated February 13, 2007.                                                                     |
| 10.36           |       | Qwest Regional Commitment Program  Acknowledgement for Mountain Telecommunications, Inc. dated  March 23, 2006.                                                            |
| 10.37           |       | Indefeasible Right of Use Agreement and  Master Service Agreement by and between AGL Networks, LLC and Mountain  Telecommunications, Inc. dated January 24, 2005.          |
| 10.38           |       | Master Terms and Conditions for License  Agreements between Arizona Public Service Company and Mountain  Telecommunication, Inc. dated February 4, 1999.                   |
| 10.39           |       | Master Fiber License Agreement by and  between Salt River Project Agricultural Improvement and Power District and  Mountain Telecommunications, Inc. dated March 15, 2006. |
| 10.40(9)        |       | Severance Pay Agreement dated  January 3, 2006, between Eschelon Telecom, Inc. and Steven Wachter.                                                                              |
| 10.41(10)       |       | Form of Severance Agreement.                                                                                                                                                         |
| 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.                                                         |

----

                  * Incorporated herein by reference to EschelonTelecom, Inc. Registration Statement on Form 10, No. 000-50706as filed with the Commission on April 26, 2004.

51

----

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

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

                  ^ Portions of this Exhibit were omitted andhave been filed separately with the Secretary of the Commission pursuant to theCompany’s Application Requesting Confidential Treatment under Rule 24b-2of the Exchange Act, filed on April 26, 2004, as amended on July 7,2005.

            ^^ Portions of this Exhibit were omitted andhave been filed separately with the Secretary of the Commission pursuant to theCompany’s Application Requesting Confidential Treatment under Rule 406 ofthe Securities Act, filed on July 7, 2005.

          (1) Incorporated herein by reference to EschelonTelecom, Inc. Annual Report on Form 10-K as filed with theCommission on March 31, 2005.

          (2) Incorporated herein by reference to EschelonTelecom, Inc. Registration Statement Amendment No. 2 to Form S-1(File No. 333-124703), as filed with the Commission on July 8,2005.

          (3) Incorporated herein by reference to EschelonTelecom, Inc. Current Report on Form 8-K as filed with theCommission on April 18, 2005.

          (4) Incorporated herein by reference to EschelonTelecom, Inc. Current Report on Form 8-K as filed with theCommission on May 27, 2005.

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

          (6) Incorporated herein by reference to EschelonTelecom, Inc. Annual Report on Form 10-K as filed with the Commissionon March 17, 2007.

          (7) Incorporated herein by reference to EschelonTelecom, Inc. Current Report on Form 8-K as filed with the Commission onMarch 27, 2006.

          (8) Incorporated herein by reference to EschelonTelecom, Inc. Current Report on Form 8-K as filed with the Commission onMarch 22, 2006.

          (9) Incorporated herein by reference to EschelonTelecom, Inc. Current Report on Form 8-K as filed with the Commission onJanuary 3, 2006.

    (10) Incorporated herein by reference to Eschelon Telecom, Inc. CurrentReport on Form 8-K as filed with the Commission on October 2, 2006.

52

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**SIGNATURES**

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, the registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized, on March 12, 2007.

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

 

Each person whose signatureappears below constitutes and appoints Richard A. Smith, Geoffrey M. Boyd and J. JeffreyOxley and each of them, his true and lawful attorney-in-fact and agent, withfull power and substitution and resubstitution, for him and in his name, placeand stead, in any and all capacities, to sign any and all amendments to thisAnnual Report on Form 10-K and to file the same, with all exhibitsthereto, and other documents in connection therewith, with the Securities andExchange Commission, granting unto said attorney-in-fact and agent full powerand authority to do and perform each and every act and thing requisite andnecessary to be done in and about the premises, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirming allthat said attorney-in-fact, agent, or his substitute may lawfully do or causeto be done by virtue hereof. Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed by the following persons inthe capacities and on the dates indicated.
|                          | **Signature** | ** **                                       | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|--------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ RICHARD A. SMITH     |          | President,  Chief Executive Officer and Director |       |                 |
| Richard A. Smith         |          | (Principal  Executive Officer)                   |       | March 12, 2007  |
| /s/ GEOFFREY M. BOYD     |          | Chief  Financial Officer                         |       |                 |
| Geoffrey M. Boyd         |          | (Principal  Financial and Accounting Officer)    |       | March 12, 2007  |
| /s/ CLIFFORD D. WILLIAMS |          | Chairman  of the Board                           |       |                 |
| Clifford D. Williams     |          |                                             |       | March 12, 2007  |
| /s/ MARVIN C. MOSES      |          | Director                                         |       |                 |
| Marvin C. Moses          |          |                                             |       | March 12, 2007  |
| /s/ LOUIS L. MASSARO     |          | Director                                         |       |                 |
| Louis L. Massaro         |          |                                             |       | March 12, 2007  |
| /s/ MARK E. NUNNELLY     |          | Director                                         |       |                 |
| Mark E. Nunnelly         |          |                                             |       | March 12, 2007  |
| /s/ JAMES P. TENBROEK    |          | Director                                         |       |                 |
| James P. TenBroek        |          |                                             |       | March 12, 2007  |
| /s/ IAN K. LORING        |          | Director                                         |       |                 |
| Ian  K. Loring           |          |                                             |       | March 12,  2007 |

 

53

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**Eschelon Telecom, Inc.Schedule II—Valuation and Qualifying AccountsYears Ended December 31, 2006, 2005 and 2004(Dollars in thousands)**

| ** **                                  | ** ** | **Balance at  Beginning  of Year** | ** ** | **Additions  Charged to  Costs and  Expenses** | ** ** | **Less  Deductions** | ** ** | **Balance Acquired  Through  Acquisitions** | ** ** | **Balance at  End  of Year** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| Allowance for Doubtful Accounts Receivable: |       |                                         |       |                                                     |       |                 |       |                                             |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| 2006                                        |       |                                         | $          | 492                                                      |       |                 |       | $                                                | 3,462      |                                   |       |   | $ | (3,368 | ) |   |   | $ | 317 |   |   |   | $ | 903 |   |   |
| 2005                                        |       |                                         | 817        |                                                     |       |                 | 2,338      |                                             |       |                                   | (2,663     | ) |   |   | — |   |   |   | 492 |   |   |
| 2004                                        |       |                                         | 739        |                                                     |       |                 | 1,567      |                                             |       |                                   | (1,894     | ) |   |   | 405 |   |   |   | 817 |   |   |
|                                             |            |                                              |            |                                                          |            |                      |            |                                                  |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **Balance at  Beginning  of Year** | ** ** | **Additions  Charged to  Costs and  Expenses** | ** ** | **Less  Deductions** | ** ** | **Balance Acquired  Through  Acquisitions** | ** ** | **Balance at  End  of Year** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------|------------|----------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| Valuation Allowance for Deferred Income Tax  Assets: |       |                                         |       |                                                     |       |                 |       |                                             |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| 2006                                                 |       |                                         | $          | 57,800                                                   |       |                 |       | $                                                | —     |                                   |       |   | $ | 1,354 |   |   |   | $ | — |   |   |   | $ | 56,446 |   |   |
| 2005                                                 |       |                                         | 46,139     |                                                     |       |                 | 11,661     |                                             |       |                                   | —     |   |   |   | — |   |   |   | 57,800 |   |   |
| 2004                                                 |       |                                         | 44,761     |                                                     |       |                 | 1,378      |                                             |       |                                   | —     |   |   |   | — |   |   |   | 46,139 |   |   |
|                                                      |            |                                              |            |                                                          |            |                      |            |                                                  |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

54

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**Eschelon Telecom, Inc.Consolidated Financial StatementsYears Ended December 31, 2006, 2005 and 2004**

**Index**

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

 

F-1

----

**Report of Independent Registered PublicAccounting Firm**

The Board of Directors andShareownersEschelon Telecom, Inc.

We have audited theaccompanying consolidated balance sheets of Eschelon Telecom, Inc. as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity (deficit) and cash flows for each of the three years inthe period ended December 31, 2006. Our audits also included the financialstatement schedule listed in the index at Item 15. These financial statementsand the schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements and theschedule based on our audits.

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Eschelon Telecom, Inc. atDecember 31, 2006 and 2005, and the consolidated results of its operationsand its cash flows for each of the three years in the period ended December 31,2006, in conformity with U.S. generally accepted accounting principles. Also,in our opinion, the related financial statement schedule, when considered inrelation to the basic financial statements taken as a whole, presents fairly inall material respects the information set forth therein.

As discussed in Note 1 tothe financial statements, in 2006 the Company adopted Financial Accounting StandardsBoard Statement No. 123 (revised 2004), *Share-BasedPayment.*

We also haveaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of Eschelon Telecom, Inc’s.internal control over financial reporting as of December 31, 2006, basedon criteria established in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated March 8, 2007 expressed an unqualified opinion thereon.

Ernst &Young LLP

March 8, 2007Minneapolis, Minnesota

F-2

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

| ** **                                                                                                                                                         | ** ** | ***December 31,*** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2006**                | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                         |       |                    |       | ** ** | ** ** |
| Current assets:                                                                                                                                                    |       |                    |       | ** ** | ** ** |
| Cash and cash equivalents                                                                                                                                          |       | $                       | 21,146     |   | $ | 26,062 | ** ** |
| Restricted cash                                                                                                                                                    |       | 1,224                   |       | 996 | ** ** |
| Available-for-sale securities                                                                                                                                      |       | 17,097                  |       | 4,760 | ** ** |
| Accounts receivable, net of allowance for  doubtful accounts of $903 and $492, respectively                                                                        |       | 27,592                  |       | 22,996 | ** ** |
| Other receivables                                                                                                                                                  |       | 4,025                   |       | 3,052 | ** ** |
| Inventories                                                                                                                                                        |       | 3,552                   |       | 2,927 | ** ** |
| Prepaid expenses                                                                                                                                                   |       | 2,314                   |       | 2,294 | ** ** |
| Total current assets                                                                                                                                               |       | 76,950                  |       | 63,087 | ** ** |
| Property and equipment, net                                                                                                                                        |       | 145,785                 |       | 126,452 | ** ** |
| Other assets                                                                                                                                                       |       | 2,185                   |       | 1,506 | ** ** |
| Goodwill                                                                                                                                                           |       | 59,670                  |       | 7,168 | ** ** |
| Intangible assets, net                                                                                                                                             |       | 45,931                  |       | 33,333 | ** ** |
| Total assets                                                                                                                                                       |       | $                       | 330,521    |   | $ | 231,546 | ** ** |
| **Liabilities and stockholders’ equity**                                                                                                                      |       |                    |       |   | ** ** |
| Current liabilities:                                                                                                                                               |       |                    |       |   | ** ** |
| Accounts payable                                                                                                                                                   |       | $                       | 17,641     |   | $ | 16,400 | ** ** |
| Accrued telecommunication costs                                                                                                                                    |       | 5,730                   |       | 4,227 | ** ** |
| Accrued office rent                                                                                                                                                |       | 2,521                   |       | 2,035 | ** ** |
| Accrued interest expense                                                                                                                                           |       | 3,829                   |       | 2,646 | ** ** |
| Other accrued expenses                                                                                                                                             |       | 7,433                   |       | 5,485 | ** ** |
| Deferred revenue                                                                                                                                                   |       | 10,109                  |       | 7,921 | ** ** |
| Accrued compensation expenses                                                                                                                                      |       | 4,174                   |       | 2,809 | ** ** |
| Capital lease obligations, current  maturities                                                                                                                     |       | 3,131                   |       | 2,430 | ** ** |
| Total current liabilities                                                                                                                                          |       | 54,568                  |       | 43,953 | ** ** |
| Long-term liabilities:                                                                                                                                             |       |                    |       |   | ** ** |
| Other long-term liabilities                                                                                                                                        |       | 1,262                   |       | 251 | ** ** |
| Capital lease obligations, less current  maturities                                                                                                                |       | 2,201                   |       | 2,964 | ** ** |
| Notes payable                                                                                                                                                      |       | 141,040                 |       | 92,125 | ** ** |
| Total liabilities                                                                                                                                                  |       | 199,071                 |       | 139,293 | ** ** |
| Stockholders’ equity:                                                                                                                                         |       |                    |       |   | ** ** |
| Common stock, $0.01 par value per share;  200,000,000 shares authorized; issued and outstanding shares—17,997,869  shares and 14,634,279 shares, respectively |       | 176                     |       | 146 | ** ** |
| Additional paid-in capital                                                                                                                                         |       | 289,101                 |       | 248,199 | ** ** |
| Accumulated other comprehensive income                                                                                                                             |       | —                  |       | 56 | ** ** |
| Accumulated deficit                                                                                                                                                |       | (157,827                | )          | (155,047 | ) |
| Deferred compensation                                                                                                                                              |       | —                  |       | (1,101 | ) |
| Total stockholders’ equity                                                                                                                                    |       | 131,450                 |       | 92,253 | ** ** |
| Total liabilities and stockholders’ equity                                                                                                                    |       | $                       | 330,521    |   | $ | 231,546 | ** ** |

 

See accompanying notes.

F-3

----

**Eschelon Telecom, Inc.**

**Consolidated Statements of Operations**

**(Dollars in Thousands, Except per ShareAmounts)**

| ** **                                                                        | ** ** | ***Year Ended December 31,*** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                                                          |       |                                         |       |   |   |   |   |
| Network services                                                                  |       | $                                            | 244,702    |   | $ | 201,835 |   | $ | 131,780 |   |
| Business telephone systems                                                        |       | 29,824                                       |       | 25,908 |   | 26,316 |   |
|                                                                              |       | 274,526                                      |       | 227,743 |   | 158,096 |   |
| Costs and expenses:                                                               |       |                                         |       |   |   |   |   |
| Network services expense (exclusive of  depreciation and amortization)            |       | 98,664                                       |       | 85,914 |   | 47,354 |   |
| Business telephone systems cost of revenue                                        |       | 18,427                                       |       | 16,139 |   | 15,979 |   |
| General and administrative                                                        |       | 65,186                                       |       | 56,431 |   | 41,755 |   |
| Sales and marketing                                                               |       | 38,383                                       |       | 33,879 |   | 27,500 |   |
| Depreciation and amortization                                                     |       | 42,247                                       |       | 39,653 |   | 31,105 |   |
| Operating income (loss)                                                           |       | 11,619                                       |       | (4,273 | ) | (5,597 | ) |
| Other income (expense):                                                           |       |                                         |       |   |   |   |   |
| Interest income                                                                   |       | 3,165                                        |       | 691 |   | 124 |   |
| Interest expense                                                                  |       | (17,532                                      | )          | (28,125 | ) | (11,452 | ) |
| Gain on extinguishment of debt                                                    |       | —                                       |       | — |   | 18,195 |   |
| Other income (expense)                                                            |       | (32                                          | )          | 65 |   | (155 | ) |
| Income (loss) before income taxes                                                 |       | (2,780                                       | )          | (31,642 | ) | 1,115 |   |
| Income taxes                                                                      |       | —                                       |       | (4 | ) | (4 | ) |
| Net income (loss) from continuing  operations                                     |       | (2,780                                       | )          | (31,646 | ) | 1,111 |   |
| Income from discontinued operation, net of  tax                                   |       | —                                       |       | 329 |   | — |   |
| Gain on sale of discontinued operation, net  of tax                               |       | —                                       |       | 326 |   | — |   |
| Net income (loss)                                                                 |       | (2,780                                       | )          | (30,991 | ) | 1,111 |   |
| Less preferred stock dividends and premium  paid on repurchase of preferred stock |       | —                                       |       | — |   | (4,292 | ) |
| Net loss applicable to common stockholders                                        |       | $                                            | (2,780     | ) | $ | (30,991 | ) | $ | (3,181 | ) |
| Basic and diluted income (loss) per share:                                        |       |                                         |       |   |   |   |   |
| Continuing operations                                                             |       | $                                            | (0.17      | ) | $ | (5.32 | ) | $ | (11.11 | ) |
| Discontinued operation                                                            |       | —                                       |       | 0.11 |   | — |   |
| Net loss                                                                          |       | $                                            | (0.17      | ) | $ | (5.21 | ) | $ | (11.11 | ) |
| Weighted average shares outstanding:                                              |       |                                         |       |   |   |   |   |
| Basic and diluted                                                                 |       | 16,467,972                                   |       | 5,949,310 |   | 287,393 |   |

 

See accompanying notes.

F-4

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**Eschelon Telecom, Inc.**

**Consolidated Statements of Stockholders’Equity (Deficit)**

**(Dollars in Thousands)**

| ** **                                                  | ** ** | ** **              | ** ** | ** **     | ** ** | **Accumulated**   | ** ** | ** **      | ** ** | ** **   | ** ** | ** **       | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|----------------|------------|-------------------|------------|-----------------|------------|--------------|------------|------------------|------------|
| ** **                                                  | ** ** | *** ***            | ** ** | **Additional** | ** ** | **Other**         | ** ** | ** **      | ** ** | ** **   | ** ** | ** **       | ** ** |
| ** **                                                  | ** ** | ***Common Stock*** | ** ** | **Paid-In**    | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Deferred** | ** ** | ** **       | ** ** |
| ** **                                                  | ** ** | **Shares**              | ** ** | **Amount**     | ** ** | **Capital**       | ** ** | **Income**      | ** ** | **Deficit**  | ** ** | **Compensation** | ** ** | **Total** | ** ** |
| 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 |   |
| Change in 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 |   |
| Sale of common stock, net of fees                           |       | 2,550,000               |       |           | 26         |              |       |            | 39,929     |         |       |             | —     |   |   |   | — |   |   |   | — |   |   | 39,955 |   |
| Stock options exercised                                     |       | 423,591                 |       |           | 4          |              |       |            | 394        |         |       |             | —     |   |   |   | — |   |   |   | — |   |   | 398 |   |
| Issuance of restricted common stock                         |       | 390,000                 |       |           | —     |              |       |            | —     |         |       |             | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Forfeiture of common stock                                  |       | (1                      | )          |           | —     |              |       |            | —     |         |       |             | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Deferred compensation related to stock  options granted     |       | —                  |       |           | —     |              |       |            | (1,101     | )            |       |             | —     |   |   |   | — |   |   |   | 1,101 |   |   | — |   |
| Share-based compensation                                    |       | —                  |       |           | —     |              |       |            | 1,680      |         |       |             | —     |   |   |   | — |   |   |   | — |   |   | 1,680 |   |
| Change in unrealized gain on  available-for-sale securities |       | —                  |       |           | —     |              |       |            | —     |         |       |             | (56        | ) |   |   | — |   |   |   | — |   |   | (56 | ) |
| Net loss for the year                                       |       | —                  |       |           | —     |              |       |            | —     |         |       |             | —     |   |   |   | (2,780 | ) |   |   | — |   |   | (2,780 | ) |
| Balance at December 31, 2006                           |       | 17,997,869              |       |           | $          | 176               |       |            |       | $            | 289,101    |             |       |   | $ | — |   |   |   | $ | (157,827 | ) |   |   | $ | — |   |   | $ | 131,450 |   |
|                                                             |            |                         |            |                |            |                   |            |                 |            |              |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Seeaccompanying notes.

F-5

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**Eschelon Telecom, Inc.Consolidated Statements of Cash Flows(In Thousands)**
|                                                                                            | ** ** | ***Year Ended December 31,*** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating  activities**                                                                  | ** ** | ** **                                   |       |   | ** ** | ** ** | ** ** |
| Net income (loss)                                                                          |       | $                                            | (2,780     | ) | $ | (30,991 | ) | $ | 1,111 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities:  |       |                                         |       |   |   |   |   |
| Depreciation and amortization expense                                                      |       | 42,247                                       |       | 39,653 |   | 31,105 |   |
| Provision for bad debt expense                                                             |       | 1,887                                        |       | 1,090 |   | 721 |   |
| Non-cash interest expense, net of non-cash  interest income                                |       | 4,384                                        |       | 7,288 |   | 2,339 |   |
| Non-cash compensation expense on restricted  and unrestricted common stock                 |       | 682                                          |       | 39 |   | 34 |   |
| Non-cash compensation expense on stock  options                                            |       | 998                                          |       | 924 |   | — |   |
| Loss on write-off and sales of assets                                                      |       | 66                                           |       | 260 |   | 162 |   |
| Gain on extinguishment of debt                                                             |       | —                                       |       | — |   | (18,195 | ) |
| Gain on sales of available-for-sale  securities                                            |       | (77                                          | )          | (326 | ) | (7 | ) |
| Gain on sale of discontinued operation                                                     |       | —                                       |       | (326 | ) | — |   |
| Changes in operating assets and  liabilities:                                              |       |                                         |       |   |   |   |   |
| Accounts receivable                                                                        |       | (1,476                                       | )          | (5,145 | ) | 658 |   |
| Other receivables                                                                          |       | (634                                         | )          | (76 | ) | (546 | ) |
| Inventories                                                                                |       | (492                                         | )          | (54 | ) | 296 |   |
| Prepaid expenses and other assets                                                          |       | 259                                          |       | 495 |   | (209 | ) |
| Discontinued assets held for sale, net of  liabilities                                     |       | —                                       |       | 222 |   | — |   |
| Accounts payable and accrued expenses                                                      |       | (374                                         | )          | 2,133 |   | 8,984 |   |
| Deferred revenue                                                                           |       | 381                                          |       | 621 |   | 878 |   |
| Accrued compensation expenses                                                              |       | 882                                          |       | (779 | ) | (1,216 | ) |
| Net cash provided by operating activities                                                  |       | 45,953                                       |       | 15,028 |   | 26,115 |   |
| **Investing  activities**                                                                  |       |                                         |       |   |   |   |   |
| Purchase of subsidiaries, net of cash  acquired                                            |       | (67,208                                      | )          | (48 | ) | (45,495 | ) |
| Purchase of assets held for sale, net of  liabilities                                      |       | —                                       |       | (216 | ) | — |   |
| Purchases of available-for-sale securities                                                 |       | (95,765                                      | )          | (30,526 | ) | (8,198 | ) |
| Purchases of property and equipment                                                        |       | (34,277                                      | )          | (19,227 | ) | (15,414 | ) |
| Cash paid for customer installation costs                                                  |       | (18,914                                      | )          | (13,551 | ) | (11,293 | ) |
| Proceeds from sales of available-for-sale  securities                                      |       | 83,462                                       |       | 32,312 |   | 2,041 |   |
| Proceeds from sales of assets                                                              |       | 174                                          |       | 239 |   | 25 |   |
| Increase in restricted cash                                                                |       | (228                                         | )          | (274 | ) | (722 | ) |
| Proceeds from sale of discontinued  operation, net of fees                                 |       | —                                       |       | 320 |   | — |   |
| Net cash used in investing activities                                                      |       | (132,756                                     | )          | (30,971 | ) | (79,056 | ) |
| **Financing  activities**                                                                  |       |                                         |       |   |   |   |   |
| Proceeds from issuance of notes payable                                                    |       | 45,600                                       |       | — |   | 136,163 |   |
| Payments made on notes and capital lease  obligations                                      |       | (2,730                                       | )          | (51,362 | ) | (66,948 | ) |
| Proceeds from issuance of preferred stock                                                  |       | —                                       |       | 154 |   | 15,000 |   |
| Payment on repurchase of preferred stock                                                   |       | —                                       |       | — |   | (5,085 | ) |
| Proceeds from issuance of common stock, net  of fees                                       |       | 40,353                                       |       | 67,126 |   | 8 |   |
| Increase in debt issuance costs                                                            |       | (1,336                                       | )          | (348 | ) | (8,368 | ) |
| Net cash provided by financing activities                                                  |       | 81,887                                       |       | 15,570 |   | 70,770 |   |
| Net increase (decrease) in cash and cash  equivalents                                      |       | (4,916                                       | )          | (373 | ) | 17,829 |   |
| Cash and cash equivalents at beginning of  year                                            |       | 26,062                                       |       | 26,435 |   | 8,606 |   |
| Cash and cash equivalents at end of year                                                   |       | $                                            | 21,146     |   | $ | 26,062 |   | $ | 26,435 |   |
| **Supplemental  cash flow information**                                                    |       |                                         |       |   | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                     |       | $                                            | 13,113     |   | $ | 20,837 |   | $ | 9,114 |   |
| **Supplemental  noncash activities**                                                       |       |                                         |       |   |   |   |   |
| Equipment purchases under capital leases                                                   |       | $                                            | 1,467      |   | $ | 3,127 |   | $ | 4,064 |   |
| Value of  common stock issued to management and certain members of the board of  directors |       | $                                            | 6,045      |   | $ | 27 |   | $ | 14 |   |

 

See accompanying notes.

F-6

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

**Note 1:   Summary of SignificantAccounting Policies**

*Organization:***  **Eschelon Telecom, Inc. (the Company) is acompetitive communications provider that targets the small and medium-sizedbusiness segment and is headquartered in Minneapolis, Minnesota. The Companywas incorporated in Delaware in 1996 under the name Advanced Telecommunications, Inc.The Company is a facilities-based competitive communication services providerof voice and data services and business telephone systems in 45 markets in thewestern United States. The Company offers voice and data services, which arereferred to as network services. The Company also sells, installs and maintainsbusiness telephone and data systems and equipment referred to as businesstelephone systems.

The Companyoffers the following products and services:

| **Voice Services**                | ** ** | **Data Services**                                 | ** ** | **Business Telephone Systems**                        |
|-----------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------|
| Local Analog and Digital Services |       | Dial-Up, Dedicated and Broadband Internet  Access |       | Customer Premise Telephone Equipment and  Accessories |
| Vertical Features                 |       | Point to Point Services                           |       | Data Communications Equipment                         |
| Long Distance                     |       | SPAM Filtering                                    |       | Voice Mail Systems                                    |
| Other Enhanced Services           |       | E-Mail                                            |       | IP Phone Systems                                      |
|                              |       | Web-Hosting                                       |       | After Market Maintenance and Upgrade  Contracts       |

 

*Principlesof Consolidation:***  **Theconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All intercompany balances and transactions have beeneliminated in consolidation.

*Reclassifications:***  ***Certain prior year items have been reclassified to conform to currentyear presentation.*

*Use ofEstimates:***  **Thepreparation of financial statements in conformity with United States generallyaccepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results could differ from those estimates.

*ReverseStock Split:***  **TheCompany completed a 0.0738-for-one reverse stock split affecting alloutstanding shares of common stock on August 2, 2005. All share and pershare data have been adjusted to reflect the stock split.

*Net Income(Loss) Per Share:***  **Basicearnings per share is computed based on the weighted average number of commonshares outstanding. Diluted earnings per share is computed based on theweighted average number of common shares outstanding adjusted by the number ofadditional shares that would have been outstanding had the potentially dilutivecommon shares been issued. Potentially dilutive shares of common stock includeunexercised stock options and unvested restricted stock grants. The Companydoes not have any potentially dilutive shares because net losses were reportedin all periods presented.

*Cash andCash Equivalents:***  **Cashequivalents represent short-term investments in money market instruments withoriginal maturities of three months or less. Cash equivalents are carried atcost which approximates market value. On December 31, 2006 and 2005, theCompany had investments in securities of $16,978 and $21,728, respectively,which are included in cash and cash equivalents.

*RestrictedCash:*   Restricted cash consists primarily ofletters of credit to collateralize performance bonds, litigation settlementsand a revolving line of credit. The Company expects restricted cash to becomeavailable upon the satisfaction of the obligation pursuant to which the lettersof credit or guarantees were issued.

*Available-for-SaleSecurities:*   Short-term investments are comprisedof municipal and United States government debt securities with maturities ofmore than three months but less than one year and auction rate securities. In 

F-7

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

**Note 1:  **Summaryof Significant Accounting Policies (Continued)

accordance with Financial Accounting Standards (SFAS) No. 115,*Accounting for Certain Investments in Debtand Equity Securities*, and based on the Company’s intentionsregarding these instruments, all investments in debt securities and auctionrate securities are classified as available-for-sale and accounted for at fairvalue. Fair value is determined by quoted market prices, with unrealized gainsand losses reported as a separate component of stockholders’ equity. TheCompany uses the specific identification of securities sold method to recognizerealized gains and losses in earnings.

*AccountsReceivable and Allowance for Doubtful Accounts:***  **Accounts receivable are initially recorded at fairvalue upon the sale of products or services to customers. Significant estimatesare required in determining the allowance for doubtful accounts receivable. TheCompany considers two primary factors in determining the proper level ofallowance, including historical collections experience and the aging of theaccounts receivable portfolio. The allowance for doubtful accounts is based onthe best facts available to the Company and is reevaluated and adjusted asadditional information is received.

*Property and Equipment:***  **Property and equipment, including leaseholdimprovements, are stated at cost. Depreciation is provided using thestraight-line method over the estimated useful 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   |   | 5-15 years |
| Switching and data software     |   | 3-5 years  |

 

Leasehold improvements are amortized over the shorterof 5 years or the related lease term. All internal costs directly related tothe construction of the switches and operating and support systems, includingcompensation of certain employees, are capitalized.

*Impairmentof Long-Lived Assets:***  **TheCompany reviews all long-lived assets for impairment in accordance with SFAS No. 144,*Accounting for the Impairment and Disposalof Long-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. The Company completed its annual impairment test during the fourth quarterof 2006 and 2005 and determined long-lived assets were not impaired.

*Goodwill andOther Intangible Assets:***  **TheCompany tests goodwill annually for impairment in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*.Under SFAS No. 144 if the implied fair value of a reporting unit is lessthan the carrying amount, an impairment charge is recognized. The Companycompleted its annual impairment test in the fourth quarter of 2006 and 2005 anddetermined that goodwill had not been impaired.

*DeferredRevenue:***  **Deferredrevenue consists of voice and data services that are billed in advance andrecorded as a liability for services provided in the future, maintenancecontracts related to servicing business telephone systems and estimatedwarranty costs associated with business telephone systems. Deferred revenuerelated to 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 twoyears.

F-8

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

**Note 1:  **Summaryof Significant Accounting Policies (Continued)

*AccumulatedOther Comprehensive Income:*   Accumulated othercomprehensive income represents unrealized gains on available-for-salesecurities, net of tax. Accumulated other comprehensive income is presented inthe consolidated statements of stockholders’ equity (deficit).

*RevenueRecognition:***  **Revenuesfrom network services are recognized in the period in which subscribers use therelated services. Revenues from equipment sales and related installationcharges are recognized upon delivery, completion of the installation of therelated equipment, and acceptance by the customer, at which point legal titlepasses to the customer. Revenues for carrier interconnection and access arerecognized in the period in which the service is provided.

*NetworkExpense:*   The Company carefully reviews allvendor invoices and frequently disputes inaccurate or inappropriate charges. Incases where the Company disputes certain charges, only undisputed amounts onvendor invoices are paid in order to pay the proper amounts owed. The Companyrecords costs net of disputed amounts based on the expected outcome of disputesthat are initiated. The Company uses significant estimates to determine thelevel of success in dispute resolution and considers past historicalexperience, basis of dispute, financial status of the vendor and currentrelationship with the vendor and aging of prior disputes in quantifyingestimates.

*AdvertisingCosts:***  **Advertisingcosts are expensed as incurred. For the years ended December 31, 2006,2005 and 2004, the Company had advertising expense of $589, $589 and $464,respectively.

*Share-BasedCompensation:***  **TheCompany accounts for its share-based compensation in accordance with SFAS No. 123(R),*Share-Based Payment.*Effective January 1,2006, the Company adopted the provisions of SFAS No. 123(R), whichrequires the measurement and recognition of compensation expense for allshare-based payment awards to employees and directors based on estimated fairvalues. Prior to the adoption of SFAS No. 123(R), the Company accountedfor its stock-based compensation under the recognition and measurementprinciples of Accounting Principles Board Opinion No. 25 (APB No. 25),*Accounting for Stock Issued to Employees,*andrelated interpretations. The Company used the Black-Scholes option-pricingmodel (“Black-Scholes Model”) for the purposes of determining the estimatedfair value of its share-based payment awards at the date of grant. TheBlack-Scholes Model requires certain assumptions that involve judgment. TheCompany’s share-based awards have characteristics significantly different frompublicly traded options, and because changes in the input assumptions canmaterially affect the fair value estimate, the existing pricing models may notprovide a reliable single measure of the fair value of its share-based paymentawards. The Company will continue to assess the assumptions and methodologiesused to calculate estimated fair value of share-based compensation.

*IncomeTaxes:***  **TheCompany accounts for income taxes under the liability method in accordance withSFAS No. 109, *Accounting for IncomeTaxes*. Deferred tax liabilities are recognized for temporarydifferences that will result in taxable amounts in future years. Deferred taxassets are recognized for deductible temporary differences and tax operatingloss and tax credit carryforwards. Deferred tax assets and liabilities aremeasured using the enacted tax rates expected to apply to taxable income in theperiods in which the deferred tax asset or liability is expected to be realizedor settled. The Company assesses the likelihood that its deferred tax assetswill be recovered from future taxable income and the Company records avaluation allowance to reduce its deferred tax assets to the amounts itbelieves to be realizable. The Company has concluded that a full valuationallowance against its deferred tax assets was appropriate.

*RecentAccounting Pronouncements:***  **In June 2006, the Financial Accounting StandardsBoard (FASB) issued FASB Interpretation No. 48 (FIN 48), *Accounting for Uncertainty in Income Taxes*. FIN 48 clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109*,*and prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and 

F-9

----

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

**Note 1:  **Summary of Significant Accounting Policies (Continued)

measurement of a tax position taken or expected to betaken in a tax return. The Company has determined the adoption of FIN 48 willnot have a material impact on its consolidated financial statements.

In September 2006, the FASBissued SFAS No. 157, *Fair Value Measurements*.The standard provides guidance for using fair value to measure assets andliabilities. The standard clarifies the principle that fair value should bebased on the assumptions market participants would use when pricing the assetor liability and establishes a fair value hierarchy that prioritizes theinformation used to develop those assumptions. Under the standard, fair valuemeasurements would be separately disclosed by level within the fair valuehierarchy. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007 and interim periods withinthose fiscal years. The Company has not yet determined the impact, if any, thatthe adoption of SFAS No. 157 will have on its consolidated financialstatements.

**Note 2:   Investments**

Available-for-salesecurities consist of the following:

| *** ***             | *** *** | ***December 31, 2006*** | *** *** | ***December 31, 2005*** | *** *** |
|--------------------------|--------------|-----------------------------------|--------------|-----------------------------------|--------------|
| ** **               | ** **   | **Amortized**                     | ** **   | **Unrealized**                    | ** **   | **Amortized** | ** ** | **Unrealized** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** **   | **Cost**                          | ** **   | **Holding**                       | ** **   | **Fair** | ** ** | **Cost** | ** ** | **Holding** | ** ** | **Fair** | ** ** |
| ** **               | ** **   | **Basis**                         | ** **   | **Losses**                        | ** **   | **Value** | ** ** | **Basis** | ** ** | **Gains** | ** ** | **Value** | ** ** |
| U.S. government agencies |         |                              | $            | —                            |         |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 1,961 |   |   |   | $ | 26 |   |   | $ | 1,987 |   |
| Corporate obligations    |         |                              | 1,497        |                              |         |   | — |   |   |   | 1,497 |   |   |   | 2,743 |   |   |   | 30 |   |   | 2,773 |   |
| Auction rate securities  |         |                              | 15,600       |                              |         |   | — |   |   |   | 15,600 |   |   |   | — |   |   |   | — |   |   | — |   |
| Total                    |         |                              | $            | 17,097                            |         |   |   | $ | — |   |   |   | $ | 17,097 |   |   |   | $ | 4,704 |   |   |   | $ | 56 |   |   | $ | 4,760 |   |

 

As of December 31, 2006, theavailable-for-sale securities classified as corporate obligations haveremaining maturities of six months.

**Note 3:   Property and equipment**

Property andequipment consists of the following:

| ** **                                | ** ** | ***December 31,*** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **2006**                | ** ** | **2005** | ** ** |
| Vehicles                                  |       |                    | $          | 2,312 |   |   | $ | 1,375 |   |
| Office furniture and equipment            |       |                    | 26,559     |   |   | 18,229 |   |
| Computer equipment and software           |       |                    | 49,620     |   |   | 41,897 |   |
| Leasehold improvements                    |       |                    | 27,272     |   |   | 23,765 |   |
| Switching and data equipment and software |       |                    | 172,899    |   |   | 134,661 |   |
|                                      |       |                    | 278,662    |   |   | 219,927 |   |
| Less accumulated depreciation             |       |                    | (132,877   | ) |   | (93,475 | ) |
|                                      |       |                    | $          | 145,785 |   |   | $ | 126,452 |   |

 

Depreciation expense was $27,596,$25,565 and $18,684 for the years ended December 31, 2006, 2005 and 2004,respectively.

F-10

----

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

**Note 4:   Goodwill and Other IntangibleAssets**

*Goodwill:*   Goodwillrepresents the excess cost over the fair value of the net assets acquired. In2006, the Company recorded $52,502 of goodwill in connection with theacquisitions of Oregon Telecom, Inc. (OTI), OneEighty Communications, Inc.(OneEighty) and Mountain Telecommunications, Inc. (MTI). Goodwill relatedto the OneEighty and MTI acquisitions is not deductible for tax purposes.

In 2005, the Company completed the purchase priceallocation for the acquisition of Advanced TelCom, Inc. (ATI), resultingin a $31,608 reduction in goodwill, primarily consisting of increases in fixedassets and intangible assets.

The changes in the carrying valueof goodwill are as follows:

| Balance as of December 31, 2004              |   | $       | 38,776 |   |
|---------------------------------------------------|--------|---------|--------|--------|
| Purchase accounting adjustments                   |   | (31,608 | )      |
| Balance as of December 31, 2005              |   | 7,168   |   |
| Goodwill related to the acquisition of OTI        |   | 14,635  |   |
| Goodwill related to the acquisition of  OneEighty |   | 5,643   |   |
| Goodwill related to the acquisition of MTI        |   | 32,224  |   |
| Balance as of December 31, 2006              |   | $       | 59,670 |   |

 

*OtherIntangible Assets:*   In November 2006, theCompany recorded intangible assets of $2,122 in connection with the acquisitionof MTI, consisting of several right to use agreements.

In August 2006, the Company entered into anagreement to purchase a selected customer base from Tel West Communications,LLC (TelWest) in exchange for $500 per access line, not to exceed $5,300. As ofDecember 31, 2006, the Company paid Tel West $4,070 and recorded $3,483 ofcustomer installation costs. The customer installation costs are recognized asthe Company converts the TelWest customers to its network.

In June 2006, the Company recorded intangibleassets of $5,800 in connection with the acquisition of OTI, consisting ofcustomer relationships and non-compete agreements.

In December 2005, the Company recorded intangibleassets of $3,913 in connection with the acquisition of ATI, consisting ofcustomer relationships and developed technology.

In September 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.

Intangibleassets consist of the following:

| *** ***                | *** *** | *** ***                      | *** *** | ***December 31, 2006***   | *** *** | ***December 31, 2005*** | *** *** |
|-----------------------------|--------------|-----------------------------------|--------------|-------------------------------------|--------------|-----------------------------------|--------------|
| ** **                  | ** **   | **Useful**

**Life**

**(years)** | ** **   | **Gross**

**Carrying**

**Amount** | ** **   | **Accumulated**

**Amortization** | ** **   | **Net** | ** ** | **Gross**

**Carrying**

**Amount** | ** ** | **Accumulated**

**Amortization** | ** ** | **Net** | ** ** |
| Customer installation costs |         |                              | 3-5          |                                |         | $                                 | 96,565       |   |   | $ | 64,364 |   |   | $ | 32,201 |   | $ | 77,650 |   |   | $ | 52,034 |   |   | $ | 25,616 |   |
| Debt issuance costs         |         |                              | 4-6          |                                |         | 7,001                             |         |   | 2,159 |   |   | 4,842 |   | 5,666 |   |   | 1,077 |   |   | 4,589 |   |
| Customer relationships      |         |                              | 4            |                                |         | 8,520                             |         |   | 2,792 |   |   | 5,728 |   | 3,820 |   |   | 955 |   |   | 2,865 |   |
| Right to use agreements     |         |                              | 10-20        |                                |         | 2,122                             |         |   | 29 |   |   | 2,093 |   | — |   |   | — |   |   | — |   |
| Non-compete agreements      |         |                              | 3-5          |                                |         | 1,400                             |         |   | 365 |   |   | 1,035 |   | 300 |   |   | 100 |   |   | 200 |   |
| Developed technology        |         |                              | 3            |                                |         | 94                                |         |   | 62 |   |   | 32 |   | 94 |   |   | 31 |   |   | 63 |   |
| Total                       |         |                              |         |                                |         | $                                 | 115,702      |   |   | $ | 69,771 |   |   | $ | 45,931 |   | $ | 87,530 |   |   | $ | 54,197 |   |   | $ | 33,333 |   |

 

F-11

----

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

**Note 4:  **Goodwilland Other Intangible Assets (Continued)

Total amortization expense was$15,733, $15,153 and $13,076 for the years ended December 31, 2006, 2005and 2004, respectively. Estimated amortization expense for each of the fivesucceeding fiscal years based on current intangible assets is expected to be asfollows:

| 2007       |   | $      | 16,426 |   |
|------------|--------|--------|--------|--------|
| 2008       |   | 13,692 |   |
| 2009       |   | 9,483  |   |
| 2010       |   | 4,401  |   |
| 2011       |   | 691    |   |
| Thereafter |   | 1,238  |   |
| Total      |   | $      | 45,931 |   |

 

**Note 5:   Accumulated Other ComprehensiveIncome**

Thecomponents of accumulated other comprehensive income are as follows:

| Balance, December 31, 2004                       |   | $   | 30     |   |
|-------------------------------------------------------|--------|-----|--------|--------|
| Net unrealized gain on available-for-sale  securities |   | 26  |   |
| Balance, December 31, 2005                       |   | 56  |   |
| Net unrealized loss on available-for-sale  securities |   | (56 | )      |
| Balance, December 31, 2006                       |   | $   | — |   |

 

**Note 6:   Acquisitions**

*MountainTelecommunications, Inc (MTI):*   OnNovember 1, 2006, the Company completed the acquisition of MTI, acompetitive services provider based in Tempe, Arizona. MTI provides services inPhoenix, Tucson and markets throughout the state of Arizona expanding theCompany’s market presence in Arizona. The Company expects to benefit fromoperating synergies by consolidating MTI’s operation into its existingbusiness. The results of MTI subsequent to November 1, 2006 are includedin the results of operations.

In the MTI transaction, the Company acquired all ofthe outstanding shares of MTI in exchange for $37,256 (net of cash acquired)and certain assumed liabilities. As of December 31, 2006 the purchaseprice has been allocated on a preliminary basis, resulting in $32,224 ofgoodwill. None of this goodwill is deductible for tax purposes. The Companyaccrued $340 of acquisition related expenses, which include severance benefits,relocation and contract termination fees. As of December 31, 2006 noacquisition related expenses have been paid.

*OneEightyCommunication, Inc (OneEighty):*   OnOctober 1, 2006, the Company completed the acquisition of OneEighty, acompetitive services provider based in Billings, Montana. The acquisition ofOneEighty expands the Company’s market presence into Montana. The Companyexpects that through market growth, leveraging its size, and existinginvestments in infrastructure OneEighty can benefit from operating synergies.The results of OneEighty subsequent to October 1, 2006 are included in theresults of operations.

In the OneEighty transaction, the Company acquired allof the outstanding shares of OneEighty in exchange for $9,959 (net of cashacquired) and certain assumed liabilities. As of December 31, 2006 thepurchase price has been allocated on a preliminary basis, resulting in $5,643of goodwill. None of this goodwill is deductible for tax purposes. The Companyaccrued $21 of acquisition related expenses, which relate to severancebenefits. As of December 31, 2006 no acquisition related expenses havebeen paid.

 

F-12

----

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

**Note 6:   Acquisitions (Continued)**

*OregonTelecom, Inc (OTI):*   On April 1, 2006, theCompany completed the acquisition of OTI, a privately-held competitive servicesprovider based in Salem, Oregon. The acquisition expands the Company’s marketpresence in the Pacific Northwest. The Company expects to benefit fromoperating synergies by consolidating OTI’s operation into its existing business.The results of OTI subsequent to April 1, 2006 are included in the resultsof operations.

In the OTI transaction, the Company acquired all ofthe outstanding shares of OTI in exchange for $19,993 (net of cash acquired)and certain assumed liabilities. The Company acquired $5,800 of intangibleassets, consisting of customer relationships and non-compete agreements andrecorded $14,635 of goodwill as a result of the acquisition. The Companyaccrued $867 of acquisition related expenses, which include severance benefits,relocation and contract termination fees. As of December 31, 2006 $73 ofacquisition related expenses have been paid. 

*AdvancedTelCom, Inc. (ATI):***  **On December 31,2004, the Company completed the acquisition of ATI increasing the Company’smarket share among competitive service providers in the Pacific Northwest. TheCompany expects to benefit from operating synergies by consolidating ATI’soperation into its existing business. The results of ATI subsequent to December 31,2004 are included in the results of operations.

Inthe ATI transaction, the Company acquired all of the outstanding shares of ATIin exchange for $45,543 (net of cash acquired) and certain assumedliabilities. During the fourth quarter of 2005, the Company finalized thepurchase price allocation increasing the fair value assigned to fixed assetsand other intangible assets by $27,340 and $3,913 respectively with acorresponding $31,253 reduction to goodwill. On December 31, 2004, theCompany accrued $2,531 in acquisition related expenses, which includedseverance benefits, relocation costs and contract termination fees. During thefourth quarter of 2005 the Company finalized its liabilities incurred inconnection with the acquisition and recorded an adjustment to decrease therecorded liabilities by $403, which was recorded as a reduction to goodwill. Asof December 31, 2006 and 2005, $2,128 and $1,753, respectively, of theacquisition related expenses have been paid.

The following table summarizesthe allocation of the purchase price to the fair value of the assets acquiredand liabilities assumed at the date of each acquisition described above,including any adjustments to the purchase price allocation through December 31,2006:

| *** ***              | *** *** | ***MTI***                      | *** *** | ***OneEighty***               | *** *** | ***OTI***                   | *** *** | ***ATI***                       | *** *** |
|---------------------------|--------------|--------------------------------|--------------|-------------------------------|--------------|-----------------------------|--------------|---------------------------------|--------------|
| ** **                | ** **   | **November 1,**

**2006** | ** **   | **October 1,**

**2006** | ** **   | **April 1,**

**2006** | ** **   | **December 31,**

**2004** | ** **   |
| Current Assets            |         |                           | $            | 2,728                         |         |                        |         | $                               | 761          |   |   | $ | 3,297 |   |   | $ | 8,279 |   |   |
| Property and equipment    |         |                           | 6,947        |                          |         |                        | 4,152        |                            |         | 529 |   |   | 42,729 |   |   |
| Other assets              |         |                           | 21           |                          |         |                        | 348          |                            |         | 57 |   |   | 29 |   |   |
| Goodwill                  |         |                           | 32,224       |                          |         |                        | 5,643        |                            |         | 14,635 |   |   | — |   |   |
| Intangible assets         |         |                           | 2,122        |                          |         |                        | —       |                            |         | 5,800 |   |   | 3,913 |   |   |
| Total assets acquired     |         |                           | 44,042       |                          |         |                        | 10,904       |                            |         | 24,318 |   |   | 54,950 |   |   |
| Current liabilities       |         |                           | 4,709        |                          |         |                        | 739          |                            |         | 4,013 |   |   | 8,869 |   |   |
| Long-term liabilities     |         |                           | 2,019        |                          |         |                        | —       |                            |         | — |   |   | 217 |   |   |
| Total liabilities assumed |         |                           | 6,728        |                          |         |                        | 739          |                            |         | 4,013 |   |   | 9,086 |   |   |
| Net assets acquired       |         |                           | 37,314       |                          |         |                        | 10,165       |                            |         | 20,305 |   |   | 45,864 |   |   |
| Less cash acquired        |         |                           | 58           |                          |         |                        | 206          |                            |         | 312 |   |   | 321 |   |   |
| Net cash paid             |         |                           | $            | 37,256                        |         |                        |         | $                               | 9,959        |   |   | $ | 19,993 |   |   | $ | 45,543 |   |   |

 

The OneEighty and MTI purchase price allocation hasbeen allocated on a preliminary basis as of December 31, 2006. The Companyis still determining the valuation of separately identifiable intangibleassets.

F-13

----

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

**Note 6:  **Acquisitions(Continued)

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. Thesepro forma results are based upon the respective historical financial statementsof the respective companies, and do not incorporate, nor do they assume anybenefits from cost savings or synergies of operations of the combined company. Thepro forma results of operations do not necessarily reflect the results thatwould have occurred had the acquisition occurred at the beginning of theperiods presented or the results which may occur in the future.

The unauditedpro forma consolidated results of continuing operations, as though theacquisitions of ATI, OTI, OneEighty and MTI had taken place on January 1,2004, are as follows:

| ** **                                | ** ** | ***Year Ended December 31,*** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                   |       | $                                            | 303,191    |   | $ | 276,334 |   | $ | 261,040 |   |
| Income (loss) from continuing operations  |       | $                                            | (5,552     | ) | $ | (28,341 | ) | $ | 1,858 |   |
| Net income (loss)                         |       | $                                            | (5,552     | ) | $ | (27,686 | ) | $ | 1,858 |   |
| Net loss per share—basic and diluted |       | $                                            | (0.34      | ) | $ | (4.65 | ) | $ | (8.47 | ) |

 

**Note 7:   Discontinued Operation**

*GeneralElectric Business Productivity Solutions:*   On October 1, 2005, theCompany sold its discontinued operation for $320, net of sales costs incurred.The sale resulted in a gain of $326 and is presented in the consolidatedstatement of operations.

On October 13, 2004 theCompany entered into an agreement with General Electric Capital Corporation topurchase substantially all other assets of General Electric BusinessProductivity Solutions, Inc. (GE BPS) for $100. The transaction closed on March 31,2005 and was be accounted for as a discontinued operation. GE BPS constitutes agroup of assets that can be clearly distinguished operationally and forfinancial reporting purposes from the rest of the Company. Management hasdetermined that the group of assets does not fit the Company’s future businessmodel and committed to sell the net assets with an original carrying value of$216, which approximated the fair value less cost to sell the group of assets. AtMarch 31, 2005 the Company determined that the plan of sale criteria inSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*, had been met andclassified the assets and liabilities accordingly on the balance sheet.

**Note 8:   Operating and Capital Leases**

*OperatingLeases:*   The Company leases office space underoperating leases. The leases generally require a base rent plus amountscovering operating expenses and property taxes. Rent expense for the yearsended December 31, 2006, 2005 and 2004 was $8,267, $7,468 and $5,087,respectively.

F-14

----

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

**Note 8:  **Operatingand Capital Leases (Continued)

Future minimum lease paymentsunder operating leases with a term in excess of one year as of December 31,2006 are as follows:

| 2007       |   | $     | 6,067  |   |
|------------|--------|-------|--------|--------|
| 2008       |   | 6,031 |   |
| 2009       |   | 5,224 |   |
| 2010       |   | 3,659 |   |
| 2011       |   | 3,209 |   |
| Thereafter |   | 3,064 |   |
| Total      |   | $     | 27,254 |   |

 

*Capital Leases:*   TheCompany also leases certain vehicles, furniture and equipment under capitalleases. The cost of vehicles, furniture and equipment in the accompanyingbalance sheets includes the following amounts under capital leases:

| *** ***                  | *** *** | ***December 31,*** | *** *** |
|-------------------------------|--------------|-------------------------|--------------|
| ** **                    | ** **   | **2006**                | ** **   | **2005** | ** ** |
| Cost                          |         | $                       | 7,570        |   | $ | 9,207 |   |
| Less accumulated depreciation |         | (1,891                  | )            | (2,507 | ) |
|                          |         | $                       | 5,679        |   | $ | 6,700 |   |

 

Futureminimum lease payments required under capital leases together with the presentvalue of the net future minimum lease payments at December 31, 2006 are asfollows:

| 2007                                               |   | $      | 3,622  |   |
|----------------------------------------------------|--------|--------|--------|--------|
| 2008                                               |   | 1,570  |   |
| 2009                                               |   | 635    |   |
| 2010                                               |   | 192    |   |
| 2011                                               |   | 83     |   |
| Total minimum lease payments                       |   | 6,102  |   |
| Less amount representing interest                  |   | (770   | )      |
| Present value of minimum payments                  |   | 5,332  |   |
| Less current portion                               |   | (3,131 | )      |
| Capital lease obligations, net of current  portion |   | $      | 2,201  |   |

 

**Note 9:   Notes Payable and OtherLong-Term Liabilities**

*NotesPayable:*   In March 2006, the Companycompleted an offering of $48,000 of 83¤8%notes due March 15, 2010 at a discount resulting in a 9.92% yield. Thenotes were entered into under a supplemental indenture to the originalindenture dated March 17, 2004, and have the same terms and conditions ofthe original indenture. The Company received net proceeds of approximately$44,264 after deducting fees and expenses associated with the offering. TheCompany’s acquisition of Oregon Telecom, Inc. on April 1, 2006, wasfinanced with $20,305 of the proceeds from the offering. The remaining proceedswere used for general corporate purposes, to fund the acquisition of OneEightyand partially fund the acquisition of MTI.

In September 2005, the Company redeemed 35% ofits notes due March 15, 2010 at a redemption price of 112% of the $50,630accreted value ($57,750 principal amount). The $6,076 accreted-value premiumwas recorded 

F-15

----

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

**Note 9:  **NotesPayable and Other Long-Term Liabilities (Continued)

as interest expense. Proceedsfrom the Company’s initial public offering of common stock (see Note 11,Capital Stock) were used to redeem the notes.

In November 2004, the Company completed an offeringof $65,000 of 83¤8%notes due March 15, 2010 at a discount resulting in a 14% yield. The noteswere entered into under a supplemental indenture to the original indenturedated March 17, 2004, and have the same terms and conditions of theoriginal indenture. The Company received net proceeds of approximately $47,269after deducting fees and expenses associated with the offering. The proceedsfrom the offering were used to finance the acquisition of ATI.

In March 2004, the Company completed an offeringof $100,000 of 83¤8%senior second secured notes (“notes”) due March 15, 2010 at a discountresulting in a 12% yield. The Company received net proceeds of approximately$80,178 after deducting fees and expenses associated with the offering. Theproceeds from the offering were used to retire a Credit Agreement with aprincipal balance of $65,421 and provide additional liquidity to the Company. Therepayment of the Credit Agreement resulted in the Company recording $18,195 asa gain on extinguishment of debt, which represented $20,873 of excess carryingvalue less the write-off of $2,678 of debt issuance costs associated with theCredit Agreement.

The notes will mature on March 15, 2010, andaccrue interest at an annual rate of 83¤8% withinterest payments made on a semiannual basis on each March 15 and September 15.On or after March 15, 2007, the Company may redeem some or all of thenotes at the following redemption prices, expressed as percentages of theiraccreted value, plus accrued and unpaid interest, if any, to the date ofredemption:  1) on or after March 15,2007, at 106%; 2) on or after March 15, 2008 at 103%; and 3) on orafter March 15, 2009 at 100%. Prior to March 15, 2007, up to 35% ofthe aggregate principal amount at maturity of the notes may be redeemed at theCompany’s option with the net proceeds of certain equity offerings at 112.000%of their accreted value, plus accrued and unpaid interest, if any, to the dateof redemption, 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.

The carrying value of the notesis comprised of the following as of December 31:

| ** **                | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Principal amount due      |       | $        | 155,250    |     | $          | 107,250 |   |
| Discount on notes payable |       | (14,210  | )          | (15,125  | )          |
|                      |       | $        | 141,040    |     | $          | 92,125 |   |

 

F-16

----

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

**Note 9:  **NotesPayable and Other Long-Term Liabilities (Continued)

The accreted value of notespayable as of December 31 of the following years is:

| 2007                |   | 144,896 |   |
|---------------------|--------|---------|--------|
| 2008                |   | 149,254 |   |
| 2009                |   | 154,180 |   |
| March 15, 2010 |   | 155,250 |   |

 

The carrying amount, net of discount, of the Company’sdebt instruments in the consolidated balance sheets at December 31, 2006and 2005 approximates fair value.

*Fiber Ring Payable:*   Asa result of the MTI acquisition, the Company acquired the use of two fiberrings through a right to use agreement. In 2006, two additional service orderswere added to the agreement. The combined agreement requires monthly paymentsof $23 thru May 2009 and $12 per month for the remaining 186 months. Thepayable can be prepaid at any time. The balance is amortized based on a 10.95%interest rate. The following is a schedule by years of future minimum paymentsrequired under this agreement as of December 31, 2006:

| 2007                                               |   | $      | 270    |   |
|----------------------------------------------------|--------|--------|--------|--------|
| 2008                                               |   | 270    |   |
| 2009                                               |   | 193    |   |
| 2010                                               |   | 138    |   |
| 2011                                               |   | 138    |   |
| Thereafter                                         |   | 1,783  |   |
| Total minimum lease payments                       |   | 2,792  |   |
| Less amount representing interest                  |   | (1,428 | )      |
| Present value of minimum payments                  |   | 1,364  |   |
| Less current portion                               |   | (127   | )      |
| Capital lease obligations, net of current  portion |   | $      | 1,237  |   |

 

**Note 10:   Benefit Contribution Plan**

The Company has a definedcontribution salary deferral plan covering substantially all employees under Section 401(k) ofthe Internal Revenue Code. The Company contributes an amount equal to 45 centsfor each dollar contributed by each employee up to a maximum of 6% of eachemployee’s compensation. The Company recognized expense for contributions tothe plan of $1,014, $962 and $764 in 2006, 2005 and 2004, respectively.

**Note 11:   Capital Stock**

*CommonStock:***  **In May 2006,the Company completed an offering of 2,550,000 shares of the Company’s commonstock at $15.70 per share. After deducting fees and expenses related to theoffering, the Company received net proceeds of approximately $39,955, which wasused for general corporate purposes and to partially fund the acquisition ofMTI.

In August 2005, the Company consummated aninitial public offering of 5,357,143 of the Company’s common stock at $14.00per share. Net proceeds from the offering, after deducting underwritingdiscounts and commissions, were $69,750. Proceeds were used to redeem $50,630accreted value ($57,750 principal amount) of the Company’s 8 3/8% seniorsecond secured notes due March 15, 2010; to pay a $6,076 premium due uponredemption of the notes; and to pay $2,684 of fees and expenses associated withthe offering.

F-17

----

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

**Note 11:  **CapitalStock (Continued)

*Restrictedand Unrestricted Common Stock:***  **In June 2006, the Companygranted 390,000 shares of restricted common stock to members of management andis recording compensation expense on a straight-line basis from the date ofgrant. In March 2005, the Company granted 9,350 shares of unrestrictedcommon stock to certain directors and recorded compensation expense of $27. In February 2003,the Company granted 183,399 shares of restricted common stock to certaindirectors and members of management. The Company records compensation expenseon its restricted common stock as the restrictions are removed from the stock.

*PreferredStock:*   In December 2004, in connection withthe ATI acquisition, the Company redeemed 6,780,541 shares of its Series AConvertible Preferred Stock held by a lender for $5,085. The Company issued20,000,000 shares of its newly authorized Series B Convertible PreferredStock in December 2004, resulting in proceeds of $15,000. Under the termsof the Series A and Series B Convertible Preferred Stock(collectively, Preferred Stock), the holders are entitled to receive, when andif declared by the Board of Directors, cumulative dividends on each share ofPreferred Stock at the rate of 8% per year which shall accrue daily and, to theextent not paid, shall accumulate quarterly in arrears. At December 31,2004, dividends in arrears were $8,777. As a result of the Company’s initialpublic offering of common stock in August 2005, all of the Company’sthen-outstanding shares of convertible preferred stock and accumulateddividends were automatically converted to common stock.

After the conversion, the Companyhas 125,000,000 of undesignated preferred shares authorized and no shares ofpreferred stock outstanding.

**Note 12:   Share-Based Compensation**

*StockOptions:*   A total of 2,632,414 shares of theCompany’s common stock have been authorized for issuance under the EschelonTelecom, Inc. Stock Option Plan of 2002 (the “2002 Plan”). The 2002 Planprovides for grants of incentive stock options, non-statutory stock options,stock appreciation rights, restricted or unrestricted stock awards, phantomstock, performance awards and other stock-based awards to our employees, formeremployees, officers, directors and consultants. The 2002 Plan is administeredby the Compensation Committee of the Board of Directors, which has solediscretion and authority, consistent with the provisions of the 2002 Plan, todetermine which eligible participants will receive awards, when awards will begranted, the terms of awards, and the number of shares that will be subject toawards. The purpose of the 2002 Plan is to enable the Company to attract,retain and reward the best-available employees, to provide participants withincentives to improve stockholder value and to contribute to the growth andfinancial success of the Company through their future services with the Company.All of the Company’s employees, former employees, officers and directors areeligible to participate in the 2002 Plan.

The exercise price of incentive stock options may notbe less than the fair market value of the stock on the date of grant and theoptions are exercisable for a period not to exceed ten years from the date ofthe grant. Options and restricted stock awards are typically subject to one ofthe following vesting schedules:  (1) 20%upon the initial grant and 20% per year over four years from the date of grant,(2) 20% per year over five years from the date of grant, or (3) 33 1/3%upon the initial grant and 33 1/3% per year over two years from the dateof grant. Awards granted may be subject to other vesting terms as determined bythe Compensation Committee.

The Company adopted SFAS No. 123(R) usingthe modified prospective transition method and the straight-line attributionmethod for recognizing compensation expense. Under the modified prospectivetransition method, compensation expense recognized during the year ended December 31,2006, included:  (a) the proratedportion of compensation expense for all share-based awards granted prior to January 1,2006, but not yet vested, based on the grant date fair value estimated inaccordance with the original provisions of SFAS No. 123, and (b) theprorated portion of compensation expense for all share-based awards grantedsubsequent to adoption of SFAS No. 123(R), based on the grant date fairvalue estimated in accordance with the provisions of SFAS No. 123(R). Inaccordance 

F-18

----

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

**Note 12:  **Share-Based Compensation (Continued)

with the modified prospectivetransition method, the Company’s consolidated financial statements for periodsprior to the adoption of SFAS No. 123(R) have not been restated toreflect the impact of the provisions of SFAS No. 123(R).

The Company records compensation expense for employeestock options based on the estimated fair value of the options on the date ofgrant using assumptions required by SFAS No. 123(R). Due to insufficienthistory related to options, the Company uses the short-cut method accepted bythe SEC to determine the expected life of options. The Company expects tocontinue using the short-cut method for options granted through December 31,2007, after which the use of the short-cut method is not permitted by the SEC. Volatilityis estimated based on an exchange-traded telecommunications fund usinghistorical data that corresponds to the expected term of the options granted. Therisk-free interest rate is based on the Federal Reserve rate for U.S. governmentsecurities with a term that corresponds to the expected term of the optionsgranted.  The Company uses historicaldata and other factors to estimate the expected forfeiture rate.

The followingtable summarizes the assumptions used to estimate the fair value of optionsgranted using the Black-Scholes Model:

| *** ***                    | *** *** | ***December 31,*** | *** *** |
|---------------------------------|--------------|-------------------------|--------------|
| ** **                      | ** **   | **2006**                | ** **   | **2005** | ** ** | **2004** | ** ** |
| Expected dividend yield         |         | —                  |         | — |   | — |   |
| Expected stock price volatility |         | 24%-26                  | %            | 25 | % | 25 | % |
| Risk-free interest rate         |         | 4.45%-4.95              | %            | 3.71%-4.45 | % | 3.25%-3.88 | % |
| Expected life of options        |         | 6-6.5 years             |         | 5 years |   | 5 years |   |

 

The Company recorded stock-based compensation expenseunder SFAS No. 123(R) for stock option awards of $998 for the yearended December 31, 2006. As a result of adopting SFAS No. 123(R) onJanuary 1, 2006, the Company’s net loss for the year ended December 31,2006 was $442 greater than if it had continued to account for share-basedcompensation under APB No. 25. Basic and diluted earnings per share forthe year ended December 31, 2006 was $0.03 per share lower than if theCompany had continued to account for share-based compensation under APB No. 25.

As of December 31, 2006, there was $934 ofunrecognized compensation expense related to unvested options granted under theCompany’s share-based payment plans. The expense is expected to be recognizedover a weighted-average period of 1.5 years. The total fair value of optionsthat vested during the years ended December 31, 2006, 2005 and 2004 was$923, $817 and $30, respectively.

F-19

----

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

**Note 12:   Share-Based Compensation(Continued)**

Pro forma information regardingnet loss and net loss per share is required by SFAS No. 123, *Accounting for Stock-Based Compensation*, and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method of SFAS No. 123. The following table illustrates theeffect on net loss per share if the Company had applied the fair valuerecognition provision of SFAS No. 123**to stock-basedemployee compensation:

| *** ***                                                                                                      | *** *** | ***December 31,*** | *** *** |
|-------------------------------------------------------------------------------------------------------------------|--------------|-------------------------|--------------|
| ** **                                                                                                        | ** **   | **2005**                | ** **   | **2004** | ** ** |
| Net loss applicable to common stockholders,  as reported                                                          |         | $                       | (30,991      | ) | $ | (3,181 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                     |         | 936                     |         | 20 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value-based methods for all awards |         | (422                    | )            | (45 | ) |
| Pro forma net loss applicable to common  stockholders                                                             |         | $                       | (30,477      | ) | $ | (3,206 | ) |
| Net loss per share:                                                                                               |         |                    |         |   |   |
| Basic and diluted - as reported                                                                                   |         | $                       | (5.21        | ) | $ | (11.11 | ) |
| Basic and diluted - pro forma                                                                                     |         | $                       | (5.12        | ) | $ | (11.11 | ) |

 

The following table summarizes the options to purchaseshares of the Company’s common stock under the Eschelon Telecom, Inc.Stock Option Plan of 2002:

| ** **                        | ** ** | **Shares   Available for  Grant** | ** ** | **Plan   Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|
| 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 |   |   |
| Additional shares reserved        |       |                                        | 1,000,000  |                                 |       |                                       | —     |   |   |   | — |   |   |
| Options granted                   |       |                                        | (125,901   | )                                    |       |                                       | 125,901    |   |   |   | 16.07 |   |   |
| Restricted stock granted          |       |                                        | (390,000   | )                                    |       |                                       | —     |   |   |   | 15.50 |   |   |
| Canceled                          |       |                                        | 31,091     |                                 |       |                                       | (31,091    | ) |   |   | 9.07 |   |   |
| Exercised                         |       |                                        | —     |                                 |       |                                       | (423,591   | ) |   |   | 0.94 |   |   |
| Balance at December 31, 2006 |       |                                        | 669,269    |                                 |       |                                       | 838,709    |   |   |   | $ | 7.33 |   |   |

 

The following table contains details of the stockoptions outstanding as of December 31, 2006:

| *** ***                                | *** *** | ***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                             |         |                           | 530,228      |                                                   |         |   | 7.46 years |   |   |   | $ | 3.62 |   |   |   | 294,358 |   |   |   | $ | 3.91 |   |   |
| $10.85 - $21.68                             |         |                           | 308,481      |                                                   |         |   | 9.02 years |   |   |   | $ | 13.71 |   |   |   | 100,683 |   |   |   | $ | 13.12 |   |   |
|                                        |         |                           | 838,709      |                                                   |         |   | 8.03 years |   |   |   | $ | 7.33 |   |   |   | 395,041 |   |   |   | $ | 6.26 |   |   |

** **

F-20

----

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

**Note 12:   Share-Based Compensation (Continued)**

As of December 31, 2006, the options exercisablehave a weighted-average remaining contractual life of 7.82 years and anintrinsic value of $5,353. The options outstanding as of December 31, 2006have an intrinsic value of $10,467.

The weighted-average grant-date fair value of optionsgranted during the years ended December 31, 2006, 2005 and 2004, was $5.80,$5.68 and $0.40, respectively. The total intrinsic value for options exercisedduring the years ended December 31, 2006, 2005 and 2004, was $5,820, $295and $2, respectively.

Cash received from option exercises for the yearsended December 31, 2006, 2005 and 2004, was $398, $60 and $8,respectively.

*Restrictedand Unrestricted Common Stock:**  *Totalcompensation expense related to restricted and unrestricted common stock forthe years ended December 31, 2006, 2005 and 2004, was $682, $39 and $34,respectively.

The following table summarizes the restricted andunrestricted common stock under the Eschelon Telecom, Inc. Stock OptionPlan of 2002:

| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** ** |
|------------------------------------|------------|----------------------------|------------|--------------------------------------------------------------|------------|
| Unvested at December 31, 2003 |       |                       | 80,085     |                                                         |       |   | $ | 0.68 |   |   |
| Vested                             |       |                       | (29,958    | )                                                            |       |   | 0.68 |   |   |
| Unvested at December 30, 2004 |       |                       | 50,127     |                                                         |       |   | 0.68 |   |   |
| Granted                            |       |                       | 9,350      |                                                         |       |   | 2.93 |   |   |
| Vested                             |       |                       | (27,297    | )                                                            |       |   | 1.47 |   |   |
| Forfeited                          |       |                       | (494       | )                                                            |       |   | 0.68 |   |   |
| Unvested at December 31, 2005 |       |                       | 31,686     |                                                         |       |   | 0.68 |   |   |
| Granted                            |       |                       | 390,000    |                                                         |       |   | 15.50 |   |   |
| Vested                             |       |                       | (15,842    | )                                                            |       |   | 0.68 |   |   |
| Unvested at December 31, 2006 |       |                       | 405,844    |                                                         |       |   | $ | 14.92 |   |   |

 

**Note 13:   Income Taxes**

As of December 31, 2006, the Company had $174,314of net operating loss (NOL) carryforwards, which consist of $170,877 reflectedin the deferred tax asset below and $3,437 of excess tax deductions arisingfrom SFAS No. 123(R). These NOL carryforwards, if not utilized to reducetaxable income in future periods will begin to expire in the year 2019. Shouldthe Company incur a change in ownership in the future, Section 382 of theUnited States Internal Revenue Code may limit the amount of cumulative NOLsavailable to offset future income.

F-21

----

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

**Note 13:   Income Taxes (Continued)**

Components of the deferred tax assets and liabilities atDecember 31, 2006 and 2005 are as follows:

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:            |       |     |       |     |       |
| Net operating loss carryforward |       | $        | 67,663     |     | $          | 69,179 |   |
| Intangible assets               |       | 982      |       | 371      |       |
| Bad debts                       |       | 375      |       | 186      |       |
| Compensation accruals           |       | 541      |       | 174      |       |
| Inventory obsolescence          |       | 144      |       | 104      |       |
| Other temporary differences     |       | 800      |       | 66       |       |
|                            |       | 70,505   |       | 70,080   |       |
| Deferred tax liabilities:       |       |     |       |     |       |
| Depreciation                    |       | (13,783  | )          | (12,259  | )          |
| Other                           |       | (276     | )          | (21      | )          |
|                            |       | 56,446   |       | 57,800   |       |
| Valuation allowance             |       | (56,446  | )          | (57,800  | )          |
| Net deferred tax asset          |       | $        | —     |     | $          | — |   |

 

Income tax expense is comprised of federal taxes. The reconciliationbetween the statutory federal income tax rate and the effective rate is asfollows:

| ** **                         | ** ** | ***Year Ended December 31,*** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal statutory tax rate         |       | 34.00                                        | %          | 34.00 | % | 34.00 | % |
| State taxes                        |       | 3.72                                         |       | — |   | 0.25 |   |
| Permanent differences              |       | 3.20                                         |       | (0.01 | ) | 2.74 |   |
| Utilization of valuation allowance |       | (40.92                                       | )          | (34.00 | ) | (36.61 | ) |
| Effective tax rate                 |       | 0.00                                         | %          | (0.01 | )% | 0.38 | % |

 

**Note 14:   Condensed ConsolidatingFinancial Information**

The 8 3/8% senior second secured notes due March 15,2010 issued by Eschelon Operating Company are fully and unconditionallyguaranteed jointly and severally by the Company and all existing subsidiariesand the indenture governing the notes requires that any future subsidiariesthat are organized in the United States must also guarantee the notes on thesame basis.

Additional information regarding the 8 3/8%senior second secured notes due March 15, 2010 is included in Note 9,Notes Payable.

The following tables present condensed consolidatingbalance sheets for the years ended December 31, 2005 and 2006 andcondensed consolidating statements of operations and cash flows for the yearsended December 31, 2006, 2005 and 2004.

F-22

----

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

**Note 14:   Condensed ConsolidatingFinancial Information**

**Condensed Consolidating Balance SheetsAs of December 31, 2006**

| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                                 |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                  |       |                   | $          | 18,868        |       |             | $          | —           |       |             | $          | 2,278 |   |   |   | $ | — |   |   |   | $ | 21,146 |   |   |
| Restricted cash                                            |       |                   | 1,224      |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 1,224 |   |   |
| Available-for-sale securities                              |       |                   | 17,097     |          |       | —           |       |             | —     |             |       |   | — |   |   |   | 17,097 |   |   |
| Accounts receivable                                        |       |                   | —     |          |       | —           |       |             | 27,592     |             |       |   | — |   |   |   | 27,592 |   |   |
| Other receivables                                          |       |                   | 304        |          |       | —           |       |             | 3,721      |             |       |   | — |   |   |   | 4,025 |   |   |
| Inventories                                                |       |                   | —     |          |       | —           |       |             | 3,552      |             |       |   | — |   |   |   | 3,552 |   |   |
| Prepaid expenses                                           |       |                   | 893        |          |       | —           |       |             | 1,421      |             |       |   | — |   |   |   | 2,314 |   |   |
| Total current assets                                       |       |                   | 38,386     |          |       | —           |       |             | 38,564     |             |       |   | — |   |   |   | 76,950 |   |   |
| Property and equipment, net                                |       |                   | 97,535     |          |       | —           |       |             | 48,250     |             |       |   | — |   |   |   | 145,785 |   |   |
| Investment in affiliates                                   |       |                   | 126,830    |          |       | —           |       |             | —     |             |       |   | (126,830 | ) |   |   | — |   |   |
| Other assets                                               |       |                   | 513        |          |       | —           |       |             | 1,672      |             |       |   | — |   |   |   | 2,185 |   |   |
| Goodwill                                                   |       |                   | —     |          |       | —           |       |             | 59,670     |             |       |   | — |   |   |   | 56,670 |   |   |
| Intangible assets, net                                     |       |                   | 16,011     |          |       | 4,842            |       |             | 25,078     |             |       |   | — |   |   |   | 45,931 |   |   |
| Total assets                                               |       |                   | $          | 279,275       |       |             | $          | 4,842            |       |             | $          | 173,234 |   |   |   | $ | (126,830 | ) |   |   | $ | 330,521 |   |   |
| **Liabilities and stockholders’ equity  (deficit)**   |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Current liabilities:                                       |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Accounts payable                                           |       |                   | $          | 14,070        |       |             | $          | —           |       |             | $          | 3,571 |   |   |   | $ | — |   |   |   | $ | 17,641 |   |   |
| Accrued telecommunication costs                            |       |                   | —     |          |       | —           |       |             | 5,730      |             |       |   | — |   |   |   | 5,730 |   |   |
| Accrued office rent                                        |       |                   | 1,768      |          |       | —           |       |             | 753        |             |       |   | — |   |   |   | 2,521 |   |   |
| Accrued interest expense                                   |       |                   | —     |          |       | 3,828            |       |             | 1          |             |       |   | — |   |   |   | 3,829 |   |   |
| Other accrued expenses                                     |       |                   | 911        |          |       | —           |       |             | 6,522      |             |       |   | — |   |   |   | 7,433 |   |   |
| Deferred revenue                                           |       |                   | —     |          |       | —           |       |             | 10,109     |             |       |   | — |   |   |   | 10,109 |   |   |
| Accrued compensation expenses                              |       |                   | 2,597      |          |       | —           |       |             | 1,577      |             |       |   | — |   |   |   | 4,174 |   |   |
| Capital lease obligation, current  maturities              |       |                   | 2,616      |          |       | —           |       |             | 515        |             |       |   | — |   |   |   | 3,131 |   |   |
| Total current liabilities                                  |       |                   | 21,962     |          |       | 3,828            |       |             | 28,778     |             |       |   | — |   |   |   | 54,568 |   |   |
| Long-term liabilities:                                     |       |                   |       |          |       |             |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Other long-term liabilities                                |       |                   | 25         |          |       | —           |       |             | 1,237      |             |       |   | — |   |   |   | 1,262 |   |   |
| Capital lease obligation, less current  maturities         |       |                   | 1,490      |          |       | —           |       |             | 711        |             |       |   | — |   |   |   | 2,201 |   |   |
| Notes payable                                              |       |                   | —     |          |       | 141,040          |       |             | —     |             |       |   | — |   |   |   | 141,040 |   |   |
| Due to (from) affiliates                                   |       |                   | 336,758    |          |       | (136,599         | )          |             | (200,159   | )                |       |   | — |   |   |   | — |   |   |
| Total liabilities                                          |       |                   | 360,235    |          |       | 8,269            |       |             | (169,433   | )                |       |   | — |   |   |   | 199,071 |   |   |
| Convertible preferred stock                                |       |                   | —     |          |       | —           |       |             | —     |             |       |   | — |   |   |   | — |   |   |
| Stockholders’ equity (deficit)                        |       |                   | (80,960    | )             |       | (3,427           | )          |             | 342,667    |             |       |   | (126,830 | ) |   |   | 131,450 |   |   |
| Total liabilities and stockholders’ equity  (deficit) |       |                   | $          | 279,275       |       |             | $          | 4,842            |       |             | $          | 173,234 |   |   |   | $ | (126,830 | ) |   |   | $ | 330,521 |   |   |

 

F-23

----

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

**Note 14:   Condensed ConsolidatingFinancial Information (Continued)**

**Condensed Consolidating 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                                   |       |                   | 211,456    |          |       | (103,502         | )          |             | (107,954   | )                |       |   | — |   |   |   | — |   |   |
| Total liabilities                                          |       |                   | 235,538    |          |       | (8,732           | )          |             | (87,513    | )                |       |   | — |   |   |   | 139,293 |   |   |
| Stockholders’ equity (deficit)                        |       |                   | (47,475    | )             |       | 13,320           |       |             | 185,454    |             |       |   | (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 and per Unit Amounts)**

**Note 14:   Condensed ConsolidatingFinancial Information (Continued)**

**Condensed Consolidating Statement ofOperationsFor the Year Ended December 31, 2006**

| ** **                                                             | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                             | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                             | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| Revenue:                                                               |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services                                                       |       |                   | $          | —        |       |             |       | $                | —     |   |   |   | $ | 244,702 |   |   |   | $ | 244,702 |   |   |
| Business telephone systems                                             |       |                   | —     |          |       |             | —     |             |       |   | 29,824 |   |   |   | 29,824 |   |   |
|                                                                   |       |                   | —     |          |       |             | —     |             |       |   | 274,526 |   |   |   | 274,526 |   |   |
| Cost and expenses:                                                     |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services expense (exclusive of depreciation  and amortization) |       |                   | —     |          |       |             | —     |             |       |   | 98,664 |   |   |   | 98,664 |   |   |
| Business telephone systems                                             |       |                   | —     |          |       |             | —     |             |       |   | 18,427 |   |   |   | 18,427 |   |   |
| Sales, general and administrative                                      |       |                   | 54,489     |          |       |             | —     |             |       |   | 49,080 |   |   |   | 103,569 |   |   |
| Depreciation and amortization                                          |       |                   | 23,334     |          |       |             | —     |             |       |   | 18,913 |   |   |   | 42,247 |   |   |
| Operating income (loss)                                                |       |                   | (77,823    | )             |       |             | —     |             |       |   | 89,442 |   |   |   | 11,619 |   |   |
| Other income (expense)                                                 |       |                   | 2,361      |          |       |             | (16,747    | )                |       |   | (13 | ) |   |   | (14,399 | ) |   |
| Income (loss) before income taxes                                      |       |                   | (75,462    | )             |       |             | (16,747    | )                |       |   | 89,429 |   |   |   | (2,780 | ) |   |
| Income taxes                                                           |       |                   | —     |          |       |             | —     |             |       |   | — |   |   |   | — |   |   |
| Net income (loss)                                                      |       |                   | $          | (75,462       | )          |             |       | $                | (16,747    | ) |   |   | $ | 89,429 |   |   |   | $ | (2,780 | ) |   |

 

**Condensed Consolidating Statement ofOperationsFor 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 and expenses:                                                     |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services expense (exclusive of depreciation  and amortization) |       |                   | —     |          |       |             | —     |             |       |   | 85,914 |   |   |   | 85,914 |   |   |
| Business telephone systems                                             |       |                   | —     |          |       |             | —     |             |       |   | 16,139 |   |   |   | 16,139 |   |   |
| Sales, general and administrative                                      |       |                   | 42,551     |          |       |             | —     |             |       |   | 47,759 |   |   |   | 90,310 |   |   |
| Depreciation and amortization                                          |       |                   | 22,160     |          |       |             | —     |             |       |   | 17,493 |   |   |   | 39,653 |   |   |
| Operating income (loss)                                                |       |                   | (64,711    | )             |       |             | —     |             |       |   | 60,438 |   |   |   | (4,273 | ) |   |
| Other income (expense)                                                 |       |                   | (342       | )             |       |             | (27,093    | )                |       |   | 66 |   |   |   | (27,369 | ) |   |
| Income (loss) before income taxes                                      |       |                   | (65,053    | )             |       |             | (27,093    | )                |       |   | 60,504 |   |   |   | (31,642 | ) |   |
| Income taxes                                                           |       |                   | (4         | )             |       |             | —     |             |       |   | — |   |   |   | (4 | ) |   |
| Net income (loss) before discontinued  operation                       |       |                   | (65,057    | )             |       |             | (27,093    | )                |       |   | 60,504 |   |   |   | (31,646 | ) |   |
| Income from discontinued operation, net of  tax                        |       |                   | —     |          |       |             | —     |             |       |   | 329 |   |   |   | 329 |   |   |
| Gain on sale of discontinued operation, net  of tax                    |       |                   | 326        |          |       |             | —     |             |       |   | — |   |   |   | 326 |   |   |
| Net income (loss)                                                      |       |                   | $          | (64,731       | )          |             |       | $                | (27,093    | ) |   |   | $ | 60,833 |   |   |   | $ | (30,991 | ) |   |

 

F-25

----

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

**Note 14:   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 and expenses:                                                     |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Network services expense (exclusive of depreciation  and amortization) |       |                   | —     |          |       |             | —     |             |       |   | 47,354 |   |   |   | 47,354 |   |   |
| Business telephone systems cost of revenue                             |       |                   | —     |          |       |             | —     |             |       |   | 15,979 |   |   |   | 15,979 |   |   |
| Sales, general and administrative                                      |       |                   | 37,400     |          |       |             | —     |             |       |   | 31,855 |   |   |   | 69,255 |   |   |
| Depreciation and amortization                                          |       |                   | 20,734     |          |       |             | —     |             |       |   | 10,371 |   |   |   | 31,105 |   |   |
| 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 and per Unit Amounts)**

**Note 14:   Condensed ConsolidatingFinancial Information (Continued)**

**Condensed Consolidating Statement of CashFlowsFor the Year Ended December 31, 2006**

| ** **                                             | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                             | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating activities**                               |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Net income (loss)                                      |       |                   | $          | (75,462       | )          |             |       | $                | (16,747    | ) |   |   | $ | 89,429 |   |   |   | $ | (2,780 | ) |   |
| Adjustments to reconcile net income (loss):            |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Depreciation and amortization expense                  |       |                   | 23,499     |          |       |             | —     |             |       |   | 18,748 |   |   |   | 42,247 |   |   |
| Non-cash interest expense (interest income)            |       |                   | (13        | )             |       |             | 4,397      |             |       |   | — |   |   |   | 4,384 |   |   |
| Non-cash compensation expense                          |       |                   | 1,680      |          |       |             | —     |             |       |   | — |   |   |   | 1,680 |   |   |
| Other non-cash items                                   |       |                   | (12        | )             |       |             | —     |             |       |   | 1,888 |   |   |   | 1,876 |   |   |
| Changes in operating assets and  liabilities:          |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Accounts receivable                                    |       |                   | —     |          |       |             | —     |             |       |   | (1,476 | ) |   |   | (1,476 | ) |   |
| Accounts payable and accrued expenses                  |       |                   | (282       | )             |       |             | 1,183      |             |       |   | (1,275 | ) |   |   | (374 | ) |   |
| Other operating assets and liabilities                 |       |                   | 720        |          |       |             | —     |             |       |   | (324 | ) |   |   | 396 |   |   |
| Total cash provided by (used in) operating  activities |       |                   | (49,870    | )             |       |             | (11,167    | )                |       |   | 106,990 |   |   |   | 45,953 |   |   |
| **Investing activities**                               |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Purchase of subsidiaries, net of cash  acquired        |       |                   | (67,784    | )             |       |             | —     |             |       |   | 576 |   |   |   | (67,208 | ) |   |
| Purchases of available-for-sale securities             |       |                   | (95,765    | )             |       |             | —     |             |       |   | — |   |   |   | (95,765 | ) |   |
| Proceeds from sales of available-for-sale  securities  |       |                   | 83,462     |          |       |             | —     |             |       |   | — |   |   |   | 83,462 |   |   |
| Purchases of property and equipment                    |       |                   | (30,802    | )             |       |             | —     |             |       |   | (3,475 | ) |   |   | (34,277 | ) |   |
| Cash paid for customer installation costs              |       |                   | (8,525     | )             |       |             | —     |             |       |   | (10,389 | ) |   |   | (18,914 | ) |   |
| Increase in restricted cash                            |       |                   | (228       | )             |       |             | —     |             |       |   | — |   |   |   | (228 | ) |   |
| Proceeds from sale of assets                           |       |                   | 174        |          |       |             | —     |             |       |   | — |   |   |   | 174 |   |   |
| Total cash used in investing activities                |       |                   | (119,468   | )             |       |             | —     |             |       |   | (13,288 | ) |   |   | (132,756 | ) |   |
| **Financing activities**                               |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Proceeds from issuance of notes payable                |       |                   | —     |          |       |             | 45,600     |             |       |   | — |   |   |   | 45,600 |   |   |
| Payments made on notes and capital lease  obligations  |       |                   | (2,519     | )             |       |             | —     |             |       |   | (211 | ) |   |   | (2,730 | ) |   |
| Proceeds from issuance of stock, net of  fees          |       |                   | 40,353     |          |       |             | —     |             |       |   | — |   |   |   | 40,353 |   |   |
| Increase in debt issuance costs                        |       |                   | —     |          |       |             | (1,336     | )                |       |   | — |   |   |   | (1,336 | ) |   |
| Change in due to/from affiliates                       |       |                   | 125,302    |          |       |             | (33,097    | )                |       |   | (92,205 | ) |   |   | — |   |   |
| Total cash provided by (used in) financing  act        |       |                   | 163,136    |          |       |             | 11,167     |             |       |   | (92,416 | ) |   |   | 81,887 |   |   |
| Increase (decrease) in cash and cash  equivalents      |       |                   | (6,202     | )             |       |             | —     |             |       |   | 1,286 |   |   |   | (4,916 | ) |   |
| Cash and cash equivalents at beginning of  period      |       |                   | 25,070     |          |       |             | —     |             |       |   | 992 |   |   |   | 26,062 |   |   |
| Cash and cash equivalents at end of period             |       |                   | $          | 18,868        |       |             |       | $                | —     |   |   |   | $ | 2,278 |   |   |   | $ | 21,146 |   |   |

 

F-27

----

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

**Note 14:   Condensed Consolidating Financial Information(Continued)**

**Condensed Consolidating Statement of CashFlowsFor the Year Ended December 31, 2005**

| ** **                                               | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                               | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                               | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating activities**                                 |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Net income (loss)                                        |       |                   | $          | (64,731       | )          |             |       | $                | (27,093    | ) |   |   | $ | 60,833 |   |   |   | $ | (30,991 | ) |   |
| Adjustments to reconcile net income (loss):              |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Depreciation and amortization expense                    |       |                   | 22,160     |          |       |             | —     |             |       |   | 17,493 |   |   |   | 39,653 |   |   |
| Non-cash interest expense                                |       |                   | 116        |          |       |             | 7,172      |             |       |   | — |   |   |   | 7,288 |   |   |
| Non-cash compensation expense                            |       |                   | 963        |          |       |             | —     |             |       |   | — |   |   |   | 963 |   |   |
| Gain on sale of discontinued operation                   |       |                   | (326       | )             |       |             | —     |             |       |   | — |   |   |   | (326 | ) |   |
| Other non-cash items                                     |       |                   | (66        | )             |       |             | —     |             |       |   | 1,090 |   |   |   | 1,024 |   |   |
| Changes in operating assets and  liabilities:            |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Accounts receivable                                      |       |                   | —     |          |       |             | —     |             |       |   | (5,145 | ) |   |   | (5,145 | ) |   |
| Accounts payable and accrued expenses                    |       |                   | 10,392     |          |       |             | (1,423     | )                |       |   | (6,836 | ) |   |   | 2,133 |   |   |
| Discontinued assets, net of liabilities                  |       |                   | 222        |          |       |             | —     |             |       |   | — |   |   |   | 222 |   |   |
| Other operating assets and liabilities                   |       |                   | (36        | )             |       |             | —     |             |       |   | 243 |   |   |   | 207 |   |   |
| Total cash provided by (used in) operating  activities   |       |                   | (31,306    | )             |       |             | (21,344    | )                |       |   | 67,678 |   |   |   | 15,028 |   |   |
| **Investing activities**                                 |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Purchase of subsidiaries, net of cash  acquired          |       |                   | (48        | )             |       |             | —     |             |       |   | — |   |   |   | (48 | ) |   |
| Purchase of asset held for sale, net of  liabilities     |       |                   | (216       | )             |       |             | —     |             |       |   | — |   |   |   | (216 | ) |   |
| Purchases of available-for-sale securities               |       |                   | (30,526    | )             |       |             | —     |             |       |   | — |   |   |   | (30,526 | ) |   |
| Proceeds from sales of available-for-sale  securities    |       |                   | 32,312     |          |       |             | —     |             |       |   | — |   |   |   | 32,312 |   |   |
| Purchase of property and equipment                       |       |                   | (13,580    | )             |       |             | —     |             |       |   | (5,647 | ) |   |   | (19,227 | ) |   |
| Cash paid for customer installation costs                |       |                   | (7,116     | )             |       |             | —     |             |       |   | (6,435 | ) |   |   | (13,551 | ) |   |
| Increase in restricted cash                              |       |                   | (274       | )             |       |             | —     |             |       |   | — |   |   |   | (274 | ) |   |
| Proceeds from sale of assets                             |       |                   | 239        |          |       |             | —     |             |       |   | — |   |   |   | 239 |   |   |
| Purchase of sale of discontinued operation,  net of fees |       |                   | 320        |          |       |             | —     |             |       |   | — |   |   |   | 320 |   |   |
| Total cash used in investing activities                  |       |                   | (18,889    | )             |       |             | —     |             |       |   | (12,082 | ) |   |   | (30,971 | ) |   |
| **Financing activities**                                 |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Payments made on notes and capital lease  obligations    |       |                   | (2,083     | )             |       |             | (49,176    | )                |       |   | (103 | ) |   |   | (51,362 | ) |   |
| Proceeds from issuance of stock, net of  fees            |       |                   | 67,280     |          |       |             | —     |             |       |   | — |   |   |   | 67,280 |   |   |
| Increase in debt issuance costs                          |       |                   | —     |          |       |             | (348       | )                |       |   | — |   |   |   | (348 | ) |   |
| Change in due to/from affiliates                         |       |                   | (16,264    | )             |       |             | 70,868     |             |       |   | (54,604 | ) |   |   | — |   |   |
| Total cash provided by (used in) financing  act          |       |                   | 48,933     |          |       |             | 21,344     |             |       |   | (54,707 | ) |   |   | 15,570 |   |   |
| Increase (decrease) in cash and cash  equivalents        |       |                   | (1,262     | )             |       |             | —     |             |       |   | 889 |   |   |   | (373 | ) |   |
| Cash and cash equivalents at beginning of  period        |       |                   | 26,332     |          |       |             | —     |             |       |   | 103 |   |   |   | 26,435 |   |   |
| Cash and cash equivalents at end of period               |       |                   | $          | 25,070        |       |             |       | $                | —     |   |   |   | $ | 992 |   |   |   | $ | 26,062 |   |   |

 

F-28

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

**Note 14:   Condensed Consolidating Financial Information(Continued)**

**Condensed Consolidating Statement of CashFlowsFor the Year Ended December 31, 2004**

| ** **                                             | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                             | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating activities**                               | ** ** |                   | ** ** | ** **    |       | ** **       | ** ** |             | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income (loss)                                      |       |                   | $          | (59,217       | )          |             | $          | 7,811            |       |   | $ | 52,517 |   |   |   | $ | 1,111 |   |   |
| Adjustments to reconcile net income (loss):            |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Depreciation and amortization expense                  |       |                   | 20,734     |          |       | —           |       |             | 10,371     |   |   |   | 31,105 |   |   |
| Non-cash interest expense                              |       |                   | —     |          |       | 2,339            |       |             | —     |   |   |   | 2,339 |   |   |
| Non-cash compensation expense                          |       |                   | 34         |          |       | —           |       |             | —     |   |   |   | 34 |   |   |
| Gain on extinguishment of debt                         |       |                   | —     |          |       | (18,195          | )          |             | —     |   |   |   | (18,195 | ) |   |
| Other non-cash items                                   |       |                   | 155        |          |       | —           |       |             | 721        |   |   |   | 876 |   |   |
| Changes in operating assets and  liabilities:          |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Accounts receivable                                    |       |                   | —     |          |       | —           |       |             | 658        |   |   |   | 658 |   |   |
| Accounts payable and accrued expenses                  |       |                   | 3,002      |          |       | 4,070            |       |             | 1,912      |   |   |   | 8,984 |   |   |
| Other operating assets and liabilities                 |       |                   | (969       | )             |       | —           |       |             | 172        |   |   |   | (797 | ) |   |
| Total cash provided by (used in) operating  activities |       |                   | (36,261    | )             |       | (3,975           | )          |             | 66,351     |   |   |   | 26,115 |   |   |
| **Investing activities**                               |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Purchase of subsidiaries, net of cash  acquired        |       |                   | (45,816    | )             |       | —           |       |             | 321        |   |   |   | (45,495 | ) |   |
| Purchases of available-for-sale securities             |       |                   | (8,198     | )             |       | —           |       |             | —     |   |   |   | (8,198 | ) |   |
| Proceeds from sales of available-for-sale  securities  |       |                   | 2,041      |          |       | —           |       |             | —     |   |   |   | 2,041 |   |   |
| Purchase of property and equipment                     |       |                   | (13,101    | )             |       | —           |       |             | (2,313     | ) |   |   | (15,414 | ) |   |
| Cash paid for customer installation costs              |       |                   | (7,553     | )             |       | —           |       |             | (3,740     | ) |   |   | (11,293 | ) |   |
| Increase in restricted cash                            |       |                   | (722       | )             |       | —           |       |             | —     |   |   |   | (722 | ) |   |
| Proceeds from sale of assets                           |       |                   | 25         |          |       | —           |       |             | —     |   |   |   | 25 |   |   |
| Total cash used in investing activities                |       |                   | (73,324    | )             |       | —           |       |             | (5,732     | ) |   |   | (79,056 | ) |   |
| **Financing activities**                               |       |                   |       |          |       |             |       |             |       |   |   |   |   |   |   |
| Proceeds from issuance of notes payable                |       |                   | —     |          |       | 136,163          |       |             | —     |   |   |   | 136,163 |   |   |
| Payments made on notes and capital lease  obligations  |       |                   | (1,527     | )             |       | (65,421          | )          |             | —     |   |   |   | (66,948 | ) |   |
| Proceeds from issuance of stock, net of  fees          |       |                   | 15,008     |          |       | —           |       |             | —     |   |   |   | 15,008 |   |   |
| Payment on repurchase of preferred stock               |       |                   | (5,085     | )             |       | —           |       |             | —     |   |   |   | (5,085 | ) |   |
| Increase in debt issuance costs                        |       |                   | —     |          |       | (8,368           | )          |             | —     |   |   |   | (8,368 | ) |   |
| Change in due to/from affiliates                       |       |                   | 118,635    |          |       | (58,399          | )          |             | (60,236    | ) |   |   | — |   |   |
| Total cash provided by (used in) financing  act        |       |                   | 127,031    |          |       | 3,975            |       |             | (60,236    | ) |   |   | 70,770 |   |   |
| Increase (decrease) in cash and cash  equivalents      |       |                   | 17,446     |          |       | —           |       |             | 383        |   |   |   | 17,829 |   |   |
| Cash and cash equivalents at beginning of  period      |       |                   | 8,886      |          |       | —           |       |             | (280       | ) |   |   | 8,606 |   |   |
| Cash and cash equivalents at end of period             |       |                   | $          | 26,332        |       |             | $          | —           |       |   | $ | 103 |   |   |   | $ | 26,435 |   |   |

 

**Note 15:   Subsequent Events**

In February 2007, the Company signed a definitiveagreement to acquire United Communications, Inc., (UNICOM), aprivately-held competitive services provider based in Bend, Oregon. The Companywill pay approximately $13,900 in cash to acquire UNICOM. The transaction isexpected to close early in the second quarter of 2007.

F-29

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