**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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FORM 10-K

**(Mark one)**

**ý**                                 AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**for the fiscal year ended December 31, 2003.**

**OR**

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

**CommissionFile Number:  000-24643**

**DIGITAL RIVER, INC.**

(Exact name of registrantas specified in its charter)

| **DELAWARE**                                                                         | ** ** | **41-1901640**                        |
|--------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  Incorporation or organization)                     |       | (I.R.S. Employer  Identification No.) |
|                                                                                 |       |                                  |
| **9625  WEST 76TH STREET, SUITE 150  EDEN PRAIRIE, MINNESOTA 55344**                 |
| (Address of  principal executive offices)                                            |
|                                                                                 |       |                                  |
| **(952) 253-1234**                                                              |
| (Registrant’s  telephone number, including area code)                           |
|                                                                                 |       |                                  |
| 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:               |
|                                                                                 |       |                                  |
| **Common  Stock $0.01 par value**                                                    |

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

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

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

As ofJune 30, 2003, there were 28,502,350 shares of Digital River, Inc.common stock, issued and outstanding. As of such date, based on the closingsales price as quoted by the Nasdaq, 27,056,073 shares of common stock, havingan aggregate market value of approximately $518,124,000 were held by non-affiliates.For purposes of the above statement only, all directors and executive officersof the registrant are assumed to be affiliates.

The number of shares ofcommon stock outstanding at March 1, 2004 was 31,689,657 shares.

**DOCUMENTS INCORPORATED BY REFERENCE**

Certainsections of the Registrant’s definitive Proxy Statement for the 2004 AnnualMeeting of Stockholders are incorporated by reference in Part III of this Form 10-Kto the extent stated herein.

 

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**PART I**

**ITEM1. BUSINESS.**

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

Certain statements setforth or incorporated by reference in this Form 10-K, as well as inour Annual Report to Stockholders for the year ended December 31, 2003,constitute “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Words such as “believes”, “anticipates”,“expects”, “intends”, “estimates” and similar expressions are intended toidentify forward-looking statements, but are not the exclusive means ofidentifying such statements. These statements involve known and unknown risks,uncertainties and other factors that may cause our actual results, performanceor achievements, or industry results, to be materially different from anyfuture results, performance or achievements, or industry results, expressed orimplied by such forward-looking statements. Such factors include, among others:our limited operating history and variability of operating results; risksassociated with general economic uncertainty; our dependence on 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 riskfactors set forth under “Risk Factors” and elsewhere in this Form 10-K.We expressly disclaim any obligation to update or publicly release any revisionto these forward-looking statements after the date of this Form 10-K.

**Overview**

We are a provider of comprehensive electronic commerceoutsourcing solutions. We were incorporated in February 1994 and commencedoffering products for sale through our clients’ Web stores in August 1996.As a leading global e-commerce outsource provider, we enable our clients toaccess our proprietary electronic commerce system over the Internet. We havedeveloped a technology platform that allows us to provide a suite of electroniccommerce services, including Web commerce development and hosting, transactionprocessing, fraud screening, digital delivery, integration to physicalfulfillment and customer service. We also provide analytical marketing andmerchandising services to assist clients in increasing Web page viewtraffic to, and sales through, their Web commerce systems. We provide anoutsourcing solution that allows our clients to promote their own brands whileleveraging our investment in infrastructure and technology.  Some of our key clients includeDownloadSuperstore.com, H&R Block Inc., McAfee Security, a division ofNetwork Associates Inc., palmOne, Inc., Symantec Corp. and Trend Micro, Inc.

Our proprietary commerce network server technology, orCNS, serves as the platform for most of our solutions. Our technologyincorporates custom software applications that enable Web store authoring,electronic software delivery, fraud prevention, export control, merchandisingprograms and online registration. Using our platform, we create Web commercesystems for our clients that replicate the look and feel of each client’s Website. End-users enter the client site and are then seamlessly transferred toour commerce server. End-users can then browse for products and make purchasesonline, and once purchases are made, we either deliver the products digitallyto the end-user through the Internet or communicate the order through itsintegration into a number of third-party fulfillment agencies for physicalfulfillment. We also provide transaction processing services and collect andmaintain critical information about end-users. This information can later beused by our clients to facilitate add-on or upgrade sales and for other directmarketing purposes. We actively manage direct marketing campaigns for ourclients and also deliver purchase information and Web store traffic statisticsto our clients through online reporting.

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General information aboutus can be found at www.digitalriver.com under the “Investor Relations” link. Ourannual report on Form 10-K, quarterly reports on Form 10-Qand current reports on Form 8-K, as well as any amendments orexhibits to those reports are available free of charge through our website assoon as reasonably practicable after we provide them to the Securities andExchange Commission.

**IndustryBackground**

*Growth Of The Internet And Electronic Commerce.**  *TheInternet is a significant global communications medium, enabling millions ofpeople to share information and conduct business electronically. The increasingfunctionality, accessibility and adoption of the Internet have made it anattractive commercial medium. Online businesses can interact directly withend-users, both businesses and consumers, and can frequently adjust theirfeatured selections, shopping interfaces and pricing. The ability to reach andserve a large and global group of end-users electronically from a centrallocation and the potential for personalized low-cost customer interactionprovide additional economic benefits for online businesses. Unlike traditionalretail channels, online businesses do not have the burdensome costs of managingand maintaining a significant physical retail store infrastructure or thecontinuous printing and mailing costs of catalog marketing. Because of theseadvantages, online businesses have the potential to build large, globalcustomer bases quickly and to achieve potentially superior economic returnsover the long term. An increasingly broad base of products is being soldsuccessfully online, including computers, electronics, travel and entertainmentservices, brokerage services, apparel and music, as well as software products.

*Advantages Of Outsourcing Electronic Commerce.**  *Accordingto a Gartner Group study, the initial investment in an electronic commerce sitethat is functionally equivalent to most industry participants is $1.0 to$5.0 million and requires an average of five months to implement. Thestudy found that a market differentiating electronic commerce solution requiresan expenditure of $5.0 to $20.0 million. Additionally, to maintain ascalable, best-of-breed commerce solution, businesses must continue to investin technology, infrastructure and personnel related to electronic commercemanagement.

There are a number of advantages to outsourcingelectronic commerce, including: (i) avoiding the large, upfront and ongoinginvestment required to purchase, implement and maintain software applicationsand computer hardware; (ii) shortening the time to market as compared toin-house development and maintenance; (iii) shifting the ongoing financialburden and technology risk to a proven service provider; (iv) leveragingthe expertise of an outsource provider to accelerate growth of an onlinebusiness; and (v) allowing businesses to focus on their specific corecompetency. Because of these advantages, we believe that an increasing numberof businesses will outsource their electronic commerce needs.

*Opportunity For Electronic Commerce Outsourcing.**  *Webelieve that the market for electronic commerce outsourcing in the software anddigital products market as well as among manufacturers, distributors andretailers will continue to grow rapidly. We believe that providing anintegrated service offering of Web commerce development and hosting, ordermanagement, fraud prevention, site merchandising, reporting and analytics,digital fulfillment, integration to physical fulfillment, e-marketing andcustomer service is complex and requires upfront and ongoing investments insecure, reliable and scalable systems. Accordingly, we believe that asubstantial market opportunity exists for a comprehensive, cost-effective,outsourced electronic commerce solution for software publishers and onlineretailers as well as for manufacturers, distributors and retailers.

*The Digital River Solution.**  *We have developed a robustelectronic commerce technology platform and suite of e-commerce services tohelp businesses worldwide grow their online revenues and avoid the costs andrisks associated with running an electronic commerce operation in-house. Weprovide a complete, client-branded, electronic commerce outsourcing solutionthat includes Web commerce 

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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 ToClients.*

*Reduced Total Cost Of Ownership And Risk*

Businesses can reduce thetotal cost of ownership of their electronic commerce operation by leveragingour investment in technology, personnel and infrastructure. By reducing oreliminating the upfront and ongoing costs of hardware, software and personnelassociated with developing, customizing, deploying, maintaining and upgradingan in-house electronic commerce solution or software package, businesses canestablish and maintain an electronic commerce business at a lower total costand with little financial risk.

*Revenue Growth*

Our electronic commerce technology platform, marketingexpertise and large network of clients and partners provide our clients withthe potential to grow their online businesses.

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

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

In addition, through ourlarge client network, we believe we are uniquely positioned to help our clientsgrow their online businesses by providing them with access to new distributionchannels and products to sell. Clients can approve their products to be sold onother client sites and sell products owned and approved for sale by our otherclients. In addition, our software and digital products clients have theopportunity to increase exposure and sales of their products by offering partor all of their entire online product catalog to our network of online channelpartners, which includes online retailers, content sites and portals. This isbeneficial to both our software publishers and online channel partners becausewe eliminate the burden of developing and maintaining hundreds of relationships.The online channel partners also enjoy access to a much broader inventory ofsoftware products, and avoid the costs and risk of carrying physical inventory.

*Deployment Speed*

Companies can increase their speed to market byleveraging our outsourced business model, technology platform and remotecontrol tools to establish their electronic commerce business, typically in amatter of days or weeks.

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

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throughcomputer error or malfunction, and from our 24x7 customer service provided onbehalf of our clients.

**Strategy**

Our objective is to be the global leader in electroniccommerce outsourcing for software and digital products publishers and onlineretailers as well as for manufacturers, distributors and traditional retailersof physical goods.

We intend to achieve our objective through thefollowing key strategies:

*Promote Relationships With Software Publishers AndOnline Retailers.**  *Weplan to continue to build our inventory of software products through additionalcontractual relationships with software publishers. As of March 1, 2004,we had contracts with ­­­more than 23,000 software publishers and onlineretailers. We believe that our ability to provide comprehensive electroniccommerce 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 our online channelpartners.

Additionally, we believe that by increasing the numberof points of entry to the CNS, we will increase the number of transactions andrevenue through our network on behalf of our clients. Accordingly, in additionto expanding and developing relationships with software publishers, we seek toaggressively expand our network of online channel partners. Online channelpartners include traditional store-based and mail-order retailers with a Webpresence, online retailers dedicated to online commerce, as well as hightraffic content sites and portals desiring to add electronic commercefunctionality. Our model enables us to leverage our clients’ marketing resourcesto direct traffic to our software network.

*Develop And Expand Relationships With Manufacturers,Distributors And Retailers of Physical Goods.**  *In late1998, we began exploring electronic commerce outsourcing opportunities outsideof the software and digital products industry. During 1999, sales and marketingpersonnel were hired to develop contractual relationships to sell ourelectronic commerce outsourcing services to manufacturers, distributors andtraditional retailers. As of March 1, 2004, we were providing electroniccommerce services such as Web commerce development and hosting, transactionprocessing, fraud screening, digital delivery, integration to physicalfulfillment, merchandising services, analytical marketing and customer serviceto over 140 physical goods clients. Additionally, in September 2001, December 2001,and March 2002, we purchased certain assets of Orbit Commerce, Inc.,Network Commerce, Inc., and CCNow, Inc., respectively, allowing us tooffer Web hosting and electronic commerce services to nearly 12,000 smallbusiness sites. We believe that our ability to provide a proven, cost efficientelectronic commerce solution, which can typically be implemented in a one toeight week time frame, provides the basis for long-term relationships with ourphysical goods clients. We further believe that additional electronic commerceoutsourcing opportunities may develop as relationships with existing clientsexpand.

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

*Drive Growth Through Aggressive Merchandising AndMarketing.**  *We believe that we have developedtechnology, services, expertise and best practices in the areas of marketingand merchandising that can help our clients grow their online businesses by utilizingnumerous proven tools and programs and our expanding data warehouse of end-userpurchasing information to increase traffic, close ratios, average 

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order sizes and repeatpurchases. We will continue to develop and utilize a wide range of marketing andmerchandising programs and our growing data warehouse of end-user purchasinginformation to aggressively grow our clients’ businesses.

*Expand International Sales.**  *We believe thatthere is a significant opportunity to grow our business by expanding existingand new client sales through international online stores. Internet adoption,broadband adoption and e-commerce sales continue to show rapid growth in theEuropean and Asia-Pacific regions. We have seen significant growth in sales forthose clients that have offered international stores and we intend to continueto enhance our technology platform and services to increase sales in theseregions of the world.

*Leverage The Digital River Sales Network To ProvideNew Distribution And Sales Opportunities For Our Clients.**  *With our largenetwork of clients, catalog of software and digital products and online channelpartner relationships, we believe we can further grow our clients’ sales byoffering them more exposure and sales opportunities on a global basis. Wecontinue to expand our offering of network services to allow our clients todistribute and sell their products through new online channels and affiliates,and sell products offered by other companies. We believe our network is uniquein the marketplace, provides significant revenue opportunities and will help usbuild stronger relationships with our clients.

*Provide Clients With Value-Added Services.**  *Weproactively add new service offerings, such as our backup CD and search engineadvertising services, to help create new revenue streams for our clients andourselves.  We will continue toaggressively develop and offer new value-added services to create additionalsources of recurring revenue. Additionally, we will continue to develop andenhance our products and services that allow our clients to support newcommerce models, enhance their relationship with their customers andeffectively address new market segments. This includes but is not limited totry-before-you-buy sales, subscription sales, volume licensing, digital rightsmanagement and license management.

*Maintain TechnologyLeadership.**  *Webelieve that our CNS has given us a competitive advantage in the market forelectronic commerce outsourcing solutions. We will continue to invest in andenhance our CNS in order to increase functionality, reliability, scalabilityand performance and reduce costs. By leveraging our fixed-cost infrastructure,we will improve our ability to provide low cost, high value services to ourclients while utilizing the latest technology.

**Services**

We provide a broad range of services to our clients,including Web commerce development and hosting, digital delivery, integrationto physical fulfillment, transaction processing and fraud screening, customerservice, merchandising services and analytical-based e-marketing services.

*Web Commerce Hosting.**  *Weprovide hosted Web commerce capabilities for most of our software publisherclients and all of our online channel partners and physical goods clients. Formany of these clients, this outsourcing solution is mission critical andtherefore we operate data centers that perform and scale for continuous Webcommerce in a high demand environment. Our data centers feature fullyredundant, high-speed connections to the Internet, server capacity to handlerapid spikes in volume, 24x7 security and monitoring, back-up generators anddedicated power.

Our Web commerce capabilities are deployed quickly andefficiently for our clients, and can be implemented in many different ways,from hosted electronic commerce links behind “buy buttons” through fullymerchandised online stores. We match the branding and designs of our clients toprovide a seamless experience for end-users navigating from our clients’ Websites to their stores hosted on our CNS. We fully manage orders placed byend-users for payment processing, fraud screening and fulfillment, eitherdigitally or physically, as well as the end-user notifications that result fromthese processes. The transaction 

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information is captured inour data warehouse and made available to our clients via Web-based analysistools. This data warehouse is a powerful source for data analysis activitiesthat result in highly targeted merchandising, e-mail marketing campaigns,product offers and test/control marketing efforts.

*Digital And Physical Fulfillment Services.**  *Digitaldelivery eliminates many of the costs that exist in the physical distributionchain, such as packaging, shipping, warehousing and inventory carrying andhandling costs. We offer clients a sophisticated array of electronic softwaredelivery capabilities to permit delivery of digital products to an end-user’scomputer via the Internet, as well as more advanced OTA or “Over the Air”wireless delivery to handheld devices. Delivery is fulfilled when a copy of thedigital product is made from the master on our CNS platform and then securelydownloaded to the end-user. Optionally, end-users can create a CD on demand asa backup to their digital order. Our digital distribution model not onlyreduces costs, thereby increasing margins available to software publishers andonline channel partners, but also solves the shelf space problem constrainingproduct availability and sales. While most software publishers use our Webhosting services, certain software publishers use only our digital deliveryservices, which provide them with online distribution through our extensivenetwork of online channel partners.

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

*Transaction Processing And Fraud Screening.**  *Weprocess payment transactions generated by end-users ordering products throughour CNS. We support payments made via credit card, but also an expanding set ofnon-credit card payment methods such as wire transfers, purchase orders, moneyorders, direct debit checks and other payment methods popular in countrieslocated worldwide. The fraud screening component of the CNS uses bothrules-based and heuristic scoring methods to make a determination regarding thevalidity of the order, end-user and payment information. As the end-user isentering the order, up to 580 data reviews are processed in real-time.Depending on the contractual agreement, we can provide the use of ourproprietary fraud screening to clients for their own processing and screeningor completely shift the fraud screening and risk responsibility to us. When atransaction is completed and approved, and the ordered product has beendelivered, we process the order for payment.

*Customer Service.**  *We offerboth telephone and email customer support for products sold through our CNS onbehalf of our clients. We provide end-user assistance on order and deliveryquestions on a 24x7 basis and in more than a dozen different languages. We haveinvested, and continue to invest in, technology and infrastructure to providefast, efficient responses to customer inquiries, and to provide self-helpoptions to customers online. We also provide archiving services to theend-users that purchase digital products.

*Merchandising And Analytics-Based E-Marketing Services.**  *Weoffer a broad range of merchandising and analytics-based e-marketing servicesto our clients to help them drive additional store traffic and revenues.Clients are provided with detailed analyses of their Web stores covering sales,products, transactions, customer behavior and campaign dimensions. The CNScaptures all Web page visits, campaign tracking information, productbanner and pricing information and other data that can be used by our clientsto perform their own Web-based reporting and analyses.

We also offer advancedmarketing and merchandising services to assist clients in increasing responserates for their marketing efforts. These services include targeted andsegmented email campaigns for special promotions, upgrade notification programsand the presentation of complementary products and 

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bundledproducts or other programs designed to increase average order size based on atargeted end-user profile. In addition, through analytic services, we analyzetransaction and customer history to test and refine new marketing andmerchandising techniques and promotional approaches.

**Clients**

As a provider of comprehensive electronic commerceoutsourcing solutions, we are able to serve two distinctive client groups withone common infrastructure: (1) software publishers and online softwareretailers and (2) manufacturers, distributors and physical good retailers.

Through our software and digital commerce services, wedistribute software products through a network of software publishers andonline retailers. Online retailer clients include traditional store-based anddirect mail retailers with a Web presence, online retailers dedicated to onlinecommerce, as well as high traffic or niche Web site operators desiring to addelectronic commerce functionality. In a typical online retailer contract, weare responsible for: (i) a payment to the online retailer based on apercentage of net sales of software products that we distribute through theonline retailer’s Web site; (ii) the processing of payments made by end-users;(iii) the delivery of the software products to end-users; (iv) fraudscreening and the payment of applicable credit card transaction fees; (v) thecollection, payment and returns filing of applicable sales taxes; and (vi) thedistribution of a report to the online retailer detailing related salesactivity that we have processed. While most software publishers use our entiresuite of electronic commerce services, including Web hosting services, certainsoftware publishers use only our “channel services” whereby the softwarepublishers are provided with distribution and digital fulfillment capabilitythrough our extensive network of online retailers. In a typical softwarepublisher contract, we are responsible for: (i) the maintenance of mastercopies of software products in a secure format for distribution to end-users; (ii) apayment to the software publisher for the cost of software products that wedistribute through either a retailer’s Web site or through the publisher’s hostWeb site; (iii) fraud screening and the processing of payments made byend-users; (iv) the delivery of software products to end-users; (v) thepayment of applicable credit card transaction fees; (vi) the collection,payment and returns filing of applicable sales taxes; and (vii) thedistribution of a report to the software publisher detailing related salesactivity that we have processed.  As of March 1,2004, we had more than 23,000 contracts with software publishers and onlineretailers.

With our physical goods services, we have provided awide range of electronic commerce services to clients outside of the softwareindustry, primarily manufacturers, distributors and physical goods retailers.These services allow the client to perform electronic commerce on abusiness-to-business or business-to-consumer basis. In a typical physical goodscontract, we are responsible for: (i) Web commerce system design, hostingand integration into the client’s management system; (ii) the processingof payments made by end-users; (iii) the communication of orders to theclient or the client’s third-party fulfillment agency for delivery of theproduct to end-users; (iv) the fraud screening and processing of theapplicable credit card transaction to the client’s credit card processor; (v) customerservice; and (vi) the distribution of a report to the client detailingrelated sales activity that we have processed. As of March 1, 2004, wewere providing services to over 140 client sites, excluding nearly 12,000 smallbusiness sites serviced as a result of the purchase of certain assets ofNetwork Commerce, Inc. and Orbit Commerce, Inc. during 2001 and CCNow, Inc.in 2002.

Certain of our software publisher, online retailer andphysical goods service clients include: Autodesk, Inc., DownloadSuperstore.com, H&R Block Inc., McAfeeSecurity, a division of Network Associates Inc., palmOne Inc., PC Magazine,Scansoft, Inc., Sofware Oasis, Inc., Symantec Corp., Targus, Inc.,and Trend Micro, Inc.

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Beginning January 1,2004, we discontinued using the divisional structure of software and physicalgoods services to determine resource allocation and assess performance. Accordingly,in January 2004, we announced that we will no longer report theseactivities as separate business segments.

**Acquisitions**

In March 2002,pursuant to an Amended and Restated Asset Purchase Agreement (the “Agreement”)between us and Beyond.com Corporation (“Beyond.com”), we purchased those assetsand assumed those liabilities of Beyond.com related to its eStores business,which manages online stores for clients, in exchange for 179,096 shares of ourcommon stock. A total of 70,000 of such shares were placed in escrow (the “Escrow”)to secure certain indemnification obligations of Beyond.com under the Agreement.The purchase was approved by the U.S. Bankruptcy Court following Beyond.com’sfiling for Chapter 11 bankruptcy protection. Immediately following the closingof the Agreement, we entered into a Post-Closing Amendment to the Agreementwith Beyond.com (the “Post-Closing Amendment”) pursuant to which, among otherthings, we agreed to increase the number of shares to be delivered toBeyond.com under the Agreement to 222,842, in exchange for a release of certainclaims of Beyond.com against us. The Post-Closing Amendment was subject toapproval by the U.S. Bankruptcy Court. The Official Committee of UnsecuredCreditors (the “Committee”) of Beyond.com’s bankruptcy estate objected to thePost-Closing Amendment, asserting that the increase in shares to be deliveredto Beyond.com under the Post-Closing Amendment was inadequate, and alsoasserting the right to additional shares of our common stock under certainprovisions of the Agreement.

In April 2003,Beyond.com, the Committee and Digital River entered into a Settlement Agreement(the “Settlement Agreement”) pursuant to which we agreed to transfer anadditional 50,919 shares (in addition to the 222,842 shares previously agreedto) to Beyond.com, in exchange for the release by Beyond.com and the Committeeof their claims against us. The parties also agreed to resolve certain claimsby us against the 70,000 shares in the Escrow by transferring 55,123 of suchshares to Beyond.com and returning 14,877 of such shares to us. In May andJune 2003, the Settlement Agreement and the Post-Closing Amendment wereapproved by the Bankruptcy Court and subsequently consummated.

In January 2003,we acquired certain assets and assumed certain liabilities of Metatec®International, Inc.’s (“Metatec”) electronic software distribution (“ESD”)business in exchange for approximately $1.3 million in cash which has been paidas of December 31, 2003.  Goodwillof  $789,000 was recorded as a result ofthis agreement, including $126,000 in connection with an earn-out. We willamortize intangible assets acquired, consisting of a non-compete agreement andtechnology/tradename, over a three-year period. The agreement also providedMetatec the opportunity for additional cash earn-outs based on us achievingcertain revenue metrics related to the ESD business over the course of thetwelve months following November 1, 2002.

In March 2003,we acquired substantially all of the assets and assumed certain liabilities ofHartsell Holdings, Inc., (“Hartsell”) d/b/a Infocon America Corporation inconnection with its business of providing Web services for business-to-businesspublishers in exchange for approximately $1.1 million in cash which has been paidas of December 31, 2003. Goodwill of $953,000 was recorded as a result ofthis agreement. We will amortize other intangible assets acquired, consistingof non-compete agreements and technology/tradename, over a three-year period.The agreement also provides Hartsell the opportunity for additional cashearn-outs based on us achieving certain gross margin and revenue metricsrelated to the Web services for business-to-business publishers over the courseof the twelve months and, at our sole discretion, the twenty-four monthsfollowing the close of the acquisition. Such earn-out amounts, if paid, will berecorded as additional goodwill as they are considered incremental to thepurchase price.

In August 2003,we acquired substantially all of the assets and certain liabilities of TheRegistration Network, or Reg.Net, a provider of e-commerce services for authorsand vendors of try-before-you-buy software for the purchase price of $2.5 millionin cash, of which $1.4 million has been paid as of 

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December 31, 2003. Additional goodwill of$934,000 was recorded as a result of this acquisition. We will amortize otherintangible assets acquired, consisting of non-compete agreements, customer baseand technology/tradename, over a three-year period. The agreement also providesReg.Net the opportunity for an additional cash earn-out based on our achievingcertain revenue metrics related to the e-commerce services for authors andvendors of try-before-you-buy software over the course of the twelve monthsfollowing the close of the acquisition. Such earn-out amounts, if paid, will berecorded as goodwill as they are considered incremental to the purchase price.

In November 2003,we acquired substantially all of the assets and assumed certain liabilities ofEmetrix, Inc., a provider of e-commerce services for authors and vendorsof software for the purchase price of $2.6 million in cash, of which $1.7 millionhas been paid as of December 31, 2003. Additional goodwill of $601,000 wasrecorded as a result of this acquisition. We will amortize other intangibleassets acquired, consisting of non-compete agreements, customer base andtechnology/tradename, over a three-year period. The agreement also providesEmetrix the opportunity for additional cash or stock earn-outs based on ourachieving certain revenue metrics related to the e-commerce services forauthors and vendors of software over the course of the thirty-six months and,at our sole discretion, the sixty months following the close of the acquisition.Such earn-out amounts, if paid, will be recorded as goodwill as they areconsidered incremental to the purchase price.

In November 2003, we acquired substantially allof the assets and assumed certain liabilities of GameZone, Inc., aprovider of computer gaming resources and download destination sites on theWeb, for the purchase price of $1.1 million in cash, of which $934,000 hasbeen paid as of December 31, 2003. Additional goodwill of $821,000 wasrecorded as a result of this acquisition. We will amortize other intangibleassets acquired, consisting of non-compete agreements and technology/tradename,over a three-year period. The agreement also provides GameZone the opportunityfor additional cash or stock earn-outs based on our achieving certain revenuemetrics related to computer gaming resources and download destination sites onthe Web over the course of the thirty-six months and, at our sole discretion,the sixty months following the close of the acquisition. Such earn-out amounts,if paid, will be recorded as goodwill as they are considered incremental to thepurchase price.

**Sales And Marketing**

Wemarket our services directly to clients and prospective clients. We focus ourefforts on generating awareness for our brand, establishing our position as aglobal leader of electronic commerce outsourcing, generating leads in ourtarget markets and providing sales tools for our direct sales force. We conducta variety of highly integrated marketing programs to achieve these goals in aneffective and efficient manner. We currently market our services to clients viadirect marketing, print and electronic advertising, trade shows and events,public relations, media events and speaking engagements. We plan to increaseour overall marketing expenditures on a dollar basis, but maintain the currentlevel on a percentage basis.

Primarily,we sell our electronic commerce outsourcing services through a global, directsales force that is engaged in selling our services, which includes pre-sales,sales, sales support and staff located in offices in the United States and theUnited Kingdom. Our sales organization sells to top executives andvice-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 delivers demonstrations, presentations, collateral, ROIanalyses, proposals and contracts. We offer contract incentives on acase-by-case basis.

Wealso design and implement e-marketing and merchandising programs to help ourclients drive traffic to their online stores as well as increase close ratios,average order values and repeat purchases. Our e-marketing team utilizes arange of programs and tools such as search engine optimization, email marketingand store merchandising including specials, cross-sells and up-sells. This teamuses our extensive data warehouse tools to create targeted programs to driveincreased sales.

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As of February 29, 2004 we had 141 employeesengaged in sales and marketing including personnel in sales offices in theUnited States and the United Kingdom.

**Technology**

We deliver our electronic commerce outsourcingsolution primarily using our CNS. During 2003, we made substantial progressin  the enhancement of our nextgeneration software technology platform. The following is a brief descriptionof our CNS platform.

*Architecture.**  *Our scalable CNS is designed to handle tens ofthousands of individual electronic commerce stores and millions of products.The CNS consists of multiple pods of Sun Microsystems and Dell servers and aproprietary software application that serves dynamic Web pages usingOracle’s 8i and 9i database and 9iAS application server. Akamai’s worldwidecaching technology enables our platform engine to serve pages withconsistent page loadtimes across the world. Our CNS was designed to scaleto support growth by adding additional servers, CPUs, memory and bandwidthwithout substantial changes to the application. The CNS software code iswritten in modular layers, enabling us to quickly adapt in response to industrychanges, including bandwidth opportunities, payment processing changes,international requirements for taxes and export screening, new technologiessuch as Web Caches, ML, DHTML, VRML, SET, banking procedures and encryptiontechnologies. The CNS product search system, based on Verity’s technology,allows end-users to search for items across millions of potential products andthousands of categories specific to various product specifications, whilemaintaining a fast page response that is acceptable to the end-user. Weuse sophisticated database indexing coupled with a dynamic cache system toprovide flexibility and speed. These caches help increase the overall speed ofeach page and facilitate complex searches across our entire inventory ofsoftware products. The CNS has also been designed to index, retrieve andmanipulate all transactions that flow through the system, including detailedcommerce transaction and end-user interaction data. This enables us to createproprietary market profiles of each end-user and groups of end-users that canthen be used to create merchandising campaigns. Our CNS is also used forinternal purposes, including reporting and maintenance for fraud detection andprevention, physical shipping, return authorizations, back order processing andfull transaction auditing and reporting capabilities for all commercefunctions.

*WebCommerce System Maintenance.**  *Ourclients’ electronic commerce systems are built and maintained using the CNScentralized management system and remote control tools. Global changes thataffect all electronic commerce systems or groups of electronic commerce systemscan be made as easily as changes to an individual electronic commerce system.Client electronic commerce systems typically include a main store and mayoptionally include “channel sites” to which highly targeted traffic may berouted. Clients may also link specific locations on their Web stores todetailed product or category areas of the stores in order to better targettheir end-users’ interests.

*Security.**  *Our security systems control access to internalsystems and commerce data via the Internet. Internally, log-ins and passwordsare maintained for all systems, with additional log-ins, passwords and IPaccess control granted on an individual basis to only the required commerceareas for which the recipient is responsible. Multiple layers of firewallsprevent unauthorized access from outside or access to confidential data on theinside. We rely on certain encryption and authentication technology licensed fromthird parties to provide secure transmission of confidential information, suchas end-user credit card numbers. Unix, Oracle and Web server securityadditionally restrict access from the outside to the appropriate transactiondata. The CNS security system is designed not to interfere with the end-userexperience. We believe that clearing-house processing and additional passwordmechanisms that negatively impact digital delivery performance are not needed.The CNS security system does not allow direct access to any client or customerdata. It also ensures that all end-user requests for digital delivery ofproduct are through a valid CNS page and that the customer has purchasedthe product.

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*Data Center Operations.**  *Continuous data center operationsare crucial to our success. Our primary data center (DC1) is located in ourmain facility in Eden Prairie, Minnesota.  We also operate two additional data centers inMinneapolis, Minnesota (DC2) and in London, England (DC3). All Data centerlocations are currently processing transactions and downloads.  All transaction data is replicated from DC1 toDC2 & DC3 in less than 10 seconds. Our network software constantlymonitors clients’ electronic commerce sites and internal system functions andnotifies systems engineers if any unexpected conditions arise. We currentlylease three OC3 data lines and 2 Gigabit Ethernet lines from multiple vendorsand maintain a policy of adding additional lines if more than 50% of ourbandwidth capacity is consistently utilized. Accordingly, if one line fails,the other lines are able to assume the capacity of the failed line. In theevent of electrical power failure, we have three redundant diesel generatorsand two redundant UPS power supplies that protect the entire facility. We havealso installed a FM-200 automatic fire suppression system in the primary datacenter. All data centers currently utilize multiple levels of redundant systemsincluding load balancers, Web servers, application servers and disk arrays. Wecurrently have automatic failover processes in place in case of equipment orsoftware failure. When a fault is detected on a server, a process automaticallyde-configures that node from the production POD and processing continues on theredundant nodes of the POD.

**Product Research and Development**

Our product research and development strategy is toenhance the technology and features of our CNS. To this end, we have numerousdevelopment projects in process, including ongoing development of our CNStechnology, further advancements in our remote control technologies,business-to-business related technologies and advanced product distribution andmarketing technologies. Product research and development expenses were$10.0 million, $11.5 million and $11.2 million in 2003, 2002 and2001, respectively. As of February 29, 2004, we employed 125 persons inproduct research and development.

To remain competitive, wemust continue to enhance and improve the responsiveness, functionality andfeatures of the CNS 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 that addressthe increasingly sophisticated and varied needs of our clients, and respondingto technological advances and emerging industry standards and practices on acost-effective and timely basis. The development of our CNS technology andother proprietary technologies involves significant technical and businessrisks. We may fail to use new technologies effectively or fail to adapt ourproprietary technologies and systems to client requirements or emergingindustry standards.

**Competition**

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

·       in-housedevelopment of electronic commerce capabilities;

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·       otherproviders of 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;

·       companiesthat provide tools and services enabling one or more of the transactionprocessing functions of electronic commerce, such as transaction control, datasecurity, customer interaction and database marketing, including BroadVision, Inc.and CyberSource Corporation;

·       companiesthat sell, 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 principal competitive factors inour market are breadth of services and software product offerings, number ofsoftware publisher clients and online channel partnerships, brand recognition,system reliability and scalability, price, customer service, speed andaccessibility and ease of use, speed to market, convenience and quality offulfillment. The online channel partners and the other companies describedabove may compete directly with us by adopting a similar business model.Moreover, while some of these companies are also clients or potential clientsof ours, they may compete with our electronic commerce outsourcing solution tothe extent that they develop electronic commerce systems or acquire suchsystems from other software vendors or service providers.

Many of our competitorshave, and new potential competitors may have, more experience developingInternet-based software services and electronic commerce solutions,larger technical staffs, larger customer bases, more established distributionchannels and customer relationships, greater brand recognition and greaterfinancial, marketing and other resources than us. In addition, competitors maybe able to develop services that are superior to our services, achieve greatercustomer acceptance or have significantly improved functionality as compared toour existing and future products and services. Our competitors may be able torespond more quickly to technological developments and changes in customers’needs. Our inability to compete successfully against current and futurecompetitors could cause our revenue to decline.

**Intellectual Property**

We regard the protection of our trademarks,copyrights, trade secrets and other intellectual property as critical to oursuccess. We rely on a combination of patent, copyright, trademark, service markand trade secret laws and contractual restrictions to protect our proprietaryrights. We have entered into confidentiality and invention assignmentagreements with our employees and contractors, and nondisclosure agreementswith parties with whom we conduct business*,* in order tolimit access to and disclosure of our proprietary information. Thesecontractual arrangements and the other steps taken by us to protect ourintellectual property may not prevent misappropriation of our technology ordeter independent third-party development of similar technologies. Thus, wealso seek to protect our proprietary position by filing U.S. and foreign patentapplications related to our proprietary technology, inventions and improvementsthat are important to the development of our business. Proprietary rightsrelating to our 

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technologies will beprotected from unauthorized use by third parties only to the extent they arecovered by valid and enforceable patents or are effectively maintained as tradesecrets. We currently have six U.S. patents issued with 11 to 12 yearsremaining prior to expiration and several patent applications pending. Wepursue the registration of our trademarks and service marks in the U.S. andinternationally. We currently have 18 U.S. registered trademarks and tenregistered trademarks in the European Union and other countries. Effectivetrademark, service mark, copyright and trade secret protection may not beavailable in every country 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.

**Employees**

As of February 29,2004, we employed 503 people. We also employ independent contractors and othertemporary employees. None of our employees are represented by a labor union,and we consider our employee relations to be good. Competition for qualifiedpersonnel in our industry is intense, particularly among software developmentand other technical staff. We believe that our future success will continue todepend, in part, on our continued ability to attract, hire and retain qualifiedpersonnel.

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**Executive Officers**

Thefollowing table sets forth information regarding our executive officers during2003:
| **Name**        | ** ** | ** ** | ** ** | ** **                                                  | **Age** | ** ** | ** ** | **Position** |
|-----------------|------------|------------|------------|-------------------------------------------------------------|---------|------------|------------|--------------|
| Joel A. Ronning |       | 47         |       | Chief Executive Officer                                     |
| Carter D. Hicks |       | 57         |       | Chief Financial Officer                                     |
| Jay A. Kerutis  |       | 44         |       | President, Software and  Digital Commerce Services Division |
| Gary V. Howorka |       | 45         |       | Chief Technology Officer                                    |

 

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

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

Mr. Kerutis joined us in February 1999 asVice President of Sales, served as Executive Vice President, Software andDigital Commerce Services Division from January 2000 to December 2000and was President, Software and Digital Commerce Services Division from December 2000through September 2003. From February 2001 through September 2003,Mr. Kerutis was a member of the Office of the President. From March 1997to February 1999, Mr. Kerutis was Vice President—Retail Channel forMerisel Americas, Inc., a computer distributor. From April 1995 to March 1997,Mr. Kerutis was Vice President—Sales and Marketing for New MediaCorporation, a manufacturer of PC cards for notebook computers. Mr. Kerutisresigned as an executive officer of Digital River effective as of October 1,2003 and continues to report to the Chief Executive Officer on strategic salesmatters.

Dr. Howorka joined us in June of 2000 asChief Technology Officer. From May 1999 to June 2000, Dr. Howorkaheld several key roles at Ernst & Young LLP, an internationalaccounting and consulting organization, most recently as IBM E-BusinessPractice Director. From January 1999 to May 1999, Dr. Howorkaserved as Chief Technology Officer of Zonetrader.com, a business-to-businesse-commerce asset recovery organization. From May 1995 to October 1998,Dr. Howorka co-founded and served as Executive Vice President of FeedbackPlus, Inc., a survey software and services company. Dr. Howorka resignedas an executive officer of Digital River effective as of September 29,2003 and continued to report to the Chief Executive Officer on strategictechnology matters throughout the remainder of 2003.

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**RISKFACTORS**

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

**We have a historyof losses and we have yet to achieve sustained profitability.**

We were incorporated in February 1994 andconducted our first online sale through a client’s Web store in August 1996.We have sustained profitability for only six quarters and have incurredsignificant losses since we were formed. As of December 31, 2003, we had anaccumulated deficit of approximately $86.5 million. Our limited profitableoperating history makes it difficult to evaluate our ability to sustainprofitability in the future.

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

**Our operatingresults have fluctuated in the past and are likely to continue to do so, whichcould cause the price of our common stock to be volatile.**

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

·       ourability to attract and retain software publishers and online retailers asclients;

·       ourability to attract and retain physical goods clients;

·       fluctuationsin demand for certain products or services offered by us or our clients such asanti-virus software;

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

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

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

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

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

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

·       theperformance of our newly acquired assets or companies;

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

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

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

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

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

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

**A loss of anyclient that accounts for a large portion of our revenue would cause our revenueto decline.**

One software publisherclient, Symantec Corporation, accounted for approximately 27% of our revenue in2003. In addition, a limited number of other software and physical goodsclients contribute a large portion of our annual revenue. Contracts with ourclients are generally one or two years in length. If any one of these keycontracts is not renewed or otherwise terminates, and if we are unable toreplace it with other client agreements, our revenue would decline and ourability to sustain profitability would be impaired. It is important to ourongoing success that we maintain these key client relationships and, at thesame time, develop new client relationships.

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

We market our servicesdirectly to software publishers, online retailers and other prospects outsideof the software industry. These relationships are typically complex and taketime to finalize. Due to operating procedures in many organizations, a significantamount of time may pass between selection of our products and services by keydecision-makers and the signing of a contract. The period between the initialsales call and the signing of a contract with significant sales potential isdifficult to predict and typically ranges from six to twelve months. If at theend of a sales effort a prospective client does not purchase our products orservices, we may have incurred substantial expenses and expended managementtime that cannot be recovered and that will not generate corresponding revenue.As a result, our cash flow and our ability to fund expenditures incurred duringthe sales cycle may be impaired.

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**General economicuncertainty may reduce our revenue.**

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

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

·       longersales cycles;

·       deferralor delay of electronic commerce projects and generally reduced expenditures forelectronic commerce solutions and related services; and

·       increased pricecompetition.

**Our failure toattract and retain software publishers as clients would cause our revenue todecline.**

We generate revenue byproviding outsourced services to software publishers. If we cannot develop andmaintain satisfactory relationships with software publishers on acceptablecommercial terms, we will likely experience a decline in revenue. We alsodepend on our software publisher clients creating and supporting softwareproducts that end-users will purchase. If we are unable to obtainsufficient quantities of software for any reason, or if the quality of serviceprovided by these software publishers falls below a satisfactory level, wecould also experience a decline in revenue and end-user satisfaction, and ourreputation could be harmed. Our contracts with our software publisher clientsare generally one to two years in duration, with an automatic renewal provisionfor additional one-year periods, unless we are provided with a written noticeat least 90 days before the end of the contract. As is common in our industry,we have no long-term or exclusive contracts or arrangements with any softwarepublishers that guarantee the availability of software products. Softwarepublishers that currently supply software to us may not continue to do so andwe may be unable to establish new relationships with software publishers tosupplement or replace existing relationships.

**Our business plansdepend on increasing revenue from physical goods clients.**

The success of ourbusiness strategy also depends upon increasing fee and service revenue derivedfrom the sale of non-software products. We have made substantial investments intechnology and we may fail to establish and maintain sufficient relationshipswith physical goods clients to offset these expenses. If we are unable todevelop and expand our relationships with physical goods clients, we will failto grow revenue as projected, which would have a negative impact on our profitability.

**Implementing ouracquisition strategy could result in dilution and operating difficulties.**

We have acquired, andintend to continue engaging in strategic acquisitions of, businesses,technologies, services and products, such as businesses that provideoutsourcing services to software publishers. The process of integrating anacquired business, technology, service or product into our business andoperations may result in unforeseen operating difficulties and expenditures.Integration of an acquired business also may disrupt our ongoing business,distract management and make it difficult to maintain standards, controls andprocedures. Moreover, the anticipated benefits of any acquisition may not berealized. If a significant number of clients of the acquired businesses ceasedoing business with us, we would experience lost revenue, and any synergiesfrom the acquisition may be lost. Future acquisitions 

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couldresult in potentially dilutive issuances of equity securities, the incurrenceof debt, contingent liabilities, amortization of intangible assets orimpairment of goodwill.

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

Our success will depend in large part on the continuedgrowth in end-user acceptance of ESD as a method of distributing softwareproducts. ESD is a relatively new method of distributing software products toend-users, and unless ESD gains widespread market acceptance, we will be unableto achieve our business plan. Factors that will influence the market acceptanceof ESD include:

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

·       thecost of time-based Internet access;

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

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

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

**Developments inaccounting standards may cause us to increase our recorded expenses, which inturn would jeopardize our ability to demonstrate sustained profitability.**

In July 2001, we adopted Statement of FinancialAccounting Standard No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142).The statement generally establishes that goodwill and intangible assets withindefinite lives are not amortized but are to be tested on an annual basis forimpairment and, if impaired, are recorded as an impairment charge in incomefrom operations. As of December 31, 2003, we had unamortized goodwill withan indefinite life of $23.9 million, from our acquisitions made in 2003 andprevious years. If a portion of this balance is determined for any reason to beimpaired, the subsequent accounting of the impaired portion as an expense wouldlower our earnings and jeopardize our ability to demonstrate sustainedprofitability, which could cause our stock price to decline.

Additionally, theFinancial Accounting Standards Board is currently considering a proposal torequire that a valuation of stock options be reflected as an expense item infinancial statements. If this proposal were to be adopted, our recordednon-cash expenses would significantly increase, which would impair our abilityto maintain profitability.

**Increasing consumeracceptance of the Internet as a medium of commerce is important to the successof our business strategy and our future revenue growth.**

The failure of theInternet to continue developing into a significant commercial medium would harmour ability to increase our revenue and execute our business strategy. Rapidgrowth in the acceptance and use of the Internet as an effective medium ofcommerce is a recent development. The acceptance and use of the Internet maynot continue to develop and a sufficiently broad base of consumers may notadopt and continue to use the Internet as a medium of commerce. We rely onpurchasers who have historically used traditional means of commerce to purchasegoods or transact business. If we are to be successful, these purchasers mustaccept and use the Internet as a means of purchasing goods and services andexchanging information. We cannot predict the rate at which these purchaserswill do so.

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**The growth of themarket for our services depends on the development and maintenance of theInternet 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 made to the Internet as well as to individual client’s networkinginfrastructures to alleviate overloading and congestion. In addition, anydelays in the adoption of new standards and protocols required to governincreased levels of Internet activity or increased governmental regulation mayhave a detrimental effect on the Internet infrastructure.

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

The market forelectronic 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;

·       otherproviders of 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 SystemsCorporation, and IBM Global Services;

·       companiesthat provide tools and services enabling one or more of the transactionprocessing functions of electronic commerce, such as transaction control, datasecurity, customer interaction and database marketing, including BroadVision, Inc.and CyberSource Corporation;

·       companiesthat sell, 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.

Many of our competitorshave, and potential competitors may have, more experience developingInternet-based software, services and electronic commerce solutions, largertechnical staffs, larger customer bases, more established distribution channelsand customer relationships, greater brand recognition and greater financial,marketing and other resources than us. In addition, competitors may be 

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able todevelop services that are superior to our services, achieve greater customeracceptance or have significantly improved functionality as compared to ourexisting and future products and services. Our competitors may be able torespond more quickly to technological developments and changes in customers’needs. Our inability to compete successfully against current and futurecompetitors could cause our revenue to decline.

**Failure to properlymanage and sustain our expansion efforts could strain our management and otherresources.**

Our ability to successfully offer services andimplement our business plan in a rapidly evolving market requires an effectiveplanning and management process. We have rapidly and significantly expanded thedepth and breadth of our service offerings. Failure to properly manage thisexpansion could place a significant strain on our managerial, operational andfinancial resources. To manage this expansion, we are required to continually:

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

·       installnew management information systems; and

·       train,motivate, retain and manage our employees.

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

**Failure to developour technology to accommodate increased traffic could reduce demand for ourservices and impair the growth of our business.**

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

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

**Our industry ischaracterized by rapid technological change that may make our technology andsystems obsolete or cause us to incur substantial costs to adapt to thesechanges.**

To remain competitive, wemust continue to enhance and improve the responsiveness, functionality andfeatures of the CNS platform and the underlying network infrastructure. If weincur significant costs without adequate results, or are unable to adaptrapidly to technological changes, we may fail to achieve our business plan. TheInternet and the electronic commerce industry are characterized by rapidtechnological change, changes in user and client requirements and preferences,frequent new product and 

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serviceintroductions embodying new technologies and the emergence of new industrystandards and practices that could render our technology and systems obsolete.To be successful, we must adapt to rapid technological change by licensing andinternally developing leading technologies to enhance our existing services,developing new products, services and technologies that address theincreasingly sophisticated and varied needs of our clients, and responding totechnological advances and emerging industry standards and practices on acost-effective and timely basis. The development of our CNS technology platformand other proprietary technologies involves significant technical and businessrisks. We may fail to use new technologies effectively or fail to adapt ourproprietary technology and systems to client requirements or emerging industrystandards.

**System failurescould reduce the attractiveness of our service offerings.**

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

Our systems and operations are vulnerable to damage orinterruption from:

·       fire,flood and other natural disasters;

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

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

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

**We may becomeliable to clients who are dissatisfied with our services.**

We design, develop,implement and manage electronic commerce solutions that are crucial to theoperation of our clients’ businesses. Defects in the solutions we develop couldresult in delayed or lost revenue, adverse end-user reaction, and/or negativepublicity which could require expensive corrections. As a result, clients whoexperience these adverse consequences either directly or indirectly as a resultof our services could bring claims against us for substantial damages. Anyclaims asserted could exceed the level of any insurance coverage that may beavailable to us. Moreover, the insurance we carry may not continue to beavailable on economically reasonable terms, or at all. The successful assertionof one or more large claims that are uninsured, that exceed insurance coverageor that result in changes to insurance policies (including premium increases)could adversely affect our operating results or financial condition.

**Our chief executiveofficer and key technical employees are critical to our business, and if theydo not remain with us in the future, we may be unable to effectively replacethem.**

Our future successsignificantly depends on the continued services and performance of our seniormanagement, particularly Joel A. Ronning, our chief executive officer. Ourperformance also depends on our ability to retain and motivate our keytechnical employees who are skilled in maintaining our proprietary technologyplatform. The loss of the services of any of our executive officers or key technicalemployees could harm our business if we are unable to effectively replace thatofficer or employee, or if 

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thatperson should decide to join a competitor or otherwise directly or indirectlycompete with us. Further, we may need to incur additional operating expensesand divert other management time in order to search for a replacement. We donot maintain any key person life insurance policies.

**We must continuallyattract and retain technical and other key personnel in order to successfullyexecute our business strategy.**

Our future success depends on our ability to continueto identify, attract, hire, train, retain and motivate highly skilledtechnical, managerial, operations, merchandising, sales and marketing andclient service personnel. Competition for these personnel is intense,particularly in the Internet industry. We may be unable to successfully attract, assimilate or retainsufficiently qualified personnel. Failure to do so could harm our businessgrowth and profitability.  In addition,the market price of our common stock has fluctuated substantially since ourinitial public offering in August 1998. Consequently, potential employees may perceive our equity incentives asless attractive and current employees whose equity incentives are no longer attractivelypriced may choose not to remain with our organization.  In that case, our ability to attractemployees will be adversely affected. 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, we maybe limited in the use of stock options as equity incentives, which will make itmore difficult to compete for and attract qualified personnel.  Finally, should our stock price substantiallydecline, the retention value of stock options granted since our initial publicoffering will decline and employees who hold such options may choose not toremain with our organization.

**Protecting ourintellectual property is critical to our success.**

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

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

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**Claims ofinfringement of other parties’ intellectual property rights could require us toexpend significant resources, enter into unfavorable licenses or require us tochange our business plans.**

From time to time we are named as a defendant inlawsuits claiming that we have, in some way, violated the intellectual propertyrights of others. Existing lawsuits in this area, as well as any futureassertions or prosecutions of claims like these, could require us to expendsignificant financial and managerial resources. The defense of any claims, withor without merit, could be time-consuming, result in costly litigation anddiversion of technical and management personnel, cause product enhancementdelays or require that we develop non-infringing technology or enter intoroyalty or licensing agreements. Royalty or licensing agreements, if required,may be unavailable on terms acceptable to us or at all. In the event of asuccessful claim of infringement against us and our failure or inability todevelop non-infringing technology or license the infringed or similartechnology on a timely basis, we may be unable to pursue our current businessplan.

In August 2001, anaction was brought against us and other defendants in the U.S. District Courtin the District of Columbia alleging infringement of United States Patent No. 6,014,651owned by Christopher M. Crawford of Washington, D.C. Crawford alleges that wedirectly infringe the patent by the provision of online software purchase anddelivery 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. No substantive actions have taken 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. Discovery reopened in February 2004,and is ongoing. We have been in the process of preparing materials regardingclaim interpretation to present to the court, and we expect to do so at anappropriate point in the case. Although a number of co-defendants have settledwith plaintiff Crawford, at this time, Crawford has declined to make adefinitive demand for resolution of this case. We believe that this lawsuit is without meritand intend to defend against it vigorously.

**Claims against usrelated to the software products that we deliver electronically and thetangible goods that we deliver physically could also require us to expendsignificant resources.**

Claims may be made againstus for 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 createthese products, we are generally not in a position to know the quality ornature of the content of these products. Although we carry general liabilityinsurance and require that our customers indemnify us against end-user claims,our insurance and indemnification measures may not cover potential claims ofthis type, may not adequately cover all costs incurred in defense of potentialclaims, or may not reimburse us for all liability that may be imposed. Anycosts or imposition of liability that are not covered by insurance orindemnification measures could be expensive and time-consuming to address,distract management and/or delay product deliveries, even if we are ultimatelysuccessful in the defense of these claims.

**Security breachescould hinder our ability to securely transmit confidential information.**

A significant barrier to electronic commerce andcommunications is the secure transmission of confidential information overpublic networks. Any compromise or elimination of our security could be costlyto remedy, damage our reputation and expose us to liability, and dissuadeexisting and new clients from using our services. We rely on encryption andauthentication technology licensed from third parties to provide the securityand authentication necessary for secure transmission of confidentialinformation, such as end-user credit card numbers. A party who circumvents oursecurity measures could misappropriate proprietary information or interrupt ouroperations.

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

**Loss of our creditcard acceptance privileges would seriously hamper our ability to process thesale of digital goods.**

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

**The listing of ournetwork addresses on anti-SPAM lists could harm our ability to service ourclients and deliver goods over the Internet.**

Certain privacy and anti-emailproponents have engaged in a practice of gathering, and publicly listing,network addresses that they believe have been involved in sending unwanted,unsolicited emails commonly known as SPAM. In response to user complaints aboutSPAM, Internet service providers have from time to time blocked such networkaddresses from sending emails to their users. 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.

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

We are subject to the same federal, state and locallaws as other companies conducting business on the Internet. Today, there arerelatively few laws specifically directed towards conducting business on theInternet. The adoption or modification of laws related to the Internet couldharm our business, operating results and financial condition by increasing ourcosts and administrative burdens. Due to the increasing popularity and use ofthe Internet, many laws and regulations relating to the Internet are beingdebated at the international, federal and state levels. These laws andregulations could cover issues such as:

·       userprivacy with respect to adults and minors;

·       exportcompliance;

·       pricingand taxation;

·       fraud;

·       advertising;

·       intellectualproperty rights;

·       informationsecurity; and

·       qualityof products and services.

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Applicability to theInternet of existing laws governing issues such as property ownership,copyrights and other intellectual property issues, taxation, libel, obscenityand personal privacy could also harm our operating results and substantially increasethe cost to us of doing business. For example, numerous state legislatures haveproposed that tax rules for Internet retailing and catalog salescorrespond to enacted tax rules for sales from physical stores. Anyrequirement that we collect sales tax for each online purchase and remit thetax to the appropriate state authority would be a significant administrativeburden to us and possibly depress online sales. This and any other change inlaws applicable to the Internet might also require significant managementresources to respond appropriately. The vast majority of these laws wereadopted prior to the advent of the Internet, and do not contemplate or addressthe unique issues raised thereby. Those laws that do reference the Internet,such as the Digital Millennium Copyright Act, are only beginning to beinterpreted by the courts and their applicability and reach are thereforeuncertain.

**Laws relating touser information and online privacy may limit the collection and use ofend-user data for our clients.**

We collect and maintain end-user data for our clients,which subjects us to increasing international, federal and state regulationrelated to online privacy and the use of personal user information. Congressrecently enacted anti-SPAM legislation with which we must comply when providingemail campaigns for our clients. Bills are pending in Congress and in variousstates that address online privacy protections. Several states have proposed,and some have enacted, legislation that would limit the use of personal userinformation 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 on information obtained from minors. Focus has nowshifted to include online privacy protection for adults. If such legislation isadopted, it may include requirements that companies establish procedures to,among other things:

·       giveadequate notice to users regarding information collection and disclosurepractices;

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

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

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

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

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

**The adoption andimplementation of international laws and regulations applicable to electroniccommerce may impair our efforts to expand revenue from internationaltransactions.**

The European Union has adopted a privacy directivethat regulates the collection and use of information that identifies anindividual person. These regulations may inhibit or prohibit the collection andsharing of personal information in ways that could harm our clients or us. Theglobalization of Internet commerce may be harmed by these and similarregulations because the European Union privacy directive 

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prohibits transmission ofpersonal information outside the European Union. The United States and theEuropean Union have negotiated an agreement providing a “safe harbor” for thosecompanies who agree to comply with the principles set forth by the U.S.Department of Commerce and agreed to by the European Union. Failure to complywith these principles may result in fines, private lawsuits and enforcementactions. These enforcement actions can include interruption or shutdown ofoperations relating to the collection and sharing of information pertaining tocitizens of the European Union.

In addition, effective July 1,2003, the European Union implemented new rules regarding the collectionand payment of Value Added Tax, or VAT. These new rules require VAT to becharged on supply delivered over electronic networks, including software andcomputer services, as well as information and cultural, artistic, sporting,scientific, educational, entertainment and similar services. These services arenow being taxed in the country where the purchaser resides rather than wherethe supplier is located. Historically, suppliers of digital products thatexisted outside the European Union were not required to collect or remit VAT ondigital orders made to purchasers in the European Union. With theimplementation of these rules, we are required to collect and remit VAT ondigital orders received from purchasers in the European Union which effectivelyraises the price for these goods by the VAT amount. This price increase couldserve to discourage purchasing of our products and services which in turn couldadversely affect our operating results and financial condition.

**Compliance withfuture laws imposed on electronic commerce may substantially increase our costsof doing business or otherwise adversely affect our ability to offer ourservices.**

Because our services are accessible worldwide and wefacilitate sales of products to end-users worldwide, foreign jurisdictions mayclaim that we are required to comply with their laws. Laws regulating Internetcompanies outside of the United States may be less favorable than those in theUnited States, giving greater rights to consumers, content owners and users.Compliance may be more costly or may require us to change our businesspractices or restrict our service offerings relative to those provided in theUnited States. Any failure to comply with foreign laws could subject us topenalties ranging from fines to bans on our ability to offer our services.

As our services are available over the Internet inmultiple states and foreign countries, these jurisdictions may claim that weare required to qualify to do business as a foreign corporation in each stateor foreign country. We are qualified to do business only in California,Colorado, Connecticut, Illinois, Michigan, Minnesota, Utah and Washington. Failureto qualify as a foreign corporation in a required jurisdiction could subject usto taxes and penalties and could result in our inability to enforce contractsin these jurisdictions.

In addition, we aresubject to United States laws governing the conduct of business with othercountries, such as export control laws, which prohibit or restrict the exportof goods, services and technology to designated countries, denied persons ordenied entities from the United States. Any significant changes in these laws,particularly an expansion in the export control laws, will increase our costsof compliance and may further restrict our overseas client base.

**We intend tocontinue to expand our international operations and these efforts may not besuccessful in generating additional revenue.**

We sell products and services to end-users outside theUnited States and we intend to continue to expand our international presence.Expansion into international markets, particularly the European andAsia-Pacific regions, requires significant resources that we may fail torecover by generating additional revenue. Conducting business outside of theUnited States is subject to risks, including:

·       changesin regulatory requirements and tariffs;

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·       uncertaintyof application or governing of local laws;

·       reducedprotection of intellectual property rights;

·       difficultiesin physical distribution for international sales;

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

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

·       politicalor economic constraints on international trade or instability.

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.

**New obligations tocollect or pay sales tax could substantially increase the cost to us of doingbusiness.**

Currently, we collectsales, use or other similar taxes with respect to electronic software downloadin states where we believe that we have nexus. The application of sales relatedtaxes to interstate and international sales over the Internet is unclear andevolving. We are already required to collect and remit VAT in the EuropeanUnion, for example. Local, state or foreign jurisdictions may seek to imposesales or use tax collection obligations on out-of-state companies like oursthat engage in electronic commerce. A successful assertion by one or morestates or any foreign country that we should collect sales, use or other taxeson the sale of merchandise through our physical goods clients or on physicalshipments of software could harm our results of operations. In addition, anyfailure by a physical goods client to collect obligatory sales or use taxescould cause the relevant jurisdiction to attempt imposing that obligation onus.

**Compliance withchanging regulation of corporate governance and public disclosure may result inadditional expenses.**

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

**We may need to raiseadditional capital to achieve our business objectives, which could result indilution to existing investors.**

We require substantialworking capital to fund our business. If capital requirements vary materiallyfrom those 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 

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todevelop or enhance our services, take advantage of future opportunities orrespond to competitive pressures, which would harm our operating results andadversely affect our ability to sustain profitability.

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

The stock market, and the trading prices ofInternet-related companies in particular, have been notably volatile. This volatilityis likely to continue in the short-term and is not necessarily related to theoperating performance of affected companies. This broad market and industryvolatility could significantly reduce the price of our common stock at anytime, without regard to our operating performance. Factors that could cause ourstock price in particular to fluctuate include, but are not limited to:

·       actualor anticipated variations in quarterly operating results;

·       announcementsof technological innovations;

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

·       newproducts or services that we or our competitors offer;

·       changesin financial estimates by securities analysts;

·       conditionsor trends in the Internet and online commerce industries;

·       globalunrest and terrorist activities;

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

·       ourannouncement of significant acquisitions, strategic partnerships, jointventures or capital commitments;

·       additionsor departures of key personnel; and

·       sales or other transactionsinvolving our common stock.

**Volatility in ourstock price may induce securities class-action litigation against us, and theexpense of defense could harm our results of operations.**

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

The IPO lawsuit, which is more fully described under “LegalProceedings,” as well as any future allegations that we may have, in some way,violated securities laws could require us to expend significant financial and managerialresources and could result in further volatility of our stock price. Thedefense of any claims, with or without merit, could be time-consuming, resultin costly litigation and divert technical and management personnel.

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

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

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recognitionof taxes may adversely affect the trading price of our stock in the stockmarket. It is also possible under existing accounting rules that we may berequired to record income tax expense although we may have no cash outlay forthese taxes or the ability to recognize the deferred tax asset under currentaccounting rules.

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

Certain provisions of our Amended and RestatedCertificate of Incorporation, Bylaws, other agreements and Delaware law couldmake it more difficult for a third-party to acquire us, even if a change incontrol 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 twofacilities in Eden Prairie, Minnesota. The leases on both facilities expire inSeptember 2005. We also lease approximately 4,300 square feet of officespace in Chicago, Illinois, expiring in October 2007 and approximately4,700 square feet of office space in suburban London, England, expiring inDecember 2006. In addition, we lease approximately 1,100 square feet ofoffice space in Salt Lake City, Utah, expiring in November 2005,approximately 800 square feet of office space in Issaquah, Washington, expiringin April 2007, and on a month-to-month basis approximately 500 square feetof office space in Colorado Springs, Colorado.

**ITEM 3. LEGAL PROCEEDINGS.**

Beginning in August 2001, we and certainof our officers and directors were named as defendants in several classaction shareholder complaints filed in the United States District Court for theSouthern District of New York, now consolidated as *In re DigitalRiver, Inc. Initial Public Offering Securities Litigation,* CaseNo. 01-CV-7355. Similar complaints, referred to here as the IPO Lawsuits,were filed in the same court against hundreds of other public companies,referred to here as the Issuers. In the consolidated amended complaint, theplaintiffs allege that we, certain of our officers and directors and theunderwriters of our initial public offering, or IPO, violated Section 11of the Securities Act of 1933 based on allegations that our IPO registrationstatement and prospectus failed to disclose material facts regarding thecompensation to be received by, and the stock allocation practices of, the IPOunderwriters. The complaint also contains a claim for violation ofSection 10(b) of the Securities Exchange Act of 1934 based onallegations that this omission constituted a deceit on investors. Theplaintiffs seek unspecified monetary damages and other relief.

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

In July 2002, we joined in a global motion todismiss the IPO Lawsuits filed by all of the Issuers (among others). InOctober 2002, the parties agreed to toll the statute of limitations withrespect to certain of the named officers and directors until September 30,2003 and on the basis of this agreement, our officers and directors weredismissed from the lawsuit without prejudice. In February 2003, the courtissued a decision denying the motion to dismiss the Section 11 claimsagainst us and almost all of the other Issuers and denying the motion todismiss the Section 10(b) claims against us and many ofthe Issuers.

Duringthe summer of 2003, we, along with a substantial majority of Issuers,indirectly participated in discussions with the plaintiffs and the Issuers’respective insurers regarding a tentative settlement of the IPO Lawsuits.The terms of the tentative settlement would provide for, among other things, arelease of the Issuers and their officers and directors from all furtherliability resulting from plaintiffs’ claims, and the assignment to plaintiffsof certain potential claims that the Issuers may have against their IPOunderwriters. The tentative settlement also provides that, in the event thatplaintiffs ultimately recover less than a guaranteed sum of $1 billionfrom the IPO underwriters, plaintiffs would be entitled to payment by eachparticipating Issuer’s insurer of a pro rata share of any shortfall in theplaintiffs’ guaranteed recovery. In June 2003, pursuant to theauthorization of a special litigation committee of our board ofdirectors, we entered into a non-binding memorandum of understandingreflecting the settlement terms described above. In September 2003, inconnection with the possible settlement, our officers and directors whohad entered tolling agreements with plaintiffs (described above) agreed toextend those agreements so that 

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they would not expire prior to any settlement beingfinalized. Although we have approved this settlement proposal inprinciple, it remains subject to a number of procedural conditions, as well asformal approval by the Court. Pending definitive settlement, we continueto believe that the claims against us, our officers and directors are withoutmerit and intend to defend against it vigorously.

In August 2001, anaction was brought against us and other defendants in the U.S. District Courtin the District of Columbia alleging infringement of United States Patent No. 6,014,651owned by Christopher M. Crawford of Washington, D.C. Crawford alleges that wedirectly infringe the patent by the provision of online software purchase anddelivery 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. No substantive actions have taken place in this case. The court hasdelayed substantive discovery in this case, pending a preliminary determinationof the legal scope of Crawford’s claim. Discovery reopened in February 2004,and is ongoing. We have been in the process of preparing materials regardingclaim interpretation to present to the court, and we expect to do so at anappropriate point in the case. Although a number of co-defendants have settledwith plaintiff Crawford, at this time, Crawford has declined to make adefinitive demand for the resolution of this case. We believe that this lawsuit is without meritand intend to defend against it vigorously.

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

None.

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**PART II**

**ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY ANDRELATED STOCKHOLDER MATTERS.**

Ourcommon stock is traded on the Nasdaq National Market under the symbol “DRIV”. Publictrading of our common stock commenced on August 11, 1998. Prior to that,there was no public market for our common stock. The following table setsforth, for the periods indicated, the high and low sale price per share of ourcommon stock on the Nasdaq National Market. These over-the-counter marketquotations reflect inter-dealer prices, without retail mark-up, markdown orcommission, and may not necessarily represent actual transactions.
| ** **     | ** ** | **HIGH** | ** ** | **LOW** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **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 |   |
| **2003**       |       |     |       |    |       |
| First quarter  |       | $        | 14.57      |    | $          | 8.83 |   |
| Second quarter |       | $        | 20.10      |    | $          | 10.48 |   |
| Third quarter  |       | $        | 31.50      |    | $          | 18.50 |   |
| Fourth quarter |       | $        | 34.30      |    | $          | 21.10 |   |

 

As of March 1, 2004, there were approximately 398holders of record of our common stock. On March 1, 2004, the last saleprice reported on the Nasdaq National Market for our common stock was $22.10per share.

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

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

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**ITEM 6. SELECTED FINANCIAL DATA.**

Thefollowing selected financial data should be read in conjunction with theConsolidated Financial Statements and related notes.
| ** **                                                                                       | ** ** | **YEAR ENDED DECEMBER 31,**                         | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2003**                                                           | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |
| ** **                                                                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                          |       | $                                                                  | 101,201    |   | $ | 77,783 |   | $ | 57,825 |   | $ | 31,181 |   | $ | 14,507 |   |
| Costs and expenses  (exclusive of depreciation and amortization expense shown separately below): |       |                                                               |       |   |   |   |   |   |   |   |   |
| Direct cost of services                                                                          |       | 3,585                                                              |       | 2,357 |   | 2,710 |   | 1,477 |   | 801 |   |
| Network and infrastructure                                                                       |       | 12,253                                                             |       | 11,405 |   | 10,200 |   | 7,867 |   | 4,434 |   |
| Sales and marketing                                                                              |       | 37,220                                                             |       | 32,437 |   | 27,489 |   | 25,693 |   | 17,383 |   |
| Product research and development                                                                 |       | 9,962                                                              |       | 11,454 |   | 11,192 |   | 13,063 |   | 10,251 |   |
| General and administrative                                                                       |       | 9,228                                                              |       | 6,799 |   | 4,701 |   | 4,628 |   | 4,001 |   |
| Litigation and other charges                                                                     |       | —                                                             |       | 2,500 |   | — |   | — |   | — |   |
| Depreciation and amortization                                                                    |       | 7,275                                                              |       | 6,009 |   | 4,627 |   | 3,178 |   | 1,552 |   |
| Amortization of goodwill and other intangibles and  acquisition related costs                    |       | 5,380                                                              |       | 5,738 |   | 17,009 |   | 15,387 |   | 6,886 |   |
| Total costs and  expenses                                                                        |       | 84,903                                                             |       | 78,699 |   | 77,928 |   | 71,293 |   | 45,308 |   |
| Income (loss)  from operations                                                                   |       | 16,298                                                             |       | (916 | ) | (20,103 | ) | (40,112 | ) | (30,801 | ) |
| Interest income                                                                                  |       | 838                                                                |       | 406 |   | 881 |   | 1,996 |   | 3,148 |   |
| Net income (loss)                                                                                |       | $                                                                  | 17,136     |   | $ | (510 | ) | $ | (19,222 | ) | $ | (38,116 | ) | $ | (27,653 | ) |
| Net income (loss) per share—basic                                                           |       | $                                                                  | 0.58       |   | $ | (0.02 | ) | $ | (0.79 | ) | $ | (1.78 | ) | $ | (1.36 | ) |
| Net income (loss)  per share—diluted                                                        |       | $                                                                  | 0.52       |   | $ | (0.02 | ) | $ | (0.79 | ) | $ | (1.78 | ) | $ | (1.36 | ) |
| Shares used in  per-share calculation—basic                                                 |       | 29,398                                                             |       | 26,791 |   | 24,285 |   | 21,413 |   | 20,312 |   |
| Shares used in per-share  calculation—diluted                                               |       | 33,051                                                             |       | 26,791 |   | 24,285 |   | 21,413 |   | 20,312 |   |

 
| ** **                       | ** ** | **DECEMBER 31,**   | ** ** |
|----------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **2003**                | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |
| ** **                       | ** ** | **(in thousands)** | ** ** |
| **Balance Sheet Data:**          |       |                    |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents       |       | $                       | 101,878    |   | $ | 40,801 |   | $ | 21,677 |   | $ | 16,920 |   | $ | 15,120 |   |
| Short-term  investments          |       | 30,044                  |       | — |   | 9,978 |   | 14,977 |   | 24,387 |   |
| Working capital                  |       | 85,011                  |       | 14,498 |   | 14,024 |   | 17,038 |   | 28,777 |   |
| Total assets                     |       | 189,658                 |       | 96,534 |   | 78,780 |   | 69,403 |   | 87,142 |   |
| Accumulated  deficit             |       | (86,488                 | )          | (103,624 | ) | (103,114 | ) | (83,892 | ) | (45,776 | ) |
| Total stockholders’  equity |       | $                       | 131,852    |   | $ | 57,186 |   | $ | 50,422 |   | $ | 48,518 |   | $ | 73,077 |   |

 

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**ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATION.**

We are a provider of comprehensive electronic commerceoutsourcing solutions. We were incorporated in February 1994 and commencedoffering products for sale through our clients’ Web stores in August 1996.From inception through August 1996, we had no sales, and our activitiesrelated primarily to the development of our proprietary technology platform,known as CNS. In 1996, we began to focus our business development efforts onthe software industry, building our inventory of software products throughcontracts with software publishers. In 1997, we began to develop softwaredistribution relationships through contracts with online retailers. As of March 1**,**2004, we had more than 23,000 softwarepublisher clients and online channel partners. In late 1998, we began to offerour comprehensive electronic commerce outsourcing services in the form of atransaction fee-based e-commerce service to clients outside of the softwareindustry. As of March 1, 2004, we were providing electronic commerceservices such as Web commerce development and hosting, transaction processing,fraud screening, digital delivery, integration to physical fulfillment,merchandising services, analytical marketing and customer service to over 140physical goods clients, we well as operating nearly 12,000 small businessphysical goods sites.

Prior to January 1, 2004, we managed our physicalgoods clients through a division (formerly our E-Business ServicesDivision) that was separate from our Software and Digital Commerce ServicesDivision. Beginning in January 2004, this divisional structure wasconsolidated, and we announced that we will no longer report our activities asseparate business segments. Nonetheless, we remain committed to servingexisting and new clients in the important vertical market of physical goods.

We have approximately seven years of operating historyupon which investors may evaluate our business and prospects. Until 2003, wehave incurred significant losses, and as of December 31, 2003, had anaccumulated deficit of approximately $86.5 million. We intend to expendfinancial and management resources on the development of additional services,sales and marketing, technology and operations to support larger-scaleoperations and greater service offerings. Although we expect to generatepositive cash flow from operations in 2004, there can be no assurance that ourrevenue will increase or even continue at its current level or that we will maintainprofitability or generate cash from operations in future periods.

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

Our current and futureexpense levels are based largely on our planned operations and estimates offuture revenue. Revenue and operating results generally depend on the volumeand timing of orders received, which are difficult to forecast. We may beunable to adjust spending in a timely manner to compensate for any unexpectedrevenue shortfall. Accordingly, any significant shortfall in revenue could havean immediate adverse effect on our business, financial condition and results ofoperations. We are also likely to continue to see revenue fluctuate on aseasonal basis, which is typical for the software publishing market in general andfor our existing physical goods clients. We believe that our first and fourthquarters tend to be seasonally stronger than our second and third quarters dueto the timing of demand for tax preparation software and the holiday seasonselling period. In addition, we believe that software publishers avoid newproduct releases in the summer months. In view of the rapidly evolving natureof our business, we are unable to accurately forecast our revenue and believethat period-to-period 

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comparisonsof our operating results are not necessarily meaningful and should not berelied upon as an indication of future performance.

**Critical Accounting Policies**

We prepare our consolidated financial statements inconformity with accounting principles generally accepted in the United Statesof America. As such, we are required to make certain estimates, judgments andassumptions that we believe are reasonable based upon the informationavailable. These estimates and assumptions affect the reported amounts ofassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the periods presented. The significantaccounting policies which we believe are the most critical in fullyunderstanding and evaluating our reported financial results are the following:

*Revenue Recognition.**  *We recognizerevenue from services rendered once all the following criteria for revenuerecognition have been met: (1) pervasiveevidence of an agreement exists; (2) the services have been rendered; (3) thefee is fixed and determinable and not subject to refund or adjustment; and (4) collectionof the amounts due is reasonably assured. We derive our revenue primarily fromtransaction fees based on a percentage of the products sale price and fees fromservices rendered associated with the e-commerce services provided to ourclients. These services include Web commerce development and hosting,transaction processing, fraud screening, digital delivery, integration tophysical fulfillment, merchandising services, analytical marketing and customerservice. We report our revenue on a net basis and therefore record only the netservice fees and transaction fees as our revenue. We act as the merchant ofrecord on most of the transactions processed and have contractual relationshipswith our clients, which obligate us to pay to the client a specified percentageof each sale. We retain our transaction fee and also charge fees for servicesrendered. We also derive revenue from integration, development and consultingservices. Signed contracts are obtained from clients prior to recognition ofthese revenues. Fees for 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 not havethe right to take possession of the software applications used in the deliveryof services. 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 we do not accurately estimate the resourcesrequired or the scope of work to be performed, or do not manage our projectsproperly within the planned periods of time or satisfy our obligations underthe contracts, future margins may be negatively affected.

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

*Credit Card Chargeback Reserve.**  *Estimates arealso used in determining our accrued chargeback expenses and are based on ourhistorical experience and current trends. Management makes an estimate ofanticipated future credit card chargebacks related to current period revenue byanalyzing the timing of historical credit card chargebacks as well as reviewingthe current charge back trends and applying a 

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conservative anticipatedrate to current period revenues. Significant management judgments and estimatesmust be made and used in connection with the accrued expenses in any accountingperiod. Material differences may result in the amount and timing of ouroperating results for any period if management makes different judgments orutilizes different estimates.

*Goodwill, Intangibles And Other Long-Lived Assets.**  *We amortizeproperty, plant and equipment, certain intangibles and certain other long-livedassets with definite lives over their useful lives. Useful lives are based onmanagement’s estimates of the period that the assets will generate revenue.Assets with definite lives are reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Our evaluation considers nonfinancial data such as changes inthe operating environment and business strategy, competitive information,market trends and operating performance.

In July 2001, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwilland Other Intangible Assets.”  Under SFASNo. 142, goodwill and intangible assets with indefinite lives are nolonger amortized but are reviewed annually (or more frequently if impairmentindicators arise) for impairment. For acquisitions consummated by us subsequentto July 1, 2001, we adopted the provisions of SFAS No. 142 effective July 1,2001. We adopted the full provisions of SFAS No. 142 effective January 1,2002. Upon adoption of SFAS No. 142, we discontinued the amortization ofgoodwill.

We complete our annualgoodwill impairment test using a two-step approach based on reportable segmentsin the fourth quarter of each year and reassess goodwill recorded in connectionwith earlier acquisitions.  Ourassessment has indicated that there have been no impairments of goodwill forthe years 2003 and 2002.

**Results Of Operations**

Thefollowing table sets forth certain items from our consolidated statements ofoperations as a percentage of total revenue for the years indicated.
| ** **                                                                                       | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue                                                                                          |       | 100.0    | %          | 100.0    | %          | 100.0    | %          |
| Costs and expenses  (exclusive of depreciation and amortization expense shown separately below): |       |     |       |     |       |     |       |
| Direct cost of services                                                                          |       | 3.6      |       | 3.0      |       | 4.7      |       |
| Network and infrastructure                                                                       |       | 12.1     |       | 14.7     |       | 17.6     |       |
| Sales and marketing                                                                              |       | 36.8     |       | 41.7     |       | 47.5     |       |
| Product research and development                                                                 |       | 9.8      |       | 14.7     |       | 19.4     |       |
| General and administrative                                                                       |       | 9.1      |       | 8.8      |       | 8.1      |       |
| Litigation and other charges                                                                     |       | —   |       | 3.2      |       | —   |       |
| Depreciation and amortization                                                                    |       | 7.2      |       | 7.7      |       | 8.0      |       |
| Amortization of goodwill and other intangibles and  acquisition related costs                    |       | 5.3      |       | 7.4      |       | 29.4     |       |
| Total costs and  expenses                                                                        |       | 83.9     |       | 101.2    |       | 134.7    |       |
| Income (loss)  from operations                                                                   |       | 16.1     |       | (1.2     | )          | (34.7    | )          |
| Interest income                                                                                  |       | 0.8      |       | 0.5      |       | 1.5      |       |
| Net income (loss)                                                                                |       | 16.9     | %          | (0.7     | )%         | (33.2    | )%         |

*** ***

***REVENUE.****  *Our revenueincreased to $101.2 million in 2003 from $77.8 million in 2002 and$57.8 million in 2001. The revenue increase in 2003 as compared to 2002resulted from further expansion of our key client relationships, increasingmarket acceptance of electronic software downloading, 

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merchandising activitiesthat increased the average sales generated by our software publisher clients,the acquisitions completed by the Company in 2003, and a full year of revenuefor the acquisitions completed at various times during 2002. The assetsacquired in each respective year generated approximately 1.5% and 9% of theCompany’s total revenue during 2003 and 2002, respectively. The revenueincrease in 2002 as compared to 2001 resulted from further expansion of our keyclient relationships, increasing market acceptance of electronic softwaredownloading, merchandising activities that increased the average salesgenerated by our software publisher clients, the acquisitions completed by usin 2002, and a full year of revenue for the acquisitions completed at varioustimes during 2001.

International sales represented approximately 24%, 22%and 22% of revenue in the years ended December 31, 2003, 2002 and 2001,respectively. In 2003, revenue for the Software and Digital Commerce ServicesDivision was $86.3 million, up from $63.2 million in 2002, and $44.9million in 2001. Revenue for the E-Business Services Division was $14.9 millionin 2003, up from $14.6 million in 2002, and $12.9 million in 2001.

***GROSS PROFIT.****  *Cost of revenueconsists of direct cost of services and network and infrastructure expenses andis composed of direct labor costs related to revenue and the costs to operateand maintain our CNS platform, as well as customer service and operationsfunctions. Such amounts are shown exclusive of any related depreciation andamortization expenses. Gross profit increased substantially in all yearspresented, reflecting our growth in revenue. During 2003, 2002 and 2001, ourgross profit margins were 84.3%, 82.3%, and 77.7%, respectively. The grossprofit margin increases in 2003 and 2002 were primarily due to leveraging ourinfrastructure over significantly more revenue and clients. In 2003, the grossprofit margin for the Software and Digital Commerce Services Division was86.3%, up from 84.6% in 2002 and 80.6% in 2001. The gross profit margin for theE-Business Services Division was 73.1% in 2003, up from 72.2% in 2002 and 67.4%in 2001. We continue to believe that electronic commerce and related servicesmay become more competitive in the future. Accordingly, we may reduce or alterour pricing structure and policies in the future and any such change couldnegatively impact gross margins.

***SALES AND MARKETING.****  *Sales and marketing expenseconsists primarily of personnel and related expenses, advertising andpromotional expenses, credit card chargebacks and bad debt expense, and creditcard transaction fees. Sales and marketing expense increased to $37.2 million in2003, from $32.4 million and $27.5 million in 2002 and 2001,respectively, resulting primarily from increased credit card transaction feesand credit card chargeback expense due to increased revenue as well asadditional sales and marketing personnel and related expenses. The increase in2003 from 2002 resulted primarily from increases in credit card transactionfees of $3.0 million, credit card chargeback expense of $1.5 million, andpersonnel related expenses of $0.3 million. The increase in 2002 from 2001resulted from increases in credit card transaction fees of $4.2 million, baddebt expense of $0.9 million and personnel related expenses of $1.3 million,offset by a decrease in advertising expense of $1.7 million. As a percentage ofrevenue, sales and marketing expense decreased to 36.8% in 2003 from 41.7% in2002 and 47.5% in 2001, primarily reflecting our increased revenue. In 2003,the sales and marketing expense related to the Software and Digital CommerceServices Division was $31.3 million, up from $22.7 million in 2002 and$17.5 million in 2001. The sales and marketing expense related to theE-Business Services Division was $5.9 million in 2003, down from$9.7 million in 2002 and $10.0 million in 2001.  We expect that sales and marketing expensewill continue to increase in absolute dollars as we continue to build our salesand marketing infrastructure and develop marketing programs, and asvolume-driven credit card expenses and chargebacks increase. As a percentage ofrevenue, these expenses are expected to continue to decrease.

***PRODUCT RESEARCHAND DEVELOPMENT.****  *Product research and developmentexpense consists primarily of personnel and related expenses and consultingcosts associated with developing and enhancing our CNS platform and relatedinternal systems. Product research and development expense was $10.0 million in2003, compared to $11.5 million and $11.2 million in 2002 and 2001,respectively. The decrease in 2003 from 2002 resulted primarily from a decreasein consulting expenses of $1.2 million. The increase 

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in 2002 from 2001 resultedfrom an increase in personnel related expenses. As a percentage of revenue,product research and development expense decreased to 9.8% in 2003 from 14.7%in 2002 and 19.4% in 2001, primarily reflecting our increased revenue. In 2003,the product research and development expense related to the Software andDigital Commerce Services Division was $6.7 million, up from $4.8 million inboth 2002 and 2001. Product research and development expense related to theE-Business Services Division was $3.3 million in 2003, down from$6.7 million in 2002 and down from $6.4 million in 2001. We expect thatproduct research and development expenses will remain level or increaseslightly as a percentage of revenue.

***GENERAL ANDADMINISTRATIVE.****  *General and administrative expenseconsists principally of key executive, accounting and administrative personneland related expenses, insurance expense, professional fees and investorrelations’ expenses. General and administrative expense increased to $9.2million in 2003, from $6.8 million and $4.7 million in 2002 and 2001,respectively. The increase in 2003 from 2002 resulted primarily from increasesin personnel related expenses of approximately $0.9 million, legal andprofessional fees of approximately $0.8 million and insurance charges ofapproximately $0.3 million. The increase in 2002 from 2001 resulted primarilyfrom increases in various legal and professional fees of approximately $0.8million, personnel related expenses of approximately $0.6 million and insurancecharges of approximately $0.3 million. As a percentage of revenue, general andadministrative expense increased to 9.1% in 2003 from 8.8% in 2002 and 8.1% in2001, reflecting our increased revenue as well as our growth in the expensebase from legal & professional services and infrastructure changes in2003. General and administrative expense related to the Software and DigitalCommerce Services Division was $7.6 million in 2003 up from $4.5 millionin 2002 and $3.2 million in 2001. In 2003, general and administrative expensefor the E-Business Services Division was $1.6 million, down from$2.3 million in 2002 and up from $1.5 million in 2001. We expect generaland administrative expense to increase in absolute dollars in the future,particularly as we continue to build infrastructure to support our growth. As apercentage of revenue, these expenses are expected to decrease.

***LITIGATION ANDOTHER CHARGES.******  ***During March 2002,we recorded a charge for pending litigation of $2.3 million. This reserve wasestablished based upon developments in new and existing litigation for which wedetermined, in the first quarter of 2002, that payment was both probable and estimable.In the fourth quarter of 2002, our ongoing contractual dispute with ePedas SdnBhd was settled with no admission of liability by either party and ouragreement to pay $0.6 million to ePedas. This amount was charged against thelitigation reserve. Each party released the other from all claims related tothe dispute and dismissed their respective claims with prejudice. During 2003,no charges were recorded for settlement of litigation and other charges.

***AMORTIZATION OFGOODWILL AND OTHER INTANGIBLES AND ACQUISITION RELATED COSTS.****  *Amortization ofgoodwill and other intangibles and acquisition related costs consists of theamortization of goodwill and other intangible assets recorded from our 18acquisitions in the past four years, as well as other acquisition related costssuch as earn-out payments. Amortization of goodwill and other intangibles andacquisition related costs decreased to $5.4 million in 2003 from $5.7 millionin 2002 and $17.0 million in 2001. The decrease in 2003 from 2002 reflectsthe full amortization of certain past acquisition costs which reduced expensein amounts greater than the amortization expense added by new acquisitions in2003. The decrease in 2002 from 2001 related 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, we discontinued theamortization of goodwill. We complete our annual goodwill impairment test usinga two-step approach based on reportable segments in the fourth quarter of eachyear. Our assessment has indicated that there is no impairment of goodwill forthe years ended December 31, 2003 and 2002 and thus we did not record anyexpense related to goodwill in 2003 or 2002.

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***INCOME (LOSS) FROMOPERATIONS.****  *Our income from operations in 2003was $16.3 million compared to a loss of $0.9 million in 2002, and a loss of $20.1 millionin 2001, resulting primarily from increased revenue without correspondingincreases in operating expenses. In 2003, the Software and Digital CommerceServices Division generated income from operations of $28.8 million compared toincome of $21.4 million in 2002 and $10.7 million in 2001. In 2003, theincome from operations related to the E-Business Services Division was $0.1million compared to a loss of $8.1 million in 2002 and a loss of $9.1million in 2001. In calculating segment income or loss, we do not includedepreciation and amortization of property and equipment, amortization ofgoodwill and other intangibles and acquisition related costs, or litigationcharges.

***INTEREST INCOME.****  *Interest incomeconsists of earnings on our cash and cash equivalents and short-terminvestments. Interest income increased to $0.8 million in 2003 from $0.4million in 2002 and decreased from $0.9 million in 2001, resulting primarilyfrom net effects in changes in average cash and cash equivalent and short-terminvestment balances.

***INCOME TAXES.***   We had net operating losscarryforwards of approximately $93.2 million as of December 31, 2003.Included in this amount is approximately $47.3 million of deductions resultingfrom disqualifying dispositions of stock options. When these deductionsrelating to disqualifying dispositions are realized for financial statementpurposes they will not result in a reduction in income tax expense, rather thebenefit will be recorded as additional paid-in-capital. These income tax netoperating loss 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 theuncertainty of future realization, a valuation allowance equal to the deferredtax asset has been recorded. Ownership changes resulting from the issuance ofadditional equity will limit future annual realization of the tax net operatingloss carryforwards to a specified percentage of our value under Section 382of the Internal Revenue Code.

**Liquidity and Capital Resources**

Our primary source of internal liquidity is ouroperating activities. Net cash generated by operating activities in 2003, 2002and 2001 was $47.8 million, $17.6 million and $0.5 million, respectively. Netcash generated by operating activities in 2003 was the result of net income,decreases in accounts receivable, and increases in accounts payable, deferredrevenue and other accrued liabilities. Net cash generated by operatingactivities in 2002 and 2001 was primarily due to declining net losses andgrowing accounts payable balances.

Net cash used in investing activities was $43.2million in 2003 and was the result of purchases of investments of $30.0million, purchases of capital equipment of $6.3 million and net cash paid foracquisitions of $6.9 million. Net cash used in investing activities was $0.6million in 2002 and was the result of purchases of equipment of $5.2 millionand net cash paid for acquisitions of $5.4 million offset by $10.0 million ininvestment sales. Net cash used in investing activities was $2.4 million in2001 and was the result of purchases of equipment of $5.9 million and net cashpaid for acquisitions of $1.5 million, offset by net sales of investments of$5.0 million.

Our primary source of external liquidity has beenissuances of our stock, either through public offerings or by exercise of stockoptions and through purchases under our employee stock purchase plan. Net cashprovided by financing activities in 2003, 2002 and 2001 was $56.5 million,$2.2 million, and $6.6 million, respectively. Cash provided from afollow-on offering of our common stock in 2003 totaled $43.4 million. Proceedsfrom the exercise of stock options and warrants provided cash totaling $12.3million, $4.3 million, and $6.3 million in 2003, 2002, and 2001, respectively.In 2002, we repaid the $2.5 million in notes payable related to our August 2001acquisition of RegSoft which caused a decrease in net cash provided byfinancing activities. Additionally, in April 2001, we initiated a sharerepurchase program 

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of up to $5.0 million ofour outstanding shares of common stock. Repurchases are at our discretion basedon ongoing assessments of the capital needs of the business and the marketprice of our shares. No time limit was set for the completion of the repurchaseprogram. During 2003 and 2002, no shares were repurchased under the repurchaseprogram. In 2001, we expended $267,000 to repurchase our shares.

As of December 31, 2003, we had approximately$131.9 million of cash and cash equivalents and short-term investments andworking capital of approximately $85.0 million. Significant components of ourworking capital are cash and cash equivalents, short-term investments andshort-term receivables net of client and merchant payables. Our principalcommitments consisted of long-term obligations outstanding under operatingleases. Although we have no material commitments for capital expenditures, weanticipate an increase in the rate of capital expenditures consistent with ouranticipated growth in operations, infrastructure and personnel. We anticipatethat over the next 24 months we will expend approximately $16.0 million oncapital expenditures and approximately $24.0 million on product researchand development, based on our current anticipated growth rate in operations. Wealso anticipate that we will continue to experience growth in our operatingexpenses for the foreseeable future and that our operating expenses will be amaterial use of our cash resources.

We expect to continue toevaluate and consider a wide array of potential strategic transactions,including business combinations and acquisitions of businesses, products,services and other assets as well as licenses of technology related to ourcurrent business. At any given time, we may be engaged in discussions ornegotiations with respect to one or more such transactions. Any suchtransactions could have a material impact on our financial position, results ofoperations, or cash flows. There is no assurance that any such discussions ornegotiations will result in the consummation of any transaction. The process ofintegrating any acquisition may create unforeseen challenges for ouroperational, financial and management information systems, as well asunforeseen expenditures and other risks, including diversion of management’sattention from other business concerns, the potential loss of key customers,employees and business partners, difficulties in managing facilities andemployees in different geographic areas, and difficulties in entering marketsin which we have no or limited direct prior experience and where competitors insuch markets have stronger market positions. In addition, an acquisition maycause us to assume liabilities or become subject to litigation. Further, therecan be no assurance that we will realize a positive return on any acquisitionor that future acquisitions will not be dilutive to our current shareholders’percentage ownership or to earnings. We have allocated significant valuation inthe form of goodwill and intangibles for the companies we acquired in the past,which is subject to impairment testing on a regular basis. If the individualbusinesses do not perform as expected at the acquisition dates, we may incurimpairment charges for goodwill, accelerated amortization of definite-livedintangibles due to shortened expected lives of these assets, immediatewrite-offs and restructuring or other related expenses.

**Contractual  Commitments**
| ** **                       | ** ** | **Payment due by period** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                               | ** ** | **Total Amount  Committed** | ** ** | **2004** | ** ** | **2005-2006** | ** ** | **2007-2008** | ** ** | **More than 5  years** | ** ** |
| Operating Lease  Obligations     |       | $                                        | 2,763,000  |   | $ | 1,266,000 |   | $ | 1,380,000 |   | $ | 117,000 |   |   | $ | 0 |   |   |
| Total                            |       | $                                        | 2,763,000  |   | $ | 1,266,000 |   | $ | 1,380,000 |   | $ | 117,000 |   |   | $ | 0 |   |   |
|                                  |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We believe that existingsources of liquidity and the results of our operations will provide adequatecash to fund our operations for at least the next 24 months, although wemay seek to raise additional capital during that period. In January 2002,we filed a universal shelf registration statement with the SEC pursuant towhich we could issue up to $100 million in common stock, preferred stock, debtsecurities and/or warrants.  Of thisamount, approximately $45 million was utilized to issue common stock in our July 2003public offering leaving approximately $55 million available for future use.  The sale of additional 

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equityor convertible debt securities could result in additional dilution to ourstockholders. There can be no assurances that financing will be available inamounts or on terms acceptable to us, if at all.

**Recent Accounting Pronouncements**

In May 2003, the Financial Accounting StandardsBoard (FASB) issued SFAS 150, “*Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity.*”  SFAS 150 establishes standards for issuerclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity. Instruments that fall withinthe scope of SFAS 150 must be classified as a liability, and is effective forfinancial instruments entered into or modified after May 31, 2003. Forfinancial instruments issued prior to June 1, 2003, SFAS 150 is effectivefor the Company in the second quarter of 2004. Adoption is not expected to havean impact on our consolidated financial statements.

In January 2003, the FASB issued FIN No. 46,“Consolidation of Variable Interest Entities.” In addition, in December 2003 the FASB issued a revision of theInterpretation (The Revised Interpretation). FIN No. 46 states thatcompanies that have exposure to the economic risks and potential rewards fromanother entity’s assets and activities have a controlling financial interest ina variable interest entity and should consolidate the entity, despite the absenceof clear control through a voting equity interest. The consolidationrequirements apply to all variable interest entities for the first fiscal yearor interim period ending after March 15, 2004. We do not believe that thisstatement will have a material impact on our consolidated financial statements.

In November 2002, theFASB issued Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers” (“FIN No. 45”). FIN No. 45 requires companies to recognize,at the inception of a guarantee, a liability for the fair value of theobligation undertaken in issuing the guarantee. Guarantees in existence at December 31,2002 are grandfathered for the purposes of recognition and would only need tobe disclosed. We enter into indemnification agreements with our officers anddirectors, as well as in connection with our acquisitions. It is not possibleto determine the maximum potential amount under these agreements due to the limitedhistory of prior indemnification claims and the unique facts and circumstancesinvolved in each particular agreement. The adoption of FIN No. 45 did nothave a material impact on our consolidated financial statements.

**ITEM 7a. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUTMARKET RISK.**

We do not enter into financial instruments for tradingor speculative purposes and do not currently utilize derivative financialinstruments. Our operations are conducted primarily in the United Statescurrency and as such are not subject to material foreign currency exchange raterisk. We have no long-term debt.

However, the growth in ourinternational operations is increasing our exposure to foreign currencyfluctuations. Our functional currency is the U.S. dollar. We have foreigncurrency denominated net revenues, costs and expenses. These income statementamounts are remeasured into U.S. dollars at the average exchange rates in eachapplicable period. To the extent the U.S. dollar weakens against foreigncurrencies, the remeasurement of these foreign currency denominatedtransactions results in increased net revenues, operating expenses and netincome. Conversely, our net revenues, operating expenses and net income willdecrease when the U.S. dollar strengthens against foreign currencies. We expectinternational operations to continue to grow in significance as we develop anddeploy our global marketplace presence. As a result, foreign currencyfluctuations in future periods could become more significant and may have anegative impact on our net revenues and net income.

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**ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**

Our Financial Statementsand Notes thereto appear beginning at page 50 of this report.

**QUARTERLY FINANCIALDATA (UNAUDITED)**
| ** **                        | ** ** | **QUARTER ENDED**                                             | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                        | ** ** | **March 31**                                                  | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| ** **                        | ** ** | **(in thousands, except per share data)** | ** ** |
| **2003**                          |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                           |       | $                                                                  | 24,600     |   | $ | 22,764 |   |   | $ | 26,748 |   |   |   | $ | 27,089 |   |   |
| Gross profit(a)                   |       | 20,712                                                             |       | 18,968 |   |   | 22,601 |   |   |   | 23,082 |   |   |
| Income from  operations(b)        |       | 3,952                                                              |       | 2,520 |   |   | 4,477 |   |   |   | 5,349 |   |   |
| Net income                        |       | 4,022                                                              |       | 2,767 |   |   | 4,741 |   |   |   | 5,606 |   |   |
| Net income per  share—basic  |       | 0.15                                                               |       | 0.10 |   |   | 0.16 |   |   |   | 0.18 |   |   |
| Net income per share—diluted |       | $                                                                  | 0.13       |   | $ | 0.09 |   |   | $ | 0.14 |   |   |   | $ | 0.16 |   |   |

 
| ** **                                | ** ** | **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 |   |   |
| (Loss) income  from operations(b)         |       | (3,582                                                             | )          | (505 | ) |   | 48 |   |   |   | 3,123 |   |   |
| Net (loss) income                         |       | (3,530                                                             | )          | (348 | ) |   | 98 |   |   |   | 3,270 |   |   |
| Net (loss) income  per share—basic   |       | (0.13                                                              | )          | (0.01 | ) |   | 0.00 |   |   |   | 0.12 |   |   |
| Net (loss) income per  share—diluted |       | $                                                                  | (0.13      | ) | $ | (0.01 | ) |   | $ | 0.00 |   |   |   | $ | 0.11 |   |   |

----

(a)           Gross profit iscalculated as revenue less direct cost of services and network andinfrastructure expenses and excludes depreciation and amortization expense.

(b)          Income (loss) fromoperations includes amortization of goodwill and other intangibles andacquisition related costs of $1,221, $1,246, $1,411 and $1,502 in the quartersended March 31, June 30, September 30 and December 31,2003, respectively, and $1,549, $1,651, $1,356, and $1,182 in the quartersended March 31, June 30, September 30 and December 31,2002, respectively.

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**ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE.**

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

The report of Arthur Andersen LLP on our consolidatedfinancial statements for the year ended December 31, 2001 contained noadverse opinion or disclaimer of opinion and was not qualified or modified asto uncertainty, audit scope or accounting principles.

During our year ended December 31, 2001 andthrough the subsequent interim period ended June 13, 2002, there were nodisagreements 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 year ended December 31, 2001 andthrough June 13, 2002, there were no reportable events (as defined inRegulation S-K Item 304(a)(1)(v)).

We engaged Ernst &Young LLP as our independent accountants as of June 13, 2002. During theyear ended December 31, 2001 and through June 13, 2002, we did notconsult with Ernst & Young LLP on items which (i) were or shouldhave been subject to Statement of Auditing Standard No. 50 or (ii) concernedthe subject matter of a disagreement or reportable event with Arthur AndersenLLP (as described in Regulation S-K Item 304(a)(2)).

**ITEM 9A. CONTROLS AND PROCEDURES.**

(a)  Based on their evaluation of our disclosurecontrols and procedures conducted as of December 31, 2003, our ChiefExecutive Officer and Chief Financial Officer have concluded that our disclosurecontrols and procedures (as defined in Rules 13a-14(c) and 15d-15(e) promulgatedunder the Securities Exchange Act of 1934) are effective.

(b)  This evaluationdid not identify any change in our internal controls over financial reportingthat occurred during the quarter ended December 31, 2003 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting.

**Limitationson the Effectiveness of Controls**

Our management, includingthe Chief Executive Officer and Chief Financial Officer, does not expect thatour disclosure controls and procedures or our internal controls will preventall error and fraud. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent 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 

44

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proceduresmay deteriorate. Because of the inherent limitations in a cost-effectivecontrol system, misstatements due to error or fraud may occur and not bedetected.

**PART III**

Certain informationrequired in Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2004 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT.**

Other than the identification of executive officers,which is set forth in Part I, Item 1 hereof, the information required inItem 10 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2004 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934, asamended.

We have adopted a Code ofConduct and Ethics, a copy of which we undertake to provide to any person,without charge, upon request. Such requests can be made in writing to theattention of Corporate Secretary at our principal executive offices address. Weintend to disclose any amendments to, or waivers from, the Code provisionsapplicable to our principal executive officer or senior financial officers,including our chief financial officer and controller, or with respect to therequired elements of the Code on our website, *www.digitalriver.com*under the “Investor Relations” link.

**ITEM 11. EXECUTIVE COMPENSATION.**

The information requiredin Item 11 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2004 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.**

The information requiredin Item 12 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2004 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 13. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS.**

The information requiredin Item 13 of Part III of this report is incorporated by reference to ourProxy Statement in connection with our 2004 Annual Meeting to be filed inaccordance with Regulation 14A under the Securities Exchange Act of 1934,as amended.

**ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.**

The information required in Item 14 of Part IIIof this report is incorporated by reference to our Proxy Statement inconnection with our 2004 Annual Meeting to be filed in accordance withRegulation 14A under the Securities Exchange Act of 1934, as amended.

45

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**PART IV**

**ITEM15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K**

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

(1)   FinancialStatements.

The consolidated financial statements required by thisitem are submitted in a separate section beginning on page 50 of thisreport.
| 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)   Financial Statement Schedules.

All schedules for which provision is made in theapplicable accounting regulations of the SEC have been omitted as not requiredor not applicable, or the information required has been included elsewhere byreference in the financial statements and related notes, except forSchedule II, which is included with this Form 10-K, as filed with theSEC.

(3)   Exhibits.
| **Exhibit   Number** | ** **                                                                                                                                                                                             | **Description Of Document** |
|----------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------|
| 2.1(1)               | 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. |
| 2.2(2)               | Amended and Restated Asset Purchase Agreement dated  February 9, 2002 by and between the Registrant and Beyond.com.                                                                               |
| 2.3(3)               | First Amendment to the Amended and Restated Asset  Purchase Agreement dated as of March 15, 2002 by and between the  Registrant and Beyond.com.                                                   |
| 2.4(3)               | Post-Closing Amendment to the Amended and Restated  Asset Purchase Agreement dated as of March 31, 2002 by and between the  Registrant and Beyond.com.                                            |
| 3.1(4)               | Amended and Restated Certificate of Incorporation of  the Registrant, as currently in effect.                                                                                                          |
| 3.2(6)               | Amended and Restated Bylaws of the Registrant, as  currently in effect.                                                                                                                                |
| 3.3(4)               | Certificate of Amendment of Amended and Restated  Certificate of Incorporation (amending Exhibit 3.1).                                                                                            |
| 4.1(7)               | Specimen Stock Certificate.                                                                                                                                                                            |
| 4.2(4)               | Form of Senior Debt Indenture.                                                                                                                                                                    |
| 4.3(4)               | Form of Subordinated Debt Indenture.                                                                                                                                                              |
| 4.4                  | References are hereby made to Exhibits 3.1, 3.2 and  3.3.                                                                                                                                              |
| 10.1(7)              | Form of Indemnity Agreement between Registrant  and each of its directors and executive officers.                                                                                                 |
| 10.2(7)              | Employment and Non-Competition Agreement effective  May 25, 1998 by and between Joel A. Ronning and the Registrant.                                                                               |
| 10.3(7)              | Consent to Assignment and Assumption of Lease dated  April 22, 1998 by and between CSM Investors, Inc., IntraNet  Integration Group, Inc. and Registrant.                               |

46

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| 10.4(5)   | Assignment of Lease  dated April 21, 1998 by and between Intranet Integration  Group, Inc. and Registrant.                                                                                                      |
|-----------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5(5)   | Lease Agreement dated January 18, 2000 between  Property Reserve, Inc. and Registrant.                                                                                                                          |
| 10.6(6)   | First Amendment of Lease dated January 31, 2001  to that certain Lease dated April 24, 1996 between CSM  Investors, Inc. and Registrant (as assignee of Intranet Integration  Group, Inc.).           |
| 10.7(8)   | 1998 Stock Option Plan, as amended.                                                                                                                                                                                       |
| 10.8(9)   | 1999 Stock Option Plan, formerly known as the 1999  Non-Officer Stock Option Plan, as amended.                                                                                                                            |
| 10.9(8)   | 2000 Employee Stock Purchase Plan, as amended, and  offering.                                                                                                                                                             |
| 10.10(2)  | Voting Agreement, dated March 20, 2001, by and  between the Registrant, Calico Commerce, Inc. and ConnectInc.com, Co.                                                                                           |
| 10.11(10) | Second Amendment of Lease dated April 22, 2002  to that certain Lease dated April 24, 1996 between CSM  Investors, Inc. and Registrant (as assignee of Intranet Integration  Group, Inc.) as amended. |
| 10.12(10) | Second Amendment of Lease dated April 28, 2003  to that certain Lease dated January 18, 2000 between Property Reserve  Inc. and Registrant.                                                                     |
| 10.13(11) | Employment Agreement with Jay Kerutis.                                                                                                                                                                                    |
| 10.14     | Employment Agreement with Gary Howorka.                                                                                                                                                                                   |
| 21.1      | Subsidiaries of Digital River, Inc.                                                                                                                                                                                  |
| 23.1      | Consent of Independent Auditors, dated March 9,  2004.                                                                                                                                                               |
| 24.1      | Power of Attorney, pursuant to  which amendments to this Annual Report on Form 10-K may be filed, is  included on the signature pages of this Annual Report on Form 10-K.                                  |
| 31.1      | Certification of Digital  River, Inc.’s Chief Executive Officer, pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                               |
| 31.2      | Certification of Digital  River, Inc.’s Chief Financial Officer, pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                               |
| 32.1      | Certification of Digital River, Inc.’s Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                |
| 32.2      | Certification of Digital River, Inc.’s Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                |

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

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

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

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

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

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

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

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

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

                (10)       Incorporatedby reference from the Company’s Quarterly Report on Form 10-Q forthe quarter ended March 31, 2003 filed on May 15, 2003.

                (11)       Incorporatedby reference from the Company’s Quarterly Report on Form 10-Q forthe quarter ended September 30, 2003 filed on November 13, 2003.

(b)          Reports on Form 8-K.On October 22, 2003, the Company furnished a current report on Form 8-Kfurnishing under Item 12 a press release concerning results of operations andfinancial condition for the quarter and nine months ended September 30,2003; and announcing, under Item 9 that Gary Howorka, Chief Technology Officer,is leaving his position.

(c)           Exhibits.

(d)          Financial StatementSchedules.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has caused this report on Form 10-K to besigned on its behalf by the undersigned, thereunto duly authorized, in the Cityof Eden Prairie, State of Minnesota, on the 12th of March 2004.
|   | Digital River, Inc. |
|--------|---------------------|
|   | By:                 | /s/ Joel A. Ronning |
|   |                | Joel A. Ronning |
|   |                | *CHIEF EXECUTIVE OFFICER AND DIRECTOR* |

 

We, the undersigned, directorsand officers of Digital River, Inc., do hereby severally constitute andappoint Joel A. Ronning and Carter D. Hicks and each or any of them, our trueand lawful attorneys and agents, with full power of substitution andresubstitution, for him or her and in his or her name, place and stead, in anyand all capacities, to sign any and all amendments to the Registrant’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2003, andto file the same with all exhibits thereto, and all other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorneys and agents, and each or any of them, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done, as fully to all intents and purposes as he or she mightor could do in person, hereby ratifying and confirming all that said attorneysand agents, and each of them, or his substitute or substitutes, may lawfully door cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Form 10-Khas been signed below by the following persons on behalf of the Registrant andin the capacities and on the dates indicated:
| ** **            | **SIGNATURE** | ** **                                                            | ** ** | ** **           | **TITLE** | ** ** | ** ** | ** ** | **DATE** | ** ** |
|-----------------------|---------------|-----------------------------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ Joel A. Ronning   |          |                                                                  |       |                 |
| Joel A. Ronning       |          | Chief Executive  Officer and Director (Principal Executive Officer)   |       | March 12,  2004 |
|                  |          |                                                                  |       |                 |
| /s/ Carter D. Hicks   |          |                                                                  |       |                 |
| Carter D. Hicks       |          | Chief Financial  Officer and Treasurer (Principal Accounting Officer) |       | March 12,  2004 |
|                  |          |                                                                  |       |                 |
| /s/ Perry W. Steiner  |          |                                                                  |       |                 |
| Perry W. Steiner      |          | Director                                                              |       | March 12,  2004 |
|                  |          |                                                                  |       |                 |
| /s/ William Lansing   |          |                                                                  |       |                 |
| William Lansing       |          | Director                                                              |       | March 12,  2004 |
|                  |          |                                                                  |       |                 |
| /s/ Thomas F. Madison |          |                                                                  |       |                 |
| Thomas F. Madison     |          | Director                                                              |       | March 12,  2004 |
|                  |          |                                                                  |       |                 |
| /s/ J. Paul Thorin    |          |                                                                  |       |                 |
| J. Paul Thorin        |          | Director                                                              |       | March 12,  2004 |
|                  |          |                                                                  |       |                 |
| /s/ Frederic Seegal   |          |                                                                  |       |                 |
| Frederic Seegal       |          | Director                                                              |       | March 12,  2004 |

 

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**Report of Independent Auditors**

**Board of Directorsand StockholdersDigital River, Inc.**

We have audited the accompanying consolidated balancesheets of Digital River, Inc. and subsidiaries as of December 31,2003 and  2002, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows forthe two years then ended. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits. The consolidated financial statementsof Digital River, Inc. and subsidiaries for the year ended December 31,2001 were audited by other auditors who have ceased operations and whose reportdated January 28, 2002 expressed an unqualified opinion on thosestatements.

We conducted our audits in accordance with auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion, the 2003 and 2002 financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of Digital River, Inc. and subsidiaries at December 31,2003 and 2002, and the consolidated results of their operations and their cashflows for the two years then ended in conformity with accounting principlesgenerally accepted in the United States.

As discussed above, the consolidated financialstatements of Digital River, Inc. and subsidiaries as of and for the yearended December 31, 2001 were audited by other auditors who have ceasedoperations. As described in Note 2, these consolidated financialstatements have been revised to include the transitional disclosures requiredby Financial Accounting Standard No. 142, “Goodwill and other IntangibleAssets”, which was adopted by the Company as of January 1, 2002. We haveaudited the disclosures in Note 2 and, in our opinion, the disclosures for2001 in Note 2 are appropriate. However, we were not engaged to audit,review, or apply any procedures to the 2001 consolidated financial statementsof the Company other than with respect to such disclosures and, accordingly, wedo not express an opinion or any other form of assurance on the 2001consolidated financial statements taken as a whole.

**/s/ Ernst & Young LLP**

Minneapolis, MinnesotaJanuary 29, 2004

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*The following report is a copy of a report previouslyissued by Arthur Andersen LLP (“Andersen”), which has not been reissued byAndersen. Certain financial information for each of the two years in the periodended December 31, 2001 was not reviewed by Andersen and includes: (i) reclassificationsto conform to our 2003 financial statement presentation and (ii) additionaldisclosures to conform with new accounting pronouncements and SEC rules andregulations issued during such fiscal year.*

**Report of independent public accountants**

To Digital River, Inc.:

We have audited the accompanying consolidated balancesheets of Digital River, Inc. (a Delaware corporation) and Subsidiaries asof December 31, 2001 and 2000, and the related consolidated statements ofoperations, stockholders’ equity and cash flows for each of the three years inthe period ended December 31, 2001. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

We conducted our audits in accordance with auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position ofDigital River, Inc. and Subsidiaries as of December 31, 2001 and2000, and the results of their operations and their cash flows for each of thethree years in the period ended December 31, 2001, in conformity withaccounting principles generally accepted in the United States.

**Arthur Andersen LLP**

**Minneapolis,Minnesota,January 28, 2002**

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**DIGITALRIVER, INC.Consolidated Balance Sheets as of December 31(in thousands, except share data)**
| ** **                                                                                                           | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| CURRENT ASSETS:                                                                                                      |       |       |       |       |       |
| Cash and cash equivalents                                                                                            |       | $          | 101,878    |       | $          | 40,801 |   |
| Short-term investments                                                                                               |       | 30,044     |       | —     |       |
| Accounts receivable, net of allowance of $319 and  $905                                                              |       | 9,306      |       | 11,238     |       |
| Prepaid expenses and other                                                                                           |       | 1,589      |       | 1,807      |       |
| Total current assets                                                                                                 |       | 142,817    |       | 53,846     |       |
| PROPERTY AND  EQUIPMENT:                                                                                             |       |       |       |       |       |
| Property and equipment                                                                                               |       | 32,433     |       | 29,036     |       |
| Less accumulated depreciation                                                                                        |       | (17,799    | )          | (13,399    | )          |
| Net property and equipment                                                                                           |       | 14,634     |       | 15,637     |       |
| GOODWILL                                                                                                             |       | 23,921     |       | 18,698     |       |
| INTANGIBLE  ASSETS, net of accumulated amortization of $19,976 and $14,596                                      |       | 8,172      |       | 8,346      |       |
| OTHER ASSETS                                                                                                         |       | 114        |       | 7          |       |
|                                                                                                                 |       | $          | 189,658    |       | $          | 96,534 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                        |       |       |       |       |       |
| CURRENT LIABILITIES:                                                                                                 |       |       |       |       |       |
| Accounts payable                                                                                                     |       | $          | 41,814     |       | $          | 31,126 |   |
| Accrued payroll                                                                                                      |       | 2,825      |       | 1,788      |       |
| Deferred revenue                                                                                                     |       | 3,572      |       | 1,865      |       |
| Other accrued liabilities                                                                                            |       | 9,595      |       | 4,569      |       |
| Total current liabilities                                                                                            |       | 57,806     |       | 39,348     |       |
| 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; 31,497,719 and 27,537,240 shares issued and outstanding |       | 315        |       | 275        |       |
| Additional paid-in capital                                                                                           |       | 217,981    |       | 160,535    |       |
| Accumulated deficit                                                                                                  |       | (86,488    | )          | (103,624   | )          |
| Accumulated other comprehensive income                                                                               |       | 44         |       | —     |       |
| Total stockholders’ equity                                                                                      |       | 131,852    |       | 57,186     |       |
|                                                                                                                 |       | $          | 189,658    |       | $          | 96,534 |   |

 

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

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**DIGITALRIVER, INC.Consolidated Statements of Operations for the YearsEnded December 31(in thousands, except per share data)**
| ** **                                                                                       | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| REVENUE                                                                                          |       | $        | 101,201    |     | $          | 77,783   |       | $ | 57,825 |   |
| COSTS AND EXPENSES  (exclusive of depreciation and amortization expense shown separately below): |       |     |       |     |       |     |       |
| Direct cost of services                                                                          |       | 3,585    |       | 2,357    |       | 2,710    |       |
| Network and infrastructure                                                                       |       | 12,253   |       | 11,405   |       | 10,200   |       |
| Sales and marketing                                                                              |       | 37,220   |       | 32,437   |       | 27,489   |       |
| Product research and development                                                                 |       | 9,962    |       | 11,454   |       | 11,192   |       |
| General and administrative                                                                       |       | 9,228    |       | 6,799    |       | 4,701    |       |
| Litigation and other charges                                                                     |       | —   |       | 2,500    |       | —   |       |
| Depreciation and amortization                                                                    |       | 7,275    |       | 6,009    |       | 4,627    |       |
| Amortization of goodwill and other intangibles and  acquisition related costs (Note 2)           |       | 5,380    |       | 5,738    |       | 17,009   |       |
| Total costs and expenses                                                                         |       | 84,903   |       | 78,699   |       | 77,928   |       |
| INCOME (LOSS)  FROM OPERATIONS                                                                   |       | 16,298   |       | (916     | )          | (20,103  | )          |
| INTEREST INCOME                                                                                  |       | 838      |       | 406      |       | 881      |       |
| NET INCOME (LOSS)                                                                                |       | $        | 17,136     |     | $          | (510     | )          | $ | (19,222 | ) |
| NET INCOME (LOSS)  PER SHARE                                                                     |       |     |       |     |       |     |       |
| BASIC                                                                                            |       | $        | 0.58       |     | $          | (0.02    | )          | $ | (0.79 | ) |
| DILUTED                                                                                          |       | $        | 0.52       |     | $          | (0.02    | )          | $ | (0.79 | ) |
| WEIGHTED AVERAGE  COMMON SHARES OUTSTANDING                                                      |       |     |       |     |       |     |       |
| BASIC                                                                                            |       | 29,398   |       | 26,791   |       | 24,285   |       |
| DILUTED                                                                                          |       | 33,051   |       | 26,791   |       | 24,285   |       |

 

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

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**DIGITAL R IVER,INC.Consolidated Statements of Stockholders’ Equity(in thousands)**
| ** **                                                      | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Deferred** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated**                    | ** ** | **Total  Stockholders’** | ** ** | **Comprehensive** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------|------------|---------------------------------------|------------|------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                      | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**  | ** ** | **Compensation**                      | ** ** | ** Income (Loss) ** | ** ** | **Deficit**                   | ** ** | **Equity**        | ** ** | ** Income (Loss) ** | ** ** |
| BALANCE, December 31, 2000                                 |       | 22,275                |       |                    | $          | 223          |       |                                  |       | $                                  | 132,403    |                          |       |              | $          | (194 | ) |   |   | $ | (22 | ) |   |   | $ | (83,892 | ) |   |   | $ | 48,518 |   |   |   | (37,976 | ) |   |
| Net loss                                                        |       | —                |       |                    | —     |         |       |                                  | —     |                               |       |                          | —     |              |       |   | — |   |   |   | (19,222 | ) |   |   | (19,222 | ) |   |   | (19,222 | ) |   |
| Unrealized Gain on investments                                  |       | —                |       |                    | —     |         |       |                                  | —     |                               |       |                          | —     |              |       |   | 22 |   |   |   | — |   |   |   | 22 |   |   |   | 22 |   |   |
| 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 |   |   |   |   |   |   |
| BALANCE, December 31, 2001                                 |       | 26,463                |       |                    | 265        |         |       |                                  | 153,308    |                               |       |                          | (37        | )                 |       |   | — |   |   |   | (103,114 | ) |   |   | 50,422 |   |   |   | (19,200 | ) |   |
| Net loss                                                        |       | —                |       |                    | —     |         |       |                                  | —     |                               |       |                          | —     |              |       |   | — |   |   |   | (510 | ) |   |   | (510 | ) |   |   | (510 | ) |   |
| Common Stock issued for acquisitions and earn-out  arrangements |       | 171                   |       |                    | 2          |         |       |                                  | 2,553      |                               |       |                          | —     |              |       |   | — |   |   |   | — |   |   |   | 2,555 |   |   |   |   |   |   |
| Exercise of stock options 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 |   |   |   |   |   |   |
| BALANCE, December 31, 2002                                 |       | 27,537                |       |                    | 275        |         |       |                                  | 160,535    |                               |       |                          | —     |              |       |   | — |   |   |   | (103,624 | ) |   |   | 57,186 |   |   |   | (510 | ) |   |
| Net income                                                      |       | —                |       |                    | —     |         |       |                                  | —     |                               |       |                          | —     |              |       |   | — |   |   |   | 17,136 |   |   |   | 17,136 |   |   |   | 17,136 |   |   |
| Unrealized gain on investments                                  |       | —                |       |                    | —     |         |       |                                  | —     |                               |       |                          | —     |              |       |   | 44 |   |   |   | — |   |   |   | 44 |   |   |   | 44 |   |   |
| Sales of Common Stock                                           |       | 2,100                 |       |                    | 21         |         |       |                                  | 43,385     |                               |       |                          | —     |              |       |   | — |   |   |   | — |   |   |   | 43,406 |   |   |   |   |   |   |
| Common Stock issued for acquisitions and earn-out  arrangements |       | 88                    |       |                    | 1          |         |       |                                  | 1,024      |                               |       |                          | —     |              |       |   | — |   |   |   | — |   |   |   | 1,025 |   |   |   |   |   |   |
| Exercise of stock options and warrants                          |       | 1,680                 |       |                    | 17         |         |       |                                  | 12,238     |                               |       |                          | —     |              |       |   | — |   |   |   | — |   |   |   | 12,255 |   |   |   |   |   |   |
| Common Stock issued under the Employee Stock Purchase  Plan     |       | 93                    |       |                    | 1          |         |       |                                  | 799        |                               |       |                          | —     |              |       |   | — |   |   |   | — |   |   |   | 800 |   |   |   |   |   |   |
| BALANCE,  December 31, 2003                                |       | 31,498                |       |                    | $          | 315          |       |                                  |       | $                                  | 217,981    |                          |       |              | $          | — |   |   |   | $ | 44 |   |   |   | $ | (86,488 | ) |   |   | $ | 131,852 |   |   |   | $ | 17,180 |   |   |
|                                                                 |            |                       |            |                         |            |              |            |                                       |            |                                    |            |                               |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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**DIGITALRIVER, INC.Consolidated Statements of Cash Flows For the Years EndedDecember 31,(in thousands)**
| ** **                                                                                | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| OPERATING ACTIVITIES:                                                                     |       |     |       |     |       |     |       |
| Net income (loss)                                                                         |       | $        | 17,136     |     | $          | (510     | )          | $ | (19,222 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |     |       |     |       |     |       |
| Goodwill and other intangibles amortization and  earn-out charges                         |       | 5,380    |       | 5,738    |       | 17,009   |       |
| Depreciation and amortization                                                             |       | 7,275    |       | 6,009    |       | 4,627    |       |
| Deferred compensation expense                                                             |       | —   |       | 37       |       | 157      |       |
| Litigation and other charges                                                              |       | —   |       | 1,675    |       | —   |       |
| Change in  operating assets and liabilities:                                              |       |     |       |     |       |     |       |
| Accounts receivable                                                                       |       | 2,311    |       | (2,230   | )          | (2,918   | )          |
| Prepaid and other assets                                                                  |       | 132      |       | (432     | )          | (239     | )          |
| Accounts payable                                                                          |       | 9,210    |       | 8,025    |       | 2,916    |       |
| Deferred revenue                                                                          |       | 1,671    |       | 759      |       | (727     | )          |
| Accrued payroll and other accrued liabilities                                             |       | 4,716    |       | (1,488   | )          | (1,056   | )          |
| Net cash provided by operating activities                                                 |       | 47,831   |       | 17,583   |       | 547      |       |
| INVESTING ACTIVITIES:                                                                     |       |     |       |     |       |     |       |
| Purchases of investments                                                                  |       | (30,000  | )          | —   |       | (13,000  | )          |
| Sales/maturities of investments                                                           |       | —   |       | 9,978    |       | 17,999   |       |
| Cash paid for acquisitions, net of cash received                                          |       | (6,944   | )          | (5,383   | )          | (1,460   | )          |
| Purchases of equipment                                                                    |       | (6,271   | )          | (5,236   | )          | (5,890   | )          |
| Patent acquisition costs                                                                  |       | —   |       | —   |       | (7       | )          |
| Net cash used in investing activities                                                     |       | (43,215  | )          | (641     | )          | (2,358   | )          |
| FINANCING ACTIVITIES:                                                                     |       |     |       |     |       |     |       |
| Net proceeds from sales of common stock                                                   |       | 43,406   |       | —   |       | —   |       |
| Exercise of stock options and warrants                                                    |       | 12,255   |       | 4,302    |       | 6,294    |       |
| Sales of common stock under employee stock purchase  plan                                 |       | 800      |       | 380      |       | 541      |       |
| Repurchase of common stock                                                                |       | —   |       | —   |       | (267     | )          |
| Repayment of notes payable                                                                |       | —   |       | (2,500   | )          | —   |       |
| Net cash provided by financing activities                                                 |       | 56,461   |       | 2,182    |       | 6,568    |       |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                                |       | 61,077   |       | 19,124   |       | 4,757    |       |
| CASH AND CASH  EQUIVALENTS, beginning of period                                           |       | 40,801   |       | 21,677   |       | 16,920   |       |
| CASH AND CASH  EQUIVALENTS, end of period                                                 |       | $        | 101,878    |     | $          | 40,801   |       | $ | 21,677 |   |
| NONCASH INVESTING AND  FINANCING ACTIVITIES:                                              |       |     |       |     |       |     |       |
| Common stock issued in acquisitions and earn-outs                                         |       | $        | 1,025      |     | $          | 2,555    |       | $ | 14,379 |   |
| Issuance of note  payable in acquisition                                                  |       | $        | —     |     | $          | —   |       | $ | 2,500 |   |

 

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

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**DIGITALRIVER, INC.Notes to Consolidated Financial StatementsDecember 31, 2003 and 2002**

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

Digital River, Inc., a Delaware corporation, andits wholly owned subsidiaries (collectively, the Company) provide electroniccommerce services to its clients, including Web store development and hosting,transaction processing, electronic software delivery, fraud screening, customerservice and analytical marketing. Through contractual relationships withsoftware publishers and online retailers, the Company offers software productsfor sale via the Internet. Beginning in late 1998, the Company also began tooffer electronic commerce services to companies outside of the softwarevertical market. The Company was incorporated in 1994 and conducted its firstonline sale through a client’s Web store in August 1996.

The Company hasexperienced significant losses since inception ($86.5 million through December 31,2003) and has, until the later stages of 2001, experienced significant negativecash flows from operations. The Company’s prospects must be considered in lightof the risks frequently encountered by companies in their early stage ofdevelopment, particularly companies in new and rapidly evolving markets such 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’s business,financial condition and results of operations.

***Principles ofConsolidation and Classification***

The consolidated financialstatements include the accounts of Digital River, Inc. and its whollyowned subsidiaries. All intercompany balances and transactions have beeneliminated in consolidation. Certain 2002 balance sheet and 2002 and 2001 cashflow amounts have been reclassified to conform to the 2003 presentation.

***Cash and 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, 2003 and 2002, cash balances of approximately$3.1 million and $3.0 million, respectively, were maintained relatedto potential future credit card fees and chargebacks.

***Investments***

Investments held by the Company are classified asavailable for sale securities and are carried at their market value withcumulative unrealized gains or losses recorded as a component of accumulatedother comprehensive income/(loss) within stockholders’ equity.

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Thefollowing is a summary of the Company’s investment securities:
| ** **                    | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
|-------------------------------|------------|----------|------------|---------------------|------------|
| ***December 31,  2003*** |       |     |       |                |       |
| Commercial Paper              |       | $        | 30,000,000 |                | $          | 30,044,000 |   |
|                               |            |          |            |                     |            |  |  |

 

As of December 31,2003, all securities were due in less than two years. The Company purchasedinvestments totaling $30,000,000 in 2003. The Company had proceeds from salesof investments of $9,978,000 and $17,999,000 in 2002 and 2001, respectively.The cost basis of investments and gains and losses are based on specificidentification. Realized gains and/or losses on sales of investments were notsignificant in 2003, 2002 or 2001.

***Property and Equipment***

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.

***Purchased Intangible Assets***

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

***Long-Lived Assets***

The Company reviews alllong-lived assets, including definite-lived intangible assets, for impairmentin accordance with Statement of Financial Accounting Standards No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). Under SFAS144, impairment losses are recorded whenever events or changes in circumstancesindicate the carrying value of an asset may not be recoverable. An impairmentloss is recognized when estimated undiscounted cash flows expected to resultfrom the use of the asset plus net proceeds expected from disposition of theasset (if any) are less than the carrying value of the asset. As part of itsevaluation, the Company considers certain non-financial data as indicators ofimpairment such as changes in the operating environment and business strategy,competitive information, market trends and operating performance. When animpairment loss is identified, the carrying amount of the asset is reduced toits estimated fair value. There were no impairments of long-lived assets,including definite-lived intangible assets, recorded in 2003 or 2002.

***Patents***

The costs of developingpatents are amortized over a three-year period utilizing the straight-linemethod of amortization once the patent application is filed. As of December 31,2002, currently existing patents had been fully amortized.

***Fair Value of Financial Instruments***

The carrying amount ofcash and cash equivalents, accounts receivable, notes payable and accountspayable approximates fair value because of the short maturity of theseinstruments.

***Revenue Recognition***

The Company recognizesrevenue from services rendered once all the following criteria for revenuerecognition have been met: 1) pervasive evidence of an agreement exists,2) the services have been rendered, 3) the fee is fixed anddeterminable and not subject to refund or adjustment and 4) collection ofthe amounts due is reasonably assured. The Company derives its revenueprimarily from transaction and 

57

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servicefees associated with the e-commerce services provided to its clients. Theseservices include Web commerce hosting, transaction processing, digital andphysical fulfillment services, fraud screening, customer service andmerchandising and analytical marketing services. The Company acts as themerchant of record on most of the transactions processed and has contractualrelationships with its clients, primarily software publishers and onlineretailers, 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.

***Advertising Costs***

The costs of advertisingare charged to sales and marketing expense as incurred. The Company incurredadvertising expense of $560,000, $413,000 and $2,084,000 in 2003, 2002, 2001,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-Based Compensation***

At December 31, 2003, the Company had twostock-based employee compensation plans, which are described more fully in Note7. The Company accounts for these plans under the recognition and measurementprinciples of APB Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. No stock-based employee compensationcost is reflected in net income (loss), as all options granted under theseplans had an exercise price equal to the market value of the underlying commonstock on the date of the grant.

The Company has elected to apply the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” asamended by SFAS No. 148. Accordingly, the Company accounts for stock-basedcompensation using the intrinsic value method prescribed in APB Opinion No. 25,and related interpretations. Compensation cost for stock options is measured asthe excess, if any, of the fair value of the Company’s common stock at the dateof grant over the stock option exercise price.

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Thefollowing table illustrates the effect on net income (loss) and net income(loss) per share if the Company had applied the fair value recognitionprovision of Financial Accounting Standards Board Statement No. 123, “Accountingfor Stock-Based Compensation,” to stock-based employee compensation.
| ** **                                                                                       | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2003**                                                      | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Net  income (loss), as reported**                                                              |       | $                                                             | 17,136,000 |   | $ | (510,000 | ) | $ | (19,222,000 | ) |
| Add: Stock-based  compensation, as reported                                                      |       | —                                                        |       | 37,000 |   | 218,000 |   |
| Deduct: Total  stock-based compensation determined under fair value based method for all  awards |       | (14,540,000                                                   | )          | (8,668,000 | ) | (3,164,000 | ) |
| Adjusted net  income (loss), fair value method for all stock-based awards                        |       | $                                                             | 2,596,000  |   | $ | (9,141,000 | ) | $ | (22,168,000 | ) |
| Basic income (loss) per share—as reported                                                   |       | $                                                             | 0.58       |   | $ | (0.02 | ) | $ | (0.79 | ) |
| Diluted income  (loss) per share—as reported                                                |       | $                                                             | 0.52       |   | $ | (0.02 | ) | $ | (0.79 | ) |
| Basic income  (loss) per share—SFAS No. 123 adjusted                                   |       | $                                                             | 0.09       |   | $ | (0.34 | ) | $ | (0.91 | ) |
| Diluted income (loss)  per share—SFAS No. 123 adjusted                                 |       | $                                                             | 0.08       |   | $ | (0.34 | ) | $ | (0.91 | ) |

 

The fair value of eachoption grant is estimated on the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions: risk-free interestrates of 4.0%, 3.0% and 4.5% in 2003, 2002 and 2001, respectively; no expecteddividends; expected lives of four years in 2003 and five years in 2002 and 2001and a volatility factor of 1.3, 1.4 and 1.1 in 2003, 2002 and 2001,respectively. The weighted average fair value of the options granted in 2003,2002 and 2001 was $13.46, $7.16 and $3.56, respectively.

***Net Income per Share***

Basicincome (loss) per common share is computed by dividing net income (loss) by theweighted average number of shares of common stock outstanding during the year.The computation of diluted earnings per common share is similar to thecomputation of basic income (loss) per common share, except that thedenominator is increased for the assumed conversion of convertible securitiesand the exercise of dilutive options using the treasury stock method. Stockoptions and warrants totaling 6,666,146 were included in the computation ofdiluted income per share in 2003. The weighted average shares used in computingbasic and diluted loss per share were the same in the years ended December 31,2002 and 2001. Stock options and warrants totaling 6,155,950, and 5,947,790 for2002 and 2001, respectively, were excluded from the computation of net loss pershare as their effect was anti-dilutive.
| ** **                                                         | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Earnings per  share—basic                                     |       |       |       |       |       |       |       |
| Earnings available to common shareholders                          |       | $          | 17,136,000 |       | $          | (510,000   | )          | $ | (19,222,000 | ) |
| Weighted average shares outstanding                                |       | 29,398,000 |       | 26,791,000 |       | 24,285,000 |       |
| Earnings per share—basic                                      |       | $          | 0.58       |       | $          | (0.02      | )          | $ | (0.79 | ) |
| Earnings per share—diluted                                    |       |       |       |       |       |       |       |
| Earnings available to common shareholders                          |       | $          | 17,136,000 |       | $          | (510,000   | )          | $ | (19,222,000 | ) |
| Weighted average shares outstanding                                |       | 29,398,000 |       | 26,791,000 |       | 24,285,000 |       |
| Dilutive impact of options outstanding                             |       | 3,653,000  |       | —     |       | —     |       |
| Weighted average  shares and potential dilutive shares Outstanding |       | 33,051,000 |       | 26,791,000 |       | 24,285,000 |       |
| Earnings per  share—diluted                                   |       | $          | 0.52       |       | $          | (0.02      | )          | $ | (0.79 | ) |

*** ***

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***Use of Estimates***

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

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

Research and developmentexpenses consist primarily of development personnel and external contractorcosts related to the development of new products and services, enhancement ofexisting products and services, quality assurance and testing. The Companyfollows AICPA Statement of Position No. 98-1, “Accounting for the Costs ofComputer Software Developed or Obtained for Internal Use”, in accounting forinternally developed software. To date, the Company’s capitalized  software development costs have beenimmaterial, as a majority of in-house development efforts are related todetermining specific software requirements and evaluating alternatives relatedto specific performance criteria for its products. As a result, research anddevelopment costs have been expensed as incurred.

***Recent Accounting Pronouncements***

In May 2003, the Financial Accounting StandardsBoard (FASB) issued SFAS 150, “*Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity.*”  SFAS 150 establishes standards for issuerclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity. Instruments that fall withinthe scope of SFAS 150 must be classified as a liability, and is effective forfinancial instruments entered into or modified after May 31, 2003. Forfinancial instruments issued prior to June 1, 2003, SFAS 150 is effectivefor the Company in the second quarter of 2004. Adoption is not expected to havean impact on the Company’s consolidated financial statements.

In January 2003, the FASB issued FIN No. 46,“Consolidation of Variable Interest Entities.” In addition in December 2003the FASB issued a revision of the Interpretation (The Revised Interpretation). FINNo. 46 states that companies that have exposure to the economic risks and potentialrewards from another entity’s assets and activities have a controllingfinancial interest in a variable interest entity and should consolidate theentity, despite the absence of clear control through a voting equity interest. Theconsolidation requirements apply to all variable interest entities for thefirst fiscal year or interim period ending after March 15, 2004. TheCompany does not believe that this statement will have a material impact on itsconsolidated financial statements.

In November 2002, theFASB issued Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers” (“FIN No. 45”). FIN No. 45 requires companies to recognize,at the inception of a guarantee, a liability for the fair value of theobligation undertaken in issuing the guarantee. Guarantees in existence at December 31,2002 are grandfathered for the purposes of recognition and would only need tobe disclosed. The Company enters into indemnification agreements with itsofficers and directors, as well as in connection with its acquisitions. It isnot possible to determine the maximum potential amount under these agreementsdue to the limited history of prior indemnification claims and the unique factsand circumstances involved in each particular agreement. The adoption of FIN No. 45did not have a material impact on the Company’s consolidated financialstatements.

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**2. Goodwilland Intangible Assets**

In July 2001, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standards (SFAS) No. 141, “BusinessCombinations” and No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141requires all business combinations initiated after June 30, 2001 to beaccounted for using the purchase method. 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. For acquisitions consummated by the Company subsequent to July 1,2001, the Company adopted the provisions of SFAS No. 141 and 142 effectiveJuly 1, 2001. The Company adopted the full provisions of SFAS No. 141and 142 during the first quarter of 2002.

The Company completes its annual impairment test usinga two-step approach based on reportable segments in the fourth quarter of eachyear and reassesses goodwill recorded in connection with earlier acquisitions.The Company’s assessment has indicated that there is no impairment of goodwillfor the years ended December 31, 2003 and 2002 and thus the Company didnot record any expense related to goodwill in 2003 or 2002.

Uponadoption of SFAS No. 142, the Company discontinued the amortization ofgoodwill. The following table presents a reconciliation of net income (loss)and net income (loss) per share adjusted for the exclusion of goodwillamortization:
| ** **                                    | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Reported net  income                          |       | $                                          | 17,136,000 |   | $ | (510,000 | ) | $ | (19,222,000 | ) |
| Add goodwill  amortization                    |       | —                                     |       | — |   | 10,769,000 |   |
| Adjusted net  income (loss)                   |       | $                                          | 17,136,000 |   | $ | (510,000 | ) | $ | (8,453,000 | ) |
| Reported diluted net income (loss) per share  |       | $                                          | 0.52       |   | $ | (0.02 | ) | $ | (0.79 | ) |
| Add goodwill  amortization per share          |       | —                                     |       | — |   | 0.44 |   |
| Adjusted diluted net  income (loss) per share |       | $                                          | 0.52       |   | $ | (0.02 | ) | $ | (0.35 | ) |

 

Thechanges in the net carrying amount of goodwill for the years ended December 31,2003 and 2002, by operating segment, are as follows:
| ** **                                     | ** ** | **Software and  Digital CommerceServices Division** | ** ** | **E-Business  Services 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 |   |
| Goodwill from  acquisitions and earnouts  |       |                                                               | 5,223,000  |                                   |       |      | —     |   |   | 5,223,000 |   |
| Balance as of  December 31, 2003          |       |                                                               | $          | 16,293,000                             |       |      |       | $ | 7,628,000 |   |   | $ | 23,921,000 |   |

 

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Informationregarding the Company’s other intangible assets is as follows:
| ** **              | ** ** | **December 31, 2003** | ** ** |
|-------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Carrying amount  Gross** | ** ** | **Accumulated  amortization** | ** ** | **Carrying amount  Net** | ** ** |
| Customer  relationships |       |                            | $          | 16,488,000 |   |   | $ | 11,405,000 |   |   | $ | 5,083,000 |   |   |
| Non-compete  agreements |       |                            | 3,850,000  |   |   | 2,992,000 |   |   | 858,000 |   |   |
| Technology/tradename    |       |                            | 7,810,000  |   |   | 5,579,000 |   |   | 2,231,000 |   |   |
| Total                   |       |                            | $          | 28,148,000 |   |   | $ | 19,976,000 |   |   | $ | 8,172,000 |   |   |

 
| ** **              | ** ** | **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 |   |   |

 

Estimatedamortization expense for the remaining life of the intangible assets, based onintangible assets as of December 31, 2003 is as follows:
| **Year** | ** ** | ** ** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|------------|------------|
| 2004     |       | $          | 4,924,000  |       |
| 2005     |       | 2,166,000  |       |
| 2006     |       | 1,082,000  |       |
| Total    |       | $          | 8,172,000  |       |

 

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

In January 2003, the Company acquired certainassets and assumed certain liabilities of Metatec® International, Inc.’s (“Metatec”)electronic software distribution (“ESD”) business in exchange for approximately$1.3 million in cash which has been paid as of December 31, 2003. Goodwill of $789,000was recorded as a result of this agreement, including $126,000 in connectionwith an earn-out. The Company will amortize intangible assets acquired,consisting of a non-compete agreement and technology/tradename, over athree-year period. The agreement also provided Metatec the opportunity foradditional cash earn-outs based on the Company achieving certain revenuemetrics related to the ESD business over the course of the twelve monthsfollowing November 1, 2002.

In March 2003, the Company acquired substantiallyall of the assets and assumed certain liabilities of Hartsell Holdings, Inc.,(“Hartsell”) d/b/a Infocon America Corporation in connection with its businessof providing Web services for business-to-business publishers in exchange forapproximately $1.1 million in cash which has been paid as of December 31, 2003.Goodwill of $953,000 was recorded as a result of this agreement. The Companywill amortize other intangible assets acquired, consisting of non-competeagreements and technology/tradename, over a three-year period. The agreementalso provides Hartsell the opportunity for additional cash earn-outs based onthe Company achieving certain gross margin and revenue metrics related to theWeb services for business-to-business publishers over the course of the twelvemonths and, at the Company’s sole discretion, the twenty-four months followingthe close of the acquisition. Such earn-out amounts, if paid, will be recordedas additional goodwill as they are considered incremental to the purchaseprice.

 

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In August 2003, the Company acquiredsubstantially all of the assets and certain liabilities of The RegistrationNetwork, or Reg.Net, a provider of e-commerce services for authors and vendorsof try-before-you-buy software for the purchase price of $2.5 million in cash,of which $1.4 million has been paid as of December 31, 2003. Additionalgoodwill of $934,000 was recorded as a result of this acquisition. The Companywill amortize other intangible assets acquired, consisting of non-competeagreements, customer base and technology/tradename, over a three-year period. Theagreement also provides Reg.Net the opportunity for an additional cash earn-outbased on the Company achieving certain revenue metrics related to the e-commerceservices for authors and vendors of try-before-you-buy software over the courseof the twelve months following the close of the acquisition. Such earn-outamounts, if paid, will be recorded as goodwill as they are consideredincremental to the purchase price.

In November 2003, the Company acquiredsubstantially all of the assets and assumed certain liabilities of Emetrix, Inc.,a provider of e-commerce services for authors and vendors of software for thepurchase price of $2.6 million in cash, of which $1.7 million has been paidas of December 31, 2003. Additional goodwill of $601,000 was recorded as aresult of this acquisition. The Company will amortize other intangible assetsacquired, consisting of non-compete agreements, customer base andtechnology/tradename, over a three-year period. The agreement also providesEmetrix the opportunity for additional cash or stock earn-outs based on theCompany achieving certain revenue metrics related to the e-commerce services forauthors and vendors of software over the course of the thirty-six months and,at the Company’s sole discretion, the sixty months following the close of theacquisition. Such earn-out amounts, if paid, will be recorded as goodwill asthey are considered incremental to the purchase price.

In November 2003, the Company acquiredsubstantially all of the assets and assumed certain liabilities of GameZone, Inc.,a provider of computer gaming resources and download destination sites on theWeb, for the purchase price of $1.1 million in cash, of which $934,000 has beenpaid as of December 31, 2003. Additional goodwill of $821,000 was recorded as aresult of this acquisition. The Company will amortize other intangible assetsacquired, consisting of non-compete agreements and technology/tradename, over athree-year period. The agreement also provides GameZone the opportunity foradditional cash or stock earn-outs based on the Company achieving certainrevenue metrics related to computer gaming resources and download destinationsites on the Web over the course of the thirty-six months and, at the Company’ssole discretion, the sixty months following the close of the acquisition. Suchearn-out amounts, if paid, will be recorded as goodwill as they are consideredincremental to the purchase price.

In March 2002, pursuant to an Amended andRestated Asset Purchase Agreement (the “Agreement”) between the Company andBeyond.com Corporation (“Beyond.com”), the Company purchased those assets andassumed those liabilities of Beyond.com related to its eStores business, whichmanages online stores for clients, in exchange for 179,096 shares of our commonstock. A total of 70,000 of such shares were placed in escrow (the “Escrow”) tosecure certain indemnification obligations of Beyond.com under the Agreement. Thepurchase was approved by the U.S. Bankruptcy Court following Beyond.com’sfiling for Chapter 11 bankruptcy protection. Immediately following the closingof the Agreement, the Company entered into a Post-Closing Amendment to theAgreement with Beyond.com (the “Post-Closing Amendment”) pursuant to which,among other things, the Company agreed to increase the number of shares to bedelivered to Beyond.com under the Agreement to 222,842, in exchange for arelease of certain claims of Beyond.com against us. The Post-Closing Amendmentwas subject to approval by the U.S. Bankruptcy Court. The Official Committee ofUnsecured Creditors (the “Committee”) of Beyond.com’s bankruptcy estateobjected to the Post-Closing Amendment, asserting that the increase in sharesto be delivered to Beyond.com under the Post-Closing Amendment was inadequate,and also asserting the right to additional shares of the Company’s common stockunder certain provisions of the Agreement.

In April 2003, Beyond.com, the Committee andDigital River entered into a Settlement Agreement (the “Settlement Agreement”)pursuant to which the Company agreed to transfer an additional 50,919 shares(in addition to the 222,842 shares previously agreed to) to Beyond.com, inexchange for the release 

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by Beyond.com and theCommittee of their claims against the Company. The parties also agreed toresolve certain claims by the Company against the 70,000 shares in the Escrowby transferring 55,123 of such shares to Beyond.com and returning 14,877 ofsuch shares to the Company. In May and June 2003, the SettlementAgreement and the Post-Closing Amendment were approved by the Bankruptcy Courtand subsequently consummated.

Followingis an allocation of the net assets acquired from the acquisitions consummatedand amounts paid under earn-out arrangements in 2003 and 2002:
| ** **              | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-------------------------|------------|------------|------------|------------|------------|
| Tangible assets         |       | $          | 402,000    |       | $          | 231,000 |   |
| Liabilities  assumed    |       | (2,862,000 | )          | (3,759,000 | )          |
| Customer  relationships |       | 2,371,000  |       | 4,800,000  |       |
| Non-compete  agreements |       | 700,000    |       | 100,000    |       |
| Technology/tradename    |       | 2,135,000  |       | 250,000    |       |
| Goodwill                |       | 5,223,000  |       | 7,425,000  |       |
| Net assets acquired     |       | $          | 7,969,000  |       | $          | 9,047,000 |   |

 

Thefollowing unaudited pro forma condensed results of operations for 2003, 2002,and 2001 have been prepared as if each of the acquisitions in 2003 had occurredon January 1, 2002 and as if each of the 2002 acquisitions had occurred onJanuary 1, 2001.
| ** **                       | ** ** | **2003**   | ** **  | **2002**   | ** ** | **2001**    | ** ** |
|----------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Revenue                          |       | $          | 103,108,000 |       | $          | 83,855,000  |       | $ | 73,928,000 |   |
| Income (loss)  from operations   |       | 15,465,000 |        | (4,623,000 | )          | (39,841,000 | )          |
| Net income (loss)                |       | 16,304,000 |        | (5,051,000 | )          | (40,069,000 | )          |
| Diluted income (loss)  per share |       | $          | 0.49        |       | $          | (0.19       | )          | $ | (1.59 | ) |

 

Thisfinancial information does not purport to represent results that would actuallyhave been obtained if the transactions had been in effect on January 1,2003, 2002, 2001 as applicable, or any future results that may be realized.

**4. IncomeTaxes:**

Thereconciliation of the reported income tax expense to the amount the wouldresult from applying the U.S. federal statutory rate of 35% to the net loss isas follows:
| ** **                                         | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Tax expense  (benefit) at statutory rate           |       | $                                          | 5,998,000  |   | $ | (179,000 | ) | $ | (6,728,000 | ) |
| State taxes, net  of federal benefit               |       | 725,000                                    |       | 63,000 |   | (1,000,000 | ) |
| Stock  compensation deductions                     |       | —                                     |       | — |   | (258,000 | ) |
| Non-deductible  goodwill and earn-out compensation |       | 314,000                                    |       | 712,000 |   | 3,255,000 |   |
| Non-deductible  expense and other                  |       | 35,000                                     |       | 23,000 |   | 585,000 |   |
| Change in  valuation allowance                     |       | (7,072,000                                 | )          | (619,000 | ) | 4,146,000 |   |
| Total                                              |       | $                                          | —     |   | $ | — |   | $ | — |   |

 

As of December 31, 2003, the Company had netoperating loss carryforwards of approximately $93,222,000. Included in thisamount is approximately $47,266,000 of deductions resulting from disqualifyingdispositions of stock options. When these deductions are realized for financialstatement purposes they will not result in a reduction in income tax expense,rather the benefit will be recorded as additional paid-in-capital. These incometax net operating loss carryforwards expire beginning in the year 

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2009. Deductions fromdisqualifying dispositions of stock options are included in net operating losscarryforwards with a corresponding valuation allowance. Because of the uncertaintyof future realization, a valuation allowance equal to the deferred tax assethas been recorded.

Thecomponents of deferred income taxes are as follows:
| ** **                           | ** ** | **2003**    | ** ** | **2002**    | ** ** |
|--------------------------------------|------------|-------------|------------|-------------|------------|
| Net operating  loss carryforwards    |       | $           | 36,357,000 |        | $          | 32,490,000 |   |
| Nondeductible reserves  and accruals |       | 1,796,000   |       | 1,972,000   |       |
| Depreciation and  amortization       |       | 4,791,000   |       | 4,503,000   |       |
| Valuation  allowance                 |       | (42,944,000 | )          | (38,965,000 | )          |
| Total                                |       | $           | —     |        | $          | — |   |

 

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

**5. Commitmentsand Contingencies:**

***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$1,935,000, $1,652,000, and $1,367,000 for the years ended December 31,2003, 2002 and 2001, respectively. The minimum annual rents under long-termleases at December 31, 2003 were as follows:
| **Year ending December 31,** | ** ** | ** ** | ** ** | **Lease Obligations** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------|------------|
| 2004                                        |       |       | $          | 1,266,000                  |       |   |
| 2005                                        |       |       | 1,039,000  |                       |       |
| 2006                                        |       |       | 341,000    |                       |       |
| 2007                                        |       |       | 117,000    |                       |       |
| Total future minimum  obligations           |       |       | $          | 2,763,000                  |       |   |

 

***Litigation***

We are engaged in certain legal proceedings and claimsarising in the ordinary course of our business. The ultimate liabilities, ifany, which may result from these or other pending or threatened legal actionsagainst us cannot be determined at this time. However, in the opinion of theCompany, the facts known at the present time do not indicate that suchlitigation will have a material effect on our financial position.

Beginning in August 2001, the Company and certainof its officers and directors were named as defendants in several classaction shareholder complaints filed in the United States District Court for theSouthern District of New York, now consolidated as *In reDigital River, Inc. Initial Public Offering Securities Litigation,*Case No. 01-CV-7355. Similar complaints, referred to here as the IPOLawsuits, were filed in the same court against hundreds of other publiccompanies, referred to here as the Issuers. In the consolidated amended complaint,the plaintiffs allege that the Company, certain of its officers and directorsand the underwriters of the Company’s initial public offering, or IPO, violatedSection 11 of the Securities Act of 1933 based on allegations that our IPOregistration statement and prospectus failed to disclose material factsregarding the compensation to be received by, and the stock allocationpractices of, the IPO underwriters. The complaint also contains a claim forviolation of Section 10(b) of the Securities 

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Exchange Act of 1934 basedon allegations that this omission constituted a deceit on investors. Theplaintiffs seek unspecified monetary damages and other relief.

On August 8, 2001, the IPO Lawsuits wereconsolidated for pretrial purposes before United States Judge Shira Scheindlinof the Southern District of New York. Judge Scheindlin held an initial casemanagement conference on September 7, 2001, at which time she ordered,among other things, that the time for all defendants in the IPO Lawsuits torespond to any complaint be postponed until further order of the court. Thus,the Company has not been required to answer any of the complaints, and nodiscovery has been served on the Company.

In July 2002, the Company joined in a globalmotion to dismiss the IPO Lawsuits filed by all of the Issuers (amongothers). In October 2002, the parties agreed to toll the statute oflimitations with respect to certain of the named officers and directors until September 30,2003 and on the basis of this agreement, our officers and directors weredismissed from the lawsuit without prejudice. In February 2003, the courtissued a decision denying the motion to dismiss the Section 11 claimsagainst the Company and almost all of the Issuers and denying the motion todismiss the Section 10(b) claims against the Company and many ofthe other Issuers.

During the summer of 2003, the Company, alongwith a substantial majority of Issuers, indirectly participated indiscussions with the plaintiffs and the Issuers’ respective insurers regardinga tentative settlement of the IPO Lawsuits. The terms of the tentativesettlement would provide for, among other things, a release of the Issuers andtheir officers and directors from all further liability resulting fromplaintiffs’ claims, and the assignment to plaintiffs of certain potentialclaims that the Issuers may have against their IPO underwriters. The tentativesettlement also provides that, in the event that plaintiffs ultimately recoverless than a guaranteed sum of $1 billion from the IPO underwriters,plaintiffs would be entitled to payment by each participating Issuer’s insurerof a pro rata share of any shortfall in the plaintiffs’ guaranteed recovery. InJune 2003, pursuant to the authorization of a special litigation committeeof the Company’s board of directors, the Company entered into anon-binding memorandum of understanding reflecting the settlement termsdescribed above. In September 2003, in connection with the possiblesettlement, the Company’s officers and directors who had entered tollingagreements with plaintiffs (described above) agreed to extend those agreementsso that they would not expire prior to any settlement being finalized.Although the Company has approved this settlement proposal in principle,it remains subject to a number of procedural conditions, as well as formalapproval by the Court. Pending definitive settlement, the Company continuesto believe that  the claims against theCompany, its officers and directors are without merit and intends to defendagainst it vigorously.

In August 2001, anaction was brought against the Company and other defendants in the U.S.District Court in the District of Columbia alleging infringement of UnitedStates Patent No. 6,014,651 owned by Christopher M. Crawford ofWashington, D.C. Crawford alleges that we directly infringe the patent bythe provision of online software purchase and delivery services, that weactively induce infringement of the patent by supporting and otherwisepromoting our electronic software delivery services to others and that wecontributorily infringed the patent by making, using, selling and offering tosell components of our electronic software delivery services. No substantiveactions have taken place in this case. The court has delayed substantivediscovery in this case, pending a preliminary determination of the legal scopeof Crawford’s claim. Discovery reopened in February 2004, and is ongoing. TheCompany has been in the process of preparing materials regarding claiminterpretation to present to the court, and the Company expects to do so at anappropriate point in the case. Although a number of co-defendants have settledwith plaintiff Crawford, at this time, Crawford has declined to make adefinitive demand for the resolution of this case. The Company believes thatthis lawsuit is without merit and intends to defend against it vigorously.

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***Employee Benefit Plan***

TheCompany has a defined contribution 401(k) retirement plan for eligibleemployees. Employees may contribute up to 15% of their pretax compensation tothe plan, with the Company providing a discretionary match of up to 50% of thetotal employee contribution. Amounts charged to expense related to the Company’smatching contributions for the years ended December 31, 2003, 2002 and2001 totaled $660,000, $706,000 and $559,000, respectively.

**6. Stockholders’Equity:**

***Warrants***

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

***Share RepurchaseProgram***

In April 2001,the Company announced a share repurchase program of up to $5,000,000 of itsoutstanding shares of Common Stock. Repurchases are at the Company’s discretionbased on ongoing assessments of the capital needs of the business and themarket price of its shares. No shares were repurchased under this programduring 2003 or 2002. Shares repurchased under the program totaled 57,000 fortotal consideration of $267,000 in 2001.

**7. StockOptions:**

The Company’s 1998 Stock Option Plan (the “SOP”)provides for the granting of incentive or nonqualified stock options topurchase up to 5,983,333 shares of Common Stock. Options granted to employeestypically expire no later than ten years after the date of grant. Incentivestock option grants must have an exercise price of at least 100% of the fairmarket value of a share of common stock on the grant date. Incentive stockoptions granted to employees who, immediately before such grant, owned stockdirectly or indirectly representing more than 10% of the voting power of thestock of the Company will have an exercise price of 110% of the fair marketvalue of a share of common stock on the grant date and will expire no laterthan five years from the date of grant.

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

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Asummary of the change in outstanding options under the SOP and NOP is asfollows:
| ** **                       | ** ** | **Options   Outstanding** | ** ** | **Option Price   Per Share** | ** ** |
|----------------------------------|------------|--------------------------------|------------|---------------------------------------------|------------|
| Balance,  December 31, 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                         |       |
| Grants                           |       | 2,858,651                      |       | 8.98  –  27.40                         |       |
| Exercised                        |       | (1,678,761                     | )          | 1.69  –  26.88                         |       |
| Cancelled                        |       | (568,027                       | )          | 2.59  –  31.13                         |       |
| Balance,  December 31, 2003 |       | 6,666,146                      |       | $1.69 – $31.13                         |       |

 

Asummary of information about total stock options outstanding at December 31,2003 is as follows:
| ** **                                                                 | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Exercise Price**                                                    | ** ** | ** **                   | ** ** | **Number  Outstanding**      | ** ** | **Weighted Average   Life Remaining** | ** ** | **Number   Exercisable** | ** ** | **Weighted  Average Price** | ** ** |
| $  1.69 – $  3.88                       |       | 477,699                      |       |                         | 5.6 years  |   |   | 285,396 |   |   | $ | 2.98 |   |   |
|     4.56 –     7.55 |       | 2,931,138                    |       |                         | 7.4 years  |   |   | 1,427,564 |   |   | 5.49 |   |   |
|     8.50 –   13.92            |       | 1,664,387                    |       |                         | 8.7 years  |   |   | 298,438 |   |   | 12.33 |   |   |
|   16.54 –   31.13                       |       |                         | 1,592,922  |                         |       | 8.6 years |   |   | 402,870 |   |   | 22.56 |   |   |
| $  1.69 – $31.13                                  |       | 6,666,146                    |       |                         | 7.9 years  |   |   | 2,414,268 |   |   | $ | 8.89 |   |   |
|                                                                            |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company recorded compensation expense for thedifference between the grant price and the fair market value of the Company’sCommon Stock on options to purchase 30,533 shares at an exercise price of $.01issued in January 2001.

TheCompany also sponsors an employee stock purchase plan under which 1,200,000shares have been reserved for purchase by employees. The purchase price of theshares under the plan is the lesser of 85% of the fair market value on thefirst or last day of the offering period. Offering periods currently are eachsix months ending on June 30 and December 31. Employees may designateup to ten percent of their compensation for the purchase of shares under theplan. Total shares purchased by employees under the plan were 93,000, 49,000,182,000 in the years ended December 31, 2003, 2002 and 2001, respectively.

**8. SegmentInformation:**

Sales to foreign customers accounted for 24%, 22% and22% of revenue for 2003, 2002 and 2001, respectively. In addition, revenuederived from sales of product from one software publisher, SymantecCorporation, accounted for approximately 27%, 23%, and 15% of total Companyrevenue in 2003, 2002 and 2001, respectively.

ThroughDecember 31, 2003, the Company maintained two operating segments, Softwareand Digital Commerce Services and E-Business Services, which were identified ascomponents of the Company that were reviewed regularly by management todetermine resource allocation and assess performance. Unallocated corporateitems consisted of depreciation, goodwill and other intangibles amortization,acquisition-related costs and interest income for operational results andconsisted of certain cash, 

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investments and goodwill for total assets, as well asthe $2.5 million litigation and other charges in 2002. Segment information for2003, 2002 and 2001 was as follows:
| ** **                                                     | ** ** | **Software and  Digital Commerce  Services Division** | ** ** | **E-Business  Services Division** | ** ** | **Unallocated  Corporate Items** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|------------------|------------|
| **Year  ended December 31, 2003:**                        |       |                                                                 |       |                                   |       |                                  |       |             |       |   |   |   |   |
| Revenue                                                        |       |                                                                 | $          | 86,318,000                             |       |                                  |       | $                | 14,883,000 |   |   | $ | — |   | $ | 101,201,000 |   |
| Gross profit  (excludes depreciation and amortization expense) |       |                                                                 | 74,480,000 |                                   |       |                                  | 10,883,000 |             |       | — |   | 85,363,000 |   |
| Income from  operations                                        |       |                                                                 | 28,838,000 |                                   |       |                                  | 115,000    |             |       | (12,655,000 | ) | 16,298,000 |   |
| Net income                                                     |       |                                                                 | 28,838,000 |                                   |       |                                  | 115,000    |             |       | (11,817,000 | ) | 17,136,000 |   |
| Total assets at  December 31, 2003                        |       |                                                                 | 77,133,000 |                                   |       |                                  | 13,500,000 |             |       | 99,025,000 |   | 189,658,000 |   |
| **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                        |       |                                                                 | 42,184,000 |                                   |       |                                  | 15,623,000 |             |       | 38,727,000 |   | 96,534,000 |   |
| **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                        |       |                                                                 | 21,412,000 |                                   |       |                                  | 9,159,000  |             |       | 48,209,000 |   | 78,780,000 |   |

 

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**Digital River, Inc.Schedule IIFor Years Ended December 31, 2003, 2002 & 2001**
| **2003**                         | ** ** | ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Charges to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for  doubtful accounts |       |       | $          | 905,000                                          |       |                                          | $          | 820,000        |       | $                                          | (1,406,000 | ) | $ | 319,000 |   |
| Accrued  chargeback reserve      |       |       | 841,000    |                                             |       | 3,005,000                                     |       | (2,072,000     | )          | 1,774,000                                  |       |
| Litigation  settlement reserve   |       |       | 1,675,000  |                                             |       | —                                        |       | —         |       | 1,675,000                                  |       |
|                                  |            |            |            |                                                  |            |                                               |            |                |            |                                            |            |  |  |  |  |  |  |

 
| **2002**                         | ** ** | ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Charges to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for  doubtful accounts |       |       | $          | 286,000                                          |       |                                          | $          | 1,897,000      |       | $                                          | (1,278,000 | ) | $ | 905,000 |   |
| Accrued  chargeback reserve      |       |       | 553,000    |                                             |       | 1,498,000                                     |       | (1,210,000     | )          | 841,000                                    |       |
| Litigation  settlement reserve   |       |       | —     |                                             |       | 2,300,000                                     |       | (625,000       | )          | 1,675,000                                  |       |
|                                  |            |            |            |                                                  |            |                                               |            |                |            |                                            |            |  |  |  |  |  |  |

 
| **2001**                         | ** ** | ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Charges to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for  doubtful accounts |       |       | $          | 523,000                                          |       |                                          | $          | 950,000        |       | $                                          | (1,187,000 | ) | $ | 286,000 |   |
| Accrued  chargeback reserve      |       |       | 452,000    |                                             |       | 1,551,000                                     |       | (1,450,000     | )          | 553,000                                    |       |
| Litigation settlement  reserve   |       |       | —     |                                             |       | —                                        |       | —         |       | —                                     |       |
|                                  |            |            |            |                                                  |            |                                               |            |                |            |                                            |            |  |  |  |  |  |  |

 

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**INDEX TO EXHIBITS**
| **Exhibit   Number** | ** **                                                                                                                                                                                                                | **Description Of Document** |
|----------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------|
| 2.1(1)               | 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.                    |
| 2.2(2)               | Amended and Restated Asset Purchase Agreement dated  February 9, 2002 by and between the Registrant and Beyond.com.                                                                                                  |
| 2.3(3)               | First Amendment to the Amended and Restated Asset  Purchase Agreement dated as of March 15, 2002 by and between the  Registrant and Beyond.com.                                                                      |
| 2.4(3)               | Post-Closing Amendment to the Amended and Restated  Asset Purchase Agreement dated as of March 31, 2002 by and between the  Registrant and Beyond.com.                                                               |
| 3.1(4)               | Amended and Restated Certificate of Incorporation of  the Registrant, as currently in effect.                                                                                                                             |
| 3.2(6)               | Amended and Restated Bylaws of the Registrant, as  currently in effect.                                                                                                                                                   |
| 3.3(4)               | Certificate of Amendment of Amended and Restated  Certificate of Incorporation (amending Exhibit 3.1).                                                                                                               |
| 4.1(7)               | Specimen Stock Certificate.                                                                                                                                                                                               |
| 4.2(4)               | Form of Senior Debt Indenture.                                                                                                                                                                                       |
| 4.3(4)               | Form of Subordinated Debt Indenture.                                                                                                                                                                                 |
| 4.4                  | References are hereby made to Exhibits 3.1, 3.2 and  3.3.                                                                                                                                                                 |
| 10.1(7)              | Form of Indemnity Agreement between Registrant  and each of its directors and executive officers.                                                                                                                    |
| 10.2(7)              | Employment and Non-Competition Agreement effective  May 25, 1998 by and between Joel A. Ronning and the  Registrant.                                                                                       |
| 10.3(7)              | Consent to Assignment and Assumption of Lease dated  April 22, 1998 by and between CSM Investors, Inc., IntraNet  Integration Group, Inc. and Registrant.                                                  |
| 10.4(5)              | Assignment of Lease dated April 21, 1998 by and  between Intranet Integration Group, Inc. and Registrant.                                                                                                       |
| 10.5(5)              | Lease Agreement dated January 18, 2000 between  Property Reserve, Inc. and Registrant.                                                                                                                          |
| 10.6(6)              | First Amendment of Lease dated January 31, 2001  to that certain Lease dated April 24, 1996 between CSM  Investors, Inc. and Registrant (as assignee of Intranet Integration  Group, Inc.).           |
| 10.7(8)              | 1998 Stock Option Plan, as amended.                                                                                                                                                                                       |
| 10.8(9)              | 1999 Stock Option Plan, formerly known as the 1999  Non-Officer Stock Option Plan, as amended.                                                                                                                            |
| 10.9(8)              | 2000 Employee Stock Purchase Plan, as amended, and  offering.                                                                                                                                                             |
| 10.10(2)             | Voting Agreement, dated March 20, 2001, by and  between the Registrant, Calico Commerce, Inc. and ConnectInc.com, Co.                                                                                           |
| 10.11(10)            | Second Amendment of Lease dated April 22, 2002  to that certain Lease dated April 24, 1996 between CSM  Investors, Inc. and Registrant (as assignee of Intranet Integration  Group, Inc.) as amended. |
| 10.12(10)            | Second Amendment of Lease dated April 28, 2003  to that certain Lease dated January 18, 2000 between Property Reserve  Inc. and Registrant.                                                                     |
| 10.13(11)            | Employment Agreement with Jay Kerutis.                                                                                                                                                                                    |
| 10.14                | Employment Agreement with Gary Howorka.                                                                                                                                                                                   |
| 21.1                 | Subsidiaries of Digital River, Inc.                                                                                                                                                                                  |
| 23.1                 | Consent of Independent Auditors, dated March 9,  2004.                                                                                                                                                               |
| 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.                                  |

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| 31.1 | Certification of Digital  River, Inc.’s Chief Executive Officer, pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 | Certification of Digital  River, Inc.’s Chief Financial Officer, pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
| 32.1 | Certification of Digital  River, Inc.’s Chief Executive Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.  |
| 32.2 | Certification of Digital  River, Inc.’s Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.  |

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  (1)    Incorporated by reference fromthe Company’s Current Report on Form 8-K filed on March 26, 2001.

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

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

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

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

  (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 (File No. 333-56787),declared effective on August 11, 1998.

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

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

(10)   Incorporatedby reference from the Company’s Quarterly Report on Form 10-Q for thequarter ended March 31, 2003 filed on May 15, 2003.

(11)   Incorporatedby reference from the Company’s Quarterly Report on Form 10-Q for thequarter ended September 30, 2003 filed on November 13, 2003.

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