**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

 

| **(Mark one)**                               |                                                                                                                                   |
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| **ý**                                   | **Annual Report Pursuant to Section 13 or 15(d) of the  Securities Exchange Act of 1934 for the fiscal year ended December 31, 2002.** |
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| **OR**                                       |
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| **o**                                        | **Transition Report Pursuant to Section 13 or 15(d) of the  Securities Exchange Act of 1934.**                                         |
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| **Commission File Number:   000-24643** |

 

| **DIGITAL  RIVER, INC.**                                                   |
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| (Exact name of registrant as specified in its charter)                     |
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| **DELAWARE**                                                               |   | **41-1901640** |
| (State or other jurisdiction of Incorporation or organization)             |   | (I.R.S. Employer Identification No.) |
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| **9625 WEST 76TH STREET, SUITE 150  EDEN PRAIRIE, MINNESOTA 55344**        |
| (Address of principal executive  offices)                                  |
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| **(952) 253-1234**                                                    |
| (Registrant’s telephone number,  including area code)                 |
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| Securities registered pursuant to  Section 12(b) of the Act: **None** |
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| Securities registered pursuant to  Section 12(g) of the Act:          |
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| **Common Stock $0.01 par value**                                           |

 

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

 

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

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2)  Yes  ý   No  o

 

As of June 30, 2002, there were 26,879,734 shares of Digital River,Inc. common stock, issued and outstanding. As of such date, based on the closing sales price as quoted by theNasdaq, 23,938,236 shares of common stock, having an aggregate market value of approximately$227,413,000 were held by non-affiliates. For purposes of the above statement only, all directors and executiveofficers of the registrants are assumed to be affiliates.

 

The numberof shares of common stock outstanding at March 1, 2003 was 27,647,326 shares.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Certain sections of theRegistrant’s definitive Proxy Statement for the 2003 Annual Meeting ofStockholders are incorporated by reference in Part III of thisForm 10-K to the extent stated herein.

 

 

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**PART I**

**ITEM 1. BUSINESS.**

 

**CAUTIONARY STATEMENT PURSUANT TO THE PRIVATESECURITIES LITIGATION REFORM ACT OF 1995**

 

Certain statements set forth orincorporated by reference in this Form 10-K, as well as in our AnnualReport to Stockholders for the year ended December 31, 2002, constitute“forward-looking statements” within the meaning of the Private SecuritiesLitigation 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 softwarepublishers and online retailers; the integration of acquired companies; risksassociated with electronic software delivery; our dependence on the Internetand the growth in electronic commerce and Internet infrastructure development;competition in the electronic commerce industry; our dependence on keycustomers; our dependence on key employees; system development and electroniccommerce security risks; changes in laws and regulations; and other risk factorsset forth under “Risk Factors” and elsewhere in this Form 10-K. Weexpressly disclaim any obligation to update or publicly release any revision tothese forward-looking statements after the date of this Form 10-K.

 

**Overview**

 

We are a provider of comprehensiveelectronic commerce outsourcing solutions. We were incorporated inFebruary 1994 and commenced offering products for sale through ourclients’ Web stores in August 1996. As a leading global e-commerceoutsource provider, we enable our clients to access our proprietary electroniccommerce system over the Internet. We have developed a technology platform thatallows us to provide a suite of electronic commerce services, including Webcommerce development and hosting, transaction processing, fraud screening,digital delivery, integration to physical fulfillment and customer service. Wealso provide analytical marketing and merchandising services to assist clientsto increase Web page view traffic to, and sales through, their Web commercesystems. We provide an outsourcing solution that allows our clients to promotetheir own brands while leveraging our investment in infrastructure andtechnology.   Some of our key clientsinclude Cisco, Inc., H&R Block, Inc., Johnson & Johnson, Inc., MajorLeague Baseball, McAfee.com Corporation, Microwarehouse, Inc., Software Oasis,Inc., Symantec Corporation and Visioneer, Inc.

 

Our proprietary commercenetwork server technology, or CNS, serves as the platform for the majority ofour solutions. Our technology incorporates custom software applications thatenable Web store authoring, electronic software delivery, fraud prevention,export control, merchandising programs and online registration, and features adatabase of more than 290,000 software and digital products. Using ourplatform, we create Web commerce systems for our clients that replicate thelook and feel of each client’s Web site. End-users enter the client site andare then seamlessly transferred to our commerce server. End-users can thenbrowse for products and make purchases online, and once purchases are made, weeither deliver the products digitally to the end-user through the Internet orcommunicate the order through its integration into a number of third-partyfulfillment agencies for physical fulfillment. We also provide transactionprocessing services and collect and maintain critical information aboutend-users. This information can later be used by our clients to facilitateadd-on or upgrade sales and for other direct marketing purposes. We activelymanage direct marketing campaigns for our clients and also deliver purchaseinformation and Web store traffic statistics to our clients through onlinereporting.

 

General information about uscan be found at www.digitalriver.com under the “Investor Relations” link.  Our annual report on Form 10-K, quarterlyreports on Form 10-Q and current reports on Form 8-K, as well as any amendmentsor exhibits to those reports are available free of charge through our websiteas soon as reasonably practicable after we file them with, or furnish them to,the Securities and Exchange Commission.

 

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**IndustryBackground**

 

*Growth Of The Internet And ElectronicCommerce.*  TheInternet is a significant global communications medium, enabling millions ofpeople to share information and conduct business electronically.  The increasing functionality, accessibilityand adoption of the Internet have made it an attractive commercial medium.Online businesses can interact directly with end-users, both businesses andconsumers, and can frequently adjust their featured selections, shoppinginterfaces and pricing. The ability to reach and serve a large and global groupof end-users electronically from a central location and the potential forpersonalized low-cost customer interaction provide additional economic benefitsfor online businesses. Unlike traditional retail channels, online businesses donot have the burdensome costs of managing and maintaining a significantphysical retail store infrastructure or the continuous printing and mailingcosts of catalog marketing. Because of these advantages, online businesses havethe potential to build large, global customer bases quickly and to achievesuperior economic returns over the long term. An increasingly broad base ofproducts is being sold successfully online, including computers, electronics,travel and entertainment services, brokerage services, apparel and music, aswell as software products.

 

*Advantages Of Outsourcing ElectronicCommerce.* According to a Gartner Group study, the initial investment in anelectronic commerce site that is functionally equivalent to most industryparticipants is $1.0 to $5.0 million and requires an average of fivemonths to implement. The study found that a market differentiating electroniccommerce solution requires an expenditure of $5.0 to $20.0 million.Additionally, to maintain a scaleable, best-of-breed commerce solution,businesses must continue to invest in technology, infrastructure and personnelrelated to electronic commerce management.

 

There are a number ofadvantages to outsourcing electronic commerce, including: (i) avoiding thelarge, upfront and ongoing investment required to purchase and implementsoftware applications and computer hardware; (ii) shortening the time tomarket as compared to in-house development and maintenance; (iii) shiftingthe ongoing financial burden and technology risk to a proven service provider;(iv) leveraging the expertise of an outsource provider to accelerate growth ofan online business; and (v) allowing businesses to focus on their specificcore competency. Because of these advantages, we believe that an increasingnumber of businesses will outsource their electronic commerce needs.

 

*Opportunity For Electronic CommerceOutsourcing.* We believe that the market for electronic commerce outsourcing in thesoftware and digital products market as well as among manufacturers,distributors and retailers will continue to grow rapidly.  We believe that providing an integratedservice offering of Web commerce development and hosting, order management,fraud prevention, site merchandising, reporting and analytics, digitalfulfillment, integration to physical fulfillment, e-marketing and customerservice is complex and requires upfront and ongoing investments in secure, reliableand scalable systems. Accordingly, we believe that a substantial marketopportunity exists for a comprehensive, cost-effective, outsourced electroniccommerce solution for software publishers and online retailers as well as formanufacturers, distributors and retailers.

 

*The Digital River Solution.*  We have developed a robust electroniccommerce technology platform and suite of e-commerce services to helpbusinesses grow their online revenues as well as reduce the costs and risksassociated with running an electronic commerce operation in-house.  We provide a complete, client-branded,electronic commerce outsourcing solution that includes Web commerce developmentand hosting, transaction processing, fraud screening, digital delivery,integration to physical fulfillment, site merchandising and marketing, andcustomer service that enables our clients to promote their own brands and focuson their core competencies while leveraging our world-class infrastructure andexpertise to grow their online business.

 

*Benefits To Clients.*

 

Reduced TotalCost Of Ownership And Risk

Businesses can reduce the totalcost of ownership of their electronic commerce operation by leveraging ourinvestment in technology, personnel and infrastructure.  By reducing or eliminating the up front andongoing costs of hardware, software and personnel associated with developing,customizing, deploying, maintaining and upgrading an in-house electroniccommerce solution or software package, businesses can establish and maintain anelectronic commerce business at a lower total cost and with little financialrisk.

 

Revenue Growth

Our electronic commercetechnology platform, marketing expertise and large network of clients andpartners provide our clients with the potential to grow their online businesses.

 

Working with thousands ofcompanies since 1996, we have developed the technology, expertise and bestpractices in the area of marketing and merchandising that can help our clientsgrow their online businesses by increasing traffic, close ratios, average ordersizes and repeat purchases.

 

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We also provide the technologyand services needed to support international sales.  Our technology platform supports multiple transaction currencies,payment options and localized content required to successfully sell products ininternational markets.

 

In addition, through our largeclient network, we believe we are uniquely positioned to help our clients growtheir online businesses by providing them with access to new distributionchannels and products to sell.  Clientscan approve their products to be sold on other client sites and sell productsowned and approved for sale by our other clients.  In addition, our software and digital products clients also havethe opportunity to increase distribution of their products by offering part orall of their entire online product catalog to our network of onlineretailers.  This is beneficial to bothour software publisher and online retailer clients because we eliminate theburden of developing and maintaining hundreds of relationships.  The online retailers also enjoy access to amuch broader inventory of software products, and avoid the costs and risk ofcarrying physical inventory.

 

DeploymentSpeed

Companies can increase theirspeed to market by leveraging our outsourced business model, technologyplatform and remote control tools to establish their electronic commercebusiness typically in a matter of days or weeks.

 

*Benefits To End-Users.*  Our solution emphasizes convenience byallowing end-users, both business and consumer, to purchase products onlinefrom their home or office.  Bysupporting global reach, we can deliver an extremely broad selection of digitaland physical products to end-users in remote locations that cannot supportretail stores.  In the case of softwareand digital products, users have the option to quickly and convenientlydownload and install products through electronic delivery.  Using our sophisticated search enginetechnology, end-users visiting retailers’ online Web stores can accessvirtually our entire inventory of software and digital products. End-users alsobenefit from the protection of our download assurance service, through which weguarantee replacement of software in the event of accidental destructionthrough computer error or malfunction, and from our 24x7 customer serviceprovided on behalf of our clients.

 

**Strategy**

 

Our objective is to be theglobal leader in electronic commerce outsourcing for software and digitalproducts publishers and online retailers through our Software and DigitalCommerce Services Division, as well as for manufacturers, distributors andretailers through our E-Business Services Division. We intend to achieve ourobjective through the following key strategies:

 

*Software And Digital Commerce ServicesDivision: Develop And Expand Relationships With Software Publishers And OnlineRetailers.* We plan to continue to build our inventoryof software products through additional contractual relationships with softwarepublishers. As of March 1, 2003, we had contracts with approximately ­­­14,000software publishers and online retailers, representing more than 290,000software and digital products. We believe that our ability to provide Webhosting services with our software publisher clients increases our reach toend-users and provides the basis for long-term relationships with our softwarepublisher clients. We further believe that the large number of softwareproducts that we offer from our software publisher clients will be critical toour ability to deliver a compelling inventory of products to online retailerclients.

 

Additionally, we believe thatby increasing the number of points of entry to the CNS, we will increase thenumber of transactions over our network. Accordingly, in addition to expandingand developing relationships with software publishers, we seek to expandaggressively our network of online retailer clients. Online retailer clientsinclude traditional store-based and mail-order retailers with a Web presence,online retailers dedicated to online commerce, as well as high traffic or nicheWeb site operators desiring to add electronic commerce functionality. Our modelenables us to leverage our clients’ marketing resources to direct traffic toour software network.

 

*E-Business Services Division: Develop AndExpand Relationships With Manufacturers, Distributors And Retailers.*  In late 1998, we began exploring electroniccommerce outsourcing opportunities outside of the software and digital productsindustry. During 1999, sales and marketing personnel were hired to developcontractual relationships to sell our electronic commerce outsourcing servicesto manufacturers, distributors and retailers. As of March 1, 2003, we wereproviding electronic commerce services such as Web commerce development and hosting,transaction processing, fraud screening, digital delivery, integration tophysical fulfillment, merchandising services, analytical marketing and customerservice to over 100 enterprise E-Business Services Division client sites.  Additionally, in September 2001, December2001, and March 2002, we purchased certain assets of Orbit Commerce, Inc.,Network Commerce, Inc., and CCNow, Inc., respectively, allowing us to offer webhosting and electronic commerce services to approximately 20,000 small businesssites.  We believe that our ability toprovide a proven, cost efficient electronic commerce solution, which cantypically be implemented in a one to eight week time frame, provides the basisfor a long-term relationship with our E-Business clients. We further believethat additional electronic commerce outsourcing opportunities may develop asrelationships with existing clients expand.

 

*Drive Growth Through Aggressive Merchandising And Marketing.*  We believe that we have developedtechnology, expertise and best practices in the areas of marketing andmerchandising that can help our clients grow their online businesses byutilizing numerous, proven tools and programs and our expanding data warehouseof end-user purchasing information to increase traffic, close ratios, averageorder sizes and repeat purchases.  Forexample, in the fourth quarter of 2002, 46 percent of total online revenue forour clients

 

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was the result of trackablepromotional activity, up from 34 percent in the fourth quarter of 2001.  We will continue to develop and utilize awide range of marketing and merchandising programs and our growing datawarehouse of end-user purchasing information to aggressively grow our clients’businesses.

 

*Expand International Sales.*  We believe that there is a significantopportunity to grow our business by expanding existing and new client salesthrough international online stores. Internet adoption and e-commerce sales continue to show rapid growth inthe European and Asia-Pacific regions. We have seen significant growth in sales for those clients that haveoffered international stores and we intend to continue to enhance ourtechnology platform and services to increase sales in these regions of theworld.

 

*Leverage The Digital River Network To Provide New Distribution AndSales Opportunities For Our Clients.*  With our large network of clients andproducts we believe we can further grow our clients’ sales by offering themmore distribution and sales opportunities. We intend to expand our offering of network services to allow ourclients to distribute and sell their products through new channels andaffiliates, and sell products offered by other companies.  We believe our network is unique in themarketplace and will help us to build stronger relationships with our clients.

 

*Provide Clients With Value-Added Services.*  We proactively add new service offerings,such as our backup CD and search engine submission services, to help create newrevenue streams for our clients and ourselves.   We will continue to aggressively develop and offer newvalue-added services to create additional sources of ongoing revenue.

 

*Maintain Technology Leadership.*  We believe that our CNS has given us acompetitive advantage in the market for electronic commerce outsourcing solutions.We will continue to invest in and enhance our CNS 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.

 

**Services**

 

We provide a broad range ofservices to our clients, including Web commerce development and hosting,digital delivery, integration to physical fulfillment, transaction processing andfraud screening, customer service, merchandising services and analytical-based

e-marketing services.

 

*Web Commerce Hosting.*  We provide hosted Web commerce capabilitiesfor most of our software publisher clients and all of our online retailer andE-Business clients. For many of these clients, this outsourcing solution ismission critical and therefore we operate data centers that perform and scalefor continuous Web commerce in a high demand environment. Our data centersfeature fully redundant, high-speed connections to the Internet, servercapacity to handle rapid spikes in volume, 24x7 security and monitoring,back-up generators and dedicated power.

 

Our Web commerce capabilitiesare deployed quickly and efficiently for our clients, and can be implemented inmany different ways, from hosted electronic commerce links behind “buy buttons”through fully merchandised online stores. We match the branding and designs ofour clients to provide a seamless experience for end-users navigating from ourclients’ Web sites to their stores hosted on our CNS. We fully manage ordersplaced by end-users for payment processing, fraud screening and fulfillment,either digitally or physically, as well as the end-user notifications thatresult from these processes. The transaction information is captured in ourdata warehouse and made available to our clients via web-based analysis tools.This data warehouse is a powerful source for data analysis activities thatresult in highly targeted merchandising, e-mail marketing campaigns, productoffers, and test/control marketing efforts.

 

*Digital Delivery And Physical FulfillmentServices.* Digital delivery eliminates many of the costs that exist in the physicaldistribution chain, such as manufacturing, packaging, shipping, warehousing andinventory carrying and handling costs. We offer clients a sophisticated arrayof electronic software delivery capabilities to permit delivery of digitalproducts to an end-user’s computer via the Internet, as well as more advancedOTA or “Over the Air” wireless delivery to handheld devices. Delivery isfulfilled when a copy of the digital product is made from the master on our CNSplatform and then securely downloaded to the end-user. Optionally, end userscan create a CD on demand as a backup to their digital order. Our digitaldistribution model not only reduces costs, thereby increasing margins availableto software publishers and online retailers, but also solves the shelf spaceproblem constraining product availability and sales. While most softwarepublishers use our Web hosting services, certain software publishers use onlyour digital delivery services, which provides them with online distributionthrough our extensive network of online retailers.

 

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In addition to fulfillmentthrough electronic delivery, we offer clients physical distribution services.We have contracted with third-party fulfillment agents globally that maintaininventories of physical products, generally on consignment from our clientsthat select this option, for shipment to end-users. We also communicate ordersthrough integration into many client-specific third-party fulfillment agenciesfor physical fulfillment. In both cases, we provide notifications to end-usersof shipments, shipment tracking information, inventory updates and orderstatus. We believe physical fulfillment services are important to our abilityto provide a complete electronic commerce outsourcing solution.

 

*Transaction Processing And Fraud Screening.*  We process payment transactions generated byend-users ordering products through our CNS. We support payments made viacredit card, but also an expanding set of non-credit card payment methods suchas wire transfers, purchase orders, money orders, direct debit and checks whichare being used with more frequency internationally. The fraud screeningcomponent of the CNS uses both rules-based and heuristic scoring methods tomake a determination regarding the validity of the order, end-user and paymentinformation. As the end-user is entering the order, up to 580 data reviews areprocessed in real-time. Depending on the contractual agreement, we can providethe use of our proprietary fraud screening to clients for their own processingand screening or completely shift the fraud screening and risk responsibilityto us. When a transaction is completed and approved, and the ordered producthas been delivered, we process the order for payment.

 

*Customer Service.*  We offer both telephone and email customersupport for products sold through our CNS on behalf of our clients. We provideend-user assistance on order and delivery questions on a 24x7 basis, inmultiple languages. 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 archivingservices to the end-users that purchase digital products.

 

*Merchandising And Analytics-Based E-MarketingServices.*  Weoffer a broad range of merchandising and analytics-based e-marketing servicesto our clients helping them drive additional store traffic and revenues.Clients are provided with detailed analyses of their Web stores covering sales,product, transaction, customer behavior and campaign dimensions. The CNScaptures all Web page visits, campaign tracking information, product banner andpricing information and other data that can be used by our clients to performtheir own web-based reporting and analyses.

 

We also offer advancedmerchandising services to assist clients in increasing response rates for theirmarketing efforts. These services include targeted and segmented emailcampaigns for special promotions, upgrade notification programs and thepresentation of complementary products and bundled products or other programsdesigned to increase average order size based on a targeted end-user profile.In addition, through analytic services, we analyze transaction and customerhistory to test and refine new merchandising techniques and promotionalapproaches.

 

**Clients**

 

As a provider of comprehensiveelectronic commerce outsourcing solutions, we are able to serve two distinctiveclient groups: (1) software publishers and online software retailers and (2)manufacturers, distributors and physical good retailers with one common infrastructure.

 

Through our software anddigital commerce services, we distribute software products through a network ofsoftware publishers and online retailers. Online retailer clients includetraditional store-based and direct mail retailers with a Web presence, onlineretailers dedicated to online commerce, as well as high traffic or niche Website operators desiring to add electronic commerce functionality. In a typicalonline retailer contract, we are responsible for: (i) a payment to theonline retailer based on a percentage of net sales of software products that wedistribute through the online retailer’s Web site; (ii) the processing ofpayments made by end-users; (iii) the delivery of the software products toend-users; (iv) fraud screening and the payment of applicable credit cardtransaction fees; (v) the collection, payment and returns filing ofapplicable sales taxes; and (vi) the distribution of a report to theonline retailer detailing related sales activity that we have processed. While mostsoftware publishers use our entire suite of electronic commerce services,including Web hosting services, certain software publishers use only our“channel services” whereby the software publishers are provided withdistribution and digital fulfillment capability through our extensive networkof online retailers. In a typical software publisher contract, we areresponsible for: (i) the maintenance of master copies of software productsin a secure format for distribution to end-users; (ii) a payment to thesoftware publisher for the cost of software products that we distribute througheither a retailer’s Web site or through the publisher’s host Web site;(iii) fraud screening and the processing of payments made by end-users;(iv) the delivery of software products to end-users; (v) the paymentof applicable credit card transaction fees; (vi) the collection, paymentand returns filing of applicable sales taxes; and (vii) the distributionof a report to the software publisher detailing related sales activity that wehave processed.   As of March 1, 2003,we had approximately 14,000 contracts with software publishers and onlineretailers.

 

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With our E-Business services,we provide a wide range of electronic commerce services to clients outside ofthe software industry, primarily manufacturers, distributors and physical goodsretailers. These services allow the client to perform electronic commerce on abusiness-to-business or business-to-consumer basis. In a typical E-BusinessServices contract, we are responsible for: (i) Web commerce system design,hosting and integration into the client’s management system; (ii) theprocessing of payments made by end-users; (iii) the communication oforders to the client or the client’s third-party fulfillment agency fordelivery of the product to end-users; (iv) the fraud screening andprocessing of the applicable credit card transaction to the client’s creditcard processor; (v) customer service; and (vi) the distribution of areport to the client detailing related sales activity that we have processed.As of March 1, 2003, we were providing services to over 100 client sites,excluding approximately 20,000 small business sites serviced as a result of thepurchase of certain assets of Network Commerce, Inc. and Orbit Commerce, Inc. during2001 and CCNow, Inc. in 2002.  The tablebelow sets forth certain of our software publisher, online retailer andE-Business Service clients:

 
| **Software  Publishers** |   | **Online  Retailers** |   | **E-Business  Services** |
|--------------------------|--------|-----------------------|--------|--------------------------|
| H&R Block, Inc.      |   | MicroWarehouse, Inc.  |   | Cisco, Inc.              |
| McAfee.com Corporation   |   | Software Oasis, Inc.  |   | Johnson & Johnson    |
| ScanSoft, Inc.           |   | Visioneer, Inc.       |   | Major League Baseball    |
| Symantec Corporation     |   |                  |   | USA.net                  |

 

**Acquisitions**

 

In March 2002, pursuant to anAsset Purchase Agreement between us and Innuity Acquisition Corp.("IAC"), we purchased certain assets for approximately $2,400,000 incash and assumed approximately $3,600,000 in merchant liabilities.  The agreement includes an opportunity for acash earn-out based on revenue generated from the IAC assets during the12-month period following the close of the transaction.

 

In March 2002, pursuant to anAmended and Restated Asset Purchase Agreement (the "Agreement")between us and Beyond.com Corporation ("Beyond.com"), in exchange for179,096 shares of our Common Stock, we purchased those assets and assumed thoseliabilities of Beyond.com related to its eStores business, which manages onlinestores for clients.  The purchase wasapproved by the U.S. Bankruptcy Court following Beyond.com's filing for Chapter11 bankruptcy protection.  Immediatelyfollowing the closing of the Agreement, we entered into a Post-ClosingAmendment to the Agreement with Beyond.com (the "Post-ClosingAmendment"), pursuant to which, among other things, we agreed to increasethe number of shares to be delivered to Beyond.com under the Agreement to222,842, in exchange for a release of certain potential claims by Beyond.comagainst us.  The Post-Closing Amendmentis subject to approval by the U.S. Bankruptcy Court.  The Official Committee of Unsecured Creditors("Committee") of Beyond.com's bankruptcy estate has objected to thePost-Closing Amendment, asserting that the increase in shares to be deliveredto Beyond.com under the Post-Closing Amendment is inadequate.  The hearing on Beyond.com's motion toapprove the Post-Closing Amendment was originally set for June 7, 2002.  The parties, with the approval of the U.S.Bankruptcy Court, have agreed to continue the hearing on several occasions.  The U.S. Bankruptcy Court is currentlyscheduled to consider the Post-Closing Amendment on May 23, 2003.  Beyond.com is also asserting that it isentitled to additional shares with a value of $650,000 under the Agreementpursuant to provisions of the Agreement under which Beyond.com could earnadditional consideration post-closing if certain clients of Beyond.comimmediately prior to the closing maintain or establish client relationshipswith us following the closing.  Wedisagree that any of such shares are due to Beyond.com under theAgreement.  Of the shares issued atclosing, 70,000 shares were placed in escrow to secure certain indemnificationobligations contained in the Agreement. The parties agreed to the return of 8,277 shares to us to satisfyoutstanding claims under the escrow.  Anadditional 14,482 of these shares are subject to additional outstanding claimsand will remain in escrow pending resolution of such claims; the remaining47,241 shares have been released to Beyond.com.

 

**SalesAnd Marketing**

 

We market our services directlyto clients and prospective clients.  Wefocus our efforts on generating awareness for our brand, establishing ourposition as a global leader of electronic commerce outsourcing, generatingleads in our target markets and providing sales tools for our direct salesforce.  We conduct a variety of highlyintegrated marketing programs to achieve these goals in an effective andefficient manner.  We currently marketour services to clients via direct marketing, print and electronic advertising,trade shows and events, public relations and media events and speakingengagements. We plan to increase our overall marketing expenditures on a dollarbasis, but maintain the current level on a percentage basis.

 

Primarily, we sell ourelectronic commerce outsourcing services through a global, direct sales forcethat is engaged in selling our services, which includes pre-sales, sales, salessupport, and staff located in an office in the United Kingdom.  Our sales organization sells to top executivesand vice-presidents within software and digital content publishers and onlineretailers, manufacturers, distributors and traditional retailers looking tocreate or expand their electronic commerce business.  During the sales process, our sales staff deliversdemonstrations, presentations, collateral, ROI analyses, proposals, andcontracts.  We offer contract incentiveson a case-by-case basis.

 

We also design and implemente-marketing and merchandising programs to help our clients to help drivetraffic to their online stores as well as increase close ratios, average ordervalues and repeat purchases.  Oure-marketing team utilizes a range of programs and tools such as search engineoptimization, email marketing and store merchandising including specials,cross-sells and up-sells.  This team usesour extensive data warehouse tools to create targeted programs to driveincreased sales.

 

As of March 1, 2003 we had 130employees engaged in sales and marketing including personnel in a sales officein the United Kingdom.

 

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**Technology**

 

We deliver our electroniccommerce outsourcing solution primarily using our CNS.  During 2002, we made substantial progress incompleting development of our 100% Java, J2EE-compliant software technologyplatform.  We have started migrating ourcurrent clients from CNS version 3 to our CNS version 4 platform, and we intendto continue migrating clients to this new platform throughout 2003.  The following is a brief description of ourCNS platform.

 

*Architecture.*  Our scalable CNS is designed to handle tensof thousands of individual electronic commerce stores and millions of products.The CNS consists of multiple pods of Sun Microsystems servers and a proprietarysoftware application that serves dynamic Web pages using Oracle’s 8i and 9idatabase and 9iAS application server. Akamai’s worldwide caching technologyenables our platform engine to serve pages with consistent page loadtimesacross the world. Our CNS was designed to scale to support growth by addingadditional servers, CPUs, memory and bandwidth without substantial changes tothe application. The CNS software code is written in modular layers, enablingus to quickly adapt in response to industry changes, including bandwidthopportunities, payment processing changes, international requirements for taxesand export screening, new technologies such as Web Caches, ML, DHTML, VRML,SET, banking procedures and encryption technologies. The CNS product searchsystem, based on Verity’s technology, allows end-users to search for itemsacross millions of potential products and thousands of categories specific tovarious product specifications, while maintaining a fast page response that isacceptable to the end-user. We use sophisticated database indexing coupled witha dynamic cache system to provide flexibility and speed. These caches helpincrease the overall speed of each page and facilitate complex searches acrossour entire inventory of software products. The CNS has also been designed toindex, retrieve and manipulate all transactions that flow through the system,including detailed commerce transaction and end-user interaction data. Thisenables us to create proprietary market profiles of each end-user and groups ofend-users that can then be used to create merchandising campaigns. Our CNS isalso used for internal purposes, including reporting and maintenance for frauddetection and prevention, physical shipping, return authorizations, back orderprocessing and full transaction auditing and reporting capabilities for allcommerce functions.

 

*Web Commerce System Maintenance.*  Our clients’ electronic commerce systems arebuilt and maintained using the CNS centralized management system and remotecontrol tools. Global changes that affect all electronic commerce systems orgroups of electronic commerce systems can be made as easily as changes to anindividual electronic commerce system. Client electronic commerce systemstypically include a main store and may optionally include “channel sites” towhich highly targeted traffic may be routed. Clients may also link specific locationson their Web stores to detailed product or category areas of the stores inorder to better target their end-users’ interests.

 

*Security.*  Our security systems control access tointernal systems and commerce data via the Internet. Internally, log-ins andpasswords are maintained for all systems, with additional log-ins, passwordsand IP access control granted on an individual basis to only the requiredcommerce areas for which the recipient is responsible. Firewalls preventunauthorized access from outside. We rely on certain encryption andauthentication technology licensed from third parties to provide securetransmission of confidential information, such as end-user credit card numbers.Unix, Oracle and Web server security additionally restrict access from theoutside to the appropriate transaction data. The CNS 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 CNS security systemdoes not allow direct access to any client or customer data.  It also ensures that all end-user requestsfor digital delivery of product are through a valid CNS page and that thecustomer has purchased the product.

 

*DataCenter Operations.*  Continuous data center operations arecrucial to our success. Our primary data center (DC1) is located in our mainfacility in Eden Prairie, Minnesota.  We also operate a secondary data center (DC2) at a separate location inthe Minneapolis area that serves as a disaster recovery site.  Both locations are currently processingtransactions and downloads.   Alltransaction data is replicated from DC1 to DC2 in less than 10 seconds.  Our network software constantly monitorsclients’ electronic commerce sites and internal system functions and notifiessystems engineers if any unexpected conditions arise. We currently lease threeOC3 lines and 2 DS3 lines from multiple vendors and maintain a policy of addingadditional lines if more than 50% of our bandwidth capacity is consistentlyutilized. Accordingly, if one line fails, the other lines are able to assumethe capacity of the failed line. In the event of electrical power failure, wehave 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 data center. The data center currently utilizesmultiple levels of redundant systems including load balancers, web servers,application servers and disk arrays. We currently have automatic failoverprocesses in place in case of equipment or software failure. When a fault isdetected on a server, a process automatically de-configures that node from theproduction POD and processing continues on the redundant nodes of the POD.

 

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**ProductResearch and Development**

 

Our product research anddevelopment strategy is to enhance the technology and features of our CNS. Tothis end, we have numerous development projects in process, includingdeployment of version 4 of our CNS technology, further advancements in ourremote control technologies, business-to-business related technologies andadvanced product distribution and marketing technologies. Product research anddevelopment expenses were $11.5 million, $11.2 million and $13.1million in 2002, 2001 and 2000, respectively. As of March 1, 2003, we employed 99 persons in product research anddevelopment.

 

To remain competitive, we mustcontinue to enhance and improve the responsiveness, functionality and featuresof the CNS and the underlying network infrastructure. If we incur significantcosts without adequate results, or are unable to adapt rapidly to technologicalchanges, we may fail to achieve our business plan. The Internet and theelectronic commerce industry are characterized by rapid technological change,changes in user and client requirements and preferences, frequent new productand service introductions embodying new technologies and the emergence of newindustry standards and practices that could render our technology and systemsobsolete. To be successful, we must adapt to rapid technological change bylicensing 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 CNStechnology and other proprietary technologies involves significant technicaland business risks. We may fail to use new technologies effectively or fail toadapt our proprietary technologies and systems to client requirements oremerging industry standards.

 

**Competition**

 

The market for Internet-based,electronic commerce solutions is extremely competitive and we may findourselves unable to compete effectively. Because there are relatively lowbarriers to entry in the electronic commerce market, we expect competition tointensify as current competitors expand their product offerings and newcompetitors enter the market. In addition, our clients may become competitorsin the future. Increased competition is likely to result in price reductions,lower average sales prices, reduced margins, longer sales cycles and a decreaseor loss of our market share, any of which could negatively impact our revenuesand earnings. We face competition from the following sources:

 

•                  in-housedevelopment of electronic commerce capabilities;

 

•                  other providersof outsourced electronic commerce solutions;

 

•                  softwarepublishers and online retailers who have or may choose to make substantialinitial and ongoing investments in order to develop and manage their ownelectronic commerce sites, and who may decide to market this capability toother companies;

 

•                  systemintegrators and application service providers that offer tools and services forelectronic commerce, including companies that provide a broad range of Internetand server solutions, such as Corio, Inc., Electronic Data Systems Corporation and IBM GlobalServices;

 

•                  companies thatprovide tools and services enabling one or more of the transaction processingfunctions of electronic commerce, such as transaction control, data security,customer interaction and database marketing, including BroadVision, Inc. andCyberSource Corporation;

 

•                  companies thatsell, distribute or rent software products over the Internet;

 

•                  high-traffic,branded Web sites that derive a substantial portion of their revenues fromelectronic commerce and may themselves offer, or provide means for others tooffer, software products, such as Amazon.com, Inc. and GSI Commerce, Inc.;and

 

•                  traditionalchannels and methods of retail and corporate software sales, such as mail ordercatalogs and retail superstores.

 

We believe that the principalcompetitive factors in our market are breadth of services and software productofferings, software publisher and online retailer relationships, brandrecognition, system reliability and scalability, price, customer service, speedand accessibility and ease of use, speed to market, convenience and quality offulfillment. The online retailers and the other companies described above maycompete directly with us by adopting a similar business model. Moreover, whilesome of these companies are also clients or potential clients of ours, they maycompete with our electronic commerce outsourcing solution to the extent thatthey develop electronic commerce systems or acquire such systems from othersoftware vendors or service providers.

 

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Many of our competitors have,and new potential competitors may have, more experience developing Internet-basedsoftware services and electronic 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 to decline.

 

**IntellectualProperty**

 

We regard the protection of ourtrademarks, copyrights, trade secrets and other intellectual property as criticalto our success. We rely on a combination of patent, copyright, trademark,service mark and trade secret laws and contractual restrictions to protect ourproprietary rights. We have entered into confidentiality and inventionassignment agreements with our employees and contractors, and nondisclosureagreements with parties with whom we conduct business, in order to limitaccess to and disclosure of our proprietary information. These contractualarrangements and the other steps taken by us to protect our intellectualproperty may not prevent misappropriation of our technology or deterindependent third-party development of similar technologies. Thus, we also seekto -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 six U.S. patentsissued with 12.5 to 13.5 years remaining prior to expiration. We pursue theregistration of our trademarks and service marks in the U.S. andinternationally. We currently have 16 U.S. registered trademarks and fourtrademark applications pending in the U.S., 25 registered trademarks in theEuropean Union and other countries and five trademark applications pending inthe European Union and other countries. 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 to protect ourproprietary rights may be inadequate and third parties may infringe ormisappropriate 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.

 

**Employees**

 

As of March 1, 2003, weemployed 481 people. We also employ independent contractors and other temporaryemployees. None of our employees are represented by a labor union, and weconsider our employee relations to be good. Competition for qualified personnelin our industry is intense, particularly among software development and othertechnical staff.  We believe that ourfuture success will continue to depend, in part, on our continued ability toattract, hire and retain qualified personnel.

 

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**Executive Officers**

 

The following table sets forthinformation regarding our executive officers as of December 31, 2002:

 
| **Name**         |   | **Age** |   | **Position**                                                                                           |
|------------------|--------|---------|--------|--------------------------------------------------------------------------------------------------------|
| Joel A.  Ronning |   | 46      |   | Chief  Executive Officer and member of the Office of the President                                     |
| Jay A.  Kerutis  |   | 43      |   | President,  Software and Digital Commerce Services Division and member of the Office of  the President |
| Carter D.  Hicks |   | 56      |   | Chief  Financial Officer                                                                               |
| Gary V.  Howorka |   | 44      |   | Chief  Technology Officer                                                                              |

 

Mr. Ronning founded theCompany in February 1994 and has been Chief Executive Officer and adirector of the Company since that time. In February 2001,Mr. Ronning was elected to the Office of the President. FromFebruary 1994 to July 1998, Mr. Ronning was also President ofthe Company. From May 1995 to December 1999, Mr. Ronning servedas Chairman of the Board of Directors of Tech Squared, Inc., a directcatalog marketer of software and hardware products. From May 1995 to July 1998,Mr. Ronning served as Chief Executive Officer, Chief Financial Officer andSecretary 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 toDecember 1999. From April 1990 to July 1998, Mr. Ronningalso served as the Chief Executive Officer of MacUSA, Inc.

 

Mr. Kerutis joined theCompany in February 1999 as Vice President of Sales, served as ExecutiveVice President, Software and Digital Commerce Services Division fromJanuary 2000 to December 2000 and has been President, Software andDigital Commerce Services Division since December 2000. In February 2001,Mr. Kerutis was elected to the Office of the President.  From March 1997 to February 1999,Mr. Kerutis was Vice President—Retail Channel for MeriselAmericas, Inc., a computer distributor. From April 1995 toMarch 1997, Mr. Kerutis was Vice President—Sales and Marketing forNew Media Corporation, a manufacturer of PC cards for notebook computers.

 

Mr. Hicks joined the Company in November 2000as Senior Vice President - SDCS Operations. He was elected Chief Financial Officer in April 2002.  From August 1997 to August 2000, Mr. Hicksserved as the Chief Financial Officer of Oppenheimer, Wolff & Donnelly LLP,an international, full service law firm. Prior to this time, Mr. Hicks held various senior financial positions inlarge corporations in the computer distribution and food industries.  Mr. Hicks was formerly a partner of Peat,Marwick, Mitchell & Co. (now, KPMG LLP).

 

Dr. Howorka joined the Companyin June of 2000 as Chief Technology Officer. From May 1999 to June 2000, Dr. Howorka held several key roles at Ernst& Young LLP, an international accounting and consulting organization, mostrecently as IBM E-Business Practice Director. From January 1999 to May 1999, Dr. Howorka served as Chief TechnologyOfficer of Zonetrader.com, a business-to-business e-commerce asset recoveryorganization.  From May 1995 to October1998, Dr. Howorka co-founded and served as Executive Vice President of FeedbackPlus, Inc., a survey software and services company.

 

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**RISK FACTORS**

 

In addition to the otherinformation provided in this report, stockholders or prospective investorsshould carefully consider the following risk factors:

 

**Wehave a limited operating history, a history of losses and we have yet toachieve sustained profitability.**

 

We were incorporated inFebruary 1994 and conducted our first online sale through a client’s Web storein August 1996. We have not yet achieved sustained profitability and haveincurred significant losses since we were formed. As of December 31, 2002, wehad an accumulated deficit of approximately $104 million. Our limitedprofitable operating history makes it difficult for you to evaluate our abilityto sustain profitability in the future.

 

The success of our businessmodel depends upon our success in generating sufficient transaction and servicefees from the use of our electronic commerce solutions by existing and futureclients. Accordingly, we must maintain existing, and develop new relationshipswith software publishers, online retailers and E-Business clients. To achievethis goal, we intend to continue to expend significant financial and managementresources on the development of additional services, sales and marketing,improved technology and expanded operations. If we are unable to maintainexisting, and develop new, client relationships, we will not generate aprofitable return on our investments and we will be unable to gain meaningfulmarket share to justify these investments. Further, we may be unable to achieveprofitability if our revenues increase slower than expected, or if operatingexpenses exceed our expectations and cannot be adjusted to compensate for lowerthan expected revenue volumes. Even if we are able to achieve profitability onan annual basis, we may be unable to sustain or increase this profitability ona quarterly or annual basis.

 

**Our operating results have fluctuated in thepast and are likely to continue to do so, which could cause the price of ourCommon Stock to be volatile.**

 

Our quarterly and annualoperating results have fluctuated significantly in the past and are likely tocontinue to do so in the future due to a variety of factors, some of which areoutside our control. As a result, we believe that quarter-to-quarter andyear-to-year comparisons of our revenue and operating results are notnecessarily meaningful, and that these comparisons may not be accurateindicators of future performance. If our annual or quarterly operating resultsfail to meet the guidance we provide to securities analysts and investors orotherwise fail to meet their expectations, the trading price of our CommonStock will likely decline. Some of the factors that have or may contribute tofluctuations in our quarterly and annual operating results include:

 

•                  our ability toattract and retain software publishers and online retailers as clients;

 

•                  our ability toattract and retain E-Business clients;

 

•                  the introductionby us of new Web sites, Web stores or services that may require a substantialinvestment of our resources;

 

•                  the introductionby others of competitive Web sites, Web stores or services;

 

•                  our ability tocontinue to upgrade and develop our systems and infrastructure to meet emergingmarket needs and remain competitive in our service offerings;

 

•                  economicconditions, particularly those affecting Internet-based electronic commerce;

 

•                  client decisionsto delay new product launches or to invest in e-commerce initiatives;

 

•                  national andinternational political unrest in connection with the continued military responses to the terrorist attacks on the UnitedStates, possible future terrorist attacks and the growing threat of war;

 

•                  the performanceof our newly acquired assets or companies;

 

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

 

•                  slower thananticipated growth of the online market as a vehicle for the purchase ofsoftware products;

 

•                  the cost ofcompliance with U.S. and foreign regulations relating to our business; and

 

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•                  our ability toretain and attract personnel commensurate with our business needs.

 

In addition, revenue generatedby our Software and Digital Commerce Services Division is likely to fluctuateon a seasonal basis that is typical for the software publishing market ingeneral. We believe that our first and fourth quarters are seasonally strongerthan our second and third quarters due to the timing of demand of taxpreparation software and the holiday selling period. We also believe thatsoftware publishers avoid new product releases in the summer months.

 

Our operating expenses, whichinclude sales and marketing, product research and development and general andadministrative expenses, are based on our expectations of future revenue andare relatively fixed in the short term. If our revenue for a quarter fall belowour expectations and we are unable to quickly reduce spending in response, ouroperating results for that quarter would be harmed. In addition, the operatingresults of companies in the electronic commerce industry have, in the past,experienced significant quarter-to-quarter fluctuations that may adverselyaffect our stock price.

 

**A loss of any client that accounts for alarge portion of our revenue could cause our revenue to decline.**

 

One software publisher client,Symantec Corporation, accounted for approximately 23% of our revenue in2002.  In addition, a limited number ofother software and E-business clients contribute a large portion of our annualrevenue. Contracts with our clients are generally short term in nature. If anyone of these contracts is not renewed or otherwise terminates, and if we areunable to replace it with other client agreements, our revenue would declineand our ability to sustain profitability would be impaired.  It is important to our ongoing success thatwe maintain these client relationships and, at the same time, develop newclient relationships.

 

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

 

We market our services directlyto software publishers, online retailers and E-Business prospects. Theserelationships are typically complex and take time to finalize. Due to operatingprocedures in many organizations, a significant amount of time may pass betweenselection of our products and services by key decision-makers and the signingof a contract. The period between the initial sales call and the signing of acontract with significant sales potential is difficult to predict and typicallyranges from six to 12 months. If at the end of a sales effort a prospectiveclient does not purchase our products or services, we may have incurredsubstantial expenses and expended management time that cannot be recovered andthat will not generate corresponding revenue. As a result, our cash flow andour ability to fund expenditures incurred during the sales cycle may beimpaired.

 

**General economic uncertainty may reduce ourrevenue.**

 

The revenue growth andprofitability of our business depends significantly on the overall demand forInternet-based electronic commerce solutions. We believe that the market forthese solutions may be adversely affected by a number of factors, includingreductions in capital expenditures by clients and the overall weakening of theU.S. and foreign economies.  Additionally,the continued military responses to the terrorist attacks on the United States,possible future terrorist attacks and the growing threat of war may exacerbatecurrent economic conditions and lead to further weakening in the economy.

 

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

 

•                  longer salescycles;

 

•                  deferral ordelay of electronic commerce projects and generally reduced expenditures forelectronic commerce solutions and related services; and

 

•                  increased pricecompetition.

 

If the current economicslowdown continues, the effects of the slowdown for electronic commercesolutions could reduce our revenue and limit our ability to meet ourprofitability goals.

 

**Ourfailure to attract and retain software publishers as clients would cause ourrevenue to decline.**

 

Our Software and DigitalCommerce Services Division generates revenue by providing outsourced servicesto software publishers. If we cannot develop and maintain satisfactoryrelationships with software publishers on acceptable commercial terms, we willlikely experience a decline in revenue. We also depend on our softwarepublisher clients creating and supporting software products that end-users willpurchase. If we are unable to obtain sufficient quantities of software for anyreason or if the quality of service provided by these software publishers fallsbelow a satisfactory level, we could also experience a decline in revenue andend-user satisfaction, and

 

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our reputation could be harmed.Our contracts with our software publisher clients are generally one to twoyears in duration, with an automatic renewal provision for additional one-yearperiods, unless we are provided with a written notice at least 90 days beforethe end of the contract. As is common in our industry, we have no long-term orexclusive contracts or arrangements with any software publishers that guaranteethe availability of software products. Software publishers that currentlysupply software to us may not continue to do so and we may be unable toestablish new relationships with software publishers to supplement or replaceexisting relationships.

 

**Ourbusiness plans depend on increasing revenue from E-Business clients.**

 

The success of our businessstrategy depends upon increasing fee and service revenue derived from the saleof non-software products for E-Business clients. Since initiating sales ofelectronic commerce outsourcing services in 1999, our E-Business ServicesDivision has incurred only net losses. We have made substantial investments intechnology and infrastructure and we may fail to establish and maintainsufficient relationships with E-Business clients to offset these expenses. Ifwe are unable to develop and expand our relationships with E-Business clients,we will fail to grow revenue as projected and the E-Business Services Divisionwill continue to have a negative impact on our profitability.

 

**Implementingour acquisition strategy could result in dilution and operating difficulties.**

 

We have acquired, and intend tocontinue engaging in strategic acquisitions of, businesses, technologies,services and products, such as businesses that provide outsourcing services tosoftware publishers. The process of integrating an acquired business,technology, service or product into our business and operations may result inunforeseen operating difficulties and expenditures. Integration of an acquiredbusiness also may disrupt our ongoing business, distract management and make itdifficult to maintain standards, controls and procedures. Moreover, theanticipated benefits of any acquisition may not be realized. If a significantnumber of clients of the acquired businesses cease doing business with us, wewould experience lost revenue, and any synergies from the acquisition may belost. Future acquisitions could result in potentially dilutive issuances ofequity securities, the incurrence of debt, contingent liabilities, amortizationexpenses of intangible assets or impairment of goodwill.

 

**Electronicsoftware delivery, or ESD, is still an evolving and unproven technology and theindustry may ultimately fail to accept ESD.**

 

Our success will depend inlarge part on the growth in end-user acceptance of ESD as a method ofdistributing software products. ESD is a relatively new method of distributingsoftware products to end-users, and unless ESD gains widespread marketacceptance, we will be unable to achieve our business plan. Factors that willinfluence the market acceptance of ESD include:

 

•                  the availabilityof sufficient bandwidth, both now and in the future, to enable purchasers torapidly download software products;

 

•                  the cost oftime-based Internet access;

 

•                  the number andadequacy of software products that are available for purchase through ESD ascompared to those available through physical delivery; and

 

•                  the level ofend-user comfort with the process of downloading software via the Internet,including the ease of use, lack of concern about transaction security andtechnical support.

 

Even if ESD achieves widespreadacceptance, we may be unable to overcome the substantial existing and futuretechnical challenges associated with electronically delivering softwarereliably and consistently on a long-term basis. Our failure to do so would alsoimpair our ability to execute our business plan.

 

**Developmentsin accounting standards may cause us to increase our recorded expenses, whichin turn would jeopardize our ability to demonstrate sustained profitability.**

 

In July 2001, 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, 2002, we had anunamortized goodwill with an indefinite life with balance of $18.7 million,primarily from our acquisitions made in previous years.  If a significant portion of this balance isdetermined for any reason to be impaired, the subsequent accounting of theimpaired portion as an expense would lower our earnings and jeopardize ourability to demonstrate sustained profitability, which could cause our stockprice to decline.

 

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Additionally, the Financial AccountingStandards Board is currently considering a proposal to require that the cost ofstock options be reflected as an expense item in financial statements.  If this proposal were to be adopted, ourrecorded expenses would significantly increase, which would impair our abilityto maintain profitability.

 

**Increasing consumer acceptance of theInternet as a medium of commerce is important to the success of our businessstrategy and our future revenue growth.**

 

The failure of the Internet tocontinue developing into a significant commercial medium would harm our abilityto increase our revenue and execute our business strategy. Rapid growth in theacceptance and use of the Internet as an effective medium of commerce is arecent development. The acceptance and use of the Internet may not continue todevelop and a sufficiently broad base of consumers may not adopt and continueto use the Internet as a medium of commerce. We rely on purchasers who havehistorically used traditional means of commerce to purchase goods or transactbusiness. If we are to be successful, these purchasers must accept and use theInternet as a means of purchasing goods and services and exchanginginformation. We cannot predict the rate at which these purchasers will do so.

 

**Thegrowth of the market for our services depends on the development andmaintenance 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 developmentof complementary 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 being made to the Internet as well as to individual client’snetworking infrastructures to alleviate overloading and congestion. Inaddition, any delays in the adoption of new standards and protocols required togovern increased levels of Internet activity or increased governmentalregulation may have a detrimental effect on the Internet infrastructure.

 

**Becausethe electronic commerce industry is highly competitive and has low barriers toentry, we may be unable to compete effectively.**

 

The market for Internet-based,electronic commerce solutions is extremely competitive and we may findourselves unable to compete effectively. Because there are relatively lowbarriers to entry in the electronic commerce market, we expect competition tointensify as current competitors expand their product offerings and newcompetitors enter the market. In addition, our clients may become competitorsin the future. Increased competition is likely to result in price reductions,lower average sales prices, reduced margins, longer sales cycles and a decreaseor loss of our market share, any of which could reduce our revenue. We facecompetition from the following sources:

 

•                  in-housedevelopment of electronic commerce capabilities;

 

•                  other providersof outsourced electronic commerce solutions;

 

•                  softwarepublishers and online retailers who have or may choose to make substantialinitial and ongoing investments in order to develop and manage their ownelectronic commerce sites, and who may decide to market this capability toother companies;

 

•                  systemintegrators and application service providers that offer tools and services forelectronic commerce, including companies that provide a broad range of Internetand server solutions, such as Corio, Inc., Electronic Data Systems Corporation,and IBM Global Services;

 

•                  companies thatprovide tools and services enabling one or more of the transaction processingfunctions of electronic commerce, such as transaction control, data security,customer interaction and database marketing, including BroadVision, Inc. andCyberSource Corporation;

 

•                  companies thatsell, distribute or rent software products over the Internet;

 

•                  high-traffic,branded Web sites that derive a substantial portion of their revenue fromelectronic commerce and may themselves offer, or provide means for others tooffer, software products, such as Amazon.com, Inc. and Global Commerce, Inc.;and

 

•                  traditionalchannels and methods of retail and corporate software sales, such as mail ordercatalogs and retail superstores.

 

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Many of our competitors have,and potential competitors may have, more experience developing Internet-basedsoftware, services and electronic 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 to decline.

 

**Failureto properly manage and sustain our expansion efforts could strain ourmanagement and other resources.**

 

Our ability to successfullyoffer services and implement our business plan in a rapidly evolving marketrequires an effective planning and management process. We have rapidly andsignificantly expanded the depth and breadth of our services offerings. Failureto properly manage this expansion could place a significant strain on ourmanagerial, operational and financial resources.  To manage this expansion, we are required to continually:

 

•                  improve existingand implement new operational, financial and management controls, reportingsystems and procedures;

 

•                  install newmanagement information systems; and

 

•                  train, motivate,retain and manage our employees.

 

We may be unable to installmanagement information and control systems in an efficient and timely manner,and our current or planned personnel, systems, procedures and controls may beinadequate to support our operations.

 

**Failureto develop our technology to accommodate increased traffic could reduce demandfor our services and impair the growth of our business.**

 

We periodically enhance andexpand our technology and transaction-processing systems, networkinfrastructure and other technologies to accommodate increases in the volume oftraffic on our technology platform. Our inability to add software and hardwareor to develop and upgrade existing technology, transaction-processing systemsor network infrastructure to manage increased traffic on this platform maycause unanticipated systems disruptions, slower response times and degradationin client services, including impaired quality and speed of order fulfillment.Failure to manage increased traffic could harm our reputation and significantlyreduce demand for our services, which would impair the growth of our business.We may be unable to improve and increase the capacity of our networkinfrastructure sufficiently or anticipate and react to expected increases inthe use of the platform to handle increased volume. Further, additional networkcapacity may not be available from third-party suppliers when we need it. Ournetwork and our suppliers’ networks may be unable to maintain an acceptabledata transmission capability, especially if demands on the platform increase.

 

We have started migrating ourcurrent clients from CNS version 3 to our new CNS version 4 platform.  Failure of the CNS version 4 to perform asexpected could lead to client dissatisfaction and loss of business.

 

**Ourindustry is characterized by rapid technological change that may make our technologyand systems obsolete or cause us to incur substantial costs to adapt to thesechanges.**

 

To remain competitive, we mustcontinue to enhance and improve the responsiveness, functionality and featuresof the CNS platform and the underlying network infrastructure. If we incursignificant costs without adequate results, or are unable to adapt rapidly totechnological changes, we may fail to achieve our business plan. The Internetand the electronic 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 CNStechnology platform and other proprietary technologies involves significant technicaland business risks. We may fail to use new technologies effectively or fail toadapt our proprietary technology and systems to client requirements or emergingindustry standards.

 

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**Systemfailures could reduce the attractiveness of our service offerings.**

 

We provide commerce, marketingand delivery services to our clients and end-users through our proprietarytechnology transaction processing and client management systems. These systemsalso maintain an electronic inventory of products and gather consumer marketinginformation. The satisfactory performance, reliability and availability of thetechnology and the underlying network infrastructure are critical to ouroperations, level of client service, reputation and ability to attract and retainclients. We have experienced periodic interruptions, affecting all or a portionof our systems, which we believe will continue to occur from time to time. Anysystems damage or interruption that impairs our ability to accept and fillclient orders could result in an immediate loss of revenue to us, and couldcause some clients to purchase services offered by our competitors. Inaddition, frequent systems failures could harm our reputation.

 

Our systems and operations arevulnerable to damage or interruption from:

 

•                  fire, flood andother natural disasters;

 

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

 

•                  power loss,computer systems failures, and Internet and telecommunications failure.

 

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

 

**Wemay become liable to clients who are dissatisfied with our services.**

 

We design, develop, implementand manage electronic 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 negative publicity orrequire expensive corrections. As a result, clients who experience theseadverse consequences either directly or indirectly as a result of our servicescould bring claims against us for substantial damages. Any claims assertedcould exceed the level of our insurance. The insurance we carry may notcontinue to be available on economically reasonable terms, or at all. Thesuccessful assertion of one or more large claims that are uninsured, exceedinsurance coverage or result in changes to insurance policies, including premiumincreases, could adversely affect our operating results or financial condition.

 

**Ourchief executive officer and key technical employees are critical to ourbusiness and if they do not remain with us in the future, we may be unable toeffectively 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 key technicalemployees who are skilled in maintaining our proprietary technology platform.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 do not maintain any key person life insurancepolicies.

 

**Wemust continually attract and retain technical and other key personnel in orderto be able to successfully execute our business strategy.**

 

Our future success depends onour ability to continue to identify, attract, hire, train, retain and motivatehighly skilled technical, managerial, operations, merchandising, sales andmarketing and client service personnel. Competition for these personnel isintense, particularly in the Internet industry and we may be unable tosuccessfully attract, assimilate or retain sufficiently qualified personnel.Failure to do so could harm our business growth and ability to achieveprofitability. In addition, the market price of our Common Stock has fluctuatedsubstantially since our initial public offering in August 1998. Consequently,potential employees may perceive our equity incentives such as stock options asless attractive and current employees whose options are no longer attractivelypriced may choose not to remain with our organization. In that case, ourability to attract employees will be adversely affected. Finally, should ourstock price substantially decline, the retention value of stock options grantedsince our initial public offering will decline and our employees may choose notto remain with our organization.

 

17

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**Protectingour intellectual property is critical to our success.**

 

We regard the protection of ourtrademarks, copyrights, trade secrets and other intellectual property ascritical to our success. We rely on a combination of patent, copyright,trademark, service mark and trade secret laws and contractual restrictions toprotect our proprietary rights. We have entered into confidentiality andinvention assignment agreements with our employees and contractors, andnondisclosure agreements with parties with whom we conduct business, in orderto limit 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. We also seekto 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 rights relating to ourtechnologies will be protected from unauthorized use by third parties only tothe extent they are covered by valid and enforceable patents or are effectivelymaintained as trade secrets. We pursue the registration of our trademarks andservice marks in the U.S. and internationally. Effective trademark, servicemark, copyright and trade secret protection may not be available in everycountry in which 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.

 

**Claimsof infringement of other parties’ intellectual property rights could require usto expend significant resources.**

 

From time to time, we mayreceive notice of claims of infringement of other parties’ proprietaryrights.  In August 2001, an action wasbrought against us and other defendants in the U.S. District Court in theDistrict of Columbia alleging infringement of United States Patent No.6,014,651 owned by Christopher M. Crawford of Washington, D.C.  The casehas been filed and is pending in the U.S. District Court in the District ofColumbia.  No substantive actions havetaken place as yet in this case.  Thecourt has delayed substantive discovery in this case, pending a preliminarydetermination of the legal scope of Crawford’s claim.  We have been in the process of preparing materials regardingclaim interpretation to present to the court. Once the court determines the scope of the claims, we may file for adismissal of the case if the court’s decision is consistent with our and theother defendants’ position regarding the interpretation of this patentclaim.  At this time, Crawford has notmade a definitive demand for the resolution of this case.

 

On April 25, 2002, we, alongwith RegSoft.com, Inc., a subsidiary of ours, and Register Now!, a division ofours, and other various defendants, were named as defendants in a patentlitigation regarding United States Patent No. 4,500,919 assigned to theMassachusetts Institute of Technology, or MIT, by the inventor William F.Schreiber of Cambridge, Massachusetts. MIT licensed the patent to Electronics for Imaging, Inc., or EFI, andthese parties jointly filed a lawsuit in the U.S. District Court in the EasternDistrict of Texas.  The suit is stillpending.  The court set the SchedulingOrder and the parties have exchanged documents, selected expert witnesses forclaim interpretation, and conducted depositions of the experts.  Claim interpretation determines the scope ofthe claims and whether we may be liable based on those claims.  We are currently in the process of preparingand responding to legal briefs regarding the scope of the patent claims.  Upon the determination of the claims’ scope,we may file for a dismissal of the case if the court construes the patentclaims consistently with our position. We have sought indemnification from vendors and have been indemnifiedfor portions of the potential liability, but remain potentially liable forother portions.

 

These claims and any futureassertions or prosecutions of claims like this could require us to expendsignificant financial and managerial resources. The defense of any claims,whether these claims are 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.

 

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**Claimsagainst us related to the software products that we deliver electronically andthe tangible goods that we deliver physically could also require us to expendsignificant resources.**

 

Claims may be made against usfor negligence, copyright or trademark infringement, products liability orother theories based on the nature and content of software products or tangiblegoods that we deliver electronically and physically.  Because we did not create these products, we are generally not ina position to know the quality or nature of the content of these products.Although we carry general liability insurance and require that our customersindemnify us against end-user claims, our insurance and indemnificationmeasures may not cover potential claims of this type, adequately cover allcosts incurred in defense of potential claims, or reimburse us for allliability that may be imposed. Any costs or imposition of liability that arenot covered by insurance or indemnification measures could be expensive andtime-consuming to address, distract management and delay product deliveries evenif we were ultimately successful in the defense of these claims.

 

**Securitybreaches could hinder our ability to securely transmit confidentialinformation.**

 

A significant barrier toelectronic commerce and communications is the secure transmission of confidentialinformation over public networks. Any compromise or elimination of our securitycould be costly to remedy, damage our reputation and expose us to liability,and dissuade existing and new clients from using our services. We rely onencryption and authentication technology licensed from third parties to providethe security and authentication necessary for secure transmission ofconfidential information, such as end-user credit card numbers. A party whocircumvents our security measures could misappropriate proprietary informationor interrupt our operations.

 

We may be required to expendsignificant capital and other resources to protect against security breaches oraddress problems caused by breaches. Concerns over the security of the Internetand other online transactions and the privacy of users could deter people fromusing the Internet to conduct transactions that involve transmittingconfidential information, thereby inhibiting the growth of the Internet. To theextent that our activities or those of third-party contractors involve thestorage and transmission of proprietary information, such as credit cardnumbers, security breaches could damage our reputation and expose us to a riskof loss or litigation and possible liability. Our security measures may notprevent security breaches and failure to prevent security breaches could leadto a loss of existing clients and deter potential clients away from ourservices.

 

**Lossof our credit card acceptance privileges would seriously hamper our ability toprocess the sale of digital goods.**

 

The payment by end-users forthe purchase of digital goods that we process is typically made by credit card.If we incur significant instances of credit card fraud over an extended periodof 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 onanti-SPAM lists could harm our ability to service our clients and deliver goodsover the Internet.**

 

Certain privacy and anti-emailproponents have engaged in a practice of gathering and publicly listing networkaddresses that they believe have been involved in sending unwanted, unsolicitedemails commonly known as SPAM.  Inresponse to user complaints about SPAM, Internet service providers have fromtime to time blocked such network addresses from sending emails to theirusers.  If our network addressesmistakenly end up on these SPAM lists, our ability to provide services for ourclients and consummate the sales of digital and physical goods over theInternet could be harmed.

 

19

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**Changesin government regulation could limit our Internet activities or result inadditional costs of doing business over the Internet.**

 

We are subject to the samefederal, state and local laws as other companies conducting business on theInternet. Today there are relatively few laws specifically directed towardsconducting business on the Internet. The adoption or modification of lawsrelated 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:

 

•                  user privacywith respect to adults and minors;

 

•                  exportcompliance;

 

•                  pricing andtaxation;

 

•                  fraud;

 

•                  advertising;

 

•                  intellectualproperty rights;

 

•                  informationsecurity; and

 

•                  quality of productsand services.

 

Applicability to the Internetof existing laws governing issues such as property ownership, copyrights andother intellectual property issues, taxation, libel, obscenity and personalprivacy could also harm our operating results and substantially increase thecost to us of doing business. For example, numerous state legislatures haveproposed that tax rules for Internet retailing and catalog sales correspond toenacted tax rules for sales from physical stores.  Any requirement that we collect sales tax for each onlinepurchase and remit the tax to the appropriate state authority would be asignificant administrative burden to us and possibly depress online sales.  This and any other change in laws applicableto the Internet might also require significant management resources to respondappropriately. The vast majority of these laws were adopted prior to the adventof the Internet, and do not contemplate or address the unique issues raisedthereby. Those laws that do reference the Internet, such as the DigitalMillennium Copyright Act, are only beginning to be interpreted by the courtsand their applicability and reach are therefore uncertain.

 

**Lawsrelating to user information and online privacy may limit the collection ofend-user data for our clients.**

 

We collect and maintainend-user data for our clients, which subject us to increasing international,federal and state regulation related to online privacy and the use of personaluser information.   Several states haveproposed legislation that would limit the use of personal user informationgathered online or require online services to establish privacy policies. Inaddition, the U.S. Federal Trade Commission, or FTC, has urged Congress toadopt legislation regarding the collection and use of personal identifyinginformation obtained from individuals when accessing Web sites.  In the past, the emphasis has been oninformation obtained from minors. Focus has now shifted to include onlineprivacy protections for adults.  Theseregulations may include requirements that companies establish procedures to,among other things:

 

•                  give adequatenotice to users regarding information collection and disclosure practices;

 

•                  provide userswith the ability to have personal information deleted from a company’sdatabase;

 

•                  provide userswith access to their collected personal information and the ability to correctinaccuracies;

 

•                  clearly identifyaffiliations with third parties that may collect information or sponsoractivities on another company’s Web site; and

 

•                  obtain expressparental consent prior to collecting and using personal information fromchildren under 13 years of age.

 

Bills are also pending inCongress that address online privacy protections. Laws of this kind requirethat we establish procedures to disclose and notify users of privacy andsecurity policies, obtain consent from users for collection and use ofinformation, or provide

 

20

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users with the ability toaccess, correct and delete personal information stored by us. Even in the absenceof these regulations, the FTC has settled several proceedings resulting inconsent decrees in which Internet companies have been required to establishprograms regarding the manner in which personal information is collected fromusers and provided to third parties. We could become a party to a similarenforcement proceeding. These regulatory and enforcement efforts could limitour collection of demographic and personal information from end-users, whichcould adversely affect our ability to comprehensively serve our clients.

 

**Theadoption and implementation of international laws and regulations applicable toelectronic commerce may impair our efforts to expand revenue from internationaltransactions.**

 

The European Union has adopteda privacy directive that regulates the collection and use of information thatidentifies an individual person. These regulations may inhibit or prohibit thecollection and sharing of personal information in ways that could harm ourclients or us. The globalization of Internet commerce may be harmed by theseand similar regulations because the European Union privacy directive prohibitstransmission of personal information outside the European Union. The UnitedStates and the European Union have negotiated an agreement providing a “safeharbor” for those companies who agree to comply with the principles set forthby the U.S. Department of Commerce and agreed to by the European Union.  Failure to comply with these principles mayresult in fines, private lawsuits and enforcement actions.  These enforcement actions can includeinterruption or shutdown of operations relating to the collection and sharingof information pertaining to citizens of the European Union.

 

**Compliancewith future laws imposed on electronic commerce may substantially increase ourcosts of doing business or otherwise adversely affect our ability to offer ourservices.**

 

Because our services areaccessible worldwide and we facilitate sales of products to end-usersworldwide, foreign jurisdictions may claim that we are required to comply withtheir laws. Laws regulating Internet companies outside of the United States maybe less favorable than those in the United States, giving greater rights toconsumers, content owners and users. Compliance may be more costly or may requireus to change our business practices or restrict our service offerings relativeto those provided in the United States. Any failure to comply with foreign lawscould subject us to penalties ranging from fines to bans on our ability tooffer our services.

 

As our services are availableover the Internet in multiple states and foreign countries, these jurisdictionsmay claim that we are required to qualify to do business as a foreigncorporation in each state or foreign country. We are qualified to do businessonly in California, Connecticut, Illinois, Minnesota and Washington.  Failure to qualify as a foreign corporationin a required jurisdiction could subject us to taxes and penalties and couldresult in our inability to enforce contracts in these jurisdictions.

 

In addition, we are subject toUnited States laws governing the conduct of business with other countries, suchas export control laws, which prohibit or restrict the export of goods,services and technology to designated countries, denied persons or deniedentities from the United States.  Anysignificant changes in these laws, particularly an expansion in the exportcontrol laws, will increase our costs of compliance and may further restrictour overseas client base.

 

**Weintend to continue to expand our international operations and these efforts maynot be successful in generating additional revenue.**

 

We sell software products andservices to end-users outside the United States and we intend to continue toexpand 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:

 

•                  changes inregulatory requirements and tariffs;

 

•                  uncertainty ofapplication or governing of local laws;

 

•                  reducedprotection of intellectual property rights;

 

•                  difficulties indistribution for international sales;

 

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

 

•                  the burden andcost of complying with a variety of foreign laws; and

 

•                  political oreconomic constraints on international trade or instability.

 

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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 thisexpansion, our operating results and financial condition could be harmed.

 

**Newobligations to collect or pay sales tax could substantially increase the costto us of doing business.**

 

Currently, we collect sales,use or other similar taxes with respect to electronic software download instates where we believe that we have Nexus. The application of sales relatedtaxes to interstate and international sales over the Internet is unclear andevolving. Local, state or foreign jurisdictions may seek to impose sales or usetax collection obligations on out-of-state companies like ours that engage inelectronic commerce. A successful assertion by one or more states or anyforeign country that we should collect sales, use or other taxes on the sale ofmerchandise through our E-Business Services Division or on shipments of softwarecould harm our results of operations. In addition, any failure by an E-Businessclient to collect obligatory sales or use taxes could cause the relevantjurisdiction to attempt imposing that obligation on us.

 

**Compliance with changing regulation ofcorporate governance and public disclosure may result in additional expenses.**

 

Keeping abreast of, and in compliance with,changing laws, regulations and standards relating to corporate governance andpublic disclosure, including the Sarbanes-Oxley Act of 2002, new SECregulations and Nasdaq Stock Market rules, has required an increased amount ofmanagement attention and external resources. We intend to invest all reasonablynecessary resources to comply with evolving corporate governance and publicdisclosure standards, and this investment may result in increased general andadministrative expenses and a diversion of management time and attention fromrevenue-generating activities to compliance activities.

 

**Internet-relatedstock prices are especially volatile and this volatility may depress our stockprice or cause it to fluctuate significantly.**

 

The stock market, and thetrading prices of Internet-related companies in particular, have been notablyvolatile. This volatility is likely to continue in the short-term and is notnecessarily related to the operating performance of affected companies. Thisbroad market and industry volatility could significantly reduce the price ofour Common Stock at any time, without regard to our operating performance.Factors that could cause our stock price in particular to fluctuate include andare not limited to:

 

**•**                  actual or anticipated variations inquarterly operating results;

 

**•**                  announcements of technologicalinnovations;

 

**•**                  the ability to sign new clients andretention of existing clients;

 

**•**                  new products or services that we orour competitors offer;

 

**•**                  changes in financial estimates bysecurities analysts;

 

**•**                  conditions or trends in the Internetand online commerce industries;

 

**•**                  global unrest and terroristactivities;

 

**•**                  changes in the economic performanceand/or market valuations of other Internet or online electronic commercecompanies;

 

**•**                  our announcement of significantacquisitions, strategic partnerships, joint ventures or capital commitments;

 

**•**                  additions or departures of keypersonnel; and

 

**•**                  sales of our Common Stock.

 

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**Volatility in our stock price may inducesecurities class-action litigation against us, and the expense of defense couldharm our results of operations.**

 

Beginning in August 2001, weand certain of our officers and directors were named as defendants inseveral class action shareholder complaints filed in the United States DistrictCourt for the Southern District of New York, now consolidated as *In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355.  In theconsolidated amended complaint, the plaintiffs allege that we, certain of ourofficers and directors and the underwriters of our initial public offering, orIPO, 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.  Thecomplaint also contains a claim for violation of Section 10(b) of theSecurities Exchange Act of 1934 based on allegations that this omissionconstituted a deceit on investors.  Theplaintiffs seek unspecified monetary damages and other relief.  Similar complaints, referred to here as theIPO Lawsuits, were filed in the same court against hundreds of other publiccompanies.

 

On August 8, 2001, the IPOLawsuits were consolidated for pretrial purposes before United States JudgeShira Scheindlin of the Southern District of New York.  Judge Scheindlin held an initial casemanagement conference on September 7, 2001, at which time she ordered, amongother things, that the time for all defendants in the IPO Lawsuits to respondto any complaint be postponed until further order of the court.  Thus, we have not been required to answerany of the complaints, and no discovery has been served on us.

 

On July 15, 2002, we joined ina global motion to dismiss the IPO Lawsuits filed by all of the issuers(among others).  On October 9, 2002, the court entered an orderdismissing our named officers and directors from the IPO Lawsuits withoutprejudice, pursuant to an agreement tolling the statute of limitations withrespect to these officers and directors until September 30, 2003.  OnFebruary 19, 2003, the court issued a decision denying the motion to dismissthe Section 11 claims against us and almost all of the other issuers anddenying the motion to dismiss the Section 10(b) claims against us and many ofthe other issuers.  We believe that this lawsuit is without merit andintend to defend against it vigorously. However, this litigation, as well as any other securities class-actionlitigation that might be initiated against us, could result in substantialcosts and a diversion of management's attention and resources.

 

**Wemay need to raise additional capital to achieve our business objectives, whichcould result in dilution to existing investors.**

 

We require substantial workingcapital to fund our business. If capital requirements vary materially fromthose currently planned, we may require additional financing sooner thananticipated. If additional funds are raised through the issuance of equitysecurities, the percentage ownership of our stockholders will be reduced,stockholders may experience additional dilution or these equity securities mayhave rights, preferences or privileges senior to those of our Common Stock. Ourcapital requirements depend on several factors, including the rate of marketacceptance of our products, the ability to expand our client base and thegrowth of sales and marketing. We have had significant operating losses andnegative cash flow from operations since inception. Additional financing maynot be available when needed, on terms favorable to us or at all. If adequatefunds are not available or are not available on acceptable terms, we may beunable to develop or enhance our services, take advantage of futureopportunities or respond to competitive pressures, which would harm ouroperating results and adversely affect our ability to achieve profitability.

 

**Provisionsof our charter documents, other agreements and Delaware law may inhibitpotential 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.

 

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**ITEM 2. PROPERTIES.**

 

We currently leaseapproximately 134,000 square feet of office and warehouse space in two facilitiesin Eden Prairie, Minnesota.  The leasefor one facility of approximately 82,000 square feet expires in September2005.  The lease for the second facilityof approximately 52,000 square feet expires on July 31, 2003.  We also lease approximately 9,000 squarefeet of office space in Chicago, Illinois, expiring in October 2004 andapproximately 3,300 square feet of office space in suburban London, England,expiring in September 2003. In addition, we lease on a month-to-month basisapproximately 800 square feet of office space in Issaquah, Washington.  We terminated a month-to-month lease ofapproximately 2,500 square feet of office space in San Jose, California in2002.

 

**ITEM 3. LEGALPROCEEDINGS.**

 

On February 27, 2002, ePedasinitiated arbitration before the American Arbitration Associationagainst us.  The demand forarbitration alleged breach of contract and tortious interference claimsagainst us.  The case wastransferred to the International Section of the American ArbitrationAssociation.  The matter was settled byway of a settlement agreement executed on October 22, 2002, and the arbitrationwas dismissed on November 12, 2002.

 

Beginning in August2001, we and certain of our officers and directors were named asdefendants in several class action shareholder complaints filed in the UnitedStates District Court for the Southern District of New York, now consolidatedas *In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355.  In theconsolidated amended complaint, the plaintiffs allege that we, certain of ourofficers and directors and the underwriters of our initial public offering, orIPO, 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.  Thecomplaint also contains a claim for violation of Section 10(b) of theSecurities Exchange Act of 1934 based on allegations that this omissionconstituted a deceit on investors.  Theplaintiffs seek unspecified monetary damages and other relief.  Similar complaints, referred to here as theIPO Lawsuits, were filed in the same court against hundreds of other public companies.

 

On August 8, 2001, the IPOLawsuits were consolidated for pretrial purposes before United States JudgeShira Scheindlin of the Southern District of New York.  Judge Scheindlin held an initial casemanagement conference on September 7, 2001, at which time she ordered, amongother things, that the time for all defendants in the IPO Lawsuits to respondto any complaint be postponed until further order of the court.  Thus, we have not been required to answer anyof the complaints, and no discovery has been served on us.

 

On July 15, 2002, we joined ina global motion to dismiss the IPO Lawsuits filed by all of the issuers(among others).  On October 9, 2002, the court entered an orderdismissing our named officers and directors from the IPO Lawsuits withoutprejudice, pursuant to an agreement tolling the statute of limitations withrespect to these officers and directors until September 30, 2003.  OnFebruary 19, 2003, the court issued a decision denying the motion to dismissthe Section 11 claims against us and almost all of the other issuers anddenying the motion to dismiss the Section 10(b) claims against us and many ofthe other issuers.

 

We are also party to patentlitigation, along with other defendants, regarding United States Patent No.6,014,651 owned by Christopher M. Crawford ("Crawford") ofWashington, D.C.  The case was filed onAugust 21, 2001.  Crawford alleges thatwe directly infringe the patent by the provision of online software purchaseand delivery services, that we actively induce infringement of the patent bysupporting and otherwise promoting our electronic software delivery services toothers and that we contributorily infringed the patent by making, using,selling and offering to sell components of our electronic software deliveryservices.  Crawford seeks an unspecifiedaward of damages and to enjoin us from further infringement.  We answered the complaint on September 12,2001.  The case is pending in the U.S.District Court in the District of Columbia. No substantive actions have taken place as yet in this case.  The court has delayed substantive discoveryin this case, pending a preliminary determination of the legal scope ofCrawford's claim.  We are in the processof preparing materials regarding claim interpretation to present to thecourt.  Once the court determines thescope of the claims, we may file for a dismissal of the case if the court'sdecision is consistent with ours and the other defendants' position regardingthe interpretation of this patent claim.

We, along with RegSoft.com, Inc., a subsidiary of ours, and RegisterNow, a division of ours, and other various defendants, were named as defendantsin a patent litigation regarding United States Patent No. 4,500,919 assigned tothe Massachusetts Institute of Technology, or MIT, by the inventor William F.Schreiber of Cambridge, Massachusetts.  MIT licensed the patent toElectronics for Imaging, Inc. or EFI, and these parties jointly filed a lawsuitin the U.S. District Court in the Eastern District of Texas on December 28,2001.  EFI served us its First AmendedComplaint on April 25, 2002, alleging that we infringed its patent by offeringto sell and selling infringing color image editing software in the UnitedStates.  EFI seeks to enjoin us frominfringing, inducing infringement and contributing to infringement.  EFI seeks an award for monetary damages,prejudgment interest and attorney's fees. We answered EFI's complaint on June 17, 2002.  The suit is still pending. The court has accepted documents from the parties and held a hearingregarding claim interpretation.   Theclaim interpretation process will determine both the scope of the claims andwhether we may be liable based on this interpretation of the claims.  Upon the determination of the claims' scope,we may file for a dismissal of the case if the court construes the patentclaims consistently with our position. The parties have sought indemnification from vendors.  We have been indemnified for portions of theliability, but remain potentially liable for other portions.  

 

 

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**ITEM 4. SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None.

 

**PARTII**

 

**ITEM 5. MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

 

Our Common Stock is traded onthe Nasdaq National Market under the symbol “DRIV”.  Public trading of our Common Stock commenced on August 11,1998. Prior to that, there was no public market for our Common Stock. 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** |   |
|----------------|--------|----------|--------|---------|--------|
| **2001**       |   |     |   |    |   |
| First quarter  |   | $        | 9.50   |    | $      | 2.50 |   |
| Second quarter |   | $        | 7.50   |    | $      | 3.50 |   |
| Third quarter  |   | $        | 7.93   |    | $      | 4.00 |   |
| Fourth quarter |   | $        | 19.60  |    | $      | 6.26 |   |
|           |   |     |   |    |   |
| **2002**       |   |     |   |    |   |
| First quarter  |   | $        | 21.94  |    | $      | 10.85 |   |
| Second quarter |   | $        | 9.50   |    | $      | 4.25 |   |
| Third quarter  |   | $        | 9.94   |    | $      | 6.40 |   |
| Fourth quarter |   | $        | 15.00  |    | $      | 7.41 |   |

 

As of February 28, 2003, therewere approximately 480 holders of record of our Common Stock. On February 28,2003, the last sale price reported on the Nasdaq National Market System for ourCommon Stock was $8.98 per share.

 

We have never declared or paidany cash dividends on our capital stock. We intend to retain any futureearnings to support operations and to finance the growth and development of ourbusiness and do not anticipate paying cash dividends for the foreseeable future.

 

See Part III, Item 12 hereofwith respect to securities authorized for issuance under equity compensationplans.

 

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**ITEM 6. SELECTEDFINANCIAL DATA.**

 
|                                                                                             |   | **YEAR ENDED DECEMBER 31,**               |   |
|--------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                             |   | **2002**                                  |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                             |   | **(in thousands, except per share data)** |   |
| **Statement of Operations Data:**                                                                |   |                                      |   |   |   |   |   |   |   |   |   |
| Revenue                                                                                          |   | $                                         | 77,783 |   | $ | 57,825 |   | $ | 31,181 |   | $ | 14,507 |   | $ | 3,424 |   |
| Costs and expenses (exclusive of  depreciation and amortization expense shown separately below): |   |                                      |   |   |   |   |   |   |   |   |   |
| Direct cost of services                                                                          |   | 2,357                                     |   | 2,710 |   | 1,477 |   | 801 |   | 116 |   |
| Network and infrastructure                                                                       |   | 11,405                                    |   | 10,200 |   | 7,867 |   | 4,434 |   | 1,836 |   |
| Sales and marketing                                                                              |   | 32,437                                    |   | 27,489 |   | 25,693 |   | 17,383 |   | 9,310 |   |
| Product research and development                                                                 |   | 11,454                                    |   | 11,192 |   | 13,063 |   | 10,251 |   | 3,140 |   |
| General and administrative                                                                       |   | 6,799                                     |   | 4,701 |   | 4,628 |   | 4,001 |   | 3,111 |   |
| Litigation and other charges                                                                     |   | 2,500                                     |   | — |   | — |   | — |   | — |   |
| Depreciation and amortization                                                                    |   | 6,009                                     |   | 4,627 |   | 3,178 |   | 1,552 |   | 604 |   |
| Amortization of goodwill and other  intangibles and acquisition related costs                    |   | 5,738                                     |   | 17,009 |   | 15,387 |   | 6,886 |   | — |   |
| Total costs and expenses                                                                         |   | 78,699                                    |   | 77,928 |   | 71,293 |   | 45,308 |   | 18,117 |   |
| Loss from operations                                                                             |   | (916                                      | )      | (20,103 | ) | (40,112 | ) | (30,801 | ) | (14,693 | ) |
| Interest income                                                                                  |   | 406                                       |   | 881 |   | 1,996 |   | 3,148 |   | 895 |   |
| Net loss                                                                                         |   | $                                         | (510   | ) | $ | (19,222 | ) | $ | (38,116 | ) | $ | (27,653 | ) | $ | (13,798 | ) |
| Basic and diluted net loss per share                                                             |   | $                                         | (0.02  | ) | $ | (0.79 | ) | $ | (1.78 | ) | $ | (1.36 | ) | $ | (1.01 | ) |
| Shares used in per share computation                                                             |   | 26,791                                    |   | 24,285 |   | 21,413 |   | 20,312 |   | 13,691 |   |

 
|                            |   | **DECEMBER 31,**   |   |
|---------------------------------|--------|--------------------|--------|
|                            |   | **2002**           |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                            |   | **(in thousands)** |   |
| **Balance Sheet Data:**         |   |               |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents       |   | $                  | 40,801 |   | $ | 21,677 |   | $ | 16,920 |   | $ | 15,120 |   | $ | 63,503 |   |
| Short-term investments          |   | —             |   | 9,978 |   | 14,977 |   | 24,387 |   | 10,894 |   |
| Working capital                 |   | 14,498             |   | 14,024 |   | 17,038 |   | 28,777 |   | 70,563 |   |
| Total assets                    |   | 95,693             |   | 78,227 |   | 69,403 |   | 87,142 |   | 80,328 |   |
| Accumulated deficit             |   | (103,624           | )      | (103,114 | ) | (83,892 | ) | (45,776 | ) | (18,123 | ) |
| Total stockholders’ equity |   | $                  | 57,186 |   | $ | 50,422 |   | $ | 48,518 |   | $ | 73,077 |   | $ | 74,587 |   |

 

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATION.**

 

The Company is a leadingprovider of comprehensive electronic commerce outsourcing solutions. TheCompany was incorporated in February 1994 and commenced offering productsfor sale through its clients’ Web stores in August 1996. From inceptionthrough August 1996, the Company had no sales, and its activities relatedprimarily to the development of its proprietary technology platform, known asCNS. In 1996, the Company began to focus its business development efforts onthe software industry, building its inventory of software products throughcontracts with software publishers. In 1997, the Company began to developsoftware distribution relationships through contracts with online retailers. Asof March 1, 2003, the Companyhad approximately 14,000 software publisher clients and online retailer clientsserved by the Software and Digital Commerce Services Division. In late 1998,the Company began to offer its comprehensive electronic commerce outsourcingservices in the form of a transaction fee-based e-commerce service to clientsoutside of the software industry. As of March 1, 2003, the Company wasoperating approximately 20,000 sites under its E-Business Services Division.

 

The Company has approximatelysix years of operating history upon which investors may evaluate its businessand prospects. Since inception, the Company has incurred significant losses,and as of December 31, 2002, had an accumulated deficit of approximately$104 million. The Company intends to expend financial and managementresources on the development of additional services, sales and marketing,technology and operations to support larger-scale operations and greaterservice offerings. Although the Company expects to generate positive cash flowfrom operations in 2003, there can be no assurance that the Company’s revenuewill increase or even continue at its current level or that the Company willachieve or maintain profitability or generate cash from operations in futureperiods.

 

The Company’s prospects must beconsidered in light of the risks, expenses and difficulties frequentlyencountered by companies in new and rapidly evolving markets such as electroniccommerce. To address these risks, the Company must, among other things, attractand retain software publishers and online retailers as clients, attract andretain E-Business clients, introduce new Web sites, Web stores or services,continue to upgrade and develop our systems and infrastructure to meet emergingmarket needs and remain competitive in our service offerings, and retain andattract personnel commensurate with our business needs. There can be noassurance that the Company will be successful in addressing these risks, andany failure to do so could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

The Company’s current andfuture expense levels are based largely on its planned operations and estimatesof future revenue. Revenue and operating results generally depend on the volumeand timing of orders received, which are difficult to forecast. The Company maybe unable to adjust spending in a timely manner to compensate for anyunexpected revenue shortfall. Accordingly, any significant shortfall in revenuecould have an immediate adverse effect on the Company’s business, financialcondition and results of operations. The Company is also likely to continue tosee revenue fluctuate on a seasonal basis, which is typical for the softwarepublishing market in general and its current E-Business Service clients. TheCompany believes that its first and fourth quarters tend to be seasonallystronger than its second and third quarters due to the timing of demand for taxpreparation software and the holiday season selling period. In addition, it isthe Company’s belief that software publishers avoid new product releases in thesummer months. In view of the rapidly evolving nature of the Company’sbusiness, the Company is unable to accurately forecast its revenue and believesthat period-to-period comparisons of its operating results are not necessarilymeaningful and should not be relied upon as an indication of futureperformance.

 

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**CriticalAccounting Policies**

 

We prepare our consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States of America. As such, we are required to makecertain estimates, judgments and assumptions that we believe are reasonablebased upon the information available. These estimates and assumptions affectthe reported amounts of assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the periodspresented. The significant accounting policies which we believe are the mostcritical to aid in fully understanding and evaluating our reported financialresults are the following:

 

*Revenue Recognition.*  The Company recognizes revenue from services rendered once allthe following criteria for revenue recognition have been met: (1) Pervasive evidence of anagreement exists; (2) the services have been rendered; (3) the fee isfixed and determinable and not subject to refund or adjustment; and(4) collection of the amounts due is reasonably assured. The Company derivesits revenue primarily from transaction fees based on a percentage of theproducts sale price and fees from services rendered associated with thee-commerce services provided to its clients. These services include Webcommerce development and hosting, transaction processing, fraud screening,digital delivery, integration to physical fulfillment, merchandising services,analytical marketing and customer service. The Company reports its revenue on anet basis and therefore records only the net service fees and transaction feesas its revenue.  The Company acts as themerchant of record on the majority of the transactions processed and hascontractual relationships with its clients, which obligate the Company to payto the client a specified percentage of each sale. The Company retains itstransaction fee and also charges fees for services rendered. The Company alsoderives revenue from integration, development and consulting services. Signedcontracts are obtained from clients prior to recognition of these revenues.Fees for any integration and development work required to provide on-goinghosting services for the client are recognized ratably over the term of thecontract once collection is reasonably assured. Clients do not have the rightto take possession of the software applications used in the delivery ofservices. Payments received in advance of rendering the service, even ifnon-refundable, are recorded as deferred revenue until earned. Revenues fromconsulting services are recognized using the percentage-of-completion methodfor fixed-fee arrangements or as the services are provided fortime-and-materials arrangements. If the Company does not accurately estimatethe resources required or the scope of work to be performed, or does not manageits projects properly within the planned periods of time or satisfy itsobligations under the contracts, future margins may be negatively affected.

 

*Allowance for Doubtful Accounts*.  Thepreparation of financial statements requires management to make estimates andassumptions that affect the reported amount of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Estimates are used in determining our allowance for doubtful accountsand are based on our historical experience and current trends.  Management makes an estimate of anticipatedfuture credit card chargebacks and product returns related to current periodrevenue by analyzing the timing of historical credit card chargebacks andapplying anticipated percentages to current period revenues. Similarly,management must make estimates of the uncollectability of our billed accountsreceivable. Management specifically analyzes accounts receivable and historicalbad debts, customer credit-worthiness, current economic trends and changes inour customer payment terms when evaluating the adequacy of the allowance fordoubtful accounts.  Significantmanagement judgments and estimates must be made and used in connection with theallowance in any accounting period. Material differences may result in the amount and timing of our revenuefor any period if management makes different judgments or utilizes differentestimates.

 

*Goodwill, Intangibles And Other Long-Lived Assets.*  The Company amortizes property, plant andequipment, 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. Intangible assetswith definitive lives are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. The Company’s evaluation considers nonfinancial data such aschanges in the operating environment and business strategy, competitiveinformation, market trends and operating performance.

 

In July 2001, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards (SFAS) No.142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and intangible assets with indefinite livesare no longer amortized but are reviewed annually (or more frequently ifimpairment indicators arise) for impairment.  For acquisitions consummatedby the Company subsequent to July 1, 2001, the Company adopted the provisionsof SFAS No. 142 effective July 1, 2001.  The Company has adopted the fullprovisions of SFAS No. 142 effective January 1, 2002.  Upon adoption ofSFAS No. 142, the Company discontinued the amortization of goodwill.

 

The Company has assessed in 2002 whether ornot there was a goodwill impairment using a two-step approach based onreportable segments and reassessed any intangible assets, including goodwill,recorded in connection with earlier acquisitions. The Company’s assessment hasindicated that there is no impairment of goodwill or other intangibles for theyear ended December 31, 2002.

 

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**Results Of Operations**

 

The following table sets forthcertain items from the Company’s consolidated statements of operations as apercentage of total revenue for the years indicated.

 
|                                                                                             |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Revenue                                                                                          |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |
| Costs and expenses (exclusive  of depreciation and amortization expense shown separately below): |   |     |   |     |   |     |   |
| Direct cost of services                                                                          |   | 3.0      |   | 4.7      |   | 4.7      |   |
| Network and infrastructure                                                                       |   | 14.7     |   | 17.6     |   | 25.2     |   |
| Sales and marketing                                                                              |   | 41.7     |   | 47.5     |   | 82.4     |   |
| Product research and  development                                                                |   | 14.7     |   | 19.4     |   | 41.9     |   |
| General and administrative                                                                       |   | 8.8      |   | 8.1      |   | 14.9     |   |
| Litigation and other charges                                                                     |   | 3.2      |   | —   |   | —   |   |
| Depreciation and amortization                                                                    |   | 7.7      |   | 8.0      |   | 10.2     |   |
| Amortization of goodwill and  other intangibles and acquisition related costs                    |   | 7.4      |   | 29.4     |   | 49.3     |   |
| Total costs and expenses                                                                         |   | 101.2    |   | 134.7    |   | 228.6    |   |
| Loss from operations                                                                             |   | (1.2     | )      | (34.7    | )      | (128.6   | )      |
| Interest income                                                                                  |   | 0.5      |   | 1.5      |   | 6.4      |   |
| Net loss                                                                                         |   | (0.7     | )%     | (33.2    | )%     | (122.2   | )%     |

 

The Company has two operatingsegments, Software and Digital Commerce Services and E-Business Services, whichhave been identified as components of the Company that are reviewed regularlyby management to determine resource allocation and assess performance.

 

*Revenue.* The Company’s revenue increased to $77.8 million in 2002 from$57.8 million in 2001 and $31.2 million in 2000. The revenue increasein 2002 resulted from further expansion of the Company’s key clientrelationships, increasing market acceptance of electronic software downloading,merchandising activities that increased the average sales generated by theCompany’s software publisher clients, the two acquisitions completed by theCompany in 2002, and a full year of revenue for the four acquisitions completedat various times during 2001. The assets acquired generated approximately 9%and 7% of the Company’s total revenue during 2002 and 2001, respectively.  The revenue increases in 2002 and 2001resulted from significant growth in the number of Company clients, theincreasing market acceptance of electronic software downloading andmerchandising activities that increased the average sales generated by theCompany’s software publisher clients. International sales representedapproximately 22%, 22% and 25% of sales in the years ended December 31,2002, 2001 and 2000, respectively. In 2002, revenue for the Software andDigital Commerce Services Division was $63.2 million, up from$44.9 million in 2001, and $25.2 million in 2000.  Revenue for the E-Business Services Divisionwas $14.6 million in 2002, up from $12.9 million in 2001, and 6.0 millionin 2000.

 

*Gross Profit.* Cost of revenue consists of direct cost of services and network andinfrastructure expenses and is composed of direct labor costs related torevenue and the costs to operate and maintain the Company’s CNS platform, aswell as customer service and operations functions.  Such amounts are shown exclusive of any related depreciation andamortization expenses. Gross profit increased substantially in all yearspresented, reflecting the Company’s growth in revenue. During 2002, 2001 and2000, the Company’s gross profit margins were 82.3%, 77.7%, and 70.0%,respectively. The gross profit margin increases in 2002 and 2001 were primarilydue to leveraging the Company’s infrastructure over significantly more revenueand clients. In 2002, the gross profit margin for the Software and DigitalCommerce Services Division was 84.6%, up from 80.6% in 2001and 71.8% in2000.  The gross profit margin for theE-Business Services Division was 72.2% in 2002, up from 67.4% in 2001 and 62.4%in 2000. The Company continues to believe that Internet commerce and relatedservices may become more competitive in the future. Accordingly, the Companymay reduce or alter its pricing structure and policies in the future and anysuch change could negatively impact gross margins.

 

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*Sales And Marketing.*  Sales and marketing expense consists primarily of personnel andrelated expenses, advertising and promotional expenses, credit card chargebacksand bad debt expense, and credit card transaction fees. Sales and marketingexpense increased to $32.4 million in 2002, from $27.5 million and $25.7 millionin 2001and 2000, respectively, resulting primarily from increased credit cardtransaction fees and bad debt expense due to increased revenue as well asadditional sales and marketing personnel and related expenses. The increase in2002 from 2001 resulted primarily from increases in credit card transactionfees of $4.2 million, bad debt expense of $0.9 million, personnel relatedexpenses of $1.3 million offset by a decrease in advertising expense of $1.7million. The increase in 2001 from 2000 resulted from an increase in credit card transaction fees of $3.3 million.  As a percentage of revenue, sales andmarketing expense decreased to 41.7% in 2002 from 47.5% in 2001 and 82.4% in2000, primarily reflecting the Company’s increased revenue. In 2002, the salesand marketing expense related to the Software and Digital Commerce ServicesDivision was $22.7 million, up from $17.5 million in 2001 and $14.7million in 2000.  The sales andmarketing expense related to the E-Business Services Division was $9.7 millionin 2002, down from $10.0 million in 2001and $11.0 million in 2000.   The Company expects that sales andmarketing expense will continue to increase in absolute dollars as the Companycontinues to build its sales and marketing infrastructure and develops marketingprograms, and as volume-driven credit card expenses increase. As a percentageof revenue, these expenses are expected to continue to decrease as revenueincreases.

 

*Product Research And Development.*  Product research and development expenseconsists primarily of personnel and related expenses and consulting costsassociated with developing and enhancing the Company’s CNS platform and relatedinternal systems. Product research and development expense was $11.5 million in2002, compared to $11.2 million and $13.1 million in 2001 and 2000,respectively. The increase in 2002 from 2001 resulted from an increase inpersonnel related expenses.  The decrease in 2001 from 2000 resulted froma decrease in consulting costs of $5.0 million, partially offset by an increasein wages and benefit costs of $2.6 million. As a percentage of revenue,product research and development expense decreased to 14.7% in 2002 from 19.4%in 2001 and 41.9% in 2000, primarily reflecting the Company’s increasedrevenue. In 2002, the product research and development expense related to theSoftware and Digital Commerce Services Division was $4.8 million, the same asin 2001 and down from $5.8 million in 2000. Product research and developmentexpense related to the E-Business Services Division was $6.7 million in 2002,up from $6.4 million in 2001 and down from $7.3 million in 2000. TheCompany expects that product research and development expenses will continue todecrease as a percentage of revenue as revenue increases.

 

*General And Administrative.*  General and administrative expense consistsprincipally of executive, accounting and administrative personnel and relatedexpenses, including deferred compensation expense, professional fees andinvestor relations’ expenses. General and administrative expense increased to$6.8 million in 2002, from $4.7 million and $4.6 million in 2001 and2000, respectively. The increase in 2002 from 2001 resulted primarily from anincrease in various legal and professional fees of approximately $800,000,personnel related expenses of approximately $600,000 and insurance charges ofapproximately $300,000.  The increase in 2001 from 2000 resulted froman increase in professional fees of $108,000. As a percentage ofrevenue, general and administrative expense increased to 8.8% in 2002 from 8.1%in 2001 and 14.9% in 2000, primarily reflecting the Company’s increased revenueand the growth in the expense base in 2002. General and administrative expenserelated to the Software and Digital Commerce Services Division was$4.5 million in 2002 up from $3.2 million in both 2001 and 2000.  In 2002, general and administrative expensefor the E-Business Services Division was $2.3 million, up from$1.5 million in 2001 and $1.4 million in 2000. The Company expects generaland administrative expense to increase in absolute dollars in the future,particularly as the Company continues to build infrastructure to support itsgrowth. As a percentage of revenue, these expenses are expected to decrease asrevenue increases.

 

*Amortization Of Goodwill And Other Intangibles And Acquisition RelatedCosts.* Amortization of goodwill and other intangibles and acquisition relatedcosts consists of the amortization of goodwill and other intangible assetsrecorded from the Company’s eleven acquisitions in the past three years, aswell as other acquisition related costs such as earn-out payments. Amortizationof goodwill and other intangibles and acquisition related costs decreased to$5.7 million in 2002 from $17.0 million in 2001 and $15.4 million in2000.  The decrease in 2002 from 2001related to the implementation of SFAS No. 142,“Goodwill and Other Intangible Assets”. Under SFAS No. 142, goodwill andintangible assets with indefinite lives are no longer amortized but arereviewed annually (or more frequently if impairment indicators arise) forimpairment.  Upon adoption of SFAS No. 142, the Companydiscontinued the amortization of goodwill. The Company has assessed goodwillimpairment in 2002 using a two-step approach based on reportable segments andreassessed any intangible assets, including goodwill, recorded in connectionwith earlier acquisitions. The Company’s assessment has indicated that there isno impairment of goodwill or other intangibles for the year ended December 31,2002 and thus the Company did not record any expense related to goodwill in2002. The increase in 2001 from 2000 related to the amortization of goodwilland other intangibles from the four acquisitions consummated during 2001.

 

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*Loss From Operations.*  The Company’s loss from operations decreasedto $916,000 in 2002 from $20.1 million in 2001 and $40.1 million in2000, resulting primarily from increased revenue without correspondingincreases in operating expenses. In 2002, the Software and Digital CommerceServices Division generated income from operations of $21.4 million compared toincome of $10.7 million in 2001 and a loss of $5.6 million in 2000.  In 2002, the loss from operations related tothe E-Business Services Division was $8.1 million compared to a loss of$9.1 million in 2001 and $15.9 million in 2000. In calculating segmentlosses, the Company does not include depreciation and amortization of propertyand equipment or amortization of goodwill and other intangibles and acquisitionrelated costs.

 

*Interest Income.*  Interest income consists of earnings on the Company’s cash andcash equivalents and short-term investments. Interest income decreased to$406,000 in 2002 from $881,000 in 2001 and $2.0 million in 2000, resultingfrom net effects in changes in average cash and cash equivalent balances anddecreases in interest rates.

 

*Income taxes*. The Company had net operating loss carryforwards of approximately$81,700,000 as of December 31, 2002. Included in this amount is approximately$16,700,000 of deductions resulting from disqualifying dispositions of stockoptions. When these deductions are realized for financial statement purposesthey will not result in a reduction in income tax expense, rather the benefitwill be recorded as additional paid-in-capital. These income tax net operatingloss carryforwards expire beginning in the year 2009. Deductions fromdisqualifying dispositions of stock options are included in net operating losscarryforwards with a corresponding valuation allowance.  Because of the uncertainty of futurerealization, a valuation allowance equal to the deferred tax asset has beenrecorded.  Ownership changes resultingfrom the issuance of additional equity will limit future annual realization ofthe tax net operating loss carryforwards to a specified percentage of the valueof the Company under Section 382 of the Internal Revenue Code.

 

**Liquidity and CapitalResources**

 

Net cash provided by operatingactivities in 2002 and 2001 was $17.6 million and $0.5 million,respectively. Net cash used in operations was $17.0 million in 2000. Thenet cash provided by operating activities in 2002 and 2001 and used inoperating activities in 2000 was primarily the result of declining net losses,offset by goodwill and other intangibles amortization and earn-out charges,increases in accounts payable and increases in depreciation and amortization.

 

Net cash used in investingactivities was $0.6 million in 2002 and was the result of purchases ofequipment of $5.2 million and net cash paid for acquisitions of $5.4 millionoffset by $10.0 million in investment sales. Net cash used in investing activities was $2.4 million in 2001and was the result of purchases of equipment of $5.9 million and net cash paidfor acquisitions of $1.5 million, offset in part by net sales of investments of$5.0 million. Net cash provided by investing activities was$14.9 million in 2000 and was the result of net sales of investments of$24.4 million partially offset by purchases of equipment of$9.4 million.

 

Net cash provided by financingactivities in 2002, 2001 and 2000 was $2.2 million, $6.6 million, and$3.9 million, respectively. The cash provided by financing activities ineach year was mainly the result of proceeds from the exercise of stock optionsand warrants. However, in 2002 the Company repaid the $2.5 million in notespayable related to its August 2001 acquisition of RegSoft which caused adecrease in cash provided by financing activities. Additionally, in April 2001,the Company initiated a share repurchase program of up to $5.0 million of itsoutstanding shares of Common Stock. Repurchases will be at the Company’sdiscretion based on ongoing assessments of the capital needs of the businessand the market price of its shares.  Notime limit was set for the completion of the repurchase program.  During 2002, no shares were repurchasedunder the repurchase program.  In 2001,the Company expended $267,000 to repurchase its shares.

 

As of December 31, 2002,the Company had approximately $40.8 million of cash and cash equivalentsand working capital of approximately $14.5 million.  Significant components of the Company’s working capital are cashand cash equivalents and short term receivables net of client and merchantpayables. The Company’s principal commitments consisted of long termobligations outstanding under operating leases. Although the Company has nomaterial commitments for capital expenditures, it anticipates an increase inthe rate of capital expenditures consistent with its anticipated growth inoperations, infrastructure and personnel. The Company anticipates that over thenext 24 months it will expend approximately $17.0 million on capitalexpenditures and approximately $20.0 million on product research anddevelopment, based on the Company’s current anticipated growth rate inoperations. The Company may also use cash to acquire or license technology,products or businesses related to the Company’s current business. The Companyalso anticipates that it will continue to experience growth in its operatingexpenses for the foreseeable future and that its operating expenses will be amaterial use of the Company’s cash resources.

 

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The Company believes thatexisting sources of liquidity and the results of its operations will provideadequate cash to fund its operations for at least the next 24 months,although the Company may seek to raise additional capital during that period.In January 2002, the Company filed a universal shelf registration statementwith the SEC pursuant to which the Company will be permitted to issue up to$100 million in common stock, preferred stock, debt securities and/orwarrants.  The sale of additional equityor convertible debt securities could result in additional dilution to theCompany’s stockholders. There can be no assurances that financing will beavailable in amounts or on terms acceptable to the Company, if at all.

 

**RecentAccounting Pronouncements**

 

In December 2002, the FASBissued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure—an amendment of SFAS No. 123.” This statement provides alternativemethods of transition for a voluntary change to the fair value method ofaccounting for stock-based employee compensation.  This statement also amends the disclosure requirements of SFASNo. 123 and APB Opinion No. 28, “Interim Financial Reporting,” to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. The Company has implemented the annual reporting requirements for SFASNo. 148 at December 31, 2002.  TheCompany has determined at this time to continue to account for all stock-basedemployee compensation plans under APB Opinion No. 25.

 

In June 2002, theFinancial Accounting Standards Board issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities”.  SFAS No. 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities.  It nullifies Emerging Issues Task Force Issue No. 94-3,“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity”.  SFAS No. 146 requires that a liability berecognized for costs associated with an exit or disposal activity only when theliability is incurred.  SFAS No. 146 also establishes fair value as theobjective for initial measurement of liabilities related to exit or disposalactivities.  SFAS No. 146 is effective for exit or disposal activitiesthat are initiated after December 31, 2002.  The Company does not believethat this statement will have a material impact on its consolidated financialstatements.

 

**ITEM 7a. QUALITATIVE AND QUANTITATIVEDISCLOSURE ABOUT MARKET RISK.**

 

We do not enter into financialinstruments for trading or speculative purposes and do not currently utilizederivative financial instruments. Our operations are conducted primarily in theUnited States and as such are not subject to material foreign currency exchangerate risk. We have no long-term debt.

 

**ITEM 8. FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA.**

 

OurFinancial Statements and Notes thereto appear beginning at page 41 of thisreport.

 

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**QUARTERLYFINANCIAL DATA**

 
|                                        |   | **QUARTER ENDED**                         |   |
|---------------------------------------------|--------|-------------------------------------------|--------|
|                                        |   | **March 31**                              |   | **June 30** |   | **September 30** |   | **December 31** |   |
|                                        |   | **(in thousands, except per share data)** |   |
| **2002**                                    |   |                                      |   |   |   |   |   |   |   |
| Revenue                                     |   | $                                         | 18,070 |   | $ | 19,347 |   | $ | 18,872 |   | $ | 21,494 |   |
| Gross profit (a)                            |   | 14,743                                    |   | 15,981 |   | 15,315 |   | 17,982 |   |
| Income (loss) from operations  (b)          |   | (3,582                                    | )      | (505 | ) | 48 |   | 3,123 |   |
| Net income (loss)                           |   | (3,530                                    | )      | (348 | ) | 98 |   | 3,270 |   |
| Net income (loss) per  share-basic          |   | (0.13                                     | )      | (0.01 | ) | 0.00 |   | 0.12 |   |
| Net income (loss) per share —  diluted |   | $                                         | (0.13  | ) | $ | (0.01 | ) | $ | 0.00 |   | $ | 0.11 |   |

 
|                    |   | **QUARTER ENDED**                         |   |
|-------------------------|--------|-------------------------------------------|--------|
|                    |   | **March 31**                              |   | **June 30** |   | **September 30** |   | **December 31** |   |
|                    |   | **(in thousands, except per share data)** |   |
| **2001**                |   |                                      |   |   |   |   |   |   |   |
| Revenue                 |   | $                                         | 13,047 |   | $ | 13,055 |   | $ | 13,991 |   | $ | 17,732 |   |
| Gross profit(a)         |   | 9,526                                     |   | 9,906 |   | 11,069 |   | 14,414 |   |
| Loss from operations(b) |   | (6,589                                    | )      | (5,324 | ) | (4,548 | ) | (3,642 | ) |
| Net loss                |   | (6,241                                    | )      | (5,062 | ) | (4,374 | ) | (3,545 | ) |
| Net loss per share(c)   |   | $                                         | (0.28  | ) | $ | (0.21 | ) | $ | (0.18 | ) | $ | (0.14 | ) |

 

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(a)                                  Grossprofit is calculated as revenue less direct cost of services and network andinfrastructure expenses and excludes depreciation and amortization expense.

 

(b)                                 Income(loss) from operations includes amortization of goodwill and other intangiblesand acquisition related costs of $1,549, $1,651, $1,356 and $1,182 in thequarters ended March 31, June 30, September 30 andDecember 31, 2002, respectively, and includes amortization of goodwill andother intangibles and acquisition related costs of $4,644, $3,839, $3,912, and$4,611 in the quarters ended March 31, June 30, September 30 andDecember 31, 2001, respectively.

 

(c)                                  Netloss per share is the same for both basic and diluted.

 

33

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**ITEM 9. CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

 

On June 13, 2002, our Board of Directorsterminated its relationship with Arthur Andersen LLP as the independent publicaccountants of Digital River based upon the recommendation and approval of itsAudit Committee.

 

The reports of Arthur Andersen LLP on ourconsolidated financial statements for the years ended December 31, 2001 and2000 contained no adverse opinion or disclaimer of opinion and were notqualified or modified as to uncertainty, audit scope or accounting principles.

 

During our years ended December 31, 2001 and2000 and through the subsequent interim period ended June 13, 2002, there wereno disagreements with Arthur Andersen LLP on any matter of accounting principlesor practices, financial statement disclosure or auditing scope or procedure,which disagreements if not resolved to the satisfaction of Arthur Andersen LLPwould have caused it to make reference thereto in their report.

 

During the years ended December 31, 2001 and2000 and through June 13, 2002, there were no reportable events (asdefined in Regulation S-K Item 304(a)(1)(v)).

 

We engaged Ernst & Young LLP as ourindependent accountants as of June 13, 2002.  During the years endedDecember 31, 2001 and 2000 and through June 13, 2002, we did not consult withErnst & Young LLP on items which (i) were or should have been subject toStatement of Auditing Standard No. 50 or (ii) concerned the subject matter of adisagreement or reportable event with Arthur Andersen LLP (as described inRegulation S-K Item 304(a)(2)).

 

 

**PARTIII**

 

Certain information required inPart III of this report is incorporated by reference to our ProxyStatement in connection with our 2002 Annual Meeting to be filed in accordancewith Regulation 14A under the Securities Exchange Act of 1934, as amended.

 

**ITEM 10. DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT.**

 

Other than the identificationof executive officers, which is set forth in Part I, Item 1 hereof, theinformation required in Item 10 of Part III of this report is incorporated byreference to our Proxy Statement in connection with our 2003 Annual Meeting tobe filed in accordance with Regulation 14A under the Securities Exchange Act of1934, as amended.

 

**ITEM 11. EXECUTIVE COMPENSATION.**

 

The information required inItem 11 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2003 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

 

**ITEM 12. SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS.**

 

The information required inItem 12 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2003 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

 

**ITEM 13. CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS.**

 

The information required inItem 13 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2003 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

 

34

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**ITEM 14. CONTROLS AND PROCEDURES.**

 

(a) Based on their evaluation of our disclosure controls and proceduresconducted within 90 days of the date of filing this report on Form 10-K, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c)promulgated under the Securities Exchange Act of 1934) are effective.

 

(b) There have been no significant changes(including corrective actions with regard to significant deficiencies ormaterial weaknesses) in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of the evaluationreferenced in paragraph (a) above.

 

Limitations on the Effectiveness of Controls

 

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

 

35

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**PARTIV**

 

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

 

(a)           The following documentsare filed as part of this report:

 

(1)           Indexto Consolidated Financial Statements and Report of Independent PublicAccountants.

 

Theconsolidated financial statements required by this item are submitted in aseparate section beginning on page 41 of this report.

 
| Report of Independent Auditors                        |
|-------------------------------------------------------|
| Report of Independent Public Accountants              |
| Consolidated Balance Sheets                           |
| Consolidated Statements of Operations                 |
| Consolidated Statements of Stockholders’  Equity |
| Consolidated Statements of Cash Flows                 |
| Notes to Consolidated Financial Statements            |

 

(2)           FinancialStatement Schedules.

 

All schedulesfor which 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 asExhibit 99-3 to this Form 10-K, as filed with the SEC.

 

(3)           Exhibits.

 
| **Exhibit  Number** |   | **Description Of Document**                                                                                                                                                              |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)              |   | Asset  Purchase Agreement, dated August 24, 2000, by and between the Registrant and  NetSales, Inc.                                                                                      |
| 2.2(2)              |   | Asset Purchase  Agreement dated as of March 20, 2001, by and between the Registrant, Calico  Commerce, Inc. and ConnectInc.com, Co., a wholly-owned subsidiary of Calico  Commerce, Inc. |
| 2.3(3)              |   | Amended and Restated Asset  Purchase Agreement dated February 9, 2002 by and between the Registrant  and Beyond.com.                                                                |
| 2.4(4)              |   | First Amendment to the  Amended and Restated Asset Purchase Agreement dated as of March 15, 2002  by and between the Registrant and Beyond.com.                                     |
| 2.5(4)              |   | 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(5)              |   | 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(5)              |   | Certificate  of Amendment of Amended and Restated Certificate of Incorporation (amending  Exhibit 3.1).                                                                                  |
| 4.1(7)              |   | Specimen  Stock Certificate.                                                                                                                                                             |
| 4.2(5)              |   | Form of  Senior Debt Indenture.                                                                                                                                                          |
| 4.3(5)              |   | Form of  Subordinated Debt Indenture.                                                                                                                                                    |
| 4.4                 |   | References  are hereby made to Exhibits 3.1, 3.2 and 3.3.                                                                                                                                |
| 10.1(5)             |   | Form of  Indemnity Agreement between Registrant and each of its directors and  executive officers.                                                                                       |
| 10.2(5)             |   | 1998 Stock  Option Plan.                                                                                                                                                                 |
| 10.3(5)             |   | Employment  and Non-Competition Agreement effective May 25, 1998 by and between Joel A.  Ronning and the Registrant.                                                                     |
| 10.4(5)             |   | Heads of  Agreement for International Agreement dated February 25, 1998 by and between  Christopher J. Sharples, David A. Taylor and the Registrant.                                     |
| 10.5(5)             |   | Form of  Conditional Warrant to Purchase Common Stock dated April 22, 1998 by and  between Wasserstein Adelson Ventures, L.P. and Registrant.                                            |
| 10.6(5)             |   | Form of  Warrant to Purchase Common Stock by and between certain investors and  Registrant.                                                                                              |
| 10.7(5)             |   | Consent to  Assignment and Assumption of Lease dated April 22, 1998 by and between CSM  Investors, Inc., IntraNet Integration Group, Inc. and Registrant.                                |
| 10.8(5)             |   | Assignment  of Lease dated April 21, 1998 by and between Intranet Integration Group, Inc.  and Registrant.                                                                               |

 

36

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| 10.9(5)  |   | Lease  Agreement dated January 18, 2000 between Property Reserve, Inc. and  Registrant.                                                                                                     |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10(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.). |
| 10.11(6) |   | 1999 Stock  Option Plan, formerly known as the 1999 Non-Officer Stock Option Plan.                                                                                                          |
| 10.12(8) |   | 2000 Employee Stock  Purchase Plan.                                                                                                                                                         |
| 10.13(2) |   | Voting  Agreement, dated March 20, 2001, by and between the Registrant, Calico  Commerce, Inc. and ConnectInc.com, Co.                                                                 |
| 21.1     |   | Subsidiaries  of Digital River, Inc.                                                                                                                                                        |
| 23.1     |   | Consent of  Independent Auditors, dated March 24, 2003.                                                                                                                                     |
| 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.                   |
| 99.1     |   | Certification of Digital River, Inc.’s Chief Executive Officer, Joel  A. Ronning, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                           |
| 99.2     |   | Certification of Digital River, Inc.’s Chief Financial Officer,  Carter D. Hicks, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                           |
| 99.3     |   | Report of Independent Auditors                                                                                                                                                              |

 

----

(1)           Incorporated byreference from the Company’s Current Report on Form 8-K filed onSeptember 8, 2000.

(2)           Incorporated byreference from the Company’s Current Report on Form 8-K filed onMarch 26, 2001.

(3)           Incorporated by reference fromthe Company’s Current Report onForm 8-K filed February 11, 2002

(4)           Incorporated by reference fromthe Company’s Current Report onForm 8-K filed April 15, 2002

(5)           Incorporated byreference from the Company’s Registration Statement on Form S-3 (FileNo. 333-81626), declared effective on February 12, 2002.

(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 (FileNo. 333-56787), declared effective on August 11, 1998.

(8)           Incorporated byreference from the Company’s Registration Statement on Form S-8 (File No.333- 53332) declared effective on January 8, 2001.

 

(b)           None.

 

(c)           See Exhibits listed under Item15(a)(3).

 

(d)           The financial statement schedules required by this itemare listed under 15(a)(2).

 

37

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**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the Registranthas caused this report on Form 10-K to be signed on its behalf by theundersigned, thereunto duly authorized, in the City of Eden Prairie, State ofMinnesota, on the 28th of March 2003.

 
|   | DIGITAL RIVER, INC. |
|--------|---------------------|
|   |                |
|   |                |
|   | By:                 | /s/ Joel A. Ronning |
|   |                | Joel A. Ronning |
|   |                | CHIEF EXECUTIVE OFFICER AND DIRECTOR |

 

We, theundersigned, directors and officers of Digital River, Inc., do hereby severallyconstitute and appoint Joel A. Ronning and Carter D. Hicks and each or any ofthem, our true and lawful attorneys and agents, with full power of substitutionand resubstitution, for him or her and in his or her name, place and stead, inany and all capacities, to sign any and all amendments to the Registrant’sAnnual Report on Form 10-K for the fiscal year ended December 31, 2002, and tofile the same with all exhibits thereto, and all other documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys and agents, and each or any of them, full power and authority to doand perform each and every act and thing requisite and necessary to be done, asfully to all intents and purposes as he or she might or could do in person,hereby ratifying and confirming all that said attorneys and agents, and each ofthem, or his substitute or substitutes, may lawfully do or cause to be done byvirtue hereof.

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this Form 10-K has been signed belowby the following persons on behalf of the Registrant and in the capacities andon the dates indicated:

 
| **SIGNATURE**         |   | **TITLE**                                                          |   | **DATE**       |
|-----------------------|--------|--------------------------------------------------------------------|--------|----------------|
|                  |   |                                                               |   |           |
| /s/ Joel A. Ronning   |   |                                                               |   |           |
| Joel A. Ronning       |   | Chief Executive Officer and Director (Principal Executive Officer) |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ Carter D. Hicks   |   |                                                               |   |           |
| Carter D. Hicks       |   | Chief Financial Officer and Treasurer                              |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ Perry W. Steiner  |   |                                                               |   |           |
| Perry W. Steiner      |   | Director                                                           |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ William Lansing   |   |                                                               |   |           |
| William Lansing       |   | Director                                                           |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ Thomas F. Madison |   |                                                               |   |           |
| Thomas F. Madison     |   | Director                                                           |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ J. Paul Thorin    |   |                                                               |   |           |
| J. Paul Thorin        |   | Director                                                           |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ Frederic Seegal   |   |                                                               |   |           |
| Frederic Seegal       |   | Director                                                           |   | March 28, 2003 |
|                  |   |                                                               |   |           |
| /s/ Timothy C. Choate |   |                                                               |   |           |
| Timothy C. Choate     |   | Director                                                           |   | March 28, 2003 |

 

38

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**CERTIFICATIONS**

 

I, Joel A. Ronning, certify that:

 

1.                                     Ihave reviewed this annual report on Form 10-K of Digital River, Inc.;

 

2.                                     Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                     Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                     Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)  Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)  Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c) Presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                                     Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)  All significant deficiencies in the designor operation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

(b)  Any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.                                     Theregistrant’s other certifying officers and I have indicated in this annualreport whether  there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 

 
| Date:  | March  28, 2003 |   | /s/ Joel A. Ronning      |   |
|--------|----------------------|--------|--------------------------|--------|
|   |                 |   | Joel A. Ronning          |
|   |                 |   | Chief  Executive Officer |

 

39

----

 

I, Carter D. Hicks, certify that:

 

1.                                     Ihave reviewed this annual report on Form 10-K of Digital River, Inc.;

 

2.                                     Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                     Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                     Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)  Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report is beingprepared;

 

(b)  Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)  Presented in this annual report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.                                     Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)  All significant deficiencies in the designor operation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

(b)  Any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.                                     Theregistrant’s other certifying officers and I have indicated in this annualreport whether  there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 

 
| Date:  | March 28,  2003 | /s/ Carter D. Hicks      |   |
|--------|-----------------|--------------------------|--------|
|   |            | Carter D. Hicks          |
|   |            | Chief  Financial Officer |

 

40

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**Report of Independent Auditors**

 

**Board of Directors and StockholdersDigital River, Inc.**

 

We have audited the accompanying consolidatedbalance sheet of Digital River, Inc. and subsidiaries as ofDecember 31, 2002 and the related consolidated statements of operations,stockholders’ equity, and cash flows for the year then ended. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit. The consolidated financial statements of Digital River, Inc.and subsidiaries as of December 31, 2001 and 2000, and for the two yearsthen ended, were audited by other auditors who have ceased operations and whosereports dated January 28, 2002 expressed an unqualified opinion on thosestatements.

 

We conducted our audit in accordance withauditing standards generally accepted in the United States. Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides a reasonable basis for our opinion.

 

In our opinion, the 2002 financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of Digital River, Inc. and subsidiaries as ofDecember 31, 2002 and the consolidated results of their operations andtheir cash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States.

 

As discussed above, the consolidatedfinancial statements of Digital River, Inc. and subsidiaries as ofDecember 31, 2001 and 2000, and for the two years then ended, were audited byother auditors who have ceased operations. As described in Note 2, theseconsolidated financial statements have been revised to include the transitionaldisclosures required by Financial Accounting Standard No. 142, “Goodwilland other Intangible Assets”, which was adopted by the Company as of January 1,2002. We have audited the disclosures in Note 2 and, in our opinion, thedisclosures for 2001 and 2000 in Note 2 are appropriate. However, we werenot engaged to audit, review, or apply any procedures to the 2001 and 2000 consolidatedfinancial statements of the Company other than with respect to such disclosuresand, accordingly, we do not express an opinion or any other form of assuranceon the 2001 and 2000 consolidated financial statements taken as a whole.

 

 
| **/s/ Ernst & Young LLP** |   |
|------------------------------------|--------|
|                               |
| Minneapolis, Minnesota             |
| January 28, 2003                   |

 

41

----

 

*Thefollowing report is a copy of a report previously issued by Arthur Andersen LLP(“Andersen”), which has not been reissued by Andersen. Certain financialinformation for each of the two years in the period ended December 31,2001 was not reviewed by Andersen and includes: (i) reclassifications toconform to our 2002 financial statement presentation and (ii) additionaldisclosures to conform with new accounting pronouncements and SEC rules andregulations issued during such fiscal year.*

 

**Report ofindependent public accountants**

 

 

To Digital River, Inc.:

 

We have audited theaccompanying consolidated balance sheets of Digital River, Inc. (aDelaware corporation) and Subsidiaries as of December 31, 2001 and 2000,and the related consolidated statements of operations, stockholders’ equity andcash flows for each of the three years in the period ended December 31,2001. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the 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 financialstatements referred to above present fairly, in all material respects, thefinancial position of Digital River, Inc. and Subsidiaries as ofDecember 31, 2001 and 2000, and the results of their operations and theircash flows for each of the three years in the period ended December 31,2001, in conformity with accounting principles generally accepted in the UnitedStates.

 

Arthur Andersen LLP

 

Minneapolis, Minnesota,

January 28, 2002

 

42

----

 

 

**DIGITALRIVER, INC.**

ConsolidatedBalance Sheets as of December 31

(in thousands, except share data)

 
|                                                                                                                  |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| **ASSETS**                                                                                                            |   |     |   |     |   |
| CURRENT ASSETS:                                                                                                       |   |     |   |     |   |
| Cash and cash equivalents                                                                                             |   | $        | 40,801 |     | $      | 21,677 |   |
| Short-term investments                                                                                                |   | —   |   | 9,978    |   |
| Accounts receivable, net of  allowance of $1,746 and $839                                                             |   | 10,397   |   | 8,719    |   |
| Prepaid expenses and other                                                                                            |   | 1,807    |   | 1,455    |   |
|                                                                                                                  |   |     |   |     |   |
| Total current assets                                                                                                  |   | 53,005   |   | 41,829   |   |
|                                                                                                                  |   |     |   |     |   |
| PROPERTY AND EQUIPMENT:                                                                                               |   |     |   |     |   |
| Property and equipment                                                                                                |   | 29,036   |   | 25,374   |   |
| Less accumulated depreciation                                                                                         |   | (13,399  | )      | (9,228   | )      |
|                                                                                                                  |   |     |   |     |   |
| Net property and equipment                                                                                            |   | 15,637   |   | 16,146   |   |
|                                                                                                                  |   |     |   |     |   |
| GOODWILL                                                                                                              |   | 18,698   |   | 11,273   |   |
| INTANGIBLE ASSETS, net of  accumulated amortization of $14,596 and $8,858                                             |   | 8,346    |   | 8,934    |   |
| OTHER ASSETS                                                                                                          |   | 7        |   | 45       |   |
|                                                                                                                  |   | $        | 95,693 |     | $      | 78,227 |   |
|                                                                                                                  |   |     |   |     |   |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                        |   |     |   |     |   |
| CURRENT LIABILITIES:                                                                                                  |   |     |   |     |   |
| Notes payable                                                                                                         |   | $        | — |     | $      | 2,500 |   |
| Accounts payable                                                                                                      |   | 31,126   |   | 19,360   |   |
| Accrued payroll                                                                                                       |   | 1,788    |   | 2,803    |   |
| Deferred revenue                                                                                                      |   | 1,865    |   | 1,106    |   |
| Other accrued liabilities                                                                                             |   | 3,728    |   | 2,036    |   |
|                                                                                                                  |   |     |   |     |   |
| Total current liabilities                                                                                             |   | 38,507   |   | 27,805   |   |
|                                                                                                                  |   |     |   |     |   |
| 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; 27,537,240 and 26,462,905 shares issued and  outstanding |   | 275      |   | 265      |   |
| Additional paid-in capital                                                                                            |   | 160,535  |   | 153,308  |   |
| Deferred compensation                                                                                                 |   | —   |   | (37      | )      |
| Accumulated deficit                                                                                                   |   | (103,624 | )      | (103,114 | )      |
|                                                                                                                  |   |     |   |     |   |
| Total stockholders’ equity                                                                                       |   | 57,186   |   | 50,422   |   |
|                                                                                                                  |   |     |   |     |   |
|                                                                                                                  |   | $        | 95,693 |     | $      | 78,227 |   |

 

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

 

43

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**DIGITALRIVER, INC.**

Consolidated Statements of Operations for the Years Ended December 31

(in thousands, except per share data)

 
|                                                                                            |   | **2002** |   | **2001** |   | **2000** |   |
|-------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| REVENUE                                                                                         |   | $        | 77,783 |     | $      | 57,825   |   | $ | 31,181 |   |
| COSTS AND EXPENSES (exclusive  of depreciation and amortizationexpense shown separately below): |   |     |   |     |   |     |   |
| Direct cost of services                                                                         |   | 2,357    |   | 2,710    |   | 1,477    |   |
| Network and infrastructure                                                                      |   | 11,405   |   | 10,200   |   | 7,867    |   |
| Sales and marketing                                                                             |   | 32,437   |   | 27,489   |   | 25,693   |   |
| Product research and  development                                                               |   | 11,454   |   | 11,192   |   | 13,063   |   |
| General and administrative                                                                      |   | 6,799    |   | 4,701    |   | 4,628    |   |
| Litigation and other charges                                                                    |   | 2,500    |   | —   |   | —   |   |
| Depreciation and amortization                                                                   |   | 6,009    |   | 4,627    |   | 3,178    |   |
| Amortization of goodwill and  other intangibles and acquisition related costs (Note 2)          |   | 5,738    |   | 17,009   |   | 15,387   |   |
| Total costs and expenses                                                                        |   | 78,699   |   | 77,928   |   | 71,293   |   |
| LOSS FROM OPERATIONS                                                                            |   | (916     | )      | (20,103  | )      | (40,112  | )      |
| INTEREST INCOME                                                                                 |   | 406      |   | 881      |   | 1,996    |   |
|                                                                                            |   |     |   |     |   |     |   |
| NET LOSS                                                                                        |   | $        | (510   | )        | $      | (19,222  | )      | $ | (38,116 | ) |
|                                                                                            |   |     |   |     |   |     |   |
| BASIC AND DILUTED NET LOSS PER  SHARE                                                           |   | $        | (0.02  | )        | $      | (0.79    | )      | $ | (1.78 | ) |
|                                                                                            |   |     |   |     |   |     |   |
| BASIC AND DILUTED WEIGHTED  AVERAGECOMMON SHARES  OUTSTANDING                                   |   | 26,791   |   | 24,285   |   | 21,413   |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

 

44

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**DIGITALRIVER, INC.**

Consolidated Statements of Stockholders’Equity

(in thousands)

 
|                                                            |   |       |   |   |   | **Additional  Paid-In  Capital** |   | **Deferred  Compensation** |   | **Accumulated  Other Comprehensive  Loss** |   | **Accumulated  Deficit** |   | **Total  Stockholders’  Equity** |   | **Comprehensive  Loss** |          |
|-----------------------------------------------------------------|--------|------------|--------|--------|--------|----------------------------------|--------|----------------------------|--------|--------------------------------------------|--------|--------------------------|--------|---------------------------------------|--------|-------------------------|---------------|
|                                                            |   |       |
|                                                            |
| **Common Stock**                                                |
| **Shares**                                                      |   | **Amount** |
| BALANCE, December 31, 1999                                      |   | 20,699     |   | $      | 207    |                             | $      | 119,445                    |   | $                                          | (637   | )                        | $      | (162                                  | )      | $                       |  (45,776 | ) | $ |  73,077 |   | $ |  (27,815 | ) |
| Common Stock issued for  acquisitions and earn-out arrangements |   | 1,124      |   | 11     |   | 9,082                            |   | —                     |   | —                                     |   | —                   |   | 9,093                                 |   |                    |          |
| Exercise of stock options and  warrants                         |   | 339        |   | 4      |   | 3,585                            |   | —                     |   | —                                     |   | —                   |   | 3,589                                 |   |                    |          |
| Common Stock issued under the  Employee Stock Purchase Plan     |   | 113        |   | 1      |   | 291                              |   | —                     |   | —                                     |   | —                   |   | 292                                   |   |                    |          |
| Deferred compensation expense                                   |   | —     |   | — |   | —                           |   | 443                        |   | —                                     |   | —                   |   | 443                                   |   |                    |          |
| Unrealized gain on investments                                  |   | —     |   | — |   | —                           |   | —                     |   | 140                                        |   | —                   |   | 140                                   |   | 140                     |          |
| Net loss                                                        |   | —     |   | — |   | —                           |   | —                     |   | —                                     |   | (38,116                  | )      | (38,116                               | )      | (38,116                 | )             |
|                                                            |   |       |   |   |   |                             |   |                       |   |                                       |   |                     |   |                                  |   |                    |          |
| BALANCE, December 31, 2000                                      |   | 22,275     |   | 223    |   | 132,403                          |   | (194                       | )      | (22                                        | )      | (83,892                  | )      | 48,518                                |   | (37,976                 | )             |
| Common Stock issued for  acquisitions and earn-out arrangements |   | 2,817      |   | 28     |   | 14,351                           |   | —                     |   | —                                     |   | —                   |   | 14,379                                |   |                    |          |
| Exercise of stock options and  warrants                         |   | 1,246      |   | 13     |   | 6,281                            |   | —                     |   | —                                     |   | —                   |   | 6,294                                 |   |                    |          |
| Common Stock issued under the  Employee Stock Purchase Plan     |   | 182        |   | 2      |   | 539                              |   | —                     |   | —                                     |   | —                   |   | 541                                   |   |                    |          |
| Repurchase of Common Stock                                      |   | (57        | )      | (1     | )      | (266                             | )      | —                     |   | —                                     |   | —                   |   | (267                                  | )      |                    |          |
| Deferred compensation expense                                   |   | —     |   | — |   | —                           |   | 157                        |   | —                                     |   | —                   |   | 157                                   |   |                    |          |
| Unrealized gain on investments                                  |   | —     |   | — |   | —                           |   | —                     |   | 22                                         |   | —                   |   | 22                                    |   | 22                      |          |
| Net loss                                                        |   | —     |   | — |   | —                           |   | —                     |   | —                                     |   | (19,222                  | )      | (19,222                               | )      | (19,222                 | )             |
|                                                            |   |       |   |   |   |                             |   |                       |   |                                       |   |                     |   |                                  |   |                    |          |
| BALANCE, December 31, 2001                                      |   | 26,463     |   | 265    |   | 153,308                          |   | (37                        | )      | —                                     |   | (103,114                 | )      | 50,422                                |   | (19,200                 | )             |
| Common Stock issued for  acquisitions and earn-out arrangements |   | 171        |   | 2      |   | 2,553                            |   | —                     |   | —                                     |   | —                   |   | 2,555                                 |   |                    |          |
| Exercise of stock options and  warrants                         |   | 854        |   | 8      |   | 4,294                            |   | —                     |   | —                                     |   | —                   |   | 4,302                                 |   |                    |          |
| Common Stock issued under the  Employee Stock Purchase Plan     |   | 49         |   | — |   | 380                              |   | —                     |   | —                                     |   | —                   |   | 380                                   |   |                    |          |
| Deferred compensation expense                                   |   | —     |   | — |   | —                           |   | 37                         |   | —                                     |   | —                   |   | 37                                    |   |                    |          |
| Net loss                                                        |   | —     |   | — |   | —                           |   | —                     |   | —                                     |   | (510                     | )      | (510                                  | )      | (510                    | )             |
|                                                            |   |       |   |   |   |                             |   |                       |   |                                       |   |                     |   |                                  |   |                    |          |
| BALANCE, December 31, 2002                                      |   | 27,537     |   | $      | 275    |                             | $      | 160,535                    |   | $                                          | — |                     | $      | —                                |   | $                       | (103,624      | ) | $ | 57,186 |   | $ | (510 | ) |

 

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

45

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**DIGITALRIVER, INC.**

Consolidated Statements of Cash Flows For the Years Ended December 31,

(in thousands)

 
|                                                                                       |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| OPERATING ACTIVITIES:                                                                      |   |     |   |     |   |     |   |
| Net loss                                                                                   |   | $        | (510   | )        | $      | (19,222  | )      | $ | (38,116 | ) |
| Adjustments to reconcile net  loss to net cash provided by (used in) operating activities: |   |     |   |     |   |     |   |
| Goodwill and other intangibles  amortization and earn-out charges                          |   | 5,738    |   | 17,009   |   | 13,354   |   |
| Depreciation and amortization                                                              |   | 6,009    |   | 4,627    |   | 3,178    |   |
| Deferred compensation expense                                                              |   | 37       |   | 157      |   | 443      |   |
| Litigation and other charges                                                               |   | 1,675    |   | —   |   | —   |   |
| Change in operating assets and  liabilities:                                               |   |     |   |     |   |     |   |
| Accounts receivable                                                                        |   | (1,942   | )      | (2,817   | )      | (2,448   | )      |
| Prepaid and other assets                                                                   |   | (432     | )      | (239     | )      | (243     | )      |
| Accounts payable                                                                           |   | 8,025    |   | 2,916    |   | 3,319    |   |
| Deferred revenue                                                                           |   | 759      |   | (727     | )      | 1,681    |   |
| Accrued payroll and other  accrued liabilities                                             |   | (1,776   | )      | (1,157   | )      | 1,820    |   |
| Net cash provided by (used in)  operating activities                                       |   | 17,583   |   | 547      |   | (17,012  | )      |
| INVESTING ACTIVITIES:                                                                      |   |     |   |     |   |     |   |
| Purchases of investments                                                                   |   | —   |   | (13,000  | )      | (12,034  | )      |
| Sales and maturities of  investments                                                       |   | 9,978    |   | 17,999   |   | 36,416   |   |
| Cash paid for acquisitions,  net of cash received                                          |   | (5,383   | )      | (1,460   | )      | (45      | )      |
| Purchases of equipment                                                                     |   | (5,236   | )      | (5,890   | )      | (9,380   | )      |
| Patent acquisition costs                                                                   |   | —   |   | (7       | )      | (26      | )      |
| Net cash provided by (used in)  investing activities                                       |   | (641     | )      | (2,358   | )      | 14,931   |   |
| FINANCING ACTIVITIES:                                                                      |   |     |   |     |   |     |   |
| Net proceeds from sales of  common stock                                                   |   | 380      |   | 541      |   | 292      |   |
| Exercise of stock options and  warrants                                                    |   | 4,302    |   | 6,294    |   | 3,589    |   |
| Repurchase of common stock                                                                 |   | —   |   | (267     | )      | —   |   |
| Repayment of notes payable                                                                 |   | (2,500   | )      | —   |   | —   |   |
| Net cash provided by financing  activities                                                 |   | 2,182    |   | 6,568    |   | 3,881    |   |
| NET INCREASE (DECREASE) IN  CASH AND CASH EQUIVALENTS                                      |   | 19,124   |   | 4,757    |   | 1,800    |   |
| CASH AND CASH EQUIVALENTS,  beginning of period                                            |   | 21,677   |   | 16,920   |   | 15,120   |   |
| CASH AND CASH EQUIVALENTS, end  of period                                                  |   | $        | 40,801 |     | $      | 21,677   |   | $ | 16,920 |   |
|                                                                                       |   |     |   |     |   |     |   |
| NONCASH INVESTING AND  FINANCING ACTIVITIES:                                               |   |     |   |     |   |     |   |
| Common stock issued in  acquisitions and earn-outs                                         |   | $        | 2,555  |     | $      | 14,379   |   | $ | 9,093 |   |
| Issuance of note payable in  acquisition                                                   |   | —   |   | 2,500    |   | —   |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

46

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**DIGITALRIVER, INC.**

**Notesto Consolidated Financial Statements**

**December 31,2002 and 2001**

 

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

 

Digital River, Inc., aDelaware corporation, and its wholly owned subsidiaries (collectively, theCompany) provide a suite of electronic commerce services to its clients,including web store development and hosting, transaction processing, electronicsoftware delivery, fraud screening, customer service and analytical marketing. Throughcontractual relationships with software publishers and online retailers, theCompany offers software products for sale via the Internet. Beginning in late1998, the Company also began to offer electronic commerce services to companiesoutside of the software vertical market. The Company was incorporated in 1994and conducted its first online sale through a client’s Web store inAugust 1996.

 

The Company has experiencedsignificant losses since inception ($103.6 million through December 31, 2002)and has, until the later stages of 2001, experienced significant negative cashflows from operations. The Company’s prospects must be considered in light ofthe risks frequently encountered by companies in their early stage ofdevelopment, particularly companies in new and rapidly evolving markets such aselectronic commerce. To address these risks, the Company must, among othersthings, maintain existing and develop new relationships with independentsoftware publishers, online retailers and other companies outside of thesoftware market, maintain and increase its client base, implement andsuccessfully execute its business and marketing strategy, continue to developand upgrade its technology and transaction-processing systems, provide superiorcustomer service and order fulfillment, respond to competitive developments,and attract, retain and motivate qualified personnel. There can be noassurances that the Company will be successful in addressing such risks, andthe failure to do so could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

***Principlesof Consolidation***

 

The consolidated financialstatements include the accounts of Digital River, Inc. and its whollyowned subsidiaries. All intercompany balances and transactions have beeneliminated in consolidation.

 

***Cashand Cash Equivalents***

 

The Company considers 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 maturities of three months or less to be cashequivalents.  As of December 31, 2002and 2001, cash balances of approximately $3.0 million and $1.4 million,respectively were maintained related to potential future creditcard fees and chargebacks.

 

***Investments***

 

Investments held by the Companyare classified as available for sale securities and are carried at their marketvalue with cumulative unrealized gains or losses recorded as a component ofaccumulated other comprehensive losses within stockholders’ equity.

 

The following is a summary ofthe Company’s investment securities:

 
|              |   | **Cost** |      | **Fair Value** |   |
|-------------------|--------|----------|-----------|----------------|--------|
| December 31, 2001 |   |     |      |           |   |
| Commercial Paper  |   | $        | 9,978,000 |           | $      | 9,978,000 |   |
|                   |        |          |           |                |        |  |  |

 

As of December 31, 2001,all securities were due in less than one year. The Company had proceeds fromsales of investments of $9,978,000, $17,999,000, and $36,416,000 in 2002, 2001and 2000, respectively. The cost basis of investments and gains and losses arebased on specific identification. Realized gains and/or losses on sales ofinvestments were not significant in the 2002, 2001 and 2000.

 

47

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***Property andEquipment***

 

Property and equipment isstated at cost and is being depreciated under the straight-line method usinglives of three to seven years and consists mainly of computer equipment andsoftware licenses.

 

***Long-Lived Assets***

 

The Company will recordimpairment losses on long-lived assets when indicators of impairment arepresent and the undiscounted cash flows estimated to be generated by the assetsare less than the carrying amount of such assets.

 

***Patents***

 

The costs of developing patentsare amortized over a three-year period utilizing the straight-line method ofamortization once the patent application is filed. As of December 31, 2002,currently existing patents have been fully amortized.  Patents are included in other assets on the accompanyingconsolidated balance sheets, net of accumulated amortization of $435,000 and$400,000 as of December 31, 2002 and 2001.

 

**FairValue of Financial Instruments**

 

Thecarrying amount of cash and cash equivalents, accounts receivable, notespayable and accounts payable approximates fair value because of the shortmaturity of these instruments.

 

***RevenueRecognition***

 

The Company recognizes revenuefrom services rendered once all the following criteria for revenue recognitionhave been 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. The Company derives its revenue primarily from transactionand service fees associated with the e-commerce services provided to itsclients. These services include Web commerce hosting, transaction processing, digitaland physical fulfillment services, fraud screening, customer service andmerchandising and analytical marketing services. The Company acts as themerchant of record on the majority of the transactions processed and hascontractual relationships with its clients, primarily software publishers andonline retailers, which obligate the Company to pay to the client a specifiedpercentage of each sale. The Company retains its transaction fee and alsocharges for various service fees. The Company also derives revenue fromproviding clients the right to use its software applications, integration,development and consulting services provided to clients. Signed contracts areobtained from clients prior to recognition of these revenues. Fees for the useof software applications and any integration and development work required toprovide on-going hosting services for the client are recognized ratably overthe term of the contract once collection is reasonably assured. Clients do nothave the right to take possession of the software applications used in thedelivery of services. Payments received in advance of revenue recognition, evenif non-refundable, are recorded as deferred revenue and recognized when earned.Revenues from consulting services are recognized as the services are provided.

 

Sales to foreign customersaccounted for 22%, 22% and 25% of sales for 2002, 2001 and 2000,respectively.  In addition, revenuederived from sales of product from one software publisher accounted forapproximately 23%, 15%, and 0% of total Company revenue in 2002, 2001 and 2000,respectively.

 

48

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***AdvertisingCosts***

 

The costs of advertising arecharged to sales and marketing expense as incurred. The Company incurredadvertising expense of $413,000, $2,084,000 and $2,253,000 in 2002, 2001, 2000,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. No income taxes were paid in any of the years presented.

 

***Stock-BasedCompensation***

 

At December 31, 2002, theCompany has two stock-based employee compensation plans, which are describedmore fully in Note 7.  The Companyaccounts for these plans under the recognition and measurement principles ofAPB Opinion No. 25, “Accounting for Stock Issued to Employees,” and relatedInterpretations.  No stock-basedemployee compensation cost is reflected in net loss, as substantially alloptions granted under these plans had an exercise price equal to the marketvalue of the underlying common stock on the date of the grant.  The following table illustrates the effecton net loss and net loss per share if the Company had applied the fair valuerecognition provision of Financial Accounting Standards Board Statement No.123, “Accounting for Stock-Based Compensation,” to stock-based employeecompensation.

 

The Company has elected toapply the disclosure-only provisions of SFAS No. 123, “Accounting forStock-Based Compensation” as amended by SFAS No. 148. Accordingly, the Companyaccounts for stock-based compensation using the intrinsic value methodprescribed in Accounting Principles Board Opinion (APB) 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 the Company’s Common Stock at the date of grant over the stockoption exercise price. Had compensation costs for these plans been determinedconsistent with SFAS No. 123, the Company’s net loss would have beenadjusted to the following pro forma amounts:

 
|                                                                                            |   | **For the Years Ended December 31,** |       |
|-------------------------------------------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                                                            |   | **2002**                             |       | **2001** |   | **2000** |   |
| Net loss, as reported                                                                           |   | $                                    | (510,000   | ) | $ | (19,222,000 | ) | $ | (38,116,000 | ) |
| Add: Stock-based compensation,  as reported                                                     |   | 37,000                               |       | 218,000 |   | 443,000 |   |
| Deduct: Total stock-based  compensation determined under fair value based method for all awards |   | (8,668,000                           | )          | (3,164,000 | ) | (11,484,000 | ) |
| Adjusted net loss, fair value  method for all stock-based awards                                |   | $                                    | (9,141,000 | ) | $ | (22,168,000 | ) | $ | (49,157,000 | ) |
|                                                                                            |   |                                 |       |   |   |   |   |
| Basic and diluted loss per  share — as reported                                            |   | $                                    | (0.02      | ) | $ | (0.79 | ) | $ | (1.78 | ) |
| Basic and diluted loss per  share — SFAS No. 123 adjusted                                  |   | $                                    | (0.34      | ) | $ | (0.91 | ) | $ | (2.30 | ) |

 

The fair value of each optiongrant is estimated on the date of grant using the Black-Scholes option pricingmodel with the following weighted average assumptions used: risk-free interestrates of 3.0%, 4.5%, and 6% in 2002, 2001, and 2000, respectively; no expecteddividends; expected lives of five years; and a volatility factor of 1.4, 1.1,and 1.2 in 2002, 2001, and 2000, respectively. The weighted average fair valueof the options granted in 2002, 2001, and 2000 was $7.16, $3.56, and $20.46,respectively.

 

***Net Loss per Share***

 

Basic loss per common share iscomputed by dividing net loss by the weighted average number of shares ofcommon stock outstanding during the year. The computation of diluted earningsper common share is similar to the computation of basic loss per common share,except that the denominator is increased for the assumed conversion ofconvertible securities and the exercise of dilutive options using the treasurystock method. The weighted average shares used in computing basic and dilutedloss per share were the same in each of the three years ended December 31,2002. Stock options and warrants totaling 6,115,950, 5,947,790 and 5,383,113for 2002, 2001 and 2000, respectively, were excluded from the computation ofloss per share as their effect was antidilutive.

 

***Useof Estimates***

 

The preparation of financialstatements in accordance with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Ultimate resultscould differ from those estimates.

 

49

----

 

***RecentAccounting Pronouncements***

 

In December 2002, the FASBissued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure—an amendment of SFAS No. 123.” This statement provides alternativemethods of transition for a voluntary change to the fair value method ofaccounting for stock-based employee compensation.  This statement also amends the disclosure requirements of SFASNo. 123 and ABP Opinion No. 28, “Interim Financial Reporting,” to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. The Company has implemented the annual reporting requirements for SFASNo. 148 at December 31, 2002 (see above). The Company has determined at this time to continue to account for allstock-based employee compensation plans under ABP Opinion No. 25.

 

In June 2002, theFinancial Accounting Standards Board issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities”.  SFAS No. 146 addresses financialaccounting and reporting for costs associated with exit or disposalactivities.  It nullifies Emerging Issues Task Force Issue No. 94-3,“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity”.  SFAS No. 146 requires that a liability berecognized for costs associated with an exit or disposal activity only when theliability is incurred.  SFAS No. 146 also establishes fair value as theobjective for initial measurement of liabilities related to exit or disposalactivities.  SFAS No. 146 is effective for exit or disposal activitiesthat are initiated after December 31, 2002.  The Company does not believethat this statement will have a material impact on its consolidated financialstatements.

 

**2. Goodwill and intangible assets**

 

In July 2001, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards(SFAS) No. 141, “Business Combinations” and No. 142, “Goodwill and OtherIntangible Assets.” SFAS No. 141 requires all business combinations initiatedafter June 30, 2001 to be accounted for using the purchase method.  Under SFAS No. 142, goodwill and intangibleassets with indefinite lives will no longer be amortized but are reviewed annually(or more frequently if impairment indicators arise) for impairment.  For acquisitions consummated by the Companysubsequent to July 1, 2001, the Company adopted the provisions of SFAS No. 141and 142 effective July 1, 2001.  TheCompany adopted the full provisions of SFAS No. 141 and 142 during the firstquarter of 2002.

 

The Company has assessedgoodwill impairment using a two-step approach based on reportable segments andreassessed any intangible assets, including goodwill, recorded in connectionwith earlier acquisitions. The Company completed its initial and annualrequired goodwill impairment tests under SFAS No. 142 in the first and fourthquarters of 2002, respectively, which indicated that there was no impairment ofgoodwill or other intangibles.

 

Upon adoption of SFAS No. 142,the Company discontinued the amortization of goodwill.  The following table presents areconciliation of net income (loss) and net income (loss) per share adjustedfor the exclusion of goodwill amortization:

 
|                                 |   | **Year ended  December 31,** |     |
|--------------------------------------|--------|------------------------------|----------|
|                                 |   | **2002**                     |     | **2001** |   | **2000** |   |
| Reported net income                  |   | $                            | (510,000 | ) | $ | (19,222,000 | ) | $ | (38,116,000 | ) |
| Add goodwill amortization            |   | —                       |     | 10,769,000 |   | 7,594,000 |   |
| Adjusted net income (loss)           |   | $                            | (510,000 | ) | $ | (8,453,000 | ) | $ | (30,522,000 | ) |
|                                 |   |                         |     |   |   |   |   |
| Reported net income (loss) per share |   | $                            | (0.02    | ) | $ | (0.79 | ) | $ | (1.78 | ) |
| Add goodwill amortization per share  |   | —                       |     | 0.44 |   | 0.35 |   |
| Adjusted net income (loss) per share |   | $                            | (0.02    | ) | $ | (0.35 | ) | $ | (1.43 | ) |

 

50

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The changes in the net carryingamount of goodwill for the year ended December 31, 2002, by operating segment,are as follows:

 
|                                     |   | **Software  andDigital Commerce  Services Division** |       | **E-BusinessServices Division** |   | **Total** |   |
|------------------------------------------|--------|------------------------------------------------------|------------|---------------------------------|--------|-----------|--------|
| Balance as of December 31,  2001         |   | $                                                    | 8,280,000  |                            | $      | 2,993,000 |   | $ | 11,273,000 |   |
| Goodwill from acquisitions and  earnouts |   | 2,790,000                                            |       | 4,635,000                       |   | 7,425,000 |   |
| Balance as of December 31,  2002         |   | $                                                    | 11,070,000 |                            | $      | 7,628,000 |   | $ | 18,698,000 |   |

 

Information regarding theCompany’s other intangible assets is as follows:

 
|                   |   | **Year Ended  December 31, 2002** |       |
|------------------------|--------|-----------------------------------|------------|
|                   |   | **Carrying amount  Gross**        |       | **Accumulated****amortization** |   | **Carrying  amount  Net** |   |
| Customer relationships |   | $                                 | 14,117,000 |   | $ | 8,171,000 |   | $ | 5,946,000 |   |
| Non-compete agreements |   | 3,150,000                         |       | 2,399,000 |   | 751,000 |   |
| Technology/tradename   |   | 5,675,000                         |       | 4,026,000 |   | 1,649,000 |   |
| Total                  |   | $                                 | 22,942,000 |   | $ | 14,596,000 |   | $ | 8,346,000 |   |

 
|                   |   | **Year Ended  December 31, 2001** |       |
|------------------------|--------|-----------------------------------|------------|
|                   |   | **Carrying  amount**              |       | **Accumulated  amortization** |   | **Net** |   |
| Customer relationships |   | $                                 | 9,317,000  |   | $ | 4,728,000 |   | $ | 4,589,000 |   |
| Non-compete agreements |   | 3,050,000                         |       | 1,610,000 |   | 1,440,000 |   |
| Technology/tradename   |   | 5,425,000                         |       | 2,520,000 |   | 2,905,000 |   |
| Total                  |   | $                                 | 17,792,000 |   | $ | 8,858,000 |   | $ | 8,934,000 |   |

 

Estimated amortization expensefor the remaining life of the intangible assets, based on intangible assets asof December 31, 2002, is as follows:

 
| 2003 |   | $         | 4,727,000 |   |
|------|--------|-----------|-----------|--------|
| 2004 |   | 3,190,000 |      |
| 2005 |   | 429,000   |      |

 

**3. Acquisitions and Purchases of Assets:**

 

In March 2002, pursuant to anAsset Purchase Agreement between the Company and Innuity Acquisition Corp.(“IAC”), the Company purchased certain assets for approximately $2,400,000 incash and assumed approximately $3,600,000 in merchant liabilities.  Goodwill of $4,215,000 was recorded as aresult of this agreement.  The Companywill amortize intangible assets acquired, consisting of customer base,non-compete agreements and technology/tradename over a three-year period.  The agreement includes an opportunity for acash earn-out based on revenue generated from the IAC assets during the12-month period following the close of the transaction.  Such earn-out amount, if any, will berecorded as additional goodwill.

 

In March 2002, pursuant toan Amended and Restated Asset Purchase Agreement (the “Agreement”) between theCompany and Beyond.com Corporation (“Beyond.com”), in exchange for 179,096shares of the Company’s Common Stock, the Company purchased those assets andassumed those liabilities of Beyond.com related to its eStores business, whichmanages online stores for clients.  TheCompany will amortize intangible assets acquired, consisting of customer relationships and non-compete agreements,over a three-year period.  The purchasewas approved by the U.S. Bankruptcy Court following Beyond.com’s filing forChapter 11 bankruptcy protection. Immediately following the closing of the Agreement, the Company enteredinto a Post-Closing Amendment to the Agreement with Beyond.com (the“Post-Closing Amendment”), pursuant to which, among other things, the Companyagreed to increase the number of shares to be delivered to Beyond.com under theAgreement to 222,842, in exchange for a release of certain potential claims byBeyond.com against the Company.  ThePost-Closing Amendment is subject to approval by the U.S. BankruptcyCourt.  The Official Committee ofUnsecured Creditors  (“Committee”) ofBeyond.com’s bankruptcy estate has objected to the Post-Closing Amendment,asserting that the increase in shares to be delivered to Beyond.com under thePost-Closing Amendment is inadequate. The hearing on Beyond.com’s motion to approve the Post-Closing Amendmentwas originally set for June 7, 2002. The 

 

51

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parties, with the approval ofthe U.S. Bankruptcy Court, have agreed to continue the hearing on severaloccasions.  The U.S. Bankruptcy Court iscurrently scheduled to consider the Post-Closing Amendment on May 23, 2003.  Beyond.com is also asserting that it isentitled to additional shares with a value of $650,000 under the Agreementpursuant to provisions of the Agreement under which Beyond.com could earnadditional consideration post-closing if certain clients of Beyond.comimmediately prior to the closing maintain or establish client relationshipswith the Company following the closing. The Company disagrees that any of such shares are due to Beyond.comunder the Agreement. Of the shares issued at closing, 70,000 shares were placedin escrow to secure certain indemnification obligations contained in theAgreement.  The parties agreed to thereturn of 8,277 shares to the Company to satisfy outstanding claims under theescrow.  An additional 14,482 of theseshares are subject to additional outstanding claims and will remain in escrowpending resolution of such claims; the remaining 47,241 shares have beenreleased to Beyond.com.

 

In connection with theCompany’s purchase of the FreeMerchant.com assets of Network Commerce inDecember 2001, the former owners of Network Commerce received earn-out paymentstotaling $420,000 during the twelve months ended December 31, 2002.  The Company recorded such amounts asadditional goodwill.

 

In connection with theCompany’s acquisition of all the outstanding stock of RegSoft.com (“Regsoft”)in February 2001, additional goodwill of $2,750,000 was recorded as part of anearn-out agreement during the twelve months ended December 31, 2002.  In consideration for this earn-out, theformer stockholders of RegSoft received earn-out payments of $2,210,000 inNovember of 2002 and a note payable for the remaining $540,000 which is payablein March of 2003.  This note payable isincluded in accounts payable in our consolidated balance sheet as of December 31,2002.

 

Following is an allocation of thenet assets acquired from the acquisitions consummated and amounts paid underearnout arrangements in 2002 and 2001.

 
|                   |   | **2002**   |      | **2001**   |   |
|------------------------|--------|------------|-----------|------------|--------|
| Tangible assets        |   | $          | 231,000   |       | $      | 2,906,000 |   |
| Liabilities assumed    |   | (3,759,000 | )         | (2,063,000 | )      |
| Customer relationships |   | 4,800,000  |      | 4,255,000  |   |
| Non-compete agreements |   | 100,000    |      | 1,350,000  |   |
| Technology/tradename   |   | 250,000    |      | 3,425,000  |   |
| Goodwill               |   | 7,425,000  |      | 8,836,000  |   |
| Net assets acquired    |   | $          | 9,047,000 |       | $      | 18,079,000 |   |

 

 

The following unaudited proforma condensed results of operations for 2002, 2001, and 2000 has beenprepared as if each of the acquisitions in 2002 had occurred on January 1, 2001and as if each of the 2001 acquisitions had occurred on January 1, 2000.

 
|                              |   | **2002**   |       | **2001**    |   | **2000**    |   |
|-----------------------------------|--------|------------|------------|-------------|--------|-------------|--------|
| Revenue                           |   | $          | 79,722,000 |        | $      | 73,928,000  |   | $ | 44,053,000 |   |
| Loss from operations              |   | (3,425,000 | )          | (39,841,000 | )      | (72,126,000 | )      |
| Net loss                          |   | (3,854,000 | )          | (40,069,000 | )      | (70,386,000 | )      |
| Basic and diluted loss per  share |   | $          | (0.14      | )           | $      | (1.59       | )      | $ | (2.96 | ) |

 

This financial information doesnot purport to represent results that would actually have been obtained if thetransactions had been in effect on January 1, 2002, 2001, 2000 asapplicable, or any future results that may in fact be realized.

 

**4. Income Taxes:**

 

The reconciliation of thereported income tax expense to the amount the would result from applying theU.S. federal statutory rate of 35% to the net loss is as follows:

 
|                                               |   | **Year ended December 31,** |     |
|----------------------------------------------------|--------|-----------------------------|----------|
|                                               |   | **2002**                    |     | **2001** |   | **2000** |   |
| Tax benefit at statutory rate                      |   | $                           | (179,000 | ) | $ | (6,728,000 | ) | $ | (13,341,000 | ) |
| State taxes, net of federal  benefit               |   | 63,000                      |     | (1,000,000 | ) | (1,982,000 | ) |
| Stock compensation deductions                      |   | —                      |     | (258,000 | ) | (1,339,000 | ) |
| Non-deductible goodwill and  earn-out compensation |   | 712,000                     |     | 3,255,000 |   | 3,453,000 |   |
| Non-deductible expense and  other                  |   | 23,000                      |     | 585,000 |   | 285,000 |   |
| Change in valuation allowance                      |   | (619,000                    | )        | 4,146,000 |   | 12,924,000 |   |
| Total                                              |   | $                           | —   |   | $ | — |   | $ | — |   |

 

52

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As of December 31, 2002,the Company had net operating loss carryforwards of approximately $81,700,000.Included in this amount is approximately $16,700,000 of deductions resultingfrom disqualifying dispositions of stock options. When these deductions arerealized for financial statement purposes they will not result in a reductionin income tax expense, rather the benefit will be recorded as additionalpaid-in-capital. These income tax net operating loss carryforwards expirebeginning in the year 2009. Deductions from disqualifying dispositions of stockoptions are included in net operating loss carryforwards with a correspondingvaluation allowance.  Because of theuncertainty of future realization, a valuation allowance equal to the deferredtax asset has been recorded.

 

The components of deferredincome taxes are as follows:

 
|                                 |   | **2002**    |       | **2001**    |   |
|--------------------------------------|--------|-------------|------------|-------------|--------|
| Net operating loss  carryforwards    |   | $           | 32,490,000 |        | $      | 32,136,000 |   |
| Nondeductible reserves and  accruals |   | 1,972,000   |       | 369,000     |   |
| Depreciation and amortization        |   | 4,503,000   |       | 4,656,000   |   |
| Valuation allowance                  |   | (38,965,000 | )          | (37,161,000 | )      |
|                                 |   | $           | —     |        | $      | **—** | ** ** |

 

Ownershipchanges resulting from the issuance of additional equity will limit futureannual realization of the tax net operating loss carryforwards to a specifiedpercentage of the value of the Company under Section 382 of the InternalRevenue Code.

 

**5. Commitments andContingencies:**

 

**Leases**

 

TheCompany currently has four facility leases in addition to leasing certaincomputer equipment under non-cancelable operating leases. Total rent expense,including common area maintenance charges, recognized under all leases was$1,652,000, $1,367,000, and $839,000 for the years ended December 31,2002, 2001 and 2000, respectively. The minimum annual rents under long-termleases at December 31, 2002 were as follows:

 
| **Year ending December 31,** |   |    |      |
|-----------------------------------|--------|---------|-----------|
| 2003                              |   | $       | 1,103,000 |   |
| 2004                              |   | 745,000 |      |
| 2005                              |   | 468,000 |      |
|                              |   | $       | 2,316,000 |   |

 

**Litigation**

 

On February 27, 2002, ePedasinitiated arbitration before the American Arbitration Association against theCompany.  The demand for arbitrationalleged breach of contract and tortious interference claims against theCompany.  The case was transferred tothe International Section of the American Arbitration Association.  The matter was settled by way of asettlement agreement executed on October 22, 2002, and the arbitration wasdismissed on November 12, 2002.

 

In April 2002, we, along withRegSoft.com, Inc., a subsidiary of the Company, and Register Now!, a divisionof the Company, and other various defendants, became party to patentlitigation, regarding United States Patent No. 4,500,919 assigned to theMassachusetts Institute of Technology (hereinafter “MIT”) by the inventorWilliam F. Schreiber of Cambridge, Massachusetts.  MIT licensed the patent to Electronics for Imaging, Inc. and theparties jointly filed a lawsuit in the U.S. District Court in the Eastern Districtof Texas.  The suit is still pending.   Upon the determination of the claims’scope, the Company may file for a dismissal of the case if the court construesthe patent claims consistently with our position.  The Company believes these lawsuits are without merit and intendto defend against them vigorously.

 

In August 2001, theCompany and certain of its officers and directors were named as defendantsin several class action shareholder complaints filed in the United StatesDistrict Court for the Southern District of New York.  These actionsinclude (1) Whalen v. Digital River, Inc., et al., Case No. 01-CV-7355; and (2)Nicolois v. Digital River, Inc., et al., Case No. 01-CV-7992.  Similarcomplaints were filed in the same Court against hundreds of other publiccompanies that conducted IPOs of their common stock in the late 1990s. In eachof these complaints, the plaintiffs allege that the Company, certainof its officers and directors and its IPO underwriters violated thefederal securities laws because the Company’s IPO registration statementand prospectus contained untrue statements of material fact or omitted materialfacts regarding the compensation to be received by, and the stock allocationpractices of, the IPO underwriters. The plaintiffs seek unspecified monetarydamages and other relief.  The Companybelieves these lawsuits are without merit and intend to defend against themvigorously.

 

53

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The Company is alsoparty to patent litigation, along with other defendants, regarding UnitedStates Patent No. 6,014,651 owned by Christopher M. Crawford of Washington,D.C. The case was filed in August 2001 and is pending in the U.S. DistrictCourt in the District of Columbia. No substantive actions have taken place asyet in this case.  The Company believesthat it has meritorious defenses to, and intends to vigorously defend against,these claims.

 

**EmployeeBenefit Plan**

 

The Company has a definedcontribution 401(k) retirement plan for eligible employees.  Employees may contribute up to 15% of theirpretax compensation to the plan, with the Company providing a discretionarymatch of the employee contribution of up to 50% of the total employeecontribution.  Amounts charged toexpense related to the Company’s matching contributions for the years ended December31, 2002, 2001 and 2000 totaled $706,000, $559,400 and $408,100, respectively.

 

**6. Stockholders’Equity:**

 

***Warrants***

 

Warrants to purchase 101,667shares of Common Stock issued principally in conjunction with sales of CommonStock at an exercise price of $3.00 per share were outstanding as ofDecember 31, 2002.  The warrantsexpire at various dates between February and August 2003.

 

***Share Repurchase Program***

 

In April 2001, the Companyannounced a share repurchase program of up to $5,000,000 of its outstandingshares of Common Stock.  Repurchaseswill be at the Company’s discretion based on ongoing assessments of the capitalneeds of the business and the market price of its shares.  No shares were repurchased under thisprogram during 2002.  Shares repurchasedunder the program totaled 57,000 for total consideration of $267,000 in 2001.

 

**7. Stock Options:**

 

The Company’s 1998 Stock OptionPlan (the “SOP”) provides for the granting of incentive or nonqualified stockoptions to purchase up to 3,983,333 shares of Common Stock. Options granted toemployees typically expire no later than ten years after the date ofgrant.  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 to employees who immediately before suchgrant owned stock directly or indirectly representing more than 10% of thevoting power of the stock of the Company will have an exercise price of 110% ofthe fair market value of a share of common stock on the grant date and willexpire no later than five years from the date of grant.

 

The Company’s 1999 Non-OfficerStock Option Plan (the “NOP”) provides for the granting of nonqualified stockoptions to purchase up to 8,450,000 shares of Common Stock and has terms similarto those of the SOP.

 

A summary of the change inoutstanding options under the SOP and NOP is as follows:

 
|                       |   | **Options  Outstanding** |   | **Option Price  Per Share** |   |
|----------------------------|--------|--------------------------|--------|-----------------------------|--------|
| Balance, December 31, 1999 |   | 3,092,786                |   | $  .38 - $31.13   |   |
| Grants                     |   | 2,641,028                |   | 6.00 - 28.88                |   |
| Exercised                  |   | (303,533                 | )      | .38 - 23.40                 |   |
| Cancelled                  |   | (817,696                 | )      | 1.69 - 31.13                |   |
| Balance, December 31, 2000 |   | 4,612,585                |   | 1.13 - 31.13                |   |
| Grants                     |   | 3,631,533                |   | .01 - 6.74                  |   |
| Exercised                  |   | (679,336                 | )      | .01 - 11.75                 |   |
| Cancelled                  |   | (1,736,608               | )      | .01 - 31.13                 |   |
| 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              |   |

 

 

 

54

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A summary of information abouttotal stock options outstanding at December 31, 2002 is as follows:

 
|               |          | **Options Outstanding** |      | **Options Exercisable**              |       |
|--------------------|---------------|-------------------------|-----------|--------------------------------------|------------|
| **Exercise Price** |          | **Number  Outstanding** |      | **Weighted Average  Life Remaining** |       | **Number  Exercisable** |   | **Weighted  Average Price** |   |
| $                  | 1.69 - $3.88  |                    | 737,511   |                                 | 7.1  years |   | 392,970 |   | $ | 3.00 |   |
| 4.56 - 7.55        |          | 4,262,605               |      | 8.6 years                            |       | 1,195,005 |   | 5.47 |   |
| 8.50 - 13.92       |          | 430,414                 |      | 8.7 years                            |       | 138,226 |   | 12.85 |   |
| 16.54 - 31.13      |          | 623,753                 |      | 6.6 years                            |       | 519,292 |   | 21.96 |   |
| $                  | 1.69 - $31.13 |                    | 6,054,283 |                                 | 8.2 years  |   | 2,245,493 |   | $ | 9.30 |   |

 

TheCompany recorded compensation expense for the difference between the grantprice and the fair market value of the Company’s Common Stock on options topurchase 30,533 shares at an exercise price of $.01 issued in January 2001.

 

The Company also sponsors anemployee stock purchase plan under which 600,000 shares have been reserved forpurchase by employees. The purchase price of the shares under the plan is thelesser of 85% of the fair market value on the first or last day of the offeringperiod. Offering periods currently are each six months ending on June 30 andDecember 31. Employees may designate up to ten percent of their compensationfor the purchase of shares under the plan. Total shares purchased by employeesunder the plan were 49,000, 182,000, 113,000 in the years ended December 31,2002, 2001 and 2000, respectively.

 

**8. SegmentInformation:**

 

The Company has two operatingsegments, Software and Digital Commerce Services and E-Business Services, whichhave been identified as components of the Company that are reviewed regularlyby management to determine resource allocation and assess performance.Unallocated corporate items consist of depreciation, goodwill and otherintangibles amortization, acquisition-related costs and interest income for operationalresults and consist of certain cash, investments and goodwill for totalassets.  Segment information for 2002,2001 and 2000 is as follows:

 
|                                                           |   | **Software and  Digital Commerce  Services Division** |       | **E-Business  Services Division** |   | **Unallocated********Corporate  Items** |   | **Consolidated** |   |
|----------------------------------------------------------------|--------|-------------------------------------------------------|------------|-----------------------------------|--------|-----------------------------------------|--------|------------------|--------|
| **Year ended December 31, 2002:**                              |   |                                                  |       |                              |   |                                    |   |             |   |
| Revenue                                                        |   | $                                                     | 63,195,000 |                              | $      | 14,588,000                              |   | $                | — |   | $ | 77,783,000 |   |
| Gross profit (excludes  depreciation and amortization expense) |   | 53,482,000                                            |       | 10,539,000                        |   | —                                  |   | 64,021,000       |   |
| Income (loss) from operations                                  |   | 21,427,000                                            |       | (8,097,000                        | )      | (14,246,000                             | )      | (916,000         | )      |
| Net income (loss)                                              |   | 21,427,000                                            |       | (8,097,000                        | )      | (13,840,000                             | )      | (510,000         | )      |
| Total assets at December 31,  2002                             |   | 41,343,000                                            |       | 15,623,000                        |   | 38,727,000                              |   | 95,693,000       |   |
|                                                           |   |                                                  |       |                              |   |                                    |   |             |   |
| **Year ended December 31, 2001:**                              |   |                                                  |       |                              |   |                                    |   |             |   |
| Revenue                                                        |   | $                                                     | 44,914,000 |                              | $      | 12,911,000                              |   | $                | — |   | $ | 57,825,000 |   |
| Gross profit (excludes  depreciation and amortization expense) |   | 36,214,000                                            |       | 8,701,000                         |   | —                                  |   | 44,915,000       |   |
| Income (loss) from operations                                  |   | 10,672,000                                            |       | (9,139,000                        | )      | (21,636,000                             | )      | (20,103,000      | )      |
| Net income (loss)                                              |   | 10,672,000                                            |       | (9,139,000                        | )      | (20,755,000                             | )      | (19,222,000      | )      |
| Total assets at December 31,  2001                             |   | 20,858,000                                            |       | 9,159,000                         |   | 48,209,000                              |   | 78,227,000       |   |
|                                                           |   |                                                  |       |                              |   |                                    |   |             |   |
| **Year ended December 31, 2000:**                              |   |                                                  |       |                              |   |                                    |   |             |   |
| Revenue                                                        |   | $                                                     | 25,221,000 |                              | $      | 5,960,000                               |   | $                | — |   | $ | 31,181,000 |   |
| Gross profit (excludes  depreciation and amortization expense) |   | 18,119,000                                            |       | 3,718,000                         |   | —                                  |   | 21,387,000       |   |
| Income (loss) from operations                                  |   | (5,611,000                                            | )          | (15,936,000                       | )      | (18,565,000                             | )      | (40,112,000      | )      |
| Net income (loss)                                              |   | (5,611,000                                            | )          | (15,936,000                       | )      | (16,569,000                             | )      | (38,116,000      | )      |
| Total assets at December 31,  2000                             |   | 16,256,000                                            |       | 7,051,000                         |   | 46,096,000                              |   | 69,403,000       |   |

 

55

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** **

**INDEX TO EXHIBITS**

 
| **Exhibit  Number** |   | **Description Of Document**                                                                                                                                                                 |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)              |   | Asset  Purchase Agreement, dated August 24, 2000, by and between the Registrant and  NetSales, Inc.                                                                                         |
| 2.2(2)              |   | Asset  Purchase Agreement dated as of March 20, 2001, by and between the Registrant,  Calico Commerce, Inc. and ConnectInc.com, Co., a wholly-owned subsidiary of  Calico Commerce, Inc.    |
| 2.3(3)              |   | Amended and Restated Asset  Purchase Agreement dated February 9, 2002 by and between the Registrant  and Beyond.com.                                                                   |
| 2.4(4)              |   | First Amendment to the  Amended and Restated Asset Purchase Agreement dated as of March 15, 2002  by and between the Registrant and Beyond.com.                                        |
| 2.5(4)              |   | 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(5)              |   | 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(5)              |   | Certificate  of Amendment of Amended and Restated Certificate of Incorporation (amending  Exhibit 3.1).                                                                                     |
| 4.1(7)              |   | Specimen  Stock Certificate.                                                                                                                                                                |
| 4.2(5)              |   | Form of Senior  Debt Indenture.                                                                                                                                                             |
| 4.3(5)              |   | Form of  Subordinated Debt Indenture.                                                                                                                                                       |
| 4.4                 |   | References  are hereby made to Exhibits 3.1, 3.2 and 3.3.                                                                                                                                   |
| 10.1(5)             |   | Form of  Indemnity Agreement between Registrant and each of its directors and  executive officers.                                                                                          |
| 10.2(5)             |   | 1998 Stock  Option Plan.                                                                                                                                                                    |
| 10.3(5)             |   | Employment  and Non-Competition Agreement effective May 25, 1998 by and between Joel A.  Ronning and the Registrant.                                                                        |
| 10.4(5)             |   | Heads of  Agreement for International Agreement dated February 25, 1998 by and between  Christopher J. Sharples, David A. Taylor and the Registrant.                                        |
| 10.5(5)             |   | Form of  Conditional Warrant to Purchase Common Stock dated April 22, 1998 by and  between Wasserstein Adelson Ventures, L.P. and Registrant.                                               |
| 10.6(5)             |   | Form of  Warrant to Purchase Common Stock by and between certain investors and  Registrant.                                                                                                 |
| 10.7(5)             |   | Consent to  Assignment and Assumption of Lease dated April 22, 1998 by and between CSM  Investors, Inc., IntraNet Integration Group, Inc. and Registrant.                                   |
| 10.8(5)             |   | Assignment  of Lease dated April 21, 1998 by and between Intranet Integration Group, Inc.  and Registrant.                                                                                  |
| 10.9(5)             |   | Lease  Agreement dated January 18, 2000 between Property Reserve, Inc. and  Registrant.                                                                                                     |
| 10.10(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.). |
| 10.11(6)            |   | 1999 Stock  Option Plan, formerly known as the 1999 Non-Officer Stock Option Plan.                                                                                                          |
| 10.12(8)            |   | 2000 Employee Stock  Purchase Plan.                                                                                                                                                         |
| 10.13(2)            |   | Voting Agreement,  dated March 20, 2001, by and between the Registrant, Calico Commerce,  Inc. and ConnectInc.com, Co.                                                                 |
| 21.1                |   | Subsidiaries  of Digital River, Inc.                                                                                                                                                        |
| 23.1                |   | Consent of  Independent Auditors, dated March 24, 2003.                                                                                                                                     |
| 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.                   |
| 99.1                |   | Certification of Digital River, Inc.’s Chief Executive Officer, Joel  A. Ronning, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                           |
| 99.2                |   | Certification of Digital River, Inc.’s Chief Financial Officer,  Carter D. Hicks, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                           |
| 99.3                |   | Report of Independent Auditors                                                                                                                                                              |

 

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(1)                                  Incorporatedby reference from the Company’s Current Report on Form 8-K filed onSeptember 8, 2000.

(2)                                  Incorporatedby reference from the Company’s Current Report on Form 8-K filed onMarch 26, 2001.

(3)                                  Incorporated by reference from the Company’s Current Report on Form 8-Kfiled February 11, 2002

(4)                                  Incorporated by reference from the Company’s Current Report on Form 8-Kfiled April 15, 2002

(5)                                  Incorporatedby reference from the Company’s Registration Statement on Form S-3 (FileNo. 333-81626), declared effective on February 12, 2002.

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

(7)                                  Incorporatedby reference from the Company’s Registration Statement on Form S-1 (FileNo. 333-56787), declared effective on August 11, 1998.

(8)                                  Incorporatedby reference from the Company’s Registration Statement on Form S-8 (FileNo. 333- 53332) declared effective on January 8, 2001.

 

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