**UNITED STATES**SECURITIES AND EXCHANGE COMMISSION

**Washington,D.C. 20549**

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FORM 10-K

**(Mark one)**

**x**                              AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934 for the fiscal year ended December 31, 2004.

**OR**

**o**                                 TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934.

**CommissionFile Number:  000-24643**

**DIGITAL RIVER, INC.**

(Exact name of registrantas specified in its charter)

| **DELAWARE**                                                      | ** ** | **41-1901640**                        |
|-------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of   Incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**9625 WEST 76TH STREET,SUITE 150EDEN PRAIRIE, MINNESOTA 55344**

(Address of principalexecutive offices)

**(952) 253-1234**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act: None

Securities registeredpursuant to Section 12(g) of the Act:

**CommonStock $0.01 par value**

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to filing requirements forthe past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot 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 amendment tothis Form 10-K. o

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2) Yes x  No o

Asof June 30, 2004, there were 32,394,116 shares of Digital River, Inc.common stock, issued and outstanding. As of such date, based on the closingsales price as quoted by the Nasdaq, 31,298,984 shares of common stock, havingan aggregate market value of approximately $1,021,286,000 were held by non-affiliates.For purposes of the above statement only, all directors and executive officersof the registrant are assumed to be affiliates.

The number of shares ofcommon stock outstanding at March 1, 2005 was 34,179,543 shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

Certainsections of the Registrant’s definitive Proxy Statement for the 2005 AnnualMeeting of Stockholders are incorporated by reference in Part III of this Form 10-Kto the extent stated herein.

 

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**PART I**

**ITEM 1.   BUSINESS.**

**CAUTIONARYSTATEMENT PURSUANT TO THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

Certain statements setforth or incorporated by reference in this Form 10-K, as well as in ourAnnual Report to Stockholders for the year ended December 31, 2004,constitute “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Words such as “believes”, “anticipates”,“expects”, “intends”, “estimates” and similar expressions are intended toidentify forward-looking statements, but are not the exclusive means ofidentifying such statements. These statements involve known and unknown risks,uncertainties and other factors that may cause our actual results, performanceor achievements, or industry results, to be materially different from anyfuture results, performance or achievements, or industry results, expressed orimplied by such forward-looking statements. Such factors include, among others:our limited operating history and variability of operating results; risksassociated with general economic uncertainty; our dependence on software anddigital products publishers, manufacturers, online retailers and online channelpartners; the integration of acquired companies; risks associated with electronicsoftware delivery; our dependence on the Internet and the growth in e-commerceand Internet infrastructure development; competition in the e-commerceindustry; our dependence on key customers; our dependence on key employees;system development and e- commerce security risks; changes in laws andregulations; and other risk factors set forth under “Risk Factors” andelsewhere in this Form 10-K. We expressly disclaim any obligation toupdate or publicly release any revision to these forward-looking statementsafter the date of this Form 10-K.

**Overview**

We are a provider of comprehensive e-commerceoutsourcing solutions. We were incorporated in February 1994 and commencedoffering products for sale through our clients’ e-commerce stores in August 1996.As a leading global e-commerce outsource provider, we have developed aproprietary technology platform that allows us to provide our clients with asuite of e-commerce services, including e-commerce site development andhosting, site merchandising, order management, fraud prevention, denied partiesscreening, export controls, tax management, digital and physical productfulfillment, multi-lingual customer service, email marketing and advancedreporting and web analytics.

Our solution allows our clients to promote andmaintain their brands while leveraging our investment in infrastructure andtechnology. Our clients access our e-commerce platform over the Internet. Froma shopper perspective, end-users enter the client site and are then seamlesslytransferred to our e-commerce platform. End-users can then browse for productsand make purchases online, and once purchases are made, we either deliver theproducts digitally to the end-user through the Internet or communicate theorder through a third-party fulfillment agency for physical delivery.

We also offer a wide range of analytics-based,strategic marketing services to help our clients increase their customeracquisition, retention and lifetime value. These services include paid searchadvertising, search engine optimization, affiliate marketing, site/storeoptimization and email optimization to help our clients increase their customeracquisition, retention and lifetime value.

Some of our key clients include Allume Systems, Inc.,Autodesk, Inc., CompUSA, DownloadSuperstore.com, eBay, Inc., H&RBlock Inc., McAfee, Inc., Microsoft Corporation, OfficeMax Incorporated,PC Magazine, Scansoft, Inc., Software Oasis, Inc., SymantecCorporation, Targus Inc. and Trend Micro, Inc.

General information aboutus can be found at *www.digitalriver.com*under the “Investor Relations” link. Our annual report on Form 10-K,quarterly reports on Form 10-Q and current reports on Form 8-K, 

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as wellas any amendments or exhibits to those reports are available free of chargethrough our website as soon as reasonably practicable after we provide them tothe Securities and Exchange Commission.

**Industry Background**

*Growth of the Internet and E-Commerce.  *E-commercesales continue to grow at a rapid pace. On the consumer front, resultspublished by the U.S. Department of Commerce, in November 2004, show quarterlyU.S. e-commerce retail sales have grown 20 percent on a year over year basissince the first quarter of 2002. Many industry analysts predict stronge-commerce growth rates to continue in the U.S., with even higher expectedgrowth rates in European and Asia-Pacific markets. There are a number offactors that are fueling the growth of e-commerce: (i) adoption of theInternet continues to rise, especially in international markets; (ii) broadbandis becoming more widely available and adopted by Internet users, especiallywith lower-penetrated consumer and small to medium sized business markets, andaccording to recent studies, usage of consumer broadband has eclipsed the usageof dial-up within the U.S. for the first time; (iii) Internet users likethe convenience of buying products online and they are becoming more familiarand comfortable with the online buying process; (iv) enhancements toonline store functionality, such as new payment methods, browsing/searchoptions, pricing models and delivery options are improving end-user acceptance;and (v) businesses are placing increased emphasis on their online businessbecause they can reach a large group of end-users through personalized,low-cost interactions without having to bear the costs associated withmaintaining a physical retail store infrastructure or the continuous printingand mailing costs of direct marketing. Because of these advantages, onlinebusinesses have the potential to build large, global customer bases quickly andto achieve potentially superior economic returns over the long term.

*Shift From Physical to ElectronicDelivery.  *In addition to the trends that continue todrive the growth of e-commerce, the shift continues from physical to electronicdelivery of digital products, including music, video and software. This shiftis being driven by both buyers and sellers due to increased broadband adoption,increased consumer confidence with downloading digital files, enhancements inthe protection of digital content, economic benefits derived from electronicdelivery and increasing shelf-space pressures at physical retail outlets. Accordingto a study conducted by a leading industry analyst firm, digital delivery ofsoftware is expected to grow by nearly 40 percent in North America and bynearly 60 percent outside of North America, per year, through 2006.

*Advantages and Opportunities forE-Commerce Outsourcing.  *There are a number ofadvantages to outsourcing e-commerce, including: (i) avoiding the large,upfront and ongoing investment required to purchase, implement and maintainsoftware applications and computer hardware; (ii) shortening the time tomarket as compared to in-house development and maintenance; (iii) shiftingthe ongoing financial, technology and other risks to a proven service provider;(iv) leveraging the expertise of an outsource provider to accelerategrowth of an online business; and (v) allowing businesses to focus ontheir specific core competency. Because of these advantages, we believe that anincreasing number of businesses will outsource their e-commerce needs. Theseadvantages are supported by industry trends. Some industry studies indicateoutsourcing of customer relationship management applications, such ase-commerce, will rise from under 20 percent currently, to over 50 percent inthe next three years.

We believe that the market for e-commerce outsourcingwill continue to grow rapidly. We believe that providing an integrated,end-to-end service offering is complex and requires significant upfront andongoing investments in robust, secure, reliable and scalable systems. Accordingly,we believe that a substantial market opportunity exists for a comprehensive,cost-effective, outsourced e-commerce solution that provides global support forsoftware and digital products publishers, manufacturers and online retailers.

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*TheDigital River Solution.  *We have developed a robuste-commerce technology platform and suite of e-commerce services to helpbusinesses worldwide grow their online revenues and avoid the costs and risksassociated with running a global e-commerce operation in-house. We provide acomplete, client-branded, e-commerce outsourcing solution that includese-commerce site development and hosting, site merchandising, order management,fraud prevention, denied parties screening, export controls, tax management,digital and physical product fulfillment, multi-lingual customer service, emailmarketing, reporting and web analytics and strategic marketing services. Wealso provide our clients with increased product visibility and salesopportunities through our large network of online channel partners, includingretailers, content sites and portals.

***BenefitsTo Clients***.

*Reduced Total Costof Ownership and Risk*

Businesses can reduce thetotal cost of ownership of their e-commerce operation by leveraging ourinvestment in technology, personnel and infrastructure. By reducing oreliminating the upfront and ongoing costs of hardware, software and personnelassociated with developing, customizing, deploying, maintaining and upgradingan in-house e-commerce solution or software package, businesses can establishand maintain an e-commerce business at a lower total cost and with littlefinancial risk. Additionally, our ongoing investment in the latest technologiesand e-commerce functionality helps our clients ensure that they maintain pacewith the newest industry advances.

*Revenue Growth*

Our e-commerce technology platform, marketingexpertise and large network of clients and partners provide our clients withthe potential to grow their online businesses by: (1) increasing theacquisition, retention and lifetime value of new customers; (2) extendingtheir businesses into international markets; and (3) expanding thevisibility and sales of their products through new online sales channels.

Working with thousands of companies since 1996, wehave developed the technology, services, expertise and best practices in thearea of marketing and merchandising that can help our clients grow their onlinebusinesses by increasing traffic, close ratios, average order sizes and repeatpurchases.

We also provide the technology and services needed tosupport international sales. Our technology platform supports multipletransaction currencies, payment options and localized content required tosuccessfully sell products in international markets.

In addition, through ourlarge sales network, we believe we are uniquely positioned to help our clientsgrow their online businesses by providing them with access to new onlinechannels. Our software and digital products clients have the opportunity toincrease availability and sales of their products by offering part or all oftheir entire online product catalog to our network of online channel partners,which includes online retailers, content sites and portals. This arrangement isbeneficial to both our software and digital products clients and online channelpartner clients because we eliminate the burden of developing and maintaininghundreds of relationships. The online channel partners also enjoy access to amuch broader inventory of software products, and avoid the costs and risk ofcarrying physical inventory.

*Deployment Speed*

Companies can increasetheir speed to market by leveraging our outsourced business model, technologyplatform and remote control tools to establish their e-commerce business,typically in a matter of days or weeks. Once up and running, clients can useour remote control toolset to continue to make real-time changes to theire-commerce site, allowing them to address or respond to both opportunities andproblems without technological assistance.

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*Focus on CoreCompetency*

Companies can focus their efforts on developing,marketing and selling their products and services instead of deployingresources to develop and maintain an end-to-end e-commerce infrastructure. Thishelps minimize management distractions and ensure they have access to thelatest technologies and tools to run a successful e-commerce business.

*Benefits To End-Users.  *Oursolution emphasizes convenience by allowing end-users, both business andconsumer, to purchase products online from their home or office. By supportingglobal markets, we can deliver an extremely broad selection of digital andphysical products to end-users in remote locations that cannot support retailstores. In the case of software and digital products, users have the option toquickly and conveniently download and install products through electronicdelivery. Using our sophisticated search engine technology, end-users visitingretailers’ e-commerce stores can access virtually our entire inventory ofsoftware and digital products. End-users also benefit from the protection ofour download assurance service, through which we guarantee replacement ofsoftware in the event of accidental destruction through computer error ormalfunction, and from our 24x7 customer service provided on behalf of ourclients.

**Strategy**

Our objective is to be the global leader in e-commerceoutsourcing for software and digital products publishers, manufacturers, onlineretailers and online channel partners.

We intend to achieve our objective through thefollowing key strategies:

*Attract New Clients and Expand Relationships WithExisting Clients.  *We intend to focus our efforts onsecuring new relationships and expanding our existing relationships withsoftware publishers, manufacturers, online retailers and online channelpartners. In 2004, we entered into contracts with Circuit City Stores, Inc.,CompUSA, Computer Associates International, Inc., eBay, Inc.,Microsoft Corporation, Newegg.com, PC Universe, Inc., and the DigitalProducts Division of Toshiba America Information Systems, Inc. By furtherincreasing the range of products, services and pricing alternatives we offer,we intend to attract new clients and secure additional business from ourexisting clients. Furthermore, by increasing the size of our software anddigital products catalog through new client relationships, we believe we willcontinue to attract new online retailers, content sites and portals. As of March 1,2005, we were providing e-commerce services for more than 40,000 software anddigital products publishers, manufacturers, online retailers and online channelpartners.

*Expand International Sales.  *Webelieve that there is a substantial opportunity to grow our business byexpanding existing and new client sales through international online stores. Internetadoption, broadband penetration and e-commerce sales growth continue to showrapid growth in the European and Asia-Pacific regions. We have seen significantgrowth in sales for those clients that have offered international stores and weintend to continue to enhance our technology platform and services to increasesales in these regions of the world. We plan to continue to expand our supportfor international stores with new payment methods, shipping options andon-the-ground operational support.

*Leverage The Digital River SalesNetwork To Expand Sales Opportunities For Our Clients.  *Webelieve we have amassed one of the largest catalogs of software and digitalproducts in the industry as a result of our client relationships. By makingthis catalog available to our large network of online channel partners, whichincludes online retailers, content sites, portals and entrepreneurs, we believewe can further grow our clients’ sales by delivering a large, global network ofbuyers. We plan to continue to aggressively expand our catalog of products,pursue new online partners and expand our offering of programs and tools toallow our clients to sell their products through our vast partner network. Webelieve our network is 

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unique in the marketplace,provides significant revenue opportunities and will help us build strongerrelationships with our clients.

*Drive Growth Through AggressiveMerchandising and Marketing.  *We believe that we havedeveloped technology, services, expertise and best practices in the areas ofmarketing and merchandising that can help our clients grow their onlinebusinesses by utilizing numerous proven tools and programs and our expandingdata warehouse of end-user purchasing information to increase traffic, closeratios, average order sizes and repeat purchases. We will continue to developand utilize a wide range of marketing and merchandising programs and ourgrowing data warehouse of end-user purchasing information to help grow ourclients’ businesses.

*Provide Clients With Strategic Marketing Services.  *Weproactively develop and deliver new products and services designed to help ourclients increase their customer acquisition and retention and maximize lifetimevalue. We have launched several strategic marketing services such as paidsearch advertising, search engine optimization, affiliate marketing, site/storeoptimization and email marketing/optimization. With these Digital River-managedprograms, we have achieved significant improvements in revenue,return-on-investment or both, in comparison to what our clients accomplished ontheir own. We plan to continue to aggressively develop and offer newvalue-added strategic marketing services and supporting technologies to createadditional sources of recurring revenue for our clients and for Digital River.

*Expand the Breadth and Use of OurRemote Control Tool Set.  *We will continue to expand ourremote control tool set to give our clients more hands-on control over theirsite on a day-to-day basis and give us more time to help our clients launchmore strategic revenue-generating programs.

*Provide Clients With FlexibleSolution Options.  *We offer our clients a wide range ofservice options from a simple shopping cart solution to an end-to-ende-commerce store. This approach is designed to give our clients a variety ofchoices based upon their specific needs. We plan to continue expanding thesolution choices we offer our clients to provide even more alternatives and theoption to expand their services as their needs grow.

*Maintain Technology Leadership.  *Webelieve that our technology infrastructure and platform have given us acompetitive advantage in the market for e-commerce outsourcing solutions. In2004, we expanded our technology footprint to include advanced optimization,web analytics and email marketing capabilities designed to help our clientsfurther attract, retain and maximize the lifetime value of their customers. Weplan to continue to invest in and enhance our platform in order to increasefunctionality, reliability, scalability and performance and reduce costs. Byleveraging our fixed-cost infrastructure, we will improve our ability toprovide low cost, high value services to our clients while utilizing the latesttechnology. Additionally, we plan to continue to develop and enhance ourtechnology to allow our clients to support new sales models, enhance theirrelationship with their customers and address new market segments throughtry-before-you-buy sales, subscription sales, volume licensing, digital rightsmanagement and license management, among others.

**Services**

We provide a broad range of services to our clients,including e-commerce site development and hosting, site merchandising, ordermanagement, fraud prevention, denied parties screening, export controls, taxmanagement, digital and physical product fulfillment, multi-lingual customerservice, email marketing, advanced reporting and analytics and a wide range ofstrategic marketing services. Management of most of these services is performedthrough a rich set of client-facing remote control tools designed for businessusers.

*Web Site Development and Hosting.  *Weprovide hosted e-commerce capabilities for our software and digital productspublishers, manufacturers, online retailers and online channel partners. Formany of these 

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clients, this outsourcingsolution is mission critical and therefore we operate data centers that performand scale for continuous e-commerce in a high demand environment. Our multiple,global data centers feature fully redundant, high-speed connections to theInternet, server capacity to handle rapid spikes in traffic and transactions,24x7 security and monitoring, back-up generators and dedicated power.

Our e-commerce capabilities are deployed quickly andefficiently for our clients, and can be implemented in many different ways,from hosted e-commerce links behind “buy buttons” through fully merchandisedonline stores. We match the branding and designs of our clients to provide aseamless experience for end-users navigating from our clients’ Web sites totheir stores hosted on our technology platform. We fully manage orders placedby end-users for payment processing, fraud screening and fulfillment, eitherdigitally or physically, as well as the end-user notifications that result fromthese processes. The transaction information is captured in our data warehouseand made available to our clients for reporting and analysis. This datawarehouse is a powerful source for data analysis activities that result inhighly targeted merchandising, e-mail marketing campaigns, product offers andtest/control marketing efforts.

*Site Merchandising.  *Ourtechnology platform supports a wide range of merchandising alternatives thatallow our clients to feature, promote, up-sell and cross-sell specific productsor services during any phase of the shopping process. From the store home page throughthe checkout pages and “thank you” page, our solution allows our clientsto deliver targeted offers designed to increase close ratios and average ordervalues.

*Order Management and Fraud Screening.  *Weprocess payment transactions generated by end-users ordering products throughour platform. We support payments made via credit cards, but also an expandingset of non-credit card payment methods such as wire transfers, purchase orders,money orders, direct debit checks and many other payment methods popular in theUnited States and worldwide. As part of the payment process, we also ensurethat the appropriate taxes are displayed to the end-user, collected, remittedand reported.

The fraud-screening component of our platform usesboth rules-based and heuristic scoring methods to make a determinationregarding the validity of the order, end-user and payment information. As theend-user is entering the order, hundreds of data reviews can be processed inreal-time. Depending on the contractual agreement, we can provide the use ofour proprietary fraud screening technology to clients for their own processingor completely shift the fraud screening and risk responsibility to us. We alsoprovide denied parties screening and export controls, ensuring persons and/or organizationsappearing on government denied parties lists are blocked from making purchasesthrough our system and providing tools and reporting that enable clients to setup and manage products for international commerce. When a transaction isapproved, and the ordered product has been delivered, we process the order forpayment.

*Digital and Physical Fulfillment Services.  *Digitaldelivery eliminates many of the costs that exist in the physical distributionsupply chain, such as packaging, shipping, warehousing and inventory carryingand handling costs. We offer clients a sophisticated array of electronicsoftware delivery capabilities to permit delivery of digital products to anend-user’s computer via the Internet. Delivery is fulfilled when a copy of thedigital product is made from the master on our technology platform and thensecurely downloaded to the end-user. Optionally, end-users can create a CD ondemand as a backup to their digital order. Our digital distribution model notonly reduces costs, thereby increasing margins available to software anddigital products publishers and online channel partners, but also solves theshelf space problem constraining product availability and sales at physicalstores. While most software and digital products publishers use our e-commercehosting services, certain software and digital products publishers use only ourdigital delivery services, which provide them with online distribution throughour extensive network of online sales partners.

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In addition to fulfillment through electronicdelivery, we offer clients physical distribution services. We have contractedwith third-party fulfillment agents globally that maintain inventories ofphysical products, generally on consignment from our clients that select thisoption, for shipment to end-users. We also communicate orders throughintegration into many client-specific third-party fulfillment agencies forphysical fulfillment. In both cases, we provide notifications to end-users ofshipments, shipment tracking information, inventory updates and order status.We believe physical fulfillment services are important to our ability to providea complete e-commerce outsourcing solution.

*Customer Service.  *We offerboth telephone and email customer support for products sold through ourplatform on behalf of our clients. We provide end-user assistance on order anddelivery questions on a 24x7 basis and in more than a dozen differentlanguages. We have invested, and continue to invest in, technology andinfrastructure to provide fast, efficient responses to customer inquiries, andto provide self-help options to customers online. We also provide extendeddownload services to the end-users that purchase digital products.

*Advanced Reporting and Analytics.  *Weprovide our clients with access to a large library of standard and customizablereports as well as our web analytics technology. This allows our clients totrack and analyze sales, products, transactions, customer behavior and campaignresults so they can maximize their marketing efforts to increase traffic, closeratios and average order values. This information is captured in our datawarehouse and made available to our clients via our web-based, remote controltoolset.

*StrategicMarketing Services.  *We offer a broad range of strategicmarketing services designed to increase customer acquisition, retention andlifetime value. Through a combination of web analytics, statisticalanalytics-based testing, optimization and proven direct marketing practices, ourteam of strategic marketing experts delivers and manages programs such as paidsearch advertising, search engine optimization, affiliate marketing, site/storeoptimization and email optimization on behalf of our clients.

**Clients**

As a provider of comprehensive e-commerce outsourcingsolutions, we are able to serve two distinctive client groups with one commoninfrastructure:  (1) software anddigital products publishers, manufacturers and online retailers; and (2) onlinechannel partners.

In a typical contract with a software and digitalproducts publisher, manufacturer, online retailer or online channel partner, weare responsible for many or all of the following services: (i) initiale-commerce store design/setup, hosting and integration with their web site andorder management system; (ii) fraud screening and the processing ofpayments made by end-users; (iii) management of denied parties screeningand export compliance; (iv) collection, payment and filing of applicabletaxes; (v) product delivery to the end-user in either electronic orphysical form—for electronic delivery we maintain master copies of digitalproducts in a secure format for distribution, and for physical delivery wecommunicate order information to our pre-integrated third-party fulfillmentagencies or integrate with our clients’ fulfillment agencies; (vi) customerservice via email and phone; (vii) returns management (viii) thedistribution of a report to the client detailing related sales activity that wehave processed during the period; and (ix) payment to the client forproducts that we sell and distribute through their store or online partnerstore, excluding our sales fee percentage. As of March 1, 2005, we hadmore than 40,000 contracts with software and digital products publishers,manufacturers, online retailers and online channel partners.

Certain of our softwareand digital products publishers, manufacturers, online retailers and onlinechannel partners clients include:  AllumeSystems, Inc., Autodesk, Inc., CompUSA, DownloadSuperstore.com, eBay, Inc.,H&R Block Inc., McAfee, Inc., Microsoft Corporation, OfficeMaxIncorporated, PC Magazine, Scansoft, Inc., Software Oasis, Inc.,Symantec Corporation, Targus Inc. and Trend Micro, Inc.

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**Acquisitions**

We have been an active acquirer of businesses over thepast several years and expect to continue to actively pursue acquisitions thatfit with our strategy. Important strategic factors that we consider whenevaluating an acquisition opportunity include improving our catalog of contentfor our network partners, extending our service offerings, expanding ourgeographic reach and diversifying our revenue stream into adjacent marketopportunities. Acquisitions of high-technology companies are inherently risky. Noassurance can be given that our previous or future acquisitions will besuccessful or will not materially adversely affect our financial condition oroperating results. The risks associated with acquisitions are more fullydiscussed in the section of this report entitled “Risk Factors.”

In April 2004, we acquired element 5 AG, aprivately held company based in Germany and a leading European e-commercesolution provider for software publishers. Under the terms of the acquisition,we paid $120 million in cash to acquire all of the outstanding shares ofcapital stock of element 5. We also agreed to pay up to an additional $2.5million in cash based on element 5’s operating performance over the first 24months following the closing of the acquisition.

On January 18, 2005, we entered into an agreementwith senior employees of element 5 AG, pursuant to which these employees agreedto cease providing services to element 5 sixty days after the date of theagreement. Pursuant to the agreement, we also agreed to resolve a $12 millionescrow associated with our acquisition of element 5 by distributing $10 millionto the former element 5 shareholders, and $2 million to us. Certain adjustmentswere also made to our earn-out obligations under the April 2004acquisition agreement. Under the restructured earn-out, $2.5 million of cashwill be paid to the former element 5 shareholders in equal increments of $1.25million on March 1, 2005 and 2006. These earn-out amounts have beenrecorded as additional goodwill as they were incremental to the purchase price.Goodwill of  $110.8 million has beenrecorded related to this acquisition. We are amortizing other intangible assetsacquired, consisting of technology/tradename, customer relationships andnon-compete agreements, over a three-year period. The allocation of the purchase price of element 5 to amortizable costsand goodwill has not yet been finalized. The allocation will be finalized at alater date following analysis of the fair value of element 5’s assets. Theresult of the allocation of the purchase price between amortizable costs andgoodwill could have an impact on our future operating results.

In June 2004, we announced that we acquiredsubstantially all of the assets and assumed certain liabilities of Fireclick, Inc.,a leading provider of Web-analysis solutions for online retailers, providingweb site owners with the tools necessary to measure campaign ROI, track userpath analysis and enhance web site user experience. Under the terms of theagreement, we paid $7.5 million in cash and an additional $0.3 million in cashupon the completion of certain integration milestones. Goodwill of  $7.5 million has been recorded as a result ofthis acquisition. We are amortizing other intangible assets acquired,consisting of non-compete agreements and technology/tradename, over athree-year period. The agreement also provides Fireclick the opportunity for anearn-out based on our achieving certain revenue and profitability targetsattributable to Fireclick over the course of the 36 months following theclosing of the acquisition. These earn-out amounts, if paid, will be recordedas goodwill as they are considered incremental to the purchase price.

In November 2004, weacquired all of the outstanding capital stock of BlueHornet Networks, Inc.BlueHornet is a leading provider of e-mail marketing campaign managementservices and related customer relationship management (CRM) tools. Asconsideration for the acquisition, we issued a total of 160 thousand shares ofour common stock to the BlueHornet stockholders, valued at approximately $5.3million, paid off $0.7 million of BlueHornet debt obligations at closing andagreed to pay an additional $0.5 million in cash to the former BlueHornetstockholders following the transition of certain BlueHornet assets to ourfacilities in Eden Prairie, Minnesota. Goodwill of  $4.3 million has been recorded as a result ofthis acquisition. We are amortizing other intangible assets acquired,consisting of technology/tradename, 

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customerrelationships and non-compete agreements, over a three-year period. Inaddition, the former BlueHornet stockholders may receive additional earn-outpayments of cash or our common stock, at our discretion, based on BlueHornet’soperating performance over the first 36 months following the closing of theacquisition. These earn-out amounts, if paid, will be recorded as goodwill asthey are considered incremental to the purchase price.

**Sales and Marketing**

We market our products and services directly toclients and prospective clients. We focus our efforts on generating awarenessfor our brand, establishing our position as a global leader of e-commerceoutsourcing, generating leads in our target markets and providing sales toolsfor our direct sales force. We conduct a variety of highly integrated marketingprograms to achieve these goals in an effective and efficient manner. Wecurrently market our services to clients and prospects via direct marketing,print and electronic advertising, trade shows and events, public relations,media events and speaking engagements. We plan to increase our overallmarketing expenditures on a dollar basis, but maintain the current level on apercentage basis.

We sell our e-commerce outsourcing services primarilythrough a global, direct sales force that is engaged in selling our services,which includes pre-sales, sales, sales support and staff located in offices inthe United States, Europe and Taiwan. Our sales organization sells to topexecutives and vice-presidents within software and digital content publishers,manufacturers, online retailers and online channel partners looking to createor expand their e-commerce business. During the sales process, our sales staffdelivers demonstrations, presentations, collateral, ROI analyses, proposals andcontracts. We offer contract incentives on a case-by-case basis.

We also design, implement and manage marketing andmerchandising programs to help our clients drive traffic to their online storesas well as increase close ratios, average order values and repeat purchases. Ourstrategic e-marketing team delivers a range of marketing and merchandisingprograms such as paid search advertising, search engine optimization, affiliatemarketing, site/store optimization, email marketing/optimization and sitemerchandising, including promotions, cross-sells and up-sells. This teamcombines their marketing domain expertise with our entire suite of technology,including reporting, web analytics, optimization and email to drive increasedsales.

As of March 1, 2005we had 196 employees engaged in sales and marketing including personnel insales offices in the United States, Europe and Taiwan.

**Technology**

We deliver our e-commerce outsourcing solutionprimarily using our Digital River CommerceSuite Technology platform, orCST. The following is a brief description of our CST platform.

*Architecture.  *Our scalableCST platform is designed to handle tens of thousands of individual e-commercestores and millions of products. The CST platform consists of multiple pods ofSun Microsystems and Dell servers and a proprietary software application thatserves dynamic Web pages using Oracle’s 8i and 9i database and 9iASapplication server. Akamai’s worldwide caching technology enables our platformengine to serve pages with consistent page loadtimes across theworld. Our CST platform was designed to scale to support growth by addingadditional servers, CPUs, memory and bandwidth without substantial changes tothe application. The CST platform software code is written in modular layers,enabling us to quickly adapt in response to industry changes, including bandwidthopportunities, payment processing changes, international requirements for taxesand export screening, technologies such as Web Caches, ML, DHTML, VRML, SET,banking procedures and encryption technologies. The CST product search system,based on Verity’s technology, allows end-users to search for items acrossmillions of potential products and thousands of categories specific to variousproduct specifications, while maintaining 

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a fast page responsethat is acceptable to the end-user. We use sophisticated database indexingcoupled with a dynamic cache system to provide flexibility and speed. Thesecaches help increase the overall speed of each page and facilitate complexsearches across our entire inventory of software products. The CST platform hasalso been designed to index, retrieve and manipulate all transactions that flowthrough the system, including detailed commerce transaction and end-userinteraction data. This capability enables us to create proprietary marketprofiles of each end-user and groups of end-users that can then be used tocreate merchandising campaigns. Our CST platform is also used for internalpurposes, including reporting and maintenance for fraud detection andprevention, physical shipping, return authorizations, back order processing andfull transaction auditing and reporting capabilities for all commercefunctions.

*E-Commerce System Maintenance.  *Ourclients’ e-commerce systems are built and maintained using the CST centralizedmanagement system and remote control tools. Global changes that affect alle-commerce systems or groups of e-commerce systems can be made as easily aschanges to an individual e-commerce system. Client e-commerce systems typicallyinclude a main store and may optionally include “channel sites” to which highlytargeted traffic may be routed. Clients may also link specific locations ontheir e-commerce stores to detailed product or category areas of the stores inorder to better target their end-users’ interests.

*Security.  *Our securitysystems control access to internal systems and commerce data via the Internet.Internally, log-ins and passwords are maintained for all systems, withadditional log-ins, passwords and IP access control granted on an individualbasis to only the required commerce areas for which the recipient isresponsible. Multiple layers of firewalls prevent unauthorized access fromoutside or access to confidential data on the inside. We rely on certainencryption and authentication technology licensed from third parties to providesecure transmission of confidential information, such as end-user credit cardnumbers. Unix, Oracle and Web server security additionally restrict access fromthe outside to the appropriate transaction data. The CST security system isdesigned not to interfere with the end-user experience. We believe thatclearing-house processing and additional password mechanisms that negativelyimpact digital delivery performance are not needed. The CST security systemdoes not allow direct access to any client or customer data. It also ensuresthat all end-user requests for digital delivery of product are through a validCST page and that the customer has purchased the product.

*DataCenter Operations.  *Continuous data center operationsare crucial to our success. Our primary data center (DC1) is located in ourmain facility in Eden Prairie, Minnesota.  We also operate two additional data centers inMinneapolis, Minnesota (DC2) and in London, England (DC3). All Data centerlocations are currently processing transactions and downloads.  All transaction data is replicated from DC1 toDC2 and DC3 in less than ten seconds. Our network software constantly monitorsclients’ e-commerce sites and internal system functions and notifies systemsengineers if any unexpected conditions arise. We currently lease five OC3 datalines and two Gigabit Ethernet lines from multiple vendors and maintain apolicy of adding additional lines if more than 50 percent of our bandwidthcapacity is consistently utilized. Accordingly, if one line fails, the otherlines are able to assume the capacity of the failed line. In 2004, we completedvendor qualification process to supply downloads to our customers viadistributed caching servers. Currently, 20 percent of our downloads are servedvia the Mirror Image server network. In the event of electrical power failure,we have three redundant diesel generators and two redundant UPS power suppliesthat protect the entire facility. We have also installed a FM-200 automaticfire suppression system in the primary data center. All data centers currentlyutilize multiple levels of redundant systems including load balancers, Webservers, application servers and disk arrays. We currently have automaticfailover processes in place in case of equipment or software failure. When afault is detected on a server, a process automatically de-configures that nodefrom the production POD and processing continues on the redundant nodes of thePOD.

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**Product Research and Development**

Our product research and development strategy is toenhance the technology and features of our CST platform. To this end, we havenumerous development projects in process, including ongoing development of ourCST platform, further advancements in our remote control technologies, enhancedinternational support, business-to-business related technologies and advancedproduct distribution and marketing technologies. Product research anddevelopment expenses were $14.1 million, $10.0 million and$11.5 million in 2004, 2003 and 2002, respectively. In addition, weexpanded and redeployed our R&D team in 2004 to advance our newself-service, remote control technology, and to develop the international ande-marketing capabilities of our next-generation e-commerce platform, andcapitalized approximately $2.7 million of software development costs related tothose efforts. As of March 1, 2005, we employed 179 persons in productresearch and development.

To remain competitive, wemust continue to enhance and improve the responsiveness, functionality andfeatures of the CST platform and the underlying network infrastructure. If weincur significant costs without adequate results, or are unable to adaptrapidly to technological changes, we may fail to achieve our business plan. TheInternet and the e-commerce industry are characterized by rapid technologicalchange, changes in user and client requirements and preferences, frequent newproduct and service introductions embodying new technologies and the emergenceof new industry standards and practices that could render our technology andsystems obsolete. To be successful, we must adapt to rapid technological changeby licensing and internally developing leading technologies to enhance ourexisting services, developing new products, services and technologies thataddress the increasingly sophisticated and varied needs of our clients, andresponding to technological advances and emerging industry standards andpractices on a cost-effective and timely basis. The development of our CSTplatform and other proprietary technologies involves significant technical andbusiness risks. We may fail to use new technologies effectively or fail toadapt our proprietary technologies and systems to client requirements or emergingindustry standards.

**Competition**

The market fore-commerce solutions is extremely competitive and we may find ourselves unableto compete effectively. Because there are relatively low barriers to entry inthe e-commerce market, we expect competition to intensify as currentcompetitors expand their product offerings and new competitors enter themarket. In addition, our clients may become competitors in the future.Increased competition is likely to result in price reductions, lower averagesales prices, reduced margins, longer sales cycles and a decrease or loss ofour market share, any of which could negatively impact our revenue and earnings.We face competition from the following sources:

·       in-housedevelopment of e-commerce capabilities using tools or applications fromcompanies such as BroadVision, Inc. and ATG, Inc.;

·       otherproviders of outsourced e-commerce solutions, such as GSI Commerce, Inc.and eSellerate;

·       systemintegrators and application service providers that offer tools and services fore-commerce, including companies that provide a broad range of Internet andserver solutions, such as Electronic Data Systems Corporation and IBM GlobalServices;

·       companiesthat provide technologies, services or products that support a portion of thee-commerce value chain, such as payment processing, including CyberSourceCorporation;

·       companiesthat offer a range of online marketing services, technology and programs suchas DoubleClick, Inc. and ValueClick, Inc.; and

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·       high-traffic,branded Web sites that derive a substantial portion of their revenues frome-commerce and may themselves offer, or provide means for others to offer theirproducts for sale, such as Amazon.com, Inc.

We believe that the principal competitive factors inour market are breadth of products and services, number of clients and onlinechannel partnerships, brand recognition, system reliability and scalability,price, customer service, speed and accessibility and ease of use, speed tomarket, convenience and quality of delivery. The online channel partners andthe other companies described above may compete directly with us by adopting asimilar business model. Moreover, while some of these companies are alsoclients or potential clients of ours, they may compete with our e-commerceoutsourcing solution to the extent that they develop e-commerce systems oracquire such systems from other software vendors or service providers.

Many of our competitorshave, and new potential competitors may have, more experience developingInternet-based software services and e-commerce solutions, largertechnical staffs, larger customer bases, more established distribution channelsand customer relationships, greater brand recognition and greater financial,marketing and other resources than us. In addition, competitors may be able todevelop services that are superior to our services, achieve greater customeracceptance or have significantly improved functionality as compared to ourexisting and future products and services. Our competitors may be able torespond more quickly to technological developments and changes in customers’needs. Our inability to compete successfully against current and future competitorscould cause our revenue and earnings to decline.

**Intellectual Property**

We regard the protection of our trademarks,copyrights, trade secrets and other intellectual property as critical to oursuccess. We rely on a combination of patent, copyright, trademark, service markand trade secret laws and contractual restrictions to protect our proprietaryrights. We have entered into confidentiality and invention assignmentagreements with our employees and contractors, and nondisclosure agreementswith parties with whom we conduct business*,* in order tolimit access to and disclosure of our proprietary information. Thesecontractual arrangements and the other steps taken by us to protect ourintellectual property may not prevent misappropriation of our technology ordeter independent third-party development of similar technologies. Thus, wealso seek to protect our proprietary position by filing U.S. and foreign patentapplications related to our proprietary technology, inventions and improvementsthat are important to the development of our business. Proprietary rightsrelating to our technologies will be protected from unauthorized use by thirdparties only to the extent they are covered by valid and enforceable patents orare effectively maintained as trade secrets. We currently have seven U.S.patents issued with ten to eleven years remaining prior to expiration andseveral patent applications pending. We pursue the registration of ourtrademarks and service marks in the U.S. and internationally. We currently have22 U.S. registered trademarks and 15 registered trademarks in the EuropeanUnion and other countries. Effective trademark, service mark, copyright andtrade secret protection may not be available in every country in which ourservices are made available online.

The steps we have taken toprotect our proprietary rights may be inadequate and third parties may infringeor misappropriate our trade secrets, trademarks and similar proprietary rights.Any significant failure on our part to protect our intellectual property couldmake it easier for our competitors to offer similar services and therebyadversely affect our market opportunities. In addition, litigation may benecessary in the future to enforce our intellectual property rights, to protectour trade secrets or to determine the validity and scope of the proprietaryrights of others. Litigation could result in substantial costs and diversion ofmanagement and technical resources.

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**Employees**

As of March 1, 2005,we employed 727 people. We also employ independent contractors and othertemporary employees. None of our employees are represented by a labor union,and we consider our employee relations to be good. Competition for qualifiedpersonnel in our industry is intense, particularly among software developmentand other technical staff. We believe that our future success will continue todepend, in part, on our continued ability to attract, hire and retain qualifiedpersonnel.

**Executive Officers**

Thefollowing table sets forth information regarding our executive officers during2004:
| **Name**        | ** ** | ** ** | ** ** | **Age**                 | ** ** | **Position** |
|-----------------|------------|------------|------------|-------------------------|------------|--------------|
| Joel A. Ronning |       | 48         |       | Chief Executive Officer |
| Carter D. Hicks |       | 58         |       | Chief Financial Officer |

 

Mr. Ronning founded Digital River in February 1994and has been our Chief Executive Officer and a director since that time. From February 2001through February 2004, Mr. Ronning was also a member of the Office ofthe President. From February 1994 to July 1998, Mr. Ronning wasalso President of Digital River. From May 1995 to December 1999, Mr. Ronningserved as Chairman of the Board of Directors of Tech Squared, Inc., adirect catalog marketer of software and hardware products. From May 1995to July 1998, Mr. Ronning served as Chief Executive Officer, ChiefFinancial Officer and Secretary of Tech Squared. From May 1995 to August 1996,Mr. Ronning also served as President of Tech Squared. Mr. Ronningfounded MacUSA, Inc., formerly a wholly-owned subsidiary of Tech Squared,and served as a director of MacUSA, Inc. from April 1990 to December 1999.From April 1990 to July 1998, Mr. Ronning also served as theChief Executive Officer of MacUSA, Inc.

Mr. Hicks joined us in November 2000 asSenior Vice President—Software and Digital Commerce Services Operations. He waselected Chief Financial Officer in April 2002. From August 1997 to August 2000,Mr. Hicks served as the Chief Financial Officer of Oppenheimer, Wolff &Donnelly LLP, an international, full service law firm. Prior to that time, Mr. Hicksheld various senior financial positions in large corporations in the computerdistribution and food industries. Mr. Hicks was formerly a partner ofPeat, Marwick, Mitchell & Co. (now, KPMG LLP).

 

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**RISKFACTORS**

*The risks described below are not the only ones facingour company. Additional risks not presently known to us or that we currentlydeem immaterial may also impair our business operations. Our business,financial condition or results of operations could be materially adverselyaffected by any of these risks and the value of our common stock could declinedue to any of these risks. This annual report also contains forward-lookingstatements that involve risks and uncertainties. Our actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of certain factors, including the risks faced by us described belowand elsewhere in this report.*

***We have a history of losses.***

We were incorporated in February 1994 andconducted our first online sale through a client’s Web store in August 1996.We have been in business for approximately 44 quarters, but have only sustainedprofitability for the last ten quarters through December 31, 2004, andhave incurred significant losses since we were formed. As of December 31,2004, we had an accumulated deficit of approximately $51.2 million. Ourlimited profitable operating history makes it difficult to evaluate our abilityto sustain profitability in the future.

The success of ourbusiness model depends upon our success in generating sufficient transactionand service fees from the use of our e-commerce solutions by existing andfuture clients. Accordingly, we must maintain our existing relationships anddevelop new relationships with software publishers, online retailers andphysical goods clients. To achieve this goal, we intend to continue to expendsignificant financial and management resources on the development of additionalservices, sales and marketing, improved technology and expanded operations. Ifwe are unable to maintain existing, and develop new, client relationships, wewill not generate a profitable return on our investments and we will be unableto gain meaningful market share to justify those investments. Further, we maybe unable to sustain profitability if our revenues decrease or increase at aslower rate than expected, or if operating expenses exceed our expectations andcannot be adjusted to compensate for lower than expected revenues.

***Our operating results are subject to fluctuations indemand for products and services offered by us or our clients.***

Our quarterly and annualoperating results are subject to fluctuations in demand for the products orservices offered by us or our clients, such as anti-virus software,anti-spyware software, and tax preparation software.  In particular, sales of anti-virus softwarerepresented a significant portion of our revenues in recent years, and continueto be very important to our business. In February 2005, MicrosoftCorporation announced plans to acquire Sybari Software Inc., a producer ofcommercial anti-virus products. Microsoft simultaneously announced plans tointroduce products to protect businesses and consumers from computer virusesand other security risks. To the extent that Microsoft or others successfullyintroduce products or services not sold through our platform that arecompetitive with products and services sold by current Digital River clients(including anti-virus products and services), our revenues could be materiallyadversely affected.  If, as a result, ourannual or quarterly revenues or operating profits fail to meet the guidance weprovide to securities analysts and investors, or we otherwise fail to meettheir expectations, the trading price of our common stock will likely decline.

***Our operating results have fluctuated in the past andare likely to continue to do so, which could cause the price of our commonstock to be volatile.***

Our quarterly andannual operating results have fluctuated significantly in the past and arelikely to continue to do so in the future due to a variety of factors, some ofwhich are outside our control. As a result, we believe that quarter-to-quarterand year-to-year comparisons of our revenue and operating results are notnecessarily meaningful, and that these comparisons may not be accurateindicators of future 

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performance.If our annual or quarterly operating results fail to meet the guidance weprovide to securities analysts and investors or otherwise fail to meet theirexpectations, the trading price of our common stock will likely decline. Someof the factors that have or may contribute to fluctuations in our quarterly andannual operating results include:

·       ourability to attract and retain software and digital products publishers,manufacturers, online retailers and online channel partners as clients;

·       theintroduction by us of new Web sites, Web stores or services that may require asubstantial investment of our resources;

·       theintroduction by others of competitive Web sites, Web stores or services orproducts;

·       ourability to continue to upgrade and develop our systems and infrastructure tomeet emerging market needs and remain competitive in our service offerings;

·       economicconditions, particularly those affecting Internet-based e-commerce;

·       clientdecisions to delay new product launches or to invest in e-commerce initiatives;

·       nationaland international political unrest in connection with the continued militaryresponses to the terrorist attacks on the United States, possible futureterrorist attacks and the possibility of future armed conflicts;

·       theperformance of our newly acquired assets or companies, particularly element 5;

·       technicaldifficulties or system downtime leading to termination of client contracts andharm to our reputation;

·       slowerthan anticipated growth of the online market as a vehicle for the purchase ofsoftware products;

·       thecost of compliance with U.S. and foreign regulations relating to our business;and

·       ourability to retain and attract personnel commensurate with our business needs.

In addition, revenue generated by our software anddigital commerce services is likely to fluctuate on a seasonal basis that istypical for the software publishing market in general. We believe that ourfirst and fourth quarters are generally seasonally stronger than our second andthird quarters due to the timing of demand of tax preparation software, theholiday selling period, and the post-holiday retail season. We also believethat software publishers avoid new product releases in the summer months.

Our operating expenses,which include: sales & marketing, product research &development and general & administrative expenses, are based on ourexpectations of future revenue. These expenses are relatively fixed in theshort-term. If our revenue for a quarter falls below our expectations and weare unable to quickly reduce spending in response, our operating results forthat quarter would be harmed. In addition, the operating results of companiesin the electronic commerce industry have, in the past, experienced significantquarter-to-quarter fluctuations that may adversely affect our stock price.

***A loss of any client that accounts for a large portionof our revenue would cause our revenue to decline.***

Sales of products for onesoftware publisher client, Symantec Corporation, accounted for approximately27% of our revenue in 2004. In addition, Digital River independently sellsproprietary Digital River services directly to customers as they purchaseSymantec products. These services include product recovery services provided byDigital River for which separate fees are charged to end-users. In addition,Digital River derives revenues from e-commerce retailers and dealers who sellSymantec products or related Digital River services. In 2004, revenues derivedfrom proprietary Digital River 

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servicessold to Symantec end-users and dealer network sales of Symantec products togetheramounted to approximately $16.6 million, or approximately 10.8 % of totalDigital River revenue. Inaddition, a limited number of other software and physical goods clientscontribute a large portion of our annual revenue. Contracts with our clientsare generally one or two years in length. If any one of these key contracts isnot renewed or otherwise terminates,  or if revenues from these clients decline forany other reason (such as competitive developments), our revenue would decline and our ability to sustain profitabilitywould be impaired. It is important to our ongoing success that we maintainthese key client relationships and, at the same time, develop new clientrelationships.

***Our sales cycle is lengthy, which may cause us toincur substantial expenses and expend management time without generatingcorresponding revenue, which would impair our cash flow.***

We market our servicesdirectly to software publishers, online retailers and other prospectivecustomers outside of the software industry. These relationships are typicallycomplex and take time to finalize. Due to operating procedures in manyorganizations, a significant amount of time may pass between selection of ourproducts and services by key decision-makers and the signing of a contract. Theperiod between the initial sales call and the signing of a contract withsignificant sales potential is difficult to predict and typically ranges fromsix to twelve months. If at the end of a sales effort a prospective client doesnot purchase our products or services, we may have incurred substantialexpenses and expended management time that cannot be recovered and that willnot generate corresponding revenue. As a result, our cash flow and our abilityto fund expenditures incurred during the sales cycle may be impaired.

***General economic uncertainty may reduce our revenueand operating profits.***

The revenue growth and profitability of our businessdepends significantly on the overall demand for e-commerce solutions. Webelieve that the market for these solutions may be adversely affected by anumber of factors, including reductions in capital expenditures by clients andpotential weakening of the U.S. and foreign economies. The continued militaryresponses to the 2001 terrorist attacks on the United States, the ongoingpossibility of future terrorist attacks and the possibility of future armedconflicts may create adverse economic conditions and lead to weakening in theeconomy.

These factors may,in turn, give rise to a number of market trends that may slow our revenuegrowth, including:

·       longersales cycles;

·       deferralor delay of e-commerce projects and generally reduced expenditures fore-commerce solutions and related services; and

·       increasedprice competition.

***Our failure to attract and retain software and digitalproducts publishers, manufacturers, online retailers and online channelpartners as clients would cause our revenue and operating profits to decline.***

We generate revenue byproviding outsourced services to software and digital products publishers,manufacturers, online retailers and online channel partners. If we cannotdevelop and maintain satisfactory relationships with software and digitalproducts publishers, manufacturers, online retailers and online channelpartners on acceptable commercial terms, we will likely experience a decline inrevenue and operating profit. We also depend on our software and digitalpublisher clients creating and supporting software and digital products thatend-users will purchase. If we are unable to obtain sufficient quantities ofsoftware and digital products for any reason, or if the quality of serviceprovided by these software and digital products publishers falls below asatisfactory level, we could also experience a decline in revenue, operatingprofit and end-user satisfaction, and our reputation could be harmed. Ourcontracts with our 

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softwareand digital products publisher clients are generally one to two years induration, with an automatic renewal provision for additional one-year periods,unless we are provided with a written notice at least 90 days before theend of the contract. As is common in our industry, we have no long-term orexclusive contracts or arrangements with any software or digital productspublishers that guarantee the availability of software or digital products.Software and digital products publishers that currently supply software ordigital products to us may not continue to do so and we may be unable toestablish new relationships with software or digital product publishers to supplementor replace existing relationships.

***Implementing our acquisition strategy could result indilution and operating difficulties leading to a decline in revenue andoperating profit.***

We have acquired, andintend to continue engaging in strategic acquisitions of, businesses,technologies, services and products, such as businesses that provideoutsourcing services to software publishers. For example, in April 2004,we acquired element 5, a provider of outsourced e-commerce solutions. Theprocess of integrating an acquired business, technology, service or productinto our business and operations may result in unforeseen operatingdifficulties and expenditures. Integration of an acquired business also maydisrupt our ongoing business, distract management and make it difficult tomaintain standards, controls and procedures. Moreover, the anticipated benefitsof any acquisition may not be realized. If a significant number of clients ofthe acquired businesses cease doing business with us, we would experience lostrevenue and operating profit, and any synergies from the acquisition may belost. Future acquisitions could result in potentially dilutive issuances ofequity securities, the incurrence of debt, contingent liabilities, amortizationof intangible assets or impairment of goodwill.

***Electronic software delivery, or ESD, is still anevolving and unproven technology and the industry may ultimately fail to acceptESD.***

Our success willdepend in large part on the continued growth in end-user acceptance of ESD as amethod of distributing software products. ESD is a relatively new method ofdistributing software products to end-users, and unless ESD gains widespreadmarket acceptance, we will be unable to achieve our business plan. Factors thatare likely to influence the market acceptance of ESD include:

·       theavailability of sufficient bandwidth, both now and in the future, to enablepurchasers to rapidly download software products;

·       thecost of time-based Internet access;

·       thenumber, adequacy and commercial desirability of software products that areavailable for purchase through ESD as compared to those available throughphysical delivery; and

·       thelevel of end-user comfort with the process of downloading software via theInternet, including the ease of use of, and lack of concern about, transactionsecurity and technical support.

Even if ESD achieveswidespread acceptance, we may be unable to overcome the substantial existingand future technical challenges associated with electronically deliveringsoftware reliably and consistently on a long-term basis. Our failure to do sowould also impair our ability to execute our business plan.

***Developments in accounting standards may cause us toincrease our recorded expenses, which in turn would jeopardize our ability todemonstrate sustained profitability.***

In January 2002, we adopted Statement ofFinancial Accounting Standard No. 142, “Goodwill and Other IntangibleAssets” (SFAS No. 142). The statement generally establishes that goodwilland intangible assets with indefinite lives are not amortized but are to betested on an annual basis for impairment and, if impaired, are recorded as animpairment charge in income from operations. As of December 31, 2004, wehad unamortized goodwill with an indefinite life of $148.1 million, fromour acquisitions made in 2004 and 

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previous years. Ouracquisition of element 5, for example, has resulted in a significant increasein unamortized goodwill. If a portion of our unamortized goodwill is determinedfor any reason to be impaired, the subsequent accounting of the impairedportion as an expense would lower our earnings and jeopardize our ability todemonstrate sustained profitability, which could cause our stock price todecline.

The Financial AccountingStandards Board also recently adopted a proposal to require that the fair valueof stock options and other share based payments be reflected as an expense itemin the financial statements of public companies for quarters beginning after June 15,2005. As a result of the adoption of this proposal, our recorded non-cashexpenses will significantly increase, which will impair our ability to maintainprofitability.

***Increasing consumer acceptance of the Internet as amedium of commerce is important to the success of our business strategy and ourfuture revenue growth.***

The failure of theInternet to continue developing into a significant commercial medium would harmour ability to increase our revenue and execute our business strategy. Rapidgrowth in the acceptance and use of the Internet as an effective medium ofcommerce is a recent development. The acceptance and use of the Internet maynot continue to develop and a sufficiently broad base of consumers may notadopt and continue to use the Internet as a medium of commerce. We rely on purchaserswho have historically used traditional means of commerce to purchase goods ortransact business. If we are to be successful, these purchasers must accept anduse the Internet as a means of purchasing goods and services and exchanginginformation. We cannot predict the rate at which these purchasers will do so.

***The growth of the market for our services depends onthe development and maintenance of the Internet infrastructure.***

Our business is based ondelivering services over the Internet, and the success of our businesstherefore depends on the development and maintenance of a sound Internetinfrastructure. This includes maintenance of a reliable network backbone withthe necessary speed, data capacity and security, as well as timely development ofcomplementary products such as high-speed modems, for providing reliableInternet access and services. Our ability to increase the speed and scope ofour services is limited by, and depends upon, the speed and reliability of boththe Internet and our clients’ internal networks. Consequently, as Internetusage increases, the growth of the market for our services depends uponimprovements made to the Internet as well as to individual client’s networkinginfrastructures to alleviate overloading and congestion. In addition, anydelays in the adoption of new standards and protocols required to governincreased levels of Internet activity or increased governmental regulation mayhave a detrimental effect on the Internet infrastructure.

***Because the e-commerce industry is highly competitiveand has low barriers to entry, we may be unable to compete effectively.***

Themarket for e-commerce solutions is extremely competitive and we may findourselves unable to compete effectively. Because there are relatively lowbarriers to entry in the e-commerce market, we expect competition to intensifyas current competitors expand their product offerings and new competitors enterthe market. In addition, our clients may become competitors in the future.Increased competition is likely to result in price reductions, lower averagesales prices, reduced margins, longer sales cycles and a decrease or loss ofour market share, any of which could negatively impact our revenue andearnings. We face competition from the following sources:

·       in-housedevelopment of e-commerce capabilities using tools or applications fromcompanies such as BroadVision, Inc. and ATG, Inc.;

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·       otherproviders of outsourced e-commerce solutions, such as GSI Commerce, Inc.and eSellerate;

·       systemintegrators and application service providers that offer tools and services fore-commerce, including companies that provide a broad range of Internet andserver solutions, such as Electronic Data Systems Corporation and IBM GlobalServices;

·       companiesthat provide technologies, services or products that support a portion of thee-commerce value chain, such as payment processing, including CyberSourceCorporation;

·       companiesthat offer a range of online marketing services, technology programs such asDoubleClick, Inc. and ValueClick, Inc.; and

·       high-traffic,branded Web sites that derive a substantial portion of their revenue frome-commerce and may themselves offer, or provide means for others to offer theirproducts for sale, such as Amazon.com, Inc.

We believe that the principal competitive factors inour market are breadth of products and services, number of clients and onlinechannel partnerships, brand recognition, system reliability and scalability,price, customer service, speed and accessibility and ease of use, speed tomarket, convenience and quality of delivery. The online channel partners andthe other companies described above may compete directly with us by adopting asimilar business model. Moreover, while some of these companies are alsoclients or potential clients of ours, they may compete with our e-commerceoutsourcing solution to the extent that they develop e-commerce systems oracquire such systems from other software vendors or service providers.

Many of our competitorshave, and new potential competitors may have, more experience developingInternet-based software and e-commerce solutions, larger technical staffs,larger customer bases, more established distribution channels and customerrelationships, greater brand recognition and greater financial, marketing andother resources than us. In addition, competitors may be able to developservices that are superior to our services, achieve greater customer acceptanceor have significantly improved functionality as compared to our existing andfuture products and services. Our competitors may be able to respond morequickly to technological developments and changes in customers’ needs. Ourinability to compete successfully against current and future competitors couldcause our revenue and earnings to decline.

***Failure to properly manage and sustain our expansionefforts could strain our management and other resources.***

Our ability tosuccessfully offer services and implement our business plan in a rapidlyevolving market requires an effective planning and management process. We haverapidly and significantly expanded the depth and breadth of our serviceofferings. Failure to properly manage this expansion could place a significantstrain on our managerial, operational and financial resources. To manage this expansion,we are required to continually:

·       improveexisting and implement new operational, financial and management controls,reporting systems and procedures;

·       installnew management information systems; and

·       train,motivate, retain and manage our employees.

We may be unable toinstall management information and control systems in an efficient and timelymanner, and our current or planned personnel, systems, procedures and controlsmay be inadequate to support our operations.

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***Failure to develop our technology to accommodateincreased traffic could reduce demand for our services and impair the growth ofour business.***

We periodically enhance and expand our technology andtransaction-processing systems, network infrastructure and other technologiesto accommodate increases in the volume of traffic on our technology platform.Any inability to add software and hardware or to develop and upgrade existingtechnology, transaction-processing systems or network infrastructure to manageincreased traffic on this platform may cause unanticipated systems disruptions,slower response times and degradation in client services, including impairedquality and speed of order fulfillment. Failure to manage increased trafficcould harm our reputation and significantly reduce demand for our services,which would impair the growth of our business. We may be unable to improve andincrease the capacity of our network infrastructure sufficiently or anticipateand react to expected increases in the use of the platform to handle increasedvolume. Further, additional network capacity may not be available fromthird-party suppliers when we need it. Our network and our suppliers’ networksmay be unable to maintain an acceptable data transmission capability,especially if demands on the platform increase.

We continue to enhance oure-commerce platforms to better support new features and functionality demandedby our client base. Failure of these to perform as expected could lead toclient dissatisfaction and loss of business.

***Our industry is characterized by rapid technologicalchange that may make our technology and systems obsolete or cause us to incursubstantial costs to adapt to these changes.***

To remain competitive, wemust continue to enhance and improve the responsiveness, functionality andfeatures of our CST technology platform and the underlying networkinfrastructure. If we incur significant costs without adequate results, or areunable to adapt rapidly to technological changes, we may fail to achieve ourbusiness plan. The Internet and the e-commerce industry are characterized byrapid technological change, changes in user and client requirements andpreferences, frequent new product and service introductions embodying newtechnologies and the emergence of new industry standards and practices thatcould render our technology and systems obsolete. To be successful, we mustadapt to rapid technological change by licensing and internally developingleading technologies to enhance our existing services, developing new products,services and technologies that address the increasingly sophisticated andvaried needs of our clients, and responding to technological advances andemerging industry standards and practices on a cost-effective and timely basis.The development of our CST platform and other proprietary technologies involvessignificant technical and business risks. We may fail to use new technologieseffectively or fail to adapt our proprietary technology and systems to clientrequirements or emerging industry standards.

***System failures could reduce the attractiveness of ourservice offerings.***

We provide commerce, marketing and delivery servicesto our clients and end-users through our proprietary technology transactionprocessing and client management systems. These systems also maintain anelectronic inventory of products and gather consumer marketing information. Thesatisfactory performance, reliability and availability of the technology andthe underlying network infrastructure are critical to our operations, level ofclient service, reputation and ability to attract and retain clients. We haveexperienced periodic interruptions, affecting all or a portion of our systems,which we believe will continue to occur from time to time. Any systems damageor interruption that impairs our ability to accept and fill client orders couldresult in an immediate loss of revenue to us, and could cause some clients topurchase services offered by our competitors. In addition, frequent systemsfailures could harm our reputation.

Our systems and operationsare vulnerable to damage or interruption from:

·       fire,flood and other natural disasters;

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·       operatornegligence, improper operation by, or supervision of, employees, physical andelectronic break-ins, misappropriation, computer viruses and similar events;and

·       powerloss, computer systems failures, and Internet and telecommunications failure.

We do not carry sufficientbusiness interruption insurance to fully compensate us for losses that mayoccur.

***We may become liable to clients who are dissatisfiedwith our services.***

We design, develop,implement and manage e-commerce solutions that are crucial to the operation ofour clients’ businesses. Defects in the solutions we develop could result indelayed or lost revenue, adverse end-user reaction, and/or negative publicitywhich could require expensive corrections. As a result, clients who experiencethese adverse consequences either directly or indirectly as a result of ourservices could bring claims against us for substantial damages. Any claims assertedcould exceed the level of any insurance coverage that may be available to us.Moreover, the insurance we carry may not continue to be available oneconomically reasonable terms, or at all. The successful assertion of one ormore large claims that are uninsured, that exceed insurance coverage or thatresult in changes to insurance policies (including premium increases) couldadversely affect our operating results or financial condition.

***Our chief executive officer and key technicalemployees are critical to our business, and if they do not remain with us inthe future, we may be unable to effectively replace them.***

Our future successsignificantly depends on the continued services and performance of our seniormanagement, particularly Joel A. Ronning, our chief executive officer. Ourperformance also depends on our ability to retain and motivate our keytechnical employees who are skilled in maintaining our proprietary technologyplatform. The loss of the services of any of our executive officers or key technicalemployees could harm our business if we are unable to effectively replace thatofficer or employee, or if that person should decide to join a competitor orotherwise directly or indirectly compete with us. Further, we may need to incuradditional operating expenses and divert other management time in order tosearch for a replacement.

***We must continually attract and retain technical andother key personnel in order to successfully execute our business strategy.***

Our future success dependson our ability to continue to identify, attract, hire, train, retain andmotivate highly skilled technical, managerial, operations, merchandising, salesand marketing and client service personnel. Competition for these personnel isintense, particularly in the Internet industry. We may be unable tosuccessfully attract, assimilate or retain sufficiently qualified personnel.Failure to do so could harm our business growth and profitability. In addition,the market price of our common stock has fluctuated substantially since ourinitial public offering in August 1998. Consequently, potential employeesmay perceive our equity incentives as less attractive and current employeeswhose equity incentives are no longer attractively priced may choose not toremain with our organization. In that case, our ability to attract employeeswill be adversely affected. Additionally, the Financial Accounting StandardsBoard recently adopted a proposal requiring that the fair value of stockoptions and other share based payments be reflected as an expense item in thefinancial statements of public companies for quarters beginning after June 15,2005. As a result, our ability to use stock options as equity incentives willbe adversely affected, which will make it more difficult to compete for andattract qualified personnel. Finally, should our stock price substantiallydecline, the retention value of stock options granted since our initial publicoffering will decline and employees who hold such options may choose not toremain with our organization.

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***Protecting our intellectual property is critical toour success.***

We regard the protection of our trademarks,copyrights, trade secrets and other intellectual property as critical to oursuccess. We rely on a combination of patent, copyright, trademark, service markand trade secret laws and contractual restrictions to protect our proprietaryrights. We have entered into confidentiality and invention assignmentagreements with our employees and contractors, and nondisclosure agreementswith parties with whom we conduct business, in order to limit access to anddisclosure of our proprietary information. These contractual arrangements andthe other steps taken by us to protect our intellectual property may notprevent misappropriation of our technology or deter independent third-partydevelopment of similar technologies. We also seek to protect our proprietaryposition by filing U.S. and foreign patent applications related to ourproprietary technology, inventions and improvements that are important to thedevelopment of our business. Proprietary rights relating to our technologieswill be protected from unauthorized use by third parties only to the extentthey are covered by valid and enforceable patents or are effectively maintainedas trade secrets. We pursue the registration of our trademarks and servicemarks in the U.S. and internationally. Effective trademark, service mark,copyright and trade secret protection may not be available in every country inwhich our services are made available online.

The steps we have taken toprotect our proprietary rights may be inadequate and third parties may infringeor misappropriate our trade secrets, trademarks and similar proprietary rights.Any significant failure on our part to protect our intellectual property couldmake it easier for our competitors to offer similar services and therebyadversely affect our market opportunities. In addition, litigation may benecessary in the future to enforce our intellectual property rights, to protectour trade secrets or to determine the validity and scope of the proprietaryrights of others. Litigation could result in substantial costs and diversion ofmanagement and technical resources.

***Claims of infringement of other parties’ intellectualproperty rights could require us to expend significant resources, enter intounfavorable licenses or require us to change our business plans.***

From time to time we arenamed as a defendant in lawsuits claiming that we have, in some way, violatedthe intellectual property rights of others. Existing lawsuits in this area, aswell as any future assertions or prosecutions of claims like these, couldrequire us to expend significant financial and managerial resources. Thedefense of any claims, with or without merit, could be time-consuming, resultin costly litigation and diversion of technical and management personnel, causeproduct enhancement delays or require that we develop non-infringing technologyor enter into royalty or licensing agreements. Royalty or licensing agreements,if required, may be unavailable on terms acceptable to us or at all. In theevent of a successful claim of infringement against us and our failure orinability to develop non-infringing technology or license the infringed orsimilar technology on a timely basis, we may be unable to pursue our currentbusiness plan.

***Claims against us related to the software productsthat we deliver electronically and the tangible goods that we deliverphysically could also require us to expend significant resources.***

Claims may be made against us for negligence,copyright or trademark infringement, products liability or other theories basedon the nature and content of software products or tangible goods that wedeliver electronically and physically. Because we did not create these products,we are generally not in a position to know the quality or nature of the contentof these products. Although we carry general liability insurance and requirethat our customers indemnify us against end-user claims, our insurance andindemnification measures may not cover potential claims of this type, may notadequately cover all costs incurred in defense of potential claims, or may notreimburse us for all liability that may be imposed. Any costs or imposition ofliability that are not covered by insurance or indemnification measures couldbe 

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expensiveand time-consuming to address, distract management and delay productdeliveries, even if we are ultimately successful in the defense of theseclaims.

***Security breaches could hinder our ability to securelytransmit confidential information.***

A significant barrier to e-commerce and communicationsis the secure transmission of confidential information over public networks.Any compromise or elimination of our security could be costly to remedy, damageour reputation and expose us to liability, and dissuade existing and newclients from using our services. We rely on encryption and authenticationtechnology licensed from third parties to provide the security andauthentication necessary for secure transmission of confidential information,such as end-user credit card numbers. A party who circumvents our securitymeasures could misappropriate proprietary information or interrupt ouroperations.

We may be required toexpend significant capital and other resources to protect against securitybreaches or address problems caused by breaches. Concerns over the security ofthe Internet and other online transactions and the privacy of users could deterpeople from using the Internet to conduct transactions that involvetransmitting confidential information, thereby inhibiting the growth of ourbusiness. To the extent that our activities or those of third-party contractorsinvolve the storage and transmission of proprietary information, such as creditcard numbers, security breaches could damage our reputation and expose us to arisk of loss or litigation and possible liability. Our security measures maynot prevent security breaches and failure to prevent security breaches couldlead to a loss of existing clients and deter potential clients away from ourservices.

***Loss of our credit card acceptance privileges wouldseriously hamper our ability to process the sale of digital goods.***

The payment by end-usersfor the purchase of digital goods that we process is typically made by creditcard. If we incur significant instances of credit card fraud over an extendedperiod of time, it may result in penalties and termination of our credit cardacceptance privileges. Loss of our credit card acceptance privileges wouldseverely impact our ability to process the sale of digital goods where thepayment method is by credit card. We may be required to expend significantcapital and other resources to protect against these fraudulent transactions.

***The listing of our network addresses on anti-SPAMlists could harm our ability to service our clients and deliver goods over theInternet.***

Certain privacy andanti-email proponents have engaged in a practice of gathering, and publiclylisting, network addresses that they believe have been involved in sendingunwanted, unsolicited emails commonly known as SPAM. In response to usercomplaints about SPAM, Internet service providers have from time to timeblocked such network addresses from sending emails to their users. If ournetwork addresses mistakenly end up on these SPAM lists, our ability to provideservices for our clients and consummate the sales of digital and physical goodsover the Internet could be harmed.

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***Changes in government regulation could limit ourInternet activities or result in additional costs of doing business over theInternet.***

We are subject tothe same federal, state and local laws as other companies conducting businessover the Internet. Today, there are relatively few laws specifically directedtowards conducting business over the Internet. The adoption or modification oflaws related to the Internet could harm our business, operating results andfinancial condition by increasing our costs and administrative burdens. Due tothe increasing popularity and use of the Internet, many laws and regulationsrelating to the Internet are being debated at the international, federal andstate levels. These laws and regulations could cover issues such as:

·       userprivacy with respect to adults and minors;

·       ourability to collect necessary information that allows us to conduct business onthe Internet;

·       exportcompliance;

·       pricingand taxation;

·       fraud;

·       advertising;

·       intellectualproperty rights;

·       informationsecurity; and

·       qualityof products and services.

Applicability to theInternet of existing laws governing issues such as property ownership,copyrights and other intellectual property issues, taxation, libel, obscenityand personal privacy could also harm our operating results and substantiallyincrease the cost to us of doing business. For example, numerous statelegislatures have proposed that tax rules for Internet retailing andcatalog sales correspond to enacted tax rules for sales from physicalstores. Any requirement that we collect sales tax for each online purchase andremit the tax to the appropriate state authority would be a significantadministrative burden to us and possibly depress online sales. This and anyother change in laws applicable to the Internet might also require significantmanagement resources to respond appropriately. The vast majority of these lawswere adopted prior to the advent of the Internet, and do not contemplate oraddress the unique issues raised thereby. Those laws that do reference theInternet, such as the Digital Millennium Copyright Act, are only beginning tobe interpreted by the courts and their applicability and reach are thereforeuncertain.

***Laws relating to user information and online privacymay limit the collection and use of end-user data for our clients.***

We collect andmaintain end-user data for our clients, which subjects us to increasinginternational, federal and state regulation related to online privacy and theuse of personal user information. Congress recently enacted anti-SPAMlegislation with which we must comply when providing email campaigns for ourclients. Bills are pending in Congress and in various states that addressonline privacy protections. Several states have proposed, and some haveenacted, legislation that would limit the use of personal user information orrequire online services to establish privacy policies. In addition, the U.S.Federal Trade Commission, or FTC, has urged Congress to adopt legislationregarding the collection and use of personal identifying information obtainedfrom individuals when accessing Web sites. In the past, the emphasis has beenon information obtained from minors. Focus has now shifted to include onlineprivacy protection for adults. If such legislation is adopted, it may includerequirements that companies establish procedures to, among other things:

·       giveadequate notice to users regarding information collection and disclosurepractices;

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·       provideusers with the ability to have personal information deleted from a company’sdatabase;

·       provideusers with access to their collected personal information and the ability tocorrect inaccuracies;

·       clearlyidentify affiliations with third parties that may collect information orsponsor activities on another company’s Web site; and

·       obtainexpress parental consent prior to collecting and using personal informationfrom children under 13 years of age.

Even in the absence oflaws requiring companies to establish these procedures, the FTC has settledseveral proceedings resulting in consent decrees in which Internet companieshave been required to establish programs regarding the manner in which personalinformation is collected from users and provided to third parties. We couldbecome a party to a similar enforcement proceeding. These regulatory andenforcement efforts could limit our collection of demographic and personalinformation from end-users, which could adversely affect our ability tocomprehensively serve our clients.

***The adoption and implementation of international lawsand regulations applicable to e-commerce may impair our efforts to expandrevenue from international transactions.***

The European Union has adopted a privacy directivethat regulates the collection and use of information that identifies anindividual person. These regulations may inhibit or prohibit the collection andsharing of personal information in ways that could harm our clients or us. Theglobalization of Internet commerce may be harmed by these and similarregulations because the European Union privacy directive prohibits transmissionof personal information outside the European Union. The United States and theEuropean Union have negotiated an agreement providing a “safe harbor” for thosecompanies who agree to comply with the principles set forth by the U.S.Department of Commerce and agreed to by the European Union. Failure to complywith these principles may result in fines, private lawsuits and enforcementactions. These enforcement actions can include interruption or shutdown ofoperations relating to the collection and sharing of information pertaining tocitizens of the European Union. Certain countries in the Asia-Pacific regionhave also adopted, or are considering adopting, privacy laws similar to thoseof the European Union, which may impair our ability to expand our revenue fromthose countries.

In addition, in July 2003,the European Union implemented rules regarding the collection and paymentof Value Added Tax, or VAT. These rules require VAT to be charged onsupply delivered over electronic networks, including software and computerservices, as well as information and cultural, artistic, sporting, scientific,educational, entertainment and similar services. These services are now beingtaxed in the country where the purchaser resides rather than where the supplieris located. Historically, suppliers of digital products that existed outsidethe European Union were not required to collect or remit VAT on digital ordersmade to purchasers in the European Union. With the implementation of theserules, we are required to collect and remit VAT on digital orders received frompurchasers in the European Union which effectively raises the price for thesegoods by the VAT amount. This price increase could serve to discouragepurchasing of our products and services which in turn could adversely affectour operating results and financial condition.

***Compliance with future laws imposed on e-commerce maysubstantially increase our costs of doing business or otherwise adverselyaffect our ability to offer our services.***

Because our services are accessible worldwide, and wefacilitate sales of products to end-users worldwide, foreign jurisdictions mayclaim that we are required to comply with their laws. Laws regulating Internetcompanies outside of the United States may be less favorable than those in theUnited States, giving greater rights to consumers, content owners and users.Compliance may be more costly or may 

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require us to change ourbusiness practices or restrict our service offerings relative to those providedin the United States. Any failure to comply with foreign laws could subject usto penalties ranging from fines to bans on our ability to offer our services.

As our services are available over the Internet inmultiple states and foreign countries, these jurisdictions may claim that weare required to qualify to do business as a foreign corporation in each stateor foreign country. We and/or our subsidiaries are qualified to do businessonly in California, Colorado, Connecticut, Delaware, Georgia, Iowa, Michigan,Minnesota, New Jersey, New York, North Carolina, Ohio, Utah and Washington.Failure to qualify as a foreign corporation in a required jurisdiction couldsubject us to taxes and penalties and could result in our inability to enforcecontracts in these jurisdictions.

In addition, we aresubject to United States laws governing the conduct of business with othercountries, such as export control laws, which prohibit or restrict the exportof goods, services and technology to designated countries, denied persons ordenied entities from the United States. Violation of these laws could result infines or other actions by regulatory agencies and result in increased cost ofdoing business and reduced profits. In addition, any significant changes inthese laws, particularly an expansion in the export control laws, will increaseour costs of compliance and may further restrict our overseas client base.

***We intend to continue to expand our internationaloperations and these efforts may not be successful in generating additionalrevenue.***

We sell productsand services to end-users outside the United States and we intend to continueto expand our international presence. Expansion into international markets,particularly the European and Asia-Pacific regions, requires significantresources that we may fail to recover by generating additional revenue.Conducting business outside of the United States is subject to risks,including:

·       changesin regulatory requirements and tariffs;

·       uncertaintyof application or governing of local laws;

·       reducedprotection of intellectual property rights;

·       difficultiesin physical distribution for international sales;

·       higherincidences of credit card fraud and difficulties in accounts receivablecollection;

·       theburden and cost of complying with a variety of foreign laws;

·       thepossibility of unionization of our workforce outside the United States,particularly in Europe; and

·       politicalor economic constraints on international trade or instability.

These risks have grown with the recent acquisition ofelement 5, which has substantial operations outside the U.S., and our expansioninto the Asia-Pacific region.

We may be unable tosuccessfully and cost-effectively market, sell and distribute our services inforeign markets. This may be more difficult or take longer than anticipatedespecially due to international challenges, such as language barriers, currencyexchange issues and the fact that the Internet infrastructure in foreigncountries may be less advanced than the U.S. Internet infrastructure. If we areunable to successfully expand our international operations, or manage this expansion,our operating results and financial condition could be harmed.

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***New obligations to collect or pay sales tax couldsubstantially increase the cost to us of doing business.***

Currently, we collectsales, use or other similar taxes with respect to electronic software downloadin states where we believe that we have nexus. The application of sales relatedtaxes to interstate and international sales over the Internet is unclear andevolving. We are already required to collect and remit VAT in the European Union,for example. Local, state or foreign jurisdictions may seek to impose sales oruse tax collection obligations on out-of-state companies like ours that engagein e-commerce. A successful assertion by one or more states or any foreigncountry that we should collect sales, use or other taxes on the sale ofmerchandise through our physical goods clients or on physical shipments ofsoftware could harm our results of operations. In addition, any failure by aphysical goods client to collect obligatory sales or use taxes could cause therelevant jurisdiction to attempt imposing that obligation on us.

***Compliance with changing regulation of corporategovernance and public disclosure may result in additional expenses.***

Keeping abreast of, and incompliance with, changing laws, regulations and standards relating to corporategovernance and public disclosure, including the Sarbanes-Oxley Act of 2002, newSEC regulations and Nasdaq Stock Market rules, have required an increasedamount of management attention and external resources. We intend to invest allreasonably necessary resources to comply with evolving corporate governance andpublic disclosure standards, and this investment may result in increasedgeneral and administrative expenses and a diversion of management time andattention from revenue-generating activities to compliance activities.

***We may need to raise additional capital to achieve ourbusiness objectives, which could result in dilution to existing investors orincrease our debt obligations.***

We require substantialworking capital to fund our business. If capital requirements vary materiallyfrom those currently planned, we may require additional financing sooner thananticipated. We have filed a universal shelf registration statement on Form S-3with the Securities and Exchange Commission to allow us to sell up to $255million in equity or debt securities, and we have filed an acquisition shelfregistration statement with the Securities and Exchange Commission that wouldallow us to issue up to 1,480,000 shares of common stock in acquisitions ofother companies or businesses. If additional funds are raised through theissuance of equity securities, the percentage ownership of our stockholderswill be reduced, stockholders may experience additional dilution or theseequity securities may have rights, preferences or privileges senior to those ofour common stock. In June 2004, we issued 1.25% convertible notes whichrequire us to make interest payments and will require us to pay principal whenthe notes become due in 2024 or in the event of acceleration under certaincircumstances, unless the notes are converted into our common stock prior tothat. We may not have sufficient capital to service this or any future debtsecurities that we may issue, and the conversion of the notes into our commonstock may result in further dilution to our stockholders. Our capitalrequirements depend on several factors, including the rate of market acceptanceof our products, the ability to expand our client base and the growth of salesand marketing. We have had significant operating losses and negative cash flowfrom operations since inception. Additional financing may not be available whenneeded, on terms favorable to us or at all. If adequate funds are not availableor are not available on acceptable terms, we may be unable to develop orenhance our services, take advantage of future opportunities or respond tocompetitive pressures, which would harm our operating results and adverselyaffect our ability to sustain profitability.

***Internet-related stock prices are especially volatileand this volatility may depress our stock price or cause it to fluctuatesignificantly.***

The stock market,and the trading prices of Internet-related companies in particular, have beennotably volatile. This volatility is likely to continue in the short-term andis not necessarily related to the 

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operatingperformance of affected companies. This broad market and industry volatilitycould significantly reduce the price of our common stock at any time, withoutregard to our operating performance. Factors that could cause our stock pricein particular to fluctuate include, but are not limited to:

·       actualor anticipated variations in quarterly operating results;

·       announcementsof technological innovations;

·       theability to sign new clients and the retention of existing clients;

·       newproducts or services that we offer;

·       competitivedevelopments including new products or services, or new relationships by ourcompetitors;

·       changesthat affect our clients or the viability of their product lines;

·       changesin financial estimates by securities analysts;

·       conditionsor trends in the Internet and online commerce industries;

·       globalunrest and terrorist activities;

·       changesin the economic performance and/or market valuations of other Internet oronline e-commerce companies;

·       requiredchanges in generally accepted accounting principles and disclosures;

·       ourannouncement of significant acquisitions, strategic partnerships, jointventures or capital commitments or results of operations or other developmentsrelated to those acquisitions;

·       additionsor departures of key personnel; and

·       salesor other transactions involving our common stock or our convertible notes.

In addition, our stockprice may be impacted by the short sales and actions of other parties who maydisseminate misleading information about us in an effort to profit fromfluctuations in our stock price.

***Our involvement in class-action litigation relating toour IPO may adversely affect our results of operations and distract management.***

We are party to a lawsuit which alleges that we,certain of our officers and directors and the underwriters of our initialpublic offering, or IPO, violated Section 11 of the Securities Act of 1933based on allegations that our IPO registration statement and prospectus failedto disclose material facts regarding the compensation to be received by, andthe stock allocation practices of, the IPO underwriters. Similar complaints,pursuing similar theories, were filed in the same court against hundreds ofother public companies.

The IPO lawsuit, as wellas any future allegations that we may have, in some way, violated securitieslaws could require us to expend significant financial and managerial resourcesand could result in further volatility of our stock price. The defense of anyclaims, with or without merit, could be time-consuming, result in costlylitigation and divert technical and management personnel.

***We may need to recognize and record income tax expensein the future while having no cash outlay for these taxes.***

Because we have asubstantial net operating loss carryforward, the related deferred tax asset isfully reserved on our balance sheet. At some future date when we meet therequirements, we may reflect the benefit of the deferred tax asset and taxationof our financial results in our financial statements. The 

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recognitionof taxes may adversely affect the trading price of our stock in the stockmarket. It is also possible under existing accounting rules that we may berequired to record income tax expense although we may have no cash outlay forthese taxes or the ability to recognize the deferred tax asset under currentaccounting rules. In addition, we may also be expected to pay alternativeminimum tax or foreign taxes even though we have a net operation losscarryforward.

***Provisions of our charter documents, other agreementsand Delaware law may inhibit potential acquisition bids for us.***

Certain provisions of ouramended and restated certificate of incorporation, bylaws, other agreements andDelaware law could make it more difficult for a third party to acquire us, evenif a change in control would be beneficial to our stockholders.

**Risks Related to the Acquisition of Element 5 AG**

***element 5 has a history of losses and has yet toachieve sustained profitability.***

element 5 has experiencedsignificant losses since inception ($10.2 million through March 31,2004) and has experienced significant negative cash flows from operations. Toaddress these risks, we and element 5 must, among others things, maintainexisting and develop new relationships with independent software publishers,online retailers and other companies outside of the software market, maintainand increase element 5’s client base, implement and successfully execute itsbusiness and marketing strategy, continue to develop and upgrade its technologyand transaction-processing systems, provide superior customer service and orderfulfillment, respond to competitive developments, and attract, retain and motivatequalified personnel. There can be no assurances that we will be successful inaddressing such risks, and the failure to do so could have a material adverseeffect on our business, financial condition and results of operations.

***If we do not successfully integrate element 5, ourbusiness will be adversely affected.***

Our acquisition ofelement 5 in April 2004 is recent. We therefore have a very limitedoperating history with element 5 and limited experience in managing itsbusiness. Integrating element 5 is a complex and time-consuming process. Priorto the acquisition, Digital River and element 5 operated independently, eachwith its own business, corporate culture, locations, employees and systems.Eventually, we intend to operate as a combined organization utilizing commontechnology, information and communication systems, operating procedures,financial controls, and human resource practices. There may be substantialdifficulties, costs and delays involved in any integration of element 5 intoDigital River. These may include:

·       distractingmanagement from day-to-day operations;

·       potentialincompatibility of corporate cultures;

·       potentialdifficulties in transitioning customers to new platforms;

·       aninability to achieve synergies as planned;

·       costsand delays in implementing common systems and procedures; and

·       increaseddifficulties in managing our business due to the addition of an internationallocation and two locations in the U.S.

Many of these risks areaccentuated because element 5’s operations, employees and customers are largelylocated outside of the U.S. Any one or all of these factors may increaseoperating costs or lower anticipated financial performance. Many of thesefactors are also outside of our control. Achieving anticipated synergies andthe potential benefits underlying our reasons for the acquisition will dependon 

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successfulintegration of the two businesses. The failure to integrate element 5successfully would have a material adverse effect on our business, financialcondition and results of operations.

***We may be unable to retain element 5’s customers.***

There can be no assurancethat we will be able to retain element 5’s customers following the acquisition.A failure to retain element 5’s customers could have a material adverse effecton our financial condition and profitability.

***As a result of the acquisition of element 5, we willbe exposed to greater risk from currency fluctuations.***

Approximately one half ofelement 5’s revenue and most of its costs are denominated in Euros and currenciesother than U.S. dollars. As a result, a greater proportion of our revenues,earnings and costs will now be subject to currency fluctuations. We do nothave, and we do not have plans to implement, a currency hedging program tomitigate the effect of fluctuations of currency prices on our financialresults. As a result, our future operating results may be subject tofluctuations due to volatility in foreign currency exchange markets.

**ITEM 2.**   PROPERTIES.

We currently leaseapproximately 134,000 square feet of office and warehouse space in twofacilities in Eden Prairie, Minnesota. The leases on both facilities expire in September 2005.We have the option of extending our headquarter building lease for anadditional three years if we so choose. We lease approximately 27,000 squarefeet of office space in our facilities in Cologne, Germany, expiring in March 2010.We also lease approximately 6,200 square feet of office space in Chicago,Illinois, expiring in September 2010 and approximately 4,700 square feetof office space in suburban London, England, expiring in December 2006. Inaddition, we lease approximately 7,000 square feet of office space in MountainView, California expiring in October 2006, and 2,600 square feet of officespace in San Diego, California, expiring in October 2005.

**ITEM 3.**   LEGALPROCEEDINGS.

Beginning in August 2001, we and certainof our officers and directors were named as defendants in several classaction shareholder complaints filed in the United States District Court for theSouthern District of New York, now consolidated as *In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355. Similar complaints, referred to here asthe IPO Lawsuits, were filed in the same court against hundreds of other publiccompanies, referred to here as the Issuers. In the consolidated amendedcomplaint against us, the plaintiffs allege that we, certain of our officersand directors and the underwriters of our initial public offering, or IPO,violated Section 11 of the Securities Act of 1933 based on allegationsthat our IPO registration statement and prospectus failed to disclose materialfacts regarding the compensation to be received by, and the stock allocationpractices of, the IPO underwriters. The complaint also contains a claim forviolation of Section 10(b) of the Securities Exchange Act of 1934based on allegations that this omission constituted a deceit on investors. Theplaintiffs seek unspecified monetary damages and other relief.

In July 2002, we joined in a global motion todismiss the IPO Lawsuits filed by all of the Issuers (among others). In October 2002,the parties agreed to toll the statute of limitations with respect to certainof the named officers and directors until September 30, 2003 and on thebasis of this agreement, our officers and directors were dismissed fromthe lawsuit without prejudice. In February 2003, the court issued adecision denying the motion to dismiss the Section 11 claims against usand almost all of the other Issuers and denying the motion to dismiss the Section 10(b) claimsagainst us and many of the Issuers.

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During the summer of 2003, we, along with asubstantial majority of Issuers, indirectly participated in discussions withthe plaintiffs and the Issuers’ respective insurers regarding a tentativesettlement of the IPO Lawsuits. The terms of the tentative settlementwould provide for, among other things, a release of the Issuers and theirofficers and directors from all further liability resulting from plaintiffs’claims, and the assignment to plaintiffs of certain potential claims that theIssuers may have against their IPO underwriters. The tentative settlement alsoprovides that, in the event that plaintiffs ultimately recover less than aguaranteed sum of $1 billion from the IPO underwriters, plaintiffs would beentitled to payment by each participating Issuer’s insurer of a pro rata shareof any shortfall in the plaintiffs’ guaranteed recovery. In June 2003,pursuant to the authorization of a special litigation committee of ourboard of directors, we entered into a non-binding memorandum ofunderstanding reflecting the settlement terms described above. In September 2003,in connection with the possible settlement, our officers and directors whohad entered tolling agreements with plaintiffs (described above) agreed toextend those agreements so that they would not expire prior to any settlementbeing finalized. In June 2004, we executed a final settlement agreementwith the plaintiffs consistent with the terms of the memorandum ofunderstanding. On February 15, 2005, the Court issued a decisioncertifying a class action for settlement purposes and granting preliminaryapproval of the settlement, subject to modification of certain bar orderscontemplated by the settlement. In addition, the settlement is still subject tostatutory notice requirements as well as final judicial approval. Pending finalapproval of the settlement, we continue to believe that the claims againstus, our officers and directors are without merit and intend to defend against themvigorously.

On December 29, 2004, we announced that we hadsettled, for an undisclosed amount and terms, the action brought by ChristopherM. Crawford against us which had alleged infringement of United States Patent No. 6,014,651.The amount of the settlement is not considered material to our operations orfinancial position.

In addition, we aresubject to legal proceedings, claims, and litigation arising in the ordinarycourse of business. While the final outcome of these matters is currently notdeterminable, we believe there is no litigation pending against us that couldhave, individually or in the aggregate, a material adverse effect on ourconsolidated financial position, results of operation or cash flows. As of December 31,2004, we had $1.1 million accrued for various legal matters where it wasestimable and probable that an unfavorable outcome will occur.

**ITEM4.**   SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.

None.

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**PART II**

**ITEM5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

Ourcommon stock is traded on the Nasdaq National Market under the symbol “DRIV”. Thefollowing table sets forth, for the periods indicated, the high and low saleprice per share of our common stock on the Nasdaq National Market. Theseover-the-counter market quotations reflect inter-dealer prices, without retailmark-up, markdown or commission, and may not necessarily represent actualtransactions.
| ** **     | ** ** | **HIGH** | ** ** | **LOW** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2003**       |       |     |       |    |       |
| First quarter  |       | $        | 14.57      |    | $          | 8.83 |   |
| Second quarter |       | $        | 20.10      |    | $          | 10.48 |   |
| Third quarter  |       | $        | 31.50      |    | $          | 18.50 |   |
| Fourth quarter |       | $        | 34.30      |    | $          | 21.10 |   |
|           |       |     |       |    |       |
| **2004**       |       |     |       |    |       |
| First quarter  |       | $        | 27.11      |    | $          | 19.38 |   |
| Second quarter |       | $        | 34.83      |    | $          | 22.44 |   |
| Third quarter  |       | $        | 33.55      |    | $          | 22.75 |   |
| Fourth quarter |       | $        | 44.51      |    | $          | 28.83 |   |

 

As of March 1, 2005, there were approximately 397holders of record of our common stock. On March 1, 2005, the last saleprice reported on the Nasdaq National Market for our common stock was $28.77per share.

We have never declared or paid any cash dividends onour capital stock. We intend to retain any future earnings to supportoperations and to finance the growth and development of our business and do notanticipate paying cash dividends for the foreseeable future.

On November 1, 2004, we acquired all of theoutstanding stock of BlueHornet Networks, Inc., a leading e-mail marketingtechnology and service provider. As partial consideration for the acquisition,we issued a total of 160,185 shares of our common stock to the BlueHornetshareholders. The sale and issuance of securities listed above were determinedto be exempt from registration under Regulation D promulgated under theSecurities Act as a transaction by an issuer not involving a public offering.

In April 2001, we announced a share repurchaseprogram of up to $5.0 million of our outstanding shares of common stock. Repurchasesare at our discretion based on ongoing assessments of the capital needs of thebusiness and the market price of our shares. No shares were repurchased underthis program during 2004, 2003 or 2002.

See Part III, Item 12hereof with respect to securities authorized for issuance under equitycompensation plans.

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**ITEM 6. SELECTED FINANCIAL DATA.**

Thefollowing selected financial data should be read in conjunction with theConsolidated Financial Statements and related notes.
| ** **                                                                                      | ** ** | **YEAR ENDED DECEMBER 31,**                         | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                                                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                         |       | $                                                                  | 154,130    |   | $ | 101,201 |   | $ | 77,783 |   | $ | 57,825 |   | $ | 31,181 |   |
| Cost and expenses  (exclusive of depreciation and amortization expense shown separately below): |       |                                                               |       |   |   |   |   |   |   |   |   |
| Direct cost of services                                                                         |       | 5,013                                                              |       | 3,585 |   | 2,357 |   | 2,710 |   | 1,477 |   |
| Network and infrastructure                                                                      |       | 15,143                                                             |       | 12,253 |   | 11,405 |   | 10,200 |   | 7,867 |   |
| Sales and marketing                                                                             |       | 51,749                                                             |       | 37,220 |   | 32,437 |   | 27,489 |   | 25,693 |   |
| Product research and development                                                                |       | 14,097                                                             |       | 9,962 |   | 11,454 |   | 11,192 |   | 13,063 |   |
| General and administrative                                                                      |       | 17,056                                                             |       | 9,228 |   | 6,799 |   | 4,701 |   | 4,628 |   |
| Litigation and other charges                                                                    |       | (162                                                               | )          | — |   | 2,500 |   | — |   | — |   |
| Depreciation and amortization                                                                   |       | 8,203                                                              |       | 7,275 |   | 6,009 |   | 4,627 |   | 3,178 |   |
| Amortization of goodwill and other intangibles and  acquisition related costs(a)                |       | 8,269                                                              |       | 5,380 |   | 5,738 |   | 17,009 |   | 15,387 |   |
| Total costs and  expenses                                                                       |       | 119,368                                                            |       | 84,903 |   | 78,699 |   | 77,928 |   | 71,293 |   |
| Income (loss)  from operations                                                                  |       | 34,762                                                             |       | 16,298 |   | (916 | ) | (20,103 | ) | (40,112 | ) |
| Other income, net                                                                               |       | 1,641                                                              |       | 838 |   | 406 |   | 881 |   | 1,996 |   |
| Income before  income tax expense                                                               |       | 36,403                                                             |       | 17,136 |   | (510 | ) | (19,222 | ) | (38,116 | ) |
| Income tax  expense                                                                             |       | (1,079                                                             | )          | — |   | — |   | — |   | — |   |
| Net income (loss)                                                                               |       | $                                                                  | 35,324     |   | $ | 17,136 |   | $ | (510 | ) | $ | (19,222 | ) | $ | (38,116 | ) |
| Net income (loss)  per share—basic                                                         |       | $                                                                  | 1.09       |   | $ | 0.58 |   | $ | (0.02 | ) | $ | (0.79 | ) | $ | (1.78 | ) |
| Net income (loss)  per share—diluted                                                       |       | $                                                                  | 0.96       |   | $ | 0.52 |   | $ | (0.02 | ) | $ | (0.79 | ) | $ | (1.78 | ) |
| Shares used in  per-share calculation—basic                                                |       | 32,328                                                             |       | 29,398 |   | 26,791 |   | 24,285 |   | 21,413 |   |
| Shares used in per-share  calculation—diluted                                              |       | 38,532                                                             |       | 33,051 |   | 26,791 |   | 24,285 |   | 21,413 |   |

 
| ** **                       | ** ** | **DECEMBER 31,**   | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                       | ** ** | **(in thousands)** | ** ** |
| **Balance Sheet Data:**          |       |                    |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents       |       | $                       | 127,734    |   | $ | 72,885 |   | $ | 40,801 |   | $ | 21,677 |   | $ | 16,920 |   |
| Short-term  investments          |       | 164,402                 |       | 59,037 |   | — |   | 9,978 |   | 14,977 |   |
| Working capital                  |       | 198,747                 |       | 85,011 |   | 14,498 |   | 14,024 |   | 17,038 |   |
| Total assets                     |       | 504,521                 |       | 189,658 |   | 96,534 |   | 78,780 |   | 69,403 |   |
| Long-term  obligations           |       | 195,000                 |       | — |   | — |   | — |   | — |   |
| Accumulated  deficit             |       | (51,164                 | )          | (86,488 | ) | (103,624 | ) | (103,114 | ) | (83,892 | ) |
| Total stockholders’  equity |       | $                       | 192,769    |   | $ | 131,852 |   | $ | 57,186 |   | $ | 50,422 |   | $ | 48,518 |   |

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(a)           In2002, upon adoption of SFAS No. 142, “Goodwill and Other Intangible Assets”, we discontinued theamortization of goodwill. We included $10.8 million and $7.6 million ofgoodwill amortization in 2001 and 2000, respectively.

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**ITEM7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATION.**

We are a provider of comprehensive e-commerceoutsourcing solutions. We were incorporated in February 1994 and commencedoffering products for sale through our clients’ e-commerce stores in August 1996.From inception through August 1996, we had no sales, and our activitiesrelated primarily to the development of our proprietary technology platform. In1996, we began to focus our business development efforts on the softwareindustry, building our catalog of software products through contracts withsoftware publishers. In 1997, we began to develop software distributionrelationships through contracts with online retailers. In late 1998, we beganto offer our comprehensive e-commerce outsourcing services in the form of atransaction fee-based e-commerce service to clients outside of the softwareindustry. As of March 1, 2005, we were providing e-commerce services formore than 40,000 software and digital products publishers, manufacturers,online retailers and online channel partners.

Prior to January 1, 2004, we managed our physicalgoods clients through a division (formerly our E-Business Services Division)that was separate from our Software and Digital Commerce Services Division. Beginningin January 2004, this divisional structure was consolidated, and weannounced that we will no longer report our activities as separate businesssegments. Nonetheless, we remain committed to serving existing and new clientsin the important vertical market of physical goods.

We have approximately eight years of operating historyupon which investors may evaluate our business and prospects. Until 2003, weincurred significant losses, and as of December 31, 2004, had anaccumulated deficit of approximately $51.2 million. We intend to expendfinancial and management resources on the development of additional services,sales and marketing, technology and operations to support larger-scaleoperations and greater service offerings. Although we expect to generatepositive cash flow from operations in 2005, there can be no assurance that ourrevenue will increase or even continue at its current level or that we willmaintain profitability or generate cash from operations in future periods.

Our prospects must be considered in light of therisks, expenses and difficulties frequently encountered by companies in new andrapidly evolving markets such as e-commerce. To address these risks, we must,among other things, attract and retain software publishers and online retailersas clients, attract and retain physical goods clients, introduce new Web sites,online stores or services, continue to upgrade and develop our systems andinfrastructure to meet emerging market needs and remain competitive in ourservice offerings, and retain and attract personnel commensurate with ourbusiness needs. There can be no assurance that we will be successful inaddressing these risks, and any failure to do so could have a material adverseeffect on our business, financial condition and results of operations.

Our current and futureexpense levels are based largely on our planned operations and estimates offuture revenue. Revenue and operating results generally depend on the volumeand timing of orders received, which are difficult to forecast. We may beunable to adjust spending in a timely manner to compensate for any unexpectedrevenue shortfall. Accordingly, any significant shortfall in revenue could havean immediate adverse effect on our business, financial condition and results ofoperations. Our quarterly and annual operating results are subject tofluctuations in demand for the products or services offered by us or ourclients, such as anti-virus software and tax preparation software, among others. In particular, sales of anti-virussoftware represented a significant portion of our revenues in recent years, andcontinue to be very important to our business. To the extent that ourcompetitors successfully introduce products or services not sold through ourplatform that are competitive with products and services sold by currentDigital River clients (including anti-virus products and services), ourrevenues will be adversely affected. We are also likely to continue to seerevenue fluctuate on a seasonal basis, which is typical for the softwarepublishing market in general and for our existing physical goods clients. Webelieve that our first and fourth quarters tend to be seasonally stronger thanour second and third quarters due to the timing of demand for tax preparationsoftware and the holiday season selling period. In addition, we believe that 

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softwarepublishers avoid new product releases in the summer months. In view of therapidly evolving nature of our business, we are unable to accurately forecastour revenue and believe that period-to-period comparisons of our operatingresults are not necessarily meaningful and should not be relied upon as anindication of future performance.

***Critical Accounting Policies***

We prepare ourconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America. As such, we are required tomake certain estimates, judgments and assumptions that we believe arereasonable based upon the information available. These estimates andassumptions affect the reported amounts of assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the periods presented. The significant accounting policies which webelieve are the most critical in fully understanding and evaluating ourreported financial results are the following:

*Revenue Recognition.**  *We recognizerevenue from services rendered once all the following criteria for revenuerecognition have been met: (1) pervasiveevidence of an agreement exists; (2) the services have been rendered; (3) thefee is fixed and determinable and not subject to refund or adjustment; and (4) collectionof the amounts due is reasonably assured. We derive our revenue primarily fromtransaction fees based on a percentage of the products sale price and fees fromservices rendered associated with the e-commerce services provided to ourclients and end customers. These services include e-commerce development andhosting, transaction processing, fraud screening, digital delivery, integrationto physical fulfillment, merchandising services, analytical marketing, customerservice and proprietary software backup services. We report our revenue on anet basis and therefore record only the net service fees and transaction feesas our revenue. We act as the merchant of record on most of the transactionsprocessed and have contractual relationships with our clients, which obligateus to pay to the client a specified percentage of each sale. We retain ourtransaction fee and also charge fees for services rendered. Signed contractsare obtained from clients prior to recognition of these revenues. Clients donot have the right to take possession of the software applications used in thedelivery of services. Payments received in advance of rendering the service,even if non-refundable, are recorded as deferred revenue until earned.

*Allowance for Doubtful Accounts*.   The preparation of financialstatements requires management to make estimates and assumptions that affectthe reported amount of assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reportingperiod. Estimates are used in determining our allowance for doubtful accountsand are based on our historical experience and current trends. Management mustmake estimates of the uncollectability of our billed accounts receivable.Management specifically analyzes accounts receivable and historical bad debts,customer credit-worthiness, current economic trends and changes in our customerpayment terms when evaluating the adequacy of the allowance for doubtfulaccounts. Significant management judgments and estimates must be made and usedin connection with the allowance in any accounting period. Material differencesmay result in the amount and timing of our operating results for any period ifmanagement makes different judgments or utilizes different estimates.

*Credit Card Chargeback Reserve.**  *Estimates arealso used in determining our accrued chargeback expenses and are based on ourhistorical experience and current trends. Management makes an estimate ofanticipated future credit card chargebacks related to current period revenue byanalyzing the timing of historical credit card chargebacks as well as reviewingthe current charge back trends and applying a conservative anticipated rate tocurrent period revenues. Significant management judgments and estimates must bemade and used in connection with the accrued expenses in any accounting period.Material differences may result in the amount and timing of our operatingresults for any period if management makes different judgments or utilizesdifferent estimates.

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*Goodwill, Intangibles And OtherLong-Lived Assets.**  *We amortize property, plantand equipment, certain intangibles and certain other long-lived assets withdefinite lives over their useful lives. Useful lives are based on management’sestimates of the period that the assets will generate revenue. Assets withdefinite lives are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Our evaluation considers nonfinancial data such as changes in theoperating environment and business strategy, competitive information, markettrends and operating performance. If indicators of impairment are present, weutilize an undiscounted cash flow analysis to determine the impairment amount, ifany. Assets with indefinite lives are reviewed annually (or more frequently ifimpairment indicators are present) for impairment utilizing the two-stepapproach prescribed in Statement of Financial Accounting Standards (SFAS)No. 142, “Goodwill and Other Intangible Assets.”Our assessment has indicated that there havebeen no impairments of goodwill for the years 2004, 2003 and 2002.

*IncomeTaxes and Deferred Taxes.**  *Wecurrently have significant U.S. tax loss carryforwards resulting primarily fromthe tax deduction for disqualifying disposition of stock options, and a lesseramount of acquired foreign operating tax loss carryforwards. The deferred taxbenefit of the loss carryforwards has been fully reserved by a valuationallowance pursuant to GAAP. The benefit of the loss carryforwards fromdisqualifying disposition of stock options will be recognized as additionalpaid in capital when these deductions are utilized in future periods. Thevaluation reserve of the deferred tax asset will be removed if and when we havemet the requirements under GAAP of more likely than not that we will realizethe benefit of the deferred tax asset. Deferred tax assets are the tax value oftemporary timing differences for financial reporting and tax basis of assetsand liabilities.

**Results OfOperations**

Thefollowing table sets forth certain items from our consolidated statements ofoperations as a percentage of total revenue for the years indicated.
| ** **                                                                                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                                                                                          |       | 100.0    | %          | 100.0    | %          | 100.0    | %          |
| Costs and expenses  (exclusive of depreciation and amortization expense shown separately below): |       |     |       |     |       |     |       |
| Direct cost of services                                                                          |       | 3.3      |       | 3.6      |       | 3.0      |       |
| Network and infrastructure                                                                       |       | 9.8      |       | 12.1     |       | 14.7     |       |
| Sales and marketing                                                                              |       | 33.6     |       | 36.8     |       | 41.7     |       |
| Product research and development                                                                 |       | 9.1      |       | 9.8      |       | 14.7     |       |
| General and administrative                                                                       |       | 11.1     |       | 9.1      |       | 8.8      |       |
| Litigation and other charges                                                                     |       | (0.1     | )          | —   |       | 3.2      |       |
| Depreciation and amortization                                                                    |       | 5.3      |       | 7.2      |       | 7.7      |       |
| Amortization of acquisition related intangibles                                                  |       | 5.4      |       | 5.3      |       | 7.4      |       |
| Total costs and  expenses                                                                        |       | 77.5     |       | 83.9     |       | 101.2    |       |
| Income (loss)  from operations                                                                   |       | 22.5     |       | 16.1     |       | (1.2     | )          |
| Other  income/(expense), net                                                                     |       | 1.1      |       | 0.8      |       | 0.5      |       |
| Income (loss)  before income tax expense                                                         |       | 23.6     |       | 16.9     |       | (0.7     | )          |
| Income tax  expense                                                                              |       | (0.7     | )          | —   |       | —   |       |
| Net income (loss)                                                                                |       | 22.9     | %          | 16.9     | %          | (0.7     | )%         |

 

***REVENUE****.  *Our revenue increased to $154.1million in 2004 from $101.2 million in 2003 and $77.8 million in2002. The revenue increase in 2004 was primarily attributable to higher onlineactivity across our client base, growth in the number of software publishersand online retailer clients, increased international sites, and accretiveacquisitions. The revenue increase in 2003 as compared to 2002 resulted 

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from further expansion ofour key client relationships, increasing market acceptance of electronicsoftware downloading, merchandising activities that increased the average salesgenerated by our software publisher clients, the acquisitions completed by usin 2003, and a full year of revenue for the acquisitions completed at varioustimes during 2002. New acquisitions during each respective year generatedapproximately 16.1%, 1.5% and 9% of our total revenue during 2004, 2003 and2002, respectively.

International sales represented approximately 31%, 24%and 22% of revenue in the years ended December 31, 2004, 2003 and 2002,respectively.

***GROSS MARGIN(Exclusive of depreciation and amortization, consistent with our ConsolidatedStatement of Operations.)  ***Cost of revenue consistsof direct cost of services and network and infrastructure costs and is composedof direct labor costs related to revenue and the costs to operate and maintainour technology platform, as well as customer service and operations functions. Suchamounts are shown exclusive of any related depreciation and amortizationexpenses. Gross margin increased substantially in all years presented,reflecting our growth in revenue. Gross margin was$134.0 million in 2004, up from$85.4 million in 2003 and $64.0 million in 2002. Gross profit margins were86.9%, 84.3% and 82.3% in the years ended December 31, 2004, 2003 and2002, respectively. The gross profit margin increases in 2004, 2003 and 2002were primarily due to leveraging our infrastructure over significantly morerevenue and clients. We continue to believe that e-commerce and relatedservices may become more competitive in the future. Accordingly, we may have toreduce our pricing or alter our pricing structure and policies in the futureand any such change could negatively impact gross margins. We expect directcost of services and network and infrastructure to increase in absolute dollarsand remain relatively flat as a percent of revenue.

***GROSS MARGIN (Inclusive ofdepreciation and amortization, an alternative to our Consolidated Statement ofOperations presentation.).***   Gross margin, inclusiveof deprecation and amortization was$127.5 million in 2004, up from$79.6 million in 2003 and $59.2 million in 2002. Gross profit margins,inclusive of depreciation and amortization, were 82.7%, 78.6% and 76.2% in theyears ended December 31, 2004, 2003 and 2002, respectively. This inclusivepresentation is an allocation of depreciation and amortization costs from thatline item in our Consolidated Statement of Operations. This inclusiveallocation impacts neither net income (loss), nor net income (loss) per shareas reported.

***SALES AND MARKETING****.  *Sales and marketing expenseconsists primarily of personnel and related expenses, advertising andpromotional expenses, credit card chargebacks and bad debt expense, and creditcard transaction fees. Sales and marketing expense increased to $51.7 million in2004, from $37.2 million and $32.4 million in 2003 and 2002,respectively. The increase in 2004 from 2003 resulted primarily from increasesin credit card transaction fees of $8.0 million and personnel related expenses,including personnel of acquired businesses, of $4.8 million. The increase in2003 from 2002 resulted primarily from increases in credit card transactionfees of $3.0 million, credit card chargeback expense of $1.5 million, andpersonnel related expenses of $0.3 million. As a percentage of revenue, salesand marketing expense decreased to 33.6% in 2004 from 36.8% in 2003 and 41.7%in 2002, primarily reflecting our increased revenue. We expect that sales andmarketing expense will continue to increase in absolute dollars as we continueto build our sales and marketing infrastructure and develop marketing programs,and as volume-driven credit card expenses and chargebacks increase. As apercentage of revenue, these expenses are expected to continue to moderatelydecrease.

***PRODUCT RESEARCHAND DEVELOPMENT****.  *Productresearch and development expense consists primarily of personnel and relatedexpenses and consulting costs associated with developing and enhancing ourtechnology platform and related internal systems. Product research anddevelopment expense was $14.1 million in 2004, compared to $10.0 millionand $11.5 million in 2003 and 2002, respectively. The increase in 2004from 2003 resulted primarily from increases in personnel related expenses,including personnel of acquired businesses, of $3.9 million offset by adecrease of $0.3 million in consulting related expenses. In addition, weexpanded and redeployed our R&D team in 2004 to advance our new

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self-service, remotecontrol technology, and to develop the international and e-marketing capabilitiesof our next-generation e-commerce platform, and capitalized approximately $2.7million of software development costs related to those efforts. Theamortization of capitalized development costs is included in our depreciationexpense line shown separately on our statement of operations. The decrease in2003 from 2002 resulted primarily from a decrease in consulting expenses of$1.2 million. As a percentage of revenue, product research and developmentexpense decreased to 9.1% in 2004 from 9.8% in 2003 and 14.7% in 2002,primarily reflecting our increased revenue. We expect that product research anddevelopment expenses will increase in absolute dollars but decline slightly ona percentage basis as revenues increase.

***GENERAL ANDADMINISTRATIVE****.  *Generaland administrative expense consists principally of executive, accounting andadministrative personnel and related expenses, insurance expense, professionalfees and investor relations’ expenses. General and administrative expenseincreased to $17.1 million in 2004 from $9.2 million in 2003 and$6.8 million in 2002. The increase in 2004 from 2003 resulted primarilyfrom increases in personnel and consulting related expenses, includingpersonnel and consulting expenses of acquired businesses, of approximately $2.6million in support of our infrastructure, as well as increases of approximately$3.4 million in professional and legal fees and audit and tax servicespredominantly associated with compliance with the Sarbanes-Oxley Act andrelated rules and regulations, international tax planning, foreigngovernance compliance, and ongoing litigation expenses. The increase in 2003from 2002 resulted primarily from increases in personnel related expenses ofapproximately $0.9 million, legal and professional fees of approximately $0.8million and insurance charges of approximately $0.3 million. As a percentage ofrevenue, general and administrative expense increased to 11.1% in 2004 from9.1% in 2003 and 8.8% in 2002, reflecting our increased revenue as well as ourgrowth in the expense base from legal and professional services andinfrastructure changes in 2004 and 2003. We expect general and administrativeexpense to increase in absolute dollars in the future and moderately decreaseas a percentage of revenue.

***LITIGATION ANDOTHER CHARGES.  ***In December 2004, we announcedthat we had settled, for an undisclosed amount and terms, the action brought byChristopher M. Crawford against us which had alleged infringement of U.S.Patent No. 6,014,651. This amount was charged against the previouslyestablished litigation reserve. The balance of the litigation reserve wascredited to litigation expense. In addition, various other legal matters, notpreviously reserved, were charged to litigation expense in 2004. In 2004, wealso reviewed all outstanding legal matters and based on that reviewestablished a litigation reserve, and incurred litigation expense, of $1.1million. The net result of these actions resulted in a credit to litigationexpense of $0.2 million in 2004. During 2003, no charges were recorded forsettlement of litigation and other charges. During March 2002, we recordeda charge for pending litigation of $2.3 million. This reserve was establishedbased upon developments in new and existing litigation for which we determined,in the first quarter of 2002, that payment was both probable and estimable. Inthe fourth quarter of 2002, our ongoing contractual dispute with ePedas Sdn Bhdwas settled with no admission of liability by either party and our agreement topay $0.6 million to ePedas. This amount was charged against the litigationreserve. Each party released the other from all claims related to the disputeand dismissed their respective claims with prejudice.

***DEPRECIATION ANDAMORTIZATION****.  *Depreciationand amortization expense consists primarily of depreciation of computerequipment, office furniture and amortization of purchased and internallydeveloped software as well as leasehold improvements made to our leasedfacilities as well as amortization of debt financing costs. Computer equipment,software and furniture are depreciated under the straight-line method usinglives of three to seven years, and leasehold improvements are amortized overthe shorter of the asset life or remaining length of the lease. Depreciationand amortization expense increased to $8.2 million in 2004 from $7.3 million in2004 and $6.0 million in 2002. The increased expenses in 2004 and 2003 resultedprimarily from increases in our assets as gross capitalized property andequipment increased to 

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$41.1 million by December 31,2004 from $32.4 million on December 31, 2003 and $29.0 million on December 31,2002.

***AMORTIZATION OFACQUISITION RELATED INTANGIBLES****.  *Amortization of acquisition related intangiblesconsists of the amortization of other intangible assets recorded from our 17acquisitions in the past four years. Amortization of acquisition relatedintangibles increased to $8.3 million in 2004 from  $5.4 million in 2003 and $5.7 million in 2002.The increase in 2004 from 2003 reflects the increased amortization of 2004acquisitions only partially offset by full amortization of certain pastacquisitions. The decrease in 2003 from 2002 reflects the full amortization ofcertain past acquisition costs which reduced expense in amounts greater thanthe amortization expense added by new acquisitions in 2003. We complete ourannual goodwill impairment test using a two-step approach in the fourth quarterof each year. Our assessment has indicated that there is no impairment ofgoodwill for the years ended December 31, 2004, 2003 and 2002.

***INCOME (LOSS) FROMOPERATIONS****.  *Ourincome from operations in 2004 was $34.8 million, up from $16.3 million in 2003and a loss of $0.9 million in 2002. As a percentage of revenue, income fromoperations was 22.5% in 2004, 16.1% in 2003 and a loss of 1.2% in 2002. Theincrease in income from operations in 2004 and 2003 resulted primarily fromincreased revenue without corresponding increases in operating expenses.

***OTHERINCOME/(EXPENSE), NET****.  *Otherincome/(expense), net consists of interest income on our cash and cashequivalents and short-term investments, interest expense on debt financingobligations, currency gain or loss from remeasured foreign transactions orassets from their native currency to their functional currency, as well as gainor loss on the sale of investments. Interest income was $3.2 million, $0.8million and $0.4 million in 2004, 2003 and 2002, respectively. Interest expensewas $1.5 million in 2004 with no corresponding interest expense in 2003 or 2002.Gains or losses from currency re-measurement and the sale of investments wereimmaterial in 2004, 2003, and 2002.

***INCOME TAXES***.   In 2004, we hadtax expense of $1.1 million primarily related to corporate tax expense inGermany. U.S. net income was almost fully offset by net operating losscarryforwards. As of December 31, 2004, we had net U.S. operating losscarryforwards of approximately $96.7 million, and foreign tax losscarryforwards of $7.8 million. Included in this amount are approximately $88.3million of deductions resulting from disqualifying dispositions of stockoptions. When these disqualifying disposition deductions are realized forfinancial statement purposes they will not result in a reduction in income taxexpense, rather the benefit will be recorded as additional paid-in-capital.These income tax net operating loss carryforwards expire in the years 2012 through 2024. Additionally, we have made a Section338 election allowing us to deduct the step up basis in acquisitions ofapproximately $100 million over 15 years. Deductions from disqualifyingdispositions of stock options are included in net operating loss carryforwardswith a corresponding valuation allowance. Because of the uncertainty of futurerealization, a valuation allowance equal to the deferred tax asset has beenrecorded. Ownership changes resulting from the issuance of additional equitymay limit future annual realization of the tax net operating loss carryforwardsto a specified percentage of our value under Section 382 of the InternalRevenue Code.

**Liquidity and Capital Resources**

As of December 31, 2004, we had $127.7 million ofcash and cash equivalents, $164.4 million of short-term investments and workingcapital of approximately $198.7 million. Significantcomponents of our working capital are cash and cash equivalents, short-terminvestments and short-term receivables net of client and merchant payables. Ourprimary source of internal liquidity is our operating activities. Net cashgenerated by operating activities in 2004, 2003 and 2002 was $85.1million, $47.8 million and $17.6 million, respectively. Net cash generatedby operating activities in 2004 was the result of net income, increases inaccounts payable and other accrued liabilities offset by increases in accountsreceivable. Net cash 

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generated by operatingactivities in 2003 was the result of net income, decreases in accountsreceivable, and increases in accounts payable, deferred revenue and otheraccrued liabilities. Net cash generated by operating activities in 2002 wasprimarily due to declining net losses and growing accounts payable balances.

Net cash used in investing activities was $241.4million in 2004 and was the result of net purchases of investments of $105.6million, cash paid for acquisitions, net of cash received, of $126.5million and purchases of capital equipment of $6.6million and capitalized internal-use software of $2.7 million. Net cash used ininvesting activities was $72.2 million in 2003 and was the result of purchasesof investments of $59.0 million, purchases of capital equipment of $6.3 millionand cash paid for acquisitions, net of cash received, of $6.9 million. Net cashused in investing activities was $0.6 million in 2002 and was the result ofpurchases of equipment of $5.2 million and cash paid for acquisitions, net ofcash received, of $5.4 million offset by $10.0 million in investment sales. In April 2004,we acquired element 5 AG, a privately held company based in Germany. Under theterms of the acquisition, we paid $120 million in cash to acquire all of theoutstanding shares of capital stock of element 5. In June 2004, weannounced that we acquired substantially all of the assets and assumed certainliabilities of Fireclick, Inc. Under the terms of the agreement, we paid$7.5 million in cash. In November 2004, we acquired all of the outstandingstock of BlueHornet Networks, Inc. Under the terms of the agreement weissued 160,185 shares of common stock to BlueHornet shareholders and assumeddebt obligations of BlueHornet totaling approximately $0.7 million.

In June 2004 we soldand issued $175 million in aggregate principal amount of 1.25% convertiblesenior notes due January 1, 2024, in a private, unregistered offering. Thenotes were sold at 100% of their principal amount. The initial purchasersexercised in full their option to purchase up to an additional $20 million inaggregate principal amount of the notes, closing on July 6, 2004. Ourprimary other source of external liquidity has been issuances of our stock,either through public offerings or by exercise of stock options and throughpurchases under our employee stock purchase plan. Net cash provided byfinancing activities in 2004, 2003 and 2002 was $209.0 million, $56.5 millionand $2.2 million, respectively. Cash provided from the issuance ofconvertible senior notes in 2004 totaled $188.4 million, net of financingexpense. Cash provided from a follow-on offering of our common stock in 2003totaled $43.4 million. Proceeds from the exercise of stock options and warrantsprovided cash totaling $19.7 million, $12.3 million and $4.3 million in 2004,2003 and 2002, respectively. In 2002, we repaid the $2.5 million in notespayable related to our August 2001 acquisition of RegSoft which caused adecrease in net cash provided by financing activities.

**Contractual Obligations**

At December 31,2004, our principal commitments consisted of interest and principal on ourconvertible senior notes and long-term obligations outstanding under operatingleases. Although we have no material commitments for capital expenditures, weanticipate continued capital expenditures consistent with our anticipated growthin operations, infrastructure and personnel as well as those that may arise inconnection with our integration of element 5, Fireclick, Inc. andBlueHornet Networks. We also anticipate that we will continue to experiencegrowth in our operating expenses for the foreseeable future and that ouroperating expenses will be a material use of our cash resources.
| ** **                       | ** ** | **Payment due by period (in thousands)** | ** ** |
|----------------------------------|------------|-------------------------------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                                        | ** ** | **Total Amount  Committed** | ** ** | **2005** | ** ** | **2006-2007** | ** ** | **2008-2009** | ** ** | **2010 and  Thereafter** | ** ** |
| Operating Lease  Obligations     |       |                                                              | $          | 5,465 |   |   | $ | 1,921 |   |   | $ | 1,896 |   |   |   | $ | 1,405 |   |   | $ | 243 |   |
| Convertible  Senior Notes        |       |                                                              | $          | 241,313 |   |   | $ | 2,438 |   |   | $ | 4,875 |   |   |   | $ | 4,875 |   |   | $ | 229,125 |   |
| Total                            |       |                                                              | $          | 246,778 |   |   | $ | 4,359 |   |   | $ | 6,771 |   |   |   | $ | 6,280 |   |   | $ | 229,368 |   |
|                                  |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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We expect to continue to evaluate and considerpotential strategic transactions, including business combinations andacquisitions of businesses, products, services and other assets as well aslicenses of technology related to our current business. At any given time, wemay be engaged in discussions or negotiations with respect to one or more suchtransactions. Any such transactions could have a material impact on ourfinancial position, results of operations, and cash flows. There is noassurance that any such discussions or negotiations will result in theconsummation of any transaction. The process of integrating any acquisition maycreate unforeseen challenges for our operational, financial and managementinformation systems, as well as unforeseen expenditures and other risks,including diversion of management’s attention from other business concerns, thepotential loss of key customers, employees and business partners, difficultiesin managing facilities and employees in different geographic areas, anddifficulties in entering markets in which we have no or limited direct priorexperience and where competitors in such markets have stronger market positions.In addition, an acquisition may cause us to assume liabilities or becomesubject to litigation. Further, there can be no assurance that we will realizea positive return on any acquisition or that future acquisitions will not bedilutive to our current shareholders’ percentage ownership or to earnings. Wehave allocated significant value in the form of goodwill and intangibles forthe companies we acquired in the past, which is subject to impairment testingon a regular basis. If the individual businesses do not perform as expected atthe acquisition dates, we may incur impairment charges for goodwill,accelerated amortization of definite-lived intangibles due to shortenedexpected lives of these assets, immediate write-offs and restructuring or otherrelated expenses.

In April 2004, inconnection with our acquisition of element 5, we established a $45million secured revolving credit facility with Harris Trust and Savings Bank. Thisfacility was repaid in full and terminated in connection with the sale andissuance of our 1.25% convertible senior notes in June 2004.

With respect to ourconvertible senior notes, we are required to pay interest on the notes on January 1and July 1 of each year beginning January 1, 2005. The notes bearinterest at a rate of 1.25% and, if specified conditions are met, areconvertible into our common stock at a conversion price of $44.063 per share. Thenotes may be surrendered for conversion under certain circumstances, includingthe satisfaction of a market price condition, such that the price of our commonstock reaches a specified threshold; the satisfaction of a trading pricecondition, such that the trading price of the notes falls below a specifiedlevel; the redemption of the notes by us, the occurrence of specified corporatetransactions, as defined in the related indenture; and the occurrence of afundamental change, as defined in the related indenture. The initial conversionprice is equivalent to a conversion rate of approximately 22.6948 shares per$1,000 of principal amount of the notes. We will adjust the conversion price ifcertain events occur, as specified in the related indenture, such as the issuanceof our common stock as a dividend or distribution or the occurrence of a stocksubdivision or combination. If a fundamental change, such as a change in ourcontrol, as defined in the related indenture, occurs on or before January 1,2009, we may also be required to purchase the notes for cash and pay anadditional make whole premium payable in our common stock upon the repurchaseor conversion of the notes in connection with the fundamental change. Holdersof the notes have the right to require us to repurchase their notes prior tomaturity on January 1, 2009, 2014 and 2019. We have the right to redeemthe notes, under certain circumstances, on or after July 1, 2007 and priorto January 1, 2009, and we may redeem the notes at anytime on or after January 1,2009.

**Liquidityand Capital Resource Requirements**

We believe that existingsources of liquidity and the results of our operations will provide adequatecash to fund our on-going operations for the foreseeable future, although wemay seek to raise additional capital during that period. In January 2002,we filed a universal shelf registration statement with the SEC pursuant towhich we could issue up to $100 million in common stock, preferred stock, debtsecurities and/or warrants.  Of thisamount, approximately $45 million was utilized to issue common stock in our July 2003public offering leaving approximately $55 million available for future use.  In January 2005, we 

42

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filed aregistration statement to increase our available shelf registration amount fromapproximately $55 million to $255 million. In addition, we filed an acquisitionshelf for up to approximately 1.5 million shares. These filings were made toprovide future flexibility for acquisition and financing purposes. The sale ofadditional equity or convertible debt securities could result in additionaldilution to our stockholders. There can be no assurances that financing will beavailable in amounts or on terms acceptable to us, if at all.

**Recent Accounting Pronouncements**

In December 2004, theFinancial Accounting Standards Board issued SFAS 123 (R), “Share-Based Payment.”  This Statement is a revision to SFAS 123, “Accountingfor Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  SFAS 123(R) requiresthe measurement of the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award. Nocompensation cost is recognized for equity instruments for which employees donot render service. We will adopt SFAS 123(R) effective on July 1,2005, requiring compensation cost to be recognized as expense for the portionof outstanding unvested awards, and any new awards made thereafter, based onthe grant-date fair value of those awards.

**ITEM7a. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK.**

**Interest Rate Risk**

We maintain our portfolioof cash equivalents and short-term investments in a variety of securities,including government obligations andmoney market funds. Investments are classified as available-for-salesecurities and carried at their market value with cumulative unrealized gainsor losses recorded as a component of accumulated other comprehensiveincome/(loss) within stockholders’ equity. As of December 31, 2004, allsecurities held had maturities of less than three years. A sharp rise in interest rates could have anadverse impact on the market value of certain securities in our portfolio. Wedo not currently hedge our interest rate exposure and do not enter into financialinstruments for trading or speculative purposes or utilize derivative financialinstruments. A hypothetical and immediate 1 percent increase in interest rateswould decrease the fair value in our investment portfolio held at December 31,2004 by $0.3 million. A hypothetical and immediate 1 percent decrease ininterest rates would increase the fair value in our investment portfolio heldat December 31, 2004 by $0.4 million. Such hypothetical changes ininterest rates would not materially impact our investment portfolio held at December 31,2003. The approximate gains or losses in earnings are estimates, andactual results could vary due to the assumptions used. We currently have $195 million of 1.25% fixed rate continent convertibledebt outstanding. We believe there is minimal risk that market interest rateswill drop significantly below 1.25%.

**Foreign Currency Risk**

Our operations havehistorically been conducted primarily in the United States currency and as suchhave not been subject to material foreign currency exchange rate risk.  However, the growth in our internationaloperations is increasing our exposure to foreign currency fluctuations as wellas other risks typical of international operations, including, but not limitedto differing economic conditions, changes in political climate, differing taxstructures and other regulations and restrictions. Accordingly, our futureresults could be materially adversely impacted by changes in these or otherfactors. For example, approximately half of our recently acquired subsidiaryelement 5’s revenue is denominated in euros or currencies other than the U.S.dollar. As a result, a greater proportion of our revenues and earnings are nowsubject to currency fluctuations. We translate statement of operations amountsthat are denominated in foreign currency into U.S. dollars at the averageexchange rates in each applicable period. To the extent the U.S. dollar weakensagainst foreign currencies, the translation of these foreign currencydenominated transactions results in increased net revenues, operating expensesand net income. Conversely, our net 

43

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revenues,operating expenses and net income will decrease when the U.S. dollarstrengthens against foreign currencies. We do not currently have a currencyhedging program to mitigate the effect of fluctuations of currency prices onour financial results. Were the foreign currency exchange rates to depreciateimmediately and uniformly against the U.S. dollar by 10 percent from levels at December 31,2004 and 2003, our reported cash balances would decrease $2.1 million and $0.8million, or 1.6 and 1.1 percent, respectively, and net investment in foreignoperations would decrease by $0.1 million. The approximate gain or losses inearnings or foreign investment are estimates, and actual results could vary dueto the assumptions used.

**ITEM8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**

Our Financial Statementsand Notes thereto appear beginning at page 52 of this report.

**QUARTERLYFINANCIAL DATA (UNAUDITED)**
| ** **                            | ** ** | **QUARTER ENDED**                                             | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                            | ** ** | **March 31**                                                  | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| ** **                            | ** ** | **(in thousands, except per share data)** | ** ** |
| **2004**                              |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                               |       | $                                                                  | 31,855     |   | $ | 34,877 |   |   | $ | 39,439 |   |   |   | $ | 47,959 |   |   |
| Income from  operations(a)            |       | 7,518                                                              |       | 6,888 |   |   | 7,809 |   |   |   | 12,547 |   |   |
| Net income                            |       | 7,615                                                              |       | 6,756 |   |   | 8,126 |   |   |   | 12,828 |   |   |
| Net income per  share—basic      |       | 0.24                                                               |       | 0.21 |   |   | 0.25 |   |   |   | 0.39 |   |   |
| Net income per  share—diluted(b) |       | $                                                                  | 0.22       |   | $ | 0.19 |   |   | $ | 0.22 |   |   |   | $ | 0.33 |   |   |

 
| ** **                         | ** ** | **QUARTER ENDED**                                             | ** ** |
|------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                         | ** ** | **March 31**                                                  | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| ** **                         | ** ** | **(in thousands, except per share data)** | ** ** |
| **2003**                           |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                            |       | $                                                                  | 24,600     |   | $ | 22,764 |   |   | $ | 26,748 |   |   |   | $ | 27,089 |   |   |
| Income from  operations(a)         |       | 3,952                                                              |       | 2,520 |   |   | 4,477 |   |   |   | 5,349 |   |   |
| Net income                         |       | 4,022                                                              |       | 2,767 |   |   | 4,741 |   |   |   | 5,606 |   |   |
| Net income per  share—basic   |       | 0.15                                                               |       | 0.10 |   |   | 0.16 |   |   |   | 0.18 |   |   |
| Net income per  share—diluted |       | $                                                                  | 0.13       |   | $ | 0.09 |   |   | $ | 0.14 |   |   |   | $ | 0.16 |   |   |

----

(a)           Income from operationsincludes amortization of acquisition related intangibles of $1,579, $2,267,$2,434 and $1,989 in the quarters ended March 31, June 30, September 30and December 31, 2004, respectively, and $1,221, $1,246, $1,411, and$1,502 in the quarters ended March 31, June 30, September 30 andDecember 31, 2003, respectively.

(b)          Subsequent to ourissuance of 1.25% convertible senior notes on June 1, 2004, the EmergingIssues Task Force (EITF), Issue No. 04-08, proposed that theunissued shares underlying contingent convertible notes be treated as if suchshares were issued and outstanding for the purposes of calculating GAAP dilutedearnings per share. On October 13, 2004, the Financial AccountingStandards Board (FASB) ratified this new accounting treatment for periodsending after December 15, 2004 and is retroactive for all period reported.As a result, the dilutive effect of our 1.25% convertible senior notes is nowreflected in our quarterly diluted earnings per share numbers in 2004.

**ITEM9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE.**

None.

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**ITEM9A. CONTROLS AND PROCEDURES.**

Based on their evaluationof our disclosure controls and procedures conducted as of December 31,2004, our Chief Executive Officer and Chief Financial Officer have concludedthat our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) promulgated under the Securities Exchange Act of 1934) areeffective at the reasonable assurance level. This evaluation did not identifyany change in our internal control over financial reporting that occurredduring the quarter ended December 31, 2004 that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

**Management’sReport on Internal Control Over Financial Reporting**

Our management, includingthe Chief Executive Officer and Chief Financial Officer, is responsible forestablishing and maintaining an adequate system of internal control overfinancial reporting. This system of internal accounting controls is designed toprovide reasonable assurance that assets are safeguarded, transactions areproperly recorded and executed in accordance with management’s authorizationand financial statements are prepared in accordance with generally acceptedaccounting principles. A control system, no matter how well conceived and operated,can provide only reasonable, not absolute, assurance that the objectives of thecontrol system are met. Further, the design of a control system must reflectthe fact that there are resource constraints, and the benefits of controls mustbe considered relative to their costs. Because of the inherent limitations inall control systems, no evaluation of controls can provide absolute assurancethat all control issues and instances of fraud, if any, within our company havebeen detected. These inherent limitations include the realities that judgmentsin decision-making can be faulty, and that breakdowns can occur because ofsimple error or mistake. Additionally, controls can be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the control. The design of any system of controls alsois based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions; over time, control maybecome inadequate because of changes in conditions, or the degree of compliancewith the policies or procedures may deteriorate. Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud may occur and not be detected.

Managementconducted an evaluation of the effectiveness of the system of internal controlover financial reporting based on the framework in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO). Based on this evaluation, management concluded that ourinternal control over financial reporting was effective as of December 31,2004 to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Management’sassessment of the effectiveness of our internal control over financialreporting has been audited by Ernst & Young LLP, an independentregistered public accounting firm, as stated in their report in which theyexpressed an unqualified opinion, which is included herein.
| /s/ JOEL A. RONNING       |
|---------------------------|
| Joel A. Ronning           |
| *Chief Executive Officer* |
| March 14, 2005       |
| /s/ CARTER D. HICKS       |
| Carter D. Hicks           |
| *Chief Financial Officer* |
| March 14, 2005       |

 

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**Reportof Independent Registered Public Accounting Firm**

**Boardof Directors and Stockholders**

**Digital River, Inc.**

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that Digital River, Inc. maintained effective internal controlover financial reporting as of December 31, 2004, based on criteriaestablished in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (the COSO criteria). Digital River, Inc.’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis 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, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material 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 may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that DigitalRiver, Inc. maintained effective internal control over financial reportingas of December 31, 2004, is fairly stated, in all material respects, basedon the COSO criteria. Also, in our opinion, Digital River, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2004, based on the COSO criteria.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of Digital River, Inc. as of December 31,2004 and 2003, and the related consolidated statements of operations,stockholders’ equity and cash flows for each of the three years in the periodended December 31, 2004 of Digital River, Inc. and our report dated March 14,2005 expressed an unqualified opinion thereon.
| /s/  ERNST & YOUNG LLP |
|-------------------------------------------|
| Minneapolis, Minnesota                    |
| March 14, 2005                       |

 

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**ITEM 9B.**       OTHER INFORMATION.

None.

**PART III**

Certain informationrequired in Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2005 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 10.**         DIRECTORS AND EXECUTIVEOFFICERS OF THE REGISTRANT.

Other than the identification of executive officers,which is set forth in Part I, Item 1 hereof, the information required inItem 10 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2005 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934, asamended.

We have adopted a Code ofConduct and Ethics, a copy of which we undertake to provide to any person,without charge, upon request. Such requests can be made in writing to theattention of Corporate Secretary at our principal executive offices address. Tothe extent permitted by the rules promulgated by the NASD, we intend to discloseany amendments to, or waivers from, the Code provisions applicable to ourprincipal executive officer or senior financial officers, including our chieffinancial officer and controller, or with respect to the required elements ofthe Code, on our website, www.digitalriver.com under the “Investor Relations”link.

**ITEM 11.**         EXECUTIVE COMPENSATION.

The information requiredin Item 11 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2005 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 12.**         SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.

The information requiredin Item 12 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2005 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 13.**         CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS.

The information requiredin Item 13 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2005 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 14.**         PRINCIPAL ACCOUNTANT FEESAND SERVICES.

The information requiredin Item 14 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2005 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934, asamended.

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**PART IV**

**ITEM 15.**         EXHIBITS, FINANCIALSTATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)           Thefollowing documents are filed as part of this report:

(1)         Financial Statements.

The consolidatedfinancial statements required by this item are submitted in a separate sectionbeginning on page 52 of this report.

*Reportof Independent Registered Public Accounting Firm*

*ConsolidatedBalance Sheets*

*ConsolidatedStatements of Operations*

*ConsolidatedStatements of Stockholders’ Equity*

*ConsolidatedStatements of Cash Flows*

*Notes toConsolidated Financial Statements*

(2)   FinancialStatement Schedules.

All schedules forwhich provision is made in the applicable accounting regulations of the SEChave been omitted as not required or not applicable, or the informationrequired has been included elsewhere by reference in the financial statementsand related notes, except for Schedule II, which is included with this Form 10-K,as filed with the SEC.

(3)   Exhibits.
| Exhibit Number | ** ** | **Description Of Document**                                                                                                                                                                                                                                                                                                                                                               |
|----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)         |       | Stock Purchase  Agreement, dated as of April 17, 2004 by and among Digital  River, Inc., Blitz F03-1424 GmbH, a company organized under the laws of  Germany and a wholly owned subsidiary of Digital River, and the selling  shareholders of element 5 Informationstechnologien und —dienstleistungen Aktiengesellschaft,  a company organized under the laws of Germany. |
| 2.2(2)         |       | Amended and Restated  Asset Purchase Agreement dated February 9, 2002 by and between the  Registrant and Beyond.com.                                                                                                                                                                                                                                                                 |
| 2.3(3)         |       | First Amendment to the  Amended and Restated Asset Purchase Agreement dated as of March 15, 2002  by and between the Registrant and Beyond.com.                                                                                                                                                                                                                                      |
| 2.4(3)         |       | Post-Closing Amendment  to the Amended and Restated Asset Purchase Agreement dated as of  March 31, 2002 by and between the Registrant and Beyond.com.                                                                                                                                                                                                                               |
| 3.1(4)         |       | Amended and Restated  Certificate of Incorporation of the Registrant, as currently in effect.                                                                                                                                                                                                                                                                                             |
| 3.2(6)         |       | Amended and Restated  Bylaws of the Registrant, as currently in effect.                                                                                                                                                                                                                                                                                                                   |
| 3.3(4)         |       | Certificate of Amendment  of Amended and Restated Certificate of Incorporation (amending Exhibit 3.1).                                                                                                                                                                                                                                                                               |
| 4.1(7)         |       | Specimen Stock  Certificate.                                                                                                                                                                                                                                                                                                                                                              |
| 4.2(4)         |       | Form of Senior Debt  Indenture.                                                                                                                                                                                                                                                                                                                                                      |
| 4.3(4)         |       | Form of  Subordinated Debt Indenture.                                                                                                                                                                                                                                                                                                                                                |
| 4.4            |       | References are hereby  made to Exhibits 3.1, 3.2 and 3.3.                                                                                                                                                                                                                                                                                                                                 |

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| 4.5(13)   |   | Indenture dated as of  June 1, 2004 between Digital River, Inc. and Wells Fargo Bank, N.A.  as trustee, including therein the form of the Note.                                                                 |
|-----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(7)   |   | Form of Indemnity  Agreement between Registrant and each of its directors and executive  officers.                                                                                                                   |
| 10.2(7)   |   | Employment and  Non-Competition Agreement effective May 25, 1998 by and between Joel A.  Ronning and the Registrant. *                                                                                               |
| 10.3(7)   |   | Consent to Assignment  and Assumption of Lease dated April 22, 1998 by and between CSM  Investors, Inc., IntraNet Integration Group, Inc. and Registrant.                                                  |
| 10.4(5)   |   | Assignment of Lease  dated April 21, 1998 by and between Intranet Integration  Group, Inc. and Registrant.                                                                                                      |
| 10.5(5)   |   | Lease Agreement dated  January 18, 2000 between Property Reserve, Inc. and Registrant.                                                                                                                          |
| 10.6(6)   |   | First Amendment of Lease  dated January 31, 2001 to that certain Lease dated April 24, 1996  between CSM Investors, Inc. and Registrant (as assignee of Intranet  Integration Group, Inc.).           |
| 10.7(8)   |   | 1998 Stock Option Plan,  as amended. *                                                                                                                                                                                    |
| 10.8(9)   |   | 1999 Stock Option Plan,  formerly known as the 1999 Non-Officer Stock Option Plan, as amended. *                                                                                                                          |
| 10.9(8)   |   | 2000 Employee Stock  Purchase Plan, as amended, and offering. *                                                                                                                                                           |
| 10.11(10) |   | Second Amendment of  Lease dated April 22, 2002 to that certain Lease dated April 24,  1996 between CSM Investors, Inc. and Registrant (as assignee of Intranet  Integration Group, Inc.) as amended. |
| 10.12(10) |   | Second Amendment of  Lease dated April 28, 2003 to that certain Lease dated January 18,  2000 between Property Reserve Inc. and Registrant.                                                                     |
| 10.13(11) |   | Employment Agreement  with Jay Kerutis. *                                                                                                                                                                                 |
| 10.14(12) |   | Employment Agreement  with Gary Howorka. *                                                                                                                                                                                |
| 10.15(13) |   | Registration Rights  Agreement dated as of June 1, 2004 between Digital River, Inc. and  the initial purchasers of Senior Convertible Notes due January 1, 2024.                                           |
| 12.1      |   | Computation of Ratio of  Earnings to Fixed Charges                                                                                                                                                                        |
| 21.1      |   | Subsidiaries of Digital  River, Inc.                                                                                                                                                                                 |
| 23.1      |   | Consent of Independent  Registered Public Accounting Firm, dated March 14, 2005.                                                                                                                                     |
| 24.1      |   | Power  of Attorney, pursuant to which amendments to this Annual Report on  Form 10-K may be filed, is included on the signature pages of this  Annual Report on Form 10-K.                                 |
| 31.1      |   | Certification  of Digital River, Inc.’s Chief Executive Officer, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                               |
| 31.2      |   | Certification  of Digital River, Inc.’s Chief Financial Officer, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                               |
| 32.1      |   | Certification of Digital  River, Inc.’s Chief Executive Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                |
| 32.2      |   | Certification of Digital  River, Inc.’s Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                |
| *         |   | Management contract or  compensatory plan.                                                                                                                                                                                |

----

  (1)    Incorporated by reference fromthe Company’s Current Report on Form 8-K filed May 4, 2004.

49

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  (2)    Incorporatedby reference from the Company’s Current Report on Form 8-K filed February 11,2002.

  (3)    Incorporatedby reference from the Company’s Current Report on Form 8-K filed April 15,2002.

  (4)    Incorporatedby reference from the Company’s Registration Statement on Form S-3(File No. 333-81626), declared effective on February 12, 2002.

  (5)    Incorporatedby reference from the Company’s Annual Report on Form 10-K for theyear ended December 31, 1999 filed on March 30, 2000.

  (6)    Incorporatedby reference from the Company’s Annual Report on Form 10-K for theyear ended December 31, 2000 filed on March 27, 2001.

  (7)    Incorporatedby reference from the Company’s Registration Statement on Form S-1(File No. 333-56787), declared effective on August 11, 1998.

  (8)    Incorporatedby reference from the Company’s Registration Statement on Form S-8(File No. 333-105864) filed on June 5, 2003.

  (9)    Incorporatedby reference from the Company’s Quarterly Report on Form 10-Q forthe quarter ended June 30, 2003 filed on August 14, 2003.

(10)   Incorporated by reference fromthe Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,2003 filed on May 15, 2003.

(11)   Incorporated by reference fromthe Company’s Quarterly Report on Form 10-Q for the quarter ended September 30,2003 filed on November 13, 2003.

(12)   Incorporated by reference fromthe Company’s Annual Report on Form 10-K for the year ended December 31,2003 filed on March 15, 2004.

(13)   Incorporated by reference fromthe Company’s Current Report on Form 8-K filed July 13, 2004.

50

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report on Form 10-K to besigned on its behalf by the undersigned, thereunto duly authorized, in the Cityof Eden Prairie, State of Minnesota, on the 15th of March 2005.
|        | DIGITAL  RIVER, INC. |
|--------|----------------------|
|   | By:                  | /s/ JOEL A. RONNING |
|   |                 | Joel A. Ronning |
|   |                 | CHIEF EXECUTIVE OFFICER AND DIRECTOR |

e

We, the undersigned, directorsand officers of Digital River, Inc., do hereby severally constitute andappoint Joel A. Ronning and Carter D. Hicks and each or any of them, our trueand lawful attorneys and agents, with full power of substitution andresubstitution, for him or her and in his or her name, place and stead, in anyand all capacities, to sign any and all amendments to the Registrant’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2004, andto file the same with all exhibits thereto, and all other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorneys and agents, and each or any of them, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done, as fully to all intents and purposes as he or she mightor could do in person, hereby ratifying and confirming all that said attorneysand agents, and each of them, or his substitute or substitutes, may lawfully door cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Form 10-Khas been signed below by the following persons on behalf of the Registrant andin the capacities and on the dates indicated:
|                        | **SIGNATURE** | ** **                                        | ** ** | ** **          | **TITLE** | ** ** | ** ** | ** ** | **DATE** | ** ** |
|------------------------|---------------|---------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  JOEL A. RONNING   |          | Chief Executive Officer  and Director (Principal  |       | March 15, 2005 |
| Joel A. Ronning        |          | Executive Officer)                                |       |                |
| /s/  CARTER D. HICKS   |          | Chief Financial Officer  and Treasurer (Principal |       | March 15, 2005 |
| Carter D. Hicks        |          | Accounting Officer)                               |       |                |
| /s/  PERRY W. STEINER  |          | Director                                          |       | March 15, 2005 |
| Perry W. Steiner       |          |                                              |       |                |
| /s/  WILLIAM LANSING   |          | Director                                          |       | March 15, 2005 |
| William Lansing        |          |                                              |       |                |
| /s/  THOMAS F. MADISON |          | Director                                          |       | March 15, 2005 |
| Thomas F. Madison      |          |                                              |       |                |
| /s/  J. PAUL THORIN    |          | Director                                          |       | March 15, 2005 |
| J. Paul Thorin         |          |                                              |       |                |
| /s/  FREDERIC SEEGAL   |          | Director                                          |       | March 15, 2005 |
| Frederic Seegal        |          |                                              |       |                |

 

 

51

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**Reportof Independent Registered Public Accounting Firm**

**Board of Directors and Stockholders**

**Digital River, Inc.**

We have audited the accompanying consolidated balancesheets of Digital River, Inc. and subsidiaries as of December 31,2004 and 2003, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2004. These financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

We conducted our audits in accordance with auditingstandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Digital River, Inc. and subsidiaries at December 31, 2004and 2003, and the consolidated results of their operations and their cash flowsfor each of the three years in the period ended December 31, 2004, inconformity with U.S. generally accepted accounting principles.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Digital River, Inc.’sinternal control over financial reporting as of December 31, 2004, basedon criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission and our report dated March 14, 2005 expressed an unqualifiedopinion thereon.
| /s/ ERNST & YOUNG LLP              |
|---------------------------------------------|
| Minneapolis, Minnesota

March 14, 2005 |

 

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**DIGITAL RIVER, INC.**Consolidated Balance Sheets as of December 31(in thousands, except share data)
| ** **                                                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                                           |       |     |       |     |       |
| CURRENT ASSETS:                                                                                                      |       |     |       |     |       |
| Cash and cash equivalents                                                                                            |       | $        | 127,734    |     | $          | 72,885 |   |
| Short-term investments                                                                                               |       | 164,402  |       | 59,037   |       |
| Accounts receivable, net of allowance of $1,146 and  $319                                                            |       | 21,520   |       | 9,306    |       |
| Prepaid expenses and other                                                                                           |       | 1,843    |       | 1,589    |       |
| Total current assets                                                                                                 |       | 315,499  |       | 142,817  |       |
| PROPERTY AND EQUIPMENT, NET                                                                                          |       | 17,367   |       | 14,634   |       |
| GOODWILL                                                                                                             |       | 148,086  |       | 23,921   |       |
| INTANGIBLE  ASSETS, net of accumulated amortization of $28,245 and $19,976                                           |       | 17,297   |       | 8,172    |       |
| OTHER ASSETS                                                                                                         |       | 6,272    |       | 114      |       |
|                                                                                                                 |       | $        | 504,521    |     | $          | 189,658 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                        |       |     |       |     |       |
| CURRENT  LIABILITIES:                                                                                                |       |     |       |     |       |
| Accounts payable                                                                                                     |       | $        | 88,052     |     | $          | 41,814 |   |
| Accrued payroll                                                                                                      |       | 5,332    |       | 2,825    |       |
| Deferred revenue                                                                                                     |       | 3,901    |       | 3,572    |       |
| Accrued acquisitions expenses                                                                                        |       | 6,720    |       | 1,333    |       |
| Other accrued liabilities                                                                                            |       | 12,747   |       | 8,262    |       |
| Total current liabilities                                                                                            |       | 116,752  |       | 57,806   |       |
| NON-CURRENT  LIABILITIES:                                                                                            |       |     |       |     |       |
| Convertible senior notes                                                                                             |       | 195,000  |       | —   |       |
| COMMITMENTS AND  CONTINGENCIES (NOTE 8)                                                                              |       |     |       |     |       |
| STOCKHOLDERS’  EQUITY:                                                                                          |       |     |       |     |       |
| Preferred Stock, $.01 par value; 5,000,000 shares  authorized; no shares issued or outstanding                       |       | —   |       | —   |       |
| Common Stock, $.01 par value; 60,000,000 shares  authorized; 33,652,149 and 31,497,719 shares issued and outstanding |       | 337      |       | 315      |       |
| Additional paid-in capital                                                                                           |       | 243,926  |       | 217,981  |       |
| Accumulated deficit                                                                                                  |       | (51,164  | )          | (86,488  | )          |
| Accumulated other comprehensive income (loss)                                                                        |       | (330     | )          | 44       |       |
| Total stockholders’ equity                                                                                      |       | 192,769  |       | 131,852  |       |
|                                                                                                                 |       | $        | 504,521    |     | $          | 189,658 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**DIGITAL RIVER, INC.**Consolidated Statements of Operations for the YearsEnded December 31(in thousands, except per share data)
| ** **                                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| REVENUE                                           |       | $        | 154,130    |     | $          | 101,201  |       | $ | 77,783 |   |
| COSTS AND EXPENSES (exclusive of depreciation and |       |     |       |     |       |     |       |
| amortization expense shown separately below):     |       |     |       |     |       |     |       |
| Direct  cost of services                          |       | 5,013    |       | 3,585    |       | 2,357    |       |
| Network  and infrastructure                       |       | 15,143   |       | 12,253   |       | 11,405   |       |
| Sales and  marketing                              |       | 51,749   |       | 37,220   |       | 32,437   |       |
| Product  research and development                 |       | 14,097   |       | 9,962    |       | 11,454   |       |
| General  and administrative                       |       | 17,056   |       | 9,228    |       | 6,799    |       |
| Litigation  and other charges                     |       | (162     | )          | —   |       | 2,500    |       |
| Depreciation  and amortization                    |       | 8,203    |       | 7,275    |       | 6,009    |       |
| Amortization  of acquisition related intangibles  |       | 8,269    |       | 5,380    |       | 5,738    |       |
| Total  cost and expenses                          |       | 119,368  |       | 84,903   |       | 78,699   |       |
| INCOME  (LOSS) FROM OPERATIONS                    |       | 34,762   |       | 16,298   |       | (916     | )          |
| OTHER INCOME/(EXPENSE), NET                       |       | 1,641    |       | 838      |       | 406      |       |
| INCOME (LOSS) BEFORE INCOME TAX EXPENSE           |       | 36,403   |       | 17,136   |       | (510     | )          |
| INCOME TAX EXPENSE                                |       | (1,079   | )          | —   |       | —   |       |
| NET  INCOME (LOSS)                                |       | $        | 35,324     |     | $          | 17,136   |       | $ | (510 | ) |
| NET INCOME (LOSS) PER SHARE:                      |       |     |       |     |       |     |       |
| BASIC                                             |       | $        | 1.09       |     | $          | 0.58     |       | $ | (0.02 | ) |
| DILUTED                                           |       | $        | 0.96       |     | $          | 0.52     |       | $ | (0.02 | ) |
| WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:       |       |     |       |     |       |     |       |
| BASIC                                             |       | 32,328   |       | 29,398   |       | 26,791   |       |
| DILUTED                                           |       | 38,532   |       | 33,051   |       | 26,791   |       |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**DIGITAL RIVER, INC.**Consolidated Statements of Stockholders’ Equity(in thousands)
| ** **                                                      | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total**         | ** ** | ** **             | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                      | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Deferred**   | ** ** | **Comprehensive** | ** ** | **Accumulated**        | ** ** | **Stockholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                      | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Compensation**  | ** ** | **Income (Loss)** | ** ** | **Deficit**            | ** ** | **Equity**        | ** ** | **Income (Loss)** | ** ** |
| BALANCE, December 31, 2001                                 |       | 26,463                |       |        | $          | 265            |       |              | $          | 153,308                |       |                   | $          | (37               | )          |                   |       | $ | — |   |   |   | $ | (103,114 | ) |   |   | $ | 50,422 |   |   |   | $ | (19,200 | ) |   |
| Net loss                                                        |       | —                |       |        | —     |           |       | —            |       |                   | —     |                   |       |              | —     |                   |       |   | (510 | ) |   |   | (510 | ) |   |   | (510 | ) |   |
| Common  stock issued for acquisitions and earn-out arrangements |       | 171                   |       |        | 2          |           |       | 2,553             |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 2,555 |   |   |   |   |   |   |
| Exercise  of stock options                                      |       | 854                   |       |        | 8          |           |       | 4,294             |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 4,302 |   |   |   |   |   |   |
| Common  stock issued under the Employee Stock Purchase Plan     |       | 49                    |       |        | —     |           |       | 380               |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 380 |   |   |   |   |   |   |
| Deferred  compensation expense                                  |       | —                |       |        | —     |           |       | —            |       |                   | 37         |                   |       |              | —     |                   |       |   | — |   |   |   | 37 |   |   |   |   |   |   |
| BALANCE, December 31, 2002                                 |       | 27,537                |       |        | 275        |           |       | 160,535           |       |                   | —     |                   |       |              | —     |                   |       |   | (103,624 | ) |   |   | 57,186 |   |   |   | (510 | ) |   |
| Net  income                                                     |       | —                |       |        | —     |           |       | —            |       |                   | —     |                   |       |              | —     |                   |       |   | 17,136 |   |   |   | 17,136 |   |   |   | 17,136 |   |   |
| Unrealized  gain on investments                                 |       | —                |       |        | —     |           |       | —            |       |                   | —     |                   |       |              | 44         |                   |       |   | — |   |   |   | 44 |   |   |   | 44 |   |   |
| Sales of  common stock                                          |       | 2,100                 |       |        | 21         |           |       | 43,385            |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 43,406 |   |   |   |   |   |   |
| Common  stock issued for acquisitions and earn-out arrangements |       | 88                    |       |        | 1          |           |       | 1,024             |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 1,025 |   |   |   |   |   |   |
| Exercise  of stock options                                      |       | 1,680                 |       |        | 17         |           |       | 12,238            |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 12,255 |   |   |   |   |   |   |
| Common  stock issued under the Employee Stock Purchase Plan     |       | 93                    |       |        | 1          |           |       | 799               |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 800 |   |   |   |   |   |   |
| BALANCE, December 31, 2003                                 |       | 31,498                |       |        | 315        |           |       | 217,981           |       |                   | —     |                   |       |              | 44         |                   |       |   | (86,488 | ) |   |   | 131,852 |   |   |   | 17,180 |   |   |
| Net  income                                                     |       | —                |       |        | —     |           |       | —            |       |                   | —     |                   |       |              | —     |                   |       |   | 35,324 |   |   |   | 35,324 |   |   |   | 35,324 |   |   |
| Unrealized  loss on investments                                 |       | —                |       |        | —     |           |       | —            |       |                   | —     |                   |       |              | (275       | )                      |       |   | — |   |   |   | (275 | ) |   |   | (275 | ) |   |
| Foreign  currency translation                                   |       | —                |       |        | —     |           |       | —            |       |                   | —     |                   |       |              | (99        | )                      |       |   | — |   |   |   | (99 | ) |   |   | (99 | ) |   |
| Common  stock issued for acquisitions                           |       | 160                   |       |        | 2          |           |       | 5,342             |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 5,344 |   |   |   |   |   |   |
| Exercise  of stock options                                      |       | 1,943                 |       |        | 19         |           |       | 19,700            |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 19,719 |   |   |   |   |   |   |
| Common  stock issued under the Employee Stock Purchase Plan     |       | 51                    |       |        | 1          |           |       | 903               |       |                   | —     |                   |       |              | —     |                   |       |   | — |   |   |   | 904 |   |   |   |   |   |   |
| BALANCE, December 31, 2004                                 |       | 33,652                |       |        | $          | 337            |       |              | $          | 243,926                |       |                   | $          | —            |       |                   |       | $ | (330 | ) |   |   | $ | (51,164 | ) |   |   | $ | 192,769 |   |   |   | $ | 34,950 |   |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

55

 

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**DIGITAL RIVER, INC.**Consolidated Statements of Cash Flows For the YearsEnded December 31,(in thousands)
| ** **                                                                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| OPERATING ACTIVITES:                                                                      |       |     |       |     |       |     |       |
| Net income (loss)                                                                         |       | $        | 35,324     |     | $          | 17,136   |       | $ | (510 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |     |       |     |       |     |       |
| Amortization of acquisition related intangibles                                           |       | 8,269    |       | 5,380    |       | 5,738    |       |
| Change in accounts receivable allowance (net of  acquisitions)                            |       | 709      |       | (1,247   | )          | 908      |       |
| Depreciation and amortization                                                             |       | 8,203    |       | 7,275    |       | 6,009    |       |
| Deferred compensation expense                                                             |       | —   |       | —   |       | 37       |       |
| Litigation and other charges                                                              |       | 1,090    |       | —   |       | 1,675    |       |
| Change in  operating assets and liabilities (net of acquisitions):                        |       |     |       |     |       |     |       |
| Accounts receivable                                                                       |       | (8,223   | )          | 3,558    |       | (3,138   | )          |
| Prepaid and other assets                                                                  |       | 1,037    |       | 132      |       | (432     | )          |
| Accounts payable                                                                          |       | 34,433   |       | 9,210    |       | 8,025    |       |
| Deferred revenue                                                                          |       | (230     | )          | 1,671    |       | 759      |       |
| Accrued payroll and other accrued liabilities                                             |       | 4,523    |       | 4,716    |       | (1,488   | )          |
| Net cash provided by operating activities                                                 |       | 85,135   |       | 47,831   |       | 17,583   |       |
| INVESTING  ACTIVITIES:                                                                    |       |     |       |     |       |     |       |
| Purchases of investments                                                                  |       | (199,699 | )          | (58,993  | )          | —   |       |
| Sales of investments                                                                      |       | 94,059   |       | —   |       | 9,978    |       |
| Cash paid for acquisitions, net of cash received                                          |       | (126,457 | )          | (6,944   | )          | (5,383   | )          |
| Purchases of equipment and capitalized software                                           |       | (9,255   | )          | (6,271   | )          | (5,236   | )          |
| Net cash used in investing activities                                                     |       | (241,352 | )          | (72,208  | )          | (641     | )          |
| FINANCING  ACTIVITIES:                                                                    |       |     |       |     |       |     |       |
| Principal amount on line of credit                                                        |       | 45,000   |       | —   |       | —   |       |
| Repayment of principal on line of credit                                                  |       | (45,000  | )          | —   |       | —   |       |
| Net proceeds on issuance of 1.25% convertible senior  notes due 1/1/2024                  |       | 188,371  |       | —   |       | —   |       |
| Proceeds from sales of common stock                                                       |       | —   |       | 43,406   |       | —   |       |
| Exercise of stock options and warrants                                                    |       | 19,719   |       | 12,255   |       | 4,302    |       |
| Sales of common stock under employee stock purchase  plan                                 |       | 904      |       | 800      |       | 380      |       |
| Repayment of notes payable                                                                |       | —   |       | —   |       | (2,500   | )          |
| Net cash provided by financing activities                                                 |       | 208,994  |       | 56,461   |       | 2,182    |       |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH                                                  |       | 2,072    |       | —   |       | —   |       |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                                |       | 54,849   |       | 32,084   |       | 19,124   |       |
| CASH AND CASH  EQUIVALENTS, beginning of period                                           |       | 72,885   |       | 40,801   |       | 21,677   |       |
| CASH AND CASH  EQUIVALENTS, end of period                                                 |       | $        | 127,734    |     | $          | 72,885   |       | $ | 40,801 |   |
| NONCASH INVESTING AND  FINANCING ACTIVITIES:                                              |       |     |       |     |       |     |       |
| Common stock  issued in acquisitions and earn-outs                                        |       | $        | 5,344      |     | $          | 1,025    |       | $ | 2,555 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**DIGITAL RIVER, INC.Notes to ConsolidatedFinancial StatementsDecember 31, 2004 and 2003**

**1.   Nature ofOperations and Summary of Significant Accounting Policies:**

We provide e-commerce services to our clients,including online store development and hosting, transaction processing,electronic software delivery, fraud screening, customer service and analyticalmarketing. Through contractual relationships with software publishers andonline retailers, we offer software products for sale via the Internet. Beginningin late 1998, we also began to offer e-commerce services to companies outsideof the software vertical market. We were incorporated in 1994 and conducted ourfirst online sale through a client’s Web store in August 1996.

We have experiencedsignificant losses since inception ($51.2 million through December 31,2004) and have, until the later stages of 2001, experienced significantnegative cash flows from operations. Our prospects must be considered in lightof the risks frequently encountered by companies in their early stage ofdevelopment, particularly companies in new and rapidly evolving markets such ase-commerce. To address these risks, we must, among others things, maintainexisting and develop new relationships with independent software publishers,online retailers and other companies outside of the software market, maintainand increase our client base, implement and successfully execute our businessand marketing strategy, continue to develop and upgrade our technology andtransaction-processing systems, provide superior customer service and orderfulfillment, respond to competitive developments, and attract, retain andmotivate qualified personnel. There can be no assurances that we will besuccessful in addressing such risks, and the failure to do so could have amaterial adverse effect on our business, financial condition and results ofoperations.

***Principles of Consolidation and Classification***

The consolidated financialstatements include the accounts of Digital River, Inc. and our whollyowned subsidiaries. All intercompany balances and transactions have beeneliminated in consolidation. Certain reclassifications have been made to prioryear balances in order to conform to the current year’s presentation, includingcertain cash equivalents and short-term investments.

***Foreign Currency Translation***

Foreign currencydenominated revenue and expense transactions are remeasured to our functionalcurrency using average exchange rates for the fiscal period. Foreign currencydenominated assets and liabilities are remeasured to our functional currencyusing exchange rate in effect at the respective balance sheet dates. Any gainsor losses are included in the consolidated statement of operations within otherincome (expense), net. The financial position and results of operations of ourforeign subsidiaries are measured using local currency as the functionalcurrency. Assets and liabilities are translated to their U.S. dollarequivalents at rates in effect at the respective balance sheet dates and statementsof operations and cash flows are translated using average exchange rates forthe fiscal period. The resulting translation adjustments are recorded as acomponent of stockholders’ equity.

***Cash and Cash Equivalents***

We consider allshort-term, highly liquid investments, primarily high grade commercial paperand money market accounts, that are readily convertible into known amounts ofcash and that have original or remaining maturities of three months or less atthe date of purchase to be cash equivalents. As of 

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December 31,2004 and 2003, cash balances of $2.8 million and $3.1 million,respectively, were held by a credit card processor tosecure potential future credit card fees and chargebacks.

***Short-Term Investments***

Our short-term investmentsconsist of debt securities that are classified as available-for-sale and arecarried on our balance sheet at their market value with cumulative unrealizedgains or losses recorded as a component of accumulated other comprehensiveincome/(loss) within stockholders’ equity. As of December 31, 2004, allsecurities had dates to maturity of less than three years. We classify all ofour available-for-sale securities as current assets, as these securitiesrepresent investments available for current corporate purposes.

***Property and Equipment***

Propertyand equipment is stated at historical cost. Computer equipment, software andfurniture are depreciated under the straight-line method using estimated usefullives of three to seven years and leasehold improvements are amortized over theshorter of the asset life or remaining length of the lease. Property andequipment at December 31 consisted of the following (in thousands):
| ** **                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Computer hardware and software                 |       | $        | 35,292     |     | $          | 27,947 |   |
| Furniture, fixtures and leasehold improvements |       | 5,847    |       | 4,486    |       |
| Total property and equipment                   |       | $        | 41,139     |     | $          | 32,433 |   |
| Accumulated depreciation                       |       | (23,772  | )          | (17,799  | )          |
| Net property and equipment                     |       | $        | 17,367     |     | $          | 14,634 |   |

 

***Purchased Intangible Assets***

Purchased intangibleassets are carried at cost less accumulated amortization. Amortization isrecorded over the estimated useful lives of the respective assets, generallythree years.

***Long-Lived Assets***

We review all long-livedassets, including definite-lived intangible assets, for impairment in accordancewith Statement of Financial Accounting Standards No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). Under SFAS 144,impairment losses are recorded whenever events or changes in circumstancesindicate the carrying value of an asset may not be recoverable. An impairmentloss is recognized when estimated undiscounted cash flows expected to resultfrom the use of the asset plus net proceeds expected from disposition of theasset (if any) are less than the carrying value of the asset. As part of ourevaluation, we consider certain non-financial data as indicators of impairmentsuch as changes in the operating environment and business strategy, competitiveinformation, market trends and operating performance. When an impairment lossis identified, the carrying amount of the asset is reduced to its estimatedfair value. There were no significant impairments of long-lived assets,including definite-lived intangible assets, recorded in 2004, 2003 or 2002.

***Fair Value of Financial Instruments***

The carrying amount ofcash and cash equivalents, accounts receivable, notes payable and accountspayable approximates fair value because of the short maturity of theseinstruments. As of December 31, 2004, the fair value of our $195 million 1.25%fixed rate convertible senior notes was valued at $229.5 million on the openmarket.

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***Other Assets***

At December 31, 2004,other assets included $6.3 million of unamortized debt financing costs relatedto the 1.25% convertible senior notes that were issued in 2004.

***Revenue Recognition***

We recognize revenue fromservices rendered once all the following criteria for revenue recognition havebeen met: (1)** **pervasive evidence of an agreement exists; (2) theservices have been rendered; (3) the fee is fixed and determinable and notsubject to refund or adjustment; and (4) collection of the amounts due isreasonably assured. We derive our revenue primarily from transaction fees basedon a percentage of the products sale price and fees from services renderedassociated with the e-commerce services provided to our clients and endcustomers. These services include e-commerce development and hosting,transaction processing, fraud screening, digital delivery, integration tophysical fulfillment, merchandising services, analytical marketing, customerservice and proprietary software backup services. We report our revenue on anet basis and therefore record only the net service fees and transaction feesas our revenue. We act as the merchant of record on most of the transactionsprocessed and have contractual relationships with our clients, which obligateus to pay to the client a specified percentage of each sale. We retain ourtransaction fee and also charge fees for services rendered. Signed contractsare obtained from clients prior to recognition of these revenues. Clients donot have the right to take possession of the software applications used in thedelivery of services. Payments received in advance of rendering the service,even if non-refundable, are recorded as deferred revenue until earned.

***Advertising Costs***

The costs of advertisingare charged to sales and marketing expense as incurred. We incurred advertisingexpense of $1.0 million, $0.6 million and $0.4 million in 2004, 2003 and 2002,respectively.

***Income Taxes***

Deferred tax assets andliabilities are determined based on the difference between the financialstatement and tax bases of assets and liabilities using currently enacted taxrates. We currently have significant U.S. tax loss carryforwards resultingprimarily from the tax deduction for disqualifying disposition of stockoptions, and a lesser amount of acquired foreign operating tax losscarryforwards. The deferred tax benefit of the loss carryforwards has beenfully reserved by a valuation allowance pursuant to GAAP. The benefit of theloss carryforwards from disqualifying disposition of stock options will berecognized as additional paid in capital when these deductions are utilized infuture periods. The valuation reserve of the deferred tax asset will be removedif and when we have met the requirements under GAAP of more likely than notthat we will realize the benefit of the deferred tax asset. Deferred tax assetsare the tax value of temporary timing differences for financial reporting andtax basis of assets and liabilities.

***Use of Estimates***

The preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

***Research and Development and Software Development***

Research and developmentexpenses consist primarily of development personnel and external contractorcosts related to the development of new products and services, enhancement ofexisting 

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productsand services, quality assurance and testing. We follow AICPA Statement ofPosition No. 98-1, “Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use”, in accounting for internally developedsoftware. Prior to the second quarter of 2004, capitalizable softwaredevelopment costs were immaterial. During the second quarter of 2004, weexpanded and redeployed our R&D team to advance our new self-service,remote control technology, as well as develop the international and e-marketingcapabilities on our next-generation e-commerce platform and, consistent withthe requirements of SOP 98-1, we have capitalized approximately $2.7 million ofsoftware development costs related to those efforts. These capitalized costsare included in purchases of equipment and capitalized software withininvesting activities on our consolidated statement of cash flows.

***Recent Accounting Pronouncements***

In December 2004,the Financial Accounting Standards Board issued SFAS 123 (R), “Share-BasedPayment.” This Statement is a revision to SFAS 123, “Accounting for Stock-BasedCompensation”, and supersedes APB Opinion No. 25, “Accounting for StockIssued to Employees.” SFAS 123(R) requires the measurement of the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award. No compensation cost is recognizedfor equity instruments for which employees do not render service. We will adoptSFAS 123(R) effective on July 1, 2005, requiring compensation cost tobe recognized as expense for the portion of outstanding unvested awards, andany new awards made thereafter, based on the grant-date fair value of thoseawards.

**2.   Net Income (Loss)per Share:**

Basic income (loss) per common share is computed bydividing net income (loss) by the weighted average number of shares of commonstock outstanding during the period. Diluted earnings per common share iscalculated by dividing net income (loss), adjusted to exclude interest expenseand financing cost amortization related to potentially dilutive securities, bythe weighted average number of common shares outstanding during the period,plus any additional common shares that would have been outstanding ifpotentially dilutive common shares had been issued during the period. In 2002,the dilutive impact of approximately 2.5 million options outstanding was notincluded in the diluted loss per share calculation because any potentiallydilutive securities would have reduced the loss per share.

The following tablesummarizes the computation of basic and diluted earnings per share (inthousands, except per share data):
| ** **                                                                          | ** ** | **For the Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                                                      | ** ** | **2003** | ** ** | **2002** | ** ** |
| Earnings (loss) per share—basic                                                |       |                                                          |       |   |   |   |   |
| Net  income (loss)—basic                                                       |       | $                                                             | 35,324     |   | $ | 17,136 |   | $ | (510 | ) |
| Weighted  average shares outstanding—basic                                     |       | 32,328                                                        |       | 29,398 |   | 26,791 |   |
| Earnings (loss) per share—basic                                                |       | $                                                             | 1.09       |   | $ | 0.58 |   | $ | (0.02 | ) |
| Earnings (loss) per share—diluted                                              |       |                                                          |       |   |   |   |   |
| Net  income (loss)—basic                                                       |       | $                                                             | 35,324     |   | $ | 17,136 |   | $ | (510 | ) |
| Exclude:  Interest expense and amortized financing cost of convertible senior notes |       | 1,772                                                         |       | — |   | — |   |
| Net  income (loss)—diluted                                                     |       | $                                                             | 37,096     |   | $ | 17,136 |   | $ | (510 | ) |
| Weighted  average shares outstanding—basic                                     |       | 32,328                                                        |       | 29,398 |   | 26,791 |   |
| Dilutive  impact of options outstanding                                             |       | 3,626                                                         |       | 3,653 |   | — |   |
| Dilutive  impact of convertible senior notes                                        |       | 2,578                                                         |       | — |   | — |   |
| Weighted  average shares outstanding—diluted                                   |       | 38,532                                                        |       | 33,051 |   | 26,791 |   |
| Earnings (loss) per share—diluted                                              |       | $                                                             | 0.96       |   | $ | 0.52 |   | $ | (0.02 | ) |

 

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Subsequentto our issuance of 1.25% convertible senior notes on June 1, 2004, theEmerging Issues Task Force (EITF), Issue No. 04-08, proposed that theunissued shares underlying contingent convertible notes be treated as if suchshares were issued and outstanding for the purposes of calculating GAAP dilutedearnings per share. On October 13, 2004, the Financial AccountingStandards Board (FASB) ratified this new accounting treatment for periodsending after December 15, 2004. Consequently, we reflect the dilutiveeffect of our 1.25% convertible senior notes on diluted earnings per share in2004. The notes are contingently convertible into approximately 4.4 millionshares of common stock at an initial conversion price of $44.063 per share,which have been included in our weighted average shares outstanding calculationsince the date of issuance.

**3.   Short-TermInvestments:**

As of December 31, 2004 and 2003, ouravailable-for-sale securities consisted of the following (in thousands):
| ** **                | ** ** | ** ** | ** ** | ** **                        | ** ** | ** **          | ** ** | **Maturities**                     | ** ** |
|---------------------------|------------|------------|------------|-----------------------------------|------------|---------------------|------------|------------------------------------|------------|
| **2004**                  | ** ** | **Cost**   | ** ** | **Unrealized   Gain/(Lo**ss) | ** ** | **Fair Value** | ** ** | **Less Than 12  Months** | ** ** | **1 to 3 Years** | ** ** |
| U.S. government  agencies |       | $          | 164,633    |                              |       | $                   | (231       | )                                  |       | $ | 164,402 |   |   | $ | 90,163 |   |   |   | $ | 74,239 |   |   |
| **2003**                  |       |       |       |                              |       |                |       |                               |       |   |   |   |   |   |   |   |   |
| U.S. government agencies  |       | $          | 58,993     |                              |       | $                   | 44         |                               |       | $ | 59,037 |   |   | $ | 28,993 |   |   |   | $ | 30,044 |   |   |

Realized gains or losses on investments are recordedon our statement of operations within other income /(expense), net. Realizedlosses on sales of investments were immaterial in 2004, 2003 and 2002. Interestincome of $3.2 million, $0.8 million and $0.4 million was recorded in 2004,2003 and 2002, respectively.

**4.   Goodwill andIntangible Assets:**

We account for our goodwill in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets.”       SFASNo. 142 precludes the amortization of goodwill and intangible assets withindefinite lives, but these assets are reviewed annually (or more frequently ifimpairment indicators arise) for impairment.

We complete our annual impairment test using atwo-step approach based in the fourth quarter of each fiscal year andreassesses any intangible assets, including goodwill, recorded in connectionwith earlier acquisitions. Our assessment has indicated that there is noimpairment of goodwill for the years ended December 31, 2004, 2003 and2002.

Thechanges in the net carrying amount of goodwill for the years ended December 31,2004 and 2003 are as follows (in thousands):
| ** **                                | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|-----------|------------|
| Balance as of  December 31, 2002     |       | $         | 18,698     |   |
| Goodwill from  acquisitions and earn-outs |       | 5,223     |       |
| Balance as of  December 31, 2003     |       | $         | 23,921     |   |
| Goodwill from  acquisitions and earn-outs |       | 124,165   |       |
| Balance as of  December 31, 2004     |       | $         | 148,086    |   |

 

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Informationregarding our other intangible assets is as follows (in thousands):
| ** **              | ** ** | **December 31, 2004** | ** ** |
|-------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Carrying Amount  Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Carrying Amount  Net** | ** ** |
| Customer  relationships |       |                            | $          | 25,406 |   |   |   | $ | 14,784 |   |   |   | $ | 10,622 |   |   |
| Non-compete  agreements |       |                            | 5,134      |   |   |   | 3,549 |   |   |   | 1,585 |   |   |
| Technology/tradename    |       |                            | 15,002     |   |   |   | 9,912 |   |   |   | 5,090 |   |   |
| Total                   |       |                            | $          | 45,542 |   |   |   | $ | 28,245 |   |   |   | $ | 17,297 |   |   |

 
| ** **              | ** ** | **December 31, 2003**       | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **Carrying Amount   Gross** | ** ** | **Accumulated  Amortization** | ** ** | **Carrying Amount  Net** | ** ** |
| Customer  relationships |       |                                  | $          | 16,488 |   |   |   | $ | 11,405 |   |   |   | $ | 5,083 |   |   |
| Non-compete  agreements |       |                                  | 3,850      |   |   |   | 2,992 |   |   |   | 858 |   |   |
| Technology/tradename    |       |                                  | 7,810      |   |   |   | 5,579 |   |   |   | 2,231 |   |   |
| Total                   |       |                                  | $          | 28,148 |   |   |   | $ | 19,976 |   |   |   | $ | 8,172 |   |   |

 

Estimated amortizationexpense for the remaining life of the intangible assets, based on intangibleassets as of December 31, 2004 is as follows (in thousands):
| **Year** | ** ** | ** ** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|------------|------------|
| 2005     |       | $          | 8,116      |       |
| 2006     |       | 7,033      |       |
| 2007     |       | 2,148      |       |
| Total    |       | $          | 17,297     |       |

 

**5.   Stock-BasedCompensation:**

At December 31, 2004, we had two stock-basedemployee compensation plans, which are described more fully in Note 11. Weaccount for these plans under the recognition and measurement principles of APBOpinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations. No stock-based employee compensation cost is reflected in netincome (loss), as all options granted under these plans had an exercise priceequal to the market value of the underlying common stock on the date of thegrant.

We have elected to apply the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” asamended by SFAS No. 148. Accordingly, we account for stock-basedcompensation using the intrinsic value method prescribed in APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and related interpretations.Compensation cost for stock options is measured as the excess, if any, of thefair value of our common stock at the date of grant over the stock optionexercise price.

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Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share if we had applied the fair value recognition provision ofFinancial Accounting Standards Board Statement No. 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation (in thousands,except per share amounts):
| ** **                                                                                       | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                                                      | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Net  income (loss), as reported**                                                              |       | $                                                             | 35,324     |   | $ | 17,136 |   | $ | (510 | ) |
| Add: Stock-based  compensation, as reported                                                      |       | —                                                        |       | — |   | 37 |   |
| Deduct: Total  stock-based compensation determined under fair value based method for all  awards |       | (26,426                                                       | )          | (14,540 | ) | (8,668 | ) |
| Adjusted net  income (loss), fair value method for all stock-based awards                        |       | $                                                             | 8,898      |   | $ | 2,596 |   | $ | (9,141 | ) |
| Basic income  (loss) per share—as reported                                                  |       | $                                                             | 1.09       |   | $ | 0.58 |   | $ | (0.02 | ) |
| Diluted income  (loss) per share—as reported                                                |       | $                                                             | 0.96       |   | $ | 0.52 |   | $ | (0.02 | ) |
| Basic income  (loss) per share—SFAS No. 123 adjusted                                   |       | $                                                             | 0.28       |   | $ | 0.09 |   | $ | (0.34 | ) |
| Diluted income (loss)  per share—SFAS No. 123 adjusted                                 |       | $                                                             | 0.29       |   | $ | 0.08 |   | $ | (0.34 | ) |

 

The fair value of eachoption grant is estimated on the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions:
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rate                        |       | 4        | %          | 4        | %          | 3        | %          |
| Expected life  (years)                          |       | 1 - 4    |       | 4        |       | 5        |       |
| Volatility factor                               |       | 1.3      |       | 1.3      |       | 1.4      |       |
| Expected  dividends                             |       | —   |       | —   |       | —   |       |
| Weighted average fair  value of options granted |       | $        | 13.14      |     | $          | 13.46    |       | $ | 7.16 |   |
|                                                 |            |          |            |          |            |          |            |  |  |  |

 

In December 2004, theFinancial Accounting Standards Board issued SFAS 123 (R), “Share-BasedPayment.” This Statement is a revision to SFAS 123, “Accounting for Stock-BasedCompensation,” and supersedes APB Opinion No. 25, “Accounting for StockIssued to Employees.” SFAS 123(R) requires the measurement of the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award. No compensation cost is recognizedfor equity instruments for which employees do not render service. We will adoptSFAS 123(R) effective on July 1, 2005, requiring compensation cost tobe recognized as expense for the portion of outstanding unvested awards, andany new awards made thereafter, based on the grant-date fair value of thoseawards.

**6.   Acquisitionsand Earn-Out Arrangements:**

In April 2004, we acquired element 5 AG, aprivately held company based in Germany and a leading European e-commercesolution provider for software publishers. Under the terms of the acquisition,we paid $120 million in cash to acquire all of the outstanding shares of capitalstock of element 5. We also agreed to pay up to an additional $2.5 million incash based on element 5’s operating performance over the first 24 monthsfollowing the closing of the acquisition.

In the second quarter of 2004, in connection with ouracquisition of element 5, we began implementation of a plan intended toeliminate duplication of resources within the consolidated company. The planincludes the elimination of customer service positions at element 5’sGreenburg, Pennsylvania customer service center and the termination of theGreenburg facility lease by the end of the third quarter of 2004.

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On January 18, 2005, we entered into an agreementwith senior employees of element 5 AG, pursuant to which these employees agreedto cease providing services to element 5 sixty days after the date of theagreement. Pursuant to the agreement, we also agreed to resolve a $12 millionescrow associated with our acquisition of element 5 by distributing $10 millionto the former element 5 shareholders, and $2 million to us. Certain adjustmentswere also made to our earn-out obligations under the April 2004acquisition agreement. Under the restructured earn-out, $2.5 million of cashwill be paid to the former element 5 shareholders in equal increments of $1.25million on March 1, 2005 and 2006. These earn-out amounts have beenrecorded as additional goodwill as they were incremental to the purchase price.Goodwill of $110.8 million was recorded as a result of this acquisition. We areamortizing other intangible assets acquired, consisting oftechnology/tradename, customer relationships and non-compete agreements, over athree-year period. The allocation of thepurchase price of element 5 to amortizable costs and goodwill has not yet beenfinalized. The allocation will be finalized at a later date following analysisof the fair value of element 5’s assets. The result of the allocation of thepurchase price between amortizable costs and goodwill could have an impact onour future operating results.

As of December 31,2004, we had included $4.9 million as part of the acquisition cost of element 5related to these acquisition restructuring plans. The following table providesdetail on the activity and our remaining accrual balance by category as of December 31,2004 (in thousands):
| ** **                | ** ** | **Accrual  June 30, 2004** | ** ** | **Net Additions** | ** ** | **Charges** | ** ** | **Accrual  December 31, 2004** | ** ** |
|---------------------------|------------|--------------------------------------|------------|------------------------|------------|-------------|------------|------------------------------------------|------------|
| Employee  severance costs |       |                                 | $          | 700                    |       |        |       | $                                        | 4,600      |   |   |   | $ | (400 | ) |   |   | $ | 4,900 |   |   |
| Facilities  consolidation |       |                                 | 200        |                   |       |        | 100        |                                     |       |   | (300 | ) |   |   | — |   |   |
| Total                     |       |                                 | $          | 900                    |       |        |       | $                                        | 4,700      |   |   |   | $ | (700 | ) |   |   | $ | 4,900 |   |   |

 

In June 2004, we announced that we acquiredsubstantially all of the assets and assumed certain liabilities of Fireclick, Inc.,a leading provider of Web-analysis solutions for online retailers, providingweb site owners with the tools necessary to measure campaign ROI, track userpath analysis and enhance web site user experience. Under the terms of theagreement, we paid $7.5 million in cash and an additional $0.3 million in cashupon the completion of certain integration milestones. Goodwill of  $7.5 million has been recorded as a result ofthis acquisition. We are amortizing other intangible assets acquired,consisting of non-compete agreements and technology/tradename, over athree-year period. The agreement also provides Fireclick the opportunity for anearn-out based on our achieving certain revenue and profitability targetsattributable to Fireclick over the course of the 36 months following theclosing of the acquisition. These earn-out amounts, if paid, will be recordedas goodwill as they are considered incremental to the purchase price.

In November 2004, we acquired all of theoutstanding capital stock of BlueHornet Networks, Inc. BlueHornet is aleading provider of e-mail marketing campaign management services and relatedcustomer relationship management (CRM) tools. As consideration for theacquisition, we issued a total of 160 thousand shares of our common stock tothe BlueHornet stockholders, valued at approximately $5.3 million, paid off$0.7 million of BlueHornet debt obligations at closing and agreed to pay anadditional $0.5 million in cash to the former BlueHornet stockholders followingthe transition of certain BlueHornet assets to our facilities in Eden Prairie,Minnesota. Goodwill of  $4.3 million wasrecorded as a result of this acquisition. We are amortizing other intangibleassets acquired, consisting of technology/tradename, customer relationships andnon-compete agreements, over a three-year period. In addition, the formerBlueHornet stockholders may receive additional earn-out payments of cash or ourcommon stock, at our discretion, based on BlueHornet’s operating performanceover the first 36 months following the closing of the acquisition. Theseearn-out amounts, if paid, will be recorded as goodwill as they are consideredincremental to the purchase price.

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In January 2003, we acquired certain assets andassumed certain liabilities of Metatec International, Inc.’s electronicsoftware distribution (“ESD”) business in exchange for approximately $1.3million in cash.  Goodwill of  $0.8 million was recorded as a result of thisagreement. We are amortizing intangible assets acquired, consisting of anon-compete agreement and technology/tradename, over a three-year period.

In March 2003,we acquired substantially all ofthe assets and assumed certain liabilities of Hartsell Holdings, Inc., (“Hartsell”)d/b/a Infocon America Corporation in connection with its business of providingWeb services for business-to-business publishers in exchange for approximately$1.1 million in cash. Goodwill of $1.0 million was recorded as a result of thisagreement. We are amortizing other intangible assets acquired, consisting ofnon-compete agreements and technology/tradename, over a three-year period.

In August 2003, we acquired substantially all ofthe assets and certain liabilities of The Registration Network, or Reg.Net, aprovider of e-commerce services for authors and vendors of try-before-you-buysoftware for the purchase price of $2.5 million in cash. Additional goodwill of$0.9 was recorded as a result of this acquisition. We are amortizing otherintangible assets acquired, consisting of non-compete agreements, customer baseand technology/tradename, over a three-year period. The agreement also providesReg.Net the opportunity for an additional cash earn-out based on our achievingcertain revenue metrics related to the e-commerce services for authors andvendors of try-before-you-buy software over the course of the twelve monthsfollowing the closing of the acquisition. Earn-outs totaling $0.4 million wererecorded as goodwill in 2004 as it was incremental to the purchase price.

In November 2003, we acquired substantially allof the assets and assumed certain liabilities of Emetrix, Inc., a providerof e-commerce services for authors and vendors of software for the purchaseprice of $2.6 million in cash.   Additional goodwill of $0.6 million wasrecorded as a result of this acquisition. We are amortizing other intangibleassets acquired, consisting of non-compete agreements, customer base andtechnology/tradename, over a three-year period. The agreement also providesEmetrix the opportunity for additional cash or stock earn-outs based on ourachieving certain revenue metrics related to the e-commerce services forauthors and vendors of software over the course of the thirty-six months and,at our sole discretion, the sixty months following the closing of theacquisition. Such earn-out amounts, if paid, will be recorded as goodwill asthey are considered incremental to the purchase price.

In November 2003, we acquired substantially allof the assets and assumed certain liabilities of GameZone, Inc., aprovider of computer gaming resources and download destination sites on theWeb, for the purchase price of $1.1 million in cash. Additional goodwill of $0.8million was recorded as a result of this acquisition. We will amortize otherintangible assets acquired, consisting of non-compete agreements andtechnology/tradename, over a three-year period. The agreement also providesGameZone the opportunity for additional cash or stock earn-outs based on ourachieving certain revenue metrics related to computer gaming resources anddownload destination sites on the Web over the course of the thirty-six monthsand, at our sole discretion, the sixty months following the closing of theacquisition. Earn-outs totaling $1.0 million were recorded as goodwill in 2004as they are considered incremental to the purchase price.

In March 2002, pursuant to an Amended andRestated Asset Purchase Agreement (the “Agreement”) between us and Beyond.comCorporation (“Beyond.com”), we purchased those assets and assumed thoseliabilities of Beyond.com related to its eStores business, which manages onlinestores for clients, in exchange for 179,096 shares of our common stock. A totalof 70,000 of such shares were placed in escrow (the “Escrow”) to secure certainindemnification obligations of Beyond.com under the Agreement. The purchase wasapproved by the U.S. Bankruptcy Court following Beyond.com’s filing for Chapter11 bankruptcy protection. Immediately following the closing of the Agreement,we entered into a Post-Closing Amendment to the Agreement with Beyond.com (the “Post-ClosingAmendment”) pursuant to 

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which, among other things,we agreed to increase the number of shares to be delivered to Beyond.com underthe Agreement to 222,842, in exchange for a release of certain claims ofBeyond.com against us. The Post-Closing Amendment was subject to approval bythe U.S. Bankruptcy Court. The Official Committee of Unsecured Creditors (the “Committee”)of Beyond.com’s bankruptcy estate objected to the Post-Closing Amendment,asserting that the increase in shares to be delivered to Beyond.com under thePost-Closing Amendment was inadequate, and also asserting the right toadditional shares of our common stock under certain provisions of theAgreement.

In April 2003, Beyond.com, the Committee and usentered into a Settlement Agreement (the “Settlement Agreement”) pursuant towhich we agreed to transfer an additional 50,919 shares (in addition to the222,842 shares previously agreed to) to Beyond.com, in exchange for the releaseby Beyond.com and the Committee of their claims against us. The parties alsoagreed to resolve certain claims by us against the 70,000 shares in the Escrowby transferring 55,123 of such shares to Beyond.com and returning 14,877 ofsuch shares to us. In May and June 2003, the Settlement Agreement andthe Post-Closing Amendment were approved by the Bankruptcy Court andsubsequently consummated.

As of December 31, 2004, there was a maximumpotential for future earn-outs of approximately $3.0 million related to allprior acquisitions.

Followingis an allocation of the net assets acquired from the acquisitions consummatedand amounts paid under earn-out arrangements in 2004 and 2003 (in thousands):
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Tangible assets         |       | $        | 15,869     |     | $          | 402 |   |
| Liabilities  assumed    |       | (17,064  | )          | (2,862   | )          |
| Customer  relationships |       | 8,918    |       | 2,371    |       |
| Non-compete  agreements |       | 1,284    |       | 700      |       |
| Technology/tradename    |       | 7,192    |       | 2,135    |       |
| Goodwill                |       | 124,165  |       | 5,223    |       |
| Net assets acquired     |       | $        | 140,364    |     | $          | 7,969 |   |

 

Theconsolidated financial statements include the operating results of eachbusiness acquired from the date of acquisition. The following unaudited proforma condensed results of operations for 2004, 2003, and 2002 have beenprepared as if each of the acquisitions in 2004 had occurred on January 1,2003 and as if each of the 2003 acquisitions had occurred on January 1,2002 (in thousands except per share data):
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                          |       | $        | 162,465    |     | $          | 121,025  |       | $ | 83,855 |   |
| Income (loss)  from operations   |       | 33,037   |       | 6,488    |       | (4,623   | )          |
| Net income (loss)                |       | 33,227   |       | 6,786    |       | (5,051   | )          |
| Diluted income (loss)  per share |       | $        | 0.86       |     | $          | 0.21     |       | $ | (0.19 | ) |

 

This pro forma financialinformation does not purport to represent results that would actually have beenobtained if the transactions had been in effect on January 1, 2004, 2003,2002 as applicable, or any future results that may be realized.

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**7.   Income Taxes:**

Thereconciliation of the reported income tax expense to the amount the wouldresult from applying the U.S. federal statutory rate of 35% to the net loss isas follows (in thousands):
| ** **                                          | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Tax expense  (benefit) at statutory rate            |       | $                                          | 12,740     |   | $ | 5,998 |   | $ | (179 | ) |
| International provision  in excess of U.S. tax rate |       | 128                                        |       | — |   | — |   |
| State taxes, net  of federal benefit                |       | 1,484                                      |       | 725 |   | 63 |   |
| Stock  compensation deductions                      |       | —                                     |       | — |   | — |   |
| Non-deductible  goodwill and earn-out compensation  |       | 183                                        |       | 314 |   | 712 |   |
| Non-deductible  expense and other                   |       | 1,012                                      |       | 35 |   | 23 |   |
| Change in  valuation allowance                      |       | (14,468                                    | )          | (7,072 | ) | (619 | ) |
| Total                                               |       | $                                          | 1,079      |   | $ | — |   | $ | — |   |

 

As of December 31, 2004, we had net U.S.operating loss carryforwards of approximately $96.7 million, and foreign taxloss carryforwards of $7.8 million. Included in the U.S. amount areapproximately $88.3 million of deductions resulting from disqualifyingdispositions of stock options. When these deductions from disqualifyingdispositions are realized for financial statement purposes they will not resultin a reduction in income tax expense, rather the benefit will be recorded asadditional paid-in-capital. These income tax net operating loss carryforwardsexpire in the years 2012 through 2024. Additionally, we have made a Section 338election allowing us to deduct the step up basis in acquisitions ofapproximately $100 million over 15 years. Deductions from disqualifyingdispositions of stock options are included in net operating loss carryforwardswith a corresponding valuation allowance. Because of the uncertainty of futurerealization, a valuation allowance equal to the deferred tax asset has beenrecorded.

Taxableincome, net of tax strategies, before provision for the income taxes is asfollows (in thousands):
| ** **    | ** ** | **Year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| United States |       | $                                          | 33,778     |   | $ | 17,136 |   | $ | (510 | ) |
| International |       | 2,625                                      |       | — |   | — |   |
| Total         |       | $                                          | 36,403     |   | $ | — |   | $ | — |   |

 

Thecomponents of deferred income taxes are as follows (in thousands):
| ** **                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| Net operating  loss carryforwards    |       | $        | 40,809     |     | $          | 36,357 |   |
| Nondeductible  reserves and accruals |       | 1,761    |       | 1,796    |       |
| Depreciation and  amortization       |       | 5,718    |       | 4,791    |       |
| Valuation  allowance                 |       | (48,288  | )          | (42,944  | )          |
| Total                                |       | $        | —     |     | $          | — |   |

 

Ownership changesresulting from the issuance of additional equity may limit future annualrealization of the tax net operating loss carryforwards to a specifiedpercentage of our value under Section 382 of the Internal Revenue Code.

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**8.   Commitments and Contingencies:**

***Leases***

Wecurrently have eleven facility leases in addition to leasing certain computerequipment under non-cancelable operating leases. Total rent expense, includingcommon area maintenance charges, recognized under all leases was $2.4 million,$1.9 million and $1.7 million for the years ended December 31, 2004, 2003and 2002, respectively. The minimum annual rents under long-term leases at December 31,2004 were as follows (in thousands):

| **Year ending December 31,** | ** ** | ** ** | ** ** | **Lease Obligations** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------|------------|
| 2005                                        |       |       | $          | 1,921                      |       |   |
| 2006                                        |       |       | 1,154      |                       |       |
| 2007                                        |       |       | 742        |                       |       |
| 2008                                        |       |       | 701        |                       |       |
| 2009-2010                                   |       |       | 947        |                       |       |
| Total future minimum  obligations           |       |       | $          | 5,465                      |       |   |

 

***Litigation***

Beginning in August 2001, we and certainof our officers and directors were named as defendants in several classaction shareholder complaints filed in the United States District Court for theSouthern District of New York, now consolidated as *In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355. Similar complaints, referred to here as the IPOLawsuits, were filed in the same court against hundreds of other publiccompanies, referred to here as the Issuers. In the consolidated amendedcomplaint against us, the plaintiffs allege that we, certain of our officersand directors and the underwriters of our initial public offering, or IPO,violated Section 11 of the Securities Act of 1933 based on allegationsthat our IPO registration statement and prospectus failed to disclose materialfacts regarding the compensation to be received by, and the stock allocationpractices of, the IPO underwriters. The complaint also contains a claim forviolation of Section 10(b) of the Securities Exchange Act of 1934based on allegations that this omission constituted a deceit on investors. Theplaintiffs seek unspecified monetary damages and other relief.

In July 2002, we joined in a global motion todismiss the IPO Lawsuits filed by all of the Issuers (among others). In October 2002,the parties agreed to toll the statute of limitations with respect to certainof the named officers and directors until September 30, 2003 and on thebasis of this agreement, our officers and directors were dismissed fromthe lawsuit without prejudice. In February 2003, the court issued adecision denying the motion to dismiss the Section 11 claims against usand almost all of the other Issuers and denying the motion to dismiss the Section 10(b) claimsagainst us and many of the Issuers.

During the summer of 2003, we, along with asubstantial majority of Issuers, indirectly participated in discussions withthe plaintiffs and the Issuers’ respective insurers regarding a tentativesettlement of the IPO Lawsuits. The terms of the tentative settlementwould provide for, among other things, a release of the Issuers and theirofficers and directors from all further liability resulting from plaintiffs’claims, and the assignment to plaintiffs of certain potential claims that theIssuers may have against their IPO underwriters. The tentative settlement alsoprovides that, in the event that plaintiffs ultimately recover less than aguaranteed sum of $1 billion from the IPO underwriters, plaintiffs wouldbe entitled to payment by each participating Issuer’s insurer of a pro ratashare of any shortfall in the plaintiffs’ guaranteed recovery. In June 2003,pursuant to the authorization of a special litigation committee of ourboard of directors, we entered into a non-binding memorandum ofunderstanding reflecting the settlement terms described above. In September 2003,in connection with the possible settlement, our officers and directors whohad entered tolling agreements with plaintiffs (described above) agreed toextend those agreements so that 

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they would not expireprior to any settlement being finalized. In June 2004, we executed a finalsettlement agreement with the plaintiffs consistent with the terms of thememorandum of understanding. On February 15, 2005, the Court issued adecision certifying a class action for settlement purposes and grantingpreliminary approval of the settlement, subject to modification of certain barorders contemplated by the settlement. In addition, the settlement is stillsubject to statutory notice requirements as well as final judicial approval. Pendingfinal approval of the settlement, we continue to believe that the claimsagainst us, our officers and directors are without merit and intend to defendagainst them vigorously.

On December 29, 2004, we announced that we hadsettled, for an undisclosed amount and terms, the action brought by ChristopherM. Crawford against us which had alleged infringement of United States Patent No. 6,014,651.The amount of the settlement is not considered material to our operations orfinancial position.

In addition, we aresubject to legal proceedings, claims, and litigation arising in the ordinarycourse of business. While the final outcome of these matters is currently notdeterminable, we believe there is no litigation pending against us that couldhave, individually or in the aggregate, a material adverse effect on ourconsolidated financial position, results of operation or cash flows. As of December 31,2004, we had $1.1 million accrued for various legal matters where it wasestimable and probable that an unfavorable outcome will occur.

***Employee Benefit Plan***

Wehave a defined contribution 401(k) retirement plan for eligible employees.Employees may contribute up to 15% of their pretax compensation to the plan,with us providing a discretionary match of up to 50% of the total employeecontribution. Amounts charged to expense related to our matching contributionswere $0.7 million for the all years, 2002 through 2004.

**9.   Long-Term Debt:**

On April 16, 2004, inconnection with our acquisition of element 5, we established a $45million secured revolving credit facility with Harris Trust and Savings Bank. Thisfacility was repaid in full and terminated in connection with the sale andissuance of our 1.25% convertible senior notes on June 1, 2004.

On June 1, 2004 we sold and issued $175 millionin aggregate principal amount of 1.25% convertible senior notes due January 1,2024, in a private, unregistered offering. The notes were sold at 100% of theirprincipal amount. The initial purchasers exercised in full their option topurchase up to an additional $20 million in aggregate principal amount of thenotes on June 30, 2004, which purchase transaction closed on July 6,2004.

We are required to pay interest on the notes on January 1and July 1 of each year beginning January 1, 2005. The notes bearinterest at a rate of 1.25% and, if specified conditions are met, areconvertible into our common stock at a conversion price of $44.063 per share. Thenotes may be surrendered for conversion under certain circumstances, includingthe satisfaction of a market price condition, such that the price of our commonstock reaches a specified threshold; the satisfaction of a trading pricecondition, such that the trading price of the notes falls below a specifiedlevel; the redemption of the notes by us, the occurrence of specified corporatetransactions, as defined in the related indenture; and the occurrence of afundamental change, as defined in the related indenture. The initial conversionprice is equivalent to a conversion rate of approximately 22.6948 shares per$1,000 of principal amount of the notes. We will adjust the conversion price ifcertain events occur, as specified in the related indenture, such as theissuance of our common stock as a dividend or distribution or the occurrence ofa stock subdivision or combination. If a fundamental change, such as a changein our control, as defined in the related indenture, occurs on or before January 1,2009, we may also be required to purchase the notes for cash and pay anadditional make whole premium payable in our common stock upon the repurchaseor conversion of the 

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notes in connection withthe fundamental change. Holders of the notes have the right to require us torepurchase their notes prior to maturity on January 1, 2009, 2014 and2019. We have the right to redeem the notes, under certain circumstances, on orafter July 1, 2007 and prior to January 1, 2009, and we may redeemthe notes at anytime on or after January 1, 2009.

A portion of the net proceeds of the offering was usedto repay our senior secured revolving credit facility with Harris Trust andSavings Bank. The balance will be used for general corporate purposes,including working capital, capital expenditures, potential future acquisitions,investments, and the potential repurchase of shares of our common stock.

Weincurred interest expense of $1.5 million in 2004 and made interest payments of$0.1 million. No interest expense was incurred in 2003 or 2002.

**10.   Stockholders’ Equity:**

***Warrants***

Warrants to purchase101,667 shares of common stock issued principally in conjunction with sales ofcommon stock at an exercise price of $3.00 per share were outstanding as of December 31,2002. The warrants expired at various dates between February and August 2003.There were no warrants outstanding as of December 31, 2004.

***Share RepurchaseProgram***

In April 2001,we announced a share repurchase program of up to $5.0 million of ouroutstanding shares of common stock. Repurchases are at our discretion based onongoing assessments of the capital needs of the business and the market priceof our shares. No shares were repurchased under this program during 2004, 2003or 2002.

**11.   Stock Options:**

Our 1998 Stock Option Plan (the “SOP”) provides forthe granting of incentive or nonqualified stock options to purchase up to5,983,333 shares of common stock. Options granted to employees typically expireno later than ten years after the date of grant. Incentive stock option grantsmust have an exercise price of at least 100% of the fair market value of ashare of common stock on the grant date. Incentive stock options granted toemployees who, immediately before such grant, owned stock directly orindirectly representing more than 10% of the voting power of our stock willhave an exercise price of 110% of the fair market value of a share of commonstock on the grant date and will expire no later than five years from the dateof grant.

Our 1999 Non-Officer Stock Option Plan (the “NOP”)provides for the granting of nonqualified stock options to purchase up to8,450,000 shares of common stock and has terms similar to those of the SOP.

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Asummary of the change in outstanding options under the SOP and NOP is asfollows:
| ** **                       | ** ** | **Options Outstanding** | ** ** | **Option Price Per Share** | ** ** |
|----------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| Balance,  December 31, 2001 |       |                         | 5,828,174  |                                      |       |   | $ | 1.69 – $31.13 |   |   |
| Grants                           |       |                         | 2,305,850  |                                      |       |   | 4.65 – 16.54 |   |   |
| Exercised                        |       |                         | (836,878   | )                                         |       |   | 1.69 – 11.75 |   |   |
| Cancelled                        |       |                         | (1,242,863 | )                                         |       |   | 1.69 – 31.13 |   |   |
| Balance,  December 31, 2002 |       |                         | 6,054,283  |                                      |       |   | 1.69 – 31.13 |   |   |
| Grants                           |       |                         | 2,858,651  |                                      |       |   | 8.98 – 27.40 |   |   |
| Exercised                        |       |                         | (1,678,761 | )                                         |       |   | 1.69 – 26.88 |   |   |
| Cancelled                        |       |                         | (568,027   | )                                         |       |   | 2.59 – 31.13 |   |   |
| Balance,  December 31, 2003 |       |                         | 6,666,146  |                                      |       |   | 1.69 – 31.13 |   |   |
| Grants                           |       |                         | 1,603,600  |                                      |       |   | 20.60 – 24.86 |   |   |
| Exercised                        |       |                         | (1,942,212 | )                                         |       |   | 2.59 – 31.13 |   |   |
| Cancelled                        |       |                         | (612,794   | )                                         |       |   | 2.59 – 31.13 |   |   |
| Balance,  December 31, 2004 |       |                         | 5,714,740  |                                      |       |   | $ | 1.69 – $31.13 |   |   |

 

Asummary of information about total stock options outstanding at December 31,2004 is as follows:
| ** **              | ** **                           | **Options Outstanding** | ** ** | **Options Exercisable**                   | ** ** |
|-------------------------|--------------------------------------|------------------------------|------------|------------------------------------------------|------------|
| **Exercise Price** | ** **                           | **Number  Outstanding**      | ** ** | **Weighted Average  Life Remaining** | ** ** | **Number**

**Exercisable** | ** ** | **Weighted  Average Price** | ** ** |
|                    | $1.69 – $3.88         |                         |       | 188,205                                        |       |   | 4.4 years |   |   | 147,187 |   |   | $ | 2.91 |   |   |
|                    |  4.56 –** **7.55 |                         |       | 1,830,232                                      |       |   | 6.4 years |   |   | 1,316,287 |   |   | 5.36 |   |   |
|                    |  9.13 – 13.92    |                         |       | 1,336,865                                      |       |   | 6.8 years |   |   | 477,826 |   |   | 12.23 |   |   |
|                    | 16.72 – 22.98         |                         |       | 1,753,961                                      |       |   | 8.8 years |   |   | 1,069,575 |   |   | 22.68 |   |   |
|                    | 23.01 – 31.13         |                         |       | 605,477                                        |       |   | 8.6 years |   |   | 120,636 |   |   | 25.29 |   |   |
|                    | $1.69 – $31.13        |                         |       | 5,714,740                                      |       |   | 7.4 years |   |   | 3,131,511 |   |   | $ | 12.97 |   |   |

 

We also sponsor anemployee stock purchase plan under which 1,200,000 shares have been reservedfor purchase by employees. The purchase price of the shares under the plan isthe lesser of 85% of the fair market value on the first or last day of theoffering period. Offering periods are currently every six months ending on June 30and December 31. Employees may designate up to ten percent of theircompensation for the purchase of shares under the plan. Total shares purchasedby employees under the plan were 51,000, 93,000 and 49,000 in the years ended December 31,2004, 2003 and 2002, respectively.

**12.   Segment Information:**

Prior to January 1, 2004, we managed our physicalgoods clients through a division (formerly our E-Business Services Division)that was separate from our Software and Digital Commerce Services Division. Beginningin January 2004, this divisional structure was consolidated, and weannounced that we would no longer report our activities as separate businesssegments.

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Salesto foreign customers accounted for 31%, 24% and 22% of revenue for 2004, 2003,and 2002, respectively.   Revenue is attributedto a geographic region based on the ordering location of the customer.Summarized revenue information by region for fiscal 2004, 2003 and 2002 is asfollows (dollars in thousands):
| ** **    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------|------------|----------|------------|----------|------------|----------|------------|
| United States |       | $        | 106,350    |     | $          | 76,913   |       | $ | 60,671 |   |
| Europe        |       | 35,450   |       | 16,192   |       | 10,890   |       |
| Other         |       | 12,330   |       | 8,096    |       | 6,222    |       |
| Total         |       | $        | 154,130    |     | $          | 101,201  |       | $ | 77,783 |   |

 

In addition, revenue derived from sales of productfrom one software publisher, Symantec Corporation, accounted for approximately27%, 27%, and 23% of our total revenue in 2004, 2003 and 2002, respectively.

Themajority of our assets, as of December 31, 2004 and 2003, wereattributable to our U.S. operations. Property and equipment information isbased on the physical location of the assets. The following table presentsproperty and equipment information by geographic area (in thousands):
| ** **                   | ** ** | **2004**               | ** ** | **2003**   | ** ** |
|------------------------------|------------|------------------------|------------|------------|------------|
| ** **                   | ** ** | **United States** | ** ** | **Europe** | ** ** | **United States** | ** ** | **Europe** | ** ** |
| Total property and equipment |       |                   | $          | 37,588     |       |   | $ | 3,551 |   |   | $ | 31,934 |   |   | $ | 499 |   |
| Accumulated depreciation     |       |                   | (21,406    | )          |       | (2,366 | ) |   | (17,620 | ) |   | (179 | ) |
| Net property and equipment   |       |                   | $          | 16,182     |       |   | $ | 1,185 |   |   | $ | 14,314 |   |   | $ | 320 |   |

 

**13.   Subsequent Events:**

In March 2005, we acquired certain assets andassumed certain liabilities, vendor contracts and intellectual property ofSWReg, an operating business of Atlantic Coast plc, a private limited UKcompany for $8.8 million in cash. SWReg is a provider of e-commerceservices for software authors. We may also make additional earn-out payments ofcash based on achieving specific revenue and development goals over the first12 months following the closing of the acquisition.

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**DigitalRiver, Inc.Schedule IIFor Years Ended December 31, 2004, 2003 & 2002In thousands**
| **2004**                         | ** ** | ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Charges to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for  doubtful accounts |       |       | $          | 319                                              |       |                                          |       | $              | 1,061      |                                       |       |   | $ | (234 | ) |   |   | $ | 1,146 |   |   |
| Accrued  chargeback reserve      |       |       | 1,774      |                                             |       |                                          | 3,008      |           |       |                                       | (2,536     | ) |   |   | 2,246 |   |   |
| Litigation settlement  reserve   |       |       | 1,675      |                                             |       |                                          | 1,090      |           |       |                                       | (1,675     | ) |   |   | 1,090 |   |   |

 
| **2003**                         | ** ** | ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Charges to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for  doubtful accounts |       |       | $          | 905                                              |       |                                          |       | $              | 820        |                                       |       |   | $ | (1,406 | ) |   |   | $ | 319 |   |   |
| Accrued  chargeback reserve      |       |       | 841        |                                             |       |                                          | 3,005      |           |       |                                       | (2,072     | ) |   |   | 1,774 |   |   |
| Litigation settlement  reserve   |       |       | 1,675      |                                             |       |                                          | —     |           |       |                                       | —     |   |   |   | 1,675 |   |   |

 
| **2002**                         | ** ** | ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Charges to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for  doubtful accounts |       |       | $          | 286                                              |       |                                          |       | $              | 1,897      |                                       |       |   | $ | (1,278 | ) |   |   | $ | 905 |   |   |
| Accrued  chargeback reserve      |       |       | 553        |                                             |       |                                          | 1,498      |           |       |                                       | (1,210     | ) |   |   | 841 |   |   |
| Litigation settlement  reserve   |       |       | —     |                                             |       |                                          | 2,300      |           |       |                                       | (625       | ) |   |   | 1,675 |   |   |

 

 

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**INDEX TO EXHIBITS**
| Exhibit Number | ** ** | **Description  Of Document**                                                                                                                                                                                                                                                                                                                                                              | ** ** | ** ** |
|----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|           |       |                                                                                                                                                                                                                                                                                                                                                                                      |
| 2.1(1)         |       | Stock Purchase Agreement, dated as of April 17,  2004 by and among Digital River, Inc., Blitz F03-1424 GmbH, a company  organized under the laws of Germany and a wholly owned subsidiary of Digital  River, and the selling shareholders of element 5 Informationstechnologien und  —dienstleistungen Aktiengesellschaft, a company organized under the laws of  Germany. |
| 2.2(2)         |       | Amended and Restated Asset Purchase Agreement dated  February 9, 2002 by and between the Registrant and Beyond.com.                                                                                                                                                                                                                                                                  |
| 2.3(3)         |       | First Amendment to the Amended and Restated Asset  Purchase Agreement dated as of March 15, 2002 by and between the  Registrant and Beyond.com.                                                                                                                                                                                                                                      |
| 2.4(3)         |       | Post-Closing Amendment to the Amended and Restated  Asset Purchase Agreement dated as of March 31, 2002 by and between the  Registrant and Beyond.com.                                                                                                                                                                                                                               |
| 3.1(4)         |       | Amended and Restated Certificate of Incorporation of  the Registrant, as currently in effect.                                                                                                                                                                                                                                                                                             |
| 3.2(6)         |       | Amended and Restated Bylaws of the Registrant, as  currently in effect.                                                                                                                                                                                                                                                                                                                   |
| 3.3(4)         |       | Certificate of Amendment of Amended and Restated  Certificate of Incorporation (amending Exhibit 3.1).                                                                                                                                                                                                                                                                               |
| 4.1(7)         |       | Specimen Stock Certificate.                                                                                                                                                                                                                                                                                                                                                               |
| 4.2(4)         |       | Form of Senior Debt Indenture.                                                                                                                                                                                                                                                                                                                                                       |
| 4.3(4)         |       | Form of Subordinated Debt Indenture.                                                                                                                                                                                                                                                                                                                                                 |
| 4.4            |       | References are hereby made to Exhibits 3.1, 3.2 and  3.3.                                                                                                                                                                                                                                                                                                                                 |
| 4.5(13)        |       | Indenture dated as of June 1, 2004 between  Digital River, Inc. and Wells Fargo Bank, N.A. as trustee, including  therein the form of the Note.                                                                                                                                                                                                                                 |
| 10.1(7)        |       | Form of Indemnity Agreement between Registrant  and each of its directors and executive officers.                                                                                                                                                                                                                                                                                    |
| 10.2(7)        |       | Employment and Non-Competition Agreement effective  May 25, 1998 by and between Joel A. Ronning and the Registrant.*                                                                                                                                                                                                                                                                 |
| 10.3(7)        |       | Consent to Assignment and Assumption of Lease dated  April 22, 1998 by and between CSM Investors, Inc., IntraNet  Integration Group, Inc. and Registrant.                                                                                                                                                                                                                  |
| 10.4(5)        |       | Assignment of Lease dated April 21, 1998 by and  between Intranet Integration Group, Inc. and Registrant.                                                                                                                                                                                                                                                                       |
| 10.5(5)        |       | Lease Agreement dated January 18, 2000 between  Property Reserve, Inc. and Registrant.                                                                                                                                                                                                                                                                                          |
| 10.6(6)        |       | First Amendment of Lease dated January 31, 2001  to that certain Lease dated April 24, 1996 between CSM  Investors, Inc. and Registrant (as assignee of Intranet Integration  Group, Inc.).                                                                                                                                                                           |
| 10.7(8)        |       | 1998 Stock Option Plan, as amended.*                                                                                                                                                                                                                                                                                                                                                      |
| 10.8(9)        |       | 1999 Stock Option Plan, formerly known as the 1999  Non-Officer Stock Option Plan, as amended.*                                                                                                                                                                                                                                                                                           |
| 10.9(8)        |       | 2000 Employee Stock Purchase Plan, as amended, and  offering.*                                                                                                                                                                                                                                                                                                                            |
|           |       |                                                                                                                                                                                                                                                                                                                                                                                      |
| 10.11(10)      |       | Second Amendment of Lease dated April 22, 2002  to that certain Lease dated April 24, 1996 between CSM  Investors, Inc. and Registrant (as assignee of Intranet Integration  Group, Inc.) as amended.                                                                                                                                                                 |
| 10.12(10)      |       | Second Amendment of Lease dated April 28, 2003  to that certain Lease dated January 18, 2000 between Property Reserve  Inc. and Registrant.                                                                                                                                                                                                                                     |
| 10.13(11)      |       | Employment Agreement with Jay Kerutis.*                                                                                                                                                                                                                                                                                                                                                   |
| 10.14(12)      |       | Employment Agreement with Gary Howorka.*                                                                                                                                                                                                                                                                                                                                                  |
| 10.15(13)      |       | Registration Rights Agreement dated as of  June 1, 2004 between Digital River, Inc. and the initial purchasers  of Senior Convertible Notes due January 1, 2024.                                                                                                                                                                                                           |
| 12.1           |       | Computation of Ratio of Earnings to Fixed Charges                                                                                                                                                                                                                                                                                                                                         |
| 21.1           |       | Subsidiaries of Digital River, Inc.                                                                                                                                                                                                                                                                                                                                                  |

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| 23.1 |   | Consent of Independent Registered Public Accounting  Firm, dated March 14, 2005.                                                                                                    |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 24.1 |   | Power of Attorney, pursuant to  which amendments to this Annual Report on Form 10-K may be filed, is  included on the signature pages of this Annual Report on Form 10-K. |
| 31.1 |   | Certification of Digital River, Inc.’s  Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                              |
| 31.2 |   | Certification of Digital  River, Inc.’s Chief Financial Officer, pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                              |
| 32.1 |   | Certification of Digital River, Inc.’s  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                               |
| 32.2 |   | Certification of Digital  River, Inc.’s Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                               |
| *    |   | Management contract or compensatory  plan.                                                                                                                                               |

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(1)          Incorporated byreference from the Company’s Current Report on Form 8-K filed May 4,2004.

(2)          Incorporated byreference from the Company’s Current Report on Form 8-K filed February 11,2002.

(3)          Incorporated byreference from the Company’s Current Report on Form 8-K filed April 15,2002.

(4)          Incorporated byreference from the Company’s Registration Statement on Form S-3 (File No. 333-81626),declared effective on February 12, 2002.

(5)          Incorporated byreference from the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1999 filed on March 30, 2000.

(6)          Incorporated byreference from the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2000 filed on March 27, 2001.

(7)          Incorporated byreference from the Company’s Registration Statement on Form S-1 (File No. 333-56787),declared effective on August 11, 1998.

(8)          Incorporated byreference from the Company’s Registration Statement on Form S-8 (File No. 333-105864)filed on June 5, 2003.

(9)          Incorporated byreference from the Company’s Quarterly Report on Form 10-Q for the quarterended June 30, 2003 filed on August 14, 2003.

(10)   Incorporated by reference fromthe Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,2003 filed on May 15, 2003.

(11)   Incorporated by reference fromthe Company’s Quarterly Report on Form 10-Q for the quarter ended September 30,2003 filed on November 13, 2003.

(12)   Incorporated by reference fromthe Company’s Annual Report on Form 10-K for the year ended December 31,2003 filed on March 15, 2004.

(13)   Incorporated by reference fromthe Company’s Current Report on Form 8-K filed July 13, 2004.

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