**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-K**

 
| **(Mark one)** |   |
|----------------|--------|

 
| ý | **Annual Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934 for the fiscal year ended  December 31, 2001.** |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------|

**OR**

 
| **o** | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934.** |
|-------|-------------------------------------------------------------------------------------------------|

 

**Commission File Number:  000-24643**

 

**DIGITAL RIVER, INC.**

(Exact name of registrant as specified in its charter)

 
| **DELAWARE**                                                           |   | **41-1901640**                      |
|------------------------------------------------------------------------|--------|-------------------------------------|
| (State or other jurisdiction  ofIncorporation or  organization)        |   | (I.R.S. EmployerIdentification 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 |
|                                                                   |
| Securities registered pursuant  to Section 12(g) of the Act:      |
|                                                                   |
| **Common Stock  $0.01 par value**                                      |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such 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 if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference inPart III of this Form 10-K or any amendment to thisForm 10-K.  ý

 

The aggregate market value of the CommonStock of the registrant held by non-affiliates as of March 20, 2002 wasapproximately $380,542,000.

 

The number of shares of Common Stock outstandingat March 20, 2002 was 26,583,247 shares.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Certain sections of the Registrant’sdefinitive Proxy Statement for the 2002 Annual Meeting of Stockholders areincorporated by reference in Part III of this Form 10-K to the extentstated herein.

 

# ** **

 

 

# **PART I**

**ITEM 1. BUSINESS.**

 

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

 

Certain statements set forth or incorporatedby reference in this Form 10-K, as well as in our Annual Report to Stockholdersfor the year ended December 31, 2001, constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Words such as “believes”, “anticipates”, “expects”, “intends”,“estimates” and similar expressions are intended to identify forward-lookingstatements, but are not the exclusive means of identifying such statements.These statements involve known and unknown risks, uncertainties and otherfactors that may cause our actual results, performance or achievements, orindustry results, to be materially different from any future results,performance or achievements, or industry results, expressed or implied by suchforward-looking statements. Such factors include, among others: our limitedoperating history and variability of operating results, the expectation offuture losses, risks associated with electronic software delivery, ourdependence on the Internet and the growth in electronic commerce and Internetinfrastructure development, our dependence on software publishers, ourdependence on online retailers, system development and electronic commercesecurity risks, rapid technological changes, competition in the electroniccommerce industry, the importance of attracting and retaining personnel, managementof our growth, the integration of acquired companies, our dependence on keyemployees, and other risk factors set forth under “Risk Factors” and elsewherein this Form 10-K. We expressly disclaim any obligation to update orpublicly release any revision to these forward-looking statements after thedate of this Form 10-K.

 

**Overview**

 

We are a provider of comprehensive electroniccommerce outsourcing solutions. We were incorporated in February 1994 andcommenced offering products for sale through our clients’ Web stores inAugust 1996. As an application service 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 view trafficto, and sales through, their Web commerce systems. We provide an outsourcingsolution that allows our clients to promote their own brands while leveragingour investment in infrastructure and technology. Our Software and DigitalCommerce Services Division serves the software and digital products market, andour E-Business Services Division serves manufacturers, distributors andretailers outside the software industry. Our clients include H&R Block,Inc., Major League Baseball, National Geographic Society, Symantec Corporationand ScanSoft, Inc.

 

Our proprietary commerce network server, orCNS, technology serves as the platform for the majority of our solutions. TheCNS incorporates custom software applications that enable Web store authoring,electronic software delivery, fraud prevention, export control, merchandisingprograms and online registration, and features a database of more than 200,000software and digital products. Using our CNS 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 CNS. End-users can then browse for products and make purchases online, andonce purchases are made, we either deliver the products digitally to theend-user through the Internet or communicate the order through its integrationinto a number of third-party fulfillment agencies for physical fulfillment. Wealso provide transaction processing services and collect and maintain criticalinformation about end-users. This information can later be used by our clientsto facilitate add-on or upgrade sales and for other direct marketing purposes.We actively manage direct marketing campaigns for our clients and also deliverpurchase information and Web store traffic statistics to our clients throughonline reporting.

 

# **Subsequent Developments**

 

## ***Results of Operations***

 

In February 2002, ePedas Sdn Bhd initiated anarbitration before the American Arbitration Association against theCompany.  The demand for arbitration alleges breach of contract andtortious interference claims against the Company.  The prayer for reliefrequests RM 28,809,137.09 (Ringit Malaysia or approximately US $7,581,150) pluspre-judgment interest, punitive damages, all legal costs and otherunspecified fees and expenses.   An arbitrator has not been selectedand no arbitration date has been set. The Company believes this lawsuit iswithout merit and intends to defend against it vigorously.

 

On March 29, 2002, the Company announced thatit would record a reserve for pending litigation of $2,300,000 in the firstquarter of 2002.  Additionally, theCompany announced that it would take a charge of $200,000 in the first quarterof 2002 in connection with its decision during the quarter to consolidate oneof its offices.

 

*Acquisitions*

 

On March 19, 2002, pursuant to an AssetPurchase Agreement between Digital River and Innuity Acquisition Corp. (“IAC”),we purchased certain assets and assumed approximately $3.6 million in merchantliabilities in exchange for approximately $2.4 million in cash. The agreementincludes an opportunity for a cash earn-out based on revenue generated from theIAC assets during the 12-month period following the close of the transaction.

 

On March 31, 2002, pursuant to an Amended andRestated Asset Purchase Agreement (the “Agreement”) dated February 9, 2002,between Digital River and Beyond.com Corporation (“Beyond.com”), in exchangefor $2,910,311 in shares of our Common Stock (valued at the average of theclosing price of our Common Stock for the 15 trading days ending on the secondday prior to closing and the seven trading days immediately following theclosing), we purchased those assets and assumed those liabilities of Beyond.comrelated to its eStores business, which manages online stores for clients. Thepurchase was approved by the U.S. Bankruptcy Court following Beyond.com’sfiling for Chapter 11 bankruptcy protection, and certain elements of thepurchase remain subject to further approval by the court. The agreementincludes contingent earn-out provisions whereby Beyond.com may receive (i)additional shares of our Common Stock valued at $962,500 if specified customersof Beyond.com remain our customers for 90 days post closing, (ii) additionalshares of our Common Stock valued at $500,000 if 90% or more of specifiedcustomers of Beyond.com enter into 12 month contracts with us within 60 days ofthe closing and (iii) additional shares of our Common Stock valued at approximately$1.35 million if specified customers enter into 12 month contracts with uswithin 60 days of the closing (with such shares valued as described above). Ofthe shares issued at closing, 70,000 shares were placed in an escrow to securecertain indemnification obligations contained in the agreement. Subject tooutstanding claims, the escrow will terminate 90 days following the closing.

2

----

 

 

# **Industry Background**

 

*Growth Of TheInternet And Electronic Commerce.*  The Internet has emerged as a significantglobal communications medium, enabling millions of people to share informationand conduct business electronically. The increasing functionality, accessibility and overall usage of theInternet have made it an attractive commercial medium. Online businesses caninteract directly with end-users, both businesses and consumers, and canfrequently adjust their featured selections, shopping interfaces and pricing.The ability to reach and serve a large and global group of end-userselectronically from a central location and the potential for personalizedlow-cost customer interaction provide additional economic benefits for onlinebusinesses. Unlike traditional retail channels, online businesses do not havethe burdensome costs of managing and maintaining a significant physical retailstore infrastructure or the continuous printing and mailing costs of catalogmarketing. Because of these advantages, online businesses have the potential tobuild large, global customer bases quickly and to achieve superior economicreturns over the long term. An increasingly broad base of products is beingsold successfully online, including computers, travel services, brokerageservices, automobiles and music, as well as software products.

 

*Advantages Of Outsourcing Electronic Commerce.*  According to a Gartner Group study, theinitial investment in an electronic commerce site that is functionallyequivalent to most industry participants is $1.0  to $5.0 million andrequires an average of five months to implement. The study found that a marketdifferentiating electronic commerce solution requires an expenditure of $5.0 to$20.0 million. Additionally, to maintain a scaleable, best-of-breedcommerce solution, businesses must continue to invest in technology,infrastructure and personnel related to electronic commerce management.

 

There are a number of advantages tooutsourcing electronic commerce, including: (i) avoiding the large,upfront investment required to purchase and implement software applications andcomputer hardware; (ii) a shorter time to market as compared to in-housedevelopment and maintenance; (iii) the opportunity to shift the ongoingfinancial and technology risk to a proven service provider; and (iv) allowingbusinesses to focus on their specific core competency. Because of theseadvantages, we believe that an increasing number of businesses will outsourcetheir electronic commerce needs.

 

*Opportunity For Electronic Commerce Outsourcing.*  We believe that the market for electroniccommerce outsourcing in the software and digital products market as well asamong manufacturers, distributors and retailers will continue to grow rapidly.However, unlike established physical distribution channels, there is currentlyno established, comprehensive electronic distribution source for businesses. Webelieve that providing an integrated service offering of Web commercedevelopment and hosting, transaction processing, fraud screening, digitaldelivery, integration to physical fulfillment and customer service is complexand requires upfront and ongoing investments in secure, reliable and scaleablesystems. Accordingly, we believe that a substantial market opportunity existsfor a comprehensive, cost-effective, outsourced electronic commerce solutionfor software publishers and online retailers as well as for manufacturers,distributors and retailers.

 

*The Digital River Solution.*  We have developed a technology platform thatenables us to provide a comprehensive suite of electronic commerce services toour clients. We also leverage our merchandising and marketing expertise toincrease traffic and sales for our clients. Rather than maintaining our ownbranded Web store, we provide an outsourcing solution for Web commercedevelopment and hosting, transaction processing, fraud screening, digitaldelivery and merchandising and marketing services that enables our clients topromote their own brands while leveraging our investment in infrastructure. Inaddition, this approach enables us to leverage our clients’ brand investmentsand the traffic at our clients’ sites to maximize the number of transactionscompleted through Digital River.

 

*Benefits To Clients.*  Our electronic commerce solution enables our clients to leverageour investment in technology, personnel and infrastructure to provide abusiness-to-business or business-to-consumer electronic commerce solution. Thisprovides our clients with a cost-effective, proven solution that allows them tofocus on their core competency. Clients have the ability to offer the completelibrary of their products directly to end-users from their Web commercesystems, and for software publishers, through our network of online retailers.This benefit is particularly significant for smaller software

 

3

----

 

publishers who have limited market accessthrough traditional distribution methods. Our solution also provides a channelfor underdistributed products permitting clients to offer online their completeproduct catalog. In addition, through our 100% end-user registration and datawarehousing, we provide clients with valuable end-user information that canfacilitate targeted marketing, upgrade notification and sophisticatedmerchandising strategies. Finally, by exploiting the distribution relationshipswe have developed with a large network of online retailers, software publisherscan reduce or eliminate the need for multiple retailer relationships, therebylowering administrative costs and reducing the number of master copies of theirsoftware in existence for distribution.

 

Additionally, online retailers can use ourrobust CNS technology to sell software products online without having to buildand maintain their own electronic commerce infrastructure. We enable online retailersto offer their end-users access to virtually all of our inventory of softwareproducts without the burden of developing and maintaining relationships withhundreds of software publishers. Like software publishers, online retailersenjoy the cost savings from online fulfillment and the database marketingbenefits we offer. Online retailers can effectively outsource electroniccommerce functionality while building their own brands online. Online retailersalso eliminate the cost and risk associated with carrying inventory and therisk of inventory obsolescence. In addition, niche market and high traffic Websites can become online retailers at minimal cost using our solution.

 

*Benefits ToEnd-Users.*  Oursolution emphasizes convenience by allowing end-users, both business andconsumer, to purchase products online twenty-four hours a day, seven days aweek, or 24x7, from their home or office. End-users are not required to make atrip to the store, can act immediately on a purchase impulse and can locate productsthat are difficult to find.  Because wehave a global reach, we can deliver an extremely broad selection to end-usersin rural, international or other locations that cannot support retail stores.Software and digital products purchased online can either be quickly andconveniently downloaded and installed through digital delivery or deliveredphysically. Using our sophisticated search engine technology, end-usersvisiting retailers’ online Web stores can access virtually all of our inventoryof products. End-users also benefit from the protection of our archivingservice, through which we guarantee replacement of software in the event ofaccidental destruction through computer error or malfunction, and from our 24x7customer service provided on behalf of our clients.

 

# **Strategy**

 

Our objective is to be the world’s leadingprovider of electronic commerce services to software publishers and onlineretailers through our Software and Digital Commerce Services Division, as wellas to manufacturers, distributors and retailers through our E-Business ServicesDivision. We intend to achieve our objective through the following keystrategies:

 

*Software And Digital Commerce Services Division: Develop And ExpandRelationships With Software Publishers And Online Retailers.*We plan to continue to build our inventory of software products throughadditional contractual relationships with software publishers. As of March 1,2002, we had contracts with approximately 10,000 software publishers and onlineretailers, representing more than 200,000 software products. We believe thatour ability to develop Web hosting relationships with our software publisherclients increases our reach to end-users and provides the basis for a long-termrelationship with our software publisher clients. We further believe that thelarge number of software products that we offer from our software publisherclients will be critical to our ability to deliver a compelling inventory ofproducts to online retailer clients.

 

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

 

*E-Business Services Division: Develop And Expand Relationships WithManufacturers, Distributors And Retailers.*  In late 1998, we began exploring electroniccommerce outsourcing opportunities outside of the software industry. During1999, sales and marketing personnel were hired to develop contractualrelationships to sell our electronic commerce outsourcing services to manufacturers,distributors and retailers. As of March 1, 2002, we were providing commerceservices, such as Web commerce development and hosting, transaction processingand fraud screening, customer service, integration into

 

4

----

 

third-party physical fulfillment, andmerchandising and analytical marketing services to over 100 E-Business ServicesDivision client sites. In March 2001, we acquired our Market Maker technology,which allows  us to offer a stand-aloneelectronic commerce software application for sale to our current or prospectiveclients.  Additionally, in September2001 and December 2001, we purchased certain assets of Orbit Commerce, Inc. andNetwork Commerce, Inc., respectively, allowing us to offer web hosting andelectronic commerce services to approximately 11,000 small business sites.  We believe that our ability to provide aproven, cost efficient electronic commerce solution, which can typically be implementedin a one to eight week time frame, provides the basis for a long-termrelationship with our E-Business clients. We further believe that additionalelectronic commerce outsourcing opportunities may develop as relationships withexisting clients expand.

 

*Provide Clients Value-Added Services.*  We believe that our growing data warehouseof end-user purchasing information provides us with a powerful tool to assistclients with value–added services, such as targeted advertising,promotions and direct response merchandising. We offer merchandising andanalytical marketing programs, customer support and communications programs,advertising placement services, Web commerce system design services, a returnsmanagement module and fraud screening services. We intend to continue to expandour programs and believe that these programs help build stronger partnershipswith our clients, while enabling them to increase their Web site sales.

 

*Maintain Technology Leadership.*  We believe that our CNS technology has givenus a competitive advantage in the market for outsourcing solutions. We willcontinue to invest in and enhance our CNS technology in order to increaseredundancy, reliability and bandwidth, and to expand services and reduce costs.By leveraging our fixed-cost infrastructure, we will improve our ability toprovide low cost, high value services to our clients while utilizing the latesttechnology.

 

# **Services**

 

We provide a broad range of services to our clients, including Webcommerce development and hosting, digital delivery and physical fulfillmentservices, transaction processing and fraud screening, customer service andmerchandising and analytical marketing services.

 

*Web Commerce Hosting.*  We host Web commerce activities for all ofour online retailer clients, our E-Business clients and those softwarepublisher clients that choose this option. Our outsourcing solution ismission-critical for many of our clients. Therefore, we have a data center thatis designed to provide our clients with the performance they require forcontinuous Web commerce operations. The data center features redundant,high-speed connections to the Internet, 24x7 security and monitoring, back-upgenerators and dedicated power.

 

We can quickly and efficiently create a Webcommerce system for our clients, which can be accessed easily by clicking on a“buy button” on a client’s existing Web site. The end-user is then transferredto a Web commerce system hosted on our CNS, which replicates the look and feelof the client Web site. The end-user can then shop for products and make purchasesonline. By replicating the look and feel of our clients’ Web sites, we supportclients in conducting electronic commerce under their own brands. Our solutionallows clients to choose either digital or, when available, physical delivery.The transaction information is captured and added to our data warehouse. Ourability to retrieve and manipulate this information creates a powerful datamining tool, which can be used for targeted merchandising to end-users throughemails, banner presentations and special offers.

 

*Digital And Physical Fulfillment Services.*  We offer clients access to our electronicsoftware delivery capabilities to permit delivery of digital products to anend-user’s computer via the Internet. Digital delivery eliminates many of thecosts that exist in the physical distribution chain, such as manufacturing,packaging, shipping, warehousing and inventory carrying and handling costs.Delivery is fulfilled when a copy is made from the master on our CNS and isthen securely downloaded to the end-user via the Internet. Our digitaldistribution model not only reduces costs, thereby increasing margins availableto software publishers and online retailers, but also solves the shelf spaceproblem constraining product availability and sales. While most softwarepublishers use our Web hosting services, certain software publishers use onlyour digital delivery services, which provide them with online distributionthrough our extensive network of online retailers.

 

5

----

 

In addition to fulfillment through electronicsoftware delivery, we offer clients physical distribution services. We havecontracted with a third-party fulfillment agency that maintains an inventory ofphysical software products, generally on consignment from our clients thatselect this option, for shipment to end-users. We also communicate ordersthrough integration into many third-party fulfillment agencies for physicalfulfillment for our clients. We believe physical fulfillment services areimportant to our ability to provide a comprehensive electronic commerceoutsourcing solution.

 

*TransactionProcessing And Fraud Screening.*  We process transactions, primarily viacredit card, generated by end-users ordering products through our CNS. Weobtain customer and payment information required to process transactions. Thefraud screening component of the CNS uses both rules-based and heuristicscoring methods to make a determination regarding the validity of the order,end-user and payment information. As the end-user is entering the order, up to580 data reviews are processed real-time. Depending on the contractualagreement, we either offer the use of our proprietary fraud screening toclients to either significantly reduce the number of fraudulent transactions orto completely shift the risk of fraud to us. When a credit card transaction iscompleted and approved, and the ordered product has been delivered, we processthe order for payment.

 

*Customer Service.*  We offer both telephone and email customer support for productssold through our CNS on behalf of our clients. We will provide end-userassistance on order and delivery questions on a 24x7 basis. We have investedand continue to invest in technology and infrastructure to provide fast, efficientresponses to customer inquiries. We also provide archiving service to theend-users that purchase digital products.

 

*Merchandising And Analytical Marketing Services.*  We offer a range of merchandising andanalytical marketing services to our clients to help them drive additionaltraffic to their Web stores. Clients are provided with detailed reports oftransactions on their Web stores, as well as marketing information related toend-user visits to their Web stores. The CNS captures Web page visits, bannerand pricing information and other data that can be used by the softwarepublishers and online retailers to analyze their Web stores’ performance.

 

We also offer advanced merchandising servicesto assist clients in increasing response rates for their marketing efforts.These services include email campaigns for special promotions, upgradenotification programs and the presentation of complementary products, bundledproducts or other programs designed to increase average order size based on atargeted end-user profile. In addition, we test and analyze merchandisingtechniques, such as promotional pricing, pop-up windows and banner advertising,based on information gathered in the CNS data warehouse.

 

# **Clients**

 

Within the Software and Digital Commerce ServicesDivision, we distribute software products through a network of softwarepublishers and online retailers. Online retailer clients include traditionalstore-based and direct mail retailers with a Web presence, online retailersdedicated to online commerce, as well as high traffic or niche Web siteoperators desiring to add electronic commerce functionality. In a typicalonline retailer contract, we are responsible for: (i) a payment to theonline retailer based on a percentage of net sales of software products that wedistribute through the online retailer’s Web site; (ii) the processing ofpayments made by end-users; (iii) the delivery of the software products toend-users; (iv) the payment of applicable credit card transaction fees; (v) thecollection, payment and returns filing of applicable sales taxes; and(vi) the distribution of a report to the online retailer detailing relatedsales activity that we have processed. We also expect to support traditionalphysical retailers in developing their online stores for the sale of softwareproducts online. While most software publishers use our Web hosting services,certain software publishers use only our “channel services” whereby thesoftware publishers are provided with digital and physical 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) a payment to the software publisher for the cost of software productsthat we distribute through either a retailer’s Web site or through thepublisher’s host Web site; (iii) the processing of payments made byend-users; (iv) the delivery of software products to end-users;(v) the payment of applicable credit card transaction fees; (vi) thecollection, payment and returns filing of applicable sales taxes; and(vii) the distribution of a report to the software publisher detailingrelated sales activity that we have processed.

 

6

----

 

As of March 1, 2002, we had approximately10,000 contracts with software publishers and online retailers. Our Softwareand Digital Commerce Services Division clients include:

 
| **Software  Publishers**           |   | **Online  Retailers** |
|------------------------------------|--------|-----------------------|
| *Web Hosting And Channel Services* |   | MicroWarehouse, Inc.  |
| Autodesk, Inc.                     |   | Software Oasis, Inc.  |
| H&R Block, Inc.                |   | Visioneer, Inc.       |
| ScanSoft, Inc.                     |   |                  |
| Symantec Corporation               |   |                  |
| Trend Micro, Inc.                  |   |                  |
| *Channel Services Only*            |   |                  |
| McAfee.com Corporation             |   |                  |
| PowerQuest Corporation             |   |                  |
| Qualcomm, Inc.                     |   |                  |

 

Within the E-Business Services Group, weprovide a variety of electronic commerce services to clients outside of thesoftware industry, primarily manufacturers, distributors and retailers. Theseservices allow the client to perform electronic commerce on abusiness-to-business or business-to-consumer basis. In a typical E-BusinessServices contract, we are responsible for: (i) Web commerce system design,hosting and integration into the client’s management system; (ii) theprocessing of payments made by end-users; (iii) the communication oforders to the client or the client’s third–party fulfillment agency fordelivery of the product to end-users; (iv) the fraud screening andprocessing of the applicable credit card transaction to the client’s creditcard processor; (v) customer service; and (vi) the distribution of areport to the client detailing related sales activity that we have processed.

 

As of March 1, 2002, we were providingservices to over 100 client sites, excluding approximately 11,000 smallbusiness sites serviced as a result of the purchase of certain assets of OrbitCommerce, Inc. and Network Commerce, Inc. during 2001. Our E-Business ServicesDivision clients include:

 
| **E–Business Services** |
|------------------------------|
| 3M Company                   |
| Major League Baseball        |
| National Geographic Society  |
| Nokia Corporation            |
| SONICblue Incorporated       |

 

# **Sales And Marketing**

 

We market our services directly to clientsand prospective clients. Generally, our direct marketing to end-users focuseson supporting the marketing and promotional efforts of our clients in drivingtraffic to their Web stores. This direct marketing effort leverages ourextensive data warehouse, which enables us to create and quickly implementmarketing programs targeted at specific end-user segments. By providingconsistent quality service, branding client order pages with our name and logo,billing credit card transactions under our name and engaging in brandpositioning, advertising and promotion, we believe we have established our brandas a trusted name for electronic software delivery and electronic commerceoutsourcing solutions among current and prospective clients and end-users.

 

Our sales and marketing organization isdivided into two divisions: the Software and Digital Commerce Services Divisionand the E-Business Services Division. The Software and Digital CommerceServices Division focuses on software and digital content publishers and onlineretailers of all sizes, including traditional physical retailers, withsignificant online revenue potential. Contracts with larger clients ofteninvolve certain incentives, principally pricing concessions. We make decisionswith respect to contract incentives on a case-by-case basis. The E-BusinessServices Division focuses on companies in the manufacturing, distribution andretail sectors looking to establish or expand their electronic commercepresence.  These sales process for bothdivisions is complex in nature and lengthy. Both the Software and DigitalCommerce Services Division and the E-Business Services Division serve existingclients and provide them with merchandising and analytical marketing assistancedesigned to increase revenues. As of March 1, 2002, we had 143 employeesengaged in sales and marketing, including personnel in a sales office in theUnited Kingdom.

 

7

----

 

We currently market our services to clientsvia direct marketing, print advertising, trade show participation and othermedia events. We plan to increase our expenditures on direct marketing andprint advertising, primarily directed at potential E-Business Services clients.

 

# **Technology**

 

We deliver our electronic commerceoutsourcing solution primarily using our proprietary CNS technology, which isdescribed below:

 

*Architecture.* Our scaleable CNS is designed to handle tens of thousands of individualWeb commerce stores and millions of products. The CNS consists of multiple podsof Sun Microsystems servers and a proprietary software application that servesdynamic Web pages using Oracle’s database, application server and cachingtechnology. Our CNS was designed to scale to support growth by addingadditional servers, CPUs, memory, disk drives and bandwidth without substantialchanges to the application. The CNS software code is written in modular layers,enabling us to quickly adapt in response to industry changes, includingbandwidth opportunities, payment processing changes, international requirementsfor taxes and export screening, new technologies such as Web Caches, Java, ML,DHTML, VRML, SET, banking procedures and encryption technologies. The CNSproduct search system, based on Verity’s technology, allows end-users to searchfor items across millions of potential products and thousands of categoriesspecific to various product specifications, while maintaining a fast pageresponse that is acceptable to the end-user. We use sophisticated databaseindexing coupled with a dynamic cache system to provide flexibility and speed.These caches help increase the overall speed of each page and facilitatecomplex searches across our entire inventory of software products. The CNS hasalso been designed to index, retrieve and manipulate all transactions that flowthrough the system, including detailed commerce transaction and end-userinteraction data. This enables us to create proprietary market profiles of eachend-user and groups of end-users that can then be used to create merchandisingcampaigns. Our CNS is also used for internal purposes, including reporting andmaintenance for fraud detection and prevention, physical shipping, returnauthorizations, back order processing and full transaction auditing andreporting capabilities for all commerce functions.

 

*Web Commerce System Maintenance.*  Clients’ Web commerce systems are built andmaintained using the CNS centralized management system. Global changes thataffect all Web commerce systems or groups of Web commerce systems can be madeas easily as changes to an individual Web commerce system. Client Web commercesystems typically include a main store and may optionally include several“focus stores” and “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 address access to internal systems and illegalaccess to commerce data via the Internet. Internally, log-ins and passwords aremaintained for all systems, with additional log-ins, passwords and IP accesscontrol granted on an individual basis to only the required commerce areas forwhich the recipient is responsible. Firewalls prevent unauthorized access fromoutside. We rely on certain encryption and authentication technology licensedfrom third parties to provide secure transmission of confidential information,such as 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. Product wrappers, 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 the clients’ productsand ensures that an end-user requests digital delivery through a valid page andhas purchased the product.

 

*Data Center Operations.*  Continuous data center operations arecrucial to our success. All transaction data is backed up hourly and allinventory data is archived and kept in fireproof storage facilities. Ournetwork software constantly monitors clients’ Web commerce systems and internalsystem functions and notifies systems engineers if any unexpected conditionsarise. We currently lease one OC3 line and 3 DS3 lines from multiple vendorsand maintain a policy of adding additional lines if more than 50% of ourbandwidth capacity is utilized. Accordingly, if one line fails the other linesare able to assume the capacity of the failed line. Our data center is locatedin a single location at our main facility in Eden Prairie, Minnesota. In theevent of electrical power failure, we have redundant diesel generators and UPSpower supplies that protect the entire facility. We have also installed aFM-200 automatic fire suppression system in the data center. The data centercurrently incorporates redundant systems consisting of additional servers andarrays. We currently have no automatic switchover in the case of equipment orsoftware failure, although we have plans to implement further redundancy in thefuture.

 

8

----

 

# **Product Research and Development**

 

Our product research and development strategyis to enhance the technology and features of our CNS. To this end, we havenumerous development projects in process, including Internet optimizationtools, personalization, business-to-business related technologies and onlineinteractive customer service. Product research and development expenses were$11.2 million, $13.1 million and $10.3 million in 2001, 2000 and1999, respectively.  As of March 1,2002, we employed 123 persons in product research and development.

 

To remain competitive, we must continue toenhance and improve the responsiveness, functionality and features of the CNSand the underlying network infrastructure. If we incur significant costswithout adequate results, or are unable to adapt rapidly to technologicalchanges, we may fail to achieve our business plan. The Internet and theelectronic commerce industry are characterized by rapid technological change,changes in user and client requirements and preferences, frequent new productand service introductions embodying new technologies and the emergence of newindustry standards and practices that could render our technology and systemsobsolete. To be successful, we must adapt to rapid technological change bylicensing and internally developing leading technologies to enhance ourexisting services, developing new products, services and technologies thataddress the increasingly sophisticated and varied needs of our clients, andresponding to technological advances and emerging industry standards andpractices on a cost-effective and timely basis. The development of our CNStechnology and other proprietary technology involves significant technical andbusiness risks. We may fail to use new technologies effectively or fail toadapt our proprietary technology and systems to client requirements or emergingindustry standards.

 

# **Competition**

 

The market for Internet-based, 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 and partners may become competitors in thefuture. Increased competition is likely to result in price reductions, loweraverage sales prices, reduced margins, longer sales cycles and a decrease orloss of our market share, any of which could reduce our revenues. 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. and USinternetworking, Inc.;

 

•                    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 Global Sports, Inc;and

 

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

 

9

----

 

We believe that the principal competitivefactors in our market are breadth of services and software product offerings,software publisher and online retailer relationships, brand recognition, systemreliability and capacity, price, customer service, speed and accessibility andease of use, speed to market, scalability, convenience and speed offulfillment. The online retailers and the other companies listed above maycompete directly with us by adopting a similar business model. Moreover, whilesome of these companies are also clients or potential clients of ours, they maycompete with our electronic commerce outsourcing solution to the extent thatthey develop electronic commerce systems or acquire such systems from othersoftware vendors or service providers.

 

Many of our competitors have, and newpotential competitors may have, more experience developing Internet–basedsoftware services and electronic commerce solutions, larger technical staffs,larger customer bases, more established distribution channels and customerrelationships, greater brand recognition and greater financial, marketing andother resources than us. In addition, competitors may be able to developservices that are superior to our services, achieve greater customer acceptanceor have significantly improved functionality as compared to our existing andfuture products and services. Our competitors may be able to respond morequickly to technological developments and changes in customers’ needs. Ourinability to compete successfully against current and future competitors couldcause our revenues 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 assignment agreementswith our employees and contractors, and nondisclosure agreements with partieswith whom we conduct business, in order to limit access to and disclosure ofour proprietary information. These contractual arrangements and the other stepstaken by us to protect our intellectual property may not preventmisappropriation of our technology or deter independent third-party developmentof similar technologies. We also seek to protect our proprietary position byfiling U.S. and foreign patent applications related to our proprietarytechnology, inventions and improvements that are important to the developmentof our business. Proprietary rights relating to our technologies will beprotected from unauthorized use by third parties only to the extent they are coveredby valid and enforceable patents or are effectively maintained as tradesecrets. We currently have six U.S. patents issued with 13.5 to 14.5 yearsremaining prior to expiration, and five U.S. patent applications pendingrelated to our electronic commerce services, including fraud screening,distribution of files over the Internet, cache management and global web sitemanagement. We pursue the registration of our trademarks and service marks inthe U.S. and internationally. We currently have fourteen U.S. registeredtrademarks and four trademark applications pending in the U.S., sevenregistered trademarks in the European Union and other countries, and threetrademark applications pending in the European Union and other countries.Effective trademark, service mark, copyright and trade secret protection maynot be available in every country in which our services are made availableonline.

 

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

 

# **Employees**

 

As of March 1, 2002, we employed 573 people.We also employ independent contractors and other temporary employees. None ofour employees are represented by a labor union, and we consider our employeerelations to be good. Competition for qualified personnel in our industry isintense, particularly among software development and other technical staff. Webelieve that our future success will depend in part on our continued ability toattract, hire and retain qualified personnel.

 

10

----

 

**Executive Officers**

 

The following table sets forth informationregarding our executive officers as of December 31, 2001:

 
| **Name**           |   | **Age** |   | **Position**                                                                                          |
|--------------------|--------|---------|--------|-------------------------------------------------------------------------------------------------------|
| Joel A. Ronning    |   | 45      |   | Chief Executive Officer and  member of the Office of the President                                    |
| Jay A. Kerutis     |   | 42      |   | President, Software and  Digital Commerce Services Division and member of the Office of the President |
| Robert E. Strawman |   | 42      |   | Chief Financial Officer,  Treasurer and member of the Office of the President                         |
| Gary V. Howorka    |   | 43      |   | Chief Technology Officer                                                                              |

 

Mr. Ronning founded the Company inFebruary 1994 and has been Chief Executive Officer and a director of theCompany since that time. In February 2001, Mr. Ronning was elected tothe Office of the President. From February 1994 to July 1998,Mr. Ronning was also President of the Company. From May 1995 toDecember 1999, Mr. Ronning served as Chairman of the Board ofDirectors of Tech Squared, Inc., a direct catalog marketer of software andhardware products. From May 1995 to July 1998, Mr. Ronningserved as Chief Executive Officer, Chief Financial Officer and Secretary ofTech Squared. From May 1995 to August 1996, Mr. Ronning alsoserved as President of Tech Squared. Mr. Ronning foundedMacUSA, Inc., formerly a wholly-owned subsidiary of Tech Squared, andserved as a director of MacUSA, Inc. from April 1990 toDecember 1999. From April 1990 to July 1998, Mr. Ronningalso served as the Chief Executive Officer of MacUSA, Inc.

 

Mr. Kerutis joined the Company inFebruary 1999 as Vice President of Sales, served as Executive VicePresident, Software and Digital Commerce Services Division fromJanuary 2000 to December 2000 and has been President, Software andDigital Commerce Services Division since December 2000. InFebruary 2001, Mr. Kerutis was elected to the Office of thePresident. From March 1997 to February 1999, Mr. Kerutis wasVice President—Retail Channel for Merisel Americas, Inc., a computer distributor.From April 1995 to March 1997, Mr. Kerutis was VicePresident—Sales and Marketing for New Media Corporation, a manufacturer of PCcards for notebook computers.

 

Mr. Strawman joined the Company inApril 1998 as Chief Financial Officer and Treasurer. InFebruary 2001, Mr. Strawman was elected to the Office of thePresident. From September 1995 to April 1998, Mr. Strawmanserved as Director of Finance and Vice President of Finance for Caribou CoffeeCompany, Inc., a gourmet coffee retailer.

 

Mr. Howorka joined the Company in June of 2000as Chief Technology Officer.  From May1999 to June 2000, Mr. Howorka held several key roles at Ernst & Young LLP,an international accounting and consulting organization, most recently as IBME-Business Practice Director.  FromJanuary 1999 to May 1999, Mr. Howorka served as Chief Technology Officer ofZonetrader.com, a business-to-business e-commerce asset recoveryorganization.  From May 1995 to October1998, Mr. Howorka co-founded and served as Executive Vice President of FeedbackPlus, Inc., a survey software and services company.

 

11

----

 

**RISK FACTORS**

 

In addition to the other information providedin this report, stockholders or prospective investors should carefully considerthe following risk factors:

 

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

 

We were incorporated in February 1994 andconducted our first online sale through a client’s Web store in August 1996. Wehave not yet achieved profitability and have incurred significant losses sincewe were formed. As of December 31, 2001, we had an accumulated deficit ofapproximately $103.1 million. Our limited operating history makes it difficultfor you to evaluate our ability to achieve profitability in the future.

 

The success of our business model dependsupon our success in generating sufficient transaction and service fees from theuse of our electronic commerce solutions by existing and future clients.Accordingly, we must maintain existing, and develop new relationships withsoftware publishers, online retailers and E-Business clients. To achieve thisgoal, we intend to continue to expend significant financial and managementresources on the development of additional services, sales and marketing,improved technology and expanded operations. If we are unable to maintainexisting, and develop new client relationships, we will not generate aprofitable return on our investments and we will be unable to gain meaningfulmarket share to justify these investments. Further, we may be unable to achieveprofitability if our revenues increase slower than expected, or if operatingexpenses exceed our expectations and cannot be adjusted to compensate for lowerthan expected revenues. Even if we are able to achieve profitability, we may beunable to sustain or increase profitability on a quarterly or annual basis.

 

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

 

Our quarterly and annual operating resultshave fluctuated significantly in the past and are likely to continue to do soin the future due to a variety of factors, some of which are outside ourcontrol. As a result, we believe that quarter-to-quarter and year-to-yearcomparisons of our revenues and operating results are not necessarilymeaningful, and that these comparisons may not be accurate indicators of futureperformance. If our annual or quarterly operating results fail to meet theguidance we provide to securities analysts and investors or otherwise fail tomeet their expectations the trading price of our Common Stock will likelydecline. Some of the factors that have or may contribute to fluctuations in ourquarterly and annual operating results include:

 

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

 

•                    ourability to attract and retain E-Business clients;

 

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

 

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

 

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

 

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

 

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

 

•                    ourability to retain and attract personnel commensurate with our business needs;and

 

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

 

12

----

 

In addition, revenues generated by ourSoftware and Digital Commerce Services Division are likely to fluctuate on aseasonal basis that is typical for the software publishing market in general.We believe that our first and fourth quarters are seasonally stronger than oursecond and third quarters due to the timing of demand of tax preparationsoftware and the holiday selling period. We also believe that softwarepublishers avoid new product releases in the summer months.

 

Our operating expenses, which include salesand marketing, product research and development and general and administrativeexpenses, are based on our expectations of future revenues and are relativelyfixed in the short term. If our revenues for a quarter fall below ourexpectations and we are unable to quickly reduce spending in response, ouroperating results for that quarter would be harmed. In addition, the operatingresults of companies in the electronic commerce industry have in the pastexperienced significant quarter-to-quarter fluctuations that may adverselyaffect our stock price.

 

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

 

One software publisher client, SymantecCorporation, accounted for approximately 15% of our revenue in 2001. Inaddition, other software and E-business clients contribute a large portion ofour annual revenue. Contracts with our clients are generally short term innature. If any one of these contracts is not renewed or otherwise terminates,and if we are unable to replace it with other client agreements, our revenueswould decline and our losses would likely increase. It is important to oursuccess that we maintain these client relationships and, at the same time,develop new client relationships.

 

**The success of our business strategy and ourfuture revenue growth depends on increasing consumer acceptance of the Internetas a medium of commerce.**

 

The failure of the Internet to continuedeveloping into a significant commercial medium would harm our ability toincrease our revenues and execute our business strategy. We depend on thegrowing use and acceptance of the Internet as an effective medium of commerceby end-users. Rapid growth in the use of and interest in the Internet and otheronline services is a recent development. The acceptance and use of the Internetand other online services may not continue to develop and a sufficiently broadbase of consumers may not adopt and continue to use the Internet and otheronline services as a medium of commerce. We rely on purchasers who havehistorically used traditional means of commerce to purchase goods or transactbusiness. If we are to be successful, these purchasers must accept and use theInternet as a means of purchasing goods and services and exchanginginformation. We cannot predict the rate at which these purchasers will do so.

 

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

 

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

 

**General economic uncertainty may reduce ourrevenues.**

 

The revenue growth and profitability of ourbusiness depends significantly on the overall demand for Internet-basedelectronic commerce solutions. We believe that the market for these solutionsmay be adversely affected by a number of factors, including reductions incapital expenditures by clients and overall weakening of the U.S. and foreigneconomies.

 

13

----

 

These factors may, in turn, give rise to anumber of market 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

 

•                    increasedprice competition.

 

If the current economic slowdown continues,the effects of the slowdown for electronic commerce solutions could reduce ourrevenues and limit our ability to meet our profitability goals.

 

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

 

We have acquired, and intend to continueacquiring, businesses, technologies, services or products that we believe arestrategic, such as businesses that provide outsourcing services to softwarepublishers. The process of integrating an acquired business, technology,service or product into our business and operations may result in unforeseenoperating difficulties and expenditures. Integration of an acquired businessalso may disrupt our ongoing business, distract management and make itdifficult to maintain standards, controls and procedures. Moreover, theanticipated benefits of any acquisition may not be realized. If a significant numberof clients of the acquired businesses cease doing business with us, we wouldexperience lost revenues, and any synergies from the acquisition may be lost.Future acquisitions could result in potentially dilutive issuances of equitysecurities, the incurrence of debt, contingent liabilities, amortizationexpenses of intangible assets or impairment of goodwill.

 

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

 

The payment by end-users for the purchase ofdigital goods that we process is typically made by credit card. If we incursignificant instances of credit card fraud over an extended period of time, itmay result in penalties and termination of our credit card acceptance privileges.Loss of our credit card acceptance privileges would severely impact our abilityto process the sale of digital goods where the payment method is by creditcard. We may be required to expend significant capital and other resources toprotect against these fraudulent transactions.

 

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

 

Our success will depend in large part on thegrowth 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 and adequacy of software products that are available for purchasethrough ESD as compared to those available through physical delivery; and

 

•                    thelevel of end-user comfort with the process of downloading software via theInternet, including the ease of use and lack of concern about transaction security.

 

Even if ESD achieves widespread acceptance,we may be unable to overcome the substantial existing and future technicalchallenges associated with electronically delivering software reliably andconsistently on a long-term basis. Our failure to do so would also impair ourability to execute our business plan.

 

14

----

 

**Thegrowth of the market for our services depends on the development andmaintenance of the Internet infrastructure**.

 

Our business is based on delivering servicesover the Internet, and the success of our business therefore depends on thedevelopment and maintenance of a sound Internet infrastructure. This includesmaintenance of a reliable network backbone with the necessary speed, data capacityand security, as well as timely development of complementary products such ashigh-speed modems, for providing reliable Internet access and services. Ourability to increase the speed and scope of our services is limited by, anddepends upon, the speed and reliability of both the Internet and our clients’internal networks. Consequently, as Internet usage increases, the growth of themarket for our services depends upon improvements being made to the Internet aswell as to individual client’s networking infrastructures to alleviateoverloading and congestion. In addition, any delays in the adoption of newstandards and protocols required to govern increased levels of Internetactivity or increased governmental regulation may have a detrimental effect onthe Internet infrastructure.

 

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

 

Our Software and Digital Commerce ServicesDivision generates revenues by providing outsourced services to software publishers.If we cannot develop and maintain satisfactory relationships with softwarepublishers on acceptable commercial terms, we will likely experience a declinein revenues. We also depend on our software publisher clients creating andsupporting software products that end-users will purchase. If we are unable toobtain sufficient quantities of software for any reason or if the quality ofservice provided by these software publishers falls below a satisfactory level,we could also experience a decline in revenues and client satisfaction, and ourreputation could be harmed. Our contracts with our software publisher clientsare generally one year in duration, with an automatic renewal provision foradditional one-year periods, unless we are provided with a written notice atleast 90 days before the end of the contract. As is common in our industry, wehave 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.

 

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

 

The success of our business strategy dependsupon increasing fee and service revenues derived from the sale of non-softwareproducts for E-Business clients. Since initiating sales of electronic commerceoutsourcing services in 1999, our E-Business Services Division has incurredonly net losses. We have made substantial investments in technology andinfrastructure and we may fail to establish and maintain sufficientrelationships with E-Business clients to offset these expenses. If we areunable to develop and expand our relationships with E-Business clients, we willfail to grow revenues as projected and the E-Business Services Division willcontinue to have a negative impact on our profitability.

 

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

 

The market for Internet-based, 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 and partners 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 reduce our revenues. We face competitionfrom 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;

 

15

----

 

•                    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. and USinternetworking, Inc.;

 

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

 

•                    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 Global Sports, Inc.; and

 

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

 

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

 

**Securitybreaches could hinder our ability to securely transmit confidential information**.

 

A significant barrier to electronic commerceand communications 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.

 

We may be required to expend significantcapital and other resources to protect against security breaches or addressproblems caused by breaches. Concerns over the security of the Internet andother online transactions and the privacy of users could deter people fromusing the Internet to conduct transactions that involve transmittingconfidential information, thereby inhibiting the growth of the Internet. To theextent that our activities or those of third-party contractors involve thestorage and transmission of proprietary information, such as credit card numbers,security breaches could damage our reputation and expose us to a risk of lossor litigation and possible liability. Our security measures may not preventsecurity breaches and failure to prevent security breaches could lead to a lossof existing clients and deter potential clients away from our services.

 

**We haveexperienced rapid growth and failure to properly manage and sustain ourexpansion efforts could strain our management and other resources.**

 

Our ability to successfully offer servicesand implement our business plan in a rapidly evolving market requires aneffective planning and management process. We have rapidly and significantlyexpanded our operations. In 2001, we increased our number of employees from 381to 484 and we anticipate that further significant expansion will be required toaddress potential growth in our client base and market opportunities. Failureto properly manage this expansion could place a significant strain on ourmanagerial, operational and financial resources. Our new employees include anumber of key

 

16

----

 

managerial, technical and operationspersonnel whom we have not yet fully integrated. We expect to add additionalkey personnel in the near future, including direct sales, marketing, financialand technical personnel. To manage the expected growth of our operations andpersonnel, we will be required to:

 

•                    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 to install managementinformation and control systems in an efficient and timely manner, and ourcurrent or planned personnel, systems, procedures and controls may beinadequate to support our future operations. In addition, we may be unable tohire, train, retain, motivate and manage required personnel or to successfullyidentify, manage and exploit existing and potential market opportunities.

 

**Failureto develop our technology to accommodate increased CNS traffic could reducedemand for our services and impair the growth of our business.**

 

We periodically enhance and expand ourtechnology and transaction-processing systems, network infrastructure and othertechnologies to accommodate increases in the volume of traffic on the CNS. Ourinability to add software and hardware or to develop and upgrade existingtechnology, transaction-processing systems or network infrastructure to manageincreased traffic on the CNS 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 CNS 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 CNS increase.

 

**Ourindustry is characterized by rapid technological change that may make ourtechnology and systems obsolete or cause us to incur substantial costs to adaptto these changes.**

 

To remain competitive, we must continue toenhance and improve the responsiveness, functionality and features of our CNSand the underlying network infrastructure. If we incur significant costswithout adequate results or are unable to adapt rapidly to technologicalchanges, we may fail to achieve our business plan. The Internet and theelectronic commerce industry are characterized by rapid technological change,changes in user requirements and preferences, frequent new product and 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 technologies to enhance our existing services, developingnew products, services and technologies that address the increasinglysophisticated and varied needs of our clients, and responding to technologicaladvances and emerging industry standards and practices on a cost-effective andtimely basis. The development of our CNS technology and other proprietarytechnology involves significant technical and business risks. We may fail touse new technologies effectively or fail to adapt our proprietary technologyand systems to client requirements or emerging industry standards.

 

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

 

We provide commerce, marketing and deliveryservices to our clients and end-users through our CNS transaction processingand client management systems. These systems also maintain an electronicinventory of products and gather consumer marketing information. Thesatisfactory performance, reliability and availability of the CNS and theunderlying 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

 

17

----

 

time to time. Any systems damage orinterruption that impairs our ability to accept and fill client orders couldresult in an immediate loss of revenues 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 todamage or interruption 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 presently have no disaster recoveryfacilities and do not carry sufficient business interruption insurance to fullycompensate us for losses that may occur.

 

**We maybecome liable to clients who are dissatisfied with our services.**

 

We design, develop, implement and manageelectronic commerce solutions that are crucial to the operation of our clients’businesses. Defects in the solutions we develop could result in delayed or lostrevenues, adverse end-user reaction and negative publicity or require expensivecorrections. As a result, clients who experience these adverse consequenceseither directly or indirectly as a result of our services could bring claimsagainst us for substantial damages. Any claims asserted could exceed the levelof our insurance. The insurance we carry may not continue to be available oneconomically reasonable terms, or at all. The successful assertion of one ormore large claims that are uninsured, exceed insurance coverage or result inchanges to insurance policies, including premium increases, could adverselyaffect our operating results or financial condition.

 

**Ourchief executive officer and key technical employees are critical to ourbusiness and if they do not remain with us in the future, we may be unable toeffectively replace them.**

 

Our future success significantly depends onthe continued services and performance of our senior management, particularlyJoel A. Ronning, our chief executive officer and member of the office of thepresident. Our performance also depends on our ability to retain and motivateour key technical employees who are skilled in maintaining the CNS. The loss ofthe services of any of our executive officers or key technical employees couldharm our business if we are unable to effectively replace that officer oremployee, or if that person should decide to join a competitor or otherwisedirectly or indirectly compete with us. Further, we may need to incuradditional operating expenses and divert other management time in order tosearch for a replacement. We do not maintain any key person life insurancepolicies.

 

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

 

Our future success depends on our ability tocontinue to identify, attract, hire, train, retain and motivate highly skilledtechnical, managerial, operations, merchandising, sales and marketing andclient service personnel. Competition for this personnel is intense,particularly in the Internet industry and we may be unable to successfullyattract, assimilate or retain sufficiently qualified personnel. Failure to doso could harm our business growth and ability to achieve profitability. Inaddition, the market price of our Common Stock has fluctuated substantiallysince our initial public offering in August 1998. Consequently, potentialemployees may perceive our equity incentives such as stock options as lessattractive and current employees whose options are no longer attractivelypriced may choose not to remain with our organization. In that case, ourability to attract employees will be adversely affected. Finally, should ourstock price substantially decline, the retention value of stock options grantedsince our initial public offering will decline and our employees may choose notto remain with our organization.

 

18

----

 

**Protectingour intellectual 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 technologies will be protected fromunauthorized use by third parties only to the extent they are covered by validand enforceable patents or are effectively maintained as trade secrets. Wepursue the registration of our trademarks and service marks in the U.S. andinternationally. Effective trademark, service mark, copyright and trade secretprotection may not be available in every country in which our services are madeavailable online.

 

The steps we have taken to protect ourproprietary rights may be inadequate and third parties may infringe ormisappropriate our trade secrets, trademarks and similar proprietary rights.Any significant failure on our part to protect our intellectual property could makeit easier for our competitors to offer similar services and thereby adverselyaffect our market opportunities. In addition, litigation may be necessary inthe future to enforce our intellectual property rights, to protect our tradesecrets or to determine the validity and scope of the proprietary rights ofothers. Litigation could result in substantial costs and diversion ofmanagement and technical resources.

 

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

 

From time to time, we may receive notice ofclaims of infringement of other parties’ proprietary rights. 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.6,014,651 owned by Christopher M. Crawford of Washington, D.C.  Nosubstantive actions have taken place as yet in this case.  The Court hasdelayed substantive discovery in this case, pending a preliminary determinationof the legal scope of Crawford’s claim.  A preliminary hearing isscheduled on May 15, 2002, in which the Court will determine how it willresolve what is the legal scope of Crawford’s patent’s claim.  Subsequentto that determination, we may file for a dismissal of the case if the Court’sdecision is consistent with our and the other defendants’ position regardingthe interpretation of this patent claim.  At this time, Crawford has notmade a definitive demand for the resolution of this case.  We believe thatwe have meritorious defenses to, and intend to vigorously defend against, thisclaim.

 

This claim and any future assertions orprosecutions of claims like this could require us to expend significantfinancial and managerial resources. The defense of any claims, whether theseclaims are with or without merit, could be time-consuming, result in costlylitigation and diversion of technical and management personnel, cause productenhancement delays or require that we develop non-infringing technology orenter into royalty or licensing agreements. Royalty or licensing agreements, ifrequired, may be unavailable on terms acceptable to us or at all. In the eventof a successful claim of infringement against us and our failure or inabilityto develop non-infringing technology or license the infringed or similartechnology on a timely basis, we may be unable to pursue our current businessplan.

 

**Claimsagainst us related to the software products that we deliver electronicallycould also require us to expend significant resources**.

 

Claims may be made against us for negligence,copyright or trademark infringement or other theories based on the nature andcontent of software products that we deliver electronically and aresubsequently distributed to others. Because we did not create these softwareproducts, we are generally not in a position to know the quality or nature ofthe content of these products. Although we carry general liability insurance,our insurance may not cover potential claims of this type, adequately cover allcosts incurred in defense of potential claims or indemnify us for all liabilitythat may be imposed. Any costs or imposition of liability that are not coveredby insurance or in excess of insurance coverage could be expensive and time-consumingto address, distract management and delay product deliveries even if we wereultimately successful in the defense of these claims.

 

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

 

We are subject to the same federal, state andlocal laws as other companies conducting business on the Internet. Today thereare relatively few laws specifically directed towards conducting business onthe Internet. The adoption or modification of laws related to the Internetcould harm our business, operating results and financial condition byincreasing our costs and

 

19

----

 

administrative burdens. Due to the increasingpopularity and use of the Internet, many laws and regulations relating to theInternet are being debated at the international, federal and state levels.These laws and regulations could cover issues such as:

 

•                    userprivacy with respect to adults and minors;

 

•                    pricingand taxation;

 

•                    fraud;

 

•                    advertising;

 

•                    intellectualproperty rights;

 

•                    informationsecurity; and

 

•                    qualityof products and services.

 

Applicability to the Internet of existinglaws governing issues such as property ownership, copyrights and other intellectualproperty issues, taxation, libel, obscenity and personal privacy could alsoharm our operating results and substantially increase the cost to us of doingbusiness. It may also require significant management resources to respond toany changes in these laws. The vast majority of these laws were adopted priorto the advent of the Internet, and do not contemplate or address the uniqueissues raised thereby. Those laws that do reference the Internet, such as theDigital Millennium Copyright Act, are only beginning to be interpreted by thecourts and their applicability and reach are therefore uncertain.

 

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

 

We collect and maintain end-user data for ourclients, which subject us to increasing international, federal and stateregulation related to online privacy and the use of personal userinformation.  Several states haveproposed legislation that would limit the use of personal user informationgathered online or require online services to establish privacy policies. Inaddition, the U.S. Federal Trade Commission, or FTC, may consider adoptingregulations similar to those contemplated during the Clinton administrationregarding the collection and use of personal identifying information obtainedfrom individuals when accessing Web sites, with particular emphasis oninformation obtained from minors. These regulations may include requirementsthat 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.

 

Bills are also pending in Congress that wouldimprove online privacy protections for adults. Laws of this kind require thatwe establish procedures to disclose and notify users of privacy and security policies,obtain consent from users for collection and use of information, or provideusers with the ability to access, correct and delete personal informationstored by us. Even in the absence of these regulations, 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.

 

20

----

 

**The listing of our network addresses onanti-SPAM lists could harm our ability to service our clients and deliver goodsover the Internet.**

 

Certain privacy and anti-email proponentshave engaged in a practice of gathering and publicly listing network addressesthat they believe have been involved in sending unwanted, unsolicited emailscommonly known as SPAM.  In response touser complaints about SPAM, Internet service providers have from time to timeblocked such network addresses from sending emails to their users.  If our network addresses mistakenly end upon these SPAM lists, our ability to provide services for our clients andconsummate the sales of digital and physical goods over the Internet could beharmed.

 

**Theadoption and implementation of international laws and regulations applicable toelectronic commerce may impair our efforts to expand revenues frominternational transactions.**

 

The European Union has adopted a privacydirective that regulates the collection and use of information that identifiesan individual person. These regulations may inhibit or prohibit the collectionand sharing of personal information in ways that could harm our clients or us.The globalization of Internet commerce may be harmed by these and similarregulations because the European Union privacy directive prohibits transmissionof personal information outside the European Union. The United States and theEuropean Union have negotiated an agreement providing a “safe harbor” for thosecompanies who agree to comply with the principles set forth by the U.S.Department of Commerce and agreed to by the European Union.  Failure to comply with these principles mayresult in fines, private lawsuits and enforcement actions.  These enforcement actions can includeinterruption or shutdown of operations relating to the collection and sharingof information pertaining to citizens of the European Union.

 

**Futurelaws imposed on electronic commerce may substantially increase the costs ofdoing business or otherwise adversely affect our ability to offer our services.**

 

Because our services are accessible worldwideand we facilitate sales of products to end-users worldwide, foreignjurisdictions may claim that we are required to comply with their laws. Lawsregulating Internet companies outside of the United States may be lessfavorable than those in the United States, giving greater rights to consumers,content owners and users. Compliance may be more costly or may require us tochange our business practices or restrict our service offerings relative tothose provided in the United States. Any failure to comply with foreign lawscould subject us to penalties ranging from fines to bans on our ability tooffer our services.

 

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

 

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

 

We sell software products and services toend-users outside the United States and we intend to continue to expand ourinternational presence. Expansion into international markets, particularlyEurope, requires significant resources that we may fail to recover bygenerating additional revenues. Conducting business outside of the UnitedStates is subject to risks, including:

 

•                    changesin regulatory requirements and tariffs;

 

•                    uncertaintyof application or governing of local laws;

 

•                    reducedprotection of intellectual property rights;

 

•                    difficultiesin distribution for international sales;

 

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

 

21

----

 

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

 

•                    politicalor economic constraints on international trade or instability.

 

We may be unable to successfully and costeffectively market, sell and distribute our services in foreign markets. Thismay be more difficult or take longer than anticipated especially due tointernational challenges, such as language barriers, currency exchange issuesand the fact that the Internet infrastructure in foreign countries may be lessadvanced than the U.S. Internet infrastructure. If we are unable tosuccessfully expand our international operations, or manage this expansion, ouroperating results and financial condition could be harmed.

 

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

 

We do not currently collect sales, use orother similar taxes with respect to ESD or shipments of software products intostates other than California, Minnesota and Washington. The application ofsales tax to interstate and international sales over the Internet is unclearand evolving. Local, state or foreign jurisdictions may seek to impose sales oruse tax collection obligations on out-of-state companies like ours that engagein electronic commerce. A successful assertion by one or more states or anyforeign country that we should collect sales, use or other taxes on the sale ofmerchandise through our E-Business Services Division or on shipments ofsoftware could harm our results of operations. In addition, any failure by anE-Business client to collect obligatory sales or use taxes could cause therelevant jurisdiction to attempt imposing that obligation on us.

 

**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. Thisvolatility is likely to continue in the short-term and is not necessarilyrelated to the operating performance of affected companies. This broad marketand industry volatility could significantly reduce the price of our CommonStock at any time, without regard to our operating performance. Factors thatcould cause our stock price in particular to fluctuate include:

 

•                    actualor anticipated variations in quarterly operating results;

 

•                    announcementsof technological innovations;

 

•                    newproducts or services that we or our competitors offer;

 

•                    changesin financial estimates by securities analysts;

 

•                    conditionsor trends in the Internet and online commerce industries;

 

•                    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

 

•                    salesof our Common Stock.

 

22

----

 

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

 

In the past, followingperiods of volatility in the market price of the securities of a company,securities class-action litigation has often been instituted against thatcompany. Beginning in August 2001, we and certain of our officers anddirectors were named as defendants in several class action shareholdercomplaints filed in the United States District Court for the Southern Districtof New York.  These actions include (1) Whalen v. Digital River, Inc., etal., Case No. 01-CV-7355; and (2) Nicolois v. Digital River, Inc., et al., CaseNo. 01-CV-7992.  Similar complaints were filed in the same Court against hundredsof other public companies that conducted IPOs of their common stock in the late1990s. In each of these complaints, the plaintiffs allege that we, certainof our officers and directors and our IPO underwriters violated thefederal securities laws because our IPO registration statement andprospectus contained untrue statements of material fact or omitted materialfacts regarding the compensation to be received by, and the stock allocationpractices of, the IPO underwriters. The plaintiffs seek unspecified monetarydamages and other relief.

 

On August 8, 2001, the IPOLawsuits were consolidated for pretrial purposes before United States JudgeShira Scheindlin of the Southern District of New York. Judge Scheindlin held aninitial case management conference on September 7, 2001, at which time sheordered, among other things, that the time for all defendants in the IPOLawsuits to respond to any complaint be postponed until further order of theCourt. Thus, we have not been required to answer any of the complaints,and no discovery has been served on us.

 

At a further status conferenceon March 11, 2002, Judge Scheindlin stated that she would appoint leadplaintiffs counsel in the IPO Lawsuits by the end of March 2002, and that shewould require the appointed lead plaintiffs counsel to file amended,consolidated complaints in the IPO Lawsuits by April 17, 2002. Judge Scheindlinfurther stated that she did not expect the defendants to file motions todismiss the amended, consolidated complaints until the summer of 2002.   We believe these lawsuits are withoutmerit and intend to defend against them vigorously.  However, thislitigation, as well as any other litigation that might be instituted, couldresult in substantial costs and a diversion of management’s attention andresources.

 

 

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

 

We require substantial working capital tofund our business. If capital requirements vary materially from those currentlyplanned, we may require additional financing sooner than anticipated. Ifadditional funds are raised through the issuance of equity securities, thepercentage ownership of our stockholders will be reduced, stockholders mayexperience additional dilution or these equity securities may have rights,preferences or privileges senior to those of our Common Stock. Our capitalrequirements depend on several factors, including the rate of market acceptanceof our products, the ability to expand our client base and the growth of salesand marketing. We have had significant operating losses and negative cash flowfrom operations since inception. Additional financing may not be available whenneeded, on terms favorable to us or at all. If adequate funds are not availableor are not available on acceptable terms, we may be unable to develop orenhance our services, take advantage of future opportunities or respond tocompetitive pressures, which would harm our operating results and adversely affectour ability to achieve profitability.

 

**Provisionsof our charter documents, other agreements and Delaware law may inhibitpotential acquisition bids for us.**

 

Certain provisions of our Amended andRestated Certificate of Incorporation, Bylaws, other agreements and Delawarelaw could make it more difficult for a third-party to acquire us, even if achange in control would be beneficial to our stockholders.

 

**ITEM 2. PROPERTIES**.

 

We currentlylease approximately 99,000 square feet of office and warehouse space in twofacilities in Eden Prairie, Minnesota. Both agreements expire on July 31, 2003.  We also lease approximately 9,400 square feet of office space inChicago, Illinois, expiring in October 2004 and approximately 3,300 square feetof office space in suburban London, England, expiring in September 2003. Inaddition, we lease on a month-to-month basis, approximately 2,500 square feetof office space in San Jose, California and approximately 800 square feet ofoffice space in Issaquah, Washington.

 

23

----

 

**ITEM 3. LEGAL PROCEEDINGS.**

 

On February 27, 2002, ePedas SdnBhd initiated an arbitration before the American Arbitration Associationagainst us.  The demand for arbitration alleges breach of contract andtortious interference claims against us.  The prayer for relief requestsRM 28,809,137.09 (Ringit Malaysia or approximately US $7,581,150) pluspre-judgment interest, punitive damages, all legal costs and otherunspecified fees and expenses.  The case has been transferred to theInternational Section of the American Arbitration Association.  Currently,we must respond to the demand by April 8, 2002. An arbitrator has not beenselected and no arbitration date has been set. We believe this lawsuit iswithout merit and intend to defend against it vigorously.

 

Beginning in August 2001, weand certain of our officers and directors were named as defendants inseveral class action shareholder complaints filed in the United States DistrictCourt for the Southern District of New York.  These actions include (1)Whalen v. Digital River, Inc., et al., Case No. 01-CV-7355; and (2) Nicolois v.Digital River, Inc., et al., Case No. 01-CV-7992.  Similar complaints werefiled in the same Court against hundreds of other public companies thatconducted IPOs of their common stock in the late 1990s. In each of thesecomplaints, the plaintiffs allege that we, certain of our officersand directors and our IPO underwriters violated the federal securitieslaws because our IPO registration statement and prospectus containeduntrue statements of material fact or omitted material facts regarding thecompensation to be received by, and the stock allocation practices of, the IPOunderwriters. The plaintiffs seek unspecified monetary damages and otherrelief.

 

On August 8, 2001, the IPOLawsuits were consolidated for pretrial purposes before United States JudgeShira Scheindlin of the Southern District of New York. Judge Scheindlin held aninitial case management conference on September 7, 2001, at which time sheordered, among other things, that the time for all defendants in the IPOLawsuits to respond to any complaint be postponed until further order of theCourt. Thus, we have not been required to answer any of the complaints,and no discovery has been served on us.

 

At a further statusconference on March 11, 2002, Judge Scheindlin stated that she would appointlead plaintiffs counsel in the IPO Lawsuits by the end of March 2002, and thatshe would require the appointed lead plaintiffs counsel to file amended,consolidated complaints in the IPO Lawsuits by April 17, 2002. Judge Scheindlinfurther stated that she did not expect the defendants to file motions todismiss the amended, consolidated complaints until the summer of 2002.   We believe these lawsuits are without merit andintend to defend against them vigorously.  However, this litigation, aswell as any other litigation that might be instituted, could result insubstantial costs and a diversion of management’s attention and resources.

 

We are also party to patentlitigation, along with other defendants, regarding United States Patent No.6,014,651 owned by Christopher M. Crawford of Washington, D.C. The case wasfiled in August 2001 and is pending in the U.S. District Court in the Districtof Columbia. No substantive actions have taken place as yet in this case.  The Court has delayed substantive discoveryin this case, pending a preliminary determination of the legal scope ofCrawford’s claim.  A preliminary hearingis scheduled on May 15, 2002, in which the Court will determine how it willresolve what is the legal scope of Crawford’s patent’s claim.  Subsequent to that determination, we mayfile for a dismissal of the case if the Court’s decision is consistent with ourand the other defendants’ position regarding the interpretation of this patentclaim.  At this time, Crawford has notmade a definitive demand for the resolution of this case.

 

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

 

None.

 

24

----

 

**PART II**

 

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

 

Our Common Stock is traded on the NasdaqNational Market under the symbol “DRIV”. Public trading of our Common Stock commenced on August 11, 1998.Prior to that, there was no public market for our Common Stock. The followingtable sets forth, for the periods indicated, the high and low sale price pershare of our Common Stock on the Nasdaq National Market. These over-the-countermarket quotations reflect inter-dealer prices, without retail mark-up,mark-down or commission and may not necessarily represent actual transactions.

** **
|            |   | **HIGH** |   | **LOW** |   |
|-----------------|--------|----------|--------|---------|--------|
| **2000**        |   |     |   |    |   |
| First  quarter  |   | $        | 37.38  |    | $      | 21.00 |   |
| Second  quarter |   | $        | 22.13  |    | $      | 7.00 |   |
| Third  quarter  |   | $        | 9.13   |    | $      | 5.38 |   |
| Fourth  quarter |   | $        | 7.38   |    | $      | 2.19 |   |
|            |   |     |   |    |   |
| **2001**        |   |     |   |    |   |
| First  quarter  |   | $        | 9.50   |    | $      | 2.50 |   |
| Second  quarter |   | $        | 7.50   |    | $      | 3.50 |   |
| Third  quarter  |   | $        | 7.93   |    | $      | 4.00 |   |
| Fourth  quarter |   | $        | 19.60  |    | $      | 6.26 |   |

** **

As of March 20, 2002, there wereapproximately 480 holders of record of our Common Stock. On March 20,2002, the last sale price reported on the Nasdaq National Market System for ourCommon Stock was $16.09 per share.

 

We have never declared or paid any cashdividends on our capital stock. We intend to retain any future earnings tosupport operations and to finance the growth and development of our businessand do not anticipate paying cash dividends for the foreseeable future.

 

Since January 1, 2001, we have sold andissued the following unregistered securities:

 

The former owners of Maagnum Internet Group,Inc., a company we purchased in April 1999, received earn-out payments in March2001 of 314,531 shares of Common Stock valued at $1.5 million.

 

NetSales, Inc., from whom we purchasedcertain assets in August 2000, received an earn-out payment in March 2001 of84,000 shares of Common Stock valued at $404,000.

 

In March 2001, we purchased certain assets ofConnectInc.com, Co. (“ConnectInc”) related to ConnectInc’s Market Makerbusiness, in exchange for 1,630,368 shares of Common Stock valued at $7.8million, with a contingent earn-out whereby ConnectInc can receive additionalshares of Common Stock based upon the revenue generated by the Market Makerproducts, from sales by us and ConnectInc’s parent company, over the 13 monthsfollowing the closing.  In November2001, the former owners of ConnectInc received an earn-out payment of 59,740shares of Common Stock valued at $314,000.

 

In September 2001, we purchased substantiallyall of the assets of Orbit Commerce, Inc. in exchange for 727,939 shares ofCommon Stock valued at $4.3 million and $964,000 in cash, with a contingentearn-out whereby Orbit can receive additional shares of Common Stock based uponthe revenues generated by the assets acquired from Orbit over the 15 monthsfollowing the closing.

 

In December 2001, warrants were exercised topurchase 250,000 shares of Common Stock at a weighted average exercise price of$3.00 per share.

 

25

----

 

The sales and issuances of the unregisteredsecurities in the transactions described above were deemed to be exempt fromregistration under the Securities Act of 1993 in reliance upon Regulation Dpromulgated thereunder. The recipients of securities in each such transactionrepresented that they are accredited investors and intend to acquire thesecurities for investment only and not with a view to or for sale in connectionwith any distribution thereof and appropriate legends were affixed to thesecurities issued in such transactions. All recipients had adequate access,through their relationship with us, to information about us.

 

There were no underwritten offerings employedin connection with the sales and issuances of the unregistered securities inany of the transactions set forth above.

 

**ITEM 6. SELECTEDFINANCIAL DATA.**

 
|                                                                                             |   | **YEAR ENDED  DECEMBER 31,**               |    |
|--------------------------------------------------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                                                             |   | **2001**                                   |    | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                             |   | **(in  thousands, except per share data)** |    |
| **Statement of Operations Data:**                                                                |   |                                       |    |   |   |   |   |   |   |   |   |
| Revenue                                                                                          |   | $                                          | 57,825  |   | $ | 31,181 |   | $ | 14,507 |   | $ | 3,424 |   | $ | 420 |   |
| Costs and expenses (exclusive of depreciation and amortization  expense shown separately below): |   |                                       |    |   |   |   |   |   |   |   |   |
| Direct cost of services                                                                          |   | 2,710                                      |    | 1,477 |   | 801 |   | 116 |   | 23 |   |
| Network and infrastructure                                                                       |   | 10,200                                     |    | 7,867 |   | 4,434 |   | 1,836 |   | 580 |   |
| Sales and marketing                                                                              |   | 27,489                                     |    | 25,693 |   | 17,383 |   | 9,310 |   | 1,446 |   |
| Product research and development                                                                 |   | 11,192                                     |    | 13,063 |   | 10,251 |   | 3,140 |   | 877 |   |
| General and administrative                                                                       |   | 4,701                                      |    | 4,628 |   | 4,001 |   | 3,111 |   | 837 |   |
| Depreciation and amortization                                                                    |   | 4,627                                      |    | 3,178 |   | 1,552 |   | 604 |   | 195 |   |
| Amortization of goodwill and other intangibles and acquisition  related costs                    |   | 17,009                                     |    | 15,387 |   | 6,886 |   | — |   | — |   |
| Total costs and expenses                                                                         |   | 77,928                                     |    | 71,293 |   | 45,308 |   | 18,117 |   | 3,958 |   |
| Loss from operations                                                                             |   | (20,103                                    | )       | (40,112 | ) | (30,801 | ) | (14,693 | ) | (3,538 | ) |
| Interest income                                                                                  |   | 881                                        |    | 1,996 |   | 3,148 |   | 895 |   | 53 |   |
| Net loss                                                                                         |   | $                                          | (19,222 | ) | $ | (38,116 | ) | $ | (27,653 | ) | $ | (13,798 | ) | $ | (3,485 | ) |
| Basic and diluted net loss per share                                                             |   | $                                          | (.79    | ) | $ | (1.78 | ) | $ | (1.36 | ) | $ | (1.01 | ) | $ | (0.46 | ) |
| Shares used in per share computation                                                             |   | 24,285                                     |    | 21,413 |   | 20,312 |   | 13,691 |   | 7,514 |   |

 
|                             |   | **DECEMBER  31,**   |   |
|----------------------------------|--------|---------------------|--------|
|                             |   | **2001**            |   | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                             |   | **(in  thousands)** |   |
| **Balance  Sheet Data:**         |   |                |   |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents       |   | $                   | 21,677 |   | $ | 16,920 |   | $ | 15,120 |   | $ | 63,503 |   | $ | 2,126 |   |
| Short-term  investments          |   | 9,978               |   | 14,977 |   | 24,387 |   | 10,894 |   | — |   |
| Working capital                  |   | 14,024              |   | 17,038 |   | 28,777 |   | 70,563 |   | 1,244 |   |
| Total assets                     |   | 78,227              |   | 69,403 |   | 87,142 |   | 80,328 |   | 3,405 |   |
| Accumulated  deficit             |   | (103,114            | )      | (83,892 | ) | (45,776 | ) | (18,123 | ) | (4,325 | ) |
| Total stockholders’  equity |   | $                   | 50,422 |   | $ | 48,518 |   | $ | 73,077 |   | $ | 74,587 |   | $ | 2,329 |   |

 

26

----

 

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

 

The Company is a leading provider ofcomprehensive electronic commerce outsourcing solutions. The Company wasincorporated in February 1994 and commenced offering products for salethrough its clients’ Web stores in August 1996. From inception throughAugust 1996, the Company had no sales, and its activities relatedprimarily to the development of its Commerce Network Server (“CNS”) technologyrelated to electronic commerce. In 1996, the Company began to focus itsbusiness development efforts on the software industry, building its inventoryof software products through contracts with software publishers. In 1997, theCompany began to develop software distribution relationships through contractswith online retailers. As of December 31, 2001, the Company hadapproximately 10,000 software publisher clients and online retailer clientsserved by the Software and Digital Commerce Services Division. In late 1998,the Company began to offer its comprehensive electronic commerce outsourcingservices in the form of a transaction fee-based e-commerce service to clientsoutside of the software industry. As of December 31, 2001, the Company wasoperating approximately 11,000 sites under its E-Business Services Division.

 

The Company has a limited operating historyupon which investors may evaluate its business and prospects. Since inception,the Company has incurred significant losses, and as of December 31, 2001,had an accumulated deficit of approximately $103.1 million. The Companyintends to expend financial and management resources on the development ofadditional services, sales and marketing, technology and operations to supportlarger-scale operations and greater service offerings. Although the Companyexpects to generate positive cash flow from operations in 2002, there can be noassurance that the Company’s revenue will increase or even continue at itscurrent level or that the Company will achieve or maintain profitability orgenerate cash from operations in future periods.

 

The Company’s prospects must be considered inlight of the risks, expenses and difficulties frequently encountered bycompanies in their early stage of development, particularly companies in newand rapidly evolving markets such as electronic commerce. To address theserisks, the Company must, among other things, maintain existing and develop newrelationships with software publishers, online retailers and E-BusinessServices clients, implement and successfully execute its business and marketingstrategy, continue to develop and upgrade its technology andtransaction-processing systems, provide superior customer service and orderfulfillment, respond to competitive developments, and attract, retain andmotivate qualified personnel. There can be no assurance that the Company willbe successful in addressing these risks, and the failure to do so would have amaterial adverse effect on the Company’s business, financial condition andresults of operations.

 

The Company’s current and future expenselevels are based largely on its planned operations and estimates of futurerevenue. Revenue and operating results generally depend on the volume andtiming of orders received, which are difficult to forecast. The Company 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 the Company’s business, financial condition andresults of operations. The Company is also likely to continue to see revenue inits Software and Digital Commerce Services Division fluctuate on the seasonalbasis typical for the software publishing market in general. The Companybelieves that its first and fourth quarters are seasonally stronger than itssecond and third quarters due to the timing of demand for tax preparationsoftware and the holiday season selling period. In addition, it is theCompany’s belief that software publishers avoid new product releases in thesummer months. In view of the rapidly evolving nature of the Company’s businessand its limited operating history, the Company is unable to accurately forecastits revenue and believes that period-to-period comparisons of its operatingresults are not necessarily meaningful and should not be relied upon as anindication of future performance.

 

## ***Critical Accounting Policies***

 

We prepare our consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America. As such, we are required to make certain estimates,judgments and assumptions that we believe are reasonable based upon theinformation available. These estimates and assumptions affect the reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the periods presented. Thesignificant accounting policies which we believe are the most critical to aidin fully understanding and evaluating our reported financial results includethe following:

 

27

----

 

*Revenue Recognition.*  The Company recognizes revenue from servicesrendered once all the following criteria for revenue recognition have been met:1) Pervasive evidence of an agreement exists, 2) the services havebeen rendered, 3) the fee is fixed and determinable and not subject torefund or adjustment and 4) collection of the amounts due is reasonablyassured. The Company derives its revenue primarily from transaction and 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 reports itsrevenue on a net basis and therefore records only the net transaction fees andservice fees as its revenue.  TheCompany acts as the merchant of record on the majority of the transactionsprocessed and has contractual relationships with its clients, primarilysoftware publishers and online retailers, which obligate the Company to pay tothe client a specified percentage of each sale. The Company retains itstransaction fee and also charges for various service fees. The Company alsoderives revenue from providing clients the right to use its softwareapplications along with integration, development and consulting services.Signed contracts are obtained from clients prior to recognition of theserevenues. Fees for the use of software applications and any integration anddevelopment work required to provide on-going hosting services for the clientare recognized ratably over the term of the contract once collection isreasonably assured. Clients do not have the right to take possession of thesoftware applications used in the delivery of services. Payments received inadvance of revenue recognition, even if non-refundable, are recognized asdeferred revenue. Revenues from consulting services are recognized using thepercentage-of-completion method for fixed-fee arrangements or as the servicesare provided for time-and-materials arrangements. If the Company does notaccurately estimate the resources required or the scope of work to beperformed, or does not manage its projects properly within the planned periodsof time or satisfy its obligations under the contracts, then future margins maybe negatively affected.

 

*Allowance for Doubtful Accounts*.  Thepreparation of financial statements requires management to make estimates andassumptions that affect the reported amount of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Estimates are used in determining our allowance for doubtful accountsand are based on our historical experience and current trends.  Management makes an estimate of anticipatedfuture chargebacks and product returns related to current period revenue byanalyzing the timing of historical chargebacks and applying anticipatedpercentages to current period revenues. Similarly, management must makeestimates of the uncollectability of our billed accounts receivable. Managementspecifically analyzes accounts receivable and historical bad debts, customercredit-worthiness, current economic trends and changes in our customer paymentterms when evaluating the adequacy of the allowance for doubtful accounts.  Significant management judgments andestimates must be made and used in connection with the allowance in anyaccounting period.  Material differencesmay result in the amount and timing of our revenue for any period if managementmakes different judgments or utilizes different estimates.

 

*Goodwill, Intangibles and Other Long-LivedAssets.* Property, plant and equipment, goodwill, intangibles and certain otherlong-lived assets are amortized over their useful lives. Useful lives are basedon management’s estimates of the period that the assets will generate revenue.Intangible assets are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. The Company’s evaluation considers nonfinancial data such aschanges in the operating environment and business strategy, competitiveinformation, market trends and operating performance.  Future events could cause us to conclude that impairmentindicators exist and that goodwill and other intangibles associated with ouracquired businesses is impaired. Any resulting impairment loss could have amaterial adverse impact on our financial condition and results of operations.The Company expects amortization of goodwill and other intangibles andacquisition related costs to decrease in 2002 due to the adoption of Statementof Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” andSFAS No. 142, “Goodwill and Intangible Assets”.

 

28

----

 

**Results Of Operations**

 

The following table sets forth certain itemsfrom the Company’s consolidated statements of operations as a percentage oftotal revenue for the years indicated.

 
|                                                                                              |   | **2001** |   | **2000** |   | **1999** |   |
|---------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Revenue                                                                                           |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |
| Costs and  expenses (exclusive of depreciation and amortization expense shown separately  below): |   |     |   |     |   |     |   |
| Direct cost of  services                                                                          |   | 4.7      |   | 4.7      |   | 5.5      |   |
| Network and  infrastructure                                                                       |   | 17.6     |   | 25.2     |   | 30.6     |   |
| Sales and  marketing                                                                              |   | 47.5     |   | 82.4     |   | 119.8    |   |
| Product research  and development                                                                 |   | 19.4     |   | 41.9     |   | 70.7     |   |
| General and  administrative                                                                       |   | 8.1      |   | 14.9     |   | 27.6     |   |
| Depreciation  and amortization                                                                    |   | 8.0      |   | 10.2     |   | 10.7     |   |
| Amortization of  goodwill and other intangibles and acquisition related costs                     |   | 29.4     |   | 49.3     |   | 47.4     |   |
| Total costs and  expenses                                                                         |   | 134.7    |   | 228.6    |   | 312.3    |   |
| Loss from  operations                                                                             |   | (34.7    | )      | (128.6   | )      | (212.3   | )      |
| Interest income                                                                                   |   | 1.5      |   | 6.4      |   | 21.7     |   |
| Net loss                                                                                          |   | (33.2    | )%     | (122.2   | )%     | (190.6   | )%     |

 

**Years EndedDecember 31, 2001, 2000 and 1999**

 

The Company has two operating segments, Softwareand Digital Commerce Services and E-Business Services, which have beenidentified as components of the Company that are reviewed regularly bymanagement to determine resource allocation and assess performance.  The Company began presenting the E-BusinessServices Division as a separate segment in 2000. Prior to that, substantiallyall revenue and related expenses were associated with the Company’s Softwareand Digital Commerce Services Division.

 

*Revenue.*  The Company’s revenue increased to $57.8 millionin 2001 from $31.2 million in 2000 and $14.5 million in 1999. Therevenue increase in 2001 resulted from the expansion of the Company’s clientrelationship with Symantec Corporation, increasing market acceptance ofelectronic software downloading, merchandising activities that increased theaverage sales generated by the Company’s software publisher clients and thefour acquisitions completed by the Company in 2001. The entities acquiredduring 2001 generated approximately 7% of the Company’s total revenue duringthe year.  The revenue increases in 2000and 1999 resulted from significant growth in the number of Company clients, theincreasing market acceptance of electronic software downloading andmerchandising activities that increased the average sales generated by theCompany’s software publisher clients. International sales representedapproximately 22%, 25% and 22% of revenue in the years ended December 31,2001, 2000 and 1999, respectively. In 2001, revenue for the Software andDigital Commerce Services Division was $44.9 million, up from$25.2 million in 2000.  Revenue forthe E-Business Services Division was $12.9 million in 2001, up from$6.0 million in 2000.

 

*Gross Profit.*  Cost of revenue consists of direct cost ofservices and network and infrastructure expenses and is composed of directlabor costs related to revenue and the costs to operate and maintain the CNS,as well as customer service and operations functions.  Such amounts are shown exclusive of depreciation and amortizationexpense. Cost of revenue increased substantially in all years presented,reflecting the Company’s growth in revenue. During 2001, 2000 and 1999, theCompany’s gross profit margins were 77.7%, 70.0%, and 63.9%, respectively. Thegross profit margin increases in 2001, 2000 and 1999 were primarily due toleveraging the Company’s infrastructure over significantly more revenue andclients. In 2001, the gross profit margin for the Software and Digital CommerceServices Division was 80.6%, up from 71.8% in 2000.  The gross profit margin for the E-Business Services Division was67.4% in 2001, up from 62.4% in 2000. The Company believes that Internetcommerce and related services may become more competitive in the future.Accordingly, the Company may reduce or alter its pricing structure and policiesin the future and any such change could reduce gross margins.

 

29

----

 

*Sales and Marketing.*  Sales and marketing expense consists primarily of personnel andrelated expenses, advertising and promotional expenses, credit card chargebacksand bad debt expense, and credit card transaction fees. Sales and marketingexpense increased to $27.5 million in 2001, from $25.7 million and$17.4 million in 2000 and 1999, respectively, resulting from increasedcredit card transaction fees and bad debt expense due to increased revenue aswell as additional sales and marketing personnel and related expenses. Theincrease in 2001 from 2000 resulted from an increase in credit card transactionfees of $3.3 million. The increase in 2000 from 1999 resulted from anincrease in wages, benefits and consulting fees of $4.3 million and anincrease in credit card chargebacks, bad debt expense and credit cardtransaction fees of $2.7 million. As a percentage of revenue, sales and marketing expense decreased to47.5% in 2001 from 82.4% in 2000 and 119.8% in 1999, primarily reflecting theCompany’s increased revenue. In 2001, the sales and marketing expense relatedto the Software and Digital Commerce Services Division was $17.5 million, upfrom $14.7 million in 2000.  Thesales and marketing expense related to the E-Business Services Division was$10.0 million in 2001, down from $11.0 million in 2000. The Company expectsthat sales and marketing expense will continue to increase in absolute dollarsas the Company continues to build its sales and marketing infrastructure anddevelops marketing programs and as volume-driven credit card expenses increase.As a percentage of revenue, these expenses are expected to decrease as revenueincreases.

 

*Product Research and Development.*  Product research and development expenseconsists primarily of personnel and related expenses and consulting costsassociated with developing and enhancing the Company’s CNS and related internalsystems. Product research and development expense was $11.2 million in 2001,compared to $13.1 million and $10.3 million in 2000 and 1999,respectively. The decrease in 2001 from 2000 resulted from a decrease inconsulting costs of $5.0 million, partially offset by an increase in wages andbenefit costs of $2.6 million.  Theincrease in 2000 from 1999 resulted from an increase in wages, benefits andtemporary employee costs of $1.4 million and an increase in consultingcosts of $1.1 million. As a percentage of revenue, product research anddevelopment expense decreased to 19.4% in 2001 from 41.9% in 2000 and 70.7% in1999, primarily reflecting the Company’s increased revenue. In 2001, theproduct research and development expense related to the Software and DigitalCommerce Services Division was $4.8 million, down from $5.8 million in2000. Product research and development expense related to the E-BusinessServices Division was $6.4 million, down from $7.2 million in 2000. TheCompany expects that product research and development expenses will continue todecrease as a percentage of revenue as revenue increases.

 

*General and Administrative.*  General and administrative expense consistsprincipally of executive, accounting and administrative personnel and relatedexpenses, including deferred compensation expense, professional fees andinvestor relations expenses. General and administrative expense increased to$4.7 million in 2001, from $4.6 million and $4.0 million in 2000 and1999, respectively. The increase in 2001 from 2000 resulted from an increase inprofessional fees of $108,000.  Theincrease in 2000 from 1999 resulted from an increase in professional fees andinvestor relations-related expense of $332,000. As a percentage of revenue,general and administrative expense decreased to 8.1% in 2001 from 14.9% in 2000and 27.6% in 1999, primarily reflecting the Company’s increased revenue. In2001 and 2000, general and administrative expense related to the Software andDigital Commerce Services Division was $3.2 million. In 2001, general andadministrative expense for the E-Business Services Division was $1.5 million,up from $1.4 million in 2000. The Company expects general andadministrative expense to increase in absolute dollars in the future,particularly as the Company continues to build infrastructure to support itsgrowth. As a percentage of revenue, these expenses are expected to decrease asrevenue increases.

 

*Amortization of Goodwill and Other Intangibles and Acquisition RelatedCosts.* Amortization of goodwill and other intangibles and acquisition relatedcosts consists of the amortization of goodwill and other intangible assetsrecorded from the Company’s nine acquisitions in the past three years, as wellas other acquisition related costs such as earn-out payments. Amortization ofgoodwill and other intangibles and acquisition related costs increased to $17.0million in 2001 from $15.4 million in 2000 and $6.9 million in 1999.  The increase in 2001 from 2000 related tothe amortization of goodwill and other intangibles from the four acquisitionsconsummated during 2001. The increase in 2000 from 1999 related to a full yearof amortization of goodwill and other intangibles in 2000 from the four 1999acquisitions as well as two earn-out payments totaling $5.1 million made in2000.  The Company expects amortizationof goodwill and other intangibles and acquisition related costs to decrease in2002 due to the adoption of SFAS No. 141 and No. 142.

 

30

----

 

*Loss from Operations.*  The Company’s loss from operations decreasedto $20.1 million in 2001 from $40.1 million in 2000 and $30.8 millionin 1999, resulting primarily from increased revenue without commensurateincreases in operating expenses. In 2001, the Software and Digital CommerceServices Division generated income from operations of $10.7 million compared toa loss of $5.6 million in 2000.  In2001, the loss from operations related to the E-Business Services Division was$9.1 million compared to a loss of $15.9 million in 2000. In calculatingsegment losses, the Company does not include depreciation and amortization oramortization of goodwill and other intangibles and acquisition related costs.

 

*Interest Income.*  Interest income consists of earnings on the Company’s cash andcash equivalents and short-term investments. Interest income decreased to$881,000 in 2001 from $2.0 million in 2000 and $3.1 million in 1999,resulting from changes in average cash and cash equivalent balances anddecreases in interest rates.

 

*Income Taxes.* The Company paid no income taxes in any of the years presented. TheCompany has incurred a net loss for each year since inception. As ofDecember 31, 2001, the Company had approximately $82.4 million of netoperating loss carryforwards for federal income tax purposes, which expirebeginning in 2009. Due to the uncertainty of future profitability, a valuationallowance equal to the deferred tax asset has been recorded. Certain changes inownership that resulted from the past sales of capital stock will limit thefuture annual realization of the tax net operating loss carryforwards to aspecified percentage under Section 382 of the Internal Revenue Code.

 

**Liquidity and CapitalResources**

 

Net cash provided by operatingactivities in 2001 was $547,000 and net cash used in operating activities$17.0 million in 2000 and $13.6 million in 1999. The net cashprovided by operating activities in 2001 and used in operating activities in2000 and 1999 was primarily the result of net losses, offset by goodwill andother intangibles amortization and earn-out charges, increases in accountspayable and increases in depreciation and amortization.

 

Net cash used in investingactivities was $2.4 million in 2001 and was the result of purchases ofequipment of $5.9 million and net cash paid for acquisitions of $1.5 million,offset in part by net sales of investments of $5.0 million.  Net cash provided by investing activitieswas $14.9 million in 2000 and was the result of net sales of investmentsof $24.4 million partially offset by purchases of equipment of$9.4 million. Net cash used in investing activities was $37.5 millionin 1999 and was primarily the result of the purchases of equipment totaling$4.8 million, the net purchase of investments of $28.5 million and net cashpaid for acquisitions of $4.1 million.

 

Net cash provided by financingactivities in 2001, 2000 and 1999 was $6.6 million, $3.9 million, and$2.7 million, respectively. The cash provided by financing activities ineach year was mainly the result of proceeds from the exercise of stock optionsand warrants.  In April 2001, theCompany initiated a share repurchase program of up to $5.0 million of itsoutstanding shares of Common Stock. Repurchases will be at the Company’sdiscretion based on ongoing assessments of the capital needs of the businessand the market price of its shares.  Notime limit was set for the completion of the repurchase program.  In 2001, the Company expended $267,000 torepurchase its shares.

 

As of December 31, 2001the Company had approximately $21.7 million of cash and cash equivalentsand $10.0 million of short-term investments. The Company’s principalcommitments consisted of obligations outstanding under operating leases. OnFebruary 1, 2002, the Company paid off the $2.5 million note payable related toits August 2001 acquisition of RegSoft. Although the Company has no materialcommitments for capital expenditures, it anticipates an increase in the rate ofcapital expenditures consistent with its anticipated growth in operations,infrastructure and personnel. The Company anticipates that it will expendapproximately $15.0 million over the next 24 months on capitalexpenditures based on the Company’s current anticipated growth rate. TheCompany further anticipates that it will expend approximately$22.0 million over the next 24 months on product research anddevelopment based on the Company’s current anticipated growth rate inoperations. The Company may also use cash to acquire or license technology,products or businesses related to the Company’s current business. The Companyalso anticipates that it will continue to experience growth in its operatingexpenses for the foreseeable future and that its operating expenses will be amaterial use of the Company’s cash resources.

 

31

----

 

The Company believes thatexisting sources of liquidity and the results of its operations will provideadequate cash to fund its operations for at least the next 24 months,although the Company may seek to raise additional capital during that period.In January 2002, the Company filed a universal shelf registration statementwith the SEC pursuant to which the Company will be permitted to issue up to$100.0 million in common stock, preferred stock, debt securities andwarrants.  The sale of additional equityor convertible debt securities could result in additional dilution to theCompany’s stockholders. There can be no assurances that financing will beavailable in amounts or on terms acceptable to the Company, if at all.

 

# **Recent Accounting Pronouncements**

 

In June 2001, the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 141, “BusinessCombinations” and SFAS No. 142, “Goodwill and Intangible Assets”.  Major provisions of these statements are asfollows: all business combinations initiated after June 30, 2001 must use thepurchase method of accounting and the pooling of interest method of accountingis prohibited except for transactions initiated before July 1, 2001; intangibleassets acquired in a business combination must be recorded separately fromgoodwill if they arise from contractual or other legal rights or are separablefrom the acquired entity and can be sold, transferred, licensed, rented orexchanged, either individually or as part of a related contract, asset orliability; goodwill and intangible assets with indefinite lives are notamortized but tested for impairment annually, except in certain circumstances,and whenever there is an impairment indicator; all acquired goodwill must beassigned to reporting units for purposes of impairment testing; and effectiveJanuary 1, 2002, goodwill from acquisitions initiated prior to July 1, 2001 isno longer subject to amortization.

 

These new Statements wereapplicable to the Company’s acquisitions of RegSoft.com, Orbit Commerce, Inc.,and Network Commerce, all of which occurred after the July 1 effective date fornew acquisitions.  Accordingly, goodwilltotaling $3,615,000 resulting from these acquisitions was not amortized during2001.  The Company will adopt theprovisions of SFAS No. 142 related to all other acquisitions on January 1,2002.  The adoption of these statementsis not expected to result in any transitional goodwill impairment losses on ourunamortized goodwill balances, which totaled $11,273,000 at December 31, 2001,and for which we recorded amortization expense of $10,769,000 in the year endedDecember 31, 2001.  Other identifiedintangibles with determinable lives, which totaled $8,934,000 at December 31,2001, will continue to be amortized pursuant to the new standards.

 

In July 2001, the FASB issuedSFAS No. 144, “Impairment or Disposal of Long-Lived Assets”, which is effectivefor fiscal years beginning after December 15, 2001. The provisions of thisstatement provide a single accounting model for impairment of long-livedassets. The Company anticipates that this new standard will not have a materialimpact on its financial position or results of operations.

 

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

 

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

 

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

 

Our Financial Statements and Notes thereto appear beginning at page 38of this report.

 

32

----

 

**QUARTERLYFINANCIAL DATA**

 
|                     |   | **QUARTER ENDED**                         |   |
|--------------------------|--------|-------------------------------------------|--------|
|                     |   | **March 31**                              |   | **June 30** |   | **September 30** |   | **December 31** | ** ** |
|                     |   | **(in thousands, except per share data)** |   |
| **2001**                 |   |                                      |   |   |   |   |   |   |   |
| Revenue                  |   | $                                         | 13,047 |   | $ | 13,055 |   | $ | 13,991 |   | $ | 17,732 |   |
| Gross profit (a)         |   | 9,526                                     |   | 9,906 |   | 11,069 |   | 14,414 |   |
| Loss from operations (b) |   | (6,589                                    | )      | (5,324 | ) | (4,548 | ) | (3,642 | ) |
| Net loss                 |   | (6,241                                    | )      | (5,062 | ) | (4,374 | ) | (3,545 | ) |
| Net loss per share (c)   |   | $                                         | (.28   | ) | $ | (.21 | ) | $ | (.18 | ) | $ | (.14 | ) |

 
|                     |   | **QUARTER ENDED**                         |   |
|--------------------------|--------|-------------------------------------------|--------|
|                     |   | **March 31**                              |   | **June 30** |   | **September 30** |   | **December 31** | ** ** |
|                     |   | **(in thousands, except per share data)** |   |
| **2000**                 |   |                                      |   |   |   |   |   |   |   |
| Revenue                  |   | $                                         | 6,883  |   | $ | 6,635 |   | $ | 7,607 |   | $ | 10,056 |   |
| Gross profit (a)         |   | 4,798                                     |   | 4,403 |   | 5,298 |   | 7,339 |   |
| Loss from operations (b) |   | (12,675                                   | )      | (13,187 | ) | (8,456 | ) | (5,793 | ) |
| Net loss                 |   | (11,991                                   | )      | (12,633 | ) | (8,074 | ) | (5,418 | ) |
| Net loss per share (c)   |   | $                                         | (.58   | ) | $ | (.60 | ) | $ | (.37 | ) | $ | (.24 | ) |

 

----

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

 

(b)           Loss from operationsincludes amortization of goodwill and other intangibles and acquisition relatedcosts of $4,644, $3,839, $3,912 and $4,614 in the quarters endingMarch 31, June 30, September 30 and December 31, 2001,respectively, and includes amortization of goodwill and other intangibles andacquisition related costs of $5,394, $4,334, $2,603, and $3,056 in the quartersending March 31, June 30, September 30 and December 31, 2000,respectively.

 

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

 

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

 

None.

 

33

----

 

**PART III**

 

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

 

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

 

(a)           Identification of Directors:

 

Theinformation concerning our directors and nominee is incorporated by referenceto our Proxy Statement in connection with our 2002 Annual Meeting to be filedin accordance with Regulation 14A under the Securities Exchange Act of 1934, asamended.

 

(b)           Identification of Executive Officers:

 

Please referto the section entitled “Executive Officers” in Part I, Item 1 hereof.

 

(c)           Compliance with Section 16(a) of the Exchange Act:

 

Based solelyupon a review of Forms 3 and 4 and amendments thereto furnished to us pursuant toRule 16a-3(e) during the 2001 fiscal year and Form 5 and amendments theretofurnished to us with respect to fiscal year 2001, no director, officer orbeneficial owner of more than 10 percent of any class of equity security ofDigital River has failed to file on a timely basis, as disclosed by the aboveforms, reports required by Section 16(a) of the Securities Exchange Act of1934, as amended, during the 2001 fiscal year.

 

**ITEM 11.EXECUTIVE COMPENSATION.**

 

Theinformation required in Item 11 of Part III of this report is incorporatedby reference to our Proxy Statement in connection with our 2002 Annual Meetingto be filed in accordance with Regulation 14A under the SecuritiesExchange Act of 1934, as amended.

 

**ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.**

 

Theinformation required in Item 12 of Part III of this report is incorporatedby reference to our Proxy Statement in connection with our 2002 Annual Meetingto be filed in accordance with Regulation 14A under the Securities ExchangeAct of 1934, as amended.

 

**ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.**

 

Theinformation required in Item 13 of Part III of this report is incorporatedby reference to our Proxy Statement in connection with our 2002 Annual Meetingto be filed in accordance with Regulation 14A under the SecuritiesExchange Act of 1934, as amended.

 

34

----

 

**PART IV**

 

**ITEM 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K**

 

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

 

(1)        Index to ConsolidatedFinancial Statements and Report of Independent Public Accountants.

 

Theconsolidated financial statements required by this item are submitted in aseparate section beginning on page 38 of this report.

 
| 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 StatementSchedules.

 

Schedules notlisted above have been omitted because the information required to be set forththerein is not applicable or is included in the financial statements or notesthereto.

 

(3)        Exhibits.

 
| **ExhibitNumber** |     | **Description Of  Document** |
|-------------------|----------|------------------------------|
|              | 2.1(1)   |                         | Asset  Purchase Agreement, dated August 24, 2000, by and between the Registrant and  NetSales, Inc. |
|              | 2.2(2)   |                         | Asset  Purchase Agreement dated as of March 20, 2001, by and between the Registrant,  Calico Commerce, Inc. and ConnectInc.com, Co., a wholly-owned subsidiary of  Calico Commerce, Inc. |
|              | 3.1(3)   |                         | Amended and  Restated Certificate of Incorporation of the Registrant, as currently in  effect. |
|              | 3.2(4)   |                         | Amended and  Restated Bylaws of the Registrant, as currently in effect. |
|              | 3.3(3)   |                         | Certificate  of Amendment of Amended and Restated Certificate of Incorporation (amending  Exhibit 3.1). |
|              | 4.1(5)   |                         | Specimen  Stock Certificate. |
|              | 4.2(3)   |                         | Form of  Senior Debt Indenture. |
|              | 4.3(3)   |                         | Form of  Subordinated Debt Indenture. |
|              | 4.4      |                         | References  are hereby made to Exhibits 3.1, 3.2 and 3.3. |
|              | 10.1(3)  |                         | Form of  Indemnity Agreement between Registrant and each of its directors and  executive officers. |
|              | 10.2(3)  |                         | 1998 Stock  Option Plan. |
|              | 10.3(3)  |                         | Employment  and Non-Competition Agreement effective May 25, 1998 by and between Joel A.  Ronning and the Registrant. |
|              | 10.4(3)  |                         | Heads of  Agreement for International Agreement dated February 25, 1998 by and between  Christopher J. Sharples, David A. Taylor and the Registrant. |
|              | 10.5(3)  |                         | Stock  Subscription Warrant for Shares of Common Stock dated February 26, 1998 by  and between Christopher Sharples and Registrant. |
|              | 10.6(3)  |                         | Form of  Conditional Warrant to Purchase Common Stock dated April 22, 1998 by and  between Wasserstein Adelson Ventures, L.P. and Registrant. |
|              | 10.7(3)  |                         | Form of  Warrant to Purchase Common Stock by and between certain investors and  Registrant. |
|              | 10.8(3)  |                         | Consent to  Assignment and Assumption of Lease dated April 22, 1998 by and between CSM  Investors, Inc., IntraNet Integration Group, Inc. and Registrant. |
|              | 10.9(3)  |                         | Assignment  of Lease dated April 21, 1998 by and between Intranet Integration Group, Inc.  and Registrant. |
|              | 10.10(3) |                         | Lease  Agreement dated January 18, 2000 between Property Reserve, Inc. and  Registrant. |
|              | 10.11(4) |                         | 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.). |

 

35

----

 
|   | 10.12(4) |   | 1999 Stock  Option Plan, formerly known as the 1999 Non-Officer Stock Option Plan.                                                                                 |
|--------|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.13(4) |   | Form of  Non-Qualified Stock Option Agreement under the 1999 Stock Option Plan.                                                                                    |
|   | 10.14(6) |   | Agreement  and Plan of Merger, dated April 1, 1999, by and among the Registrant, Maagnum  Internet Group, Inc. and Cyrus Maaghul.                                  |
|   | 10.15(6) |   | Stock  Purchase Agreement, dated April 1, 1999, by and among the Registrant and  Meiman Kentjana.                                                                  |
|   | 10.16(7) |   | Asset  Purchase Agreement, dated as of April 15, 1999, by and among the Registrant,  Public Software Library Ltd. and the partners of Public Software Library Ltd. |
|   | 10.17(2) |   | Voting  Agreement, dated March 20, 2001, by and between the Registrant, Calico  Commerce, Inc. and ConnectInc.com, Co.                                        |
|   | 21.1     |   | Subsidiaries  of Digital River, Inc.                                                                                                                               |
|   | 23.1     |   | Consent of  Independent Public Accountants, dated March 31, 2002.                                                                                                  |
|   | 99       |   | Letter from  the Registrant to the SEC                                                                                                                             |

 

----

(1)           Incorporated byreference to the indicated exhibit in the Company’s Current Report onForm 8-K filed on September 8, 2000.

(2)           Incorporated byreference to the indicated exhibit in the Company’s Current Report onForm 8-K filed on March 26, 2001.

(3)           Incorporated byreference to the indicated exhibit in the Company’s Registration Statement onForm S-3 (File No. 333–81626), declared effective on February12, 2002.

(4)           Incorporated byreference to the indicated exhibit in the Company’s Annual Report onForm 10-K for the year ended December 31, 2000 filed onMarch 27, 2001.

(5)           Incorporated byreference to the indicated exhibit in the Company’s Registration Statement on Form S-1(File No. 333–56787), declared effective on August 11, 1998.

(6)           Incorporated byreference to the indicated exhibit in the Company’s Current Report onForm 8-K filed on April 16, 1999.

(7)           Incorporated byreference to the indicated exhibit in the Company’s Quarterly Report onForm 10-Q for the quarter ended June 30, 1999.

 

(b)           The Registrant filed a Current Reporton Form 8-K on November 21, 2001, amending the Current Report on Form8-K originally filed on March 26, 2001, announcing its acquisition ofcertain assets from ConnectInc.com, Co., a wholly owned subsidiary of CalicoCommerce, Inc.

 

(c)           See Exhibits listed under Item 14(a)(3).

 

(d)           The financial statement schedulesrequired by this item are listed under 14(a)(2).

 

36

----

 

**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the Registranthas caused this report on Form 10-K to be signed on its behalf by theundersigned, thereunto duly authorized, in the City of Eden Prairie, State ofMinnesota, on the 31st of March 2002.

 
|   | DIGITAL  RIVER, INC. |
|--------|----------------------|
|   | By:                  | Joel A. Ronning

CHIEF EXECUTIVE OFFICER,  MEMBER OF THE OFFICE OF THE PRESIDENT AND DIRECTOR |
|   |                 |   |

 

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

 
| **SIGNATURE**      |   | **TITLE**                                                                                                                   |   | **DATE**       |
|--------------------|--------|-----------------------------------------------------------------------------------------------------------------------------|--------|----------------|
| Joel A. Ronning    |   | Chief Executive Officer,  Member of the Office of the President and Director (Principal Executive  Officer)                 |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| Robert E. Strawman |   | Chief Financial Officer,  Member of the Office of the President and Treasurer (Principal Financial and  Accounting Officer) |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| Perry W. Steiner   |   | Director                                                                                                                    |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| William Lansing    |   | Director                                                                                                                    |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| Thomas F. Madison  |   | Director                                                                                                                    |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| J. Paul Thorin     |   | Director                                                                                                                    |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| Frederic Seegal    |   | Director                                                                                                                    |   | March 31, 2002 |
|               |   |                                                                                                                        |   |           |
| Timothy C. Choate  |   | Director                                                                                                                    |   | March 31, 2002 |

 
| *By:   | Joel A. Ronning  |   |                  |
|--------|------------------|--------|-----------------------|
|   | Attorney-in-fact |   |   March 31, 2002 |

 

37

----

 

**Report of independent public accountants**

 

 

 

To Digital River, Inc.:

 

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

 

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

 

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

 

Arthur Andersen LLP

 

Minneapolis, Minnesota,

January 28, 2002

 

38

----

 

**DIGITALRIVER, INC.**

ConsolidatedBalance Sheets as of December 31

(in thousands,except share data)

 
|                                                                                                                  |   | **2001** |       | **2000** |       |
|-----------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **ASSETS**                                                                                                            |   |     | ** ** |     | ** ** |
| CURRENT ASSETS:                                                                                                       |   |     |       |     |       |
| Cash and cash equivalents                                                                                             |   | $        | 21,677     |     | $          | 16,920 |   |
| Short-term investments                                                                                                |   | 9,978    |       | 14,977   |       |
| Accounts receivable, net of  allowance of $839 and $975                                                               |   | 8,719    |       | 4,903    |       |
| Prepaid expenses and other                                                                                            |   | 1,455    |       | 1,123    |       |
|                                                                                                                  |   |     |       |     |       |
| Total current assets                                                                                                  |   | 41,829   |       | 37,923   |       |
|                                                                                                                  |   |     |       |     |       |
| PROPERTY AND EQUIPMENT:                                                                                               |   |     |       |     |       |
| Property and equipment                                                                                                |   | 25,374   |       | 18,369   |       |
| Less accumulated depreciation                                                                                         |   | (9,228   | )          | (4,799   | )          |
|                                                                                                                  |   |     |       |     |       |
| Net property and equipment                                                                                            |   | 16,146   |       | 13,570   |       |
|                                                                                                                  |   |     |       |     |       |
| GOODWILL, net of accumulated  amortization of $22,455 and $11,686                                                     |   | 11,273   |       | 13,206   |       |
| INTANGIBLE ASSETS, net of  accumulated amortization of $8,858 and $4,134                                              |   | 8,934    |       | 4,628    |       |
| OTHER ASSETS                                                                                                          |   | 45       |       | 76       |       |
|                                                                                                                  |   | $        | 78,227     |     | $          | 69,403 |   |
|                                                                                                                  |   |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                         |   |     |       |     |       |
| CURRENT LIABILITIES:                                                                                                  |   |     |       |     |       |
| Notes payable                                                                                                         |   | $        | 2,500      |     | $          | — |   |
| Accounts payable                                                                                                      |   | 19,360   |       | 14,339   |       |
| Accrued payroll                                                                                                       |   | 2,803    |       | 2,287    |       |
| Deferred revenue                                                                                                      |   | 1,106    |       | 1,833    |       |
| Other accrued liabilities                                                                                             |   | 2,036    |       | 2,426    |       |
|                                                                                                                  |   |     |       |     |       |
| Total current liabilities                                                                                             |   | 27,805   |       | 20,885   |       |
|                                                                                                                  |   |     |       |     |       |
| COMMITMENTS AND CONTINGENCIES  (Notes 2 and 4)                                                                        |   |     |       |     |       |
| 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; 26,462,905 and 22,275,317 shares issued and  outstanding |   | 265      |       | 223      |       |
| Additional paid-in capital                                                                                            |   | 153,308  |       | 132,403  |       |
| Deferred compensation                                                                                                 |   | (37      | )          | (194     | )          |
| Accumulated other  comprehensive loss                                                                                 |   | —   |       | (22      | )          |
| Accumulated deficit                                                                                                   |   | (103,114 | )          | (83,892  | )          |
|                                                                                                                  |   |     |       |     |       |
| Total stockholders’ equity                                                                                       |   | 50,422   |       | 48,518   |       |
|                                                                                                                  |   |     |       |     |       |
|                                                                                                                  |   | $        | 78,227     |     | $          | 69,403 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

39

----

 

**DIGITAL RIVER, INC.**

Consolidated Statements of Operations for the Years EndedDecember 31

(inthousands, except per share data)

 
|                                                                                                                 |   | **2001** |    | **2000** |   | **1999** |   |
|----------------------------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| REVENUE                                                                                                              |   | $        | 57,825  |     | $      | 31,181   |   | $ | 14,507 |   |
| COSTS AND  EXPENSES (exclusive of depreciation and amortization

    expense shown separately below): |   |     |    |     |   |     |   |
| Direct cost of  services                                                                                             |   | 2,710    |    | 1,477    |   | 801      |   |
| Network and  infrastructure                                                                                          |   | 10,200   |    | 7,867    |   | 4,434    |   |
| Sales and  marketing                                                                                                 |   | 27,489   |    | 25,693   |   | 17,383   |   |
| Product  research and development                                                                                    |   | 11,192   |    | 13,063   |   | 10,251   |   |
| General and  administrative                                                                                          |   | 4,701    |    | 4,628    |   | 4,001    |   |
| Depreciation  and amortization                                                                                       |   | 4,627    |    | 3,178    |   | 1,552    |   |
| Amortization of  goodwill and other intangibles and acquisition related costs (Note 2)                               |   | 17,009   |    | 15,387   |   | 6,886    |   |
| Total costs and  expenses                                                                                            |   | 77,928   |    | 71,293   |   | 45,308   |   |
| LOSS FROM  OPERATIONS                                                                                                |   | (20,103  | )       | (40,112  | )      | (30,801  | )      |
| INTEREST INCOME                                                                                                      |   | 881      |    | 1,996    |   | 3,148    |   |
|                                                                                                                 |   |     |    |     |   |     |   |
| NET LOSS                                                                                                             |   | $        | (19,222 | )        | $      | (38,116  | )      | $ | (27,653 | ) |
|                                                                                                                 |   |     |    |     |   |     |   |
| BASIC AND  DILUTED NET LOSS PER SHARE                                                                                |   | $        | (.79    | )        | $      | (1.78    | )      | $ | (1.36 | ) |
|                                                                                                                 |   |     |    |     |   |     |   |
| BASIC AND  DILUTED WEIGHTED AVERAGE COMMON SHARES OUTSTANDING                                                        |   | 24,285   |    | 21,413   |   | 20,312   |   |

 

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

 

40

----

 

**DIGITAL RIVER, INC.**

Consolidated Statements of Stockholders’ Equity

(inthousands)

 
|                                                                 |   | **Common Stock** |   | **Additional   Paid-In **** ****Capital** |   | **Deferred  Compensation** |   | **Accumulated Other  Comprehensive  Loss** |   | **Accumulated  Deficit** |   | **Total  Stockholders’  Equity** |   | **Comprehensive Loss** |   |
|----------------------------------------------------------------------|--------|------------------|--------|-----------------------------------------------------|--------|----------------------------|--------|-------------------------------------------------|--------|--------------------------|--------|---------------------------------------|--------|-----------------------------|--------|
|                                                                 |
|                                                                 |
|                                                                 |   | **Shares**       |   | **Amount**                                          |   |
| BALANCE,  December 31, 1998                                          |   | 19,545           |   | $                                                   | 195    |                       | $      | 93,883                                          |   | $                        | (1,368 | )                                     | $      | —                      |   | $ | (18,123 | ) | $ | 74,587 |   |   |   |
| Common Stock  issued for acquisitions and earn-out arrangements      |   | 777              |   | 8                                                   |   | 22,801                     |   | —                                          |   | —                   |   | —                                |   | 22,809                      |   |   |   |
| Net Common  Stock exchanged in Tech Squared transaction              |   | (350             | )      | (3                                                  | )      | 235                        |   | —                                          |   | —                   |   | —                                |   | 232                         |   |   |   |
| Exercise of  stock options and warrants                              |   | 727              |   | 7                                                   |   | 2,416                      |   | —                                          |   | —                   |   | —                                |   | 2,423                       |   |   |   |
| Deferred  compensation related to stock options granted for services |   | —           |   | —                                              |   | 110                        |   | (110                                            | )      | —                   |   | —                                |   | —                      |   |   |   |
| Deferred  compensation expense                                       |   | —           |   | —                                              |   | —                     |   | 841                                             |   | —                   |   | —                                |   | 841                         |   |   |   |
| Unrealized loss  on investments                                      |   | —           |   | —                                              |   | —                     |   | —                                          |   | (162                     | )      | —                                |   | (162                        | )      | $ | (162 | ) |
| Net loss                                                             |   | —           |   | —                                              |   | —                     |   | —                                          |   | —                   |   | (27,653                               | )      | (27,653                     | )      | (27,653 | ) |
|                                                                 |   |             |   |                                                |   |                       |   |                                            |   |                     |   |                                  |   |                        |   |   |   |
| BALANCE,  December 31, 1999                                          |   | 20,699           |   | 207                                                 |   | 119,445                    |   | (637                                            | )      | (162                     | )      | (45,776                               | )      | 73,077                      |   | $ | (27,815 | ) |
| Common Stock  issued for acquisitions and earn-out arrangements      |   | 1,124            |   | 11                                                  |   | 9,082                      |   | —                                          |   | —                   |   | —                                |   | 9,093                       |   |   |   |
| Exercise of  stock options and warrants                              |   | 339              |   | 4                                                   |   | 3,585                      |   | —                                          |   | —                   |   | —                                |   | 3,589                       |   |   |   |
| Common Stock  issued under the Employee Stock Purchase Plan          |   | 113              |   | 1                                                   |   | 291                        |   | —                                          |   | —                   |   | —                                |   | 292                         |   |   |   |
| Deferred  compensation expense                                       |   | —           |   | —                                              |   | —                     |   | 443                                             |   | —                   |   | —                                |   | 443                         |   |   |   |
| Unrealized gain  on investments                                      |   | —           |   | —                                              |   | —                     |   | —                                          |   | 140                      |   | —                                |   | 140                         |   | $ | 140 |   |
| Net loss                                                             |   | —           |   | —                                              |   | —                     |   | —                                          |   | —                   |   | (38,116                               | )      | (38,116                     | )      | (38,116 | ) |
|                                                                 |   |             |   |                                                |   |                       |   |                                            |   |                     |   |                                  |   |                        |   |   |   |
| BALANCE,  December 31, 2000                                          |   | 22,275           |   | 223                                                 |   | 132,403                    |   | (194                                            | )      | (22                      | )      | (83,892                               | )      | 48,518                      |   | $ | (37,976 | ) |
| Common Stock  issued for acquisitions and earn-out arrangements      |   | 2,817            |   | 28                                                  |   | 14,351                     |   | —                                          |   | —                   |   | —                                |   | 14,379                      |   |   |   |
| Exercise of stock  options and warrants                              |   | 1,246            |   | 13                                                  |   | 6,281                      |   | —                                          |   | —                   |   | —                                |   | 6,294                       |   |   |   |
| Common Stock  issued under the Employee Stock Purchase Plan          |   | 182              |   | 2                                                   |   | 539                        |   | —                                          |   | —                   |   | —                                |   | 541                         |   |   |   |
| Repurchase of  Common Stock                                          |   | (57              | )      | (1                                                  | )      | (266                       | )      | —                                          |   | —                   |   | —                                |   | (267                        | )      |   |   |
| Deferred  compensation expense                                       |   | —           |   | —                                              |   | —                     |   | 157                                             |   | —                   |   | —                                |   | 157                         |   |   |   |
| Unrealized gain  on investments                                      |   | —           |   | —                                              |   | —                     |   | —                                          |   | 22                       |   | —                                |   | 22                          |   | $ | 22 |   |
| Net loss                                                             |   | —           |   | —                                              |   | —                     |   | —                                          |   | —                   |   | (19,222                               | )      | (19,222                     | )      | (19,222 | ) |
|                                                                 |   |             |   |                                                |   |                       |   |                                            |   |                     |   |                                  |   |                        |   |   |   |
| BALANCE,  December 31, 2001                                          |   | 26,463           |   | $                                                   | 265    |                       | $      | 153,308                                         |   | $                        | (37    | )                                     | $      | —                      |   | $ | (103,114 | ) | $ | 50,422 |   |   | (19,200 | ) |
|                                                                 |   |             |   |                                                |   |                       |   |                                            |   |                     |   |                                  |   |                        |   |   |   |   |   |   |   |   |   |   |

 

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

 

41

----

 

**DIGITAL RIVER, INC.**

Consolidated Statements of Cash Flows For the Years EndedDecember 31

(inthousands)

 
|                                                                                       |   | **2001** |    | **2000** |   | **1999** |   |
|--------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| OPERATING  ACTIVITIES:                                                                     |   |     |    |     |   |     |   |
| Net loss                                                                                   |   | $        | (19,222 | )        | $      | (38,116  | )      | $ | (27,653 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |   |     |    |     |   |     |   |
| Goodwill and  other intangibles amortization and earn-out charges                          |   | 17,009   |    | 13,354   |   | 6,606    |   |
| Depreciation  and amortization                                                             |   | 4,627    |    | 3,178    |   | 1,552    |   |
| Deferred  compensation expense                                                             |   | 157      |    | 443      |   | 841      |   |
| Change in  operating assets and liabilities:                                               |   |     |    |     |   |     |   |
| Accounts  receivable                                                                       |   | (3,056   | )       | (2,691   | )      | (1,226   | )      |
| Accounts  payable                                                                          |   | 2,916    |    | 3,319    |   | 5,122    |   |
| Accrued payroll  and other accrued liabilities                                             |   | (1,884   | )       | 3,501    |   | 1,184    |   |
| Net cash  provided by (used in) operating activities                                       |   | 547      |    | (17,012  | )      | (13,574  | )      |
| INVESTING  ACTIVITIES:                                                                     |   |     |    |     |   |     |   |
| Purchases of  investments                                                                  |   | (13,000  | )       | (12,034  | )      | (106,487 | )      |
| Sales/maturities  of investments                                                           |   | 17,999   |    | 36,416   |   | 78,000   |   |
| Cash paid for  acquisitions, net of cash received                                          |   | (1,460   | )       | (45      | )      | (4,077   | )      |
| Purchases of  equipment                                                                    |   | (5,890   | )       | (9,380   | )      | (4,783   | )      |
| Patent  acquisition costs                                                                  |   | (7       | )       | (26      | )      | (117     | )      |
| Net cash  provided by (used in) investing activities                                       |   | (2,358   | )       | 14,931   |   | (37,464  | )      |
| FINANCING  ACTIVITIES:                                                                     |   |     |    |     |   |     |   |
| Net proceeds  from sales of Common Stock                                                   |   | 541      |    | 292      |   | —   |   |
| Exercise of  stock options and warrants                                                    |   | 6,294    |    | 3,589    |   | 2,423    |   |
| Repurchase of  Common Stock                                                                |   | (267     | )       | —   |   | —   |   |
| Other                                                                                      |   | —   |    | —   |   | 232      |   |
| Net cash  provided by financing activities                                                 |   | 6,568    |    | 3,881    |   | 2,655    |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                      |   | 4,757    |    | 1,800    |   | (48,383  | )      |
| CASH AND CASH  EQUIVALENTS, beginning of period                                            |   | 16,920   |    | 15,120   |   | 63,503   |   |
| CASH AND CASH  EQUIVALENTS, end of period                                                  |   | $        | 21,677  |     | $      | 16,920   |   | $ | 15,120 |   |
|                                                                                       |   |     |    |     |   |     |   |
| NONCASH  INVESTING AND FINANCING ACTIVITIES:                                               |   |     |    |     |   |     |   |
| Common Stock  issued in acquisitions and earn-outs                                         |   | $        | 14,379  |     | $      | 9,093    |   | $ | 22,809 |   |
| Issuance of  note payable in acquisition                                                   |   | 2,500    |    | —   |   | —   |   |

 

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

 

42

----

 

**DIGITAL RIVER, INC.**

**Notes to Consolidated Financial Statements**

**December 31, 2001 and 2000**

 

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

 

Digital River, Inc., a Delawarecorporation, and its wholly owned subsidiaries (collectively, the Company)provide a suite of electronic commerce services to its clients, including webstore development and hosting, transaction processing, electronic softwaredelivery, fraud screening, customer service and analytical marketing. Through contractualrelationships with software publishers and online retailers, the Company offerssoftware products for sale via the Internet. Beginning in late 1998, theCompany also began to offer electronic commerce services to companies outsideof the software vertical market. The Company was incorporated in 1994 andconducted its first online sale through a client’s Web store inAugust 1996.

 

The Company has experienced significantlosses since inception ($103.1 million through December 31, 2001) and has, untilthe later stages of 2001, experienced significant negative cash flows fromoperations. The Company’s prospects must be considered in light of the risksfrequently encountered by companies in their early stage of development,particularly companies in new and rapidly evolving markets such as electroniccommerce. To address these risks, the Company must, among others things,maintain existing and develop new relationships with independent softwarepublishers, online retailers and other companies outside of the softwaremarket, maintain and increase its client base, implement and successfullyexecute its business and marketing strategy, continue to develop and upgradeits technology and transaction-processing systems, provide superior customerservice and order fulfillment, respond to competitive developments, andattract, retain and motivate qualified personnel. There can be no assurancesthat the Company will be successful in addressing such risks, and the failureto do so could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

***Principles of Consolidation***

 

The consolidated financial statements includethe accounts of Digital River, Inc. and its wholly owned subsidiaries. Allintercompany balances and transactions have been eliminated in consolidation.

 

***Cash and Cash Equivalents***

 

The Company considers all short-term, highlyliquid investments, primarily high grade commercial paper and money marketaccounts, that are readily convertible into known amounts of cash and that haveoriginal maturities of three months or less to be cash equivalents.

 

***Investments***

 

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

 

The following is a summary of the Company’sinvestment securities:

 
|                        |   | **Cost** |       | **Unrealized loss** |   | **Fair Value** |   |
|-----------------------------|--------|----------|------------|---------------------|--------|----------------|--------|
| **December 31,  2001**      |   |     |       |                |   |           |   |
| Commercial  Paper           |   | $        | 9,978,000  |                | $      | —         |   | $ | 9,978,000 |   |
|                        |   |     |       |                |   |           |   |   |   |   |
| **December 31,  2000**      |   |     |       |                |   |           |   |
| U.S. Government  securities |   | $        | 14,999,000 |                | $      | 22,000         |   | $ | 14,977,000 |   |

 

As of December 31, 2001 and 2000, allsecurities are due in less than one year. The Company had proceeds from salesof investments of $17,999,000, $36,416,000 and $78,000,000 in the years endedDecember 31, 2001, 2000 and 1999, respectively. The cost basis ofinvestments and gains and losses are based on specific identification. Realizedgains and/or losses on sales of investments were not material in the yearsended December 31, 2001, 2000 and 1999.

 

43

----

 

***Property andEquipment***

 

Property and equipment is stated at cost andis being depreciated under the straight-line method using lives of three toseven years and consists mainly of computer equipment and software licenses.

 

***Goodwill and Other Intangibles***

 

Goodwill and other intangible assets,consisting of customer base, non-compete agreements, and technology/tradenamehave been recorded as a result of certain acquisitions made by the Company andare being amortized under the straight-line method using a life of two to threeyears.

 

Impairment losses are recorded on goodwilland long-lived assets in operations when indicators of impairment are presentand the undiscounted cash flows estimated to be generated by those assets areless than the assets’ carrying amount. The Company regularly performs reviewsto determine if indicators of impairment of its goodwill and other long-livedassets exist. The Company’s evaluation considers nonfinancial data such aschanges in the operating environment and business strategy, competitiveinformation, market trends and operating performance. Impairment losses aremeasured by comparing the fair value of assets, as determined by discountingthe future cash flows at a market rate of interest, to their carrying amount.Based upon regular reviews, management believes that no conditions that wouldrequire impairment charges have arisen through December 31, 2001.

 

***Patents***

 

The costs of developing patents are amortizedover a three-year period utilizing the straight-line method of amortizationonce the patent application is filed. Patents are included in other assets onthe accompanying consolidated balance sheets, net of accumulated amortizationof $400,000 and $352,000 as of December 31, 2001 and 2000.

 

## ***Fair Value of Financial Instruments***

 

The carrying amount of cash and cashequivalents, accounts receivable, notes payable and accounts payableapproximates fair value because of the short maturity of these instruments.

 

***Revenue Recognition***

 

The Company recognizes revenue from servicesrendered once all the following criteria for revenue recognition have been met:1) Pervasive evidence of an agreement exists, 2) the services havebeen rendered, 3) the fee is fixed and determinable and not subject torefund or adjustment and 4) collection of the amounts due is reasonablyassured. The Company derives its revenue primarily from transaction and 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 the majority of the transactions processed and hascontractual relationships with its clients, primarily software publishers andonline retailers, which obligate the Company to pay to the client a specifiedpercentage of each sale. The Company retains its transaction fee and alsocharges for various service fees. The Company also derives revenue fromproviding clients the right to use its software applications, integration,development and consulting services provided to clients. Signed contracts areobtained from clients prior to recognition of these revenues. Fees for the useof software applications and any integration and development work required toprovide on-going hosting services for the client are recognized ratably overthe term of the contract once collection is reasonably assured. Clients do nothave the right to take possession of the software applications used in thedelivery of services. Payments received in advance of revenue recognition, evenif non-refundable, are recognized as deferred revenue. Revenue from consultingservices are recognized using the percentage-of-completion method for fixed-feearrangements or as the services are provided for time-and-materialsarrangements.

 

Sales to foreign customers accounted for 22%,25% and 22% of sales for the years ended December 31, 2001, 2000 and 1999,respectively.  In addition, in 2001,revenue from one software publisher accounted for approximately 15% of totalCompany revenue.

 

44

----

 

***Advertising Costs***

 

The costs of advertising are charged to salesand marketing expense as incurred. For the years ended December 31, 2001,2000 and 1999, the Company incurred advertising expense of $2,084,000,$2,253,000 and $2,442,000, respectively.

 

***Income Taxes***

 

Deferred tax assets and liabilities aredetermined based on the difference between the financial statement and taxbases of assets and liabilities using currently enacted tax rates. No incometaxes were paid in any of the years presented.

 

***Net Loss per Share***

 

Basic loss per common share is computed bydividing net loss by the weighted average number of shares of common stockoutstanding during the year. The computation of diluted earnings per commonshare is similar to the computation of basic loss per common share, except thatthe denominator is increased for the assumed conversion of convertiblesecurities and the exercise of dilutive options using the treasury stockmethod. The weighted average shares used in computing basic and diluted lossper share were the same in each of the three years ended December 31,2001. Stock options and warrants totaling 5,947,790, 5,383,113 and 3,898,313for the three years ended December 31, 2001, 2000 and 1999, respectively,were excluded from the computation of loss per share as their effect isantidilutive.

 

***Use of Estimates***

 

The preparation of financial statements inaccordance with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Ultimate results coulddiffer from those estimates.

 

***Recent Accounting Pronouncements***

 

In June 2001, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards(“SFAS”) No. 141, “Business Combinations” and SFAS No. 142, “Goodwill andIntangible Assets”.  Major provisions ofthese statements are as follows: all business combinations initiated after June30, 2001 must use the purchase method of accounting and the pooling of interestmethod of accounting is prohibited except for transactions initiated beforeJuly 1, 2001; intangible assets acquired in a business combination must berecorded separately from goodwill if they arise from contractual or other legalrights or are separable from the acquired entity and can be sold, transferred,licensed, rented or exchanged, either individually or as part of a relatedcontract, asset or liability; goodwill and intangible assets with indefinitelives are not amortized but tested for impairment annually, except in certaincircumstances, and whenever there is an impairment indicator; all acquiredgoodwill must be assigned to reporting units for purposes of impairmenttesting; and effective January 1, 2002, goodwill from acquisitions initiatedprior to July 1, 2001 is no longer subject to amortization.

 

These new Statements were applicable to theCompany’s acquisitions of RegSoft.com, Orbit Commerce, Inc., and NetworkCommerce, all of which occurred after the July 1 effective date for newacquisitions.  Accordingly, goodwilltotaling $3,615,000 resulting from these acquisitions was not amortized during2001.  The Company will adopt theprovisions of SFAS No. 142 related to all other acquisitions on January 1,2002.  The adoption of these Statementsis not expected to result in any transitional goodwill impairment losses on ourunamortized goodwill balances, which totaled $11,273,000 at December 31, 2001,and for which we recorded amortization expense of $10,769,000 in the year endedDecember 31, 2001.  Other identifiedintangibles with determinable lives, which totaled $8,934,000 at December 31,2001, will continue to be amortized pursuant to the new standards.

 

In July 2001, the FASB issued SFAS No. 144,“Impairment or Disposal of Long-Lived Assets”, which is effective for fiscalyears beginning after December 15, 2001. The provisions of this Statementprovide a single accounting model for impairment of long-lived assets. TheCompany anticipates that this new standard will not have a material impact onits financial position or results of operations.

 

45

----

 

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

 

In December 2001, the Company acquired thecustomer assets of FreeMerchant.com from Network Commerce, Inc. (“NetworkCommerce”) in exchange for $875,000. The Company will amortize intangible assets acquired, consisting ofcustomer base, non-compete agreements, and technology/tradename over athree-year period.  Under the agreement,Network Commerce has an opportunity for an additional earn-out of up to$870,000 based upon revenue generated from the acquired assets over thesucceeding ten-month period.  Suchamounts will be recorded as additional goodwill.

 

In September 2001, the Company acquiredsubstantially all of the assets and related liabilities of Orbit Commerce, Inc.(“Orbit”) in exchange for 727,939 shares of Common Stock valued at $4,301,000plus $964,000 in cash. The value of the Common Stock was based on the closingmarket price on the date the transaction was consummated.  The Company will amortize certain intangibleassets acquired, consisting of customer base, non-compete agreements, andtechnology/tradename over a three-year period. Under the agreement, Orbit has an opportunity to earn up to 4,800,000additional shares of Common Stock based on revenue contribution over thesucceeding twelve-month period. The value of such shares issued will berecorded as additional goodwill.

 

In August 2001, the Company acquired all ofthe outstanding stock of RegSoft.com (“RegSoft”) in exchange for $750,000 and a$2,500,000 note paid in full on February 1, 2002.  The Company will amortize certain intangible assets acquired,consisting of customer base, non-compete agreements, and technology/tradename overa three-year period.  The agreement alsoincludes an opportunity for an earn-out of up to $2,750,000 based on RegSoft’songoing performance. Such amounts will be recorded as additional goodwill.

 

In March 2001, the Company purchased theMarket Maker assets of Calico Commerce, Inc. (“Calico”) in exchange for1,630,368 shares of Common Stock valued at $7,846,000 plus directexpenses.  The value of the Common Stockwas based on the closing market price on the date the transaction wasconsummated.  The Company amortizesintangible assets, consisting of goodwill, customer base, non-competeagreements, and technology/tradename over a three-year period.  Under the agreement, Calico also has anearn-out arrangement whereby it can earn up to an additional 2,971,347 sharesof Common Stock upon attaining certain business goals for a period of 13 monthsfollowing the acquisition.  In November2001, the former owners of Calico received an earn-out payment of 59,740 sharesof Common Stock valued at $314,000.  TheCompany recorded such amount as additional goodwill.

 

In August 2000, the Company purchasedcertain assets of NetSales, Inc. (“NetSales”) for 1,000,000 shares ofCommon Stock valued at $6,000,000 plus transaction expenses. The Companyamortizes intangible assets acquired, consisting of goodwill, customer base andnon-compete agreements over a two-year period. Under the agreement, NetSales has an earn-out arrangement whereby it canearn up to 350,000 additional shares of Common Stock upon attaining certainbusiness goals for a six-month period following the close of the acquisition.In March 2001, NetSales received an earn-out payment of 84,000 shares of CommonStock valued at $404,000.  The Companyrecorded such amount as additional goodwill.

 

The former owners of Maagnum Internet Group,Inc., a company purchased by the Company in April 1999, received earn-outpayments of 314,531 shares of Common Stock valued at $1,514,000 in March 2001and 124,349 shares of Common Stock valued at $3,093,000 in March 2000.  The Company charged such amounts tocompensation expense and included this amount as amortization of goodwill andother intangibles and acquisition related costs in the accompanyingConsolidated Statements of Operations. This amount would have increased general and administrative expense hadit been reported outside of that caption.

 

Each of the above transactions were accountedfor using the purchase method. The excess of the purchase price over thetangible assets acquired each transaction was allocated substantially togoodwill and other intangibles (consisting of customer base, noncompeteagreements and technology/ tradename). Following is an allocation of thepurchase price for the Company’s 2001 acquisitions that were consummatedsubsequent to the July 1, 2001 effective date of SFAS No’s. 141 and 142:

 

| Tangible  assests       |   | $          | 2,906,000 |   |
|-------------------------|--------|------------|-----------|--------|
| Liabilities  acquired   |   | (2,063,000 | )         |
| Customer base           |   | 3,855,000  |      |
| Non-compete  agreements |   | 850,000    |      |
| Technology/tradename    |   | 425,000    |      |
| Goodwill                |   | 3,615,000  |      |
| Total purchase  price   |   | $          | 9,588,000 |   |

 

46

----

 

The results of each of the acquisitions madein 2001 have been reflected in the Company’s results beginning on the date ofthe respective acquisition. The following unaudited pro forma condensedconsolidated results of operations for the years ended December 31, 2001and 2000 have been prepared as if each of the 2001 acquisitions occurred onJanuary 1, 2000 and the unaudited pro forma condensed consolidated resultsof operations for the year ended December 31, 1999 has been prepared as ifthe 2000 acquisition of NetSales occurred on January 1, 1999:

 
|                              |   | **Year Ended December 31,** |       |
|-----------------------------------|--------|-----------------------------|------------|
|                              |   | **2001**                    |       | **2000** |   | **1999** |   |
| Revenue                           |   | $                           | 66,131,000 |   | $ | 44,053,000 |   | $ | 16,743,000 |   |
| Loss from  operations             |   | (31,453,000                 | )          | (72,126,000 | ) | (42,242,000 | ) |
| Net loss                          |   | (30,732,000                 | )          | (70,386,000 | ) | (39,195,000 | ) |
| Basic and  diluted loss per share |   | $                           | (1.23      | ) | $ | (2.96 | ) | $ | (1.79 | ) |

 

This financial information does not purportto represent results that would actually have been obtained if the transactionshad been in effect on January 1, 2001, 2000 or 1999, as applicable, or anyfuture results that may in fact be realized.

 

In December 1999, the Company completedits acquisition of certain assets of Tech Squared Inc., whereby theCompany purchased Tech Squared assets consisting of 3,000,000 shares of theCompany’s Common Stock and $1,200,000 in exchange for 2,650,000 shares of theCompany’s Common Stock. For financial statement presentation purposes, theimpact of this transaction was to reduce Common Stock outstanding by 350,000 sharesand is presented on the accompanying Consolidated Statement of Stockholders’Equity net of expenses incurred in conjunction with the transaction.

 

**3. Income Taxes:**

 

The reconciliation of the reported income taxexpense to the amount the would result from applying the U.S. federal statutoryrate of 35% to the net loss is as follows:

 
|                                               |   | **Year ended December 31,** |       |
|----------------------------------------------------|--------|-----------------------------|------------|
|                                               |   | **2001**                    |       | **2000** |   | **1999** |   |
| Tax benefit at  statutory rate                     |   | $                           | (6,728,000 | ) | $ | (13,341,000 | ) | $ | (9,679,000 | ) |
| State taxes,  net of federal benefit               |   | (1,000,000                  | )          | (1,982,000 | ) | (1,438,000 | ) |
| Stock  compensation deductions                     |   | (258,000                    | )          | (1,339,000 | ) | (3,343,000 | ) |
| Non-deductible  goodwill and earn-out compensation |   | 3,255,000                   |       | 3,453,000 |   | 1,783,000 |   |
| Non-deductible  expense and other                  |   | 585,000                     |       | 285,000 |   | 174,000 |   |
| Change in  valuation allowance                     |   | 4,146,000                   |       | 12,924,000 |   | 12,503,000 |   |
| Total                                              |   | $                           | —     |   | $ | — |   | $ | — |   |

 

As of December 31, 2001, the Company hadnet operating loss carryforwards of approximately $82,400,000. Included in thisamount is approximately $16,700,000 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 2009. Becauseof the uncertainty of future realization, a valuation allowance equal to thedeferred tax asset has been recorded.

 

The components of deferred income taxes areas follows:

 

|                                 |   | **2001**    |       | **2000**    |   |
|--------------------------------------|--------|-------------|------------|-------------|--------|
| Net operating  loss carryforwards    |   | $           | 32,136,000 |        | $      | 30,733,000 |   |
| Nondeductible  reserves and accruals |   | 369,000     |       | 436,000     |   |
| Depreciation  and amortization       |   | 4,656,000   |       | 1,846,000   |   |
| Valuation  allowance                 |   | (37,161,000 | )          | (33,015,000 | )      |
|                                 |   | $           | —     |        | $      | — |   |

 

47

----

 

Ownership changes resulting from the issuanceof additional equity will limit future annual realization of the tax net

operating loss carryforwards to a specifiedpercentage of the value of the Company under Section 382 of the InternalRevenue Code.

 

**4. Commitments andContingencies:**

 

# **Leases**

 

The Company currently has six facility leasesin addition to leasing certain computer equipment. Total rent expense,including common area maintenance charges, recognized under all leases was$1,367,000, $839,000 and $558,000 for the years ended December 31, 2001,2000 and 1999, respectively. The minimum annual rents under long-term leases atDecember 31, 2001 are as follows:

 

| **Year ending December 31,** |   |    |      |
|-----------------------------------|--------|---------|-----------|
| 2002                              |   | $       | 1,161,000 |   |
| 2003                              |   | 744,000 |      |
| 2004                              |   | 106,000 |      |
|                              |   |    |      |
|                              |   | $       | 2,011,000 |   |

 

**Litigation**

 

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

 

The Company is also party topatent litigation, along with other defendants, regarding United States PatentNo. 6,014,651 owned by Christopher M. Crawford of Washington, D.C. The case wasfiled in August 2001 and is pending in the U.S. District Court in the Districtof Columbia. No substantive actions have taken place as yet in this case.  The Company believes that it has meritoriousdefenses to, and intends to vigorously defend against, these claims.

 

# **Employee Benefit Plan**

 

The Company has a defined contribution 401(k)retirement plan for eligible employees. Employees may contribute up to 15% of their pretax compensation to theplan, with the Company providing a discretionary match of the employeecontribution of up to 50% of the total employee contribution.  Amounts charged to expense related to theCompany’s matching contributions for the years ended December 31, 2001, 2000and 1999 totaled $559,400, $408,100 and $274,000, respectively.

 

**5. Stockholders’Equity:**

 

***Warrants***

 

Warrants to purchase 106,087 and 356,087shares of Common Stock issued principally in conjunction with sales of CommonStock at an exercise price of $3.00 per share were outstanding as ofDecember 31, 2001 and 2000, respectively. The warrants expire at various dates between February andAugust 2003.

 

## ***Share Repurchase Program***

 

In April 2001, the Company announced a sharerepurchase program of up to $5,000,000 of its outstanding shares of CommonStock.  Repurchases will be at theCompany’s discretion based on ongoing assessments of the capital needs of thebusiness and the market price of its shares. During 2001, 57,500 shares were repurchased under the program for totalconsideration of $267,000.

 

48

----

 

**6. Stock Options:**

 

The Company’s 1998 Stock Option Plan (the“SOP”) provides for the granting of incentive or nonqualified stock options topurchase up to 3,983,333 shares of Common Stock. Options granted to employeestypically expire no later than ten years after the date of grant.  Incentive stock option grants must have anexercise price of at least 100% of the fair market value of a share of commonstock on the grant date.  Incentivestock options granted to employees who immediately before such grant ownedstock directly or indirectly representing more than 10% of the voting power ofthe stock 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 OptionPlan (the “NOP”) provides for the granting of nonqualified stock options topurchase up to 5,450,000 shares of Common Stock and has terms similar to thoseof the SOP.

 

In addition to shares granted under the SOPand NOP, the Company granted options to purchase 605,882 shares of Common Stockat an exercise price of $8.50 per share to certain members of managementoutside of both plans during 1998. At December 31, 2001, optionsoutstanding outside of both plans totaled 13,529 shares.

 

A summary of the change in outstandingoptions under the SOP and NOP is as follows:

 

|                        |   | **Options   Outstanding** |   | **Option Price   Per Share** |
|-----------------------------|--------|---------------------------|--------|------------------------------|
| Balance,  December 31, 1998 |   | 1,870,357                 |   |                         | $.38- $23.40 |   |
| Grants                      |   | 2,131,636                 |   | 19.56- 31.13                 |   |
| Exercised                   |   | (601,172                  | )      | .38- 23.40                   |   |
| Cancelled                   |   | (308,035                  | )      | 1.69- 31.13                  |   |
| Balance,  December 31, 1999 |   | 3,092,786                 |   | .38- 31.13                   |   |
| Grants                      |   | 2,641,028                 |   | 6.00- 28.88                  |   |
| Exercised                   |   | (303,533                  | )      | .38- 23.40                   |   |
| Cancelled                   |   | (817,696                  | )      | 1.69-31.13                   |   |
| Balance,  December 31, 2000 |   | 4,612,585                 |   | 1.13-31.13                   |   |
| Grants                      |   | 3,631,533                 |   | .01- 6.74                    |   |
| Exercised                   |   | (679,336                  | )      | .01-11.75                    |   |
| Cancelled                   |   | (1,736,608                | )      | .01- 31.13                   |   |
| Balance,  December 31, 2001 |   | 5,828,174                 |   |                         | $1.69- $31.13 |   |

 

A summary of information about total stockoptions outstanding at December 31, 2001 is as follows:

 

|                |   | **Options Outstanding** |   | **Options Exercisable**               |   |
|---------------------|--------|-------------------------|--------|---------------------------------------|--------|
| **Exercise  Price** |   | **Number  Outstanding** |   | **Weighted Average   Life Remaining** |   | **Number   Exercisable** |   | **Weighted  Average Price** |   |
| $1.69 - $3.88       |   | 1,240,518               |   | 8.5 years                             |   | 296,589 |   | $ | 2.97 |   |
|   4.45 - 6.74  |   | 3,476,754               |   | 9.0 years                             |   | 557,518 |   | 5.68 |   |
|   8.50 - 12.50 |   | 105,248                 |   | 6.5 years                             |   | 91,849 |   | 9.70 |   |
| 19.50 - 31.13       |   | 1,019,183               |   | 7.5 years                             |   | 634,256 |   | 22.47 |   |
| $1.69 - $31.13      |   | 5,841,703               |   | 8.5 years                             |   | 1,580,212 |   | $ | 12.14 |   |

 

The Company recorded compensation expense forthe difference between the grant price and the fair market value of theCompany’s Common Stock on options to purchase 30,533 shares at an exerciseprice of $.01 issued in January 2001. In addition, the Company recordeddeferred compensation for the difference between the grant price and the deemedfair value of the Company’s Common Stock on options to purchase 454,468 sharesat exercise prices of $3.00 to $7.50 issued during May and June 1998.During 1999, the Company recognized $110,000 in expense related to optionsgranted for consulting services.

 

49

----

 

The Company has elected to apply thedisclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation”. Accordingly, the Company accounts for stock-based compensationusing the intrinsic value method prescribed in Accounting Principles BoardOpinion (APB) No. 25, “Accounting for Stock Issued to Employees”, andrelated interpretations. Compensation cost for stock options is measured as theexcess, if any, of the fair value of the Company’s Common Stock at the date ofgrant over the stock option exercise price. Had compensation costs for theseplans been determined consistent with SFAS No. 123, the Company’s net losswould have been adjusted to the following pro forma amounts:

 
|                               |   | **2001**    |        | **2000**    |   | **1999**    |   |
|------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|
| Net loss:                          |   |        |        |        |   |        |   |
| As reported                        |   | $           | (19,222,000 | )           | $      | (38,116,000 | )      | $ | (27,653,000 | ) |
| Pro forma                          |   | (41,082,000 | )           | (56,482,000 | )      | (35,204,000 | )      |
| Basic and  diluted loss per share: |   |        |        |        |   |        |   |
| As reported                        |   | $           | (.79        | )           | $      | (1.78       | )      | $ | (1.36 | ) |
| Pro forma                          |   | (1.69       | )           | (2.64       | )      | (1.73       | )      |

 

The fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions used: risk-free interest ratesof 4.5%, 6%, and 6% in 2001, 2000, and 1999, respectively; no expecteddividends; expected lives of five years; and a volatility factor of 1.1, 1.2,and 1.1 in 2001, 2000, and 1999, respectively. The weighted average fair valueof the options granted in 2001, 2000, and 1999 was $3.56, $20.46, and $17.21,respectively.

 

The Company also sponsors an employee stockpurchase plan under which 600,000 shares have been reserved for purchase byemployees. The purchase price of the shares under the plan is the lesser of 85%of the fair market value on the first or last day of the offering period.Offering periods currently are each six months ending on June 30 and December31. Employees may designate up to ten percent of their compensation for thepurchase of shares under the plan. Total shares purchased by employees under theplan were 182,000 and 113,000 in the years ended December 31, 2001 and 2000,respectively.

 

**7. SegmentInformation:**

 

The Company has two operating segments,Software and Digital Commerce Services and E-Business Services, which have beenidentified as components of the Company that are reviewed regularly bymanagement to determine resource allocation and assess performance. Unallocatedcorporate items consist of depreciation, goodwill and other intangiblesamortization, acquisition-related costs and interest income for operationalresults and consist of certain cash, investments and goodwill for total assets.No disclosure of segment information for 1999 has been presented as Softwareand Digital Commerce Services represented substantially all operations in 1999.  Segment information for 2001 and 2000 is asfollows:

 
|                                                           |   | **Software and********Digital Commerce********Services Division** |       | **E-Business********Services Division** |   | **Unallocated********Corporate Items** |   | **Consolidated** |   |
|----------------------------------------------------------------|--------|-------------------------------------------------------------------|------------|-----------------------------------------|--------|----------------------------------------|--------|------------------|--------|
| **Year  ended December 31, 2001:**                             |   |                                                              |       |                                    |   |                                   |   |             |   |
| Revenue                                                        |   | $                                                                 | 44,914,000 |                                    | $      | 12,911,000                             |   | $                | — |   | $ | 57,825,000 |   |
| Gross profit  (excludes depreciation and amortization expense) |   | 36,214,000                                                        |       | 8,701,000                               |   | —                                 |   | 44,915,000       |   |
| Income (loss)  from operations                                 |   | 10,672,000                                                        |       | (9,139,000                              | )      | (21,636,000                            | )      | (20,103,000      | )      |
| Net income  (loss)                                             |   | 10,672,000                                                        |       | (9,139,000                              | )      | (20,755,000                            | )      | (19,222,000      | )      |
| Total assets at  December 31, 2001                             |   | 20,858,000                                                        |       | 9,159,000                               |   | 48,209,000                             |   | 78,227,000       |   |
|                                                           |   |                                                              |       |                                    |   |                                   |   |             |   |
| **Year  ended December 31, 2000:**                             |   |                                                              |       |                                    |   |                                   |   |             |   |
| Revenue                                                        |   | $                                                                 | 25,221,000 |                                    | $      | 5,960,000                              |   | $                | — |   | $ | 31,181,000 |   |
| Gross profit  (excludes depreciation and amortization expense) |   | 18,119,000                                                        |       | 3,718,000                               |   | —                                 |   | 21,837,000       |   |
| Loss from  operations                                          |   | (5,611,000                                                        | )          | (15,936,000                             | )      | (18,565,000                            | )      | (40,112,000      | )      |
| Net loss                                                       |   | (5,611,000                                                        | )          | (15,936,000                             | )      | (16,569,000                            | )      | (38,116,000      | )      |
| Total assets at  December 31, 2000                             |   | 16,256,000                                                        |       | 7,051,000                               |   | 46,096,000                             |   | 69,403,000       |   |

 

50

----

 

**8. Related-PartyTransactions:**

 

In February 1998, two stockholders, oneof whom was a director for the Company at the time, entered into an agreementwith the Company whereby the stockholders helped establish and oversee theinternational operations for the Company for a term of three years. Asconsideration for entering into the agreement, the stockholders each receivedwarrants to purchase 100,000 shares of Common Stock, exercisable at $3.00 pershare. The warrants were 100% vested at the date of grant and expire inFebruary 2003. At December 31, 2001, 100,000 warrants remain outstanding.  The fair value of the warrants granted in1998, determined to be $360,000, was based upon the value of the services to beprovided. Compensation expense of $20,000, $120,000, and $120,000 wasrecognized related to these warrants in the years ended December 31,2001, 2000and 1999, respectively.

 

**9. Subsequent Events(unaudited):**

 

## ***Results of Operations***

 

In February 2002, ePedas Sdn Bhd initiated anarbitration before the American Arbitration Association against theCompany.  The demand for arbitration alleges breach of contract andtortious interference claims against the Company.  The prayer for reliefrequests RM 28,809,137.09 (Ringit Malaysia or approximately US $7,581,150) pluspre-judgment interest, punitive damages, all legal costs and otherunspecified fees and expenses.   An arbitrator has not been selectedand no arbitration date has been set. The Company believes this lawsuit iswithout merit and intends to defend against it vigorously.

 

On March 29, 2002, the Company announced thatit would record a reserve for pending litigation of $2,300,000 in the firstquarter of 2002.  Additionally, theCompany announced that it would take a charge of $200,000 in the first quarterof 2002 in connection with its decision during the quarter to consolidate one ofits offices.

 

*Acquisitions*

 

On March 19, 2002, pursuant to an AssetPurchase Agreement between Digital River and Innuity Acquisition Corp. (“IAC”),we purchased certain assets and assumed approximately $3.6 million in merchantliabilities in exchange for approximately $2.4 million in cash. The agreementincludes an opportunity for a cash earn-out based on revenue generated from theIAC assets during the 12-month period following the close of the transaction.

 

On March 31, 2002, pursuant to an Amended andRestated Asset Purchase Agreement (the “Agreement”) dated February 9, 2002,between Digital River and Beyond.com Corporation (“Beyond.com”), in exchangefor $2,910,311 in shares of our Common Stock (valued at the average of theclosing price of our Common Stock for the 15 trading days ending on the secondday prior to closing and the seven trading days immediately following theclosing), we purchased those assets and assumed those liabilities of Beyond.comrelated to its eStores business, which manages online stores for clients. Thepurchase was approved by the U.S. Bankruptcy Court following Beyond.com’sfiling for Chapter 11 bankruptcy protection, and certain elements of thepurchase remain subject to further approval by the court. The agreementincludes contingent earn-out provisions whereby Beyond.com may receive (i)additional shares of our Common Stock valued at $962,500 if specified customersof Beyond.com remain our customers for 90 days post closing, (ii) additionalshares of our Common Stock valued at $500,000 if 90% or more of specified customersof Beyond.com enter into 12 month contracts with us within 60 days of theclosing and (iii) additional shares of our Common Stock valued at approximately$1.35 million if specified customers enter into 12 month contracts with uswithin 60 days of the closing (with such shares valued as described above). Ofthe shares issued at closing, 70,000 shares were placed in an escrow to securecertain indemnification obligations contained in the agreement. Subject tooutstanding claims, the escrow will terminate 90 days following the closing.

 

51

----