<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549



                                   FORM 10-Q

                                   (Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                                  ACT OF 1934

                 For the quarterly period ended June 30, 2000.

                                       OR

    [_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                              EXCHANGE ACT OF 1934

                       For the transition period from to.

                       Commission File Number: 000-26283


                              Digital Island, Inc.
             (Exact name of Registrant as specified in its charter)


                    Delaware                               68-0322824
          (State or other jurisdiction of      (IRS Employer Identification No.)
            Incorporation or organization)

         45 Fremont Street, Suite 1200 San Francisco, California 94105
         (Address of principal executive offices)       (Zip Code)

       Registrant's telephone number, including area code: (415) 438-4100


  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 (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

  As of June 30, 2000, there were 69,682,499 shares of the Registrant's Common
Stock outstanding, par value $0.001.
<PAGE>

                              DIGITAL ISLAND, INC.

                           Form 10-Q Quarterly Report
                      For the Quarter Ended June 30, 2000

                               TABLE OF CONTENTS


<TABLE>
<CAPTION>
                                                                        Page
                                                                       Number
                                                                       ------
<S>                                                                     <C>
PART I. Financial Information

Item 1  Financial Statements...............................................3

        Condensed Consolidated Balance Sheets as of September 30,
        1999 and June 30, 2000(unaudited)..................................3

        Condensed Consolidated Statements of Operations for the
        three and nine months ended June 30, 1999 and 2000
        (unaudited)........................................................5

        Condensed Consolidated Statements of Cash Flows for the
        nine months ended June 30, 1999 and 2000
        (unaudited)........................................................6

        Notes to Condensed Consolidated Financial
        Statements.........................................................8

Item 2  Management's Discussion and Analysis of Financial Condition
        and Results of Operations..........................................10

Item 3  Quantitative and Qualitative Disclosures About Market
        Risk...............................................................15

PART II. Other Information

Item 1   Legal Proceedings.................................................31

Item 2   Changes in Securities and Use of Proceeds.........................31

Item 3   Defaults Upon Senior Securities...................................32

Item 4   Submission of Matters to a Vote of Security Holders...............33

Item 5   Other Information.................................................33

Item 6   Exhibits and Reports on Form 8-K..................................33

Signatures.................................................................34
</TABLE>

                                       2
<PAGE>

PART I--FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                     CONDENSED CONSOLIDATED BALANCE SHEETS
                       (in thousands, except share data)

<TABLE>
<CAPTION>

                                                     September 30,       June 30,
                                                        1999               2000
                                                     ------------       ----------
                                                                       (Unaudited)
<S>                                                   <C>               <C>
                         ASSETS
Current assets:
 Cash and cash equivalents........................        $ 43,315     $  304,881
 Investments......................................          31,691        328,298
 Accounts receivable, net.........................           3,557         18,886
 Restricted cash..................................             763          7,063
 Prepaid expenses and other.......................           1,825         18,850
                                                          --------     ----------
   Total current assets...........................          81,151        677,978
Investments.......................................              --         73,734
Property and equipment, net.......................          25,273        112,150
Goodwill, net.....................................              --        823,816
Intangible assets, net............................              --        115,227
Unamortized convertible note issuance costs.......              --         10,226
Other assets, net.................................           1,224          2,890
                                                          --------     ----------
   Total assets...................................        $107,648     $1,816,021
                                                          ========     ==========

    LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Bank borrowings..................................        $    801    $       -
 Capital lease obligations........................           3,916         13,344
 Accounts payable.................................           8,621         17,963
 Accrued liabilities..............................           4,931         11,531
 Cash overdraft...................................           3,058          9,447
 Interest payable.................................              --          6,900
 Deferred revenue.................................             318          1,097
                                                          --------     ----------
   Total current liabilities......................          21,645         60,282
Bank borrowings, less current portion.............             314             --
Convertible notes.................................              --        345,000
Capital lease obligations, less current portion...           6,061          5,618
Deferred revenue..................................             410            334
Other liabilities.................................              --            358
                                                          --------     ----------
   Total liabilities..............................          28,430        411,592
                                                          --------     ----------
Stockholders' equity:
 Preferred stock, $0.001 par value: Authorized:
</TABLE>

                                       3
<PAGE>

<TABLE>
<S>                                                       <C>          <C>
  10,000,000 shares; no shares issued and
  outstanding.....................................              --             --
 Common stock, $0.001 par value: Authorized:
  100,000,000 shares; issued and outstanding:
  35,941,727 shares at September 30, 1999 and
  69,682,499 shares at June 30, 2000
  (unaudited).....................................              36             69
 Additional paid-in capital.......................         156,791      1,694,037
 Deferred compensation............................          (4,033)        (2,122)
 Stockholder notes receivable.....................            (514)          (419)
 Common stock warrants............................              --          2,785
 Accumulated deficit..............................         (73,062)      (289,921)
                                                          --------     ----------
   Total stockholders' equity.....................          79,218      1,404,429
                                                          --------     ----------
   Total liabilities and stockholders' equity.....        $107,648     $1,816,021
                                                          ========     ==========
</TABLE>

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

                                       4
<PAGE>

           DIGITAL ISLAND, INC. AND SUBSIDIARIES

                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                (in thousands, except share and per share data)

<TABLE>
<CAPTION>
                                        Three Months Ended           Nine Months Ended
                                             June 30,                    June 30,
                                    --------------------------   -------------------------
                                       1999           2000          1999           2000
                                    ----------    -----------    ----------    -----------
                                    (Unaudited)   (Unaudited)    (Unaudited)   (Unaudited)
<S>                                 <C>           <C>            <C>           <C>
Revenue..........................   $    3,700    $    16,061    $    7,495    $    34,990
Costs and expenses:
  Cost of revenue................        8,055         32,089        15,805         71,240
  Sales and marketing............        4,525         15,895         9,696         36,985
  Product development............        1,853          6,192         3,863         13,227
  General and administrative .           2,469         14,101         5,431         30,052
  Amortization of intangible
    assets.......................           --         53,064            --        106,556
  Stock compensation expense .           1,248            528         2,274          1,911
                                    ----------    -----------    ----------    -----------
   Total costs and expenses .           18,150        121,869        37,069        259,971
                                    ----------    -----------    ----------    -----------
   Loss from operations..........      (14,450)      (105,808)      (29,574)      (224,982)
                                    ----------    -----------    ----------    -----------
Interest income,net..............          387          5,650           644          8,139
                                    ----------    -----------    ----------    -----------
   Loss before income taxes .          (14,063)      (100,158)      (28,930)      (216,842)
Provision for income taxes.......           --             10             2             17
                                    ----------    -----------    ----------    -----------
   Net loss......................   $  (14,063)   $  (100,168)   $  (28,932)   $  (216,859)
                                    ==========    ===========    ==========    ===========
Basic and diluted net loss per
 share...........................   $    (3.96)   $     (1.51)   $   (10.31)   $     (3.94)
                                    ==========    ===========    ==========    ===========
Weighted average shares
 outstanding used in per share
 calculation.....................    3,555,232     66,389,483     2,806,988     55,032,310
                                    ==========    ===========    ==========    ===========

</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.

                                       5
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                         For the nine months
                                                            Ended June 30,
                                                        ------------------------
                                                         1999           2000
                                                        ----------     ----------
                                                       (unaudited)    (unaudited)
<S>                                                     <C>           <C>
Cash flows from operating activities:
 Net loss............................................    $(28,932)    $ (216,859)
 Adjustments to reconcile net loss to net cash
  used in operating activities:
   Depreciation and amortization.....................         868        123,225
   Stock compensation expense........................       2,274          1,911
   Amortization of discounts on investments..........        (419)        (7,254)
   Gain on disposal of property and equipment........          (5)            --
   Change in operating assets and liabilities, net
    of business acquisitions.........................        (889)       (17,823)
                                                         --------     ----------
     Net cash used in operating activities...........     (27,103)      (116,800)
                                                         --------     ----------
Cash flows from investing activities:
 Purchases of property and equipment.................      (5,104)       (79,153)
 Proceeds from maturities of short-term
  investments........................................      13,200         49,304
 Business acquisitions, net cash paid................          --           (543)
 Restricted cash.....................................        (500)        (6,300)
 Purchases of short-term investments.................     (26,200)      (412,391)
                                                         --------     ----------
     Net cash used in investing activities...........     (18,604)      (449,083)
                                                         --------     ----------
Cash flows from financing activities:
 Repayment of stockholder note.......................          --             93
 Payment to stockholder in exchange for Note.........        (128)            --
 Proceeds from exercise of warrant...................          10             --
 Proceeds from issuance of common stock,net..........         965        497,798
 Proceeds from issuance of convertible notes,net .             --        334,066
 Proceeds from issuance of preferred stock...........      47,461             --
 Proceeds from bank borrowings.......................         532             --
 Repayments of bank borrowings.......................        (427)        (1,199)
 Repayments of capital lease obligations.............        (732)        (3,309)
                                                         --------     ----------
     Net cash provided by financing activities.......      47,681        827,449
                                                         --------     ----------
     Net increase in cash and cash equivalents.......       1,974        261,566
Cash and cash equivalents, beginning of period.......       5,711         43,315
                                                         --------     ----------
Cash and cash equivalents, end of period.............    $  7,685     $  304,881
                                                         ========     ==========
Supplemental disclosures of cash flow information:
 Cash paid for interest..............................    $    268     $    5,372
                                                         ========     ==========
</TABLE>

                                       6
<PAGE>

<TABLE>
<S>                                                       <C>         <C>
 Cash paid for income taxes..........................    $      2     $       10
                                                         ========     ==========
Supplemental schedule of non-cash investing and
 financing activities:
 Receivable of proceeds from initial public
   Offering..........................................    $ 64,170    $     --
                                                         ========    ===========
 Note Receivable issued in exchange for common
   Stock.............................................    $    286    $     --
                                                         ========    ===========

 Fixed asset acquired in exchange for stock..........   $      --     $    5,965
                                                        =========     ==========
 Acquisition of subsidiaries in exchange for
    stock............................................   $      --     $1,033,516
                                                        =========     ==========
 Capital lease obligations for equipment.............    $  2,744     $    9,579
                                                         ========     ==========
 Warrants issued in exchange for services............   $      --     $    2,785
                                                        =========     ==========
</TABLE>

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

                                       7
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.   Basis of Presentation

      The accompanying condensed consolidated financial statements include the
accounts of Digital Island, Inc. and its wholly-owned subsidiaries, Sandpiper
Networks, Inc., Live On Line, Inc., Digital Island B.V., Digital Island, Ltd.,
Digital Island (Europe) SA, Digital Island (Hong Kong), Ltd., and Digital Island
(Japan) KK, (collectively, "Digital Island"). All intercompany accounts and
transactions have been eliminated in the accompanying condensed consolidated
financial statements.

      The interim financial data as of June 30, 2000 and for the three and six
months ended June 30, 2000 and 1999 is unaudited; however in the opinion of
management, the condensed consolidated financial statements reflect all normal
and recurring adjustments that are necessary for a fair statement of the results
for the periods shown. The results of operations for such periods are not
necessarily indicative of the results expected for the full fiscal year or for
any future period.

2.   Stock Offering and Convertible Note Issuance

      On February 23, 2000, Digital Island completed an offering of its common
stock, as well as an offering of convertible subordinated notes. Digital Island
issued 4,014,273 shares of common stock for net proceeds of approximately $409.7
million. Digital Island also issued convertible subordinated notes for net
proceeds of approximately $334.3 million. The notes bear interest at a rate of
6% per annum, which is paid twice a year, on each February 15 and August 15. The
notes mature on February 15, 2005. The notes are convertible into Digital
Island's common stock at any time prior to the maturity date. The conversion
price is approximately $131.61 per share.

3.   Acquisitions

      On December 28, 1999, Digital Island acquired Sandpiper Networks, Inc.
("Sandpiper") through the merger of a wholly owned subsidiary of Digital Island
with and into Sandpiper. In the merger, each outstanding share of Sandpiper
capital stock was exchanged for 1.0727 shares of Digital Island's common stock
and all outstanding stock options and warrants were assumed. Digital Island
issued 24.6 million shares of common stock and 3.1 million stock options and
warrants. The total purchase price of approximately $967.6 million was allocated
primarily to intangible assets and goodwill which will be amortized over 5
years.

Pro Forma Disclosure of Sandpiper Networks, Inc. Acquisition

     The following summary, prepared on a pro forma basis, combines the results
of Digital Island as if the acquisition had been made on the first day of the
fiscal years presented, after including the impact of certain pro forma
adjustments such as increased amortization expense due to recording of
intangible assets:
<TABLE>
<CAPTION>

                                                     Nine Months
                                                    Ended June 30,
                                                     (unaudited)
                                                   ---------------
                                                   1999         2000
                                                ---------    ---------
                                         (in thousands except per share data)
<S>                                            <C>          <C>
Revenues................................        $   7,612    $  35,844
Net Loss................................         (183,028)    (319,312)
Basic and diluted loss per share........           (19.29)       (5.46)
</TABLE>

On January 18, 2000, Digital Island acquired Live On Line, Inc. ("LOL") through
the merger of a wholly owned subsidiary of Digital Island with and into LOL. In
the merger, the former shareholders of LOL received a total of 799,989 shares of
Digital

                                       8
<PAGE>

Island's common stock, and $5.3 million in cash, in exchange for all
outstanding shares of LOL and the assumption of outstanding warrants. The total
purchase price of approximately $71.1 million was allocated primarily to
intangible assets and goodwill.

4.  Purchase of Technology

    In December 1999, Digital Island agreed to purchase patented technology from
SRI International ("SRI"). Under terms of the agreement, Digital Island is to
acquire the technology in exchange for $10 million of common stock, to be
distributed upon the occurrence of certain milestones. As of June 30, 2000, a
total of 120,434 shares of common stock had thus far been issued. The value of
stock issued under the agreement is recorded as network equipment and
technology. Digital Island guarantees that the value of the stock issued to SRI
will have a value of $10 million at the time of issuance, and at the time that
SRI can dispose of the stock.

5.  Strategic Relationships

    In December 1999, Digital Island entered into a memoranda of understanding
with Sun Microsystems, Inc. ("Sun") and Inktomi Corporation ("Inktomi")
providing for a joint strategic relationship. Under the terms of the
arrangement, Digital Island has agreed to purchase up to $150 million of Sun
equipment. Sun is to provide Digital Island with $100 million in lease financing
for the acquisition of the equipment. In addition, there is to be joint sales
and marketing efforts between Digital Island, and Sun and Inktomi. If Digital
Island draws on the equipment lease line, Sun will receive warrants to purchase
up to $10 million of Digital Island's common stock at points in time
corresponding to the achievement of certain milestones. As these warrants are
issued, they will be valued under the Black-Scholes model and the fair value of
the warrants will be recorded as interest expense. To date, Digital Island has
not drawn on the equipment lease line.

    In connection with this strategic relationship, Sun purchased 391,869 shares
of Digital Island's common stock for $20 million, and Inktomi purchased 117,561
shares for $6 million in January 2000. These shares were issued at fair market
value.

    In June 2000, Digital Island entered into various contractual arrangements
with Microsoft Corporation, Intel Corporation, and Compaq Computer Corporation.
The agreements are centered around the build-out of the Digital Island
infrastructure to support expanded streaming media services. Among the various
provisions of the agreements, Compaq is providing a $50 million equipment credit
facility for the purchase of Compaq servers, as well as providing $50 million in
lease financing to customers of Digital Island. Digital Island has committed to
the deployment of 8,000 servers which will contain Intel architecture and be
powered by Microsoft technology.

    Microsoft, Intel, and Compaq each purchased 618,556 shares of Digital Island
common stock for an aggregate amount of $45 million in cash at fair market
value. The parties also received warrants to purchase up to 556,701 additional
shares of Digital Island common stock at an exercise price of $24.25 per share
if Digital Island fails to meet certain milestones connected to the
infrastructure build-out. If these warrants are issued, they will be valued
using the Black-Scholes model and recorded as infrastructure expense in cost of
revenue.

6.  Issuance of Common Stock

    In June 2000, Digital Island issued 738,688 shares of common stock for
approximately $15 million in cash to a UBS O'Connor LLC.  These shares were
issued at fair market value.

7.  Warrant

    In December 1999, Digital Island entered into a Co-Location and Content
Distribution Agreement the ("Agreement") with ServiceCo LLC ("ServiceCo") The
Agreement allows Digital Island to physically locate its servers in ServiceCo
regional data center facilities.  The term of the agreement is two years. In
connection with the Agreement, Digital Island agreed to grant warrants to
ServiceCo to purchase common stock of Digital Island. The warrants are to be
issued to ServiceCo based upon the achievement of specified performance
criteria. Upon ServiceCo making space available to Digital Island in at least
four regional data centers, Digital Island agreed to grant a warrant for 26,817
shares with an exercise price of $96.95 per share. Digital Island further agreed
to grant a warrant for another 26,817 shares with an exercise price of $96.95
per share at such time as ServiceCo makes a total of eight regional data centers
available to Digital Island.

    As of June 30, 2000, ServiceCo had made eight regional data centers
available, and had thus earned the right to all warrants. The charge associated
with the warrants, determined based on the use of the Black-Scholes valuation
method, is currently valued at $2.8 million. The charge will be amortized over
the term that the services are received, which is the term of the Agreement, and
is

                                       9
<PAGE>

subject to remeasurement at the end of each accounting period. In the quarter
ended June 30, 2000, a charge of $278,000 was recorded.

8.  Calculation of Net Loss Per Share

    Shares used in computing basic and diluted net loss per share are based on
the weighted average shares outstanding in each period. The effect of
outstanding stock options and warrants is excluded from the calculation of
diluted net loss per share as their inclusion would be antidilutive.

  The following is a reconciliation of the numerator and denominator of the
basic and diluted earnings per share (EPS) calculation (in thousands, except for
share and per share amounts):

<TABLE>
<CAPTION>

                                         Three Months Ended            Nine Months Ended
                                              June 30,                     June 30,
                                     -------------------------    ---------------------------
                                        1999           2000          1999             2000
                                     ----------    -----------    ----------      -----------
                                     (Unaudited)   (Unaudited)    (Unaudited)    (Unaudited)
<S>                                 <C>           <C>            <C>              <C>
Numerator--Basic and Diluted
  EPS Net Loss....................   $  (14,063)   $  (100,168)   $  (28,932)     $  (216,859)
                                     ==========    ===========    ==========      ===========
Denominator--Basic and Diluted
 EPS
  Weighted average Common Stock
   Outstanding....................    3,759,285     67,424,607     2,977,229       55,973,564
  Common Stock subject to
   repurchase.....................     (204,053)    (1,035,124)     (170,241)        (941,254)
                                     ----------    -----------    ----------      -----------
  Total weighted average Common
   Stock outstanding..............    3,555,232     66,389,483     2,806,988       55,032,310
                                     ==========    ===========    ==========      ===========
Basic and diluted loss per
 share............................   $    (3.96)   $     (1.51)   $   (10.31)     $     (3.94)
                                     ==========    ===========    ==========      ===========
</TABLE>
9.  Subsequent event

    On July 17, 2000 reached an agreement to acquire SoftAware Networks, Inc.
The completion of the acquisition is subject to approval by SoftAware's
shareholders and certain government regulatory approvals. Under the terms of the
acquisition agreement, Digital Island will issue up to 9,375,000 shares of
common stock, and provide $20 million in cash in exchange for all of the
outstanding securities of SoftAware.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF
DIGITAL ISLAND CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION
27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934, AS AMENDED. DIGITAL ISLAND'S ACTUAL RESULTS AND THE TIMING
OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE
FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING, BUT NOT
LIMITED TO, THOSE SET FORTH UNDER "RISK FACTORS" AND

                                      10
<PAGE>

ELSEWHERE IN THIS QUARTERLY REPORT AND IN OTHER DOCUMENTS FILED BY DIGITAL
ISLAND WITH THE SECURITIES AND EXCHANGE COMMISSION.

Overview

  We provide a global e-Business delivery network and suite of services for
enterprises that use the Internet to deploy critical business applications and
conduct e-commerce worldwide. We offer a comprehensive solution that integrates
content delivery, hosting, intelligent networking and applications services. We
target global enterprises that increasingly rely on the Internet to conduct
business, but are constrained by the unreliability, slow performance and limited
range of functions of the public Internet. Our customers use our services and
proprietary technology to facilitate the deployment of a wide variety of
electronic commerce applications, including online marketing and sales, customer
service, fulfillment, software, document and multimedia distribution and online
training. As of June 30, 2000, we had contracts with 382 customers, of which 279
were deployed, including Activision, AOL, Autodesk, Canon, Cisco Systems,
CNBC.com, E*TRADE, Blue Mountain, ft.com, Intuit, Microsoft, National
Semiconductor, NetGravity, PBS.org and Value America.

  Since inception, we have incurred net losses and experienced negative cash
flow from operations. We expect to continue to operate at a net loss and to
experience negative cash flows at least through the year 2000. Our ability to
achieve profitability and positive cash flow from operations will be dependent
upon our ability to grow our revenues substantially and achieve other operating
efficiencies.

  We derive our revenues from a suite of services, which include content
delivery and network services, hosting services and application and professional
services. We currently sell our services under contracts with terms of one or
more years.

  Cost of revenues consists primarily of the cost of contracting for lines from
telecommunication service providers worldwide and, to a lesser extent, the cost
of our network operations. We lease lines under contracts of one year or more.
The leasing of transoceanic lines comprises the largest component of our
telecommunications expense, with additional costs arising from leasing local
circuits between our data centers and points of presence in the United States
and international markets. In the future, we expect to increase the size and
number of circuits leased, based on increases in network volume and geographic
expansion. The cost of our network operations is comprised primarily of data
centers, equipment maintenance, personnel and related costs associated with the
management and maintenance of the network.

  Some options granted and common stock issued from May 1, 1998 to June 30, 1999
have been accounted for as compensation. Total stock compensation expense
associated with such equity transactions as of June 30, 2000 amounted to $7.7
million. These amounts are being amortized over the vesting periods of the
relevant securities. Of the total stock compensation expense, $487,000 was
amortized in the year ended September 30, 1998, $3.2 million was amortized in
the year ended September 30, 1999, and $1.9 million was amortized in the nine
months ended June 30, 2000. We expect amortization of $2.4 million and $1.2
million in the years ending September 30, 2000 and 2001, respectively, relating
to these grants.

  In December 1999, we merged with Sandpiper Networks, Inc. The transaction was
accounted for using the purchase method of accounting. The acquisition price
included approximately 24.6 million shares of Digital Island common stock with a
fair market value of $857.0 million, 3.1 million vested and unvested stock
options and warrants with a fair market value of $96.6 million and estimated
direct transaction costs of approximately $14.0 million. Costs associated with
the merger of Digital Island and Sandpiper that impact future earnings include
the amortization of assembled workforce costs of $2.0 million, core technology
costs of $121.1 million and $ 850.8 million of goodwill to be amortized over a
period of 5 years.

  In connection with the Sandpiper merger, we expect amortization costs over the
next five years as follows (in thousands):


Year ending
September 30,
2000......................... $147,650
2001.........................  194,770
2002.........................  194,770


                                      11
<PAGE>

2003.........................  194,770
2004.........................  194,770
2005.........................   47,123

  In addition, in January 2000, we acquired Live On Line, Inc. The transaction
was accounted for using the purchase method of accounting. The acquisition price
included 799,989 shares of Digital Island common stock with a fair market value
of $65.9 million and $5.2 million in cash. Costs associated with the merger of
Digital Island and Live On Line that impact future earnings include the
amortization of assembled workforce costs of $500,000, core technology costs of
$3.1 million and $67.4 million of goodwill to be amortized over a period of 5
years.

  In connection with the Live On Line merger, we expect amortization costs over
the next five years as follows (in thousands):

Year ending
September 30,
2000......................... $  9,962
2001.........................   14,204
2002.........................   14,204
2003.........................   14,204
2004.........................   14,204
2005.........................    4,240

The following discussion comparing our historical results of operations does not
reflect the results of operations of Sandpiper or Live On Line for the three and
nine months ended June 30, 1999. The discussion comparing the three and nine
months ended June 30, 2000 reflects the results of operations of Sandpiper from
the date of acquisition, December 28, 1999, and Live On Line from the date of
acquisition, January 18, 2000.


Three months Ended June 30, 2000 and 1999

Revenue. Revenue increased to $16.1 million for the three months ended June 30,
2000 from $3.7 million for the three months ended June 30, 1999. The increase in
revenue was primarily due to increased usage per customer and an increase in the
number of deployed customers to 279 from 62.

Cost of Revenue. Cost of revenue increased to $32.1 million for the three months
ended June 30, 2000 from $8.1 million for the three months ended June 30, 2000.
The increase in cost of revenue was due to $13.7 million of spending for
additional network capacity, $4.3 million in recruitment and compensation costs
relating to the addition of network operations personnel, and $6.0 million in
additional costs associated with expansion of existing data center facilities,
deployment of the San Jose and Japan facilities, and equipment-related costs.

Sales and Marketing. Sales and marketing expenses increased to $15.9 million for
the three months ended June 30, 2000 from $4.5 million for the three months
ended June 30, 1999. This increase was due to $7.4 million of growth in
personnel and related costs and $4.0 million of program expenses.

Product Development. Product development expenses increased to $6.2 million for
the three months ended June 30, 2000 from $1.9 million for the three months
ended June 30, 1999. This increase was due to $4.3 million growth in personnel
and related expenses.

General and Administrative. General and administrative expenses increased to
$14.1 million for the three months ended June 30, 2000 from $2.5 million for
the three months ended June 30, 1999. This increase was due to $7.5 million of
depreciation of network equipment, $1.5 million in growth of personnel and
related expenses and $2.6 million of office facility expenses, legal and
accounting fees and other administrative related expenses.

                                      12
<PAGE>

Interest income, net. Interest income, net increased to $5.7 million for the
three months ended June 30, 2000 from $387,000 for the three months ended June
30, 1999. This increase was due to a higher average cash balance remaining
primarily from the proceeds of the issuance of shares of our common stock in our
secondary stock offering and issuance of convertible notes, and  was offset by
accrued interest expense on the convertible notes.

Nine Months Ended June 30, 2000 and 1999

Revenue. Revenue increased to $35.0 million for the nine months ended June 30,
2000 from $7.5 million for the nine months ended June 30, 1999. The increase in
revenue was primarily due to increased usage per customer and an increase in the
number of deployed customers to 279 from 62.

Cost of Revenue. Cost of revenue increased to $71.2 million for the nine months
ended June 30, 2000 from $15.8 million for the nine months ended June 30, 1999.
The increase in cost of revenue was due to the $35.4 million of spending for
additional network capacity and $9.9 million in recruitment and compensation
costs relating to the addition of network operations personnel and $10.1
million in additional costs associated with expansion of existing data center
facilities, the deployment of the San Jose and Japan facilities, and equipment-
related costs.

Sales and Marketing. Sales and marketing expenses increased to $37.0 million for
the nine months ended June 30, 2000 from $9.7 million for the nine months ended
June 30, 1999. This increase was due to $17.8 million of growth in personnel and
related costs and $9.5 million of program expenses.

Product Development. Product development expenses increased to $13.2 million for
the nine months ended June 30, 2000 from $3.9 million for the nine months ended
June 30, 1999. This increase was due to $9.3 million in growth of personnel and
related expenses.

General and Administrative. General and administrative expenses increased to
$30.1 million for the nine months ended June 30, 2000 from $5.4 million for the
nine months ended June 30, 1999. This increase was due to $15.0 million of
depreciation of network equipment, $3.9 million in growth of personnel and
related expenses and $5.8 million of office facility expenses, legal and
accounting fees and other administrative related expenses.

Interest Income, net. Interest income, net increased to $8.1 million for the
nine months ended June 30, 2000 from $644,000 for the nine months ended June 30,
1999. This increase was due to a higher average cash balance remaining primarily
from the proceeds of the issuance of shares of our common stock in our secondary
stock offering and issuance of convertible notes, and was offset by accrued
interest expense on the convertible notes.

Liquidity and Capital Resources

  From inception through our initial public offering in June 1999, we financed
our operations primarily through private equity placements of $86.9 million and
borrowings under notes payable and capital leases from financial institutions of
$5.7 million. We raised $63.1 million in net proceeds from our initial public
offering. In February 2000, we raised $744.0 million in net proceeds from our
secondary offering of common stock and issuance of convertible subordinated
notes. As of June 30, 2000, we had cash, cash equivalents, short-term
investments, and long-term investments totaling $706.9 million.

  Net cash used in our operating activities for the nine months ended June 30,
2000 was $116.8 million. The net cash used by operations was comprised primarily
of working capital requirements and net losses, net of amortization of
intangible assets. Net cash used in our investment activities was $449.1 million
for the nine months ended June 30, 2000 and was comprised primarily of equipment
purchases of $79.1 million, investments of $412.4 million in commercial paper
with maturities of less than one year, cash paid in the acquisition of Live On
Line of $5.3 million, and a $6.3 million increase in restricted cash, which were
offset by proceeds from investments which matured of $49.3 million and cash
acquired through business acquisitions of $4.7 million. Net cash provided by
financing activities was $827.4 million and was related primarily to proceeds
from the issuance of stock and notes of $831.9 million, which was offset by
repayments of debt of $4.5 million.

                                      13
<PAGE>

  We have a $750,000 revolving line of credit with a commercial bank for the
purpose of financing equipment purchases. The loan contains standard covenants
including minimum working capital, minimum tangible net worth, debt to equity
ratio, assets to liabilities ratio and financial reporting requirements.
Interest on borrowings thereunder accrues at the lender's prime rate plus 0.75%,
and is payable monthly.

  We also have a $7.5 million line of credit with a commercial bank, consisting
of a revolving credit facility of up to $5 million and equipment loan facilities
of up to $2.5 million. Advances under the line of credit are limited to a
percentage of our recurring contract revenue. The loan contains standard
covenants, including minimum working capital, minimum tangible net worth, debt
to equity ratio, assets to liabilities ratio and financial reporting
requirements. Interest on borrowings under the revolving credit facility accrues
at the lender's prime rate plus 0.25%, and is payable monthly. Under the terms
of the equipment loan facilities, interest is charged at the lender's prime rate
plus 0.75%, and is payable monthly. The loans mature at various times in 2001.
Between October 1, 1998 and January 31, 1999, we did not comply with the minimum
tangible net worth and financial reporting covenants. However, we obtained
waivers for all covenant violations. We have complied with all covenants since
January 31, 1999.

At June 30, 2000, there were no borrowings under any of these credit facilities.

  Pursuant to the merger with Sandpiper, we assumed from Sandpiper a $1,000,000
line of credit with a bank. The line of credit has a variable rate of interest,
based on the bank's prime rate plus 0.5%. At June 30, 2000, no amounts were
extended under this facility.

  Pursuant to the merger with Sandpiper, we assumed from Sandpiper a promissory
note with a financial institution in the amount of $84,224 at a stated interest
rate of 7% per annum, principal and interest due monthly for 36 months and
collateralized by equipment on August 31, 1998.

  In addition, we have several lease lines of credit. Total borrowings under
these lease lines of credit were $19.0 million at June 30, 2000, of which $2.4
million was assumed pursuant to the merger with Sandpiper.

  In December 1999, Sun Microsystems agreed to provide $100 million of lease
financing, subject to certain milestones, for the acquisition of equipment. We
have not drawn any amounts under the financing agreement.

  In June 2000, Compaq Computer Corporation agreed to provide $50 million of
lease financing for the acquisition of equipment. We have not drawn any amounts
under the financing agreement.

  The execution of our business plan will require substantial capital to fund
our operating losses, working capital needs, sales and marketing expenses, lease
payments and capital expenditures. In order to rapidly improve our competitive
position, we anticipate making up to approximately $150.0 million of capital
expenditures for network expansion, facilities and related costs in the next 12
months.

  We believe that the net proceeds from our secondary offering of common stock
and issuance of convertible subordinated notes, together with our existing cash
and funds available under our existing credit facilities, will be sufficient to
fund our operating losses, working capital needs and capital expenditures for at
least the next 12 months. The execution of our business plan will require
substantial capital to fund our operating losses, working capital needs, sales
and marketing expenses, lease payments and capital expenditures thereafter. We
intend to continue to consider our future financing alternatives, which may
include the incurrence of additional indebtedness, additional public or private
equity offerings or an equity investment by a strategic partner. Actual capital
requirements may vary based upon the timing and success of the expansion of our
operations. Our capital requirements may change based upon technological and
competitive developments. In addition, several factors may affect our capital
requirements:

 .  demand for our services or our anticipated cash flow from operations being
   less than expected;

                                      14
<PAGE>

 .  development plans or projections proving to be inaccurate;

 .  our engaging in acquisitions or other strategic transactions; or

 .  accelerating deployment of our network services or otherwise altering the
   schedule of our expansion plan.

   There can be no assurance that any such equity or debt financing will be
available to us on favorable terms, or at all. If we do not obtain additional
financing, we believe that our existing cash resources will be adequate to
continue expanding operations in the near term.

Recent Accounting Pronouncements

   In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133 (SFAS 133), "Accounting for Derivative Instruments and Hedging Activities."
SFAS 133 establishes accounting and reporting standards for derivative
instruments and for hedging activities. In June 1999, the FASB issued SFAS 137,
"Accounting for Derivative Instruments and Hedging Activities Deferral of
Effective Date of FASB Statement No. 133," which deferred the effective date of
SFAS 133 to all fiscal quarters of fiscal years beginning after June 15, 2000.
We do not believe the adoption of SFAS 133 will have a material effect on our
consolidated results of operations or financial condition.

   In March 2000, the Financial Accounting Standards Board issued FASB
Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation, an Interpretation of APB Opinion No. 25" (the "Interpretation").
The Interpretation is intended to clarify certain issues that have arisen in
practice since the issuance of APB 25. The Company will adopt the interpretation
on July 1, 2000 and does not expect such adoption to have an impact on the
Company's results of operations, financial position or cash flow.

   In December 1999, the Securities Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB
101 is effective no later than the quarter ended March 31, 2001. The Company
does not expect that the adoption of SAB 101 will have a material effect on the
consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   We provide a global e-Business delivery network and suite of services and
sell such services in North America, Asia and Europe. As a result, our financial
results could be affected by factors such as changes in foreign currency
exchange rates or weak economic conditions in foreign markets. As all sales are
currently made in U.S. dollars, a strengthening of the dollar could make our
services less competitive in foreign markets. We do not use derivative
instruments to hedge our foreign exchange risks. Our interest income is
sensitive to changes in the general level of U.S. interest rates, particularly
since the majority of our investments are in short-term instruments. Due to the
nature of our short-term investments, we anticipate no material market risk
exposure. Therefore, no quantitative tabular disclosures are required.

RISK FACTORS

Set forth below and elsewhere in this Quarterly Report and in the other
documents we file with the SEC are risks and uncertainties that could our cause
actual results to differ materially from the results contemplated by the
forward looking statements contained in this Quarterly Report.

Risks Related to Digital Island

We have a short operating history.

   Our limited operating history makes it difficult for us to predict future
results of operations, and makes it difficult to evaluate us or our prospects.
We were incorporated in 1994, and began offering our e-Business delivery network
services in January 1997.

                                      15
<PAGE>

Prior to such time, we were engaged in activities unrelated to our current
operations, and as a result, the results of our operations for such periods are
not comparable to our results of operations for 1997 or any subsequent periods.

  We completed a merger with Sandpiper Networks, Inc. in December 1999.
Sandpiper commenced operations in December 1996 and introduced its service in
September 1998, and therefore also has a limited operating history. The limited
operating history of the combined company and the limited operating histories of
Digital Island and Sandpiper as individual entities may limit your ability to
evaluate our prospects and performance, and an investment in our common stock,
due to:

  .  our unproven potential to generate profits;

  .  our limited historical financial data;

  .  our limited experience in operating as a combined entity; and

  .  our limited experience in addressing emerging trends that may affect
     our combined business.

  You should consider our prospects in light of the risks, expenses and
difficulties we may encounter as an early stage company in the new and rapidly
evolving market for Internet content delivery solutions. As a result of such
risks, expenses and difficulties, we may not be able to:

  .  successfully market our content delivery solution;

  .  maintain and expand our market share in the highly competitive market
     for Internet content delivery solutions;

  .  timely and effectively introduce new services and service enhancements
     that are responsive to the needs of our customers; and

  .  attract, train and retain qualified sales, technical and customer
     support personnel.

We have incurred operating losses since our inception and expect future
operating losses for the foreseeable future.

  The revenue and income potential of our business and market is unproven. From
inception, we have experienced operating losses, negative cash flows from
operations and net losses in each quarterly and annual period. For the fiscal
year ended September 30, 1999, our operating loss, negative cash flow from
operations and net loss were $52.5 million, $39.7 million and $50.9 million,
respectively. For nine months ended June 30, 2000, our operating loss,
negative cash flow from operations and net loss were $225.0 million, $116.8
million and $216.9 million, respectively.

  Our operating expenses are largely based on anticipated revenue trends, and a
high percentage of our expenses are, and will continue to be, fixed in the short
term. In addition, we expect to continue to incur increasing expenses in order
to:

  .  expand sales and marketing activities through new programs and
     additional personnel;

  .  increase product development activities;

  .  continue to grow our network infrastructure to maintain and increase
     our ability to service new and existing customers;

                                      16
<PAGE>

  .  obtain access to additional bandwidth for the transport of increasing
     volumes of data over our network; and

  .  expand our channels of distribution to increase our presence in our
     target markets.

  We have substantially increased the level of our anticipated capital
expenditures for network expansion, facilities and related costs over the next
12 months to approximately $150 million. As a result, we believe that we will
continue to experience significant losses for the foreseeable future.

  We will need to generate significantly higher revenues to achieve and maintain
profitability. Although we have experienced growth in revenues in recent
periods, this growth rate may not be indicative of future operating results. We
may never be able to achieve or sustain profitability.

The unpredictability of our quarterly results may adversely affect the trading
price of our stock.

  We expect our revenues and operating results to vary significantly from
quarter to quarter due to a number of factors, many of which we cannot control
and any of which may cause our stock price to fluctuate. These factors include
the following:

  .  demand for and market acceptance of our products and services may
     decline or fail to increase enough to offset our costs;

  .  the introduction of new products and services or enhancements by us and
     our competitors may increase our costs or make our existing products
     or services obsolete;

  .   the prices we can charge our customers may decline due to price
     competition with our competitors;

  .  utilization of our global network may increase beyond our capacity and
     we may incur significant expenses to increase such capacity;

  .  continuity of our service and network availability could be
     interrupted, reducing revenue;

  .  the availability and cost of bandwidth may reduce our ability to
     increase bandwidth as necessary;

  .  the length of our sales cycle and timing of customer installations and
     expansion of our network infrastructure may vary from quarter to
     quarter;

  .  the mix of products and services we sell may change and the new mix
     may generate less revenue;

  .  the timing and magnitude of our capital expenditures, including costs
     relating to the expansion of operations, may vary from quarter to
     quarter;

  .  bandwidth used by customers may fluctuate from quarter to quarter; and

                                      17
<PAGE>

  .  conditions specific to the Internet industry and other general
     economic factors may affect the prices we can charge or the expenses
     we incur.

  Because a relatively large portion of our expenses are fixed in the short-
term, particularly with respect to telecommunications capacity, depreciation,
real estate and interest expenses and personnel, our results of operations are
particularly sensitive to fluctuations in revenues. Due to the foregoing, we
believe that period-to-period comparisons of our operating results are not
necessarily meaningful and that such comparisons cannot be relied upon as
indicators of future performance. It is likely that, in some future quarters,
our operating results may not meet the expectations of public market analysts
and investors. In that event, the price of our common stock may fall.

We must offer services priced above the overall cost of bandwidth, and any
failure to do so would jeopardize our operating results.

  If we do not obtain adequate bandwidth capacity on acceptable terms and
realize appropriate customer volume for such bandwidth, we will not achieve
positive gross profit. We purchase our bandwidth capacity on a fixed-price basis
in advance of the sale of our services. We sell our services, by contract, on
the basis of actual usage. Our bandwidth costs currently exceed our revenues
from the sale of services, which results in negative gross profit.

  Our data replication (mirroring) and storage (caching) business is attractive
to customers primarily because these services eliminate a significant portion of
the cost of transporting data by deploying data in close proximity to the end
users. To the extent bandwidth costs decrease, the prices we may charge for
these services will decrease as well. If the cost of bandwidth decreases more
than we expect, the value of these services could be substantially reduced,
which would harm our business and financial results.

  We expect that the cost of obtaining bandwidth for the transport of data over
our network will decline over time as a result of, among other things, the large
amount of capital currently being invested to build infrastructure. We expect
the prices we charge for data transported over our network will also decline
over time as a result of, among other things, the lower cost of obtaining
bandwidth and existing and new competition in the markets we address. If we fail
to accurately predict the decline in costs of bandwidth, are unable to sell our
services at acceptable prices, or fail to offer additional services from which
we can derive additional revenues, our revenues will decrease and our business
and financial results will suffer.

We must retain and expand our customer base or else we will continue to be
unprofitable.

  For the fiscal year ended September 30, 1999, we had contracts with 83 billing
customers, of which one, E*TRADE, accounted for approximately 35% of our
revenues. As of June 30, 2000, we had contracts with 382 customers of which 279
were deployed. E*TRADE accounted for approximately 22% of our revenues during
the nine months ended June 30, 2000. We currently incur costs greater than our
revenues and need to increase customer revenue to become profitable. We incur
significant fixed costs to purchase our bandwidth capacity and maintain our
network. We also have payroll and other working capital needs. If we are unable
to retain or grow our customer base, we will not be able to achieve the
economies of scale necessary to offset our fixed and other operating costs. Our
ability to attract new customers depends on a variety of factors, including:

  .  the willingness of businesses to outsource their Internet operations;

  .  the reliability and cost-effectiveness of our services; and

  .  our ability to effectively market such services.

  To attract new customers we intend to significantly increase our sales and
marketing expenditures. However, our efforts might not result in more sales as a
result of the following factors:

  .  we may be unsuccessful in implementing our marketing strategies;

                                      18
<PAGE>

  .  we may be unsuccessful in hiring a sufficient number of qualified
     sales and marketing personnel; and

  .  our marketing strategies may not result in increased sales.

Our network infrastructure may be subject to failure or disruptions, which would
seriously harm our business.

  Our business is dependent on providing our customers with fast, efficient and
reliable network services. To meet these customer requirements we must protect
our network infrastructure against damage from:

  .  human error;

  .  fire;

  .  natural disasters;

  .  power loss;

  .  sabotage or vandalism;

  .  telecommunications failures; and

  .  similar events.

  Despite precautions taken by us, the occurrence of a natural disaster or other
unanticipated problems at one or more of our data centers could result in
service interruptions or significant damage to equipment. We have experienced
temporary service interruptions in the past, and we could experience similar
interruptions in the future. We may be subject to legal claims and be liable for
losses suffered by our customers for disruptions resulting from failures on our
network. Our agreements with our customers generally attempt to eliminate our
liability for consequential or punitive damages not caused by our gross
negligence or willful acts. However, those provisions may not protect us from
being held liable for such damages. If our disruption rate is high, clients may
seek to terminate their contracts with us and our reputation could be harmed,
which would materially harm our business.

Our Internet content delivery service is complex and may have errors or defects
that could seriously harm our business.

  Our Internet content delivery service is highly complex and is designed to be
deployed in very large and complex networks. Because of the nature of this
service, we can only fully test it when it is fully deployed in very large
networks with high traffic. We and our customers have from time to time
discovered errors and defects in our software. In the future, there may be
additional errors and defects in our software that may adversely affect our
service. If we are unable efficiently to fix errors or other problems that may
be identified in the future, we could experience:

  .  loss of or delay in revenue;

  .  loss of customers;

  .  failure to attract new customers or achieve market acceptance;

  .  diversion of development resources;

  .  loss of reputation and credibility;

                                      19
<PAGE>

  .  increased service costs; and

  .  legal actions by our customers.

Future customer warranty claims based on service failures could exceed our
insurance coverage.

  Our customer contracts currently provide a limited service level warranty
related to the continuous availability of service 24 hours a day, seven days per
week, except for certain scheduled maintenance periods. This warranty is
generally limited to a credit consisting of free service for a specified period
of time for disruptions in Internet transmission services. To date, we have
incurred no material expense related to such service level warranty. Should we
incur significant obligations in connection with system downtime, our liability
insurance may not be adequate to cover such expenses. Although our customer
contracts typically provide for no recovery with respect to incidental,
punitive, indirect and consequential damages resulting from damages to equipment
or disruption of service, in the event of such damages, we may be found liable,
and, in such event, such damages may exceed our liability insurance.

Our business will suffer if we do not anticipate and meet specific customer
requirements or respond to technological change.

  The market for Internet content delivery and network services is characterized
by rapid technological change, frequent new product introductions and changes in
customer requirements. We may be unable to respond quickly or effectively to
these developments. Our future success will depend to a substantial degree on
our ability to offer services that incorporate leading technology, address the
increasingly sophisticated and varied needs of our current and prospective
customers and respond to technological advances and emerging industry standards
and practices on a timely and cost-effective basis. You should be aware that:

  .  our technology or systems may become obsolete upon the introduction of
     alternative technologies;

  .  we may not have sufficient resources to develop or acquire new
     technologies or to introduce new services capable of competing with
     future technologies or service offerings; and

  .  the price of our services is likely to decline as rapidly as the cost
     of any competitive alternatives.

  The development of new or enhanced services through technology development
activities is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may experience design,
manufacturing, marketing and other difficulties that could delay or prevent the
development, introduction or marketing of new services and enhancements. In
addition, our inability to effectively manage the transition from older services
to newer services could cause disruptions to customer orders and harm our
business and prospects.

If we do not successfully increase the capacity of our network, demand for our
services may decrease.

  Due to the limited deployment of our services to date, the ability of our
network to connect and manage a substantially larger number of customers at high
transmission speeds is as yet unknown. Our network may not be able to serve
expected customer levels or meet performance expectations and we may be unable
to obtain additional network capacity from third-party suppliers. In addition,
as customers' usage of bandwidth increases, we will need to make additional
investments in our infrastructure to maintain adequate downstream data
transmission speeds, the cost of which may be significant. Upgrading our
infrastructure may cause delays or failures in our network. As a result, our
network may be unable to achieve or maintain a sufficiently high capacity of
data transmission which could significantly reduce demand for our services,
reducing our revenues and adversely affecting our business.

                                      20
<PAGE>

If our market does not grow as we expect, our revenues will be below our
expectations and our business and financial results will suffer.

  The market for our services is new and unproven. If our customer base does not
expand or if there is not a widespread acceptance of our products and our
services, our business and prospects will be harmed. The market for our services
depends on several uncertain events and factors, including:

  .  the effectiveness of our marketing strategy and efforts;

  .  our product and service differentiation and quality;

  .  the extent of our network coverage;

  .  our ability to provide timely, effective customer support;

  .  our distribution and pricing strategies as compared to our
     competitors;

  .  our industry reputation; and

  .  general economic conditions such as downturns in the e-Business or
     software markets.

  If the market for our services fails to develop, or develops more slowly than
expected, our business will be adversely affected.

We will require significant additional capital, and if we cannot obtain this
financing on commercially reasonable terms, our business will suffer.

  Our ability to meet our planned growth will require substantial cash
resources. The timing and amount of future capital requirements may vary
significantly depending on numerous factors including regulatory, technological,
competitive and other developments in our industry. We do not expect to generate
significant cash flow from operations in the near term. Accordingly, our ability
to meet additional future capital needs will depend on future equity or debt
financing, which we may not be able to obtain on satisfactory terms or at all.
In addition, our credit agreements contain covenants restricting our ability to
incur further indebtedness, and future borrowing instruments such as credit
facilities and lease agreements are likely to contain similar or more
restrictive covenants and will likely require us to pledge assets as security
for borrowings thereunder. Additional equity financing may not be available or
may be dilutive to existing stockholders. Our inability to obtain additional
capital on satisfactory terms may delay or prevent the expansion of our business
and cause us to forego market opportunities, which could materially adversely
affect our growth and ability to compete.

Rapid growth in our business could cause a significant strain on our business.

  The planned expansion of our operations will place a significant strain on our
management, financial controls, operations systems, personnel and other
resources. We expect that our customers increasingly will demand additional
information and reports with respect to the services we provide. To handle these
demands and enable future traffic growth, we must develop and implement an
automated customer service system. In addition, if we are successful in
implementing our marketing strategy, we also expect the demands on our network
infrastructure and technical support resources to grow rapidly. We expect that
these demands will require investments in our infrastructure, the addition of
new management personnel, the development of additional expertise by existing
management personnel and the establishment of long-term relationships with
third-party service vendors. We may not be able to keep pace with such growth,
successfully implement and maintain our operational and financial systems or
successfully obtain, integrate and utilize the employees, facilities, third-
party vendors and equipment, or management,

                                      21
<PAGE>

operational and financial resources necessary to manage a developing and
expanding business in our evolving and increasingly competitive industry. If we
are unable to manage growth effectively, our business and financial results will
suffer.

We could lose customers and expose our company to liability if breaches of our
network security disrupt service to our customers or jeopardize the security of
confidential information stored in our computer systems.

  Despite the implementation of network security measures, our network
infrastructure is vulnerable to computer viruses, break-ins and similar
disruptive problems caused by our customers or Internet users. Any of these acts
could lead to interruptions, delays or cessation in service to our customers and
subscribers. Furthermore, such inappropriate use of the network by third parties
could also potentially jeopardize the security of confidential information
stored in our computer systems and our customers computer systems, which may
result in liability to us and may deter potential customers. Although we intend
to continue to implement industry-standard security measures, any measures we
implement may be circumvented in the future. The costs and resources required to
eliminate computer viruses and alleviate other security problems may divert
resources from other activities and may result in interruptions or delays to our
customers that could cause our business and financial results to suffer.

We must retain and attract key employees or else we may not grow or be
successful.

  We are highly dependent on key members of our management and engineering
staff. The loss of one or more of these individuals might impede the achievement
of our business objectives. Furthermore, recruiting and retaining qualified
technical personnel to perform research, development and technical support work
is critical to our success. If our business grows, we will also need to recruit
a significant number of management, technical and other personnel. Competition
for employees in our industry is intense. We may not be able to continue to
attract and retain skilled and experienced personnel on acceptable terms. The
loss of the services of any of our key employees, the inability to integrate new
employees or our failure to attract or retain qualified personnel in the future
in a timely manner could harm our business.

We depend on a limited number of third party suppliers for key components of our
network infrastructure, and the loss of one or more suppliers may slow our
growth or cause us to lose customers.

  We are dependent on third party providers to supply key components of our
infrastructure, including bandwidth capacity leased from telecommunications
network providers and networking equipment that, in the quantities and quality
demanded by us, are available only from sole or limited sources. While we have
entered into various agreements for carrier line capacity, any failure to obtain
additional capacity, if required, would impede the growth of our business and
cause our financial results to suffer. The routers and switches used in our
infrastructure are currently supplied primarily by Cisco Systems. We purchase
these  components pursuant to purchase orders placed from time to time, we do
not carry significant inventories of these components and we have no guaranteed
supply arrangements with this vendor. Any failure to obtain required products or
services on a timely basis and at an acceptable cost would impede the growth of
our business and cause our financial results to suffer. In addition, any failure
of our suppliers to provide products or components that comply with evolving
Internet and telecommunications standards could cause our business and financial
results to suffer.

Our failure to adequately protect our proprietary rights may harm our
competitive position.

  We rely on a combination of copyrights, trademark, service mark and trade
secret laws and contractual restrictions to establish and protect proprietary
rights in our products and services. However, we will not be able to protect our
intellectual property if we are unable to enforce our rights or if we do not
detect unauthorized use of our intellectual property.

                                      22
<PAGE>

  Although we have filed patent applications with the United States Patent and
Trademark Office with respect to our Footprint and TraceWare technologies, as
well as some Internet technology recently acquired from SRI International, such
applications are pending and we currently have no patented technology that would
preclude or inhibit competitors from entering our market. Moreover, none of our
technology is patented abroad, nor do we currently have any international patent
applications pending. We cannot be certain that any pending or future patent
applications will be granted, that any future patent will not be challenged,
invalidated or circumvented, or that rights granted under any patent that may be
issued will provide competitive advantages to us.

  We have applied for trademarks and service marks on certain terms and symbols
that we believe are important for our business. In addition, we generally enter
into confidentiality or license agreements with our employees and consultants
and with our customers and corporations with whom we have strategic
relationships, and we attempt to maintain control over access to and
distribution of our software documentation and other proprietary information.

  The steps we have taken to protect our technology or intellectual property may
be inadequate. Our competitors may independently develop technologies that are
substantially equivalent or superior to ours. Moreover, in other countries where
we do business, there may not be effective legal protection of patents and other
proprietary rights that we believe are important to our business. Unauthorized
use of any of our proprietary information could seriously harm our business.

  If we do not effectively manage the integration of future acquisitions, it
could disrupt our business and cause increased losses.

  Part of our expansion strategy includes acquiring businesses and technologies
that we believe will complement our existing business. In the event of any
future acquisitions, we may:

  .  issue stock that would dilute the ownership of our stockholders,
     including investors who purchase common stock in this offering;

  .  incur debt;

  .  assume liabilities;

  .  incur amortization expenses related to goodwill and other intangible
     assets; and

  .  incur large and immediate write-offs.

Acquisition transactions require a significant commitment of resources and are
accompanied by a number of risks, including:

  .  the difficulty of assimilating the operations and personnel of the
     acquired companies;

  .  the potential disruption of our ongoing business and distraction of
     management;

  .  the difficulty of incorporating acquired technology and rights into
     our products and services;

  .  unanticipated expenses related to technology integration;

  .  the maintenance of uniform standards, controls, procedures and
     policies;

  .  the impairment of relationships with employees and customers as a

                                      23
<PAGE>

     result of any integration of new management personnel; and

  .  potential unknown liabilities associated with acquired businesses.

  We may need to complete these transactions to remain competitive. We cannot be
sure that we will succeed in addressing these risks or any other problems
encountered in connection with potential business combinations and acquisitions.

We have anti-takeover defenses that could delay or prevent a takeover that
stockholders may consider favorable.

  Certain provisions of our certificate of incorporation and bylaws and the
provisions of Delaware law could have the effect of delaying, deferring or
preventing an acquisition of Digital Island. For example, our board of directors
is divided into three classes to serve staggered three-year terms, we may
authorize the issuance of up to 10,000,000 shares of "blank check" preferred
stock, our stockholders may not take actions by written consent and our
stockholders are limited in their ability to make proposals at stockholder
meetings.

We may be unable to license necessary technology, and we may be subject to
infringement claims by third parties.

  Our commercial success will also depend in part on our not infringing the
proprietary rights of others and not breaching technology licenses that cover
technology used in our products. It is uncertain whether any third party patents
will require us to develop alternative technology, alter our products or
processes, obtain licenses or cease activities that infringe on third party's
intellectual property rights. If any such licenses are required, we may not be
able to obtain such licenses on commercially favorable terms, if at all. Our
failure to obtain a license to any technology that we may require to
commercialize our products and services could cause our business and prospects
to suffer.

  Companies in the Internet market are increasingly bringing suits alleging
infringement of their proprietary rights, particularly patent rights. Any
litigation or claims, whether or not valid, could result in substantial costs
and diversion of resources. Intellectual property litigation or claims could
force us to do one or more of the following:

  .  cease selling, incorporating or using products or services that
     incorporate the challenged intellectual property;

  .  obtain a license from the holder of the infringed intellectual
     property right, which license, if available at all, may not be
     available on commercially favorable terms; and

  .  redesign products or services.

  If we are forced to take any of the foregoing actions, our business may be
seriously harmed. We expect that our insurance may not cover potential claims of
this type or may not be adequate to indemnify us in the event we are found
liable.

Our participation in joint ventures and strategic relationships may involve risk
associated with inconsistent goals, exposure to unknown liabilities and
unexpected obligations.

  As part of our international expansion, we pursue relationships and joint
ventures with local Internet service providers and telecommunications carriers
in other countries. We may not have a majority interest or control of the
governing body of any such local operating joint venture and there is a risk
that the other joint venture partner may at any time have economic, business or
legal interests or goals that are inconsistent with those of the joint venture
or us. The risk also will be present that a joint venture partner may be unable
to meet its economic or other obligations and that we may be required to fulfill
those obligations. In addition, in any joint venture in which we do not have a
majority interest, we may not have control over the operations or assets of such
joint venture. We may not be able to establish peering relationships or joint
ventures with local Internet service providers and telecommunications carriers
in other countries on favorable terms or at all. Our failure to establish these
relationships may cause us to lose customers or slow our growth and harm our
business.

                                      24
<PAGE>

  Sandpiper entered into strategic relationships with America Online, or AOL, in
April 1999 and with Microsoft in October 1999 for the joint development of
technology, services and/or products. We may not be successful in developing
such products. The AOL agreement expires in December 2001 and the agreement with
Microsoft expires in August 2002. Each agreement may be terminated by either
party if the other party materially breaches the agreement. A termination of, or
significant adverse change in our relationship with AOL or Microsoft could have
a material adverse effect on our business.

Risks Related To The Sandpiper and Live On Line Mergers

If we do not successfully integrate Sandpiper's or Live On Line's operations and
personnel or effectively manage the combined company, we may not achieve the
benefits of the merger and may lose key personnel and customers.

  We undertook the mergers with the expectation that the mergers will result in
significant benefits. Achieving the benefits of the mergers depends on the
timely, efficient and successful execution of a number of post-merger events,
including the current efforts to integrate the operations and personnel of the
three companies. We will need to overcome significant obstacles, however, in
order to realize any benefits or synergies from the mergers. The successful
execution of these post-merger events will involve considerable risk and may not
be successful.

  The market price of our common stock may decline as a result of the Sandpiper
and Live On Line mergers if:

  .  the integration of Digital Island, Sandpiper and Live On Line is
     unsuccessful;

  .  Digital Island does not achieve the perceived benefits of the mergers
     as rapidly or to the extent anticipated by financial or industry
     analysts; or

  .  the effect of the mergers on Digital Island's financial results is not
     consistent with the expectations of financial or industry analysts.

Our failure to complete the integration successfully could also result in the
loss of key personnel and customers. In addition, the attention and effort
devoted to the integration of the three companies will significantly divert
management's attention from other important issues.

If we fail to successfully cross-market our products or develop new products, we
will not increase or maintain our customer base or our revenues.

  With Sandpiper and Live On Line, we intend to offer our products and services
to each other's existing customers. We cannot assure you that our respective
customers will have any interest in the other company's products and services or
that the transactions or other data in Sandpiper's and Live On Line's databases
will be predictive or useful in other sales channels, including systems
integrators, web site designers and Internet service providers. The failure of
these cross-marketing efforts would diminish the benefits realized by these
mergers.

  In addition, we intend to develop new products and services that combine the
knowledge and resources of the Digital Island, Sandpiper and Live On Line
businesses. To date, the companies have not thoroughly investigated the
obstacles, technological,

                                      25
<PAGE>

market-driven or otherwise, to developing and marketing these new products and
services in a timely and efficient way. We cannot offer any assurances that
products or services will be successful or that there will be a market for such
products and services. As a result, we may not be able to increase or maintain
our customer base. Our failure or inability to develop and market combined
products and services could have a material adverse effect on the combined
company's business, financial condition and operating results.

Risks Related to Our Industry

Competition in our industry is intense and growing and we may be unable to
compete effectively.

  Our market is highly competitive and fragmented. Our competitors include
companies such as AboveNet Communications, Adero, Akamai, AT&T, Concentric,
Digex, Exodus Communications, Global Crossing, GTE, InterNAP, MCI WorldCom and
Qwest. Many of our competitors have substantially greater financial, technical
and marketing resources, larger customer bases, longer operating histories,
greater name recognition and more established relationships in the industry than
we do. Some of our current and potential competitors have the financial
resources to withstand substantial price competition, and many may be able to
respond more quickly than we can to new or emerging technologies and changes in
customer requirements. Our competitors with more extensive customer bases,
broader customer relationships and broader industry alliances may be able to use
such resources to their advantage in competitive situations, including
relationships with many of our current and potential customers. In particular,
certain competitors have strategic alliances with entities that have entered
into similar alliances with us, including Microsoft.

  There are few substantial barriers to entry and we expect that we will face
additional competition from existing competitors and new market entrants in the
future. We compete against information technology and Internet outsourcing
firms, national and regional Internet service providers, and global, regional
and local telecommunications companies.  Our larger competitors may be able to
provide customers with additional benefits in connection with their Internet
systems and network solutions, including reduced communications costs. As a
result, these companies may be able to price their products and services more
competitively than we can and respond more quickly than us to new or emerging
technologies and changes in customer requirements. If we are unable to compete
successfully against our current or future competitors, we may lose market
share, and our business and prospects would suffer.

  We face competition, and in the future may face additional competition, from
providers of Internet content delivery services, including networking hardware
and software manufacturers, content distribution providers, traditional hardware
manufacturers, telecommunications providers, software database companies, and
large diversified software and technology companies. Some of these competitors
may bundle their services with other software or hardware in a manner that may
discourage website owners from purchasing our services or Internet service
providers from installing our servers. In addition, if those third party
telecommunications providers upon which we are currently dependent for
transmission capacity determine to compete with us in the Internet content
delivery market, their refusal to provide us with capacity, could result in a
degradation or termination of service to certain of our customers. As a result,
we could lose customers or fees charged to such customers, and our business and
financial results could suffer.

  In addition, no assurances can be given that the Internet content delivery
market will develop in a way that we currently anticipate. For example, while we
currently intend to offer our customers the most comprehensive solution
available in the marketplace today, there currently exists an array of
competitors that offer partial solutions to the problems that we intend to
address, and a number of these companies have been and are likely to continue to
be quite successful. To the extent Internet service providers utilize other
technology that reduces the need for content delivery solutions, demand for our
services could decrease.

Increased competition could result in:

  .  price and revenue reductions and lower profit margins;

  .  increased cost of service from telecommunications providers;

                                      26
<PAGE>

  .  loss of customers or failure to obtain additional customers; and

  .  loss of market share.

Liability laws are unsettled in our industry and potential liability associated
with information disseminated through our network could harm our business and
prospects.

  The law relating to the liability of online services companies and Internet
access providers for communications and commerce carried on or disseminated
through their networks is currently unsettled. The most recent session of the
United States Congress resulted in the enactment of Internet laws regarding
children's privacy, copyrights, taxation and the transmission of sexually
explicit material. The European Union issued a directive in December 1997 that
required member states to initiate the process for the adoption of privacy
regulations by October 1998. The European Union is also currently considering
copyright legislation that may extend the right of reproduction held by
copyright holders to include the right to make temporary copies for any reason.
It is possible that claims could be made against online services companies and
Internet access providers under both United States and foreign law for
defamation, negligence, copyright or trademark infringement, or other theories
based on the nature of the data or the content of the materials disseminated
through their networks. Several private lawsuits seeking to impose such
liability upon online services companies and Internet access providers are
currently pending.

  In addition, the growth and development of the market for online commerce may
prompt calls for more stringent consumer protection laws, both in the United
States and abroad, which may impose additional burdens on companies conducting
business online. Some countries may regulate or prohibit the transport of
telephony data in their territories. The imposition upon us and other Internet
network providers of potential liability for information carried on or
disseminated through our systems could require us to implement measures to
reduce our exposure to such liability, which may require the expenditure of
substantial resources, or to discontinue some of our service or product
offerings. Our ability to limit the types of data or content distributed through
our network is limited. Failure to comply with such regulation in a particular
jurisdiction could result in fines or penalties or the termination of our
service in such jurisdiction. The increased attention focused upon liability
issues as a result of these lawsuits and legislative proposals could impact the
growth of Internet use. Our professional liability insurance may not be adequate
to compensate or may not cover us in the event we become liable for information
carried on or disseminated through our networks. Any costs not covered by
insurance incurred as a result of such liability or asserted liability could
harm our business and prospects.

Risks associated with operating in international markets could restrict our
ability to expand globally and harm our business and prospects.

  We market and sell our network services and products in the United States and
internationally. While the United States currently represents the majority of
our revenues, we expect the percentage of our international sales to increase
over time and expect to commit significant resources to expand our international
sales and marketing activities throughout year 2000. However, we may not be able
to successfully market, sell, deliver and support our networking services and
products internationally. We presently conduct international sales through local
subsidiaries in the United Kingdom, Switzerland, Germany, the Netherlands,
Japan, Malaysia and China and through distributor relationships with third
parties in countries where we have no physical presence. Our failure to manage
our international operations effectively could limit the future growth of our
business, increase our costs, lengthen our sales cycle and require significant
management attention.

There are certain risks inherent in conducting our business internationally,
such as:

  .  changes in telecommunications regulatory requirements that may
     restrict our ability to deliver services to our international
     customers;

  .  export restrictions, tariffs, differing regulatory regimes and other
     trade barriers that may impede us from adequately equipping our

                                      27
<PAGE>

     network facilities;

  .  challenges in recruiting, retaining, and managing qualified staff who
     understand the highly technical aspects of our business that could
     hinder our ability to grow and compete;

  .  differing technology standards across countries that may impede our
     ability to integrate our product offerings across international
     borders;

  .  limited international collection experience in collecting accounts
     receivable in foreign jurisdictions;

  .  political and economic instability that could lead to appropriation of
     our physical assets, impeding our ability to deliver our services to
     customers and harming our financial results;

  .  protectionist laws and business practices favoring local competition
     that may give unequal bargaining leverage to key vendors in countries
     where competition is scarce, significantly increasing our operating
     costs;

  .  increased expenses associated with marketing services in foreign
     countries;

  .  potentially adverse tax consequences, including restrictions on the
     repatriation of earnings due to unfavorable changes in tax laws or our
     physical presence in foreign countries; and

  .  the risks related to the recent global economic turbulence.

  Any of these risks could harm our international operations. For example, some
European countries already have laws and regulations related to content
distributed on the Internet and technologies used on the Internet that are more
strict than those currently in force in the United States. Furthermore, there is
an on-going debate in Europe as to the regulation of certain technologies we
use, including caching and mirroring. That debate could result in a directive
relating to the reform of copyright in the European Community which will, if
made into law, restrict caching and mirroring. Any or all of these factors could
cause our business and prospects to suffer.

Foreign exchange fluctuations could decrease our revenues or cause us to lose
money, especially since we do not hedge against currency fluctuations.

  Although, to date, substantially all of our customers have paid for our
services in U.S. dollars, we currently pay some of our suppliers in foreign
currencies, which subjects us to currency fluctuation risks. For fiscal 1998 and
fiscal 1999, costs denominated in foreign currencies were nominal and we had no
foreign currency losses during those periods. However, we believe that in the
future an increasing portion of our revenues and costs will be denominated in
foreign currencies. In particular, we expect that with the introduction of the
Euro, an increasing portion of our international sales may be Euro-denominated.
We currently do not engage in foreign exchange hedging activities and, although
we have not yet experienced any material losses due to foreign currency
fluctuation, our international revenues are subject to the risks of foreign
currency fluctuations and such risks will increase as our international revenues
increase.

Government regulation and legal uncertainties could limit our business or slow
our growth.

                                      28
<PAGE>

  Our services include the transmission of data over public telephone lines.
These transmissions are subject to the regulatory authority of the Federal
Communications Commission and the state public utility commissions although, to
date, neither has elected to exercise such authority. Our services could be
affected by changes in federal and state law or regulation in the
telecommunications arena, especially changes relating to telecommunications
markets in general and the Internet in particular. Such changes could directly
or indirectly affect our costs, limit usage or subscriber-related information,
and increase the likelihood or scope of competition from Regional Bell Operating
Companies or other telecommunications companies.

  As our services become available over the Internet in additional foreign
countries, and as we facilitate sales by our customers to end users located in
such foreign countries, these foreign jurisdictions may decide that we are
required to qualify to do business in their jurisdictions, which may subject us
to taxes and other costs. It is also possible that claims could be made against
online service companies and Internet service providers under foreign law for
defamation, negligence, copyright or trademark infringement, or other theories
based on the nature and content of the materials disseminated through their
networks.

  Implementation of any future changes in law or regulation, including those
discussed herein, could cause our business and prospects to suffer. Our business
and prospects may also be harmed by the imposition of certain tariffs, duties
and other import restrictions on facilities and resources that we obtain from
non-domestic suppliers. As a result, changes in law or regulation in the United
States or elsewhere could cause our business and prospects to suffer.

Substantial leverage and debt service obligations may adversely affect our cash
flow.

  We have substantial amounts of outstanding indebtedness, primarily  consisting
of the convertible subordinated notes that were issued in February  2000. As a
result of this indebtedness, our principal and interest payment  obligations
have increased substantially. There is the possibility that we may be unable to
generate cash sufficient to pay the principal of, interest on and other amounts
due in respect of our indebtedness when due. We may also obtain  additional long
term debt and working capital lines of credit to meet future  financing needs.
There can be no assurance that any financing arrangements will be available.

  Our substantial leverage could have significant negative consequences,
including:

  .  increasing our vulnerability to general adverse economic and industry
     conditions;

  .  limiting our ability to obtain additional financing;

  .  requiring the dedication of a substantial portion of our expected cash
     flow from operations to service our indebtedness, thereby reducing
     the amount of our expected cash flow available for other purposes,
     including capital expenditures;

  .  limiting our flexibility in planning for, or reacting to, changes in our
     business and the industry in which we compete; and

  .  placing us at a possible competitive disadvantage vis-a-vis less
     leveraged competitors and competitors that have better access to
     capital resources.

The notes are subordinated to all other senior debt.

   The notes are unsecured and subordinated in right of payment to all of  our
existing and future senior indebtedness, as defined in the indenture   governing
the notes. As a result, in the event of bankruptcy, liquidation or
reorganization or upon acceleration of the notes due to an event of default,  as
defined herein, and in specific other events, our assets will be available  to
pay obligations on the notes only after all senior indebtedness has been  paid
in full in cash or other payment satisfactory to the holders of senior
indebtedness. There may not be sufficient assets remaining to pay amounts due on
any or all of the notes then

                                      29
<PAGE>

outstanding. The notes are also effectively subordinated to the liabilities,
including trade payables, of any of our subsidiaries. The indenture governing
the notes does not prohibit or limit the incurrence of senior indebtedness or
the incurrence of other indebtedness and other liabilities by us or our
subsidiaries. The incurrence of additional indebtedness and other liabilities by
us or our subsidiaries could adversely affect our ability to pay obligations on
the notes. As of June 30, 2000, we had approximately $19.0 million of
indebtedness outstanding that would have constituted senior indebtedness. We
anticipate that from time to time we will incur additional indebtedness,
including senior indebtedness.

The notes contain limitations on redemption upon a change in control.

  Upon a change in control, as defined herein, each holder of the notes has
rights, at the holder's option, to require us to redeem all or a portion of  the
holder's notes. Although the indenture allows us, subject to satisfaction of
conditions, to pay the redemption price in shares of common stock, if a change
in control were to occur, we may not have sufficient funds to pay the
redemption price for all the notes tendered by holders. Any future credit
agreements or other agreements relating to other indebtedness, including other
senior indebtedness, to which we become a party may contain restrictions or
prohibitions on the payment of the redemption price while such indebtedness is
outstanding. In the event a change in control occurs at a time when we are
prohibited from purchasing or redeeming the notes, we could seek the consent of
lenders to the purchase of the notes or could attempt to refinance the
borrowings that contain this prohibition. If we do not obtain a consent or repay
these borrowings, we would remain prohibited from purchasing or redeeming the
notes. Our failure to redeem tendered notes would constitute an event of default
pursuant to the indenture under which the notes will be issued, which might
constitute a default under the terms of other indebtedness that we may enter
into from time to time. In these circumstances, the subordination provisions in
the indenture would likely restrict payments to the holders of the notes. The
term "change in control" is limited to specified transactions and may not
include other events that might adversely affect our financial condition. In
addition, the requirement that we offer to repurchase the notes upon a change in
control does not necessarily afford holders of the notes protection in the event
of a highly leveraged transaction, reorganization, merger or similar transaction
involving us.

  Our stock has been and will likely continue to be subject to substantial price
and volume fluctuations due to a number of factors, some of which are beyond our
control.

  Stock prices and trading volumes for many Internet companies fluctuate widely
for a number of reasons, including some reasons which may be unrelated to their
businesses or results of operations. This market volatility, as well as general
domestic or international economic, market and political conditions, could
materially adversely affect the price of our common stock without regard to our
operating performance. In addition, our operating results may fall below the
expectations of public market analysts and investors. If this were to occur, the
market price of our common stock would likely significantly decrease. Sales of
substantial amounts of our common stock (including shares issued upon the
exercise of outstanding options and warrants) in the public, or the appearance
that a large number of shares is available for sale, could depress the market
price for our common stock.

  Our executive officers, directors and parties related to them own a large
enough percentage of our outstanding common stock to have an influence on the
matters presented to stockholders. As a result, these stockholders may have the
ability
                                      30
<PAGE>

to control matters requiring stockholder approval, including the election and
removal of directors, the approval of significant corporate transactions, such
as any merger, consolidation or sale of all or substantially all of Digital
Island's assets, and the control of the management and affairs of Digital
Island. Accordingly, such concentration of ownership may have the effect of
delaying, deferring or preventing a change in control of Digital Island,
impeding a merger, consolidation, takeover or other business combination
involving Digital Island or discouraging a potential acquirer from making a
tender offer or otherwise attempting to obtain control of Digital Island, which
in turn could have an adverse effect on the market price of Digital Island's
common stock.

Our management has broad discretion in allocating proceeds from the February
2000 secondary stock offering and convertible subordinated note issuance, which
it may not use effectively.

The net proceeds to us from our recent offerings, after deducting any
underwriting commissions and expenses payable by us, were approximately $744
million. The primary purpose of our recent offerings were to fund operating
losses, working capital needs and capital expenditures expected to be incurred
in connection with the execution of our business plan, including the expansion
of our operations. A portion of the net proceeds may also be used to repay
currently outstanding or future indebtedness, or to acquire or invest in
complementary businesses or products. Accordingly, our management will retain
broad discretion as to the allocation of most of the proceeds of the recent
offerings. The failure of management to apply these funds effectively could
negatively impact our business and prospects.


                           PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

  None.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.

  (c) Recent Sales of Unregistered Securities

Sale of Common Stock and Issuance of Common Stock Warrants to Microsoft
Corporation, Intel Corporation and CPQ Holdings

      On June 22, 2000, Microsoft Corporation, Intel Corporation and CPQ
Holdings, Inc. purchased an aggregate of 1,855,668 shares of our common
stock for an aggregate of approximately $45,000,000 in cash. In connection with
the stock purchase, Microsoft, Intel and CPQ Holdings were also issued warrants
to purchase a maximum of 556,701 shares of our common stock. The warrant
agreements provide that the number of shares of our common stock that can be
purchased will be reduced if we meet certain milestones. The shares and the
warrants were issued pursuant to an exemption from registration under Section
4(2) of the Securities Act of 1933, as amended.

Sale of Common Stock to UBS O'Connor LLC

  On June 2, 2000, UBS O'Connor LLC purchased 738,688 shares of our common stock
for an aggregate of approximately $15,000,000 in cash. The shares were issued
pursuant to an exemption from registration under Section 4(2) of the Securities
Act of 1933, as amended.


                                      31
<PAGE>

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

  None.

                                      32
<PAGE>

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF STOCKHOLDERS

The Company held its annual meeting of stockholders on April 20, 2000. At such
meeting the following actions were voted upon:

a. Election of Directors

<TABLE>
<CAPTION>
                    For          Against    Broker Abstentions  Non-Votes
                 ----------      -------    ------------------  ---------
<S>              <C>             <C>        <C>                 <C>
Ruann F. Ernst   40,220,711      163,648             0              0
Charlie Bass     40,230,598      153,761             0              0
</TABLE>

b. Approval of amendments to the 1999 Stock Incentive Plan to (1) increase the
number of shares of common stock available for issuance under the plan by an
additional 3,000,000 shares; (2) effect certain changes to the automatic share
increase provisions under the plan; and (3) effect certain changes to the
automatic stock option grant program in effect for the non-employee board
members under the plan.

<TABLE>
<CAPTION>
       For          Against       Broker Abstentions     Non-Votes
       ---          -------       ------------------     ---------
<S>                <C>            <C>                    <C>
   31,984,519      8,377,047             22,793              0
</TABLE>

c. Ratification of PricewaterhouseCoopers as the Company's independent
accountants for the fiscal year ending July 29, 2000.

<TABLE>
<CAPTION>
       For          Against       Broker Abstentions     Non-Votes
       ---          -------       ------------------     ---------
<S>                 <C>           <C>                    <C>
   40,346,061       30,025               8,273               0
</TABLE>

ITEM 5. OTHER INFORMATION.

  None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

  (a) Exhibits.

      4.1    Form of Amendment No. 2 to the Amended and Restated Investors'
             Rights Agreement, dated June 20, 2000.

      10.1   Form of Employment Agreement between the Registrant and Howard
             Lasky

      27.1   Financial Data Schedule

  (b) Reports on Form 8-K.

     None.

                                      33
<PAGE>

                                   SIGNATURES

  Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.


Date: August 14, 2000       DIGITAL ISLAND, INC.
                            (Registrant)

Date: August 14, 2000       By: /s/ Ruann F. Ernst

                            Ruann F. Ernst,
                            Chief Executive Officer and
                            President
                            (Principal Executive Officer)

Date: August 14, 2000       By: /s/ T.L. Thompson

                            T.L. Thompson,
                            Chief Financial Officer
                            (Principal Financial Officer and
                            Principal Accounting Officer)

                                      34