UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549







FORM
10-K










x
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the fiscal year ended December 31, 2008




OR


o
            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: 000-31989




INTERNAP
NETWORK SERVICES CORPORATION


(Exact
Name of Registrant as Specified in Its Charter)




Delaware
            
            91-2145721(State
      or Other Jurisdiction of
            
            (I.R.S.
      EmployerIncorporation
      or Organization)
            
            Identification
      No.)250
      Williams StreetAtlanta,
      Georgia
            
            30303(Address
      of principal executive offices)
            
            (Zip
      Code)




(404)
302-9700


(Registrant’s
telephone number, including area code)




Securities
registered pursuant to Section 12(b) of the Act:




Title
      of Each Class
            
            Name
      of Exchange on Which RegisteredCommon
      Stock, $0.001 par value
            
            The
      NASDAQ Stock Market LLC(NASDAQ
      Global Market)




Securities
registered pursuant to Section 12(g) of the Act: None




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes o No x




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes o No x




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 o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405) is not contained herein, and will not be contained, to
the best of registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K/A or any
amendment to this Form 10-K/A. o




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):




Large
      accelerated filer o
            Accelerated
      filer xNon-accelerated
      filer o
            Smaller
      reporting company o(Do
      not check if a smaller reporting company)




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act). Yes o No x




The
aggregate market value of the registrant’s outstanding common stock held by
non-affiliates of the registrant was $230,695,120 based on a closing price of
$4.68 on June 30, 2008, as quoted on the NASDAQ Global Market.




As of
February 28, 2009, 50,220,438 shares of the registrant’s common stock, par
value $0.001 per share, were issued and outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE




Part
III—Portions of the registrant’s definitive Proxy Statement for the Annual
Meeting of Stockholders to be filed with Securities and Exchange Commission
within 120 days after the end of our 2008 fiscal year. Except as expressly
incorporated by reference, the registrant’s Proxy Statement shall not be deemed
to be a part of this report on Form 10-K.












TABLE
OF CONTENTS


PagePART IITEM
      1.
            
            BUSINESS
            
            1ITEM
      1A.
            
            RISK
      FACTORS
            
            9ITEM
      1B.
            
            UNRESOLVED STAFF
      COMMENTS
            
            23ITEM
      2.
            
            PROPERTIES
            
            23ITEM
      3.
            
            LEGAL
      PROCEEDINGS
            
            23ITEM
      4.
            
            SUBMISSION OF MATTERS
      TO A VOTE OF SECURITY HOLDERS
            
            24PART
      IIITEM
      5.
            
            MARKET FOR
      REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES
            
            24ITEM
      6.
            
            SELECTED FINANCIAL
      DATA
            
            28ITEM
      7.
            
            MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
            
            30ITEM
      7A.
            
            QUANTITATIVE AND
      QUALITATIVE DISCLOSURES ABOUT MARKET RISK
            
            52ITEM
      8.
            
            FINANCIAL STATEMENTS
      AND SUPPLEMENTARY DATA
            
            53ITEM
      9.
            
            CHANGES IN AND
      DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE
            
            53ITEM
      9A.
            
            CONTROLS AND
      PROCEDURES
            
            53ITEM
      9B.
            
            OTHER
      INFORMATION
            
            53PART
      IIIITEM
      10.
            
            DIRECTORS, EXECUTIVE
      OFFICERS AND CORPORATE GOVERNANCE
            
            54ITEM
      11.
            
            EXECUTIVE
      COMPENSATION
            
            54ITEM
      12.
            
            SECURITY OWNERSHIP OF
      CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
      MATTERS
            
            54ITEM
      13.
            
            CERTAIN RELATIONSHIPS
      AND RELATED TRANSACTIONS, AND DIRECTOR
    INDEPENDENCE
            
            54ITEM
      14.
            
            PRINCIPAL ACCOUNTING
      FEES AND SERVICES
            
            54PART
      IVITEM
      15.
            
            EXHIBITS AND FINANCIAL
      STATEMENT SCHEDULES
            
            55SIGNATURES
            
            58




- i
-




FORWARD-LOOKING
STATEMENTS




This
Annual Report on Form 10-K contains “forward-looking statements” within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or
the Exchange Act. Forward-looking statements include statements regarding
industry trends, our future financial position and performance, business
strategy, revenues and expenses in future periods, projected levels of growth
and other matters that do not relate strictly to historical facts. These
statements are often identified by words such as “may,” “will,” “seeks,”
“anticipates,” “believes,” “estimates,” “expects,” “projects,” “forecasts,”
“plans,” “intends,” “continue,” “could,” “should” or similar expressions or
variations. These statements are based on our beliefs and expectations after
consideration of information currently available. Such forward-looking
statements are not guarantees of future performance and are subject to risks and
uncertainties that could cause actual results to differ materially from those
contemplated by forward-looking statements. Important factors currently known to
us that could cause or contribute to such differences include, but are not
limited to, those set forth in this Form 10-K under Item 1A “Risk Factors.” We
undertake no obligation to update any forward-looking statements as a result of
new information, future events or otherwise.




As used
herein, except as otherwise indicated by context, references to “we,” “us,”
“our,” “Internap” or the “Company” refer to Internap Network Services
Corporation.




PART I




ITEM 1. BUSINESS




Overview




We were
incorporated as a Washington corporation in 1996 and reincorporated in Delaware
in 2001. Our principal executive offices are located at 250 Williams Street,
Suite E-100, Atlanta, Georgia 30303, and our telephone number is (404) 302-9700.
Our common stock trades on the NASDAQ Global Market under the symbol
“INAP.”




We market
products and services that optimize the performance and reliability of strategic
business Internet applications for e-commerce, customer relationship management,
or CRM, multimedia streaming, Voice-over Internet-Protocol, or VoIP, virtual
private networks, or VPNs, and supply chain management. Our product and service
offerings are complemented by value-added services such as colocation and data
center services and managed security services. We also provide products and
services for storing and delivering audio and video digital media to large
audiences over the Internet following our acquisition of VitalStream Holdings,
Inc., or VitalStream, in February 2007. Our content delivery network, or CDN,
was purpose-built for streaming digital media and enables content owners to
monetize their digital media assets via both subscription and advertising-based
business models. Additionally, we offer Internet television solutions,
professional services, small business services and pre- and post-installation
services.




As of
December 31, 2008, we delivered services through our 64 service points across
North America, Europe, Asia, India and Australia, which feature direct
high-speed connections to multiple major Internet backbones such as AT&T
Inc.; Sprint Nextel Corporation; Verizon Communications Inc.; Global Crossing
Limited; and Level 3 Communications, Inc. Our proprietary route optimization
technology monitors the performance of Internet networks allowing our customer
traffic to be “intelligently” routed over the optimal path in a way that
maximizes performance and reliability of the transactions by minimizing loss and
delays inherent across the Internet. We believe our unique managed multi-network
approach provides better performance, control and reliability compared to
conventional Internet connectivity alternatives. Our service level agreements,
or SLAs, guarantee performance across the entire Internet, excluding local
connections, whereas providers of conventional Internet connectivity typically
only guarantee performance on their own network. We serve customers in a variety
of industries including entertainment and media, financial services, healthcare,
travel, e-commerce, retail and technology. As of December 31, 2008, we provided
services to approximately 3,600 customers in the United States and
abroad.




As
discussed below in “—Segments,” we operate in three business segments: IP
services, data center services and CDN services.


- 1
-




Developments
in 2008




Impairments




Goodwill.
We are required to assess goodwill for impairment under generally accepted
accounting principles in the United States, or GAAP, on at least an annual
basis. Our annual assessment date is August 1 of each year, following our
annual strategic planning cycle, which includes an update of our long-term
financial outlook.




As a
result of our August 1, 2008 assessment, we concluded that the current carrying
value of our goodwill in the CDN services segment was impaired. We recorded
the CDN services goodwill following our February 2007 acquisition of
VitalStream. We recorded a $99.7 million goodwill impairment charge to
adjust goodwill in our CDN services segment to an implied fair value of $54.7
million. The goodwill impairment charge was primarily due to declines in our CDN
services revenues and operating results as compared to our projections and
unfavorable changes in market factors used to estimate fair values.




The
impairment also caused us to reverse a deferred tax liability and create an
income tax benefit of $0.6 million associated with the CDN services
goodwill.




We also
assessed the likelihood of triggering events and concluded that none
had occurred that would cause us to re-assess goodwill for impairment
subsequent to August 1, 2008.




Other
Intangible Assets. In conjunction with our August 1, 2008 review of our
long-term financial outlook, we also performed an analysis of the potential
impairment, and re-assessed the remaining asset lives, of other identifiable
intangible assets acquired in the VitalStream acquisition. This analysis
and re-assessment resulted in: (1) an impairment charge of $1.9 million in
developed advertising technology due to a strategic change in market focus, (2)
an impairment charge of $0.8 million in trade names as a result of discontinuing
use of the VitalStream trade name and (3) a change in our estimates that
resulted in acceleration of amortization expense of our customer
relationships intangible asset over a shorter estimated useful life (four
remaining years instead of the original estimated nine years) due to customer
churn resulting in higher than expected attrition as of our acquisition
date.




These
non-cash charges to earnings and change in estimated useful life had no impact
on our cash balance as of December 31, 2008 and did not result in a violation of
any covenants in our debt instruments.




We
discuss these impairments in note 8 to the accompanying consolidated financial
statements and the sections captioned “Results of Operations—Other Operating
Expenses—Goodwill Impairment” and “—Restructuring and Other Impairments” under
Item 7 “Management’s Discussion and Analysis of Financial Condition and Results
of Operations.”




Restructuring.In
conjunction with the preparation of our financial statements as of and for the
year ended December 31, 2008 and in light of the recent and significant
deterioration in the real estate market, we completed an analysis of our
remaining accrued restructuring liability for leased facilities. After reviewing
the analysis and specifically the underlying assumptions related to anticipated
sublease recoveries, we concluded that certain of the facilities remaining in
the restructuring accrual were taking longer than expected to sublease or were
otherwise not generating the expected levels of sublease income. The analyses
were based on discounted cash flows using the same credit-adjusted risk-free
rate that we used to measure the initial restructuring liability for leases that
were part of the 2007 restructuring plan and undiscounted cash flows for leases
that were part of the 2001 restructuring plan. The cumulative effect of these
changes was $1.1 million, which we recorded as additional restructuring expense
and an increase to the liability. We discuss this charge in note 9 and report it
in “Restructuring and other impairments” in the accompanying consolidated
statements of operations, along with a $0.8 million impairment of the
VitalStream tradename and a reduction of the accrued liability of $0.1 million
for employee separations since we paid all such amounts. We estimated net
related expenditures for the 2007 restructuring plan to be $12.2 million, of
which we paid $4.2 million through December 31, 2008, and the balance continuing
through December 2016, the last date of the longest lease term. We expect to pay
these expenditures out of operating cash flows. We estimate cost savings from
the restructuring to be approximately $0.8 million per year through 2016,
primarily for rent.




Credit
Agreement. On September 30, 2008, we amended our credit agreement with
Bank of America, N.A. The amendment consolidated a two-tiered debt facility into
a single revolving loan. Under the amended credit facility, we converted the
previously-existing $20.0 million term loan balance and outstanding letters of
credit with Bank of America into a $35.0 million revolving loan facility. The
amendment extended the principal settlement terms from quarterly payments,
scheduled to begin in the third quarter of 2008, to a single principal repayment
due in 2011. As of December 31, 2008, we had $10.8 million of borrowing capacity
on the revolving credit facility. We discuss this amended credit agreement in
note 11 to the accompanying consolidated financial statements and the section
captioned “Liquidity and Capital Resources” under Item 7 “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations.”


- 2
-




Global Economic
Conditions. We are currently in a time of severe deteriorating economic
conditions and have seen signs of slowdowns and cautious behavior from our
customers. During the year ended December 31, 2008, we increased our
provision for doubtful accounts, in part after taking into consideration current
economic conditions. We are continuing to monitor and review our performance and
operations in light of the continuing negative global economic conditions. In
particular, we continue to analyze our business to control our costs,
principally through making process enhancements and renegotiating network
contracts for more favorable pricing and terms.




Industry
Background




The
Emergence of Multiple Internet Networks




The
Internet originated as a restricted network designed to provide efficient and
reliable long distance data communications among the disparate computer systems
used by government-funded researchers and organizations. As the Internet
evolved, businesses began to use the Internet for functions critical to their
core business and communications. Telecommunications companies established
additional networks to supplement the original public infrastructure and satisfy
increasing demand. Currently, the Internet is a global collection of multitudes
of interconnected computer networks, forming a network of networks. These
networks were developed at great expense but are nonetheless constrained by the
fundamental limitations of the Internet’s architecture. Each network must
connect to one another to permit its users to communicate with each other.
Consequently, many Internet network service providers, or ISPs, have agreed to
exchange large volumes of data traffic through a limited number of public
network access points and a growing number of private connections, called
peering.




Peering
network access points are not centrally managed. We believe that no single
entity has the economic incentive or ability to facilitate problem resolution or
to optimize peering within the public network access points, nor the authority
to bring about centralized routing administration. Additionally, since these
arrangements are based on non-regulated agreements, disagreements between
carriers impact performance. As a consequence of the lack of coordination among
networks at these public peering points, and to avoid the increasing congestion
and the potential for resulting data loss at the public network access points, a
number of ISPs have established private interfaces connecting with their peers
for the exchange of traffic. Although private peering arrangements are helpful
for exchanging traffic, they do not solve all of the structural and economic
shortcomings of the Internet.




The
Problem of Inefficient Routing of Data Traffic on the Internet




An
individual ISP, only controls the routing of data within its network, and its
routing practices tend to compound the inefficiencies of the Internet. When an
ISP receives a packet that is not destined for one of its own customers, it must
route that packet to another ISP to complete the delivery of the packet on the
Internet. Since the use of a public network access point or a private peering
point typically involves no economic settlement, an ISP will often route the
data to the nearest point of traffic exchange, in an effort to get the packet
off its network and onto a competitor’s network as quickly as possible to reduce
capacity and management burdens on its transport network. Once the origination
traffic leaves the network of an ISP, SLAs with that ISP typically do not apply
since that carrier cannot control the quality of service on the network of
another ISP. Consequently, to complete a communication, data ordinarily passes
through multiple networks and peering points without consideration for
congestion or other factors that inhibit performance. For customers of
conventional Internet connectivity providers, this transfer can result in lost
data, slower and more erratic transmission speeds and an overall lower quality
of service, especially where the ISP is not familiar with the performance of the
destination network. Equally important, these customers have no control over the
transmission arrangements and have no single point of contact that they can hold
accountable for degradation in service levels, such as poor data transmission
performance or service failures. As a result, it is virtually impossible for a
single ISP to offer a high quality of service across disparate
networks.




The
Problem of Poor Application Performance over Distant Network Paths




The major
protocols often utilized over data networks perform poorly when network latency
is large or network paths are subject to packet and data loss. Network latency
is a measure of the time it takes data to travel between two network points. In
networks, network latency often depends on physical distance but may also depend
on conditions such as congestion. One measure of performance is effective
throughput. Throughput is defined as the rate of data transfer, typically
expressed in bits per second or megabits per second, or Mbps. It can be limited
by the size of the network connection, for example, 1.5Mbps for a standard T1
data connection, or it can be limited by the protocols reacting to certain
network conditions, such as latency or packet loss. Typically, throughput is
inversely proportional to network latency. Network latency is a significant
factor when communicating over vast distances such as the global network paths
between two continents. The more distant the communicating parties are from each
other, the higher the network latency will be resulting in lower effective
throughput. This throughput may be lower than the available network capacity and
often results in poor utilization of purchased network capacity. Additionally,
many network protocols react to packet loss by requesting a retransmission of
the missing data. This retransmission is often interpreted as intermediate
network congestion by the protocol that then responds with more conservative
network usage and a further reduction of effective throughput. As a result,
business applications that must communicate over the vast distances common in
the global economy are subject to these limitations, which result in poor
application performance and poor utilization of network assets. Network
conditions vary significantly in many parts of the developing world and may also
result in poor application performance. Yet the global economy is a factor in
many businesses operating in these parts of the developing world where distances
are vast and network conditions are poor.


- 3
-




The
Growing Importance of the Internet for Business-Critical Internet-Based
Applications




Once
primarily used for e-mail and basic information retrieval, the Internet is now
used as a communications platform for an increasing number of business-critical
Internet-based applications, such as those relating to electronic commerce,
VoIP, supply chain management, customer relationship management, project
coordination, streaming media and video conferencing and
collaboration.




Businesses
are unable to benefit from the full potential of the Internet primarily because
of performance issues discussed above. The emergence of technologies and
applications that rely on network quality and require consistent, high-speed
data transfer, such as VoIP, multimedia document distribution and streaming and
audio and video conferencing and collaboration, are hindered by inconsistent
performance. We believe that providers who provide a consistently high quality
of service that enables businesses to successfully and cost effectively execute
their business-critical Internet-based applications over the public network
infrastructure through superior performance Internet routing services will drive
the market for Internet services.




The
Growing Demand for Delivery of Rich Media Content over the Internet




The
proliferation of Internet-connected devices and broadband Internet connections
coupled with increased consumption of media over the Internet including
personalized media content have created a demand for delivery of rich media
content. Increasingly, as the volume and quality of dynamic content progresses,
viewers of all ages are spending more and more time using the
Internet. Viewers now expect to be able to watch a movie or television show
online, view the latest news clips, take a virtual walk-through of a home, hear
a podcast, watch a live sporting event or concert or participate in an
educational course, just to name a few examples. Companies that need to
deliver rich media content can either deliver the content using basic Internet
connectivity or utilize a content distribution network, or CDN. Because of
the inherit weaknesses of the Internet, delivery of rich media content is not
reliable. To overcome this problem, companies can either invest substantial
capital to build the infrastructure to bypass the public Internet or utilize a
third party’s CDN.




Our
Market Opportunity




Historically,
ISPs have maintained at-will agreements to deliver Internet traffic on a “best
efforts” basis without guaranteeing various levels of quality of service. This
best efforts delivery is sub-optimal for time-sensitive and real-time
applications that require uninterrupted streams of data such as voice and video.
For companies that rely on the Internet as a medium for commerce or relationship
management, this unpredictable performance often translates into lost revenue,
decreased productivity and dissatisfied customers.




The
Internet serves as a core component of many direct sales, supply chain and
collaboration strategies and has extended our customers’ ability to reach global
partners, suppliers and customers. This changing landscape, combined with an
increasingly dispersed workforce and the adoption of emerging technologies like
VoIP and streaming media, has increased the need for fast, reliable connectivity
and delivery of content rich media. We believe Internap meets this requirement
and is well positioned to help businesses leverage the Internet to attain
improved productivity, decreased transactional costs and new revenue
streams.




Segments




We
operate in three business segments: IP services, data center services and CDN
services. The following is a brief description of each of our reportable
business segments. Financial information regarding our segments can be found in
note 4 to our accompanying consolidated financial statements and in
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Results of Operations.”




IP
Services




High
Performance Internet Protocol, or IP. Our patented and patent-pending
network performance optimization technologies address the inherent weaknesses of
the Internet, allowing enterprises to take advantage of the convenience,
flexibility and reach of the Internet to connect to customers, suppliers and
partners. Our solutions take into account the unique performance requirements of
each business application to ensure performance as designed, without unnecessary
cost. Prior to recommending appropriate network solutions for our customers’
applications, we consider key performance objectives including (1) performance
and cost optimization, (2) application control and speed and (3) delivery and
reach. Our fees for IP services are based on a fixed-fee, usage or a combination
of both.


- 4
-


Our
managed intelligent routing service provides fast, reliable connectivity to all
major backbones and dynamically identifies the optimal path for our customers’
traffic. The service is also supported by SLAs with 100% network availability,
excluding local connections. Our team of certified network engineers supports
our customers 24 hours a day, every day of the year.


Flow
Control Platform. Our IP services segment also includes our flow control
platform, or FCP. Our FCP is a premise-based intelligent routing hardware
product for customers who run their own multiple network architectures, known as
multi-homing. The prevalence of multi-homed networks is increasing. To operate
each network at the highest performance level, a significant amount of expertise
is required to monitor and adjust to global Internet routing, which is very
dynamic in nature. The FCP functions similarly to our P-NAP, monitoring the
global Internet and automatically adjusting routing real-time to balance the
traffic across multiple links to optimize performance. FCP can be tuned to
manage network traffic on two dimensions: cost and performance. The user can set
thresholds that balance performance against cost, for example routing all
traffic across low cost providers while specific minimum performance thresholds
are met. If the performance deteriorates, then the traffic can be routed over a
better performing but more costly provider to maintain minimum specified
performance. This option allows our customer to enjoy service with the optimized
performance and economics. Another key feature is minute-by-minute visibility
reports and logs on the performance and operation of the customer’s network. Our
customers find this information to be useful for carrier SLA verification,
monitoring and overall network management.




FCP is
one of only a few of the industry’s route control appliances that analyzes and
re-routes Internet traffic flows in real-time. We offer FCP as either a one-time
hardware purchase or as a monthly subscription service. Sales of FCP also
generate annual maintenance fees and professional service fees for installation
and ongoing network configuration. Since the FCP emulates our P-NAP service in
many ways, this product affords us the opportunity to serve customers outside of
our P-NAP market footprint. This product represents approximately 4% of our IP
services revenue and approximately 2% of our consolidated revenue for the year
ended December 31, 2008.




Data
Center Services




Our data
center, or colocation, services allow us to expand the reach of our high
performance IP services to customers who wish to take advantage of locating
their network and application assets in secure, high-performance facilities.
Throughout this Form 10-K, we refer to data center services and colocation
services interchangeably. We operate data centers where customers can host their
applications directly on our network to eliminate issues associated with the
quality of local connections. Data center services also enable us to have a more
flexible product offering, such as bundling our high performance IP connectivity
and managed services such as content delivery along with hosting customers’
applications. Our data center services provide a single source for network
infrastructure, IP and security, all of which are designed to maximize
solution performance while providing a more stable, dependable infrastructure,
and are backed by guaranteed service levels and our team of dedicated support
professionals.




To
maximize this footprint, we use a combination of facilities managed by us and
facilities managed by third parties, referred to as partner sites. We offer a
comprehensive solution at 46 service points, consisting of eight locations
managed by us and 38 locations managed by third parties. We charge monthly fees
for data center services based on the amount of square footage that the customer
leases in our facilities. We also have relationships with various providers to
extend our P-NAP model into markets with high demand.




CDN
Services




Our CDN
services enable our customers to quickly and securely stream and distribute
video, audio and software to audiences across the globe through strategically
located data centers. Providing capacity-on-demand to handle large events and
unanticipated traffic spikes, we deliver high-quality content regardless of
audience size or geographic location. Our MediaConsole® content management tool
provides our customers the benefit of a single, easy to navigate system
featuring Media Asset Management, Digital Rights Management, or DRM, support and
detailed reporting tools. With MediaConsole, our customers can use one
application to manage and control access to their digital assets, view network
conditions and gain insight into habits of their viewing audience. Prior to our
acquisition of VitalStream in February 2007, we did not offer proprietary CDN
services, but instead, we were a reseller of third party CDN services for
which the results of operations are included in “—Other Revenues and Direct
Costs of Network, Sales and Services,” discussed below.




We offer
the following products and services based on our CDN:




Next
Generation Route-Optimized Hybrid Content Delivery.Our route-optimized
hybrid content delivery model is a blend of both decentralized, or “edge
caching,” and centralized storage content delivery models. It incorporates large
geographically-distributed caches strategically located at “route-optimized”
locations throughout the provider’s network along with a small number of large
content storage locations. Our integration of route optimization technology
within the CDN overcomes the issues that arise when the content is being
delivered by a poorly performing network. The route optimization technology
analyzes the traffic situation on every major Internet backbone and then detects
the best route for the content to take. The technology also allows for the
adjustment of additional locations in which popular content is cached, so that
popular files may end up on many servers, as opposed to less popular or
larger-sized files that may only exist on a handful of servers. It also directs
the end-user to the most appropriate data center for streaming or downloading
content based on capacity and availability, improving delivery performance at
the source by avoiding overload at one location (thus eliminating stuttering
videos or plain stops in the stream).




- 5
-




Our
network is protected by security systems, including firewalls, proxies and
private networking to protect critical systems from intruders. We continuously
monitor for security vulnerabilities and malicious activity and employ a staff
of security experts to respond to security-related incidents. Additionally, we
provide various encryption and digital rights management services that allow our
customers to protect their content on our network.




Streaming Service for Flash.
We worked closely with Adobe and Microsoft to develop streaming platforms. We
are an experienced Flash video and Windows Media streaming service provider,
supporting Flash 8 and Flash Media Server 2.5, and we have been a Microsoft
Premier Certified Hosting Service provider since 2002. These methods of
delivering video on demand and other content are reliable, interactive and easy
to use, giving our customers the opportunity to utilize their existing
development environment and streamlining their workflow. Our video streaming
services permit our customers to upload files to our streaming network without
having to set up and maintain video servers.




Content Delivery Service. Our
streaming customers often need to utilize download services as part of their
business solution. In response to this customer demand, we provide file download
services to enable our customers to download critical content including HTML,
graphics, media files, software and podcasts to their customers.




Value-Added Services. We also
provide a suite of value-added services that provides our customers with a
comprehensive solution including Managed Server, Content Management,
Transcoding, Video Players, Authentication and various virtualization
technologies. This single-solution provider approach enables our customers to
accelerate time-to-market, lower operating expenses and simplify implementation
and on-going support.




Network
Access Points, Points of Presence and Data Centers




We
provide our services through our network access points across North America, and
in Europe, Asia, India and Australia. Our network access points and data centers
feature direct high-speed connections to multiple major Internet backbones, also
referred to as network service providers or NSPs, including AT&T Inc.;
Sprint Nextel Corporation; Verizon Communications Inc.; Global Crossing Limited;
and Level 3 Communications. Through our CDN points of presence, or POPs, we
provide access to the Internet for our CDN customers. As of December 31, 2008,
we provided services worldwide through 62 IP service points, 25 CDN POPs and 46
data center locations. We directly operate eight of these data center sites and
have operating agreements with third parties for the remaining locations in the
following markets, some of which have multiple sites:


Internap
      operated
            
            Operated
      under third party agreementsAtlanta
            
            Atlanta
            Oakland
            AmsterdamBoston
            
            Boston
            Orange
      County/
            Hong
      KongHouston
            
            Chicago
            San
      Diego
            LondonNew
      York
            
            Dallas
            Philadelphia
            MumbaiSeattle
            
            Denver
            Phoenix
            Osaka
      (1)Los
      Angeles
            San
      Francisco
            SingaporeMiami
            San
      Jose
            SydneyNew
      York
            Washington
      DC
            Tokyo
      (1)Toronto




(1)
              Through
      our joint venture in Internap Japan Co., Ltd. with NTT-ME Corporation and
      Nippon Telegraph and Telephone
Corporation.




We are
dependent upon the NSPs noted above as well as other ISPs, telecommunications
carriers and other vendors in the United States, Europe, Asia, India and
Australia.




Other




Other
revenues and direct costs of network, sales and services consist of third party
CDN services. Throughout 2007, other revenues and direct costs of network, sales
and services decreased steadily as the revenue streams from our acquisition of
VitalStream replaced the activity of the former third-party CDN service
provider.


- 6
-




Financial
Information about Geographic Areas




For each
of the years ended December 31, 2008, 2007 and 2006, we derived less than 10% of
our total revenues from our operations outside the United States.




Sales
and Marketing




Our sales
and marketing objective is to achieve market penetration and increase brand
recognition among business customers in key industries that use the Internet for
strategic and business-critical operations. We employ a direct sales team with
extensive and relevant sales experience with our target market. Our sales
offices are located in key cities across North America, as well as one office
each in the United Kingdom and Singapore.




Our sales
and service organization includes 106 employees in direct and channel sales,
professional services, account management and technical consulting. As of
December 31, 2008, we had approximately 66 direct sales representatives whose
performance is measured on the basis of achievement of quota
objectives.




To
support our sales efforts and promote the Internap brand, we conduct
comprehensive marketing programs. Our marketing strategies include on-line
advertisements, participation at trade shows, an active public relations
campaign and continuing customer communications. As of December 31, 2008,
we had seven employees in our marketing department.




Research
and Development




Product
development costs are primarily related to network engineering costs associated
with changes to the functionality of our proprietary services and network
architecture. Research and development costs, which we include in product
development cost and expense as incurred, primarily consist of
compensation related to our development and enhancement of IP
routing technology, progressive download and streaming technology for our
CDN, acceleration and cloud technologies. Research and development
costs were $5.0 million, $3.1 million and $2.4 million for the years ended
December 31, 2008, 2007 and 2006, respectively. These costs do not include $1.4
million, $1.6 million and $0.9 million in internal software development costs
capitalized during the years ended December 31, 2008, 2007 and 2006,
respectively. We also expense as incurred those costs that do not qualify
for capitalization as software development costs.




Customers




As of
December 31, 2008, we had approximately 3,600 customers. We provide
services to customers in multiple vertical industry segments including
entertainment and media, financial services, healthcare, travel, e-commerce,
retail and technology. However, our customer base is not concentrated in any
particular industry. In each of the past three fiscal years, no single customer
has accounted for 10% or more of our net sales. We did not derive any
significant amounts of revenue for any of the years ended December 31, 2008,
2007 and 2006 from contracts or subcontracts terminable or renegotiation at
the election of the federal government, and we do not expect such contracts to
be a significant percentage of our total revenue in 2009.




Competition




The
market for managed services, premise-based products and content delivery is
intensely competitive and is characterized by technological change, the
introduction of new products and services and price erosion. We believe that the
principal factors of competition for service providers in our target markets
include: speed and reliability of connectivity, quality of facilities, level of
customer service and technical support, price and brand recognition. We believe
that we compete favorably on the basis of these factors.




Our
current and potential competition primarily consists of:


●
            NSPs
      that provide connectivity services, including AT&T Inc.; Sprint Nextel
      Corporation; Verizon Communications Inc.; Level 3 Communications, Inc.;
      Global Crossing Limited and Verio, an NTT Communications
      Company;●
            regional
      Bell operating companies that offer Internet access and managed
      services;●
            global,
      national and regional ISPs such as Orange Business Services, BT Infonet,
      and Savvis, Inc.;●
            providers
      of specific applications or solutions, such as content delivery, security
      or storage such as Akamai Technologies, Inc.; Limelight Networks, Inc.; CD
      Networks Co., Ltd.; Mirror Image Internet, Inc.; Symantec Corporation;
      Network Appliance, Inc. and Virtela Communications,
  Inc.;


- 7
-





●
              software-based,
      Internet infrastructure companies focused on IP route control and wide
      area network optimization products such as Riverbed Technology, Inc.; F5
      Networks, Inc. and Radware Ltd.; and●
              colocation
      and data center providers, including Equinix, Inc.; Switch & Data
      Facilities Company, Inc.; Terremark Worldwide, Inc.; Navisite, Inc.; 365
      Main Inc.; Quality Technology Services; Savvis, Inc. and Neon
      Communications Group, Inc.




Competition
has resulted, and will likely continue to result, in declining prices for our
services.




Many of
our competitors have longer operating histories and presence in key markets,
greater name recognition, larger customer bases and significantly greater
financial, sales and marketing, distribution, technical and other resources than
we have. As a result, these competitors may be able to adapt more quickly to new
or emerging technologies and changes in customer requirements or to devote
greater resources to the promotion and sale of their products. In all of our
target markets, we also may face competition from newly established competitors,
suppliers of products or services based on new or emerging technologies and
customers that choose to develop their own network solutions. We also may
encounter further consolidation in the markets in which we compete. In addition,
competitors may develop technologies that more effectively address our markets
with services that offer enhanced features or lower costs. Increased competition
could result in pricing pressures, decreased gross margins and loss of market
share, which may materially and adversely affect our business, consolidated
financial condition, results of operations and cash flows.




See “Risk
Factors—We may not be able to compete successfully against current and future
competitors” below.




Intellectual
Property




We rely
on a combination of copyright, patent, trademark, trade secret and other
intellectual property law, nondisclosure agreements and other protective
measures to protect our proprietary rights. We also utilize unpatented,
proprietary know-how and trade secrets and employ various methods to protect
such intellectual property. As of December 31, 2008, we had 14 patents (nine
issued in the United States and five issued worldwide) that extend to various
dates between approximately 2017 and 2027, and eight registered
trademarks. We believe our intellectual property rights are significant and
that the loss of all or a substantial portion of such rights could have a
material adverse effect on our results of operations. We can offer no assurance
that our intellectual property protection measures will be sufficient to prevent
misappropriation of our technology. In addition, the laws of many foreign
countries do not protect our intellectual property rights to the same extent as
the laws of the United States. From time-to-time, third parties have or may
assert infringement claims against us or against our customers in connection
with their use of our products or services. In addition, we may desire or be
required to renew or to obtain licenses from others to further develop and
market commercially viable products or services effectively. We can offer no
assurances that any necessary licenses will be available on reasonable
terms.




Employees




As of
December 31, 2008, we had approximately 430 employees, substantially all of whom
are full-time employees. None of our employees are represented by a labor union,
and we have not experienced any work stoppages to date. We consider the
relationships with our employees to be good. Competition for technical personnel
in the industries in which we compete is intense. We believe that our future
success depends in part on our continued ability to hire, assimilate and retain
qualified personnel. We can offer no assurances that we will be successful in
recruiting and retaining qualified employees in the future.




Other
Matters




While we
are dependent upon our proprietary technology and vendors, including NSPs,
telecommunications carriers and others, we are not dependent upon raw materials.
Our business is generally not seasonal. We do not have significant backlog
orders, nor do we have any practices relating to required working capital
items.




Available
Information




The
reports we file with the Securities and Exchange Commission, or SEC, including
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and proxy statements, are available free of charge on our website at
www.internap.com. You may read and copy any materials we file with the SEC at
the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549.
For information on the operation of the Public Reference Room, call the SEC at
1-800-SEC-0330. The SEC maintains a website (www.sec.gov) that contains reports,
proxy and information statements and other information that we file with the
SEC. Our Code of Ethics is available on our website at www.internap.com under the “Investor
Services” section. Copies of the information identified above may be obtained
without charge from us by writing to Internap Network Services Corporation, 250
Williams Street, Suite E-100, Atlanta, Georgia 30303, Attention: Corporate
Secretary. Information on our website is not incorporated by reference into this
Form 10-K.


- 8
-




ITEM 1A. RISK FACTORS




We operate in a changing environment
that involves numerous known and unknown risks and uncertainties that could
materially adversely affect our operations. The risks described below highlight
some of the factors that have affected, and in the future could affect our
operations. You should carefully consider these risks. These risks are not the
only ones that we may face. Additional risks and uncertainties that we are
unaware of, or that we currently deem immaterial, also may become important
factors that affect us. If any of the following events or circumstances
described in the followings risks occurs, our business, consolidated financial
condition, results of operations or cash flows could be materially and
adversely affected.




Risks
Related to Our Business




Failure
to sustain or increase our revenues may cause our business and financial results
to suffer.




We have
considerable fixed expenses, and we plan to continue to incur significant
expenses, particularly with the expansion of our colocation and data center
facilities. We incur a substantial portion of these expenses upfront, and are
only able to recover these costs from customers over time. We must,
therefore, at least sustain or generate higher revenues to maintain
profitability. Although revenue from our data center services segment is
growing, that segment has lower margins than our other segments. If we are
unable to increase our margins in that segment, our business may
suffer.




In
addition to adding new customers, to increase our revenue, we must sell
additional services to existing customers and encourage existing customers to
increase their usage levels. If our existing and prospective customers do not
perceive our services to be of sufficiently high value and quality, we may not
be able to retain our current customers or attract new customers. Our customers
have no obligation to renew their contracts for our services after the
expiration of their initial commitment, and these service agreements may not be
renewed at the same or higher level of service, if at all. Moreover, under some
circumstances, some of our customers have the right to cancel their service
agreements prior to the expiration of the terms of their agreements. Due to the
significant upfront costs of managing data centers, if our customers fail to
renew or cancel their service agreements, we may not be able to recover the
initial costs resulting from the expansion of our facilities. Numerous factors
could affect our ability to increase revenue, either alone or in combination
with other factors, including:


●
            failure
      to increase sales of our products and services;●
            pricing
      pressures;●
            significant
      increases in bandwidth and data center costs or other operating
      expenses;●
            failure
      of our services or software to operate as expected;●
            loss
      of customers or inability to attract new customers or loss of existing
      customers at a rate greater than our increase in new
      customers;●
            inability
      of a customer to pay our fees on a timely basis or at all or failure to
      continue to purchase our services in accordance with their contractual
      commitments; or●
            network
      failures and any breach or unauthorized access to our
    network.Our
      customers’ renewal rates may decline or fluctuate as a result of a number
      of factors, including:●
            their
      satisfaction or dissatisfaction with our services;●
            the
      prices of our services and those of our competitors;●
            discontinuation
      by our customers of their Internet or web-based content distribution
      businesses;●
            mergers
      and acquisitions affecting our customer base; and●
            reduction
      in our customers’ spending levels.




- 9
-




If our
customers do not renew their service agreements with us or if they renew on less
favorable terms, our revenue may decline and our business may suffer. Similarly,
our customer agreements often provide for minimum commitments that are often
significantly below our customers’ historical usage levels. Consequently, even
if we have agreements with our customers to use our services, these customers
could significantly curtail their usage without incurring any penalties under
our agreements. In this event, our revenue would be lower than expected and our
operating results could suffer.


Pricing
pressure could decrease our revenue and threaten the attractiveness of our
premium priced services.




Pricing
for Internet connectivity services has declined significantly in recent years
and may decline in the future. An economic downturn, such as the one the
worldwide economy is now experiencing, could further contribute to this effect.
We currently charge, and expect to continue to charge, premium prices for our
high performance IP services compared to the prices charged by our competitors
for their connectivity services. By bundling their services and reducing the
overall cost of their solutions, certain of our competitors may be able to
provide customers with reduced communications costs in connection with their
Internet connectivity services or private network services, thereby
significantly increasing the pressure on us to decrease our prices. Increased
price competition, significant price deflation and other related competitive
pressures could erode our revenue and could materially and adversely affect our
results of operations if we are unable to control or reduce our costs. Because
we rely on NSPs to deliver our services and have agreed with some of these
providers to purchase minimum amounts of service at predetermined prices, our
profitability could be adversely affected by competitive price reductions to our
customers even if accompanied with an increased number of
customers.




In light
of economic factors and technological advances, companies that require Internet
connectivity have evaluated and will continue to evaluate the cost of such
services, particularly high performance connectivity services such as those we
currently offer. Consequently, existing and potential customers may be less
willing to pay premium prices for high performance Internet connectivity
services and may choose to purchase lower quality services at lower prices,
which could materially and adversely affect our business, consolidated financial
condition, results of operations and cash flows.




In
addition, prices for content delivery services have fallen in recent years and
may continue to fall further in the future. If the price that we are able to
charge customers to deliver their content falls to a greater extent than we
anticipate, if we over-estimate future demand for our services or if our costs
to deliver our services do not fall commensurate with any future price declines,
we may not be able to achieve acceptable rates of return on our infrastructure
investments, and our gross profit and results of operations may suffer
dramatically.




We
have a history of losses and may not sustain profitability.




We
incurred net losses in each quarterly and annual period since we began
operations in May 1996 through the year ended December 31, 2005. For the
years ended December 31, 2008, 2007 and 2006, we recognized net loss of $104.8
million, net loss of $5.6 million and net income of $3.7 million, respectively.
As of December 31, 2008, our accumulated deficit was $966.8 million. Considering
the competitive and evolving nature of the industry in which we operate, we may
not be able to achieve or sustain profitability on a quarterly or annual basis,
and our failure to do so could materially and adversely affect our business,
including our ability to raise additional funds.




We
may not be able to compete successfully against current and future
competitors.




The
Internet connectivity and IP services market is highly competitive, as evidenced
by recent declines in pricing for Internet connectivity services. The content
delivery market is also highly competitive and rapidly changing. We expect
competition from existing competitors to continue to intensify in the future,
and we may not have the financial resources, technical expertise, sales and
marketing abilities or support capabilities to compete successfully. Our
competitors currently include: regional Bell operating companies that offer
Internet access; global, national and regional NSPs and ISPs; providers of
specific applications or solutions such as content delivery, security or
storage; software-based and other Internet infrastructure providers and
manufacturers; and colocation and data center providers. In addition, NSPs and
ISPs may make technological advancements, such as the introduction of improved
routing protocols to enhance the quality of their services, which could
negatively impact the demand for our products and services.




In
addition, we expect that we will face additional competition as we expand our
managed services product offerings, including competition from technology and
telecommunications companies. A number of telecommunications companies, NSPs and
ISPs have offered or expanded their network services. Further, the ability of
some of these potential competitors to bundle other services and products with
their network services could place us at a competitive disadvantage. Various
companies also are exploring the possibility of providing, or are currently
providing, high-speed, intelligent data services that use connections to more
than one network or use alternative delivery methods, including the cable
television infrastructure, direct broadcast satellites and wireless local loop.
Many of our existing and future competitors may have greater market presence,
engineering and marketing capabilities and financial, technological and
personnel resources than we have. As a result, our competitors may have
significant advantages over us and may be able to respond more quickly to
emerging technologies and ensuing customer demands. Increased competition and
technological advancements by our competitors could materially and adversely
affect our business, consolidated financial condition, results of operations and
cash flows.


- 10
-




We
previously identified a material weakness in our internal control over financial
reporting which prevented us from accurately reporting our financial results in
a timely manner. We cannot guarantee that in the future we will not identify
another material weakness, which could prevent us from accurately reporting our
financial results in a future period in a timely manner, which could in turn
adversely affect our business.




We must
maintain effective internal controls to provide reliable and accurate financial
reports and prevent fraud. In addition, Section 404 of the Sarbanes-Oxley Act of
2002 requires that we assess the design and operating effectiveness of our
internal control over financial reporting. In connection with our
evaluation of internal control over financial reporting for the year ended
December 31, 2007, we identified a material weakness related to effective
controls over the analysis of requests for sales credits and billing adjustments
to provide timely information for management to assess the completeness,
accuracy, valuation and disclosure of sales adjustments. We remediated
these weaknesses during the year ended December 31, 2008. However, we may also
discover in the future additional areas of our internal controls that need
improvement. We cannot be certain that any remedial measures we may be required
to take in the future will sufficiently address and eliminate any identified
material weakness. Any additional deficiencies, significant deficiencies or
material weaknesses that we may identify in the future could require us to incur
significant costs, expend significant time and management resources or make
other changes. Any delay or failure to design and implement new or improved
controls, or difficulties encountered in their implementation or operation may
cause us to fail to meet our financial reporting obligations or prevent us from
providing reliable and accurate financial reports or avoiding or detecting
fraud. Disclosure of this material weakness, any failure to remediate such
material weakness in a timely fashion or having or maintaining ineffective
internal controls could cause investors to lose confidence in our reported
financial information.




If
we are unable to develop new and enhanced products and services that achieve
widespread market acceptance, or if we are unable to improve the performance and
features of our existing products and services or adapt our business model to
keep pace with industry trends, our business and operating results could be
adversely affected.




Our
industry is constantly evolving. The process of developing new services and
the technologies that support them is expensive, time and labor intensive and
uncertain. We may fail to understand the market demand for new services or
not be able to overcome technical problems with new services. In addition,
our customers’ needs may change in ways that we do not anticipate and these
changes could eliminate our customers’ needs for our services and render our
products and services obsolete.




Our
future success depends on our ability to respond to the rapidly changing needs
of our customers by developing or introducing new products, product upgrades and
services on a timely basis. New product development and introduction involves a
significant commitment of time and resources and is subject to a number of risks
and challenges including:


●
            managing
      the length of the development cycle for new products and product
      enhancements, which historically has been longer than
      expected;●
            adapting
      to emerging and evolving industry standards and to technological
      developments by our competitors and customers;●
            extending
      the operation of our products and services to new platforms and operating
      systems;●
            entering
      into new or unproven markets where we have limited
    experience;●
            managing
      new product and service strategies and integrating those with our existing
      products and services;●
            incorporating
      acquired products and technologies;●
            trade
      compliance issues affecting our ability to ship new products to
      international markets;●
            developing
      or expanding efficient sales channels; and●
            obtaining
      required technology licenses and technical access from operating system
      software vendors on reasonable terms to enable the development and
      deployment of interoperable
products.




In
addition, if we cannot adapt our business models to keep pace with industry
trends, our revenue could be negatively impacted. If we are not successful in
managing these risks and challenges, or if our new products, product upgrades
and services are not technologically competitive or do not achieve market
acceptance, we may lose market share, resulting in a decrease in our revenues
and earnings.


- 11
-




Many
of our current and potential customers are pursuing emerging or unproven
business models and the demand for our services and products may decline if such
models are unsuccessful.




The need
for a content delivery network is a recent technological advancement and our
customers’ business models that rely on the delivery of streaming video and
other content remain unproven. These customers will not continue to
purchase our products and services if their investment does not generate a
sufficient return. Deteriorating global economic conditions may make it
more difficult for our customers to achieve successful and sustainable returns
from business models. A reduction in spending on CDN services by such customers
could materially and adversely affect our financial condition.




We may lose
customers if they elect to develop solutions internally.




Our
customers and potential customers may decide to develop their own IP or content
delivery solutions rather than outsource these solutions to services providers
like us. In addition, our customers could decide to host their Internet
applications internally bypassing outside vendors like us. This is particularly
true as our customers increase their operations and spend greater resources on
delivering their content using third-party solutions. If we fail to offer IP,
data center or CDN services that compete favorably with in-sourced solutions, we
may lose customers or fail to attract customers that may consider pursuing this
in-sourced approach, and our business and financial results would
suffer.




We
depend on a number of NSPs to provide Internet connectivity to our network
access points. If we are unable to obtain required connectivity services on a
cost-effective basis, or at all, or if such services are interrupted or
terminated, our growth prospects and business, consolidated financial condition,
results of operations and cash flows may be adversely affected.




In
delivering our services, we rely on a number of Internet networks, many of which
are built and operated by others. In order to provide high performance
connectivity services to our customers through our network access points, we
purchase connections from several NSPs. We can offer no assurances that these
NSPs will continue to provide service to us on a cost-effective basis or on
otherwise competitive terms, if at all, or that these providers will provide us
with additional capacity to adequately meet customer demand or to expand our
business. Consolidation among NSPs limits the number of vendors from which we
obtain service, possibly resulting in higher network costs to us. We may be
unable to establish and maintain relationships with other NSPs that may emerge
or that are significant in geographic areas, such as Asia, India and Europe, in
which we may locate our future network access points. Any of these situations
could limit our growth prospects and materially and adversely affect our
business, consolidated financial condition, results of operations and cash
flows.




We
depend on third party suppliers for services and key elements of our network
infrastructure. If we are unable to obtain products or services, such as network
access loops or local loops, on favorable terms, or at all, or in the event of a
failure of these suppliers to deliver their products and services as agreed, our
ability to provide our services on a competitive and timely basis may be
impaired and our consolidated financial condition, results of operations and
cash flows could be adversely affected.




In
addition to depending on services from third party NSPs, we depend on other
companies to supply various key elements of our infrastructure, including the
network access loops between our network access points and our NSPs and the
local loops between our network access points and our customers’ networks.
Pricing for such network access loops and local loops has risen significantly
over time, and we generally bill these charges to our customers at low or no
margin. Some of our competitors have their own network access loops and local
loops and are, therefore, not subject to similar availability and pricing
issues. In addition, we currently purchase routers and switches from a limited
number of vendors. Furthermore, we do not carry significant inventories of the
products we purchase, and we have no guaranteed supply arrangements with our
vendors. A loss of a significant vendor could delay any build-out of our
infrastructure and increase our costs. If our limited source of suppliers fails
to provide products or services that comply with evolving Internet standards or
that interoperate with other products or services we use in our network
infrastructure, we may be unable to meet all or a portion of our customer
service commitments, which could materially and adversely affect our business,
consolidated financial condition, results of operations and cash
flows.




Our business
depends on continued and unimpeded access to third-party controlled end-user
access networks.




Our CDN
services depend on our ability to access certain end-user access networks. We
achieve this access through mutually beneficial cooperation with these end-user
access networks in order to complete the delivery of rich media and other online
content to end-users. Some operators of these networks may take measures, such
as the deployment of a variety of filters, that could degrade, disrupt or
increase the cost of our or our customers’ access to certain of these end-user
access networks by restricting or prohibiting the use of their networks to
support or facilitate our services, or by charging increased fees to us, our
customers or end-users in connection with our services. This or other types of
interference could result in a loss of existing customers, increased costs and
impairment of our ability to attract new customers, thereby harming our revenue
and growth. If in the future a significant percentage of these network operators
elected to no longer allow unimpeded access to our CDN, our costs could increase
as we replace the network operators, the performance of our infrastructure could
be diminished, or both, and our business could suffer.


- 12
-




The
increased use of high-power density equipment may limit our ability to fully
utilize our data centers.
  Customers
continue to increase their use of high-power density equipment, such as blade
servers, in our data centers, which has significantly increased the demand for
power on a per cabinet basis. The current demand for electrical power may exceed
our designed capacity in these facilities. As electrical power, not space, is
typically the primary factor limiting capacity in our data centers, our ability
to fully utilize our data centers may be limited in these facilities. If we
are unable to adequately utilize our data centers, our ability to grow our
business cost-effectively could be materially and adversely
affected.




Our
business could be harmed by prolonged electrical power outages or shortages,
increased costs of energy or general availability of electrical resources. In
addition, a failure in the redundancies in our network operations centers,
network access points or computer systems could cause a significant disruption
in our IP services, and we may experience significant disruptions in our ability
to service our customers.




Our data
centers and P-NAPs are susceptible to regional costs and supply of power,
electrical power shortages, planned or unplanned power outages or natural
disasters and limitations, especially internationally, and availability of
adequate power resources. Power outages could harm our customers and our
business. We attempt to limit exposure to system downtime by using backup
generators and uninterruptible power systems. We may not be able to limit our
exposure entirely, however, even with these protections in place, as has been
the case with power outages we have experienced in the past and may experience
in the future. In addition, our energy costs have recently increased and may
continue to increase for a variety of reasons including increased pressure on
legislators to pass green legislation. As energy costs increase, we may not be
able to pass on to our customers the increased cost of energy, which could harm
our business and operating results.




If we
experience a problem at our network operations centers, including the failure of
redundant systems, we may be unable to provide IP services to our customers,
provide customer service and support or monitor our network infrastructure or
network access points, any of which would seriously harm our business and
operating results. Also, because we provide continuous Internet availability
under our SLAs, we may be required to issue a significant amount of customer
credits as a result of such interruptions in service. These credits could
negatively affect our revenues and results of operations. In addition,
interruptions in service to our customers could harm our customer relations,
expose us to potential lawsuits and require additional capital
expenditures.




In each
of our markets, we rely on utility companies to provide a sufficient amount of
power for current and future customers. We generally do not control the amount
of power our customers draw from their installed circuits. Because we rely on
third parties to provide power, we cannot ensure that these third parties will
deliver such power in adequate quantities or on a consistent basis. At the same
time, power and cooling requirements are growing on a per unit basis. As a
result, some customers are consuming an increasing amount of power per cabinet.
We do not have long-term power agreements in all our markets for long-term
guarantees of provisioned amounts and may face power limitations in our centers.
This limitation could have a negative impact on the effective available capacity
of a given data center and limit our ability to grow our business, which could
have a negative impact on our relationships with our customers as well as our
consolidated financial condition, results of operations and cash
flows.




A
significant number of our network access points are located in facilities owned
and operated by third parties. In many of those arrangements, we do not have
property rights similar to those customarily possessed by a lessee or subtenant
but instead have lesser rights of occupancy. In certain situations, the
financial condition of those parties providing occupancy to us could have an
adverse impact on the continued occupancy arrangement or the level of service
delivered to us under such arrangements.




Any
failure of the physical infrastructure in our data service centers could lead to
significant costs and disruptions that could reduce our revenue and harm our
business reputation, consolidated financial condition, results of operations and
cash flows.




Our
business depends on providing customers with highly reliable service. We must
protect our infrastructure and our customers’ data and their equipment located
in our data centers. The services we provide in each of our data centers are
subject to failure resulting from numerous factors, including:


●
                    human
      error;●
                    physical
      or electronic security breaches;●
                    fire,
      earthquake, hurricane, flood, tornado and other natural
      disasters;●
                    improper
      building maintenance by the landlords of the buildings in which our data
      centers are located;●
                    water
      damage;●
                    extreme
      temperatures;


- 13
-




●
                                          fiber
      cuts;●
                                          power
      loss or equipment failure;


●
            sabotage
      and vandalism; and●
            failures
      experienced by underlying service providers upon which our business
      relies.




Problems
at one or more of the data centers operated by us or any of our colocation
providers, whether or not within our control, could result in service
interruptions or significant equipment damage. We have service level commitment
obligations to most of our customers. As a result, service interruptions or
equipment damage in our data centers could result in difficulty maintaining
service level commitments to these customers and potential claims related to
such failures. We have in the past given credits to our customers as a result of
service interruptions due to equipment failures. Because our data centers are
critical to many of our customers’ businesses, service interruptions or
significant equipment damage in our data centers also could result in lost
profits or other indirect or consequential damages to our customers. We cannot
guarantee that a court would enforce any contractual limitations on our
liability in the event that a customer brings a lawsuit against us as the result
of a problem at one of our data centers.




If we
incur significant financial commitments to our customers in connection with a
loss of power or we fail to meet other service level commitment obligations, our
revenue reserves may not be adequate. In addition, any loss of services,
equipment damage or inability to meet our service level commitment obligations
could reduce the confidence of our customers and could consequently impair our
ability to obtain and retain customers, which would adversely affect both our
ability to generate revenues and our operating results.




Furthermore,
we are dependent upon NSPs and telecommunications carriers in the United States,
Europe, Asia, India and Australia, some of whom have experienced significant
system failures and electrical outages in the past. Users of our services may
experience difficulties due to system failures unrelated to our systems and
services. If, for any reason, these providers fail to provide the required
services, our business, consolidated financial condition, results of operations
and cash flows could be materially adversely impacted.




No
ultimate prevention or defense against denial of service attacks exists. During
a prolonged denial of service attack, Internet service may not be available for
several hours, thus negatively impacting hosted customers’ on-line business
transactions. Affected customers might file claims against us under such
circumstances, and our property and liability insurance may not be adequate to
cover these claims.




Our
results of operations have fluctuated in the past and may continue to fluctuate,
which could have a negative impact on the price of our common
stock.




We have
experienced fluctuations in our results of operations on a quarterly and annual
basis. The fluctuation in our operating results may cause the market price of
our common stock to decline. We expect to experience continued fluctuations in
our operating results in the foreseeable future due to a variety of factors,
including:


●
            competition
      and the introduction of new services by our
competitors;●
            continued
      pricing pressures resulting from competitors’ strategies or excess
      bandwidth supply;●
            fluctuations
      in the demand and sales cycle for our services;●
            fluctuations
      in the market for qualified sales and other personnel;●
            changes
      in the prices for Internet connectivity we pay to NSPs;●
            the
      cost and availability of adequate public utilities, including
      power;●
            our
      ability to obtain local loop connections to our network access points at
      favorable prices;●
            integration
      of people, operations, products and technologies of acquired
      businesses;●
            general
      economic conditions; and●
            any
      impairments or restructurings charges that we may incur in the
      future.


- 14
-




In
addition, fluctuations in our results of operations may arise from strategic
decisions we have made or may make with respect to the timing and magnitude of
capital expenditures such as those associated with the expansion of our data
center facilities, the deployment of additional network access points and the
terms of our network connectivity purchase agreements. These and other factors
discussed in this Form 10-K could have a material adverse effect on our
business, consolidated financial condition, results of operations and cash
flows. In addition, a relatively large portion of our expenses are fixed in the
short-term, particularly with respect to lease and personnel expense,
depreciation and amortization and interest expense. Our results of operations,
therefore, are particularly sensitive to fluctuations in revenue. Because our
results of operations have fluctuated in the past and we expect them to
continue to fluctuate in the future, we can offer no assurance that the results
of any particular period are an indication of future performance in our business
operations. Fluctuations in our results of operations could have a negative
impact on our ability to raise additional capital and execute our business plan.
Our operating results in one or more future quarters may fail to meet the
expectations of securities analysts or investors, which could cause an immediate
and significant decline in the trading price of our stock.




We
have acquired and may acquire other businesses, and these acquisitions involve
integration and other risks that could harm our business.




We may
pursue acquisitions of complementary businesses, products, services and
technologies to expand our geographic footprint, enhance our existing services,
expand our service offerings and enlarge our customer base. If we complete
future acquisitions, we may be required to incur or assume additional debt, make
capital expenditures or issue additional shares of our common stock or
securities convertible into our common stock as consideration, which would
dilute our existing stockholders’ ownership interest and may adversely affect
our results of operations. Our ability to grow through acquisitions involves a
number of additional risks, including the following:


●
            the
      ability to identify and consummate complementary
    acquisitions;●
            the
      possibility that we may not be able to integrate the operations,
      personnel, technologies, products and services of the acquired companies
      in a timely and efficient manner or achieve the level of quality in such
      businesses to which our customers are accustomed;●
            diversion
      of management’s attention from other ongoing business
      concerns;●
            insufficient
      revenue to offset significant unforeseen costs, including transaction
      costs, and increased expenses associated with the
      acquisitions;●
            challenges
      in completing projects associated with in-process research and development
      being conducted by the acquired businesses;●
            risks
      associated with entering markets in which we have little or no prior
      experience or where competitors have a stronger market
      presence;●
            deferral
      of purchasing decisions by current and potential customers as they
      evaluate the likelihood of success of our acquisitions;●
            incurring
      or assuming contingent liabilities and amortization expense for acquired
      intangible assets;●
            incurring
      acquisition liabilities as a result of integrating acquired
      businesses;●
            difficulties
      in successfully integrating the management teams and employees of both
      companies; and●
            loss
      of key employees of the acquired
companies.




Failure
to effectively manage our growth through acquisitions could adversely affect our
growth prospects, business, consolidated financial condition, results of
operations and cash flows.




Any
failure to meet our debt obligations would damage our business.




As of
December 31, 2008, our total long-term debt, including capital leases, was
$23.2 million. If we use more cash than we generate in the future, our
level of indebtedness could adversely affect our future operations by increasing
our vulnerability to adverse changes in general economic and industry conditions
and by limiting or prohibiting our ability to obtain additional financing for
future capital expenditures, acquisitions and general corporate and other
purposes. In addition, if we are unable to make interest or principal payments
when due, we would be in default under the terms of our long-term debt
obligations, which would result in all principal and interest becoming due and
payable which, in turn, would seriously harm our business.


- 15
-




The
terms of our existing credit agreement impose restrictions upon us.




The terms
of our existing credit agreement impose operating and financial restrictions on
us and require us to meet certain financial tests. These restrictions may also
have a negative impact on our business, consolidated financial condition,
results of operations and cash flows by significantly limiting or prohibiting us
from engaging in certain transactions. Our credit agreement contains certain
covenants, including covenants that restrict our ability to incur further
indebtedness, make acquisitions or investments, make certain capital
expenditures, create liens on our assets and require us to maintain minimum
liquidity.




If we do
not satisfy these covenants we would be in default under the credit agreement.
Any defaults, if not waived, could result in the lender ceasing to make loans or
extending credit to us, accelerating or declaring all or any obligations
immediately due or taking possession of or liquidating collateral. If any of
these events occur, we may not be able to borrow sufficient funds to refinance
the credit agreement on terms that are acceptable to us, which could materially
and adversely impact our business, consolidated financial condition, results of
operations and cash flows.




As of
December 31, 2008, we were in compliance with the various loan covenants
required by the credit agreement.




Our
investments in auction rate securities are subject to risks that may cause
losses and affect the liquidity of these investments.




As of
December 31, 2008, we held $6.4 million of auction rate securities classified as
non-current investments. Auction rate securities are variable rate bonds tied to
short-term interest rates with maturities on the face of the securities in
excess of 90 days and have interest rate resets through a modified Dutch
auction, at predetermined short-term intervals, usually every seven, 28 or 35
days. Auction rate securities generally trade at par value and are callable
at par value on any interest payment date at the option of the issuer. Interest
received during a given period is based upon the interest rate determined
through the auction process. The underlying assets of our auction rate
securities are state-issued student and educational loans that are substantially
backed by the federal government and carried AAA/Aaa ratings as of December 31,
2008. Although these securities are issued and rated as long-term bonds, they
have historically been priced and traded as short-term instruments because of
the liquidity provided through the interest rate resets. While we continue
to earn and accrue interest on our auction rate securities at contractual rates,
these investments are not currently trading. Due to the uncertainty as to when
the auction rate securities markets will improve, we have classified our auction
rate securities as non-current investments as of December 31, 2008.




In
October 2008, we received an offer providing us with rights, or ARS Rights, from
one of our investment providers to sell at par value auction rate securities
originally purchased from the investment provider ($7.2 million) at anytime
during a two-year period beginning June 30, 2010. On November 14, 2008, we
accepted the offer and intend to exercise the ARS Rights if we are otherwise
unable to recover par value on the securities at an earlier date.




Continued
overcapacity in the Internet connectivity and IP services market, adverse
experience in the CDN services market or delay in subleasing certain of our
locations may result in our recording additional goodwill and other intangible
asset impairment charges, restructuring charges or both.




We are
required to assess goodwill for impairment under GAAP at least
annually. We perform our annual goodwill impairment test as of August 1 of
each calendar year, following our annual strategic planning cycle, which
includes an update of our long-term financial outlook. As a result of our
August 1, 2008 assessment, we concluded that the current carrying value of our
goodwill in the CDN services reporting unit was impaired. We recorded the
CDN services goodwill following our February 2007 acquisition of
VitalStream. For the year ended December 31, 2008, we recorded a $99.7
million goodwill impairment charge to adjust goodwill in our CDN services
segment to an implied fair value of $54.7 million. The impairment also caused us
to reverse a deferred tax liability and create an income tax benefit of $0.6
million associated with the CDN services goodwill for the year ended December
31, 2008.




In
conjunction with our review of our long-term financial outlook, we also
performed an analysis of the potential impairment, and re-assessed the remaining
asset lives, of other identifiable intangible assets acquired in the VitalStream
acquisition. This analysis and re-assessment resulted in, during the year
ended December 31, 2008: (1) an impairment charge of $1.9 million in developed
advertising technology due to a strategic change in market focus, (2) an
impairment charge of $0.8 million in trade names as a result of discontinuing
use of the VitalStream trade name and (3) a change in our estimates that
resulted in acceleration of amortization expense of our customer
relationships intangible asset over a shorter estimated useful life (four
remaining years instead of the original estimated nine years) due to customer
churn resulting in higher than expected attrition as of our acquisition
date.




We also
assessed the likelihood of triggering events and concluded that none
had occurred that would cause us to re-assess goodwill for impairment
subsequent to August 1, 2008. However, we may incur additional restructuring or
impairment charges in the future, which could materially and adversely affect
our business, consolidated financial position, results of operations and cash
flows.


- 16
-




Furthermore,
when circumstances warrant, we may elect to exit certain business activities or
change the manner in which we conduct ongoing operations. When we make such a
change, we will estimate the costs to exit a business or restructure ongoing
operations. The components of the estimates may include estimates and
assumptions regarding the timing and costs of future events and activities that
represent our best expectations based on known facts and circumstances at the
time of estimation. Should circumstances warrant, we will adjust our previous
estimates to reflect what we then believe to be a more accurate representation
of expected future costs.




Because
our estimates and assumptions regarding restructuring costs include
probabilities of future events, such as the ability to find a sublease tenant
within a reasonable period of time or the rate at which a sublease tenant will
pay for the available space, such estimates are inherently vulnerable to changes
due to unforeseen circumstances that could materially and adversely affect our
results of operations. If we do not find a sublease tenant for one of our more
significant restructured locations by the end of the second quarter of 2010 or
if we do not obtain a certain rate per square foot for the available space, we
will need to take an additional charge in our statement of operations that may
be material. We monitor market conditions at each period end reporting date and
will continue to assess our key assumptions and estimates used in the
calculation of our restructuring accrual.




If
we are unable to deploy new network access points or do not adequately control
expenses associated with the deployment of new network access points, our
results of operations could be adversely affected.




As part
of our strategy, we may continue to expand our network access points,
particularly into new geographic markets. We face various risks associated with
identifying, obtaining and integrating attractive network access point sites,
negotiating leases for data centers on competitive terms, cost estimation errors
or overruns, delays in connecting with local exchanges, equipment and material
delays or shortages, the inability to obtain necessary permits on a timely
basis, if at all, and other factors, many of which are beyond our control and
all of which could delay the deployment of new network access points. We can
offer no assurance that we will be able to open and operate new network access
points on a timely or profitable basis. Deployment of new network access points
will increase operating expenses, including expenses associated with hiring,
training, retaining and managing new employees, provisioning capacity from NSPs,
purchasing new equipment, implementing new systems, leasing additional real
estate and incurring additional depreciation expense. If we are unable to
control our expenses as we expand in geographically dispersed locations, our
consolidated financial condition, results of operations and cash flows could be
materially and adversely affected.




Our
international operations may not be successful.




We have
limited experience operating internationally and have only recently begun to
achieve successful international experiences. We currently have network access
points or CDN POPs in London, Hong Kong, Singapore, Sydney, Amsterdam and
Mumbai. We also participate in a joint venture with NTT-ME Corporation and
Nippon Telegraph and Telephone Corporation, or NTT Holdings, that operates
network access points in Tokyo and Osaka, Japan. As part of our strategy to
expand our geographic markets, we may develop or acquire network access points
or complementary businesses in additional international markets. The risks
associated with expansion of our international business operations
include:


●
            challenges
      in establishing and maintaining relationships with foreign customers as
      well as foreign NSPs and local vendors, including data center and local
      network operators;●
            challenges
      in staffing and managing network operations centers and network access
      points across disparate geographic areas;●
            potential
      loss of proprietary information due to misappropriation or laws that may
      be less protective of our intellectual property rights than the laws in
      the United States;●
            challenges
      in reducing operating expense or other costs required by local laws, and
      longer accounts receivable payment cycles and difficulties in collecting
      accounts receivable;●
            exposure
      to fluctuations in foreign currency exchange rates;●
            costs
      of customizing network access points for foreign countries and
      customers;●
            requirements
      of foreign laws and other governmental controls, including trade and labor
      restrictions and related laws that reduce the flexibility of our business
      operations;●
            protectionist
      laws and practices favoring local competition;●
            deteriorating
      economic conditions in foreign markets;●
            political
      and economic instability; and●
            compliance
      with governmental regulations.


- 17
-




We may be
unsuccessful in our efforts to address the risks associated with our
international operations, which may limit our international sales growth and
materially and adversely affect our business and results of
operations.




Disputes
with vendors regarding the delivery of services may materially impact our
results of operations and cash flows.




In
delivering our services, we rely on a number of Internet network,
telecommunication and other vendors. We work directly with these vendors to
provide services such as establishing, modifying or discontinuing services for
our customers. Because of the volume of activity, billing disputes inevitably
arise. These disputes typically stem from disagreements concerning the starting
and ending dates of service, quoted rates, usage and various other factors. We
research and discuss disputed costs, both in the vendors’ favor and our favor,
with vendors on an ongoing basis until ultimately resolved. We record the cost
and liability based on our estimate of the most likely outcome of the dispute.
We periodically review and, if necessary, modify these estimates in light of new
information or developments, if any. Because estimates regarding disputed costs
include assessments of uncertain outcomes, such estimates are inherently
vulnerable to changes due to unforeseen circumstances that could materially and
adversely affect our consolidated financial condition, results of operations and
cash flows.




Our
inability to renew our data center leases on favorable terms could have a
negative impact on our financial results.




Our
leased data centers have lease terms that expire between 2010 and 2023. The
majority of these leases provide us with the opportunity to renew the lease at
our option for periods generally ranging from five to 10 years. Many of these
options however, if renewed, provide that rent for the renewal period will be
equal to the fair market rental rate at the time of renewal. If the fair market
rental rates are significantly higher than our current rental rates, we may be
unable to offset these costs by charging more for our services, which could have
a negative impact on our financial results.




Our business
requires the continued development of effective business support systems to
support our customer growth and related services.




The
growth of our business depends on our ability to continue to develop effective
business support systems. This is a complicated undertaking requiring
significant resources and expertise. Business support systems are needed
for:


●
            implementing
      customer orders for services;●
            delivering
      these services; and●
            timely
      billing for these services.




Because
our business plan provides for continued growth in the number of customers that
we serve and services offered, there is a need to continue to develop our
business support systems on a schedule sufficient to meet proposed service
rollout dates. The failure to continue to develop effective business support
systems could harm our ability to implement our business plans and meet our
financial goals and objectives.




We
depend upon our key employees and may be unable to attract or retain sufficient
numbers of qualified personnel.




Our
future performance depends to a significant degree upon the continued
contributions of our executive management team and other key employees. To the
extent we are able to expand our operations and deploy additional network access
points, we may need to increase our workforce. Accordingly, our future success
depends on our ability to attract, hire, train and retain highly skilled
management, technical, sales, marketing and customer support personnel.
Competition for qualified employees is intense, and we compete for qualified
employees with companies that may have greater financial resources than we have.
Our employment security plan with our executive officers provides that either
party may terminate their employment at any time. Consequently, we may not be
successful in attracting, hiring, training and retaining the people we need,
which would seriously impede our ability to implement our business
strategy.




Our
senior management team has not had time to develop a working relationship with
our new Chief Executive Officer and President which could result in not being
able to manage our business effectively.




We have
hired a new Chief Executive Officer and President effective March 16,
2009. Accordingly, our senior management team has not had time to develop a
working relationship with our new Chief Executive Officer and President. If the
full senior management team is not able to develop a strong and effective
working relationship, our management team’s ability to quickly and efficiently
respond to problems and effectively manage our business could be adversely
impacted.


- 18
-




Changes
in our senior management team during the past several years also have resulted
in paying significant severance and hiring costs. If we continue to experience
similar levels of turnover in our senior management team, the costs of such
changes could harm our consolidated financial condition, results of operations
and cash flows.




If
we fail to adequately protect our intellectual property, we may lose rights to
some of our most valuable assets.




We rely
on a combination of copyright, patent, trademark, trade secret and other
intellectual property law, nondisclosure agreements and other protective
measures to protect our proprietary rights. We also utilize unpatented
proprietary know-how and trade secrets and employ various methods to protect
such intellectual property. We believe our intellectual property rights are
significant and that the loss of all or a substantial portion of such rights
could have a material adverse effect on our results of operations. We can offer
no assurance that our intellectual property protection measures will be
sufficient to prevent misappropriation of our technology. In addition, the laws
of many foreign countries do not protect our intellectual property to the same
extent as the laws of the United States. From time-to-time, third parties have
or may assert infringement claims against us or against our customers in
connection with their use of our products or services.




In
addition, we rely on the intellectual property of others. We may desire or be
required to renew or to obtain licenses from these other parties in order to
further develop and market commercially viable products or services effectively.
We can offer no assurance that any necessary licenses will be available on
reasonable terms.




We
may face litigation and liability due to claims of infringement of third party
intellectual property rights.




The
Internet services industry is characterized by the existence of a large number
of patents and frequent litigation based on allegations of patent infringement.
From time-to-time, third parties may assert patent, copyright, trademark, trade
secret and other intellectual property rights to technologies that are important
to our business. Any claims that our products or services infringe or may
infringe proprietary rights of third parties, with or without merit, could be
time-consuming, result in costly litigation, divert the efforts of our technical
and management personnel or require us to enter into royalty or licensing
agreements, any of which could significantly harm our operating results. In
addition, our customer agreements generally provide for us to indemnify our
customers for expenses and liabilities resulting from claimed infringement of
patents or copyrights of third parties, subject to certain limitations. If an
infringement claim against us were to be successful, and we were not able to
obtain a license to the relevant technology or a substitute technology on
acceptable terms or redesign our products or services to avoid infringement, our
ability to compete successfully in our market would be materially
impaired.




If our ability to deliver media
files in certain formats is restricted or becomes cost-prohibitive, demand for
our services would decline and our financial results would
suffer.




Our CDN
products and services depend on our ability to deliver media content in all
major formats. If our legal right to store and deliver content in certain
formats, like Adobe Flash or Windows Media, for example, was limited, we could
not serve our customers and the demand for our services would
decline. Owners of proprietary content formats may be able to block,
restrict or impose fees or other costs on our use of such formats, leading to
additional expenses or prevent our delivery of this type of content, which could
materially and adversely affect our operating results.




We
are currently subject to a securities class action lawsuit, the unfavorable
outcome of which could have a material adverse effect on our financial
condition, results of operations and cash flows.




On
November 12, 2008, a putative securities fraud class action lawsuit was filed
against us and our Chief Executive Officer, James P. DeBlasio, in the United
States District Court for the Northern District of Georgia, captioned Catherine Anastasio and Stephen
Anastasio v. Internap Network Services Corp. and James P. DeBlasio, Civil
Action No. 1:08-CV-3462-JOF. The complaint alleges that we and the individual
defendant violated Section 10(b) of the Exchange Act and that the individual
defendant also violated Section 20(a) of the Exchange Act as a “control person”
of Internap. Plaintiffs purport to bring these claims on behalf of a class of
our investors who purchased our stock between March 28, 2007 and March 18,
2008.




Plaintiffs
allege generally that, during the putative class period, we made misleading
statements and omitted material information regarding (1) integration of
VitalStream, (2) customer issues and related credits due to services outages,
and (3) our previously reported 2007 revenue that we subsequently reduced in
2008 as announced on March 18, 2008. Plaintiffs assert that we and the
individual defendant made these misstatements and omissions in order to keep our
stock price high. Plaintiffs seek unspecified damages and other
relief.




While we
intend to vigorously contest this lawsuit, we cannot determine the final
resolution of this lawsuit or when it might be resolved. In addition to the
expenses incurred in defending this litigation and any damages that may be
awarded in the event of an adverse ruling, our management’s efforts and
attention may be diverted from the ordinary business operations to address these
claims. Regardless of the outcome, this litigation may have a material adverse
impact on our results because of defense costs, including costs related to our
indemnification obligations, diversion of resources and other
factors.


- 19
-




We may become involved in other
litigation that may adversely affect us.




In the
ordinary course of business, we are or may become involved in litigation,
administrative proceedings and governmental proceedings. Such matters can
be time-consuming, divert management’s attention and resources and cause us to
incur significant expenses. Furthermore, the results of any such actions
could have a material adverse effect on our business, consolidated financial
condition, results of operations and cash flows.




Risks
Related to Our Industry




We
cannot predict with certainty the future evolution of the high performance
Internet connectivity market, and therefore the role of our products and
services.




We face
the risk that the market for high performance Internet connectivity services
might develop more slowly or differently than currently projected, or that our
services may not achieve continued widespread market acceptance. Furthermore, we
may be unable to market and sell our services successfully and cost-effectively
to a sufficiently large number of customers. We typically charge a premium for
our services, which may affect market acceptance of our services or adversely
impact the rate of market acceptance. We believe the danger of non-acceptance is
particularly acute during economic slowdowns, which exert significant pricing
pressure on NSPs. If the Internet becomes subject to a form of central
management, or if NSPs establish an economic settlement arrangement regarding
the exchange of traffic between Internet networks, the demand for our IP
services could be materially and adversely affected.




If
we are unable to respond effectively and on a timely basis to rapid
technological change, we may lose or fail to establish a competitive advantage
in our market.




Our
industry is characterized by rapidly changing technology, industry standards and
customer needs, as well as by frequent new product and service introductions.
New technologies and industry standards have the potential to replace or provide
lower cost alternatives to our services. The adoption of such new technologies
or industry standards could render our existing services obsolete and
unmarketable. Our failure to anticipate the prevailing standard, to adapt our
technology to any changes in the prevailing standard or the failure of a common
standard to emerge could materially and adversely affect our business. Our
pursuit of necessary technological advances may require substantial time and
expense, and we may be unable to successfully adapt our network and services to
alternative access devices and technologies.




Rapidly evolving
technologies or new business models could cause demand for our services to
decline or could cause these services to become obsolete.




Customers
or third parties may develop technological or business model innovations that
address their requirements in a manner that is, or is perceived to be,
equivalent or superior to our services. If competitors introduce new products or
services that compete with or surpass the quality or the price/performance of
our services, we may be unable to renew our agreements with existing customers
or attract new customers at the prices and levels that allow us to generate
attractive rates of return on our investment.




For
example, one or more third parties might develop improvements to current
peer-to-peer technology, which is a technology that relies upon the computing
power and bandwidth of its participants, such that this technological approach
is better able to deliver content in a way that is competitive to our CDN
services, or even that makes CDN services obsolete. We may not anticipate such
developments and may be unable to adequately compete with these potential
solutions. In addition, our customers’ business models may change in ways that
we do not anticipate and these changes could reduce or eliminate our customers’
needs for CDN services. If this occurred, we could lose customers or potential
customers, and our business and financial results would suffer. As a result of
these or similar potential developments, in the future it is possible that
competitive dynamics in our market may require us to reduce our prices, which
could harm our revenue, gross margin and operating results.




Our
network and software are subject to potential security breaches and similar
threats that could result in our liability for damages and harm our
reputation.




A number
of widespread and disabling attacks on public and private networks have occurred
recently. The number and severity of these attacks may increase in the future as
network assailants take advantage of outdated software, security breaches or
incompatibility between or among networks. Computer viruses, intrusions and
similar disruptive problems could cause us to be liable for damages under
agreements with our customers, and our reputation could suffer, thereby
deterring potential customers from working with us. Security problems or other
attacks caused by third parties could lead to interruptions and delays, or to
the cessation of service to our customers. Furthermore, inappropriate use of the
network by third parties could also jeopardize the security of confidential
information stored in our computer systems and in those of our customers and
could expose us to liability under unsolicited commercial e-mail, or “spam,”
regulations. In the past, third parties have occasionally circumvented some of
these industry-standard measures. We can offer no assurance that the measures we
implement will not be circumvented. Our efforts to eliminate computer viruses
and alleviate other security problems, or any circumvention of those efforts,
may result in increased costs, interruptions, delays or cessation of service to
our customers, which could hurt our business, consolidated financial condition,
results of operations and cash flows.


- 20
-




If the world-wide
financial crisis intensifies, potential disruptions in the capital and credit
markets may adversely affect our business, including our ability to meet
long-term commitments and our ability to grow our business.




The
global economy is currently experiencing a significant contraction, with an
almost unprecedented lack of availability of business and consumer credit. We
rely on the credit markets to meet our financial commitments and short-term
liquidity needs if internal funds are not available from our operations.
Long-term disruptions in the capital and credit market, similar to those that
have been experienced during 2008, could result from uncertainty, changing or
increased regulation, reduced alternatives or failures of significant financial
institutions and could adversely affect our access to liquidity needed for our
business. Any disruption could require us to take measures to conserve cash
until the markets stabilize or until alternative credit arrangements or other
funding for our business needs can be arranged. Such measures could include
deferring capital expenditures and reducing or eliminating discretionary uses of
cash.




Besides
our cash on hand and any financing activities we may pursue, customer
collections are our primary source of cash. While we believe we have a well
diversified customer base and no concentration of credit risk with any single
customer, if the current market conditions continue to deteriorate, we may
experience increased churn in our customer base, including reductions in their
commitments to us. This could result in an increase in our provision for
doubtful accounts and ultimately could have a material adverse effect on our
liquidity.




Continued
market disruptions could cause broader economic downturns, which may lead to
lower demand for our services and increased incidence of customers’ inability to
pay their accounts. Further, bankruptcies or similar events by customers may
cause us to incur bad debt expense at levels higher than historically
experienced. These events would adversely impact our results of operations, cash
flows and financial position.




We
may be unable to draw down on existing credit facilities if our current lender
fails and we may be unable to access, at all or on acceptable terms, alternative
sources of credit or the debt capital markets due to the global disruptions in
these markets.




The
turmoil in the financial services industry has led to the bankruptcy, failure,
collapse or sale of several large financial institutions. Despite an
unprecedented level of intervention from both the United States federal
government and certain European governments, there can be no assurance that
government responses to this crisis will stabilize the credit and debt capital
markets or increase liquidity and the availability of credit
generally.




Deteriorating
market and liquidity conditions also may give rise to issues which may impact
our lender’s ability to hold debt commitments to us to their full term.
Accordingly, while this would be highly unusual, our lender could attempt to
call this debt which would have a material adverse effect on our liquidity, even
though no call provisions exist without being in default.




Our
ability to meet our obligations depends on the financial health of our lenders,
their ability to meet their own obligations under our credit facilities and the
availability of the credit markets generally. Finally, our ability to access the
capital markets may be severely restricted at a time when we would like, or
need, to do so, which could have an impact on our flexibility to pursue
additional expansion opportunities and maintain our desired level of revenue
growth in the future.




Terrorist
activity throughout the world and military action to counter terrorism could
adversely impact our business.




The
continued threat of terrorist activity and other acts of war or hostility may
have an adverse effect on business, financial and general economic conditions
internationally. Effects from any future terrorist activity, including cyber
terrorism, may, in turn, increase our costs due to the need to provide enhanced
security, which would adversely affect our business, consolidated financial
condition, results of operations and cash flows. These circumstances may also
damage or destroy the Internet infrastructure and may materially and adversely
affect our ability to attract and retain customers, our ability to raise capital
and the operation and maintenance of our network access points.




If
governments modify or increase regulation of the Internet, the provision of our
services could become more costly.




International
bodies and federal, state and local governments have adopted a number of laws
and regulations that affect the Internet and are likely to continue to seek to
implement additional laws and regulations. In addition, federal and state
agencies are actively considering regulation of various aspects of the Internet,
including taxation of transactions, imposition of access fees for VoIP and
enhanced data privacy and retention legislation. The Federal Communications
Commission and state agencies also review the regulatory requirements, if any,
that should be applicable to VoIP. If we seek to offer additional products and
services, we could be required to obtain additional authorizations from
regulatory agencies. We may not be able to obtain such authorizations in a
timely manner, or at all, and conditions could be imposed upon such
authorization that may not be favorable to us.


- 21
-




In 2007,
the Internet Tax Freedom Act Amendment Acts of 2007 was signed into law which
extended the moratorium against certain state and local taxation of Internet
access, until November 1, 2014. Pursuant to this moratorium, most of our
services are not subject to state and local taxation. We cannot predict whether
this moratorium will be extended in the future or whether future legislation
will alter the nature of the moratorium. If this moratorium is not extended in
its current form, state and local governments could impose taxes on our
services, and these taxes could decrease our ability to compete and could have a
material adverse effect on our business, financial condition, results of
operations and cash flows.




In
addition, laws relating to the liability of private network operators and
information carried on or disseminated through their networks are unsettled,
both in the United States and abroad. Network operators have been sued in
the past based on the content of material disseminated through their
networks. We may become subject to legal claims such as defamation,
invasion of privacy, obscenity and copyright infringement in connection with
content stored on or distributed through our network. Also, our reputation
could suffer as a result of our perceived association with the type of content
that some of our customers deliver.




The
adoption of any future laws or regulations might decrease the growth of the
Internet, decrease demand for our services, impose taxes or other costly
technical requirements, regulate the Internet similar to the regulation of
traditional telecommunications services or otherwise increase the cost of doing
business on the Internet in some other manner. Any of these actions could
significantly harm our customers or us. Moreover, the nature of any new laws and
regulations and the interpretation of applicability to the Internet of existing
laws governing intellectual property ownership and infringement, copyright,
trademark, trade secret, obscenity, libel, employment, personal privacy and
other issues is uncertain and developing. We cannot predict the impact, if any,
that future regulation or regulatory changes may have on our
business.




Risks
Related to Our Capital Stock




Our
common stockholders may experience significant dilution, which could depress the
market price of our common stock.




Holders
of our stock options may exercise their options to purchase our common stock,
which would increase the number of outstanding shares of common stock in the
future. As of December 31, 2008, options to purchase an aggregate of
2.8 million shares of our common stock at a weighted average exercise price
of $11.91 were outstanding. Also, the vesting of 0.8 million outstanding
restricted stock awards will increase the weighted average number of shares used
for calculating diluted net income per share. We issued approximately 12.2
million shares of our common stock to VitalStream’s stockholders in connection
with the acquisition in February 2007. We also assumed outstanding
options for the purchase of shares of VitalStream common stock,
converted into options to purchase approximately 1.5 million shares of our
common stock. Furthermore, greater than expected capital requirements could
require us to obtain additional financing through the issuance of securities,
which could be in the form of common stock or preferred stock or other
securities having greater rights than our common stock. The issuance of our
common stock or other securities, whether upon the exercise of options, the
future vesting and issuance of stock awards to our executives and employees or
in financing transactions, could depress the market price of our common stock by
increasing the number of shares of common stock or other securities outstanding
on an absolute basis or as a result of the timing of additional shares of common
stock becoming available on the market.




Provisions
of our charter documents, our stockholder rights plan and Delaware law may have
anti-takeover effects that could prevent a change in control even if the change
in control would be beneficial to our stockholders.




Provisions
of our certificate of incorporation, bylaws and Delaware law could make an
acquisition more difficult, even if doing so would be beneficial to our
stockholders. In addition, our board of directors adopted a stockholder
rights plan in 2007 that renders the consummation of an acquisition without the
approval of the board of directors more difficult.




Our
stock price may be volatile.




The
market for our equity securities has been extremely volatile. Our stock price
could suffer in the future as a result of any failure to meet the expectations
of public market analysts and investors about our results of operations from
quarter to quarter. The following factors could cause the price of our common
stock in the public market to fluctuate significantly:


●
                    actual
      or anticipated variations in our quarterly and annual results of
      operations;●
                    changes
      in market valuations of companies in the Internet connectivity and
      services
industry;


- 22
-




●
                          changes
      in expectations of future financial performance or changes in estimates of
      securities analysts;●
                          fluctuations
      in stock market prices and volumes;


●
            future
      issuances of common stock or other securities;●
            the
      addition or departure of key personnel; and●
            announcements
      by us or our competitors of acquisitions, investments or strategic
      alliances.




Changes in financial accounting
standards may adversely affect our reported results of
operations.




A change
in financial accounting standards or practices that cause a change in the
methodology or procedures by which we track, calculate, record or report our
results of operations or financial condition or both could cause fluctuations in
and adversely affect our reported results of operations and cause our historical
financial information to not be reliable as an indicator of future results. New
pronouncements and varying interpretations of pronouncements have occurred and
may occur in the future. Changes to existing rules or the questioning of current
practices may adversely affect our reported financial results or the way we
conduct our business.




ITEM 1B. UNRESOLVED STAFF COMMENTS




None.




ITEM 2. PROPERTIES




Our
principal executive offices are located in Atlanta, Georgia adjacent to our
network operations center, one of our P-NAPs and data center facilities. Our
Atlanta facility, included in the table below, consists of 120,298 square feet
under a lease agreement that expires in 2020. We lease other facilities to
fulfill our real estate requirements in metropolitan areas and specific cities
where our service points are located. We believe our existing facilities are
adequate for our current needs and that suitable additional or alternative space
will be available in the future on commercially reasonable terms as needed. The
following table shows the number and gross square footage of our facilities in
our top markets as of March 9, 2009:


Top
      Markets
                                            
                                            Number of
                                              our Facilities
                                            
                                            Approximate
                                              Gross Square
                                              FootageNew
      York Metro area
                                            
                                            
                                            2
                                            
                                            
                                            152,848Boston area
                                            
                                            
                                            2
                                            
                                            
                                            116,699Atlanta
                                            
                                            
                                            1
                                            
                                            
                                            120,298Houston
                                            
                                            
                                            1
                                            
                                            
                                            36,649Seattle
                                            
                                            
                                            3
                                            
                                            
                                            70,535Los
      Angeles
                                            
                                            
                                            1
                                            
                                            
                                            15,320Top
      Markets Total
                                            
                                            
                                            10
                                            
                                            
                                            512,349




ITEM 3. LEGAL
PROCEEDINGS




On
November 12, 2008, a putative securities fraud class action lawsuit was filed
against us and our Chief Executive Officer, James P. DeBlasio, in the United
States District Court for the Northern District of Georgia, captioned Catherine Anastasio and Stephen
Anastasio v. Internap Network Services Corp. and James P. DeBlasio, Civil
Action No. 1:08-CV-3462-JOF. The complaint alleges that we and the individual
defendant violated Section 10(b) of the Exchange Act and that the individual
defendant also violated Section 20(a) of the Exchange Act as a “control person”
of Internap. Plaintiffs purport to bring these claims on behalf of a class of
our investors who purchased our stock between March 28, 2007 and March 18,
2008.




Plaintiffs
allege generally that, during the putative class period, we made misleading
statements and omitted material information regarding (1) integration of
VitalStream, (2) customer issues and related credits due to services outages,
and (3) our previously reported 2007 revenue that we subsequently reduced in
2008 as announced on March 18, 2008. Plaintiffs assert that we and the
individual defendant made these misstatements and omissions in order to keep our
stock price high. Plaintiffs seek unspecified damages and other
relief.


- 23
-


While we
intend to vigorously contest this lawsuit, we cannot determine the final
resolution of this lawsuit or when it might be resolved. In addition to the
expenses incurred in defending this litigation and any damages that may be
awarded in the event of an adverse ruling, our management’s efforts and
attention may be diverted from the ordinary business operations to address these
claims. Regardless of the outcome, this litigation may have a material adverse
impact on our results because of defense costs, including costs related to our
indemnification obligations, diversion of resources and other
factors.




We
currently, and from time to time, are involved in other litigation incidental to
the conduct of our business. Although the amount of liability that may result
from these matters cannot be ascertained, we do not currently believe that, in
the aggregate, such matters will result in liabilities material to our
consolidated financial condition, results of operations or cash
flows.




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




None.




PART II




ITEM 5. MARKET FOR REGISTRANT’S COMMON
EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES




Our
common stock is listed on the NASDAQ Global Market under the symbol “INAP”. The
following table presents, for the periods indicated, the range of high and low
per share sales prices of our common stock, as reported on the NASDAQ Global
Market.




On
July 11, 2006, we implemented a one-for-10 reverse stock split of our
common stock. The information in the following table has been adjusted to
reflect this stock split. Our fiscal year ends on December 31.


Year
      Ended December 31, 2008:
                    
                    High
                    
                    
                    LowFourth
      Quarter
                    
                    $
                    3.72
                    
                    
                    $
                    2.00Third
      Quarter
                    
                    
                    5.08
                    
                    
                    
                    2.65Second
      Quarter
                    
                    
                    5.90
                    
                    
                    
                    4.20First
      Quarter
                    
                    
                    9.02
                    
                    
                    
                    3.63





Year
      Ended December 31, 2007
                    
                    High
                    
                    
                    LowFourth
      Quarter
                    
                    $
                    17.18
                    
                    
                    $
                    8.14Third
      Quarter
                    
                    
                    16.15
                    
                    
                    
                    13.04Second
      Quarter
                    
                    
                    19.33
                    
                    
                    
                    12.95First
      Quarter
                    
                    
                    20.98
                    
                    
                    
                    15.60




As of
March 5, 2009, we had approximately 1,234 stockholders of record of our common
stock.




We have
never declared or paid any cash dividends on our capital stock, and we do not
anticipate paying cash dividends in the foreseeable future. We are prohibited
from paying cash dividends under covenants contained in our credit agreement. We
currently intend to retain our earnings, if any, for future growth. Future
dividends on our common stock, if any, will be at the discretion of our board of
directors and will depend on, among other things, our operations, capital
requirements and surplus, general financial condition, contractual restrictions
and such other factors as our board of directors may deem
relevant.


- 24
-




The
following table provides information regarding our current equity compensation
plans as of December 31, 2008 (shares in thousands):


Equity
      Compensation Plan InformationPlan
      category
                                
                                Number
      of securities
                                  to
      be issued upon
                                  exercise
      of
                                  outstanding
      options,
                                  warrants
      and rights
                                  (a)
                                
                                Weighted-average
                                  exercise
      price of
                                  outstanding
      options,
                                  warrants
      and rights
                                  (b)
                                
                                Number
      of securities
                                  remaining
      available
                                  for
      future issuance
                                  under
      equity
                                  compensation
                                  plans
      (excluding
                                  securities
      reflected
                                  in
      column (a))
                                  (c)Equity
      compensation plans approved by security holders
                                
                                
                                2,781
                                (1)
                                $
                                11.91
                                
                                
                                6,988
                                (2)Equity
      compensation plans not approved by security holders
                                
                                
                                —
                                
                                
                                —
                                
                                
                                —Total
                                
                                
                                2,781
                                
                                $
                                11.91
                                
                                
                                6,988




(1)
              Excludes
      purchase rights accruing under the 2004 Employee Stock Purchase Plan, or
      the Purchase Plan. Under the Purchase Plan, each eligible employee may
      purchase up to $12,500 worth of our common stock at each semi-annual
      purchase date (the last business day of June and December each year),
      but not more than $25,000 worth of such stock (determined on the basis of
      the fair market value per share on the date(s) such rights are granted)
      per calendar year that the purchase right remains outstanding. The
      purchase price payable per share is equal to 95% of the closing selling
      price per share of our common stock on the purchase
  date.(2)
              Includes
      229,000 shares available for issuance under the Purchase
    Plan.




- 25
-




STOCK
PERFORMANCE GRAPH




The
following graph compares, for the five-year period ended December 31, 2008, the
cumulative total stockholder return on our common stock with that of the NASDAQ
Market Index and the Hemscott Group Index. The graph assumes that $100 was
invested on December 31, 2003 and assumes reinvestment of any dividends. The
information in the following table has been adjusted to reflect the one-for-10
reverse stock split implemented in July 2006. Our fiscal year ends on December
31. The stock price performance on the following graph is not necessarily
indicative of future stock price performance.




This
performance graph shall not be deemed “filed” for purposes of Section 18 of the
Exchange Act or otherwise subject to the liabilities under that Section and
shall not be deemed to be incorporated by reference into any filing we make
under the Securities Act of 1933, as amended, or the Exchange Act.




(LINE GRAPH)


12/31/03
                  
                  
                  12/31/04
                  
                  
                  12/31/05
                  
                  
                  12/31/06
                  
                  
                  12/31/07
                  
                  
                  12/31/08Internap
      Network Services Corporation
                  
                  $
                  100.00
                  
                  
                  $
                  37.96
                  
                  
                  $
                  17.55
                  
                  
                  $
                  81.10
                  
                  
                  $
                  34.00
                  
                  
                  $
                  10.20Hemscott
      Group Index
                  
                  
                  100.00
                  
                  
                  
                  126.04
                  
                  
                  
                  109.07
                  
                  
                  
                  103.53
                  
                  
                  
                  110.68
                  
                  
                  
                  71.06NASDAQ
      Market Index
                  
                  
                  100.00
                  
                  
                  
                  108.41
                  
                  
                  
                  110.79
                  
                  
                  
                  122.16
                  
                  
                  
                  134.29
                  
                  
                  
                  79.25


- 26
-




ISSUER
PURCHASES OF EQUITY SECURITIES




The
following table sets forth information regarding our repurchases of securities
for each calendar month in the quarter ended December 31, 2008:


Period
                                              
                                              (a)Total
      Number of Shares(or
      Units) Purchased*
                                              
                                              
                                              (b)Average
      Price Paidper
      Share (or Unit)
                                              
                                              
                                              (c)Total
      Number ofShares
      (or Units)Purchased
      as Partof
      PubliclyAnnounced
      Plansor
      Programs
                                              
                                              
                                              (d)Maximum
      Number(or
      ApproximateDollar
      Value) ofShares
      (or Units) thatMay
      Yet BePurchased
      Under thePlans
      or ProgramsOctober
      1 to 31, 2008
                                              
                                              
                                              2,382
                                              
                                              
                                              $
                                              2.60
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —November
      1 to 30, 2008
                                              
                                              
                                              811
                                              
                                              
                                              
                                              2.71
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —December
      1 to 31, 2008
                                              
                                              
                                              8,921
                                              
                                              
                                              
                                              2.54
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —Total
                                              
                                              
                                              12,114
                                              
                                              
                                              $
                                              2.57
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              —




* These
shares were surrendered to us by employees to satisfy tax withholding
obligations in connection with the vesting of
restricted stock.


- 27
-




ITEM 6. SELECTED FINANCIAL DATA




The
selected financial data shown below for each of the five years in the period
ended December 31, 2008 has been derived from our accompanying consolidated
financial statements. The following data should be read in conjunction with the
accompanying consolidated financial statements and related notes contained and
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” included in this Form 10-K (in
thousands, except per share data).


Year
      Ended December 31,2008(1)
                              
                              
                              2007(2)
                              
                              
                              2006(3)
                              
                              
                              2005
                              
                              
                              2004Consolidated
      Statement of Operations Data:Revenues
                              
                              $
                              253,989
                              
                              
                              $
                              234,090
                              
                              
                              $
                              181,375
                              
                              
                              $
                              153,717
                              
                              
                              $
                              144,546Operating
      costs and expenses:Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization, shown below
                              
                              
                              135,877
                              
                              
                              
                              118,394
                              
                              
                              
                              97,338
                              
                              
                              
                              81,958
                              
                              
                              
                              76,990Direct
      costs of amortization of acquired technologies
                              
                              
                              6,649
                              
                              
                              
                              4,165
                              
                              
                              
                              516
                              
                              
                              
                              577
                              
                              
                              
                              579Direct
      costs of customer support
                              
                              
                              16,217
                              
                              
                              
                              16,547
                              
                              
                              
                              11,566
                              
                              
                              
                              10,670
                              
                              
                              
                              10,180Product
      development
                              
                              
                              8,477
                              
                              
                              
                              6,564
                              
                              
                              
                              4,475
                              
                              
                              
                              4,864
                              
                              
                              
                              6,412Sales
      and marketing
                              
                              
                              30,888
                              
                              
                              
                              31,533
                              
                              
                              
                              27,173
                              
                              
                              
                              25,864
                              
                              
                              
                              23,411General
      and administrative
                              
                              
                              30,675
                              
                              
                              
                              30,251
                              
                              
                              
                              21,556
                              
                              
                              
                              18,665
                              
                              
                              
                              22,357Provision
      for doubtful accounts
                              
                              
                              5,083
                              
                              
                              
                              2,261
                              
                              
                              
                              548
                              
                              
                              
                              1,431
                              
                              
                              
                              2,415Depreciation
      and amortization
                              
                              
                              23,865
                              
                              
                              
                              22,242
                              
                              
                              
                              15,856
                              
                              
                              
                              14,737
                              
                              
                              
                              15,461Goodwill
      impairment
                              
                              
                              99,700
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —Restructuring
      and other impairments
                              
                              
                              1,741
                              
                              
                              
                              11,349
                              
                              
                              
                              323
                              
                              
                              
                              44
                              
                              
                              
                              3,644Acquired
      in-process research and development
                              
                              
                              —
                              
                              
                              
                              450
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —Gain
      on disposals of property and equipment
                              
                              
                              (16
                              )
                              
                              
                              (5
                              )
                              
                              
                              (113
                              )
                              
                              
                              (19
                              )
                              
                              
                              (3
                              )Other
                              
                              
                              —
                              
                              
                              
                              50
                              
                              
                              
                              —
                              
                              
                              
                              60
                              
                              
                              
                              —Total
      operating costs and expenses
                              
                              
                              359,156
                              
                              
                              
                              243,801
                              
                              
                              
                              179,238
                              
                              
                              
                              158,851
                              
                              
                              
                              161,446(Loss)
      income from operations
                              
                              
                              (105,167
                              )
                              
                              
                              (9,711
                              )
                              
                              
                              2,137
                              
                              
                              
                              (5,134
                              )
                              
                              
                              (16,900
                              )Non-operating
      (income) expense
                              
                              
                              (245
                              )
                              
                              
                              (937
                              )
                              
                              
                              (1,551
                              )
                              
                              
                              (87
                              )
                              
                              
                              772(Loss)
      income before income taxes and equity in earnings of equity-method
      investment
                              
                              
                              (104,922
                              )
                              
                              
                              (8,774
                              )
                              
                              
                              3,688
                              
                              
                              
                              (5,047
                              )
                              
                              
                              (17,672
                              )Provision
      (benefit) for income taxes
                              
                              
                              174
                              
                              
                              
                              (3,080
                              )
                              
                              
                              145
                              
                              
                              
                              —
                              
                              
                              
                              —Equity
      in earnings of equity-method investment, net of taxes
                              
                              
                              (283
                              )
                              
                              
                              (139
                              )
                              
                              
                              (114
                              )
                              
                              
                              (83
                              )
                              
                              
                              390Net
      (loss) income
                              
                              $
                              (104,813
                              )
                              
                              $
                              (5,555
                              )
                              
                              $
                              3,657
                              
                              
                              $
                              (4,964
                              )
                              
                              $
                              (18,062
                              )Net
      (loss) income per share:Basic
                              
                              $
                              (2.13
                              )
                              
                              $
                              (0.12
                              )
                              
                              $
                              0.11
                              
                              
                              $
                              (0.15
                              )
                              
                              $
                              (0.63
                              )Diluted
                              
                              $
                              (2.13
                              )
                              
                              $
                              (0.12
                              )
                              
                              $
                              0.10
                              
                              
                              $
                              (0.15
                              )
                              
                              $
                              (0.63
                              )Weighted
      average shares used in per share calculations:Basic
                              
                              
                              49,238
                              
                              
                              
                              46,942
                              
                              
                              
                              34,748
                              
                              
                              
                              33,939
                              
                              
                              
                              28,732Diluted
                              
                              
                              49,238
                              
                              
                              
                              46,942
                              
                              
                              
                              35,739
                              
                              
                              
                              33,939
                              
                              
                              
                              28,732




- 28
-




December
      31,2008(1)
                  
                  
                  2007(2)
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Consolidated
      Balance Sheet Data:Cash,
      cash equivalents and short-term investments in marketable
      securities
                  
                  $
                  54,069
                  
                  
                  $
                  71,599
                  
                  
                  $
                  58,882
                  
                  
                  $
                  40,494
                  
                  
                  $
                  45,985Non-current
      marketable securities
                  
                  
                  6,378
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  4,656Total
      assets
                  
                  
                  330,083
                  
                  
                  
                  427,010
                  
                  
                  
                  173,702
                  
                  
                  
                  155,369
                  
                  
                  
                  168,149Note
      payable and capital lease obligations, less current
portion
                  
                  
                  23,244
                  
                  
                  
                  17,806
                  
                  
                  
                  3,364
                  
                  
                  
                  7,903
                  
                  
                  
                  12,837Total
      stockholders’ equity
                  
                  
                  248,195
                  
                  
                  
                  346,633
                  
                  
                  
                  126,525
                  
                  
                  
                  109,728
                  
                  
                  
                  113,738






Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Other
      Financial Data:Purchases
      of property and equipment
                  
                  $
                  51,154
                  
                  
                  $
                  30,271
                  
                  
                  $
                  13,382
                  
                  
                  $
                  10,161
                  
                  
                  $
                  13,066Net
      cash flows provided by (used in) operating activities
                  
                  
                  37,951
                  
                  
                  
                  27,526
                  
                  
                  
                  29,387
                  
                  
                  
                  5,493
                  
                  
                  
                  (1,150
                  )Net
      cash flows used in investing activities
                  
                  
                  (41,690
                  )
                  
                  
                  (36,393
                  )
                  
                  
                  (10,399
                  )
                  
                  
                  (9,428
                  )
                  
                  
                  (29,659
                  )Net
      cash flows (used in) provided by financing activities
                  
                  
                  (821
                  )
                  
                  
                  15,240
                  
                  
                  
                  1,957
                  
                  
                  
                  (5,454
                  )
                  
                  
                  45,747




__________________(1)
                As
      a result of our annual goodwill impairment test on August 1, 2008, we
      recorded a $99.7 million impairment charge to adjust goodwill in our CDN
      services segment to an implied fair value of $54.7
  million.(2)
                On
      February 20, 2007, we completed our acquisition of VitalStream, whereby
      VitalStream became our wholly-owned subsidiary. Prior to this acquisition,
      we did not offer proprietary CDN services, but instead, we were a reseller
      of third party CDN services. Under the purchase method of accounting, we
      allocated the total estimated purchase price to VitalStream’s net tangible
      and intangible assets based on their estimated fair values as of February
      20, 2007. We recorded the excess purchase price over the value of the net
      tangible and identifiable intangible assets as goodwill. Also, as a result
      of the acquisition, we issued approximately 12.2 million shares of our
      common stock.(3)
                Effective
      January 1, 2006, we adopted Statement of Financial Accounting Standards,
      or SFAS, No. 123 (revised 2004), Share-Based
      Payment (SFAS No. 123R) and related interpretations, using the
      modified prospective transition method and therefore have not restated
      prior periods’ results. Prior to the adoption of SFAS No. 123R on January
      1, 2006, we accounted for stock-based compensation plans under the
      recognition and measurement provisions of Accounting Principles Board
      (APB) Opinion No. 25, Accounting
      for Stock Issued to Employees, and related interpretations. We also
      provided disclosures in accordance with SFAS No. 123, Accounting
      for Stock-Based Compensation, as amended by SFAS No. 148, Accounting
      for Stock-Based Compensation—Transition and Disclosure —an Amendment of
      FASB Statement No. 123. Accordingly, we did not recognize expense
      for options to purchase our common stock that we granted with an exercise
      price equal to fair market value at the grant date and we did not
      recognize expense in connection with purchases under employee stock
      purchase plans for any periods prior to January 1,
  2006.




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-




ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS




The
following discussion should be read in conjunction with the accompanying
consolidated financial statements and notes provided under Part II, Item 8
of this Form 10-K. Certain prior year disclosures within the following
discussion have been reclassified to conform to the current year
presentation.




Overview




We
deliver Internet solutions through a suite of network optimization and delivery
products and services. These solutions and our technical support enable
companies to migrate business-critical applications, including audio and video
streaming and monetization services, to the Internet. Our suite of products and
services support a broad range of Internet applications. We currently have
approximately 3,600 customers in the United States and abroad, serving a variety
of industries, including entertainment and media, financial services,
healthcare, travel, e-commerce, retail and technology. Our product and service
offerings are complemented by Internet protocol, or IP, access solutions such as
data center services and content delivery networks, or CDN. We deliver services
through our 64 service points across North America, Europe, Asia, India and
Australia. Our Private Network Access Points, or P-NAPs, feature multiple direct
high-speed connections to multiple major Internet backbones including AT&T
Inc.; Sprint Nextel Corporation; Verizon Communications Inc.; Global Crossing
Limited; and Level 3 Communications, Inc.




We
believe our portfolio of patented and patent-pending route optimization
solutions differentiates us from our competitors. Our portfolio addresses the
inherent weaknesses of the Internet and overcomes the inefficiencies of
traditional IP connectivity options. Our intelligent routing technology can
facilitate traffic over multiple carriers, as opposed to just one carrier’s
network, to ensure highly-reliable performance over the Internet.




We
believe our unique managed multi-network approach provides better performance,
control and reliability compared to conventional Internet connectivity
alternatives. Our SLAs guarantee performance across the entire Internet in the
United States, excluding local connections, whereas providers of conventional
Internet connectivity typically only guarantee performance on their own
network.




On
February 20, 2007, we closed the acquisition of VitalStream in an all-stock
transaction accounted for using the purchase method of accounting for business
combinations. Our results of operations include the activities of VitalStream
from February 21, 2007 through December 31, 2008.




We
operate in three business segments: IP services, data center services and CDN
services. The following is a brief description of our reportable business
segments.




IP
Services




Our
patented and patent-pending network performance optimization technologies
address the inherent weaknesses of the Internet, allowing enterprises to take
advantage of the convenience, flexibility and reach of the Internet to connect
to customers, suppliers and partners. Our solutions take into account the
unique performance requirements of each business application to ensure
performance as designed, without unnecessary cost. Prior to recommending
appropriate network solutions for our customers’ applications, we consider key
performance objectives including (1) performance and cost optimization, (2)
application control and speed and (3) delivery and reach. Our fees for IP
services are based on a fixed-fee, usage or a combination of both.




Our IP
services segment also includes our flow control platform, or FCP. Our FCP is a
premise-based intelligent routing hardware product for customers who run their
own multiple network architectures, known as multi-homing. The prevalence of
multi-homed networks is increasing. To operate each network at the highest
performance level, a significant amount of expertise is required to monitor and
adjust to global Internet routing, which is very dynamic in nature. The FCP
functions similarly to our P-NAP, monitoring the global Internet and
automatically adjusting the routing in real-time to balance the traffic across
multiple links to optimize performance. FCP can be tuned to manage network
traffic on two dimensions: cost and performance. The user can set thresholds
that balance performance against cost, for example routing all traffic across
low cost providers while specific minimum performance thresholds are met. If the
performance deteriorates, then the traffic can be routed over a better
performing but more costly provider to maintain minimum specified performance.
This option allows our customer to enjoy service with the optimized performance
and economics. Another key feature is minute-by-minute visibility reports and
logs on the performance and operation of the customer’s network. Our customers
find this information to be useful for carrier SLA verification, monitoring
and overall network management. FCP is one of only a few of the industry’s route
control appliances that analyzes and re-routes Internet traffic flows in
real-time. We offer FCP as either a one-time hardware purchase or as a monthly
subscription service. Sales of FCP also generate annual maintenance fees and
professional service fees for installation and ongoing network configuration.
Since the FCP emulates our P-NAP service in many ways, this product affords us
the opportunity to serve customers outside of our P-NAP market footprint. This
product represents approximately 4% of our IP services revenue and approximately
2% of our consolidated revenue for the year ended December 31,
2008.


- 30
-




Data
Center Services




Our data
center, or colocation, services allow us to expand the reach of our high
performance IP services to customers who wish to take advantage of locating
their network and application assets in secure, high-performance facilities. We
operate data centers where customers can host their applications directly on our
network to eliminate the issues associated with the quality of local
connections. Data center services also enable us to have a more flexible product
offering, such as bundling our high performance IP connectivity and managed
services such as content delivery along with hosting customers’ applications.
Our data center services provide a single source for network infrastructure, IP
and security, all of which are designed to maximize solution performance while
providing a more stable, dependable infrastructure, and are backed by guaranteed
service levels and our team of dedicated support professionals.




To
maximize this footprint, we use a combination of facilities managed by us and
facilities managed by third parties, referred to as partner sites. We offer a
comprehensive solution at 46 service points, including eight locations managed
by us and 38 locations managed by third parties. We charge monthly fees for data
center services based on the amount of square footage that the customer leases
in our facilities. We have relationships with various providers to extend our
P-NAP model into markets with high demand.




CDN
Services




Our CDN
services enable our customers to quickly and securely stream and distribute
video, audio and software to audiences across the globe through strategically
located data centers. Providing capacity-on-demand to handle large events and
unanticipated traffic spikes, we deliver high-quality content regardless of
audience size or geographic location. Our MediaConsole® content management tool
provides our customers the benefit of a single, easy to navigate system
featuring Media Asset Management, Digital Rights Management, or DRM, support and
detailed reporting tools. With MediaConsole, our customers can use one
application to manage and control access to their digital assets, view network
conditions and gain insight into habits of their viewing audience. Prior to our
acquisition of VitalStream in February 2007, we did not offer proprietary CDN
services, but instead, we were a reseller of third party CDN services for which
results of operations are included in “—Other” below.




Other




Other
revenues and direct costs of network, sales and services consist primarily of
third party CDN services. Throughout 2007, other revenues and associated direct
costs of network, sales and services decreased steadily as the revenue streams
from our acquisition of VitalStream replaced the activity of the former third
party CDN service provider.




2008
Highlights and Outlook


●
              Although
      we experienced pricing pressure for our IP services, our revenue increased
      year-to-year due to an increase in demand for our services.We
      historically have priced our IP services at a premium compared to the
      services offered by conventional Internet connectivity service providers.
      Due to competitive forces, however, we have been required to lower pricing
      of our IP services, although this decrease in pricing has been offset by
      an increase in demand for our IP services. Our IP traffic has increased as
      a result of our customers requiring greater overall capacity due to growth
      in the usage of their applications, as well as in the nature of
      applications consuming greater amounts of bandwidth. We expect that we
      will continue to experience pricing pressure as well as gains in IP
      traffic for the reasons noted.●
              Data
      center services continue to be a source of revenue growth for our
      business, and we expect this trend to continue. We have expanded
      the sites that we operate and may add additional space in the future as
      part of our data center growth initiative. The growth in data center
      revenues and direct costs of data center services largely follows our
      expansion of data center space, and we believe the demand for data center
      services continues to outpace industry-wide supply. We experienced a net
      increase in customers in this segment as we structured our data center
      business to accommodate larger, global
      customers.●
              Although
      we experienced a net decrease in customers in our CDN segment, our revenue
      in that segment has increased. Revenues increased in our CDN
      segment, despite a net decrease in the number of our CDN customers, due to
      increased usage of our applications. Although this revenue growth has not
      met our initial expectations, we believe the growth will continue. In this
      regard, we have upgraded and expanded related infrastructure, including in
      Europe and Asia. We also have extended our 100% uptime SLA to customers
      purchasing or renewing CDN services. As discussed in note 8 to the
      accompanying financial statements and below, we recorded asset impairment
      charges of $102.3 million on our CDN services goodwill and other
      intangible
assets.




- 31
-




In
      our existing markets, we realize incremental margins as new customers are
      added. Additional volume in an existing market allows improved utilization
      of existing facilities and an improved ability to cost-effectively predict
      and acquire additional network capacity. Conversely, decreases in the
      number of customers in an established market lead to decreased facility
      utilization and increase the possibility that direct network resources are
      not cost-efficiently employed. Although we are encouraged by our revenue
      growth among a smaller customer base, we will continue to strive to add
      additional customers to achieve these cost savings.●
                We
      have experienced impairments in our goodwill and other intangible assets
      and additional adjustments to our restructuring reserve, summarized as
      follows:●          Goodwill. We are required to assess
      goodwill for impairment under generally accepted accounting principles in
      the United States, or GAAP, on at least an annual basis. Our annual
      assessment date is August 1 of each year, following our annual strategic
      planning cycle, which includes an update of our long-term financial
      outlook.As
      a result of our August 1, 2008 assessment, we concluded that the current
      carrying value of our goodwill in the CDN services segment was impaired.
      We recorded the CDN services goodwill following our February 2007
      acquisition of VitalStream. We recorded a $99.7 million goodwill
      impairment charge to adjust goodwill in our CDN services segment to an
      implied fair value of $54.7 million. The goodwill impairment charge was
      primarily due to declines in our CDN services revenues and operating
      results as compared to our projections and unfavorable changes in market
      factors used to estimate fair values.The
      impairment also caused us to reverse a deferred tax liability and create
      an income tax benefit of $0.6 million associated with the CDN services
      goodwill.We
      also assessed the likelihood of triggering events and concluded that none
      had occurred that would cause us to re-assess goodwill for impairment
      subsequent to August 1, 2008.●          Other
      Intangible Assets.In conjunction with our August 1, 2008 review of
      our long-term financial outlook, we also performed an analysis of the
      potential impairment, and re-assessed the remaining asset lives, of other
      identifiable intangible assets acquired in the VitalStream acquisition.
      This analysis and re-assessment resulted in: (1) an impairment charge of
      $1.9 million in developed advertising technology due to a strategic change
      in market focus, (2) an impairment charge of $0.8 million in trade names
      as a result of discontinuing use of the VitalStream trade name and (3) a
      change our estimates that resulted in acceleration of amortization
      expense of our customer relationships intangible asset over a shorter
      estimated useful life (four remaining years instead of the original
      estimated nine years) due to customer churn resulting in higher than
      expected attrition as of our acquisition date.These
      non-cash charges to earnings and change in estimated useful life had no
      impact on our cash balance as of December 31, 2008 and did not result in a
      violation of any covenants in our debt instruments.We
      discuss these impairments in note 8 to the accompanying consolidated
      financial statements and the section below captioned “—Results of
      Operations—Other Operating Expenses—Goodwill Impairment” and
      “—Restructuring and Other Impairments.”●          Restructuring.
      In conjunction with the preparation of our financial statements as of and
      for the year ended December 31, 2008 and in light of the recent and
      significant deterioration in the real estate market, we completed an
      analysis of our remaining accrued restructuring liability for leased
      facilities. After reviewing the analysis and specifically, the underlying
      assumptions related to anticipated sublease recoveries, we concluded that
      certain of the facilities remaining in the restructuring accrual were
      taking longer than expected to sublease or were otherwise not generating
      the expected levels of sublease income. The analyses were based on
      discounted cash flows using the same credit-adjusted risk-free rate that
      we used to measure the initial restructuring liability for leases that
      were part of the 2007 restructuring plan and undiscounted cash flows for
      leases that were part of the 2001 restructuring plan. The cumulative
      effect of these changes was $1.1 million which we recorded as additional
      restructuring expense and an increase to the liability. We discuss this
      charge in note 9 and report it in “Restructuring and other impairments” in
      the accompanying consolidated statement of operations, along with a $0.8
      million impairment of the VitalStream tradename and a reduction of the
      accrued liability of $0.1 million for employee separations since we paid
      all such amounts. We estimated net related expenditures for the 2007
      restructuring plan to be $12.2 million, of which we paid $4.2 million
      through December 31, 2008, and the balance continuing through December
      2016, the last date of the longest lease term. We expect to pay these
      expenditures out of operating cash flows. We estimate cost savings
      from the restructuring to be approximately $0.8 million per year through
      2016, primarily for
rent.




- 32
-




●
              We
      amended our Credit Agreement. On September 30, 2008, we amended our
      credit agreement with Bank of America, N.A. The amendment consolidated a
      two-tiered debt facility into a single revolving loan. Under the amended
      credit facility, we converted the previously-existing $20.0 million term
      loan balance and outstanding letters of credit with Bank of America into a
      $35.0 million revolving loan facility. The amendment extended the
      principal settlement terms from quarterly payments, scheduled to begin in
      the third quarter of 2008, to a single principal repayment due in 2011. As
      of December 31, 2008, we had $10.8 million of borrowing capacity on the
      revolving credit facility. We discuss this amended credit agreement in
      note 11 to the accompanying consolidated financial statements and the
      section below captioned “—Liquidity and Capital
      Resources.”●
              We
      have increased our provision for doubtful accounts after taking into
      consideration current economic conditions.We are continuing to
      monitor and review our performance and operations in light of the
      continuing negative global economic conditions. A prolonged recession, if
      it were to occur, may have an adverse impact on spending by the businesses
      we serve, resulting in a decline in demand for our products and services.
      In addition, deteriorating economic conditions may make it more difficult
      for these businesses to meet their obligations to us, which could result
      in delayed collection of accounts receivable and an increase in our
      provision for doubtful accounts. For the year ended December 31, 2008, we
      increased our provision for doubtful accounts by $2.8 million, compared to
      the year ended December 31, 2007, in part after taking into consideration
      current economic
conditions.




Critical
Accounting Policies and Estimates




This
discussion and analysis of our financial condition and results of operations is
based upon our consolidated financial statements, which have been prepared in
accordance with GAAP. The preparation of these financial statements requires
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenue and expense and related disclosure of contingent
assets and liabilities. On an ongoing basis, we evaluate our estimates,
including those summarized below. We base our estimates on historical experience
and on various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ materially from these
estimates.




Management
believes the following critical accounting policies affect the judgments and
estimates used in the preparation of our consolidated financial
statements.




Revenue
Recognition. The majority of our
revenue is derived from high performance IP services, related data center
services, CDN services and other ancillary products and services throughout
the United States. We derive our IP services revenue from the sale of
high performance Internet connectivity services at fixed rates or usage-based
pricing to our customers that desire a DS-3 or faster connection. We provide
slower T-1 and fractional DS-3 connections at fixed rates. Data center
revenues include both physical space for hosting customers’ network and other
equipment plus associated services such as redundant power and network
connectivity, environmental controls and security. Data center revenue is based
on occupied space and both allocated and variable-based usage. CDN product line
revenue includes three components: (1) data storage; (2) streaming/delivery and
(3) a user interface/reporting tool. We provide the CDN service components via
internally developed and acquired technology that resides on our network. CDN
services revenues are based on either fixed rates or usage-based pricing.
All of the foregoing revenue arrangements have contractual terms and in many
instances, include minimum usage commitments and
provide the rate at which the customer must pay for actual usage above the
monthly minimum. For these services, we recognize the monthly minimum as revenue
each month provided that both parties have signed an enforceable contract, we
have delivered the service to the customer, the fee for the service is fixed or
determinable and collection is reasonably assured. If a customer’s usage of our
services exceeds the monthly minimum, we recognize revenue for such excess in
the period of the usage. We record the installation fees as deferred revenue and
recognize as revenue ratably over the estimated life of the customer
arrangement. We also derive revenue from services sold as discrete,
non-recurring events or based solely on usage. For these services, we recognize
revenue after both parties have signed an enforceable contract, the fee is fixed
or determinable, the event or usage has occurred and collection is reasonably
assured. Other ancillary products and services include our FCP product,
server management and installation, virtual private networking, managed
security,
data backup,
remote storage and restoration.




We use
contracts and sales or purchase orders as evidence of an arrangement. We test
for availability or connectivity to verify delivery of our services. We assess
whether the fee is fixed or determinable based on the payment terms associated
with the transaction and whether the sales price is subject to refund or
adjustment. Because the software component of our FCP is more than incidental to
the product as a whole, we recognize associated FCP revenue in accordance with
the American Institute of Certified Public Accountants’ Statement of Position
97-2, Software
Revenue Recognition.


- 33
-




We also
enter into multiple-element arrangements or bundled services, such as combining
IP services with data center and/or CDN services. When we enter into such
arrangements, we account for each element separately over its respective service
period or at the time of delivery, provided that there is objective evidence of
fair value for the separate elements. Objective evidence of fair value includes
the price charged for the element when sold separately. If we cannot objectively
determine the fair value of each element, we recognize the total value of the
arrangement ratably over the entire service period to the extent that we have
begun to provide the services, and we have satisfied other revenue recognition
criteria.




Deferred
revenue consists of revenues for services to be delivered in the future and
consists primarily of advance billings, which we amortize over the respective
service period. We defer and amortize revenues associated with billings for
installation of customer network equipment over the estimated life of the
customer relationship, which was two to three years during the
three-year period ended December 31, 2008. We defer and amortize revenues
for installation services because the installation service is integral to our
primary service offering and does not have value to customers on a stand-alone
basis. We also defer and amortize the associated incremental direct costs. We
amortize deferred post-contract customer support associated with sales of our
FCP and similar products ratably over the contract period, which is
generally one year.




We
routinely review the collectability of our accounts receivable and payment
status of our customers. If we determine that collection of service revenue is
uncertain, we do not recognize revenue until collection is probable.
Additionally, we maintain allowances for doubtful accounts resulting from the
inability of our customers to make required payments on accounts receivable. The
allowance for doubtful accounts is based upon specific and general customer
information, which also includes estimates based on our best understanding of
the customers’ ability to pay and their payment status. Customers’ ability
to pay takes into consideration payment history, legal status (i.e., bankruptcy)
and the status of services we are providing. We assess the payment status of
customers by reference to the terms under which services or goods are provided,
with any payments not made on or before their due date considered
past-due. Once we have exhausted all collection efforts, we write the
uncollectible balance off against the allowance for doubtful
accounts.




We record
an amount for service level agreements and other sales adjustments, which
reduces net accounts receivable and revenues. Adjustments for service level
agreements are identified within the billing period and revenues are reduced
accordingly. The amount for sales adjustments is based upon
specific customer information, including outstanding promotional credits,
customer disputes, credit adjustments not yet processed through the billing
system and historical activity. If the financial condition of our customers
deteriorates, or if we become aware of new information impacting a customer's
credit risk, we may make additional adjustments.




Investments.
Pursuant to our formal investment policy, investments in marketable securities
include high credit quality corporate debt securities, auction rate securities,
commercial paper and U.S. Treasury bills. Auction rate securities are variable
rate bonds tied to short-term interest rates with maturities on the face of the
securities in excess of 90 days and have interest rate resets through a modified
Dutch auction, at predetermined short-term intervals, usually every seven, 28 or
35 days. Auction rate securities generally trade at par and are callable at par
on any interest payment date at the option of the issuer. Interest received
during a given period is based upon the interest rate determined through the
auction process. The underlying assets of our auction rate securities are
state-issued student and educational loans that are substantially backed by the
federal government and carried AAA/Aaa ratings as of December 31, 2008. Although
these securities are issued and rated as long-term bonds, they have historically
been priced and traded as short-term instruments because of the liquidity
provided through the interest rate reset. While we continue to earn and accrue
interest on our auction rate securities at contractual rates, these investments
are not currently trading. Due to initial uncertainty as to when liquidity in
the auction rate securities markets would improve, we have classified our
auction rate securities as non-current investments throughout 2008.
Subsequently, in November 2008, we accepted a rights offer, or ARS Rights, on
our auction rate securities. In conjunction with our acceptance of the ARS
Rights, we changed the designation of the auction rate securities to trading
from available for sale and continue to classify the securities as non-current
investments as of December 31,
2008.




Our
auction rate securities and ARS Rights do not have observable market information
to determine their fair value. We estimated the fair value of the auction rate
securities based on a wide array of market evidence related to each security’s
collateral, ratings and insurance to assess default risk, credit spread risk and
downgrade risk that we believe market participants would use in pricing the
securities in a current transaction. These assumptions could change
significantly over time based on market conditions. We then used a trinomial
discount model where the future cash flows of the auction rate securities were
priced by summing the present value of the future principal and forecasted
interest payments. We also considered probabilities of default, auction failure,
a successful auction at par value or repurchase at par value and recovery rates
in default for each of the securities. We then discounted the weighted average
cash flow for each period back to present value at the determined discount rate
for each auction rate security.


- 34
-




We
estimated the fair value of the ARS Rights based on a valuation approach
commonly used for forward contracts in which one party agrees to sell a
financial instrument (generating cash flows) to another party at a particular
time for a predetermined price. In this approach we subtracted the present value
of all expected future cash flows from the current fair value of the security,
and calculated the resulting value as a future value at an interest rate
reflective of counterparty risk.




See notes
5 and 6 to our accompanying consolidated financial statements for additional
information about our investments and their fair value measurement.




Goodwill
and Other Intangible Assets. We account for goodwill using an
impairment-only approach. Our assessment of goodwill for impairment includes
comparing the fair value to the net book value of each of our four reporting
units. Our IP services operating segment is comprised of two reporting units:
services and products. Our data center center services and CDN services
operating segments each represent a single reporting unit; however, the data
center services segment does not have any recorded goodwill. As a result of our
August 1, 2008 assessment, we recorded a $99.7 million goodwill impairment
charge to adjust goodwill in our CDN services segment to an implied fair value
of $54.7 million.




We
estimate fair value using a combination of discounted cash flow models and
market approaches. If the fair value of a reporting unit exceeds its net book
value, goodwill is not impaired and no further testing is necessary. If the net
book value of a reporting unit exceeds its fair value, we perform a second test
to measure the amount of impairment loss, if any. To measure the amount of any
impairment loss, we determine the implied fair value of goodwill in the same
manner as if the affected reporting unit were being acquired in a business
combination. Specifically, we allocate the fair value of the affected reporting
unit to all of the assets and liabilities of that unit, including any
unrecognized intangible assets, in a hypothetical calculation that would yield
the implied fair value of goodwill. If the implied fair value of goodwill is
less than the goodwill recorded on our consolidated balance sheet, we record an
impairment charge for the difference.




The
impairment analysis of goodwill is based on estimated fair values. The
assumptions, inputs and judgments used in performing the valuation analysis are
inherently subjective and reflect estimates based on known facts and
circumstances at the time the valuation is performed. These estimates and
assumptions primarily include, but are not limited to, revenue and market
growth, operating cash flows, earnings before interest, taxes, depreciation and
amortization, or EBITDA, capital expenditures forecasts, discount rates and
terminal growth rates. The use of different assumptions, inputs and judgments,
or changes in circumstances, could materially affect the results of the
valuation. Due to the inherent uncertainty involved in making these estimates,
actual results could differ from our estimates. The following is a description
of the valuation methodologies we used to derive the fair value of our CDN
services segment:




●
              Income
      Approach. To determine fair value, we discounted the expected cash
      flows of the CDN services reporting unit. Expected cash flows were
      calculated using a compounded annual revenue growth rate of approximately
      20%, forecasting existing cost structures and considering capital
      reinvestment requirements. We used a discount rate of 20%, representing
      the estimated weighted average cost of capital, which reflects the overall
      level of inherent risk involved in our CDN services operations and the
      rate of return an outside investor would expect to earn. To estimate cash
      flows beyond the final year of our model, we used a terminal value and
      incorporated the present value of the resulting terminal value into our
      estimate of fair value.●
              Market-Based
      Approach. To corroborate the results of the income approach
      described above, we estimated the fair value of our CDN services reporting
      unit using several market-based approaches, including the enterprise value
      that we derive based on our stock price. We also used the guideline
      company method, which focuses on comparing our risk profile and growth
      prospects, to select reasonably similar/guideline publicly traded
      companies. Using the guideline company method, we selected revenue and
      EBITDA multiples below the median for our comparable
      companies.




We used
similar valuation methodologies to derive the fair values of our other reporting
units. Adverse changes in expected operating results and/or unfavorable changes
in other economic factors used to estimate fair values could result in an
additional non-cash impairment charge in the future.




We
perform our annual goodwill impairment test as of August 1 of each calendar
year, following our annual strategic planning cycle. We also assess on a
quarterly basis whether any events have occurred or circumstances have changed
that would indicate an impairment could exist. We have considered the likelihood
of triggering events that might cause us to re-assess goodwill on an interim
basis and concluded that none had occurred subsequent to August 1,
2008.




Accruals
for Disputed Telecommunication Costs and Other Accrued Liabilities. In
delivering our services, we rely on a number of Internet network,
telecommunication, utilities and other vendors. We work directly with these
vendors to establish, modify or discontinue services for our customers. Because
of the volume of activity, billing disputes inevitably arise, and it is often
necessary to estimate certain costs of providing services to our customers given
that we may not receive invoices on a timely basis or due to the complexity
surrounding such costs. These disputes typically stem from disagreements
concerning the starting and ending dates of service, quoted rates, usage and
various other factors. For potential billing errors made in the vendor’s favor,
for example a duplicate billing, we initiate a formal dispute with the vendor
and record the related cost and liability up to 100% of the disputed amount,
depending on our assessment of the likely outcome of the dispute. Conversely,
for billing errors in our favor, such as the vendor’s failure to invoice us for
new service, we record an estimate based on the full amount that we should have
been invoiced. If an estimate is necessary, we record the related cost and
liability based on all available facts and circumstances, including but not
limited to historical trends, related usage, forecasts and
quotes.


- 35
-




We
research and discuss all disputed costs with vendors on an ongoing basis until
ultimately resolved. We periodically review and modify estimates in light of new
information or developments, if any. We recognize any resolved disputes that
will result in a credit over the disputed amounts in the appropriate month when
the resolution has been determined. Because estimates regarding disputed costs
include assessments of uncertain outcomes, such estimates are inherently
vulnerable to changes due to unforeseen circumstances that could materially and
adversely affect our consolidated financial condition, results of operations and
cash flows.




Restructuring
Liability. When circumstances warrant, we may elect to exit certain
business activities or change the manner in which we conduct ongoing operations.
When we make such a change, we will estimate the costs to exit a business or
restructure ongoing operations. The components of the estimates may include
estimates and assumptions regarding the timing and costs of future events and
activities that represent our best expectations based on known facts and
circumstances at the time of estimation. Should circumstances warrant, we will
adjust our previous estimates to reflect what we then believe to be a more
accurate representation of expected future costs. Because our estimates and
assumptions regarding restructuring costs include probabilities of future
events, such as our ability to find a sublease tenant within a reasonable period
of time or the rate at which a sublease tenant will pay for the available space,
such estimates are inherently vulnerable to changes due to unforeseen
circumstances that could materially and adversely affect our results of
operations. A 10% change in our restructuring estimates in a future period,
compared to the $9.0 million restructuring liability at December 31, 2008, would
result in a $0.9 million expense or benefit in the statement of operations
during the period in which the change in estimate occurred. If we do not find a
sublease tenant for one of our more significant restructured locations by the
end of the second quarter of 2010 or if we do not obtain a certain rate per
square foot for the available space, we will need to take an additional charge
in our statement of operations that may be material. We monitor market
conditions at each period end reporting date and will continue to assess our key
assumptions and estimates used in the calculation of our restructuring
accrual.




Deferred
Taxes. We record a valuation allowance to reduce our deferred tax assets
to the amount that is more likely than not to be realized. Historically, we have
recorded a valuation allowance equal to our net deferred tax assets. Although we
consider the potential for future taxable income and ongoing prudent and
feasible tax planning strategies in assessing the need for the valuation
allowance, in the event we determine we would be able to realize our deferred
tax assets in the future in excess of our net recorded amount, an adjustment to
reduce the valuation allowance would increase income in the period such
determination was made. We may recognize deferred tax assets in future periods
when they are estimated to be realizable, such as establishing expected
continuing profitability of us or certain of our foreign
subsidiaries.




Based on
analysis of our projected future U.S. pre-tax income, we may have sufficient
positive evidence within the next 12 months to release the valuation allowance
currently recorded against our U.S. deferred tax assets. Currently, while we
cannot guarantee that our expectations of future positive income will occur, we
may recognize an income tax benefit derived from total U.S. deferred tax assets
upon the release of the valuation allowance. This potential release of the
valuation allowance could be affected by an ownership change as defined by
Section 382 of the Internal Revenue Code which might limit the future use of our
U.S. net operating loss carryovers and thus reduce the potential benefit of such
losses in the future to offset taxable income and reduce cash outflows for
income taxes.




For the
year ended December 31, 2007, the tax provision included a net benefit of $3.5
million related to the release of the valuation allowance associated with United
Kingdom, or U.K., deferred tax assets. The gross amount of U.K. deferred tax
assets was $4.4 million, which was offset by a reserve of $0.9 million. The net
tax provision benefit of $3.5 million reduced our net loss for the year ended
December 31, 2007. The reduction in valuation allowance was due to the existence
of sufficient positive evidence as of December 31, 2007 to indicate that our net
operating losses in the U.K. would more likely than not be realized in the
future. The evidence primarily consists of the results of prior performance in
the U.K. and the expectation of future performance based on historical results.
We will continue to assess the recoverability of U.S. and other deferred tax
assets, and whether the valuation allowance should be reduced relative to the
U.S. and other deferred tax assets outside the U.K.




Stock-Based
Compensation. We measure stock-based compensation cost at the grant date
based on the calculated fair value of the award. We recognize the expense over
the employee’s requisite service period, generally the vesting period of the
award. For performance-based awards, we periodically assess whether the
performance conditions are probable of being met and record compensation expense
based on this assessment of probability. We estimate the fair value of stock
options at the grant date using the Black-Scholes option pricing model with
weighted average assumptions for the activity under our stock plans. Option
pricing model input assumptions, such as expected term, expected volatility and
risk-free interest rate, impact the fair value estimate. Further, the forfeiture
rate impacts the amount of aggregate compensation. These assumptions are
subjective and generally require significant analysis and judgment to develop.
When we
elect to pay certain bonuses in shares of stock, the total amount to be paid is
determined similarly to cash bonuses and the number of shares to be granted is
determined based on the fair value of our stock at the date of
grant.


- 36
-




The
expected term represents the weighted average period of time that we expect
granted options to be outstanding, giving consideration to the vesting schedules
and our historical exercise patterns. Because our options are not publicly
traded, assumed volatility is based on the historical volatility of our stock.
The risk-free interest rate is based on the U.S. Treasury yield curve in effect
at the time of grant for periods corresponding to the expected term of the
options. We have also used historical data to estimate option exercises,
employee termination and stock option forfeiture rates. Changes in any of these
assumptions could materially impact our results of operations in the period the
change is made.




Recent
Accounting Pronouncements




Effective
January 1, 2008, we adopted SFAS No. 157, Fair
Value Measurements. SFAS No. 157 defines fair value, establishes a
framework for measuring fair value under GAAP and expands disclosures about fair
value measurements. SFAS No. 157 is effective for fiscal years beginning after
December 15, 2007. In February 2008, the FASB issued Staff Position FAS 157-1,
Application
of FASB Statement No. 157 to FASB Statement No. 13 and Its Related Interpretive
Accounting Pronouncements That Address Leasing Transactions, which
provides supplemental guidance on the application of SFAS No. 157, and Staff
Position FAS 157-2, Effective
Date of FASB Statement No. 157,which delays the effective date of SFAS
No. 157 for nonfinancial assets and nonfinancial liabilities, except those that
are recognized or disclosed at fair value on at least an annual basis until
2009. In accordance with Staff Position FAS 157-2, we have only adopted the
provisions of SFAS No. 157 with respect to our financial assets and liabilities
that are measured at fair value within the financial statements as of December
31, 2008. We have not applied the provisions of SFAS No. 157 to
nonfinancial assets and nonfinancial liabilities. The major categories of assets
and liabilities that are measured at fair value, for which we have not applied
the provisions of SFAS No. 157, include reporting units measured at fair value
in the first step of a goodwill impairment test under SFAS No. 142, Goodwill and Other Intangible Assets. The
adoption of SFAS No. 157 did not have a material impact on our financial
position, results of operations and cash flows.




In
October 2008, the FASB issued Staff Position FAS 157-3, Determining
the Fair Value of a Financial Asset When the Market for That Asset Is Not
Active, which clarifies the application of SFAS No. 157 in a market that
is not active and provides an example to illustrate key considerations in
determining the fair value of a financial asset when the market for that
financial asset is not active. Some of the key principles illustrated
include:




●
              determining
      fair value in a dislocated market depends on facts and circumstances, and
      may require the use of significant judgment about whether individual
      market transactions are forced liquidations or distressed sales and
      therefore poor indicators of fair value;●
              when
      relevant observable market data is not available, the use of assumptions
      about future cash flows and discount rates may be appropriate in
      determining fair value; and●
              the
      value of broker quotes in determining fair value depends on facts and
      circumstances, particularly when an active market does not
      exist.




Staff
Position FAS 157-3 was effective immediately, including with respect to prior
periods for which financial statements have not been issued. We have
consistently used the methodology described in this Staff Position in
calculating the fair value of our auction rate securities throughout
2008.




In
February 2007, the FASB issued SFAS No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities. SFAS
No. 159 permits companies to choose to measure, on an instrument-by-instrument
basis, many financial instruments and certain other assets and liabilities at
fair value that are not currently required to be measured at fair value. SFAS
No. 159 was effective for fiscal years beginning after November 15, 2007. The
adoption of SFAS No. 159 did not have a material impact on our financial
condition, results of operation and cash flows since we elected to apply
the fair value option only to our ARS Rights. See note 6 for discussion of the
fair value election of our ARS Rights.




In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business
Combinations, or SFAS No. 141R. This pronouncement replaces SFAS No. 141,
Business
Combinations. SFAS No. 141R establishes principles and requirements for
how an acquirer recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, any noncontrolling
interest in the acquiree and the goodwill acquired or a gain from a bargain
purchase. SFAS No. 141R also determines disclosure requirements to enable the
evaluation of the nature and financial effects of the business combination. SFAS
No. 141R applies prospectively to business combinations for which the
acquisition date is on or after the beginning of a fiscal year that begins on or
after December 15, 2008 and there are also implications for acquisitions that
occur prior to this date. We do not expect that adoption of SFAS No.
141R will have an immediate impact on our financial position, results of
operations and cash flows.




In
December 2007, the FASB issued SFAS No. 160, Noncontrolling
Interests in Consolidated Financial Statements. SFAS No. 160 amends
Accounting Research Bulletin 51, Consolidated
Financial Statements, and requires all entities to report noncontrolling
(minority) interests in subsidiaries within equity in the consolidated financial
statements, but separate from the parent shareholders’ equity. SFAS No. 160 also
requires any acquisitions or dispositions of noncontrolling interests that do
not result in a change of control to be accounted for as equity transactions.
Further, SFAS No. 160 requires that a parent recognize a gain or loss in net
income when a subsidiary is deconsolidated. SFAS No. 160 is effective for fiscal
years beginning on or after December 15, 2008. We do not expect adoption of SFAS
No. 160 will have a material impact on our financial position, results of
operations and cash flows.


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-




In March
2008, the FASB issued SFAS No. 161, Disclosures
about Derivative Instruments and Hedging Activities, an amendment of FASB
Statement No. 133. SFAS No. 161 amends and expands the disclosure
requirements of SFAS No. 133 with the intent to provide users of financial
statements with an enhanced understanding of: (1) how and why an entity uses
derivative instruments; (2) how derivative instruments and related hedged items
are accounted for under SFAS No. 133 and its related interpretations and (3) how
derivative instruments and related hedged items affect an entity’s financial
position, financial performance and cash flows. This statement is effective for
financial statements for fiscal years and interim periods beginning after
November 15, 2008. We do not expect adoption of SFAS No. 161 to have a
material impact on our financial position, results of operations and cash
flows.




In April
2008, the FASB issued Staff Position FAS 142-3, Determination
of the Useful Life of Intangible Assets. Staff Position FAS 142-3 amends
the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142. This Staff Position is effective for financial statements
for fiscal years beginning after December 15, 2008. We do not expect adoption of
Staff Position FAS 142-3 to have a material impact on our financial position,
results of operations and cash flows.




In June
2008, the FASB issued Staff Position No. EITF 03-6-1, Determining
Whether Instruments Granted in Share-Based Payment Transactions are
Participating Securities. Staff Position No. EITF 03-6-1 provides that
unvested share-based payment awards that contain nonforfeitable rights to
dividends are participating securities and shall be included in the computation
of earnings per share pursuant to the two class method. This Staff Position is
effective for financial statements issued for fiscal years beginning after
December 15, 2008 and interim periods within those years. For the quarter ended
March 31, 2009, upon adoption, we are required to retrospectively adjust
earnings per share data to conform to the provisions in this Staff Position. We
do not expect this Staff Position to have a material impact on our calculation
of earnings per share.




In
November 2008, the FASB issued EITF 08-6, Equity
Method Investment Accounting Considerations. The goal of EITF 08-6 is to
clarify the accounting for certain transactions and impairment considerations
involving equity method investments. This EITF is effective for fiscal years
beginning on or after December 15, 2008. Early adoption is not permitted. We do
not expect adoption of EITF 08-6 to have a material effect on our financial
position, results of operations and cash flows.




Results
of Operations




Revenues.
Revenues are generated primarily from the sale of IP services, data center
services and CDN services. Our revenues typically consist of monthly recurring
revenues from contracts with terms of one year or more. These contracts usually
have fixed minimum commitments based on a certain level of usage with additional
charges for any usage over a specified limit. We also provide premise-based
route optimization products and other ancillary services, such as server
management and installation services, virtual private networking services,
managed security services,
data back-up, remote storage, restoration services and professional
services.




Direct
Costs of Network, Sales and Services. Direct costs of network, sales and
services are comprised primarily of:




●
              costs
      for connecting to and accessing NSPs and competitive local exchange
      providers;●
              facility
      and occupancy costs for hosting and operating our and our customers’
      network equipment;●
              costs
      of FCP solutions sold;●
              costs
      incurred for providing additional third party services to our customers;
      and●
              royalties
      and costs of license fees for operating systems
  software.




To the
extent a network access point is located at a distance from the respective NSP,
we may incur additional local loop charges on a recurring basis. Connectivity
costs vary depending on customer demands and pricing variables while network
access point facility costs are generally fixed in nature. Direct costs of
network, sales and services do not include compensation, depreciation or
amortization.




Direct
Costs of Amortization of Acquired Technologies. Direct costs of
amortization of acquired technologies are for technologies acquired through
business combinations that are an integral part of the services and products we
sell. We amortize the cost of the acquired technologies over original lives of
three to eight years.


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-




Direct Costs of
Customer Support. Direct costs of customer support consist primarily of
compensation and other personnel costs for employees engaged in connecting
customers to our network, installing customer equipment into network access
point facilities and servicing customers through our network operations centers.
In addition, we include facilities costs associated with the network operations
center in direct costs of customer support.
  Product
Development Costs. Product development costs consist principally of
compensation and other personnel costs, consultant fees and prototype costs
related to the design, development and testing of our proprietary technology,
enhancement of our network management software and development of internal
systems. We capitalize costs for software to be sold, leased or otherwise
marketed once we establish technological feasibility until the software is
available for general release to customers. We capitalize costs associated with
internal use software when the software enters the application development stage
until the software is ready for its intended use. We expense all other product
development costs as incurred.
  Sales and
Marketing Costs. Sales and marketing costs consist of compensation,
commissions and other costs for personnel engaged in marketing, sales and field
service support functions, as well as advertising, tradeshows, direct response
programs, new service point launch events, management of our web site and other
promotional costs.
  General and
Administrative Costs. General and administrative costs consist primarily
of compensation and other expense for executive, finance, human resources and
administrative personnel, professional fees and other general corporate
costs.
  Following
is a summary of our results of operations and financial condition, which is
followed by more in-depth discussion and analysis.
  For the
year ended December 31, 2008, total revenues were $254.0 million, an increase of
8.5% over the year ended December 31, 2007. Data center services revenue was the
primary growth driver for the year, increasing 31% compared with 2007. We
reported a net loss for the year ended December 31, 2008 of $104.8 million,
which included (1) $99.7 million in impairment charges for goodwill, (2) $2.6
million in impairment charges for other intangible assets and (3) a net
adjustment of $1.0 million to increase our restructuring liability, primarily
related to anticipated sublease recoveries on restructured real
estate.
 
 Cash and
short term investments in marketable securities were $54.1 million at December
31, 2008, compared with $71.6 million at December 31, 2007. The year-end 2007
balance included $7.2 million in auction rate securities which we reclassified
to long-term investments in the first quarter 2008. The outstanding balance on
our credit facility was $20.0 million at December 31, 2008, compared to $19.8
million at December 31, 2007.
 
 Cash flow
from operations for 2008 was $38.0 million for 2008, representing an increase of
38% over the prior year. Capital expenditures for the year ended December 31,
2008 were $51.2 million, primarily for our data center expansion plan, but also
expansion of IP and CDN service points, some of which we implemented earlier
than planned to take advantage of economic opportunities.
 The
following table sets forth, as a percentage of total revenue, selected statement
of operations data for the periods indicated:
 Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Revenues:IP
      services
                
                
                48.5
                %
                
                
                52.2
                %
                
                
                61.9
                %Data
      center services
                
                
                43.2
                
                
                
                35.7
                
                
                
                31.2CDN
      services
                
                
                8.3
                
                
                
                7.6
                
                
                
                —Other
                
                
                —
                
                
                
                4.5
                
                
                
                6.9Total
      revenues
                
                
                100.0
                
                
                
                100.0
                
                
                
                100.0Operating
      costs and expenses:Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization, shown below:IP
      services
                
                
                18.0
                
                
                
                18.8
                
                
                
                22.4Data
      center services
                
                
                32.3
                
                
                
                25.4
                
                
                
                25.6CDN
      services
                
                
                3.2
                
                
                
                2.8
                
                
                
                —Other
                
                
                —
                
                
                
                3.6
                
                
                
                5.6Direct
      costs of amortization of acquired technologies
                
                
                2.6
                
                
                
                1.8
                
                
                
                0.3Direct
      costs of customer support
                
                
                6.4
                
                
                
                7.1
                
                
                
                6.4Product
      development
                
                
                3.3
                
                
                
                2.8
                
                
                
                2.5Sales
      and marketing
                
                
                12.2
                
                
                
                13.4
                
                
                
                15.0General
      and administrative
                
                
                12.1
                
                
                
                12.9
                
                
                
                11.9Provision
      for doubtful accounts
                
                
                2.0
                
                
                
                1.0
                
                
                
                0.3Depreciation
      and amortization
                
                
                9.3
                
                
                
                9.5
                
                
                
                8.7Goodwill
      impairment
                
                
                39.3
                
                
                
                —
                
                
                
                —Restructuring
      and other impairments
                
                
                0.7
                
                
                
                4.9
                
                
                
                0.2Other
      operating costs and expenses
                
                
                —
                
                
                
                0.2
                
                
                
                (0.1
                )Total
      operating costs and expenses
                
                
                141.4
                
                
                
                104.2
                
                
                
                98.8(Loss)
      income from operations
                
                
                (41.4
                )%
                
                
                (4.2
                )%
                
                
                1.2
                %
  - 39
-
  Segment
Information. We operate in three business segments: IP services, data
center services and CDN services. IP services include managed and premise-based
high performance IP and route optimization technologies. Data center services
include hosting of customer applications directly on our network to eliminate
issues associated with the quality of local connections. Data center services
are increasingly bundled with our high performance IP connectivity services. CDN
services include products and services for storing, delivering and monetizing
digital media to large global audiences over the Internet. Prior to our
acquisition of VitalStream on February 20, 2007, we did not offer proprietary
CDN services, but instead, we were a reseller of third party CDN services
for which revenues and direct costs are included in “—Other” below. Our
reportable segments are strategic business units that offer different products
and services. As of December 31, 2008, we had approximately 3,600 customers
across more than 20 metropolitan markets.
  Revenues
  Revenues
for the years ended December 31, 2008, 2007 and 2006 are summarized as follows
(in thousands):
 Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006IP
      services
                  
                  $
                  123,268
                  
                  
                  $
                  122,205
                  
                  
                  $
                  112,250Data
      center services
                  
                  
                  109,679
                  
                  
                  
                  83,632
                  
                  
                  
                  56,548CDN
      services
                  
                  
                  21,042
                  
                  
                  
                  17,806
                  
                  
                  
                  —Other
                  
                  
                  —
                  
                  
                  
                  10,447
                  
                  
                  
                  12,577$
                  253,989
                  
                  
                  $
                  234,090
                  
                  
                  $
                  181,375
  IP
Services. Revenue for IP services increased $1.1 million, or 1%, to
$123.3 million for the year ended December 31, 2008, compared to $122.2 million
for the year ended December 31, 2007. The increase in IP revenues is driven by
an increase in demand for our services, partially offset by a decline in IP
pricing. We continue to experience increasing demand for our traditional IP
services, with IP traffic increasing approximately 44% for the year ended
December 31, 2008 compared to the year ended December 31, 2007. The increase in
IP traffic has resulted from customers requiring greater overall capacity due to
growth in the usage of their applications, as well as in the nature of
applications consuming greater amounts of bandwidth. Ongoing industry-wide
pricing declines over the last several years, however, have offset a large
portion of our gains in IP traffic. The effective price we charge our customers
for IP services, measured in megabits per second, or Mbps, decreased
approximately 33% for the year ended December 31, 2008 compared to the year
ended December 31. 2007. There was a net increase in IP services customers
from December 31, 2007 to December 31, 2008, and these new customers added
approximately $8.1 million of revenue during 2008. While these new customers are
generally using more bandwidth, their additional contribution to revenue was
partially offset by the loss of older customers who were paying higher effective
prices for IP services. IP services revenue also includes FCP sales and other
hardware sales of $4.8 million and $4.6 million for the years ended December 31,
2008 and 2007, respectively.
  Revenues
for IP services increased more than $9.9 million, or 9%, to $122.2 million for
the year ended December 31, 2007, compared to $112.3 million for the year ended
December 31, 2006. In addition to the increase in demand, as discussed above, we
experienced an increase in sales of our premise-based FCP products and other
large hardware sales of approximately $1.0 million. IP traffic for the year
ended December 31, 2007 increased approximately 35% from the year ended December
31, 2006. In addition to the demand for greater bandwidth, we added high-traffic
customers through competitive IP pricing and minimum commitments during the year
ended December 31, 2007. However, pricing declines caused the blended rate in
Mbps to decrease approximately 26% annually from December 31, 2006 to December
31, 2007. We recorded approximately $0.5 million of sales adjustments in the
fourth quarter of 2007 related primarily to disputes over contractual service
periods.
  Data Center
Services. Data center services are a significant source of revenue growth
for our business. Revenues for data center services increased approximately
$26.0 million, or 31%, to $109.7 million for the year ended December 31, 2008,
compared to $83.6 million for the year ended December 31, 2007. This increase is
primarily due to our data center growth initiative, as discussed below, which we
began executing during 2007 and is on-going. We had a net increase of customers
from December 31, 2007 to December 31, 2008 and new data center services
customers added approximately $7.8 million of revenue during 2008. Furthermore,
customer demand has resulted in a 24% increase in installed cabinets in
2008.
  Revenues
for data center services increased $27.1 million, or 48%, to $83.6 million for
the year ended December 31, 2007, compared to $56.5 million for the year ended
December 31, 2006. During the year ended December 31, 2007, we (1) implemented a
broad-based rate increase, generating additional revenues of approximately $8.0
million, (2) began executing a data center growth initiative and (3) completed
the build-out of our Seattle facility. The overall increase in revenues
resulted from both new and existing customers and was largely due to new and
existing customers using more space within our facilities, and the design and
installation revenues from new customers. We also structured our data center
business to accommodate larger, global customers and ensure a platform for
robust traffic growth.
  - 40
-
  CDN
Services. Revenues for our CDN services segment increased $3.2 million,
or 18%, to $21.0 million for the year ended December 31, 2008, compared to $17.8
million for the year ended December 31, 2007. Our 2007 results included CDN
activity from the acquisition date of VitalStream on February 20, 2007. We
expect CDN services to be an area of growth and have upgraded and expanded
related infrastructure, including in Europe and Asia, to serve the expected
industry-wide demand. Also, we extended our 100% uptime SLA to customers
purchasing or renewing CDN services after January 1, 2008. CDN services
revenues and operating results for the year ended December 31, 2008 were lower
than projected, primarily due to: (1) integration and reliability issues in the
acquired network, which we have resolved, (2) a strategic shift to larger,
higher credit quality customers and (3) more recently, a highly-competitive
market environment for CDN services that is driving our prices lower. As
discussed in note 8 to the accompanying financial statements and below, we
recorded asset impairment charges of $102.3 million related to our CDN services
goodwill and other intangible assets.
  Revenues
for the year ended December 31, 2007 were lower than originally anticipated as
we integrated the VitalStream business with and into our network and
infrastructure. We did not offer proprietary CDN services prior to our
acquisition of VitalStream, but instead, we were a reseller of third party
CDN services, which was included in “—Other” below. In the second half of 2007,
we experienced platform instability in our CDN business, which caused an
increase in customer dissatisfaction and a higher than historical amount of
customer disputes over service billings. In the fourth quarter of 2007, we
recorded approximately $1.4 million in sales and billing adjustments related to
both service interruptions and disputes over contractual service periods. We
recorded these sales and billing adjustments against revenues. As we
purchased VitalStream in 2007, we did not have revenue in that segment for the
year ended December 31, 2006.
  Other.
Other revenues consist primarily of third party CDN services. Throughout 2007,
the CDN services we began to provide following our acquisition of VitalStream
steadily replaced the activity of the former third party CDN service
provider.
  Direct
Costs of Network, Sales and Services, Exclusive of Depreciation and
Amortization
  IP
Services. Direct costs of IP network, sales and services, exclusive of
depreciation and amortization, increased $1.9 million, or 4%, to $45.8 million
for the year ended December 31, 2008, compared to $43.9 million for the year
ended December 31, 2007. Direct costs of IP network, sales and services were 37%
of IP services revenues for the year ended December 31, 2008 and 36% for the
year ended December 31, 2007. IP services segment profit decreased $0.8 million
to $77.5 million for the year ended December 31, 2008, from $78.3 million for
the year ended December 31, 2007. Connectivity costs vary based upon
customer traffic and other demand-based pricing variables. Costs for IP services
are subject to ongoing negotiations for pricing and minimum commitments. During
the year ended December 31, 2008, we continued to renegotiate our agreements
with our major network service providers, which resulted in higher minimum
commitments but lower bandwidth rates. As our IP traffic continues to grow, we
expect to have greater bargaining power for lower bandwidth rates and more
opportunities to proactively manage network costs, such as utilization and
traffic optimization among network service providers.
  Direct
costs of IP network, sales and services, exclusive of depreciation and
amortization, increased $3.2 million, or 8%, to $43.9 million for the year ended
December 31, 2007, compared to $40.7 million for the year ended December 31,
2006. While IP services revenue increased, the direct costs of IP network,
sales and services were approximately 36% of IP services revenue for both 2007
and 2006. We maintained direct costs as a percentage of IP services revenue,
even though we had a change in the mix of revenue with a number of lower margin
high volume customers and FCP and other hardware sales.
  Data Center
Services. The direct costs of data center services, exclusive of
depreciation and amortization, increased $22.6 million, or 38%, to $82.0 million
for the year ended December 31, 2008, compared to $59.4 million for the year
ended December 31, 2007. Data center services contributed $27.7 million of
segment profit for the year ended December 31, 2008, an increase of $3.5 million
from $24.2 million for the year ended December 31, 2007. Direct costs of
data center services as a percentage of corresponding revenues has increased to
75% for the year ended December 31, 2008 from 71% for the year ended December
31, 2007.
  The
direct costs of data center services, exclusive of depreciation and
amortization, increased approximately $13.0 million, or 28%, to $59.4 million
for the year ended December 31, 2007, compared to $46.5 million for the year
ended December 31, 2006. Data center services contributed $24.2 million of
segment profit for the year ended December 31, 2007, an increase of $14.1
million from $10.1 million for the year ended December 31, 2006. As data center
services revenue increased, direct costs of data center services as a percentage
of corresponding revenue decreased to approximately 71% for the year ended
December 31, 2007 from 82% for the year ended December 31, 2006. This trend was
the result of an increase in total occupancy at higher rates, as discussed with
revenues above, while substantial direct costs were subject to previously
negotiated rates.
  - 41
-
  The
growth in data center revenues and direct costs of data center services largely
follows our expansion of data center space, and we believe the demand for data
center services continues to outpace industry-wide supply. Direct costs of
data center services, exclusive of depreciation and amortization, have
substantial fixed cost components, primarily for rent, but also significant
demand-based pricing variables, such as utilities, which are highest in the
summer for cooling the facilities. Direct costs of data center services as a
percentage of revenues vary with the mix of usage between sites operated by us
and third parties, referred to as partner sites, as well as the utilization of
total available space. While we recognize some of the initial operating
costs, especially rent, of sites operated by us in advance of revenues, these
sites are more profitable at certain levels of utilization than the use of
partner sites. Conversely, costs in partner sites are more demand-based and
therefore are more closely associated with the recognition of revenues. We
seek to optimize the most profitable mix of available data center space operated
by us and our partners. The increase in initial operating costs of sites
operated by us as well as our increased use of partner sites drove the higher
percentage of direct costs for the year ended December 31, 2008 compared to the
year ended December 31, 2007. We continue to expand the sites operated by us and
expect to have more of this space available to be used in the future as part of
our data center growth initiative. We expect direct costs of data center
services as a percentage of corresponding revenues to decrease as the recently
expanded sites operated by us contribute to revenue and become more fully
utilized.
  During
the year ended December 31, 2008, we added approximately 17,000 square feet of
data center space in sites operated by us and 22,000 square feet in partner
sites. At December 31, 2008, we had approximately 218,000 square feet of data
center space with a utilization rate of 77% as compared to approximately 179,000
square feet of data center space with a utilization rate of 75%, at
December 31, 2007. At December 31, 2006, we had approximately 149,000 square
feet of data center space with a utilization rate of 79%. We expect our recent
data center expansion to provide us lower costs per occupied square foot in
future periods, enabling us to increase revenues compared to relatively lower
direct costs of data center services. At December 31, 2008, 121,000 square
feet of occupied data center space, or 55% of our total square feet, was in data
centers operated by us versus partner sites as compared to 104,000 square feet
or 58% of our total square feet at December 31, 2007 and 88,000 square feet or
59% of our total square feet at December 31, 2006. Additionally, 76% and 62% of
our available square feet as of December 31, 2008 and 2007, respectively, were
in data centers operated by us.
  CDN
Services. Direct costs of network, sales and services, exclusive of
depreciation and amortization, for our CDN services segment increased $1.5
million to $8.1 million for the year ended December 31, 2008, compared to $6.6
million for the year ended December 31, 2007. Segment profit for CDN services
increased more than $1.7 million to $13.0 million for the year ended December
31, 2008 from $11.2 million for the year ended December 31, 2007. As noted
above, costs for the year ended December 31, 2007 only included activity after
our acquisition of VitalStream on February 20, 2007. Direct costs of CDN
network, sales and services were 38% of CDN services revenues for the year ended
December 31, 2008, compared to 37% for the year ended December 31, 2007. The
direct costs in 2008 include the benefit of lower rates as we have migrated
VitalStream’s former contracts and terms to our own since the
acquisition. However, the increase in direct costs as a percentage of
revenues is primarily related to increased price competition within the
market. Direct costs of CDN network sales and services also include an
allocation of direct costs of IP network sales and services based on the average
cost of actual usage by the CDN segment. The allocation of direct costs of IP
network sales and services was $1.1 million and $0.9 million for the years ended
December 31, 2008 and 2007, respectively. The CDN segment will also further
benefit from the renegotiated rates with our network service providers discussed
above under IP Services. As we purchased VitalStream in 2007, we did not have
costs for that segment for the year ended December 31, 2006.
  Other.
Other direct costs of network, sales and services consist primarily of third
party CDN services. Throughout 2007, the CDN services we began to provide
following our acquisition of VitalStream steadily replaced the activity of the
former third party CDN service provider.
  Other
Operating Expenses
  Other
than direct costs of network, sales and services, our compensation and
facilities-related costs have the most pervasive impact on operating
expenses. Compensation and benefits comprise our next largest expense after
direct costs of network, sales and services. Cash-basis compensation and
benefits decreased $2.2 million to $50.4 million for the year ended December 31,
2008 from $52.6 million for the year ended December 31, 2007. Stock-based
compensation decreased $1.2 million to $7.5 million for the year ended December
31, 2008 from $8.7 million for the year ended December 31, 2007. The decrease in
cash-basis compensation and benefits is due to the elimination of the bonus
accrual for 2008 compared to an accrual of $2.9 million for 2007, a $2.0 million
reduction in commissions and a larger Georgia Headquarters Tax Credit, or HQC.
The elimination of the bonus accrual for 2008 was the result of our compensation
committee’s decision not to award employee bonuses given that we did not meet
established performance goals. The reduction in commissions was primarily due to
higher sales quotas under a new commission plan, adjustments for failing to meet
sales quotas and an increase in the number of new sales personnel and open sales
positions. The HQC increased to $1.3 million in 2008 from $0.3 million in 2007.
We record the HQC when approved by the Georgia Department of Revenue. These
credits were approved with the stipulation that we apply them against our
payroll tax liability. These decreases are partially offset by annual pay
increases for employees effective April 1, 2008 and having a full 12 months of
CDN employee expense compared to 10 months in 2007. The decrease in stock-based
compensation is primarily due to fewer grants of stock-based awards and
a lower fair value for new awards based on our lower stock price. Total
headcount was relatively consistent increasing to approximately 430 at December
31, 2008 compared to approximately 420 at December 31, 2007.
  - 42
-
  Cash-basis
compensation and benefits increased more than $11.5 million to $52.6 million for
the year ended December 31, 2007 from $41.0 million for the year ended December
31, 2006. Stock-based compensation increased approximately $2.7 million to $8.7
million for the year ended December 31, 2007 from $5.9 million for the year
ended December 31, 2006. The increases in compensation and benefits were
primarily due to increased headcount, largely attributable to the additional
employees resulting from the VitalStream acquisition. For the year ended
December 31, 2007, the additional VitalStream employees accounted for $6.6
million of the increase in cash-basis compensation and $1.3 million of the
increase in stock-based compensation. Compensation also increased due to the
hiring of other employees, including at the senior management level. Total
headcount increased to approximately 420 at December 31, 2007 compared to
approximately 330 at December 31, 2006.
  Stock-based
compensation is summarized by the following financial statement captions (in
thousands):
 Year
      ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Direct
      costs of customer support
                    
                    $
                    1,369
                    
                    
                    $
                    1,892
                    
                    
                    $
                    1,102Product
      development
                    
                    
                    688
                    
                    
                    
                    856
                    
                    
                    
                    628Sales
      and marketing
                    
                    
                    1,782
                    
                    
                    
                    2,135
                    
                    
                    
                    2,145General
      and administrative
                    
                    
                    3,660
                    
                    
                    
                    3,798
                    
                    
                    
                    2,067Total
      stock-based compensation expense included in net income
                    
                    $
                    7,499
                    
                    
                    $
                    8,681
                    
                    
                    $
                    5,942
  Total
unrecognized compensation costs related to unvested stock-based compensation as
of December 31, 2008 was $16.6 million with a weighted-average remaining
recognition period of 2.6 years.
  Facilities
and related costs, including repairs and maintenance, communications and office
supplies but excluding direct costs of network, sales and services, is our next
largest recurring expense and increased $0.6 million, or 8%, to $7.6 million for
the year ended December 31, 2008 compared to $7.0 million for the year ended
December 31, 2007. The increase is primarily due to the relocation and
upgrade of one of our sales offices to a new, larger space and having a full 12
months of CDN operating expenses, partly offset by ongoing cost containment
efforts.
  Facilities
and related costs, including repairs and maintenance, communications and office
supplies but excluding direct costs of network, sales and services, increased
$1.0 million, or 17%, to $7.0 million for the year ended December 31, 2007
compared to $6.0 million for the year ended December 31, 2006. The increase was
primarily attributable to $0.7 million of VitalStream post-acquisition operating
costs.
  Other
significant operating costs are discussed with the financial statement captions
below:
  Direct Costs of
Amortization of Acquired Technologies. Direct costs of amortization of
acquired technologies increased to $6.6 million for the year ended December 31,
2008, from $4.2 million for the year ended December 31, 2007. The increase
of approximately $2.4 million included a $1.9 million impairment in developed
advertising technology due to a strategic change in market focus. See “—Goodwill
Impairment” and “–Restructuring and Other Impairments” below for further
discussion of the impairment of goodwill and other intangible assets. Also
included in direct costs for 2008 is additional amortization expense
attributable to a full 12 months of amortization of post-acquisition intangible
technology assets related to CDN services.
  Direct
costs of amortization of acquired technologies increased approximately $3.6
million from $0.5 million for the year ended December 31, 2006 to $4.2 million
for the year ended December 31, 2007. The increase in amortization expense was
attributable to the amortization of the post-acquisition intangible technology
assets of VitalStream.
  Direct Costs of
Customer Support. Direct costs of customer support decreased 2% to $16.2
million for the year ended December 31, 2008, from $16.5 million for the year
ended December 31, 2007. The decrease of $0.3 million was primarily due to a
$0.5 million decrease in stock-based compensation, as previously discussed,
partially offset by a $0.3 million increase in cash-basis compensation. The
increase in cash-basis compensation is primarily due to annual employee pay
increases.
  Direct
costs of customer support increased 43% from $11.6 million for the year ended
December 31, 2006 to $16.5 million for the year ended December 31, 2007. The
increase of approximately $4.9 million was primarily due to compensation of
employees and facilities-related costs as discussed above. VitalStream employees
accounted for $1.7 million of added cash-basis compensation and benefits and
$0.5 million of additional stock-based compensation for the year ended December
31, 2007. Other increases in cash-basis and stock-based compensation amounted to
$1.7 million and $0.3 million, respectively, whereas facilities-related costs
increased $0.6 million.
  Product
Development. Product development costs for the year ended December 31,
2008 increased 29% to $8.5 million from $6.6 million for the year ended December
31, 2007. The product development cost increase of $1.9 million is attributable
to increases in cash-basis compensation and benefits and professional services.
The increase in cash-basis compensation was $1.2 million, and included the
transfer of certain employees to product development that were formerly in
professional services and customer support roles in sales and marketing and
direct costs of customer support. The increase in professional services costs of
$0.7 million was due to the use of third party vendors for certain engineering
services that were previously performed by our employees in 2007, especially
with respect to our CDN services.
  - 43
-
  Product
development costs for the year ended December 31, 2007 increased 47% to $6.6
million from $4.5 million for the year ended December 31, 2006. The increase of
$2.1 million is primarily attributable to the addition of VitalStream employees
and facilities-related costs. For the year ended December 31, 2007, the
additional VitalStream employees accounted for $1.0 million of additional
cash-basis compensation and benefits costs and $0.3 million of additional
stock-based compensation costs. In addition, facilities-related costs amounted
to $0.3 million of this increase.
  Sales and
Marketing. Sales and marketing costs for the year ended December 31, 2008
decreased 2% to $30.9 million from $31.5 million for the year ended December 31,
2007. The decrease of $0.6 million was comprised primarily of a net $0.4 million
decrease for cash-basis compensation and benefits and a $0.4 million decrease in
stock-based compensation. The net decrease in cash-basis compensation included a
$2.0 million decrease in commissions. The reduction in commissions was primarily
due to higher sales quotas under a new commission plan, adjustments for failing
to meet sales quotas and an increase in the number of new sales personnel and
open sales positions. Stock-based compensation also decreased due to the reasons
previously discussed.
  Sales and
marketing costs for the year ended December 31, 2007 increased 16% to $31.5
million from $27.2 million for the year ended December 31, 2006. The increase of
approximately $4.3 million was primarily comprised of VitalStream employee
costs. Cash-basis compensation, benefits and commissions related to VitalStream
employees accounted for $2.8 million and stock-basis compensation for these
employees amounted to $0.4 million for the year ended December 31,
2007.
  General and
Administrative. General and administrative costs for the year ended
December 31, 2008 increased 1% to $30.7 million from $30.3 million for the year
ended December 31, 2007. The increase of $0.4 million reflected a $3.4 million
increase in professional services costs, a $0.4 million increase in facilities
and related costs, partially offset by a $3.2 million decrease in cash-basis
compensation. Professional services costs were higher due primarily to
contract labor, higher accounting fees, especially associated with bringing
current our international statutory audits, use of consultants for process
improvements and other outside services. The increase in facilities and related
costs is discussed above. Cash-basis compensation and benefits decreased due
primarily to a elimination of the bonus accrual of $2.9 million, as
discussed above.
  General
and administrative costs for the year ended December 31, 2007 increased 40% to
$30.3 million from $21.6 million for the year ended December 31, 2006. The
increase of $8.7 million was primarily due to increases in cash-basis
compensation and benefits, professional services and stock-based compensation.
Cash-basis compensation and benefits for the year ended December 31, 2007
increased $3.5 million, including $1.0 million for the additional VitalStream
employees. As discussed earlier, the increase in cash-basis compensation was
also due to the hiring of other employees, including at the senior management
level. The overall increase in head count caused us to accrue employee bonuses
$0.3 million higher during 2007 than we did during 2006 and caused higher
self-insured medical claims of $0.6 million compared to 2006. Professional
services for the year ended December 31, 2007 increased $2.2 million primarily
due to consultation fees on our information technology systems, compliance
activities for domestic and international tax and financial statement
requirements, recruiting fees and contract labor to fill a number of open job
requisitions and legal fees, including those associated with new proxy
disclosure requirements and ongoing litigation. Stock-based compensation
costs increased $1.7 million for the year ended December 31, 2007 due to annual
grants of stock options and unvested restricted common stock to non-employee
directors, the stock options assumed in the VitalStream acquisition and initial
grants and awards to new members of senior management.
  On
January 29, 2009, we announced the resignation of James P. DeBlasio from
his positions as President and Chief Executive Officer effective as of March 16,
2009, or the Separation Date. Mr. DeBlasio also has resigned as a director
effective March 15, 2009. Pursuant to the terms of a separation agreement, Mr.
DeBlasio will receive (1) a cash payment of $0.9 million, (2) full vesting of
all equity awards previously granted to him as of the Separation Date and (3) if
he so elects, continued health, dental and vision insurance coverage under our
group health plan for 18 months from the Separation Date at no cost to
him. Mr. DeBlasio has 12 months following the Separation Date in which to
exercise any stock options held by him that were vested as of the Separation
Date. We will record the associated severance in general and administrative
costs during the three months ended March 31, 2009. Also on January 29,
2009, we announced the appointment of J. Eric Cooney as our President and Chief
Executive Officer and as a director, effective March 16, 2009.
  Provision for
Doubtful Accounts. The provision for doubtful accounts increased to $5.1
million for the year ended December 31, 2008, from $2.3 million for the year
ended December 31, 2007. The increase during 2008 resulted from our periodic
review of the aged accounts receivable balances, taking into consideration
current economic conditions and was primarily attributable to our CDN and IP
segments. We believe the ability to collect these valid receivables has become
uncertain due to changes in customer circumstances. A number of the CDN
customers that have been reserved as doubtful accounts were customers in 2007
and early 2008, but have since been disconnected from our service for failing to
remit payment. We will continue to strongly focus on our customers’ ability
to make payment in light of the current economic conditions and put in
additional upfront requirements such as prepayments or deposits for new
customers before commencing delivery of our services given the challenging
economic environment expected to continue in 2009 and beyond.
  - 44
-
  The
provision for doubtful accounts increased to $2.3 million for the year ended
December 31, 2007, from $0.5 million for the year ended December 31, 2006. The
increase in the provision for doubtful accounts was primarily due to our
integration of VitalStream with its legacy customers causing the provision for
doubtful accounts to be greater than our historical expense.
  Depreciation and
Amortization. For the year ended December 31, 2008, depreciation and
amortization, including other intangible assets but excluding acquired
technologies, increased 7% to $23.9 million compared to $22.2 million for the
year ended December 31, 2007. The increase of approximately $1.6 million
primarily related to the expansion of P-NAPs and on-going expansion of data
center facilities. The restructuring and asset impairment described above
initially reduced depreciation and amortization by approximately $0.4 million
per year, decreasing to $0 in 2009. The amortization of acquired technologies is
included in its own caption and discussed above.
  For the
year ended December 31, 2007, depreciation and amortization, including other
intangible assets but excluding acquired technologies, increased 40% to $22.2
million compared to $15.9 million for the year ended December 31, 2006. The
increase of approximately $6.3 million primarily related to post-acquisition
depreciation and amortization of VitalStream property and equipment and acquired
amortizable intangible assets, excluding amortization of acquired technologies.
The VitalStream property and equipment and acquired amortizable intangible
assets accounted for $5.8 million of the expense for the year ended December 31,
2007. The remaining increase in depreciation and amortization related to
the expansion of P-NAPs and on-going expansion of data center
facilities.
  Goodwill
Impairment. As a result of our August 1, 2008 annual assessment of
goodwill, we recorded a $99.7 million goodwill impairment charge to
adjust goodwill in our CDN services segment to an implied fair value of $54.7
million.
  The
goodwill impairment was primarily due to declines in our CDN services revenues
and operating results as compared to our projections and unfavorable changes in
market factors used to estimate fair values. The declines in CDN services
revenues and operating results compared to projections were attributable to
integration and reliability issues in the acquired network that have now been
resolved, a strategic shift to larger, higher credit quality customers and more
recently, a highly-competitive market environment for CDN services that is
driving lower pricing. Changes in market factors included lower market
multiples across the CDN services industry from the time we completed the
VitalStream acquisition and our own current lower market
capitalization. The culmination of these factors leading to our impairment
of goodwill did not occur until the three months ended September 30,
2008. The impairment charge did not have any impact on our
current cash balance or future cash expenditures, or result in violation of any
covenants of our debt instruments.
  The
impairment also caused us to reverse a deferred tax liability and create an
income tax benefit of $0.6 million associated with the CDN services
goodwill.
  We will
continue to perform our annual impairment testing as of August 1 each year
absent any impairment indicators that may cause more frequent analysis. We also
assessed the likelihood of triggering events and concluded that none had
occurred that would cause us to re-assess goodwill for impairment subsequent to
August 1, 2008.
  Restructuring and
Other Impairments. In conjunction with our review of our long-term
financial outlook, which includes our annual assessment of goodwill for
impairment, as discussed above, we also performed an analysis of the potential
impairment and re-assessed the remaining asset lives of other identifiable
intangible assets acquired in the VitalStream acquisition. The analysis and
re-assessment of other identifiable intangible assets recorded in the
VitalStream acquisition resulted in:
 ●
                an
      impairment charge of $1.9 million in developed advertising technology due
      to a strategic change in market focus,●
                an
      impairment charge of $0.8 million in trade names as a result of
      discontinuing use of the VitalStream trade name, and●
                a
      change in our estimates that resulted in acceleration of amortization
      expense of our customer relationships intangible asset over a shorter
      estimated useful life (four remaining years instead of the original
      estimated nine years) due to customer churn resulting in higher than
      expected attrition as of the acquisition
date.
  The impairment
charge of $1.9 million for developed advertising technology is included in
“Direct costs of amortization of acquired technologies” in the accompanying
consolidated statements of operations. The impairment charge of $0.8
million for the trade name is included in “Restructuring and other impairments”
in the accompanying consolidated statements of operations. None of
the impairment charges had any impact on our current cash balance or future
cash expenditures, or resulted in violation of any covenants of our debt
instruments. The change in accounting estimate for our customer
relationship intangible asset resulted in an increase to our net loss of $0.4
million, or less than $0.01 per basic or diluted share, for the year ended
December 31, 2008.
  - 45
-
  In
conjunction with the preparation of our financial statements as of and for the
year ended December 31, 2008 and in light of the recent and significant
deterioration in the real estate market, we completed an analysis of our
remaining accrued restructuring liability for leased facilities. After reviewing
the analysis and specifically, the underlying assumptions related to anticipated
sublease recoveries, we concluded that certain of the facilities remaining in
the restructuring accrual were taking longer than expected to sublease or were
otherwise not generating the expected levels of sublease income. The analyses
were based on discounted cash flows using the same credit-adjusted risk-free
rate that we used to measure the initial restructuring liability for leases that
were part of the 2007 restructuring plan and undiscounted cash flows for leases
that were part of the 2001 restructuring plan. The cumulative effect of these
changes was $1.1 million, which we recorded as additional restructuring expense
and an increase to the liability. We also recorded a non-cash benefit of $0.1
million in the three months ended September 30, 2008 to reduce our restructuring
liability for employee separations. This non-cash adjustment removes the
liability for employee separations since we paid all such amounts. Both of these
adjustments to the restructuring liability are reported in “Restructuring and
other impairments” in the accompanying consolidated statement of
operations.
  During
the three months ended March 31, 2007, we incurred restructuring and impairment
charges totaling $11.3 million. The charges were the result of a review of our
business, particularly in light of our acquisition of VitalStream and our plan
to finalize the overall integration and implementation plan before the end of
the first quarter of 2007. The charges to expense included $7.8 million for
leased facilities, representing both the costs less anticipated sublease
recoveries that will continue to be incurred without economic benefit to us and
costs to terminate leases before the end of their term. The charges also
included severance payments of $1.1 million for the termination of certain
employees and $1.4 million for impairment of assets. After considering the
adjustments for anticipated changes in sublease income described above, we
estimated net related expenditures for the 2007 restructuring plan to be $12.2
million, of which we paid $4.2 million through December 31, 2008, and the
balance continuing through December 2016, the last date of the longest lease
term. We expected these expenditures to be paid out of operating cash flows. We
estimated cost savings from the restructuring to be approximately $0.8 million
per year through 2016, primarily for rent.
  We also
incurred a $1.1 million impairment charge during the three months ended March
31, 2007 for the sales order-through-billing system, which was the result of an
evaluation of the existing infrastructure relative to our new financial
accounting system and the acquisition of VitalStream. This impairment charge was
not related to any specific business segment.
  Non-operating
Income and Expense. For the year ended December 31, 2008, interest income
decreased $1.3 million to $1.9 million from $3.2 million for the year ended
December 31, 2007, a decrease of 42%. The decrease reflects a reduction in total
interest-earning investments, a move toward lower-risk investments and lower
overall interest rates. Other non-operating expense for the year ended December
31, 2008 included a net reduction in fair value of $0.8 million on our auction
rate securities offset by the $0.6 million fair value of our ARS Rights, as
described in note 6 to our accompanying consolidated financial
statements.
  During
2007, we incurred a charge of $1.2 million representing the write-off of the
remaining carrying value of our investment in series D preferred stock of
Aventail Corporation, or Aventail. We made an initial cash investment of $6.0
million in Aventail series D preferred stock pursuant to an investment agreement
in February 2000. In connection with a subsequent round of financing by
Aventail, we recognized an initial loss on our investment of $4.8 million in
2001. On June 12, 2007, SonicWall, Inc. announced that it entered into an
agreement to acquire Aventail for approximately $25.0 million in cash. The
transaction closed on July 11, 2007, and all shares of series D preferred stock
were cancelled and the holders of series D preferred stock did not receive any
consideration for such shares. The write-off is included in non-operating
(income) expense in the accompanying consolidated statement of
operations.
  Provision
(Benefit) for Income Taxes. The provision for income taxes was $0.2
million for the year ended December 31, 2008 and a net benefit of $3.1 million
for the year ended December 31, 2007. For the year ended December 31, 2007, the
tax provision included a $4.4 million benefit related to the release of the
valuation allowance associated with our U.K. deferred tax assets. The U.K.
benefit is offset by a reserve of $0.9 million and a U.S. deferred tax liability
relating to the VitalStream acquisition.
  The
reduction in valuation allowance was due to the existence of sufficient positive
evidence as of December 31, 2007 to indicate that our net operating losses in
the U.K. would more likely than not be realized in the future. The evidence
primarily consisted of the results of prior performance in the U.K. and the
expectation of future performance based on historical results. We will
continue to assess the recoverability of U.S. and other deferred tax assets, and
whether the valuation allowance should be reduced relative to the U.S. and other
deferred tax assets outside the U.K. We may recognize deferred tax assets in
future periods when they are estimated to be realizable, such as establishing
expected continuing profitability of us or certain of our foreign
subsidiaries.
  Based on
analysis of our projected future U.S. pre-tax income, we may have sufficient
positive evidence within the next 12 months to release the valuation allowance
currently recorded against our U.S. deferred tax assets. Currently, while we
cannot guarantee that our expectations of future positive income will occur, we
may recognize an income tax benefit derived from total U.S. deferred tax assets
upon the release of the valuation allowance. This potential release of the
valuation allowance could be affected by an ownership change as defined by
Section 382 of the Internal Revenue Code which might limit the future use of our
U.S. net operating loss carryovers and thus reduce the potential benefit of such
losses in the future to offset taxable income and reduce cash outflows for
income taxes.
  Liquidity
and Capital Resources
  Cash
Flows for the Years Ended December 31, 2008, 2007 and 2006
  Net
Cash from Operating Activities. Net cash provided by operating activities
was $38.0 million for the year ended December 31, 2008. Our net loss, adjusted
for non-cash items, generated cash from operations of $41.7 million while
changes in operating assets and liabilities represented a use of cash from
operations of $3.8 million. We anticipate continuing to generate cash flows
from our results of operations, or net (loss) income adjusted for non-cash
items, and manage changes in operating assets and liabilities towards a net $0
change in subsequent periods. We also expect to use cash flows from operating
activities to fund a portion of our capital expenditures and other requirements
and to meet our other commitments and obligations, including outstanding debt,
as they become due.
  - 46
-
  The
primary non-cash adjustment in the year ended December 31, 2008 was $102.3
million for impairment of goodwill and other intangible assets further discussed
above in the section “Results of Operations—Other Operating Expenses—Goodwill
Impairment.” We also had a non-cash adjustment of $28.7 million for depreciation
and amortization, which included the amortizable intangible assets acquired
through the acquisition of VitalStream in 2007 and the expansion of our P-NAP
and data center facilities throughout 2007 and 2008. Non-cash adjustments in
2008 also included $7.5 million for stock-based compensation expense and $5.1
million for the provision for doubtful accounts, both of which are further
discussed above in the section “Results of Operations—Other Operating Expenses.”
The changes in operating assets and liabilities included increases in inventory,
prepaid expenses, deposits and other assets of $2.9 million, mostly due to
increases in prepaid colocation setup costs and prepaid rent, as well as two
initial deposits required by real estate leases. We had a decrease in accrued
liabilities of $1.4 million given that we did not accrue any amounts for bonuses
for the year ended December 31, 2008, which is discussed above in the section
“Results of Operations—Other Operating Expenses.” We also had a net decrease in
accrued restructuring of $1.1 million due primarily to scheduled cash payments
during the year ended December 31, 2008. These changes were partially offset by
a decrease in accounts receivable of $2.4 million. Accounts receivable as of
December 31, 2007 reflected some collection delays on certain larger, high
credit quality customers that tended to pay over longer terms and an increase
from the migration of legacy VitalStream and other customers to our billing and
systems platforms. Quarterly days sales outstanding at December 31, 2008
decreased to 40 days from 53 days at December 31, 2007. The 53 days sales
outstanding at December 31, 2007 was unusually high and related to an
increased accounts receivable balance, discussed below.
  Net cash
provided by operating activities was $27.5 million for the year ended December
31, 2007. Our net loss, adjusted for non-cash items, generated cash from
operations of $32.1 million while changes in operating assets and liabilities,
excluding effects of the VitalStream acquisition, represented a use of cash from
operations of $4.5 million. The primary non-cash adjustment was $26.4
million for depreciation and amortization, which included the amortizable
intangible assets acquired through the acquisition of VitalStream in February
2007 and the expansion of our P-NAP and data center facilities throughout 2007.
Non-cash adjustments also included $8.7 million for stock-based compensation
expense, which is discussed above in “—Results of Operations.” The change in
working capital included an increase in accounts receivable of $15.8 million.
The increase in accounts receivable resulted in quarterly days sales outstanding
at December 31, 2007 increasing to 53 days from 38 days as of December
31, 2006. This increase in accounts receivable was largely due to revenue growth
and also, in part, our day sales outstanding trending up from lower than
historical levels at December 31, 2006. We also experienced collection
delays on certain larger, high credit quality customers that tended to pay over
longer terms and in conjunction with the migration of some former VitalStream
and other customers to our billing and systems platforms. The change in working
capital also included a net increase in accounts payable of $7.9 million due to
the growth of our business, primarily attributed to the acquisition of
VitalStream and our data center growth initiative. A portion of the increase was
also caused by the implementation near year-end of a new telecommunications
expense management system for our direct costs.
  Net cash
provided by operating activities was $29.4 million for the year ended December
31, 2006, and was primarily due to net income of $3.7 million adjusted for
non-cash items of $25.2 million offset by changes in working capital items of
$0.5 million. The changes in working capital items included net use of cash for
accounts receivable of $1.7 million, inventory, prepaid expense and other assets
of $1.8 million and accrued restructuring of $1.5 million. These were offset by
net sources of cash in accounts payable of $3.0 million, accrued liabilities of
$1.4 million and deferred revenue of $1.1 million. The increase in receivables
at December 31, 2006 compared to December 31, 2005 was related to the 18%
increase in revenue. Quarterly days sales outstanding at December 31, 2006
decreased to 38 days from 43 days as of December 31, 2005. The
increase in payables was primarily related to the timing of payments with the
2006 balance being consistent with our normal operating expenses and payment
terms.
  Net
Cash from Investing Activities. Net cash used in investing activities for
the year ended December 31, 2008 was $41.7 million primarily due to capital
expenditures of $51.2 million, partially offset by net proceeds from the
maturities and sales of short-term investments in marketable securities of $5.2
million and a decrease in restricted cash of $4.1 million. Our capital
expenditures were principally for the continued expansion of our data center
facilities, CDN infrastructure and upgrading our P-NAP facilities. Restricted
cash decreased due to the maturity of certificates of deposit that were securing
certain letters of credit, which we replaced. These letters of credit are now
secured by our revolving credit facility.
  Net cash
used in investing activities for the year ended December 31, 2007 was $36.4
million primarily due to capital expenditures of $30.3 million and net purchases
of short-term investments of $6.1 million. Our capital expenditures were
principally for the expansion of our data center facilities, CDN infrastructure
and upgrading our P-NAP facilities and were funded from both cash from
operations and borrowings from the new credit agreement we entered into on
September 14, 2007. We discuss the credit agreement in greater detail below in
“Liquidity—Credit Agreement.” Investing activities for the year ended
December 31, 2007 also included purchases and sales of auction rate
securities.
  - 47
-
  Net cash
used in investing activities for the year ended December 31, 2006 was $10.4
million primarily due to capital expenditures of $13.4 million. Our capital
expenditures were principally for upgrading our P-NAP facilities and the
expansion of our data center facilities.
  Net
Cash from Financing Activities. Net cash used in financing activities for
the year ended December 31, 2008 was $0.8 million, primarily for payments on
capital leases of $0.8 million. We also repaid and re-borrowed $20.0 million on
our credit facility to best manage net interest income and expense. We entered
into the second amendment to our credit agreement on September 30,
2008. This amendment, among other things, converted our term loan balance
into a loan outstanding under the revolving line of credit facility. See
the discussion below in “Liquidity—Credit Agreement,” for more details of our
credit agreement. As a result of these activities, we had balances of $20.0
million in notes payable and $3.5 million in capital lease obligations as of
December 31, 2008 with $0.3 million in the capital leases scheduled as due
within the next 12 months. We may also utilize additional borrowings under our
credit agreement if we consider it economically favorable to do
so.
  Net cash
provided by financing activities for the year ended December 31, 2007 was $15.2
million. Cash provided by financing activities was primarily due to proceeds
from note payable of $19.7 million, net of discount, and proceeds from stock
compensation plan activity of $8.6 million, partially offset by the repayment of
prior outstanding debt of $11.3 million and payments on capital leases of $1.6
million. The proceeds from a note payable were a result of entering into the new
credit agreement on September 14, 2007. As a result of these activities, we
had balances of $19.8 million in a note payable (net of discount) and $1.3
million in capital lease obligations as of December 31, 2007.
  Net cash
provided by financing activities for the year ended December 31, 2006 was $2.0
million. Cash provided by financing activities was primarily due to proceeds
from stock options, employee stock purchase plan and exercise of warrants of
$6.8 million offset by principal payments on a note payable of $4.4 million and
payments on capital lease obligations of $0.5 million.
  Liquidity
  We are
continuing to monitor and review our performance and operations in light of the
continuing negative global economic conditions. In particular, we continue to
analyze our business to control our costs, principally through making process
enhancements and renegotiating network contracts for more favorable pricing and
terms. A prolonged recession, if it were to occur, may have an adverse impact on
spending by the businesses we serve, resulting in a decline in demand for our
products and services. In addition, deteriorating economic conditions may
make it more difficult for these businesses to meet their obligations to us,
which could result in delayed collection of accounts receivable and an increase
in our provision for doubtful accounts. To date, we have increased our
provision for doubtful accounts, in part after taking into consideration current
economic conditions, as discussed above. Furthermore, current instability
in the market for our auction rate securities has caused us to lower our
estimate of fair value for these securities, which, along with our ARS Rights
described below in “—Non-Current Investments,” represented 19% of our total
financial assets measured at fair value. Although we do not believe that
this reduction has or will have a material adverse effect on our liquidity or
capital resources, we are continuing to monitor these markets closely. We are
similarly monitoring all of our short-term investments to ensure that
instability in liquidity and credit markets do not adversely impact the fair
value of these investments. This includes transferring investments in corporate
debt securities to money market accounts and U.S. Treasury bills as the debt
securities mature.
  We expect
to meet our cash requirements in 2009 through a combination of net cash provided
by operating activities, existing cash, cash equivalents and short-term
investments in marketable securities. We may also utilize additional borrowings
under our credit agreement, especially for capital expenditures, particularly if
we consider it economically favorable to do so. We may incur capital
expenditures for the expansion of our P-NAP and data center facilities. Our
capital requirements depend on a number of factors, including the continued
market acceptance of our services and products, the ability to expand and retain
our customer base and other factors. If our cash requirements vary materially
from those currently planned, if our cost reduction initiatives have
unanticipated adverse effects on our business or if we fail to generate
sufficient cash flows from the sales of our services and products, we may
require greater or additional financing sooner than anticipated. We can offer no
assurance that we will be able to obtain additional financing on commercially
favorable terms, or at all, and provisions in our existing credit agreement
limit our ability to incur additional indebtedness. We believe we have
sufficient cash to operate our business for the foreseeable future.
  We have
experienced significant impairments and operational restructurings in recent
years, which include substantial changes in our senior management team,
streamlining our cost structure, consolidating network access points and
terminating certain non-strategic real estate leases and license arrangements.
We have a history of quarterly and annual period net losses through the year
ended December 31, 2008. For the years ended December 31, 2008 and 2007, we
recorded net losses of $104.8 million and $5.6 million, respectively. As of
December 31, 2008, our accumulated deficit was $966.8 million. Our net loss for
the year ended December 31, 2008 included $99.7 million in impairment charges
for goodwill and $2.6 million in impairment charges for other intangible assets
and approximately $1.0 million for adjustments to our restructuring liability.
Our net loss for the year ended December 31, 2007 included $13.0 million in
charges for restructuring, asset impairment, write-off of an investment and
acquired in-process research and development. We do not expect to incur any of
these charges on a regular basis, but we cannot guarantee that we will not incur
other similar charges in the future or that we will be profitable in the future,
due in part to the competitive and evolving nature of the industry in which we
operate. Also, we are currently in a time of severe deteriorating economic
conditions and have seen signs of slowdowns and cautious behavior from our
customers. We continue to analyze our business to control our costs, principally
through making process enhancements and renegotiating network contracts for more
favorable pricing and terms. We may not be able to sustain or increase
profitability on a quarterly or annual basis, and our failure to do so would
adversely affect our business, including our ability to raise additional
funds.
  - 48
-
  Short-Term Investments.Short-term investments primarily consist of high credit quality corporate
debt securities, U.S. Treasury bills and commercial paper. At December 31, 2008,
our balance in short-term investments was $7.2 million. All short-term
investments have original maturities greater than 90 days but less than one
year, are classified as available for sale and are reported at fair
value.
  Non-Current
Investments. Non-current investments include, in part, auction rate
securities whose underlying assets are state-issued student and educational
loans that are substantially backed by the federal government. At December 31,
2008, the carrying value of our auction rate securities was $6.4 million, all of
which carried AAA/Aaa ratings as of December 31, 2008. Auction rate
securities are variable rate bonds tied to short-term interest rates with
maturities on the face of the securities in excess of 90 days and have interest
rate resets through a modified Dutch auction, at predetermined short-term
intervals, usually every seven, 28 or 35 days. The securities have
historically traded at par value and are callable at par value at the option of
the issuer. Interest received during a given period is based upon the
interest rate determined through the auction process. Although these
securities are issued and rated as long-term bonds, they have historically been
priced and traded as short-term instruments because of the liquidity provided
through the interest rate resets.
  While we
continue to earn and accrue interest on our auction rate securities at
contractual rates, these investments are not currently trading and therefore do
not currently have a readily determinable market value. Accordingly, the
estimated fair value of auction rate securities no longer approximates par
value. Due to the uncertainty as to when the auction rate securities markets
will improve, we have classified our auction rate securities as non-current
investments as of December 31, 2008, versus short-term investments as of
December 31, 2007. In the meantime, we believe we have sufficient liquidity
through our cash balances, other short-term investments and available
credit.
  In
October 2008, we received an offer providing us with rights, or ARS Rights, from
one of our investment providers to sell at par value auction rate securities
originally purchased from the investment provider ($7.2 million) at anytime
during a two-year period beginning June 20, 2010. On November 14, 2008, we
accepted the offer and intend to exercise the ARS Rights if we are otherwise
unable to recover par value on the securities at an earlier date. At December
31, 2008, the carrying value of the ARS Rights was $0.6 million.
  Credit
Agreement.On
September 14, 2007, we entered into a $35.0 million credit agreement with Bank
of America, N.A., as the administrative agent, or the Credit
Agreement. Four of our subsidiaries, VitalStream Holdings, Inc.;
VitalStream, Inc.; PlayStream, Inc.; and VitalStream Advertising Services, Inc.,
are guarantors of the Credit Agreement. We subsequently amended the Credit
Agreement on May 14, 2008 and September 30, 2008, as discussed
below.
  The
Credit Agreement replaced our prior credit agreement between us and Silicon
Valley Bank that was last amended on December 27, 2006. We paid off and
terminated this prior credit facility concurrently with the execution of the
Credit Agreement.
  The
Credit Agreement originally provided for a four-year revolving credit facility,
or Revolving Credit Facility, in the aggregate amount of up to $5.0 million,
which included a $5.0 million sub-limit for letters of credit. With the
prior approval of the administrative agent, we could increase the total
commitments by up to $15.0 million for a total commitment under the Revolving
Credit Facility of $20.0 million. The Revolving Credit Facility was
available to finance working capital, capital expenditures and other general
corporate purposes. As of December 31, 2007, we had a total of $8.0 million of
letters of credit issued (including $3.9 million which were secured by the
Revolving Credit Facility and the balance secured by restricted cash) and $1.1
million in borrowing capacity on the Revolving Credit Facility. There were no
amounts outstanding on the Revolving Credit Facility as of December 31,
2007.
  The
Credit Agreement also originally provided for a term loan in the amount of $30.0
million, or the Term Loan. We borrowed $20.0 million concurrently with the
closing and used a portion of the proceeds from the Term Loan to pay off the
prior credit agreement. The Term Loan had $10.0 million in borrowing
capacity as of December 31, 2007.
  The
interest rate on the Revolving Credit Facility and Term Loan was a tiered
LIBOR-based rate that depended on our 12-month trailing EBITDA. As of December
31, 2007, the interest rate was 7.075%.
  The net
proceeds received from the Term Loan were reduced by $0.3 million for fees paid
to Bank of America and its agents. We treated these fees as a debt discount
and recorded less than $0.1 million of related amortization during the year
ended December 31, 2007. As of December 31, 2007, the balance on the Term Loan,
net of the discount, was $19.8 million. We incurred other costs of less than
$0.1 million in connection with entering into the Credit Agreement, which we
recorded as debt issue costs.
  - 49
-
  As a
result of the transactions discussed above, we recorded a loss on extinguishment
of prior debt of less than $0.1 million during the year ended December 31, 2007.
The loss on extinguishment of debt is included in the caption “Interest expense”
within the “Non-operating (income) expense” section of the accompanying
consolidated statements of operations.
  Also
during the year ended December 31, 2007, we paid off the term loans and line of
credit issued pursuant to the loan and security agreement assumed in the
VitalStream acquisition, as discussed in note 3 of the accompanying consolidated
financial statements.
  We
subsequently amended the Credit Agreement on May 14, 2008 and September 30,
2008, or the Amendment (the Credit Agreement along with the Amendment is
referred to as the Amended Credit Agreement). The Amendment modified the
original Credit Amendment as follows:
 ●
                converted
      the outstanding Term Loan balance of $20.0 million as of September 30,
      2008 into a loan under the Revolving Credit Facility;●
                terminated
      the Term Loan under the Credit Agreement;●
                increased
      the total Revolving Credit Commitment (as defined in the Amended Credit
      Agreement) from $5.0 million to $35.0 million;●
                increased
      the Letter of Credit Sublimit (as defined in the Amended Credit Agreement)
      from $5.0 million to $7.0 million;●
                provided
      us and Bank of America with an option to enter into a lease financing
      agreement not to exceed $10.0 million; and●
                modified
      certain covenants and
definitions.
  Because
the Amendment caused the Revolving Credit Facility to have substantially
different terms than the Term Loan, it is considered an extinguishment of debt.
We recorded a loss on extinguishment of debt in the amount of $0.2 million
during the year ended December 31, 2008. The loss on extinguishment of debt
is included in the caption “Interest expense” within the “Non-operating (income)
expense” section of the accompanying consolidated statements of operations. We
also incurred other costs of less than $0.1 million in connection with the
Amendment, which we recorded as debt issue costs and will amortize over the
remaining term of the Amended Credit Agreement.
  The
interest rate on the Amended Credit Agreement as of December 31, 2008 was 3.0%
and is based on Bank of America’s prime rate less a 0.25% margin. The principal
amount of $20.0 million is due September 14, 2011. As of December 31, 2008, we
had a total of $4.2 million of letters of credit issued and $10.8 million in
borrowing capacity on the Revolving Credit Facility. In January 2009, we repaid
$19.8 million of the outstanding balance.
  The
Amended Credit Agreement includes customary representations, warranties,
negative and affirmative covenants (including certain financial covenants
relating to a net funded debt to EBITDA ratio, a debt service coverage ratio and
a minimum liquidity requirement, as well as a prohibition against paying
dividends, limitations on unfunded capital expenditures of $55.0 million for
2008 and $25.0 million or an amount to be mutually agreed upon for 2009 through
2011), customary events of default and certain default provisions that could
result in acceleration of the Amended Credit Agreement. As of December 31, 2008,
we were in compliance with the various covenants in the Amended Credit
Agreement.
  Our
obligations under the Amended Credit Agreement are pledged, pursuant to a pledge
and security agreement and an intellectual property security agreement, by
substantially all of our assets including the capital stock of our domestic
subsidiaries and 65% of the capital stock of our foreign
subsidiaries.
  Capital
Leases. Our future minimum lease payments on remaining capital lease
obligations at December 31, 2008 totaled $9.4 million.
  Commitments
and Other Obligations. We have commitments and other obligations that are
contractual in nature and will represent a use of cash in the future unless
there are modifications to the terms of those agreements. Service
commitments primarily represent purchase commitments made to our largest
bandwidth vendors and contractual payments to license data center space used for
resale to customers. Our ability to improve cash used in operations in the
future would be negatively impacted if we do not grow our business at a rate
that would allow us to offset the service commitments with corresponding revenue
growth.
  - 50
-
  The
following table summarizes our credit obligations and future contractual
commitments as of December 31, 2008 (in thousands):
  Payments Due by
      PeriodTotal
                                                
                                                
                                                Less
      than1
      year
                                                
                                                
                                                1-
      3Years
                                                
                                                
                                                3-5Years
                                                
                                                
                                                Morethan
      5yearsRevolving
      line of credit(1)
                                                
                                                $
                                                21,623
                                                
                                                
                                                $
                                                600
                                                
                                                
                                                $
                                                21,023
                                                
                                                
                                                $
                                                —
                                                
                                                
                                                $
                                                —Capital
      lease obligations
                                                
                                                
                                                9,441
                                                
                                                
                                                
                                                822
                                                
                                                
                                                
                                                1,130
                                                
                                                
                                                
                                                1,150
                                                
                                                
                                                
                                                6,339Operating
      lease commitments
                                                
                                                
                                                216,125
                                                
                                                
                                                
                                                25,624
                                                
                                                
                                                
                                                51,898
                                                
                                                
                                                
                                                51,721
                                                
                                                
                                                
                                                86,882Service
      commitments
                                                
                                                
                                                27,085
                                                
                                                
                                                
                                                20,866
                                                
                                                
                                                
                                                6,219
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —$
                                                274,274
                                                
                                                
                                                $
                                                47,912
                                                
                                                
                                                $
                                                80,270
                                                
                                                
                                                $
                                                52,871
                                                
                                                
                                                $
                                                93,221
 ____________________(1)
                  As
      noted in the section captioned “—Credit
      Agreement,” the interest rate on the Revolving Credit Facility is based on
      our bank’s prime rate less a 0.25% margin. As of December 31, 2008, the
      interest rate was 3.0% and the projected interest included in the debt
      payments above incorporates this rate. We subsequently paid $19.8 million
      on the Revolving Credit Facility in January 2009 which would significantly
      lower the projected interest included above. We plan to borrow on the
      Revolving Credit Facility from time-to-time particularly if we consider it
      economically favorable to do
so.
  Common
and Preferred Stock. Our Certificate of Incorporation designates 60
million shares of common stock and 20 million shares of preferred
stock.
  We issued
approximately 12.2 million shares of our common stock to the former stockholders
of VitalStream in connection with the acquisition, which closed on February 20,
2007.
  On July
10, 2006, we implemented a one-for-10 reverse stock split and amended our
Certificate of Incorporation to reduce our authorized shares of common stock
from 600 million to 60 million. We began trading on a post-reverse split basis
on July 11, 2006. All share and per share information herein (including shares
outstanding, earnings per share and warrant and stock option data) have been
retroactively adjusted for all periods presented to reflect this reverse
split.
  At the
time of the reverse stock split, the number of authorized shares of preferred
stock was not similarly reduced. We intended the reverse stock split to reduce
the authorized number of shares of preferred stock. Accordingly, effective June
19, 2008, we reduced the number of authorized shares of preferred stock from 200
million shares to 20 million shares. Of the resulting 20 million authorized
shares of preferred stock, 19.5 million shares are blank check preferred stock,
the terms and conditions of which our board of directors may designate. Our
board of directors previously designated the remaining 0.5 million shares of
preferred stock as series B preferred stock pursuant to a certificate of
designation of rights, preferences and privileges on April 11, 2007. As of
December 31, 2008, no shares of preferred stock were issued or
outstanding.
  In June
2006, our stockholders approved a repricing of certain outstanding options under
our existing equity incentive plans. Options with an exercise price per share
greater than or equal to $13.00 were eligible for the repricing. We implemented
the repricing through an exchange program under which eligible participants
were offered the opportunity to exchange their eligible options for new options
to purchase shares. Each new option had substantially the same terms and
conditions as the eligible options cancelled except as follows:
 ●
                The
      exercise price per share of each replacement option granted in the
      exchange offer was $14.46, the average of the closing prices of our common
      stock as reported by the American Stock Exchange and the NASDAQ Global
      Market, as applicable, for the 15 consecutive trading days ending
      immediately prior to the grant date of the replacement
      options;●
                For
      all eligible options with an exercise price per share greater than or
      equal to $20.00, the exchange ratio was one-for-two;
and●
                Each
      new option had a three-year vesting period, vesting in equal monthly
      installments over three years, so long as the grantee continued to be a
      full-time employee and a 10-year
term.
  Employees
eligible to participate in the exchange offer tendered, and we accepted for
cancellation, eligible options to purchase an aggregate of 344,987 shares of
common stock, representing 49.4% of the total shares of common stock underlying
options eligible for exchange in the exchange offer. We issued replacement
options to purchase an aggregate of 179,043 shares of common stock in exchange
for the cancellation of the tendered eligible options.
  - 51
-
  ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
  Short-Term Investments in Marketable
Securities
  Short-term
investments primarily consist of high credit quality corporate debt securities,
U.S. Treasury bills and commercial paper. All of our investments have original
maturities greater than 90 days but less than one year. All short-term
investments are classified as available for sale and reported at fair value. Due
to the short-term nature of our investments in marketable securities, we do not
believe that we have any material exposure to market risk changes in interest
rates. We estimate that a change in the effective yield of 100 basis points
would change our interest income by $0.1 million per year.
  Auction
Rate Securities and ARS Rights
  Auction
rate securities are variable rate bonds tied to short-term interest rates with
maturities on the face of the securities in excess of 90 days and have interest
rate resets through a modified Dutch auction, at predetermined short-term
intervals, usually every seven, 28 or 35 days. They have historically
traded at par value and are callable at par value on any interest payment date
at the option of the issuer. Interest received during a given period is
based upon the interest rate determined through the auction
process. Although these securities are issued and rated as long-term bonds,
they have historically been priced and traded as short-term instruments because
of the liquidity provided through the interest rate resets.
  While we
continue to earn and accrue interest on our auction rate securities at
contractual rates, these investments are not currently trading and therefore do
not currently have a readily determinable market value. Accordingly, the
estimated fair value of auction rate securities no longer approximates par
value. Due to the uncertainty as to when the auction rate securities markets
will improve, we have classified our auction rate securities as non-current
investments as of December 31, 2008, versus short-term investments as of
December 31, 2007. Our accompanying consolidated statement of operations for the
year ended December 31, 2008 also includes a net reduction in fair value of $0.8
million related to these investments. In the meantime, we believe we have
sufficient liquidity through our cash balances, other short-term investments and
available credit.
  In
October 2008, we received and subsequently accepted an offer providing us with
rights, or ARS Rights, from one of our investment providers to sell at par value
auction rate securities originally purchased from the investment provider
($7.2 million) at anytime during a two-year period beginning June 30, 2010. As
described in note 6, we recorded the ARS Rights as a free standing asset
separate from the auction rate securities. In conjunction with our acceptance of
the ARS Rights, we elected to measure the ARS Rights at fair value under SFAS
No. 159. Also, in conjunction with our acceptance of the ARS Rights, we changed
the investment classification of our auction rate securities to trading from
available for sale. We expect that future changes in the fair value of the ARS
Rights will approximate fair value movements in the related auction rate
securities.
  As of
December 31, 2008, the estimated fair values of our auction rate securities and
the ARS Rights were $6.4 million and $0.6 million, respectively. We estimate
that a change in the effective yield of 100 basis points in the auction rate
securities and ARS Rights would change our interest income by $0.1 million per
year.
  Other
Investments
  We have
invested $4.1 million in Internap Japan, our joint venture with NTT-ME
Corporation and NTT Holdings. We account for this investment using the
equity-method and to date we have recognized $3.1 million in equity-method
losses, representing our proportionate share of the aggregate joint venture
losses and income. Furthermore, the joint venture investment is subject to
foreign currency exchange rate risk. The market for services offered by Internap
Japan has not been proven and may never materialize.
  Interest
Rate Risk
  Our
objective in managing interest rate risk is to maintain favorable long-term
fixed rate or a balance of fixed and variable rate debt that will lower our
overall borrowing costs within reasonable risk parameters. Currently, our
strategy for managing interest rate risk does not include the use of derivative
securities. As of December 31, 2008, our long-term debt consisted of a Revolving
Credit Facility of $20.0 million with an interest rate of 3.0% and is based on
our bank’s prime rate less a 0.25% margin. The principal amount of $20.0 million
is due September 14, 2011. We estimate that a change in the interest rate of 100
basis points would change our interest expense and payments by $0.2 million per
year, assuming
we maintain a comparable amount of outstanding principal throughout the year. We
subsequently paid $19.8 million on the Revolving Credit Facility in January 2009
and plan to borrow on the Revolving Credit Facility from time-to-time
particularly if we consider it economically favorable to do
so.
  Foreign
Currency Risk
  Substantially
all of our revenue is currently in U.S. dollars and from customers primarily in
the U.S. We do not believe, therefore, that we currently have any significant
direct foreign currency exchange rate risk.
  - 52
-
  ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA
  Our
accompanying consolidated financial statements, financial statement schedule and
the report of our independent registered public accounting firm appear in Part
IV of this Form 10-K. Our report on internal controls over financial
reporting appear in Item 9A of this Form 10-K.
  ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
  None.
  ITEM 9A. CONTROLS AND PROCEDURES
  Evaluation
of Disclosure Controls and Procedures
  We
maintain disclosure controls and procedures that are designed to provide
reasonable assurance that information required to be disclosed in our
reports filed under the Exchange Act, is recorded, processed, summarized and
reported with the time periods specified in the SEC’s rules and forms, and that
such information is accumulated and communicated to management, including
our chief executive officer and chief financial officer, as appropriate, to
allow timely decisions regarding required disclosure. Management necessarily has
applied its judgment in assessing the costs and benefits of such controls and
procedures, which, by nature, can provide only reasonable assurance regarding
management’s control objectives. Our
management, including our chief executive officer and chief financial officer,
does not expect that our disclosure controls can prevent all errors and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. There are inherent limitations in all control systems, including
the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error, mistake or collusion. The design
of any system of controls also is based in part upon certain assumptions about
the likelihood of future events. While our disclosure controls and procedures
are designed to be effective under circumstances where they should reasonably be
expected to operate effectively, we can offer no assurance that any design will
succeed in achieving its stated goals under all potential future conditions.
Because of the inherent limitations in any control system, misstatements due to
error or fraud may occur and may not be detected.
  Under the
supervision and with the participation of our management, including our chief
executive officer and chief financial officer, we conducted an evaluation of our
disclosure controls and procedures, as such term is defined under
Rule 13a-15(e) promulgated under the Exchange Act. Based on this
evaluation, our chief executive officer and our chief financial
officer concluded that our disclosure controls and procedures were effective as
of December 31, 2008 to provide reasonable assurance.
  Report
of Management on Internal Control Over Financial Reporting
  Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act
Rule 13a-15(f). Under the supervision and with the participation of our
management, including our chief executive officer and chief financial
officer, we conducted an evaluation of the effectiveness of our internal control
over financial reporting based on the framework in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission, or
COSO.
  Based on
our evaluation under the framework in Internal
Control — Integrated Framework issued by COSO, our management concluded
that our internal control over financial reporting was effective as of December
31, 2008. The effectiveness of our internal control over financial
reporting as of December 31, 2008 has been audited by PricewaterhouseCoopers
LLP, an independent registered public accounting firm, as stated in their report
which is included herein.
  Changes
in Internal Control over Financial Reporting
  During
the quarter ended December 31, 2008, the only changes in our internal control
over financial reporting that have materially affected, or are likely to
materially affect, our internal control over financial reporting are discussed
below. These changes include enhancing our existing controls for the analysis of
requests for sales adjustments, which include but are not limited to, the
following additional processes and controls:
 
 ●
                A single,
      common logging system, or portal, for customers to record all disputes,
      disconnects and requests for credits,●
                A weekly
      review of a customer request log with appropriate designated management
      and approval pursuant to the schedule of authorization,
  and●
                A review
      by the appropriate designated finance management personnel of the
      accounting estimates developed from the relevant, sufficient, and reliable
      data collected above.
 
 The
portal provides management with a more complete repository of customer issues
for assessing sales credits’ impact on revenues. Since the second quarter of
2008, designated management has met weekly to review and analyze the information
collected by the portal, along with other sources of related information, to
resolve all customer disputes and requests for credits. The results of these
weekly meetings assist finance personnel in determining appropriate accounting
estimates by providing more timely and pertinent information. In addition, we
continued to develop an automated process to monitor customer usage patterns as
a means to better manage customer billing disputes. In the fourth quarter of
2008, we completed our testing of these processes and controls, concluding that
we have remediated the material weakness in our analysis of requests for sales
adjustments.
  ITEM 9B. OTHER
INFORMATION
  None.
  - 53
-
  PART III
  ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND
CORPORATE GOVERNANCE
  Information
regarding our directors and executive officers will be included in our
definitive proxy statement for our 2009 annual meeting of stockholders, which
will be filed within 120 days after the end of the fiscal year covered by this
report, and is incorporated in this Form 10-K by reference.
  Code
of Conduct
  We have
adopted a code of conduct that applies to our officers and all of our employees,
which includes an addendum that applies to our senior executive and financial
officers. A copy of the code of conduct is available on our website at www.internap.com. We
will furnish copies without charge upon request at the following address:
Internap Network Services Corporation, Attn: General Counsel, 250 Williams
Street, Atlanta, Georgia 30303.
  If we
make any amendments to the code of conduct other than technical, administrative
or other non-substantive amendments, or grant any waivers, including implicit
waivers, from the addendum to this code, we will disclose the nature of the
amendment or waiver, its effective date and to whom it applies on our website or
in a current report on Form 8-K filed with the SEC.
  ITEM 11. EXECUTIVE
COMPENSATION
  The
information under the captions, “Executive Officers and Compensation” and
“Compensation Committee Report” contained in our definitive proxy statement for
our 2009 annual meeting of stockholders, which will be filed within 120 days
after the end of the fiscal year covered by this report, is hereby incorporated
in this Form 10-K by reference.
  ITEM 12. SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS
  The
information under the caption “Security Ownership of Certain Beneficial Owners
and Management” contained in our definitive proxy statement for our 2009 annual
meeting of stockholders, which will be filed within 120 days after the end of
the fiscal year covered by this report, is hereby incorporated in this Form 10-K
by reference.
  ITEM 13. CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS, AND DIRECTOR INDEPENDENCE
  The
information under the caption “Certain Relationships and Related Transactions”
contained in our definitive proxy statement for our 2009 annual meeting of
stockholders, which will be filed within 120 days after the end of the fiscal
year covered by this report, hereby is incorporated in this Form 10-K by
reference.
  ITEM 14. PRINCIPAL ACCOUNTING FEES AND
SERVICES
  The
information under the caption “Ratification of Appointment of Independent
Registered Public Accounting Firm” in our definitive proxy statement for our
2009 annual meeting of stockholders, which will be filed within 120 days after
the end of the fiscal year covered by this report, is hereby incorporated in
this Form 10-K by reference.
  - 54
-
  PART IV
  ITEM 15. EXHIBITS AND FINANCIAL STATEMENT
SCHEDULES
 (a)
              Documents
      filed as a part of the report:
 
 (1)
                Consolidated
      Financial Statements.
  The
following consolidated financial statements of the Company and its subsidiaries
are filed herewith:
 PageReport
      of Independent Registered Public Accounting Firm
                
                F-2Consolidated
      Statements of Operations
                
                F-3Consolidated
      Balance Sheets
                
                F-4Consolidated
      Statement of Stockholders’ Equity and Comprehensive Loss
                
                F-5Consolidated
      Statements of Cash Flows
                
                F-6Notes
      to Consolidated Financial Statements
                
                F-8
 
 (2)
                Financial
      Statement Schedule.
  The
following financial statement schedule of the Company and its subsidiaries is
filed herewith:
 PageSchedule
      II - Valuation and Qualifying Accounts for the Three Years Ended December
      31, 2008
              
              S-1
 
 (3)
              Index
      to Exhibits.
 
 ExhibitNumber
                    
                    Description2.1
                    
                    Agreement
      and Plan of Merger dated October 12, 2006, by and among the Company, Ivy
      Acquisition Corp. and VitalStream Holdings, Inc. (incorporated herein by
      reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K,
      filed on October 12, 2006).3.1
                    
                    Certificate
      of Incorporation of the Company, as amended (incorporated by reference
      herein to Exhibit 4.1 to the Company’s Registration Statement on Form S-3,
      filed on September 8, 2003, File No. 333-108573).3.2
                    
                    Certificate
      of Amendment of Certificate of Incorporation of the Company (incorporated
      by reference herein to Exhibit 3.1 to the Company’s Current Report on Form
      8-K filed on July 11, 2006).3.3
                    
                    Certificate
      of Amendment of Certificate of Incorporation of the Company dated June 19,
      2008 (incorporated by reference herein to Exhibit 3.1 to the Company’s
      Quarterly Report on Form 10-Q for the quarter ended June 30, 2008, filed
      on August 11, 2008).3.4
                    
                    Amended
      and Restated Bylaws of the Company (incorporated by reference herein to
      Exhibit 4.2 to the Company’s Registration Statement on Form S-3, filed
      September 8, 2003, File No. 333-108573).3.5
                    
                    Certificate
      of Designation of Rights, Preferences and Privileges of Series B Preferred
      Stock (incorporated by reference herein to Exhibit 3.4 to the Company’s
      Current Report on Form 8-K filed on April 13, 2007).4.1
                    
                    Rights
      Agreement, dated as of April 11, 2007, between the Company and American
      Stock Transfer & Trust Company, as Rights Agreement (incorporated by
      reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K,
      filed on April 13, 2007).10.1
                    
                    Amended
      and Restated Internap Network Services Corporation 1998 Stock Option/Stock
      Issuance Plan.* +10.2
                    
                    Internap
      Network Services Corporation 1999 Non-Employee Directors’ Stock Option
      Plan.* +10.3
                    
                    First
      Amendment to the Internap Network Services Corporation 1999 Non-Employee
      Directors’ Stock Option Plan.* +10.4
                    
                    Internap
      Network Services Corporation 1999 Employee Stock Purchase Plan
      (incorporated herein by reference to Exhibit 10.4 to the Company’s
      Registration Statement on Form S-1, File No. 333-84035 dated July 29,
      1999).+10.5
                    
                    Amended
      and Restated Internap Network Services Corporation 1999 Stock Incentive
      Plan for Non-Officers.*
+
  - 55
-
 
 10.6
                    
                    Amended
      Internap Network Services Corporation 1999 Equity Incentive Plan
      (incorporated herein by reference to Exhibit 10.7 to the Company’s
      Registration Statement on Form S-1, File No. 333-95503 dated January 27,
      2000).+10.7
                    
                    Form
      of 1999 Equity Incentive Plan Stock Option Agreement (incorporated herein
      by reference to Exhibit 10.8 to the Company’s Registration Statement on
      Form S-1, File No. 333-84035 dated July 29, 1999).+10.8
                    
                    Internap
      Network Services Corporation 2000 Non-Officer Equity Incentive Plan
      (incorporated herein by reference to Exhibit 99.1 to the Company’s
      Registration Statement on Form S-8, File No. 333-37400 dated May 19,
      2000).+10.9
                    
                    Internap
      Network Services Corporation 2002 Stock Compensation Plan.*
    +10.10
                    
                    Form
      of Nonstatutory Stock Option Agreement under the Internap Network Services
      Corporation 2002 Stock Compensation Plan.* +10.11
                    
                    Form
      of Employee Confidentiality, Nonraiding and Noncompetition Agreement used
      between Company and its Executive Officers (incorporated herein by
      reference to Exhibit 10.11 to the Company’s Registration Statement on Form
      S-1, File No. 333-84035 dated July 29, 1999).+10.12
                    
                    Amended
      and Restated 2005 Incentive Stock Plan, dated March 15, 2006 (incorporated
      by reference to Appendix B to the Company’s Definitive Proxy Statement
      filed May 8, 2008).+10.13
                    
                    Employment
      Agreement dated as of July 10, 2007 between the Company and James DeBlasio
      (incorporated herein by reference to Exhibit 99.1 to the Company’s Current
      Report on Form 8-K, filed on July 11, 2007).+10.14
                    
                    First
      Amendment to Employment Agreement between James P. DeBlasio and the
      Company dated November 14, 2007 (incorporated herein by reference to
      Exhibit 99.1 to the Company’s Current Report on Form 8-K, filed on
      November 19, 2007).+10.15
                    
                    Amended
      and Restated 2004 Internap Network Services Corporation Employee Stock
      Purchase Plan, dated January 11, 2006 (incorporated by reference to
      Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the
      quarter ended March 31, 2006, filed on May 10, 2006).+10.16
                    
                    Form
      of Stock Grant Certificate under the Amended and Restated Internap Network
      Services Corporation 2005 Incentive Stock Plan (incorporated by reference
      to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2006, filed on August 8, 2006).+10.17
                    
                    Form
      of Stock Option Grant Certificate under the Amended and Restated Internap
      Network Services Corporation 2005 Incentive Stock Plan (incorporated by
      reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended June 30, 2006, filed on August 8,
      2006).+10.18
                    
                    VitalStream
      Holdings, Inc. 2001 Stock Incentive Plan (Third Amended and Restated)
      (incorporated by reference to Exhibit 4.4 to the Company’s Registration
      Statement on Form S-8, File No. 333-141245 , filed on March 13,
      2007).+10.19
                    
                    General
      Release Agreement dated as of April 9, 2008 between the Company and
      Vincent Molinaro (incorporated by reference to Exhibit 10.1 to the
      Company’s Current Report on Form 8-K, filed on April 18,
      2008).+10.20
                    
                    2007
      Executive Bonus Award Incentive Plan (incorporated by reference to Exhibit
      10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended
      March 31, 2007, filed on May 10, 2007).+10.21
                    
                    Amendment
      to the 2007 Executive Bonus Award Incentive Plan (incorporated herein by
      reference to Exhibit 99.6 to the Company’s Current Report on Form
      8-K, filed on November 19, 2007).+10.22
                    
                    2008
      Executive Bonus Award Incentive Plan (incorporated herein by reference to
      Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed March 24,
      2008).+10.23
                    
                    2008
      Long-Term Incentive Plan (incorporated herein by reference to Exhibit 10.2
      to the Company’s Current Report on Form 8-K, filed March 24,
      2008).+10.24
                    
                    Credit
      Agreement dated as of September 14, 2007 by and among the Company, as the
      Borrower, Bank of America, N.A., as Administrative Agent, Swing Line
      Lender and L/C Issuer, and the other Lenders party thereto (incorporated
      by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K,
      filed on September 19,
2007).
  - 56
-
 
 10.25
                    
                    Pledge
      and Security Agreement dated as of September 14, 2007 among the Company,
      and certain of its Subsidiaries party thereto from time to time, as
      Grantors, and Bank of America, N.A., as Administrative Agent (incorporated
      by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K,
      filed on September 19, 2007).10.26
                    
                    Intellectual
      Property Security Agreement dated as of September 14, 2007 among the
      Company, and certain of its Subsidiaries party thereto from time to time,
      as Grantors, and Bank of America, N.A., as Administrative Agent
      (incorporated by reference to Exhibit 10.3 to the Company’s Current Report
      on Form 8-K, filed on September 19, 2007).10.27
                    
                    Amendment
      No. 1 to Credit Agreement entered into as of May 14, 2008 by and among
      Bank of America, N.A. as Administrative Agent, Swing Line Lender, L/C
      Issuer and sole Lender, the Company and the Subsidiaries of the Company
      party thereto as Guarantors (incorporated herein by reference to Exhibit
      10.1 to the Company’s Current Report on Form 8-K, filed May 16,
      2008).10.28
                    
                    Amendment
      No. 2 dated September 30, 2008 to Credit Agreement, dated as of September
      14, 2007, by and among the Company, as the Borrower, Bank of America,
      N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, and the
      other Lenders party thereto (incorporated herein by reference to Exhibit
      10.1 to the Company’s Current Report on Form 8-K, filed October 6,
      2008).10.29
                    
                    Joinder
      Agreement to the Employment Security Plan executed by Richard Dobb
      (incorporated herein by reference to Exhibit 99.3 to the Company’s Current
      Report on Form 8-K, filed on November 19, 2007).+10.30
                    
                    Joinder
      Agreement to the Employment Security Plan executed by Phil Kaplan
      (incorporated herein by reference to Exhibit 99.4 to the Company’s Current
      Report on Form 8-K, filed on November 19, 2007).+10.31
                    
                    Joinder
      Agreement to the Employment Security Plan executed by Vince Molinaro
      (incorporated herein by reference to Exhibit 99.5 to the Company’s Current
      Report on Form 8-K, filed on November 19, 2007).+10.32
                    
                    Joinder
      Agreement to the Employment Security Plan executed by George E. Kilguss
      (incorporated herein by reference to Exhibit 99.1 to the Company’s Current
      Report on Form 8-K, filed on March 28, 2008).+10.33
                    
                    Joinder
      Agreement to the Employment Security Plan executed by Tim Sullivan.
      +10.34
                    
                    Offer
      Letter between the Company and Eric Cooney, dated January 16, 2009
      (incorporated herein by reference to Exhibit 10.1 to the Company’s Current
      Report on Form 8-K, filed on February 2, 2009).+10.35
                    
                    Joinder
      Agreement to the Employment Security Plan executed by Eric Cooney
      (incorporated herein by reference to Exhibit 10.2 to the Company’s Current
      Report on Form 8-K, filed on February 2, 2009).+10.36
                    
                    Agreement
      between the Company and James P. DeBlasio, dated January 29, 2009
      (incorporated herein by reference to Exhibit 10.3 to the Company’s Current
      Report on Form 8-K, filed on February 2, 2009). +21.1
                    
                    List
      of Subsidiaries (incorporated herein by reference to Exhibit 21.1 to the
      Company’s Form 10-K, filed on March 31, 2008).23.1*
                    
                    Consent
      of PricewaterhouseCoopers LLP, Independent Registered Public Accounting
      Firm.31.1*
                    
                    Rule
      13a-14(a)/15d-14(a) Certification, executed James P. DeBlasio, President,
      Chief Executive Officer and Director the Company.31.2*
                    
                    Rule
      13a-14(a)/15d-14(a) Certification, executed by George Kilguss, III, Vice
      President and Chief Financial Officer of the
  Company.32.1*
                    
                    Section
      1350 Certification, executed by James P. DeBlasio, President, Chief
      Executive Officer and Director the Company.32.2*
                    
                    Section
      1350 Certification, executed by George Kilguss, III, Vice President and
      Chief Financial Officer of the
Company.
 
 *
                Documents
      filed herewith.+
                Management
      contracts and compensatory plans and arrangements required to be filed as
      exhibits pursuant to Item 15(c) of this
Report.
  - 57
-
  SIGNATURES
  Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, as amended, the Company has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
 INTERNAP
      NETWORK SERVICES CORPORATIONDate:
      March 12, 2009By:
                    /s/
      George E. Kilguss, IIIGeorge
      E. Kilguss, IIIVice
      President and Chief Financial Officer(Principal
      Accounting Officer)
  Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, this
report has been signed below by the following persons on behalf of the Company
and in the capacities and on the dates indicated:
 Signature
                                                          
                                                          Title
                                                          
                                                          Date/s/
      James P. DeBlasioJames
      P. DeBlasio
                                                          
                                                          President,
      Chief Executive Officer and Director (Principal Executive
      Officer)
                                                          
                                                          March
      12, 2009/s/
      George E. Kilguss, IIIGeorge
      E. Kilguss, III
                                                          
                                                          Vice
      President and Chief Financial Officer (Principal Accounting
      Officer)
                                                          
                                                          March
      12, 2009/s/
      Eugene
      EidenbergEugene
      Eidenberg
                                                          
                                                          Non-Executive
      Chairman and Director
                                                          
                                                          March
      12, 2009/s/
      Charles
      B. CoeCharles
      B. Coe
                                                          
                                                          Director
                                                          
                                                          March 12,
      2009/s/
      William
      J. HardingWilliam
      J. Harding
                                                          
                                                          Director
                                                          
                                                          March
      12, 2009/s/
      Patricia
      L. HigginsPatricia
      L. Higgins
                                                          
                                                          Director
                                                          
                                                          March
      12, 2009/s/
      Kevin
      L. OberKevin
      L. Ober
                                                          
                                                          Director
                                                          
                                                          March
      12, 2009/s/
      Gary
      PfeifferGary
      Pfeiffer
                                                          
                                                          Director
                                                          
                                                          March
      12, 2009/s/
      Daniel
      C. StanzioneDaniel
      C. Stanzione
                                                          
                                                          Director
                                                          
                                                          March
      12,
2009
  - 58
-




Internap
      Network Services CorporationIndex
      to Consolidated Financial StatementsPageReport
      of Independent Registered Public Accounting Firm
              
              F-2Consolidated
      Statements of Operations
              
              F-3Consolidated
      Balance Sheets
              
              F-4Consolidated
      Statement of Stockholders’ Equity and Comprehensive (Loss)
      Income
              
              F-5Consolidated
      Statements of Cash Flows
              
              F-6Notes
      to Consolidated Financial Statements
              
              F-8Financial
      Statement Schedule
              
              S-1
  F-1
  Report
of Independent Registered Public Accounting Firm
  To the
Board of Directors and Stockholders of Internap Network Services
Corporation:
  In our
opinion, the consolidated financial statements listed in the accompanying index
present fairly, in all material respects, the financial position of Internap
Network Services Corporation and its subsidiaries at December 31, 2008 and 2007,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2008 in conformity with accounting
principles generally accepted in the United States of America. In addition, in
our opinion, the financial statement schedule listed in the accompanying index
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated financial statements.
Also in our opinion, the Company maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2008, based on
criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). The Company’s management is responsible for these
financial statements and financial statement schedule, for maintaining effective
internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting, included in
Management’s Report on Internal Control Over Financial Reporting appearing under
Item 9A. Our responsibility is to express opinions on these financial
statements, on the financial statement schedule, and on the Company’s internal
control over financial reporting based on our integrated audits. We conducted
our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the financial
statements are free of material misstatement and whether effective internal
control over financial reporting was maintained in all material respects. Our
audits of the financial statements included examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. Our audit of internal
control over financial reporting included obtaining an understanding of internal
control over financial reporting, assessing the risk that a material weakness
exists, and testing and evaluating the design and operating effectiveness of
internal control based on the assessed risk. Our audits also included performing
such other procedures as we considered necessary in the circumstances. We
believe that our audits provide a reasonable basis for our
opinions.
  As
discussed in Notes 2 and 6 to the consolidated financial statements, in 2008 the
Company changed the manner in which it measures fair value of financial assets
and liabilities in accordance with SFAS No. 157, Fair Value Measurements and
SFAS No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities. Additionally,
as discussed in Note 2 to the consolidated financial statements, the Company
changed the manner in which it accounts for share-based compensation in 2006 and
the manner in which it accounts for uncertain tax positions in
2007.
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (i) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company;
(ii) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management
and directors of the company; and (iii) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the company’s assets that could have a material effect on the
financial statements.
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
 /s/
      PricewaterhouseCoopers LLPAtlanta,
      GeorgiaMarch
      12, 2009
  F-2
 
 INTERNAP
      NETWORK SERVICES CORPORATION AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF OPERATIONS(In
      thousands, except per share
amounts)
  Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Revenues:Internet
      protocol (IP) services
                
                $
                123,268
                
                
                $
                122,205
                
                
                $
                112,250Data
      center services
                
                
                109,679
                
                
                
                83,632
                
                
                
                56,548Content
      delivery network (CDN) services
                
                
                21,042
                
                
                
                17,806
                
                
                
                —Other
                
                
                —
                
                
                
                10,447
                
                
                
                12,577Total
      revenues
                
                
                253,989
                
                
                
                234,090
                
                
                
                181,375Operating
      costs and expenses:Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization, shown below:IP
      services
                
                
                45,782
                
                
                
                43,925
                
                
                
                40,723Data
      center services
                
                
                82,009
                
                
                
                59,439
                
                
                
                46,474CDN
      services
                
                
                8,086
                
                
                
                6,594
                
                
                
                —Other
                
                
                —
                
                
                
                8,436
                
                
                
                10,141Direct
      costs of amortization of acquired technologies
                
                
                6,649
                
                
                
                4,165
                
                
                
                516Direct
      costs of customer support
                
                
                16,217
                
                
                
                16,547
                
                
                
                11,566Product
      development
                
                
                8,477
                
                
                
                6,564
                
                
                
                4,475Sales
      and marketing
                
                
                30,888
                
                
                
                31,533
                
                
                
                27,173General
      and administrative
                
                
                30,675
                
                
                
                30,251
                
                
                
                21,556Provision
      for doubtful accounts
                
                
                5,083
                
                
                
                2,261
                
                
                
                548Depreciation
      and amortization
                
                
                23,865
                
                
                
                22,242
                
                
                
                15,856Goodwill
      impairment
                
                
                99,700
                
                
                
                —
                
                
                
                —Restructuring
      and other impairments
                
                
                1,741
                
                
                
                11,349
                
                
                
                323Acquired
      in-process research and development
                
                
                —
                
                
                
                450
                
                
                
                —Gain
      on disposals of property and equipment
                
                
                (16
                )
                
                
                (5
                )
                
                
                (113
                )Other
                
                
                —
                
                
                
                50
                
                
                
                —Total
      operating costs and expenses
                
                
                359,156
                
                
                
                243,801
                
                
                
                179,238(Loss)
      income from operations
                
                
                (105,167
                )
                
                
                (9,711
                )
                
                
                2,137Non-operating
      (income) expense:Interest
      income
                
                
                (1,884
                )
                
                
                (3,228
                )
                
                
                (2,305
                )Interest
      expense
                
                
                1,251
                
                
                
                1,150
                
                
                
                883Write-off
      of investment
                
                
                —
                
                
                
                1,178
                
                
                
                —Other,
      net
                
                
                388
                
                
                
                (37
                )
                
                
                (129
                )Total
      non-operating (income) expense
                
                
                (245
                )
                
                
                (937
                )
                
                
                (1,551
                )(Loss)
      income before income taxes and equity in earnings of equity-method
      investment
                
                
                (104,922
                )
                
                
                (8,774
                )
                
                
                3,688Provision
      (benefit) for income taxes
                
                
                174
                
                
                
                (3,080
                )
                
                
                145Equity
      in earnings of equity-method investment, net of taxes
                
                
                (283
                )
                
                
                (139
                )
                
                
                (114
                )Net
      (loss) income
                
                $
                (104,813
                )
                
                $
                (5,555
                )
                
                $
                3,657Net
      (loss) income per share:Basic
                
                $
                (2.13
                )
                
                $
                (0.12
                )
                
                $
                0.11Diluted
                
                $
                (2.13
                )
                
                $
                (0.12
                )
                
                $
                0.10Weighted
      average shares used in per share calculations:Basic
                
                
                49,238
                
                
                
                46,942
                
                
                
                34,748Diluted
                
                
                49,238
                
                
                
                46,942
                
                
                
                35,739
  The
accompanying notes are an integral part of these consolidated financial
statements.
  F-3
 
 INTERNAP
      NETWORK SERVICES CORPORATION AND SUBSIDIARIESCONSOLIDATED
      BALANCE SHEETS(In
      thousands, except per share
amounts)
  
 December
      31,2008
                            
                            
                            2007ASSETSCurrent
      assets:Cash
      and cash equivalents
                            
                            $
                            46,870
                            
                            
                            $
                            52,030Short-term
      investments in marketable securities
                            
                            
                            7,199
                            
                            
                            
                            19,569Accounts
      receivable, net of allowance for doubtful accounts of $2,777 and $2,351,
      respectively
                            
                            
                            28,634
                            
                            
                            
                            36,429Inventory
                            
                            
                            381
                            
                            
                            
                            304Prepaid
      expenses and other assets
                            
                            
                            10,866
                            
                            
                            
                            8,464Deferred
      tax asset, current portion
                            
                            
                            1
                            
                            
                            
                            479Total
      current assets
                            
                            
                            93,951
                            
                            
                            
                            117,275Property
      and equipment, net
                            
                            
                            97,350
                            
                            
                            
                            65,491Investments
      and other related assets, $7,027 and $0, respectively measured at fair
      value
                            
                            
                            8,650
                            
                            
                            
                            1,138Intangible
      assets, net
                            
                            
                            33,942
                            
                            
                            
                            43,008Goodwill
                            
                            
                            90,977
                            
                            
                            
                            190,677Restricted
      cash
                            
                            
                            —
                            
                            
                            
                            4,120Deposits
      and other assets
                            
                            
                            2,763
                            
                            
                            
                            2,287Deferred
      tax asset, non-current
                            
                            
                            2,450
                            
                            
                            
                            3,014Total
      assets
                            
                            $
                            330,083
                            
                            
                            $
                            427,010LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Note
      payable, current portion
                            
                            $
                            —
                            
                            
                            $
                            2,413Accounts
      payable
                            
                            
                            19,642
                            
                            
                            
                            19,624Accrued
      liabilities
                            
                            
                            8,756
                            
                            
                            
                            10,159Deferred
      revenues, current portion
                            
                            
                            3,710
                            
                            
                            
                            4,807Capital
      lease obligations, current portion
                            
                            
                            274
                            
                            
                            
                            805Restructuring
      liability, current portion
                            
                            
                            2,800
                            
                            
                            
                            2,396Other
      current liabilities
                            
                            
                            116
                            
                            
                            
                            108Total
      current liabilities
                            
                            
                            35,298
                            
                            
                            
                            40,312Note
      payable, less current portion
                            
                            
                            20,000
                            
                            
                            
                            17,354Deferred
      revenues, less current portion
                            
                            
                            2,248
                            
                            
                            
                            2,275Capital
      lease obligations, less current portion
                            
                            
                            3,244
                            
                            
                            
                            452Restructuring
      liability, less current portion
                            
                            
                            6,222
                            
                            
                            
                            7,697Deferred
      rent
                            
                            
                            14,114
                            
                            
                            
                            11,011Deferred
      tax liability
                            
                            
                            —
                            
                            
                            
                            398Other
      long-term liabilities
                            
                            
                            762
                            
                            
                            
                            878Total
      liabilities
                            
                            
                            81,888
                            
                            
                            
                            80,377Commitments
      and contingenciesStockholders’
      equity:Preferred
      stock, $0.001 par value, 20,000 shares authorized; no shares issued or
      outstanding
                            
                            
                            —
                            
                            
                            
                            —Common
      stock, $0.001 par value; 60,000 shares authorized; 50,224 and 49,759
      shares outstanding at December 31, 2008 and 2007,
    respectively
                            
                            
                            50
                            
                            
                            
                            50Additional
      paid-in capital
                            
                            
                            1,216,267
                            
                            
                            
                            1,208,191Treasury
      stock, at cost, 83 shares at December 31, 2008
                            
                            
                            (370
                            )
                            
                            
                            —Accumulated
      deficit
                            
                            
                            (966,823
                            )
                            
                            
                            (862,010
                            )Accumulated
      items of other comprehensive income
                            
                            
                            (929
                            )
                            
                            
                            402Total
      stockholders’ equity
                            
                            
                            248,195
                            
                            
                            
                            346,633Total
      liabilities and stockholders’ equity
                            
                            $
                            330,083
                            
                            
                            $
                            427,010
  The
accompanying notes are an integral part of these consolidated financial
statements.
  F-4
  INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS) INCOME
 For
the Three Years Ended December 31, 2008
 (In
thousands)
 Common
      StockShares
                                                                                                                      
                                                                                                                      Par
      Value
                                                                                                                      
                                                                                                                      Additional
      Paid-In
      Capital
                                                                                                                      
                                                                                                                      Treasury
      Stock
                                                                                                                      
                                                                                                                      Deferred
      Stock
      Compensation
                                                                                                                      
                                                                                                                      Accumulated
      Deficit
                                                                                                                      
                                                                                                                      Accumulated
      Items
      of ComprehensiveIncome
      (Loss)
                                                                                                                      
                                                                                                                      Total
      Stockholders’
      EquityBalance,
      December 31, 2005
                                                                                                                      
                                                                                                                      
                                                                                                                      34,168
                                                                                                                      
                                                                                                                      $
                                                                                                                      34
                                                                                                                      
                                                                                                                      $
                                                                                                                      970,221
                                                                                                                      
                                                                                                                      $
                                                                                                                      —
                                                                                                                      
                                                                                                                      $
                                                                                                                      (420
                                                                                                                      )
                                                                                                                      $
                                                                                                                      (860,112
                                                                                                                      )
                                                                                                                      $
                                                                                                                      5
                                                                                                                      
                                                                                                                      $
                                                                                                                      109,728Net
      income
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      3,657
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      3,657Change
      in unrealized gains and losses on investments, net of
taxes
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      80
                                                                                                                      
                                                                                                                      
                                                                                                                      80Foreign
      currency translation adjustment
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      235
                                                                                                                      
                                                                                                                      
                                                                                                                      235Total
      comprehensive income
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      3,972Reclassification
      of deferred stock compensation resulting from implementation of SFAS No.
      123R
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (420
                                                                                                                      )
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      420
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —Stock
      compensation plans activity and stock-based compensation
      expense
                                                                                                                      
                                                                                                                      
                                                                                                                      1,154
                                                                                                                      
                                                                                                                      
                                                                                                                      2
                                                                                                                      
                                                                                                                      
                                                                                                                      9,015
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      9,017Exercise
      of warrants
                                                                                                                      
                                                                                                                      
                                                                                                                      551
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      3,808
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      3,808Balance,
      December 31, 2006
                                                                                                                      
                                                                                                                      
                                                                                                                      35,873
                                                                                                                      
                                                                                                                      
                                                                                                                      36
                                                                                                                      
                                                                                                                      
                                                                                                                      982,624
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (856,455
                                                                                                                      )
                                                                                                                      
                                                                                                                      320
                                                                                                                      
                                                                                                                      
                                                                                                                      126,525Net
      loss
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (5,555
                                                                                                                      )
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (5,555
                                                                                                                      )Change
      in unrealized gains and losses on investments, net of
taxes
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (25
                                                                                                                      )
                                                                                                                      
                                                                                                                      (25
                                                                                                                      )Foreign
      currency translation adjustment
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      107
                                                                                                                      
                                                                                                                      
                                                                                                                      107Total
      comprehensive loss
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      (5,473
                                                                                                                      )Stock
      issued in connection with VitalStream acquisition
                                                                                                                      
                                                                                                                      
                                                                                                                      12,206
                                                                                                                      
                                                                                                                      
                                                                                                                      12
                                                                                                                      
                                                                                                                      
                                                                                                                      208,281
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      208,293Stock
      compensation plans activity and stock-based compensation
      expense
                                                                                                                      
                                                                                                                      
                                                                                                                      1,680
                                                                                                                      
                                                                                                                      
                                                                                                                      2
                                                                                                                      
                                                                                                                      
                                                                                                                      17,286
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      17,288Balance,
      December 31, 2007
                                                                                                                      
                                                                                                                      
                                                                                                                      49,759
                                                                                                                      
                                                                                                                      
                                                                                                                      50
                                                                                                                      
                                                                                                                      
                                                                                                                      1,208,191
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (862,010
                                                                                                                      )
                                                                                                                      
                                                                                                                      402
                                                                                                                      
                                                                                                                      
                                                                                                                      346,633Net
      loss
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (104,813
                                                                                                                      )
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (104,813
                                                                                                                      )Change
      in unrealized gains and losses on investments, net of
taxes
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (29
                                                                                                                      )
                                                                                                                      
                                                                                                                      (29
                                                                                                                      )Foreign
      currency translation adjustment
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      (1,302
                                                                                                                      )
                                                                                                                      
                                                                                                                      (1,302
                                                                                                                      )Total
      comprehensive loss
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      
                                                                                                                      (106,144
                                                                                                                      )Stock
      compensation plans activity and stock-based compensation
      expense
                                                                                                                      
                                                                                                                      
                                                                                                                      465
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      8,076
                                                                                                                      
                                                                                                                      
                                                                                                                      (370
                                                                                                                      )
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      —
                                                                                                                      
                                                                                                                      
                                                                                                                      7,706Balance,
      December 31, 2008
                                                                                                                      
                                                                                                                      
                                                                                                                      50,224
                                                                                                                      
                                                                                                                      $
                                                                                                                      50
                                                                                                                      
                                                                                                                      $
                                                                                                                      1,216,267
                                                                                                                      
                                                                                                                      $
                                                                                                                      (370
                                                                                                                      )
                                                                                                                      $
                                                                                                                      —
                                                                                                                      
                                                                                                                      $
                                                                                                                      (966,823
                                                                                                                      )
                                                                                                                      $
                                                                                                                      (929
                                                                                                                      )
                                                                                                                      $
                                                                                                                      248,195
  See note
2 for information on effect of one-for-10 reverse stock split in July
2006.
  The
accompanying notes are an integral part of these consolidated financial
statements.
  F-5
  INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (In
thousands)
 Year Ended December
      31,2008
                
                
                2007
                
                
                2006Cash
      flows from operating activities:Net
      (loss) income
                
                $
                (104,813
                )
                
                $
                (5,555
                )
                
                $
                3,657Adjustments
      to reconcile net (loss) income to net cash provided by operating
      activities:Depreciation
      and amortization
                
                
                28,663
                
                
                
                26,407
                
                
                
                16,372Gain
      on disposal of property and equipment, net
                
                
                (16
                )
                
                
                (5
                )
                
                
                (113
                )Goodwill
      and other intangible asset impairments
                
                
                102,336
                
                
                
                2,454
                
                
                
                319Acquired
      in-process research and development
                
                
                —
                
                
                
                450
                
                
                
                —Stock-based
      compensation expense
                
                
                7,499
                
                
                
                8,681
                
                
                
                5,942Write-off
      of investment
                
                
                —
                
                
                
                1,178
                
                
                
                —Equity
      in earnings from equity-method investment
                
                
                (283
                )
                
                
                (139
                )
                
                
                (114
                )Provision
      for doubtful accounts
                
                
                5,083
                
                
                
                2,261
                
                
                
                548Non-cash
      changes in deferred rent
                
                
                3,102
                
                
                
                (421
                )
                
                
                2,247Deferred
      income taxes
                
                
                644
                
                
                
                (3,095
                )
                
                
                —Other,
      net
                
                
                (477
                )
                
                
                (150
                )
                
                
                —Changes
      in operating assets and liabilities, excluding effects of
      acquisition:Accounts
      receivable
                
                
                2,424
                
                
                
                (15,825
                )
                
                
                (1,702
                )Inventory,
      prepaid expenses, deposits and other assets
                
                
                (2,919
                )
                
                
                (2,182
                )
                
                
                (1,778
                )Accounts
      payable
                
                
                18
                
                
                
                7,920
                
                
                
                3,010Accrued
      and other liabilities
                
                
                (1,404
                )
                
                
                (2,466
                )
                
                
                1,422Deferred
      revenue
                
                
                (836
                )
                
                
                2,704
                
                
                
                1,070Accrued
      restructuring liability
                
                
                (1,070
                )
                
                
                5,309
                
                
                
                (1,493
                )Net
      cash flows provided by operating activities
                
                
                37,951
                
                
                
                27,526
                
                
                
                29,387Cash
      flows from investing activities:Purchases
      of investments in marketable securities
                
                
                (21,422
                )
                
                
                (38,508
                )
                
                
                (17,427
                )Maturities
      and sales of investments in marketable securities
                
                
                26,591
                
                
                
                32,395
                
                
                
                20,277Purchases
      of property and equipment
                
                
                (51,154
                )
                
                
                (30,271
                )
                
                
                (13,382
                )Proceeds
      from disposal of property and equipment
                
                
                175
                
                
                
                5
                
                
                
                133Cash
      received from acquisition, net of costs incurred for the
      transaction
                
                
                —
                
                
                
                3,203
                
                
                
                —Change
      in restricted cash, excluding effects of acquisition
                
                
                4,120
                
                
                
                (3,217
                )
                
                
                —Net
      cash flows used in investing activities
                
                
                (41,690
                )
                
                
                (36,393
                )
                
                
                (10,399
                )
  F-6
  INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)
 (In
thousands)
 Year
      Ended December 31,2008
                
                
                2007
                
                
                2006Cash
      flows from financing activities:Proceeds
      from notes payable, net of discount
                
                
                20,000
                
                
                
                19,742
                
                
                
                —Principal
      payments on notes payable
                
                
                (20,000
                )
                
                
                (11,318
                )
                
                
                (4,375
                )Payments
      on capital lease obligations
                
                
                (807
                )
                
                
                (1,617
                )
                
                
                (538
                )Debt
      issuance costs
                
                
                (14
                )
                
                
                (65
                )
                
                
                —Stock-based compensation
      plans
                
                
                108
                
                
                
                8,582
                
                
                
                3,031Proceeds
      from exercise of warrants
                
                
                —
                
                
                
                —
                
                
                
                3,808Other,
      net
                
                
                (108
                )
                
                
                (84
                )
                
                
                31Net
      cash flows (used in) provided by financing activities
                
                
                (821
                )
                
                
                15,240
                
                
                
                1,957Effect
      of exchange rates on cash and cash equivalents
                
                
                (600
                )
                
                
                66
                
                
                
                212Net
      (decrease) increase in cash and cash equivalents
                
                
                (5,160
                )
                
                
                6,439
                
                
                
                21,157Cash
      and cash equivalents at beginning of period
                
                
                52,030
                
                
                
                45,591
                
                
                
                24,434Cash
      and cash equivalents at end of period
                
                $
                46,870
                
                
                $
                52,030
                
                
                $
                45,591Supplemental
      disclosure of cash flow information:Common
      stock issued and stock options assumed in VitalStream
      acquisition
                
                $
                —
                
                
                $
                208,293
                
                
                $
                —Cash
      paid for interest, net of amounts capitalized
                
                
                1,403
                
                
                
                1,152
                
                
                
                793Cash
      paid for income taxes
                
                
                361
                
                
                
                103
                
                
                
                149Non-cash
      acquisition of property and equipment
                
                
                3,069
                
                
                
                148
                
                
                
                162Capitalized
      stock-based compensation
                
                
                97
                
                
                
                25
                
                
                
                44
  The
accompanying notes are an integral part of these consolidated financial
statements.
  F-7
  INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  1.
                DESCRIPTION
      OF THE COMPANY AND NATURE OF
OPERATIONS
  Internap
Network Services Corporation (“Internap,” “we,” “us,” “our,” or the “Company”)
delivers high performance and reliable Internet solutions through a suite of
network optimization and delivery products and services. These solutions and our
technical support enable companies to migrate business-critical applications,
including audio and video streaming and monetization services, to the Internet.
Our suite of products and services support a broad range of Internet
applications. We serve both domestic and international customers in the
entertainment and media, financial services, healthcare, travel,
e-commerce, retail and technology. Our product and service offerings are
complemented by Internet Protocol, or IP, access solutions such as colocation
and data center services, content delivery networks, or CDN, and managed
security. We deliver services through our 64 service points across North
America, Europe, Asia, India and Australia. Our Private Network Access Points,
or P-NAPs, feature multiple direct high-speed connections to multiple major
Internet backbones, also referred to as network service providers or NSPs,
including AT&T Inc.; Sprint Nextel Corporation; Verizon Communications
Inc.; Global Crossing Limited; and Level 3 Communications, Inc. We operate in
three business segments: IP services, data center services and CDN services.
Prior to February 2007, we operated as a single business segment.
  The
nature of our business subjects us to certain risks and uncertainties frequently
encountered by rapidly evolving markets. These risks are described in “Risk
Factors” in this Form 10-K.
  Although
we have been in existence since 1996, we have incurred significant operational
restructurings in recent years, which have included substantial changes in our
senior management team, streamlining our cost structure, consolidating network
access points and terminating certain non-strategic real estate leases and
license arrangements. We have a history of quarterly and annual period net
losses through the year ended December 31, 2005. For the year ended December 31,
2006, we recognized net income in each quarter. For the years ended December 31,
2008 and 2007, we recognized net losses of $104.8 million and $5.6 million,
respectively. At December 31, 2008, our accumulated deficit was $966.8 million.
However, for the years ended December 31, 2008, 2007 and 2006, we generated net
cash flows from operating activities of $38.0 million, $27.5 million and $29.4
million, respectively.
 2.
                SUMMARY
      OF SIGNIFICANT ACCOUNTING
POLICIES
  Accounting
Principles
  The
consolidated financial statements and accompanying notes are prepared in
accordance with accounting principles generally accepted in the United States of
America, or GAAP. The consolidated financial statements include our accounts and
those of our wholly-owned subsidiaries. Significant inter-company transactions
have been eliminated in consolidation.
  Estimates
and Assumptions
  The
preparation of these financial statements requires management to make estimates
and judgments that affect the reported amounts of assets, liabilities, revenue
and expense and related disclosure of contingent assets and liabilities. On an
ongoing basis, we evaluate our estimates, including those related to revenue
recognition, doubtful accounts, cost-basis investments, auction rate securities,
goodwill and intangible assets, accruals, stock-based compensation, income
taxes, restructuring costs, long-term service contracts, contingencies and
litigation. We base our estimates on historical experience and on various other
assumptions that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ materially from these estimates.
  Cash
and Cash Equivalents
  We
consider all highly-liquid investments purchased with an original maturity of
three months or less at the date of purchase and money market mutual funds to be
cash equivalents. We invest our cash and cash equivalents with major financial
institutions and may at times exceed federally insured limits. We believe that
the risk of loss is minimal. To date, we have not experienced any losses related
to cash and cash equivalents.
  F-8
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
   Restricted
Cash
  Restricted
cash represented time deposits used to secure letters of credit on certain of
our real estate leases and a capital lease for equipment in 2007. The letters of
credit for the real estate leases were secured by our former credit agreement
with Silicon Valley Bank and were in the process of being secured under the
original Credit Agreement executed in 2007. We assumed the letter of
credit securing the capital lease for equipment in the VitalStream acquisition.
As of December 31, 2008, we had no restricted cash, as these letters of credit
were secured by our Amended Credit Agreement, which is defined and described
below in note 11.
  Investments
in Marketable Securities
  We
determine the appropriate classification of all marketable securities at the
time of purchase, and re-evaluate such classification as of each reporting
period. Available-for-sale securities are carried at fair value, with the
unrealized gains and losses reported in other comprehensive (loss) income,
a component of stockholders’equity in our accompanying consolidated balance
sheets. We also review available-for-sale securities each reporting period for
declines in value that we consider to be other-than-temporary and, if
appropriate, write down the securities to their estimated fair value. Any
declines in value judged to be other-than-temporary on available-for-sale
securities are included in “Non-operating (income) expense” in the accompanying
consolidated statements of operations. Trading securities are carried at fair
value with all changes in fair value reported in “Non-operating (income)
expense” in the accompanying consolidated statements of operations. The cost of
securities sold is based on the specific identification method. At December 31,
2008, the fair value of our short-term investments in marketable securities was
$7.2 million, all designated as available for sale, and the fair value of our
non-current investments in marketable securities was $6.4 million, all
designated as trading. At December 31, 2007, we had $19.6 million of investments
in marketable securities, all of which were classified as short-term and
designated as available for sale. See note 5 for further discussion of our
investments.
  Other
Investments
  We
account for investments that provide us with the ability to exercise significant
influence, but not control, over an investee using the equity method of
accounting. Significant influence, but not control, is generally deemed to exist
if we have an ownership interest in the voting stock of the investee of between
20% and 50%, although other factors, such as minority interest protections, are
considered in determining whether the equity method of accounting is
appropriate. As of December 31, 2008, Internap Japan Co. Ltd., or Internap
Japan, our joint venture with NTT-ME Corporation and Nippon Telegraph and
Telephone Corporation, or NTT Holdings, qualifies for equity method accounting.
We record our proportional share of the income and losses of Internap Japan one
month in arrears on the consolidated balance sheets as a component of
non-current investments and our share of Internap Japan’s income and losses, net
of taxes, as a separate caption in our consolidated statement of
operations.
  We
account for investments without readily determinable fair values at historical
cost, as determined by our initial investment. We periodically review the
recorded value of cost basis investments to determine the propriety of the
recorded basis. When a decline in the value that is judged to be
other-than-temporary has occurred based on available data, we reduce the cost
basis and record an investment loss. At December 31, 2008, we had no investments
accounted for under the cost method.
 We
incurred a charge during the three months ended June 30, 2007, totaling $1.2
million, representing the write-off of the remaining carrying value of our
investment in series D preferred stock of Aventail Corporation, or Aventail. See
note 5 for further discussion of this investment and the recorded
loss.
  Fair
Value of Financial Instruments
  Effective
January 1, 2008, we adopted the provisions of SFAS No. 157, Fair Value Measurements,
which defines fair value and provides guidance for using fair value to measure
assets and liabilities. In accordance with SFAS No. 157 and Staff
Position FAS 157-2, Effective
Date of FASB Statement No. 157, we adopted SFAS No. 157
with regard to all financial assets and liabilities in our financial statements
in the first quarter of 2008 and have elected to delay the adoption of
SFAS No. 157 for nonfinancial assets and nonfinancial liabilities
until the first quarter of 2009. SFAS No. 157 is applicable whenever
other standards require or permit assets or liabilities to be measured at fair
value but does not expand the use of fair value in any new circumstances.
Accordingly, the carrying amounts of certain of our financial instruments,
including cash equivalents and marketable securities, continue to be valued at
fair value on a recurring basis.
  SFAS
No. 157 introduced new disclosures about how we value certain assets. Much
of the disclosure focuses on the inputs used to measure fair value, particularly
in instances in which the measurement uses significant unobservable inputs. The
fair value estimates presented in this report reflect the information available
to us as of December 31, 2008. See note 6 for further discussion of
the fair value of our financial instruments.
  F-9
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  The
carrying amounts of our financial instruments, including cash and cash
equivalents, accounts receivable, and other current liabilities, approximate
fair value due to the short-term nature of these assets and liabilities. The
fair value of our debt approximates the carrying value due to the nature of our
credit facility.
  We
elected to record rights, or ARS Rights, from one of our investment providers at
fair value. The ARS Rights are more fully described in note 5. Recording the ARS
Rights at fair value enables us to match changes in the fair value of the ARS
Rights to changes in the fair value of the associated auction rate
securities.
  Financial
Instrument Credit Risk
  Financial
instruments that potentially subject us to a concentration of credit risk
principally consist of cash, cash equivalents, marketable securities and trade
receivables. We currently invest the majority of our cash and cash equivalents
in money market funds. We also have invested, in accordance with our formal
investment policy, in high credit quality corporate debt securities, U.S.
Treasury bills and commercial paper. Our investments in marketable securities
also include auction rate securities whose underlying assets are state-issued
student and educational loans which are substantially backed by the federal
government. Under our current investment policy, new or additional auction rate
securities are not eligible investment instruments, but we will hold our
existing auction rate securities until liquidity returns or we exercise our ARS
Rights, as discussed below. As of December 31, 2008 and 2007, our investments in
auction rate securities having a par value of $7.2 million had carrying values
of $6.4 million and $7.2 million, respectively. The carrying amount at
December 31, 2008 includes a reduction in fair value of $0.8 million. While
we continue to earn and accrue interest on our auction rate securities at
contractual rates, these investments are not currently trading. During
2008, we classified our auction rate securities as non-current investments on
our accompanying consolidated balance sheet versus short-term investments as of
December 31, 2007.  This change in classification was initially due to
the uncertainty as to when the auction rate securities markets would
improve. As described in note 5, in October 2008, we received and
subsequently accepted rights, or ARS Rights, from one of our investment
providers to sell at par value auction rate securities originally purchased
from the investment provider ($7.2 million) at any time during a two-year
period beginning June 30, 2010. The fair value and carrying value of the ARS
Rights was $0.6 million as of December 31, 2008.
  Inventory
  We carry
inventory at the lower of cost or market using the first-in, first-out method.
Cost includes materials related to the assembly of our Flow Control Platform, or
FCP, solutions.
  Property
and Equipment
  We carry
property and equipment at original acquisition cost less accumulated
depreciation and amortization. We calculate depreciation and amortization on a
straight-line basis over the lesser of the estimated useful lives of the assets
or the lease term. Estimated useful lives used for network equipment are
generally three years; furniture, equipment and software are three to seven
years; and leasehold improvements are seven years or over the lease term,
depending on the nature of the improvement, but in no event beyond the expected
lease term. The duration of lease obligations and commitments range from 24
months for certain networking equipment to 240 months for certain facility
leases. We capitalize additions and improvements that increase the value or
extend the life of an asset. We expense maintenance and repairs as incurred. We
charge gains or losses from disposals of property and equipment to
operations.
  Leases
and Leasehold Improvements
  We record
leases in which we have substantially all of the benefits and risks of ownership
as capital leases and all other leases as operating leases. For leases
determined to be capital leases, the assets held under capital lease and related
obligations are recorded at the lesser of the present value of aggregate future
minimum lease payments or the fair value of the assets held under capital lease.
The assets are amortized over the shorter of the lease term or the estimated
useful life. For leases determined to be operating leases, lease expense is
recorded on a straight-line basis over the lease term. Certain leases include
renewal options that, at the inception of the lease, are considered reasonably
assured of being renewed. The lease term begins when the Company controls the
leased property, which is typically before lease payments begin under the terms
of the lease. The difference between the expense recorded in the consolidated
statements of operations and the amount paid is recorded as deferred rent and is
included in the consolidated balance sheets.
  F-10
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Costs
of Computer Software Development
  We
capitalize certain direct costs incurred developing internal use software. We
capitalized $1.4 million, $1.6 million and $0.9 million in internal software
development costs for the years ended December 31, 2008, 2007 and 2006,
respectively. During the year ended December 31, 2007, we impaired $1.1 million
of software development costs capitalized prior to December 31, 2006 related to
the implementation of a billing and order entry system initiated during 2004.
Subsequent to our acquisition of VitalStream, we determined that we would
utilize our legacy billing system and abandon the former project because (1) the
developer of our financial software purchased the developer of our legacy
billing system, and (2) the legacy billing system would be more flexible in
integrating the VitalStream business. During the year ended December 31,
2006, we impaired $0.3 million of software development costs related to the
implementation of our financial system software also initiated during 2004.
Amortization expense on internally developed software commences when the
software project is ready for its intended use.
  As of
December 31, 2008 and 2007, the balance of unamortized software costs was $3.8
million and $2.7 million, respectively, and for the years ended December 31,
2008 and 2007, amortization expense was $0.4 million and $0.2 million,
respectively. The software was not ready for its intended use and had not been
placed in service as of December 31, 2006; therefore, no amortization expense
was recorded for the year ended December 31, 2006.
  Valuation
of Long-Lived Assets
  We
periodically evaluate the carrying value of our long-lived assets, including,
but not limited to, property and equipment. The carrying value of a long-lived
asset is considered impaired when the undiscounted cash flows from such asset is
separately identifiable and is estimated to be less than its carrying value. In
that event, we would recognize a loss based on the amount by which the carrying
value exceeds the fair value of the long-lived asset. Fair value is determined
primarily using the anticipated cash flows discounted at a rate commensurate
with the risk involved. Losses on long-lived assets to be disposed of would be
determined in a similar manner, except that fair values would be reduced by the
cost of disposal. Losses due to impairment of long-lived assets are charged to
operations during the period in which the impairment is identified.
  Goodwill
and Other Intangible Assets
  We
perform our annual goodwill impairment test as of August 1 of each calendar
year, following our annual strategic planning cycle. Our assessment of
goodwill for impairment includes comparing the fair value to the net book value
of each of our four reporting units. Our IP services operating segment is
comprised of two reporting units: services and products. Our data center center
services and CDN services operating segments each represent a single reporting
unit; however, the data center services segment does not have any recorded
goodwill.
  We
estimate fair value using a combination of discounted cash flow models and
market approaches. If the fair value of a reporting unit exceeds its net
book value, goodwill is not impaired and no further testing is
necessary. If the net book value of a reporting unit exceeds its fair
value, we perform a second test to measure the amount of impairment loss, if
any. To measure the amount of any impairment loss, we determine the implied
fair value of goodwill in the same manner as if the affected reporting unit were
being acquired in a business combination. Specifically, we allocate the fair
value of the affected reporting unit to all of the assets and liabilities of
that unit, including any unrecognized intangible assets, in a hypothetical
calculation that would yield the implied fair value of goodwill. If the implied
fair value of goodwill is less than the goodwill recorded on our balance sheet,
we record an impairment charge for the difference.
  As a
result of our August 1, 2008 assessment, we recorded a
$99.7 million goodwill impairment charge to adjust goodwill in our CDN
services segment to an implied fair value of $54.7 million. The goodwill
impairment charge is presented separately in the accompanying statement of
operations for the year ended December 31, 2008. The goodwill impairment is
primarily due to declines in our CDN services revenues and operating results as
compared to our projections and unfavorable changes in market factors used to
estimate fair values. The declines in CDN services revenues and operating
results compared to projections are attributable to integration and reliability
issues in the acquired network and have now been resolved, a strategic shift to
larger, higher credit quality customers and more recently, a highly-competitive
market environment for CDN services that is driving lower pricing. Changes
in market factors include lower market multiples across the CDN services
industry from when we completed the acquisition of VitalStream and our own
now-lower market capitalization. The culmination of these factors leading
to our impairment of goodwill did not occur until the three months ended
September 30, 2008. The impairment charge does not have any impact on
our current cash balance or result in violation of any covenants of our debt
instruments.
  We also
assessed the likelihood of triggering events that might cause us to re-assess
goodwill on an interim basis and concluded that no such triggering events have
occurred that would cause us to re-assess goodwill for impairment subsequent to
August 1, 2008.
  F-11
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Other
intangible assets, including developed technologies and patents, have finite
lives and we have recorded these assets at cost less accumulated amortization.
We calculate amortization on a straight-line basis over the estimated economic
useful life of the assets, which are three to seven years for developed
technologies and 15 years for patents.
  In
conjunction with our review of our long-term financial outlook, we also
performed an analysis of the potential impairment and re-assessed the remaining
asset lives of other identifiable intangible assets acquired in the VitalStream
acquisition. The analysis and re-assessment of other identifiable intangible
assets recorded in the VitalStream acquisition resulted in:
 ●
                      An
      impairment charge of $1.9 million in developed advertising technology due
      to a strategic change in market focus,●
                      An
      impairment charge of $0.8 million in trade names as a result of
      discontinuing use of the VitalStream trade name,
  and●
                      a
      change in our estimates that resulted in acceleration of amortization
      expense of our customer relationships intangible asset over a shorter
      estimated useful life (four remaining years instead of the original
      estimated useful life of nine years) due to customer churn resulting in
      higher than expected attrition as of the acquisition
  date.
  The
impairment analysis of goodwill is based on estimated fair values. The valuation
of goodwill requires assumptions and estimates of many critical factors,
including revenue and market growth, operating cash flows, market multiples and
discount rates. Adverse changes in expected operating results and/or unfavorable
changes in other economic factors used to estimate fair values could result in
an additional non-cash impairment charge in the future.
  Accruals
for Disputed Telecommunication Costs and Other Accrued Liabilities
  In
delivering our services, we rely on a number of Internet network,
telecommunication, utilities and other vendors. We work directly with these
vendors to establish, modify or discontinue services for our customers. Because
of the volume of activity, billing disputes inevitably arise, and it is often
necessary to estimate certain costs of providing services to our customers given
that we may not receive invoices on a timely basis or due to the complexity
surrounding such costs. These disputes typically stem from disagreements
concerning the starting and ending dates of service, quoted rates, usage and
various other factors. For potential billing errors made in the vendor’s favor,
for example a duplicate billing, we initiate a formal dispute with the vendor
and record the related cost and liability up to 100% of the disputed amount,
depending on our assessment of the likely outcome of the dispute. Conversely,
for billing errors in our favor, such as the vendor’s failure to invoice us for
new service, we record an estimate based on the full amount that we should have
been invoiced. If an estimate is necessary, we record the related cost and
liability based on all available facts and circumstances, including but not
limited to historical trends, related usage, forecasts and quotes.
  We
research all disputed costs with vendors on an ongoing basis until ultimately
resolved. We periodically review and modify estimates in light of new
information or developments, if any. We recognize any resolved disputes that
will result in a credit over the disputed amounts in the appropriate month when
the resolution has been determined. Because estimates regarding disputed
costs include assessments of uncertain outcomes, such estimates are inherently
vulnerable to changes due to unforeseen circumstances that could materially and
adversely affect our consolidated financial condition, results of operations and
cash flows.
  Restructuring
Liability
  When
circumstances warrant, we may elect to exit certain business activities or
change the manner in which we conduct ongoing operations. When we make such a
change, we will estimate the costs to exit a business or restructure ongoing
operations. The components of the estimates may include estimates and
assumptions regarding the timing and costs of future events and activities that
represent our best expectations based on known facts and circumstances at the
time of estimation. Should circumstances warrant, we will adjust our
previous estimates to reflect what we then believe to be a more accurate
representation of expected future costs. Because our estimates and assumptions
regarding restructuring costs include probabilities of future events, such as
our ability to find a sublease tenant within a reasonable period of time or the
rate at which a sublease tenant will pay for the available space, such estimates
are inherently vulnerable to changes due to unforeseen circumstances that could
materially and adversely affect our results of operations. A 10% change in our
restructuring estimates in a future period, compared to the $9.0 million
restructuring liability at December 31, 2008, would result in a $0.9 million
expense or benefit in the statement of operations during the period in which the
change in estimate occurred. If we do not find a sublease tenant for one of our
more significant restructured locations by the end of the second quarter of 2010
or if we do not obtain a certain rate per square foot for the available space,
we will need to take an additional charge in our statement of operations that
may be material. We monitor market conditions at each period end reporting date
and will continue to assess our key assumptions and estimates used in the
calculation of our restructuring accrual.
  Taxes
  We
account for income taxes under the liability method. We determine deferred tax
assets and liabilities based on differences between financial reporting and tax
bases of assets and liabilities, and we measure the tax assets and liabilities
measured using the enacted tax rates and laws that will be in effect when we
expect the differences to reverse. We provide a valuation allowance to reduce
our deferred tax assets to their estimated realizable value. We may realize
deferred tax assets in future periods when they are estimated to be realizable,
such as establishing expected continuing profitability of the Company or certain
of our foreign subsidiaries.
  F-12
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  We accrue
liabilities for uncertain tax positions and, as of December 31, 2008 and 2007,
we recognized associated liabilities of $0 and $0.9 million, respectively that
were netted on the balance sheet with U.K. deferred tax assets. We have recorded
nominal interest and penalties arising from the underpayment of income taxes in
the statement of operations under general and administrative expenses. As of
December 31, 2008 and 2007, we had no accrued interest or penalties related to
uncertain tax positions, as a result of substantial U.K. net operating loss
carryforwards.
  We
account for telecommunication, sales and other similar taxes on a net basis in
general and administrative expense.
  Stock-Based
Compensation
  Stock-based
compensation cost is measured at the grant date based on the calculated fair
value of the award. We recognize the expense over the employees’ requisite
service period, generally the vesting period of the award. For
performance-based awards, we periodically assess whether the performance
conditions are probable of being met and record compensation expense based on
this assessment of probability.We estimate the fair value of stock
options at the grant date using the Black-Scholes option pricing model with
weighted average assumptions for the activity under our stock plans. Option
pricing model input assumptions such as expected term, expected volatility and
risk-free interest rate, impact the fair value estimate. Further, the forfeiture
rate impacts the amount of aggregate compensation. These assumptions are
subjective and generally require significant analysis and judgment to develop.
When we
elect to pay certain bonuses in shares of stock, the total amount to be paid is
determined similarly to cash bonuses and the number of shares to be granted is
determined based on the fair value of our stock at the date of
grant.
  We do not
recognize a deferred tax asset for unrealized tax benefits associated with the
tax deductions in excess of the compensation recorded (excess tax benefit). We
apply the “with and without” approach for utilization of tax attributes upon
realization of net operating losses in the future. This method allocates stock
compensation benefits last among other tax benefits recognized. In
addition, we apply the “direct only” method of calculating the amount of
windfalls or shortfalls.
  Treasury
Stock
  As
permitted by our stock-based compensation plans, we acquire, from time-to-time,
shares of treasury stock as payment of taxes due from employees for stock-based
compensation. During 2006, shares of treasury stock were acquired as payment of
taxes and subsequently reissued as part of our stock-based compensation plans.
Shares of treasury stock acquired in 2008 will also be subsequently reissued as
part of our stock-based compensation plans. When we reissue the shares, we use
the weighted average cost method for determining cost. The difference between
the cost of the shares and the issuance price is added or deducted from
additional contributed capital. We did not acquire shares of treasury stock
during 2007.
  Reverse
Stock Split
  On July
10, 2006, we implemented a one-for-10 reverse stock split on our common stock
and amended our Certificate of Incorporation to reduce our authorized shares of
common stock from 600 million to 60 million. We began trading on a post reverse
split basis on July 11, 2006. All share and per share information herein
(including shares outstanding, earnings per share and warrant and stock option
data) have been retroactively adjusted for all periods presented to reflect
this reverse split.
  Revenue
Recognition
  The
majority of our revenues are derived from high performance IP services, related
data center services, CDN services and other ancillary products and services
throughout the United States. We derive our IP services revenues from the sale
of high performance Internet connectivity services at fixed rates or usage-based
pricing to our customers that desire a DS-3 or faster connection. We provide
slower T-1 and fractional DS-3 connections at fixed rates. Data center
revenues include both physical space for hosting customers’ network and other
equipment plus associated services such as redundant power and network
connectivity, environmental controls and security. Data center revenues are
based on occupied square feet and both allocated and variable-based
usage. CDN services revenues include three components: (1) data storage;
(2) streaming/delivery and (3) a user interface/reporting tool. We provide
the CDN service components via internally developed and acquired technology that
resides on our network. CDN services revenues are based on either fixed
rates or usage-based pricing. All of the foregoing revenue arrangements
have contractual terms and, in many instances, include minimum usage commitments
and provide the rate at which the customer must pay for actual usage above the
monthly minimum. For these services, we recognize the monthly minimum as revenue
each month provided that both parties have signed an enforceable contract, we
have delivered the service to the customer, the fee for the service is fixed or
determinable and collection is reasonably assured. If a customer’s usage of our
services exceeds the monthly minimum, we recognize revenue for such excess in
the period of the usage. We record the installation fees as deferred revenue and
recognize as revenue ratably over the estimated life of the customer
arrangement. We also derive revenue from services sold as discrete,
non-recurring events or based solely on usage. For these services, we recognize
revenue after both parties have signed an enforceable contract, the fee is fixed
or determinable, the event or usage has occurred and collection is reasonably
assured. Other ancillary products and services include our FCP product, server
management and installation, virtual private networking, managed security, data backup, remote storage and
restoration.
  We use
contracts and sales or purchase orders as evidence of an arrangement. We test
for availability or connectivity to verify delivery of our services. We assess
whether the fee is fixed or determinable based on the payment terms associated
with the transaction and whether the sales price is subject to refund or
adjustment. Because the software component of our FCP product is more than
incidental to the product as a whole, we recognize associated FCP revenue in
accordance with the American Institute of Certified Public Accountants’
Statement of Position 97-2, Software Revenue
Recognition.
  F-13
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  We also
enter into multiple-element arrangements or bundled services, such as combining
IP services with data center and/or CDN services. When we enter into such
arrangements, we account for each element separately over its respective service
period or at the time of delivery, provided that there is objective evidence of
fair value for the separate elements. Objective evidence of fair value includes
the price charged for the element when sold separately. If we cannot objectively
determine the fair value of each element, we recognize the total value of the
arrangement ratably over the entire service period to the extent that we have
begun to provide the services, and we have satisfied other revenue recognition
criteria.
  Deferred
revenue consists of revenues for services to be delivered in the future and
consists primarily of advance billings, which we amortize over the respective
service period. We defer and amortize revenues associated with billings for
installation of customer network equipment over the estimated life of the
customer relationship, which was two to three years during the three-year period
ended December 31, 2008. We defer and amortize revenues for installation
services because the installation service is integral to our primary service
offering and does not have value to customers on a stand-alone basis. We also
defer and amortize the associated incremental direct costs. We amortize deferred
post-contract customer support associated with sales of our FCP product and
similar products ratably over the contract period, which is generally one
year.
  We
routinely review the collectability of our accounts receivable and payment
status of our customers. If we determine that collection of service revenue is
uncertain, we do not recognize revenue until collection is probable.
Additionally, we maintain allowances for doubtful accounts resulting from the
inability of our customers to make required payments on accounts receivable. The
allowance for doubtful accounts is based upon specific and general customer
information, which also includes estimates based on our best understanding of
our customers’ ability to pay and their payment status. Customers’ ability to
pay takes into consideration payment history, legal status (i.e.,
bankruptcy) and the status of services we are providing. We assess the
payment status of customers by reference to the terms under which services or
goods are provided, with any payments not made on or before their due date
considered past-due. Once we have exhausted all collection efforts, we
write the uncollectible balance off against the allowance for doubtful
accounts.
  We record
an amount for service level agreements and other sales adjustments, which
reduces net accounts receivable and revenues. Adjustments for service level
agreements are identified within the billing period and revenues are reduced
accordingly.The amount for sales adjustments is based upon specific
customer information, including outstanding promotional credits, customer
disputes, credit adjustments not yet processed through the billing system and
historical activity. If the financial condition of our customers
deteriorates, or if we become aware of new information impacting a customer’s
credit risk, we may make additional adjustments.
  Research
and Product Development Costs
  Product
development costs are primarily related to network engineering costs associated
with changes to the functionality of our proprietary services and network
architecture. Research and development costs, which we include in product
development cost and expense as incurred, primarily consist of
compensation related to our development and enhancement of IP
routing technology, progressive download and streaming technology for our
CDN, acceleration and cloud technologies. Research and development costs
were $5.0 million, $3.1 million and $2.4 million for the years ended December
31, 2008, 2007 and 2006, respectively. We also expense as incurred those costs
that do not qualify for capitalization as software development
costs.
  Advertising
Costs
  We
expense all advertising costs as incurred. Advertising costs for the years ended
December 31, 2008, 2007 and 2006 were $1.3 million, $1.2 million and $1.3
million, respectively.
  F-14
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Net
(Loss) Income Per Share
  We
compute basic and diluted net (loss) income per share using the weighted average
number of shares of common stock outstanding during the period. We compute
diluted net (loss) income per share using the weighted average number of common
and potentially dilutive shares outstanding during the period. Potentially
dilutive shares consist of the incremental shares of common stock issuable upon
the exercise of outstanding stock options and warrants and unvested restricted
stock using the treasury stock method. The treasury stock method calculates the
dilutive effect for only those stock options and warrants for which the sum of
proceeds, including unrecognized compensation and windfall tax benefits, if any,
is less than the average stock price during the period presented. Potentially
dilutive shares are excluded from the computation of net (loss) income per share
if their effect is anti-dilutive.
  Basic and
diluted net (loss) income per share for the years ended December 31, 2008, 2007
and 2006 is calculated as follows (in thousands, except per share
amounts):
 Year
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Net
      (loss) income
                    
                    $
                    (104,813
                    )
                    
                    $
                    (5,555
                    )
                    
                    $
                    3,657Weighted
      average shares outstanding, basic
                    
                    
                    49,238
                    
                    
                    
                    46,942
                    
                    
                    
                    34,748Effect
      of dilutive securities:Stock
      compensation plans
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    984Warrants
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    7Weighted
      average shares outstanding, diluted
                    
                    
                    49,238
                    
                    
                    
                    46,942
                    
                    
                    
                    35,739Net
      (loss) income per share:Basic
                    
                    $
                    (2.13
                    )
                    
                    $
                    (0.12
                    )
                    
                    $
                    0.11Diluted
                    
                    $
                    (2.13
                    )
                    
                    $
                    (0.12
                    )
                    
                    $
                    0.10Anti-dilutive
      securities not included in diluted net (loss) income per share
      calculation:Stock
      compensation plans
                    
                    
                    3,651
                    
                    
                    
                    3,860
                    
                    
                    
                    1,408Warrants
      to purchase common stock
                    
                    
                    —
                    
                    
                    
                    34
                    
                    
                    
                    —3,651
                    
                    
                    
                    3,894
                    
                    
                    
                    1,408
  Reclassifications
  Beginning
in 2008, we classified all revenues and direct costs of network, sales and
services previously reported in other, non-segmented results, except for third
party CDN services, in the most closely-related business segments to provide a
more accurate view of the results of operations of the business
segments. Financial information for 2007 and 2006 has also been
reclassified to conform to the current period presentation. None of the
reclassifications had any effect on previously reported total revenues, total
direct costs of network, sales and services, exclusive of depreciation and
amortization or net (loss) income.
  F-15
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  The
effect of these reclassifications on revenues and direct costs of network, sales
and services is shown below (in thousands):
 IP
                  Services
                
                
                Data
                  Center
                  Services
                
                
                CDN
                  Services
                
                
                Other
                
                
                TotalYear
      ended December 31, 2007:Revenues:Previously
      reported
                
                $
                119,848
                
                
                $
                83,058
                
                
                $
                17,718
                
                
                $
                13,466
                
                
                $
                234,090Reclassification
      of termination fees and professional and reseller products and
      services
                
                
                2,357
                
                
                
                574
                
                
                
                88
                
                
                
                (3,019
                )
                
                
                —Revised
                
                $
                122,205
                
                
                $
                83,632
                
                
                $
                17,806
                
                
                $
                10,447
                
                
                $
                234,090Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization:Previously
      reported
                
                $
                43,681
                
                
                $
                59,439
                
                
                $
                6,584
                
                
                $
                8,690
                
                
                $
                118,394Reclassification
      of professional and reseller products and services
                
                
                244
                
                
                
                —
                
                
                
                10
                
                
                
                (254
                )
                
                
                —Revised
                
                $
                43,925
                
                
                $
                59,439
                
                
                $
                6,594
                
                
                $
                8,436
                
                
                $
                118,394Year
      ended December 31, 2006:Revenues:Previously
      reported
                
                $
                109,748
                
                
                $
                56,152
                
                
                $
                —
                
                
                $
                15,475
                
                
                $
                181,375Reclassification
      of termination fees and professional and reseller products and
      services
                
                
                2,502
                
                
                
                396
                
                
                
                —
                
                
                
                (2,898
                )
                
                
                —Revised
                
                $
                112,250
                
                
                $
                56,548
                
                
                $
                —
                
                
                $
                12,577
                
                
                $
                181,375Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization:Previously
      reported
                
                $
                39,744
                
                
                $
                46,474
                
                
                $
                —
                
                
                $
                11,120
                
                
                $
                97,338Reclassification
      of professional and reseller products and services
                
                
                979
                
                
                
                —
                
                
                
                —
                
                
                
                (979
                )
                
                
                —Revised
                
                $
                40,723
                
                
                $
                46,474
                
                
                $
                —
                
                
                $
                10,141
                
                
                $
                97,338
  Segment
Information
  We use
the management approach for determining which, if any, of our services and
products, locations, customers or management structures constitute a reportable
business segment. The management approach designates the internal organization
that is used by management for making operating decisions and assessing
performance as the source of any reportable segments. As a result of our
acquisition of VitalStream Holdings, Inc., as discussed in note 3, and the
information presented to executive management, we classified our operations into
three reportable business segments: IP services, data center services and CDN
services. We have presented the corresponding items of segment information for
the year ended December 31, 2006.
  Recent
Accounting Pronouncements
  Effective
January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements. SFAS
No. 157 defines fair value, establishes a framework for measuring fair
value under GAAP and expands disclosures about fair value measurements. SFAS
No. 157 is effective for fiscal years beginning after December 15,
2007. In February 2008, the FASB issued Staff Position 157-1, Application of FASB Statement No.
157 to FASB Statement No. 13 and Its Related Interpretive Accounting
Pronouncements That Address Leasing Transactions, which provides
supplemental guidance on the application of SFAS No. 157, and Staff
Position 157-2, Effective Date
of FASB Statement No. 157, which delays the effective date of SFAS
No. 157 for nonfinancial assets and nonfinancial liabilities, except those
that are recognized or disclosed at fair value on at least an annual basis until
2009. In accordance with Staff Position 157-2, we have only adopted the
provisions of SFAS No. 157 with respect to our financial assets and liabilities
that are measured at fair value within the financial statements as of December
31, 2008. The provisions of SFAS No. 157 have not been applied to nonfinancial
assets and nonfinancial liabilities. The major categories of assets and
liabilities that are measured at fair value, for which we have not applied the
provisions of SFAS No. 157, include reporting units measured at fair value in
the first step of a goodwill impairment test under SFAS No. 142, Goodwill and Other Intangible
Assets. The adoption of SFAS No. 157 did not have a material impact
on our financial position, results of operations and cash
flows.
  F-16
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  In
October 2008, the FASB issued Staff Position FAS 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active which
clarifies the application of SFAS No. 157 in a market that is not active and
provides an example to illustrate key considerations in determining the fair
value of a financial asset when the market for that financial asset is not
active. Some of the key principles illustrated include:
 ●
                determining
      fair value in a dislocated market depends on facts and circumstances, and
      may require the use of significant judgment about whether individual
      market transactions are forced liquidations or distressed sales and
      therefore poor indicators of fair value;●
                when
      relevant observable market data is not available, the use of assumptions
      about future cash flows and discount rates may be appropriate in
      determining fair value; and●
                the
      value of broker quotes in determining fair value depends on facts and
      circumstances, particularly when an active market does not
      exist.
  Staff
Position FAS 157-3 was effective immediately, including with respect to prior
periods for which financial statements have not been issued. We have
consistently used the methodology described in this Staff Position in
calculating the fair value of our auction rate securities throughout
2008.
  In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities. SFAS No. 159 permits companies to
choose to measure, on an instrument-by-instrument basis, many financial
instruments and certain other assets and liabilities at fair value that are not
currently required to be measured at fair value. SFAS No. 159 was effective
as of the beginning of a fiscal year that begins after November 15, 2007.
The adoption of SFAS No. 159 did not have a material impact on our financial
condition, results of operations and cash flows since we elected to apply the
fair value option only for our ARS Rights. See note 6 for discussion
of the fair value election of our ARS Rights.
  In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, or
SFAS No. 141R. This pronouncement replaces SFAS No. 141, Business Combinations. SFAS
No. 141R establishes principles and requirements for how an acquirer recognizes
and measures in its financial statements the identifiable assets acquired, the
liabilities assumed, any noncontrolling interest in the acquiree and the
goodwill acquired or a gain from a bargain purchase. SFAS No. 141R also
determines disclosure requirements to enable the evaluation of the nature and
financial effects of the business combination. SFAS No. 141R applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of a fiscal year that begins on or after December 15,
2008 and there are also implications for acquisitions that occur prior to this
date. We do not expect that the adoption of SFAS No. 141R will have an
immediate material impact on our financial position, results of operations and
cash flows.
  In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements. SFAS No. 160 amends Accounting
Research Bulletin 51, Consolidated Financial
Statements, and requires all entities to report noncontrolling
(minority) interests in subsidiaries within equity in the consolidated
financial statements, but separate from the parent shareholders’ equity. SFAS
No. 160 also requires any acquisitions or dispositions of noncontrolling
interests that do not result in a change of control to be accounted for as
equity transactions. Further, SFAS No. 160 requires that a parent recognize
a gain or loss in net income when a subsidiary is deconsolidated. SFAS
No. 160 is effective for fiscal years beginning on or after
December 15, 2008. We do not expect the adoption of SFAS No. 160 will
have a material impact on our financial position, results of operations and cash
flows.
  In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities, an amendment of FASB Statement
No. 133. SFAS No. 161 amends and expands the disclosure
requirements of SFAS No. 133 with the intent to provide users of financial
statements with an enhanced understanding of: (1) how and why an entity uses
derivative instruments; (2) how derivative instruments and related hedged items
are accounted for under SFAS No. 133 and its related interpretations and
(3) how derivative instruments and related hedged items affect an entity’s
financial position, financial performance and cash flows. This statement is
effective for financial statements issued for fiscal years and interim periods
beginning after November 15, 2008. We do not expect the adoption of SFAS
No. 161 to have a material impact on our financial position, results of
operations and cash flows.
  In April
2008, the FASB issued Staff Position FAS 142-3, Determination of the Useful Life of
Intangible Assets. Staff Position FAS 142-3 amends the factors that
should be considered in developing renewal or extension assumptions used to
determine the useful life of a recognized intangible asset under SFAS
No. 142. This Staff Position is effective for financial statements issued
for fiscal years beginning after December 15, 2008. We do not expect the
adoption of Staff Position FAS 142-3 to have a material impact on our financial
position, results of operations and cash flows.
  F-17
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




In June
2008, the FASB issued Staff Position No. EITF 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions are Participating Securities.
Staff Position No. EITF 03-6-1 provides that unvested share-based
payment awards that contain nonforfeitable rights to dividends are participating
securities and shall be included in the computation of earnings per share
pursuant to the two class method. This Staff Position is effective for financial
statements issued for fiscal years beginning after December 15, 2008 and
interim periods within those years. For the quarter ended March 31, 2009,
upon adoption, we are required to retrospectively adjust earnings per share data
to conform to the provisions in this Staff Position. We do not expect this Staff
Position to have a material impact on our calculation of earnings per
share.
  In
November 2008, the FASB issued EITF 08-6, Equity Method Investment Accounting
Considerations. The goal of EITF 08-6 is to clarify the accounting for
certain transactions and impairment considerations involving equity method
investments. This issue is effective for fiscal years beginning on or after
December 15, 2008. Early adoption is not permitted. We do not expect the
adoption of EITF 08-6 to have a material impact on our financial position,
results of operations and cash flows.
 3.
              BUSINESS
      COMBINATION
  On
February 20, 2007, we completed the acquisition of VitalStream Holdings, Inc.,
or VitalStream, for approximately $214.0 million, whereby VitalStream became our
wholly-owned subsidiary. The acquisition allows us to provide products and
services for storing and delivering digital media to large audiences over the
Internet. The acquisition also enhances our position as a leading provider of
high performance route control products and services by adding complementary
service offerings in the rapidly growing content delivery markets. We accounted
for the transaction using the purchase method of accounting in accordance with
SFAS No. 141, Business
Combinations. Our results of operations include the activities of
VitalStream from February 21, 2007.
  Purchase
Price
  We
recorded assets acquired and liabilities assumed at their fair values as of
February 20, 2007. The total $214.0 million purchase price is comprised of
the following (in thousands):
 Value
      of Internap stock issued
                      
                      $
                      197,272Fair
      value of stock options assumed
                      
                      
                      11,021Direct
      transaction costs
                      
                      
                      5,729Total purchase
      price
                      
                      $
                      214,022
  As a
result of the acquisition, we issued approximately 12.2 million shares of
our common stock based on an exchange ratio of 0.5132 shares of our common
stock for each outstanding share of VitalStream common stock as of February 20,
2007. This fixed exchange ratio gave effect to the one-for-10 reverse stock
split we implemented on July 11, 2006 and the one-for-four reverse stock
split VitalStream implemented on April 4, 2006. The average market price
per share of our common stock of $16.16 was based on an average of the closing
prices for a range of trading days from October 10, 2006 through October 16,
2006, which range spanned the announcement date of the transaction on October
12, 2006.
  Under the
terms of the merger agreement, each VitalStream stock option that was
outstanding and unexercised was converted into an option to purchase our common
stock and we assumed that stock option in accordance with the terms of the
applicable VitalStream stock option plan and terms of the stock option
agreement. Based on VitalStream’s stock options outstanding at February 20,
2007, we converted options to purchase approximately 3.0 million shares of
VitalStream common stock into options to purchase approximately 1.5 million
shares of our common stock.
  Purchase
Price Allocation
  Under the
purchase method of accounting, we allocated the total estimated purchase price
to VitalStream’s net tangible and intangible assets based on their estimated
fair values as of February 20, 2007. We recorded the excess purchase price over
the value of the net tangible and identifiable intangible assets as goodwill. We
determined the fair value assigned to identifiable intangible assets acquired
using the income approach, which discounts expected future cash flows to present
value using estimates and assumptions determined by management. The allocation
of the purchase price and the estimated useful lives are as follows (dollars in
thousands):
 Amount
                          
                          Estimated
                            Useful
      LifeNet
      tangible assets
                          
                          $
                          12,286
                          
                          
                          —Identifiable
      intangible assets:Developed
      technologies
                          
                          
                          36,000
                          
                          
                          8
      yearsCustomer
      relationships
                          
                          
                          9,000
                          
                          
                          9
      yearsTrade
      name and other
                          
                          
                          1,500
                          
                          
                          3-6
      yearsAcquired
      in-process research and development
                          
                          
                          450
                          
                          
                          —Goodwill
      (1)
                          
                          
                          154,786
                          
                          
                          —Total
      estimated purchase price
                          
                          $
                          214,022
  (1)
              Subsequent
      to the finalization of the purchase price allocation, we recorded a net
      increase of $0.1 million to goodwill as a result of adjustments to
      certain pre-acquisition assets and liabilities and decrease of $0.4
      million as a result of the utilization of a portion of VitalStream’s net
      operating loss carryforwards.
  F -
18
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Net Tangible
Assets
  We
recorded VitalStream’s tangible assets and liabilities as of February 20, 2007
at their fair value. Net tangible assets included restricted and unrestricted
cash of $9.8 million, accounts receivable of $3.2 million, property and
equipment of $11.2 million, other assets of $2.2 million, loan and security
agreement (including both term loans and an outstanding line of credit) and
capital lease obligations of $6.1 million and accounts payable and other
liabilities of $8.0 million. Subsequent to the acquisition of VitalStream, we
paid off the term loans and line of credit assumed in the VitalStream
acquisition.
  Identifiable
Intangible Assets
  Developed
technologies relate to products acquired in the VitalStream acquisition that
have reached technological feasibility and include processes and trade secrets
acquired or developed through design and development of products. Customer
relationships represent contracts with existing customers. Trade name primarily
relates to the VitalStream and other product names. We valued each of the
identifiable intangible assets using various forms of the income approach,
detailed financial projections and various assumptions, including, among others,
the evolution of the existing technology platforms to future technology,
expected net cash flows, customer attrition rates, tax rates and discount
rates. Amortization of identifiable intangibles is on a straight-line basis
over their respective useful lives. See note 8 for discussion of the impairment
charge recorded during the year ended December 31, 2008 for developed
technologies and trade names, as well as a change in estimated life of customer
relationships.
  In-Process
Research and Development
  As of the
closing date, one project was in development that had not reached technological
feasibility and therefore qualified as in-process research and development. The
amount allocated to in-process research and development was charged to the
statement of operations as of the date of acquisition.
  Goodwill
  Goodwill
is the residual of the excess of fair value over the book value of the acquired
entity’s net assets at the date of acquisition. Pursuant to the guidance in SFAS
No. 141, an assembled workforce is not recognized apart from goodwill and
therefore is embedded in goodwill. We acquired an assembled workforce in the
VitalStream acquisition that we included as a component of
goodwill. Another component of goodwill is the estimated fair value of the
expected synergies and other benefits from combining the net assets and business
of us and VitalStream. We expected significant synergies in this acquisition,
including synergies in the sales channel, our network costs, general and
administrative costs and capital expenditures. We allocated approximately $154.8
million to goodwill for the CDN services segment. In accordance with
SFAS No. 142, we will not amortize goodwill but instead will test it
for impairment at least annually, or more frequently if certain indicators are
present. See note 8 for discussion of the goodwill impairment charge recorded
during the year ended December 31, 2008. A total of $17.1 million of
goodwill will be deductible for tax purposes.
  Pro
Forma Results (Unaudited)
  VitalStream
provided products and services for storing and delivering digital media to large
audiences over the Internet and ad insertion and related advertising services to
companies that stream digital media over the Internet. The acquisition enhanced
our position as a leading provider of high performance route control products
and services by adding complementary service offerings in the rapidly growing
content delivery market. Integrating VitalStream’s digital media delivery
platform into our portfolio of products and services enables us to provide
customers with one of the most complete product lines in content delivery
solutions, while supporting the significant long-term growth opportunities in
the network services market.
  The
following unaudited pro forma consolidated financial information reflects the
results of our operations for the year ended December 31, 2007 and 2006, as if
the acquisition of VitalStream had occurred at the beginning of each period.
Prior to the acquisition, VitalStream was a customer of ours, and for the years
ended December 31, 2007 and 2006 we recognized revenues of $0.4 million and $0.2
million, respectively, from VitalStream which were excluded from pro forma
revenues below. The related receivables were settled in the normal course of
business. The pro forma results presented below are not necessarily indicative
of what our operating results would have been had the acquisition actually taken
place at the beginning of each period (in thousands, except per share
amounts):
  F -
19
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Year
      Ended December 31,2007
                                              
                                              
                                              2006Pro
      forma revenues
                                              
                                              $
                                              236,418
                                              
                                              
                                              $
                                              205,052Pro
      forma net loss
                                              
                                              
                                              (14,269
                                              )
                                              
                                              
                                              (16,153
                                              )Pro
      forma net loss per share, basic and diluted
                                              
                                              
                                              (0.25
                                              )
                                              
                                              
                                              (0.34
                                              )
 
 4.
              OPERATING
      SEGMENTS
  We
operate in three business segments: IP services, data center services and CDN
services. IP services primarily include our high performance Internet
connectivity as well as sales of our FCP products. Data center services
primarily include physical space for hosting customers’ network and other
equipment plus associated services such as redundant power and network
connectivity, environmental controls and security. CDN services primarily
include data storage, streaming/delivery and a user interface/reporting tool.
Other revenues and direct costs represent third party CDN services prior to the
acquisition of VitalStream. The following tables show operating results for our
reportable segments, along with reconciliations from segment gross profit to
(loss) income before income taxes and equity in earnings of equity-method
investment (in thousands):
 Year
      Ended December 31, 2008IP
      Services
                      
                      
                      Data
                        Center
                        Services
                      
                      
                      CDN
                        Services
                      
                      
                      Other
                      
                      
                      TotalRevenues
                      
                      $
                      123,268
                      
                      
                      $
                      109,679
                      
                      
                      $
                      21,042
                      
                      
                      $
                      —
                      
                      
                      $
                      253,989Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization
                      
                      
                      45,782
                      
                      
                      
                      82,009
                      
                      
                      
                      8,086
                      
                      
                      
                      —
                      
                      
                      
                      135,877Segment
      profit
                      
                      $
                      77,486
                      
                      
                      $
                      27,670
                      
                      
                      $
                      12,956
                      
                      
                      $
                      
                      
                      
                      
                      118,112Other
      operating expenses
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      223,279Loss
      from operations
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (105,167
                      )Non-operating
      income
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      245Loss
      before income taxes and equity in earnings of equity-method
      investment
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      (104,922
                      )
  Direct
costs of network, sales and services, exclusive of depreciation and
amortization, includes an allocation of $1.1 million from the IP services
segment to the CDN services segment based on the average cost of actual usage by
the CDN segment for 2008.
 Year
      Ended December 31, 2007IP
      Services
                  
                  
                  Data
                    Center
                    Services
                  
                  
                  CDN
                    Services
                  
                  
                  Other
                  
                  
                  TotalRevenues
                  
                  $
                  122,205
                  
                  
                  $
                  83,632
                  
                  
                  $
                  17,806
                  
                  
                  $
                  10,447
                  
                  
                  $
                  234,090Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization
                  
                  
                  43,925
                  
                  
                  
                  59,439
                  
                  
                  
                  6,594
                  
                  
                  
                  8,436
                  
                  
                  
                  118,394Segment
      profit
                  
                  $
                  78,280
                  
                  
                  $
                  24,193
                  
                  
                  $
                  11,212
                  
                  
                  $
                  2,011
                  
                  
                  
                  115,696Other
      operating expenses
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  125,407Loss
      from operations
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (9,711
                  )Non-operating
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  937Loss
      before income taxes and equity in earnings of equity-method
      investment
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  (8,774
                  )
  Direct
costs of network, sales and services, exclusive of depreciation and
amortization, included an allocation of $0.9 million from the IP services
segment to the CDN services segment based on the average cost of actual usage by
the CDN segment for 2007.
  F -
20
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Year
      Ended December 31, 2006IP
      Services
                    
                    
                    Data
                      Center
                      Services
                    
                    
                    CDN
                      Services
                    
                    
                    Other
                    
                    
                    TotalRevenues
                    
                    $
                    112,250
                    
                    
                    $
                    56,548
                    
                    
                    $
                    —
                    
                    
                    $
                    12,577
                    
                    
                    $
                    181,375Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization
                    
                    
                    40,723
                    
                    
                    
                    46,474
                    
                    
                    
                    —
                    
                    
                    
                    10,141
                    
                    
                    
                    97,338Segment
      profit
                    
                    $
                    71,527
                    
                    
                    $
                    10,074
                    
                    
                    $
                    —
                    
                    
                    $
                    2,436
                    
                    
                    
                    84,037Other
      operating expenses
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    81,900Income
      from operations
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2,137Non-operating
      income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,551Income
      before income taxes and equity in earnings of equity-method
      investment
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    3,688
  The
following table includes selected segment financial information as of December
31, 2008 and 2007, related to goodwill and total assets (in
thousands):
 IP
      Services
                  
                  
                  Data
                    Center
                    Services
                  
                  
                  CDN
                    Services
                  
                  
                  Other
                  
                  
                  TotalDecember
      31, 2008:Goodwill
                  
                  $
                  36,314
                  
                  
                  $
                  —
                  
                  
                  $
                  54,663
                  
                  
                  $
                  —
                  
                  
                  $
                  90,977Total
      assets
                  
                  
                  151,839
                  
                  
                  
                  69,317
                  
                  
                  
                  108,927
                  
                  
                  
                  —
                  
                  
                  
                  330,083December
      31, 2007:Goodwill
                  
                  $
                  36,314
                  
                  
                  $
                  —
                  
                  
                  $
                  154,363
                  
                  
                  $
                  —
                  
                  
                  $
                  190,677Total
      assets
                  
                  
                  148,697
                  
                  
                  
                  64,498
                  
                  
                  
                  211,469
                  
                  
                  
                  2,346
                  
                  
                  
                  427,010
  As
discussed in note 8, we recorded impairment charges in the CDN services segment
of $99.7 million for goodwill and $2.6 million for other intangible
assets.
  Through
December 31, 2008, neither revenues generated nor long-lived assets located
outside the United States were significant (all less than 10%).
 5.
              INVESTMENTS
  Investment
in Marketable Securities
  Pursuant
to our formal investment policy, investments in marketable securities primarily
consist of high credit quality corporate debt securities, U.S. Treasury bills
and commercial paper. All short-term investments in marketable securities have
original maturities greater than 90 days but less than one year, are designated
as available for sale and are recorded at fair value with changes in fair value
reflected in other comprehensive (loss) income, a component of stockholders’
equity in our accompanying consolidated balance sheets, unless the change in
fair value is determined to be an other-than-temporary impairment. Our
investments in marketable securities also include auction rate securities whose
underlying assets are state-issued student and educational loans which are
substantially backed by the federal government. Under our current investment
policy, new or additional auction rate securities are not eligible instruments,
but we will hold the existing auction rate securities until liquidity returns or
we exercise our ARS Rights, as discussed below.
  Auction
rate securities are variable rate bonds tied to short-term interest rates with
maturities on the face of the securities in excess of 90 days and have interest
rate resets through a modified Dutch auction, at predetermined short-term
intervals, usually every seven, 28 or 35 days. Auction rate securities generally
trade at par value and are callable at par value on any interest payment date at
the option of the issuer. Interest received during a given period is based
upon the interest rate determined through the auction process. Although these
securities are issued and rated as long-term bonds, they have historically been
priced and traded as short-term instruments because of the liquidity provided
through the interest rate resets. While we continue to earn and accrue interest
on our auction rate securities at contractual rates, these investments are not
currently trading. During 2008, we classified our auction rate securities as
non-current investments on our accompanying consolidated balance sheet versus
short-term investments as of December 31, 2007. This change in classification
was initially due to the uncertainty as to when the auction rate securities
markets would improve. In November 2008, as further described below, we accepted
an offer for the ARS Rights on our auction rate securities. In conjunction with
our acceptance of the ARS Rights, we changed the designation of the auction rate
securities to trading from available for sale and continue to classify the
securities as non-current investments as of December 31, 2008.
  F -
21
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Summaries
of our investments in short-term available for sale securities are as follows
(in thousands):
 December
      31, 2008Cost
      Basis
                                              
                                              
                                              Unrealized

                                                Gain
      (Loss)
                                              
                                              
                                              Carrying
      ValueCorporate
      debt securities
                                              
                                              $
                                              5,706
                                              
                                              
                                              $
                                              (7
                                              )
                                              
                                              $
                                              5,699U.S.
      Treasury bills
                                              
                                              
                                              1,500
                                              
                                              
                                              
                                              —
                                              
                                              
                                              
                                              1,500Total
      short-term investments in marketable securities
                                              
                                              $
                                              7,206
                                              
                                              
                                              $
                                              (7
                                              )
                                              
                                              $
                                              7,199
 
 December
      31, 2007Cost
      Basis
                        
                        
                        Unrealized
                          Gain
      (Loss)
                        
                        
                        Carrying
                          ValueCorporate
      debt securities
                        
                        $
                        7,607
                        
                        
                        $
                        3
                        
                        
                        $
                        7,610Auction
      rate securities
                        
                        
                        7,150
                        
                        
                        
                        —
                        
                        
                        
                        7,150Commercial
      paper
                        
                        
                        4,787
                        
                        
                        
                        2
                        
                        
                        
                        4,789Other
                        
                        
                        24
                        
                        
                        
                        (4
                        )
                        
                        
                        20Total
      short-term investments in marketable securities
                        
                        $
                        19,568
                        
                        
                        $
                        1
                        
                        
                        $
                        19,569
  Proceeds
from the sale of short-term available-for-sale securities, primarily commercial
paper, were $3.2 million during the year ended December 31, 2008. The related
gross realized gains and losses were less than $0.1 million. For the year ended
December 31, 2007, all proceeds on short-term marketable securities were from
the maturity of the securities or sales of auction rate securities at par
value. Accordingly, we did not recognize any realized gains or losses on
short-term marketable securities.
  In
October 2008, we received an offer providing us with rights, or the ARS Rights,
from one of our investment providers to sell at par value auction rate
securities originally purchased from the investment provider ($7.2 million)
at anytime during a two-year period beginning June 30, 2010. On November 14,
2008, we accepted the offer. By accepting the offer, we are able to sell our
auction rate securities back to our investment provider at par value, which is
defined as the price equal to the liquidation preference of the auction rate
securities plus accrued but unpaid dividends or interest, during the period of
June 30, 2010 to July 2, 2012. In consideration for the ARS Rights, we granted
the investment provider the right to sell or otherwise dispose of, and/or enter
orders in the auction process for our auction rate securities until July 2, 2012
without prior notification, so long as we receive payment of par value upon any
sale or disposition.
  The ARS
Rights represent a firm agreement in accordance with SFAS No. 133, which defines
a firm agreement as an agreement with an unrelated party, binding on both
parties and usually legally enforceable, with the following
characteristics: (1) the agreement specifies all significant terms,
including the quantity to be exchanged, the fixed price and the timing of the
transaction, and (2) the agreement includes a disincentive for nonperformance
that is sufficiently large to make performance probable. The enforceability
of the rights results in a put option and should be recognized as a free
standing asset separate from the auction rate securities. The ARS Rights
cannot be net settled, so they do not meet the definition of a derivative
instrument under SFAS No. 133. Therefore, we have elected to measure the
ARS Rights at fair value under SFAS No. 159, which permits an entity to elect
the fair value option for selected recognized financial assets, in order to
match the changes in the fair value of the auction rate securities. As a
result, changes in fair value will be included in earnings in future
periods. For the year ended December 31, 2008, we have recorded an
unrealized gain of $0.6 million on the ARS Rights, representing the fair value
as of December 31, 2008. The unrealized gain is included in “Non-operating
(income) expense” in the accompanying consolidated statements of operations
and the fair value is included in “Investments and other related assets” in the
accompanying consolidated balance sheets.
  In
connection with our acceptance of the ARS Rights in November 2008, we
transferred our auction rate securities from investments available for sale to
trading securities in accordance with SFAS No. 115, Accounting for Certain Investments
in Debt and Equity Securities. The transfer to trading securities
reflects our intent to exercise the ARS Rights during the period June 30, 2010
to July 2, 2012. As a result of the transfer, we immediately recognized in
earnings the other-than-temporary impairment on our auction rate securities
previously recorded in other comprehensive income (loss). For the year
ended December 31, 2008, we recorded a cumulative other-than-temporary
impairment and net change in fair value of $0.8 million on the auction rate
securities, included in “Non-operating (income) expense” in the accompanying
consolidated statements of operations.
  F -
22
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Investment
in Internap Japan
  We
maintain a 51% ownership interest in Internap Japan, a joint venture with NTT-ME
Corporation and NTT Holdings. We are unable to assert control over the joint
venture’s operational and financial policies and practices required to account
for the joint venture as a subsidiary whose assets, liabilities, revenue and
expense would be consolidated (due to certain minority interest protections
afforded to our joint venture partners). We are, however, able to assert
significant influence over the joint venture and, therefore, account for our
joint venture investment using the equity-method of accounting.
  Our
investment activity in the joint venture is included in the IP services
operating segment and summarized as follows (in thousands):
 Year
      Ended December 31,2008
                              
                              
                              2007
                              
                              
                              2006Investment
      Balance, January 1,
                              
                              $
                              1,138
                              
                              
                              $
                              958
                              
                              
                              $
                              823Proportional
      share of net income
                              
                              
                              283
                              
                              
                              
                              139
                              
                              
                              
                              114Unrealized
      foreign currency translation gain, net
                              
                              
                              201
                              
                              
                              
                              41
                              
                              
                              
                              21Investment
      Balance, December 31,
                              
                              $
                              1,622
                              
                              
                              $
                              1,138
                              
                              
                              $
                              958
  Investment
in Aventail
  We
account for investments without readily determinable fair values at cost. We
include realized gains and losses and declines in value of securities judged to
be other-than-temporary in other expense. We incurred a charge during the three
months ended June 30, 2007, totaling $1.2 million, representing the write-off of
the remaining carrying value of our investment in series D preferred stock of
Aventail. We made an initial cash investment of $6.0 million in Aventail series
D preferred stock pursuant to an investment agreement in February 2000. In
connection with a subsequent round of financing by Aventail, we recognized an
initial loss on our investment of $4.8 million in 2001. On June 12, 2007,
SonicWall, Inc. announced that it entered into an agreement to acquire Aventail
for approximately $25.0 million in cash. The transaction closed on July 11,
2007, with all shares of series D preferred stock being cancelled and the
holders of series D preferred stock not receiving any consideration for such
shares.
 6.
              FAIR
      VALUE MEASUREMENTS
  Effective
January 1, 2008, we adopted SFAS No. 157. We also adopted SFAS No. 159 for
our ARS Rights, as described in note 5. SFAS No. 157 describes a fair value
hierarchy based on three levels of inputs, of which the first two are considered
observable and the last unobservable, that may be used to measure fair value.
See note 2 for a further description of this standard. The fair value
hierarchy is summarized as follows:
 ●
                  Level
      1: Quoted prices in active markets for identical assets or
      liabilities;●
                  Level
      2: Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities;
      quoted prices in markets that are not active or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or liabilities;
    and●
                  Level
      3: Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.
  The
following table represents the fair value hierarchy for our financial assets
(cash equivalents and investments in marketable securities) measured at fair
value on a recurring basis as of December 31, 2008 (in thousands):
 Level
      1
                  
                  
                  Level
      2
                  
                  
                  Level
      3
                  
                  
                  TotalMoney
      market funds and other
                  
                  $
                  21,877
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  21,877Corporate
      debt securities
                  
                  
                  —
                  
                  
                  
                  5,699
                  
                  
                  
                  —
                  
                  
                  
                  5,699U.S.
      Treasury bills
                  
                  
                  —
                  
                  
                  
                  1,500
                  
                  
                  
                  —
                  
                  
                  
                  1,500Auction
      rate securities
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  6,378
                  
                  
                  
                  6,378ARS
      Rights
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  649
                  
                  
                  
                  649Total
                  
                  $
                  21,877
                  
                  
                  $
                  7,199
                  
                  
                  $
                  7,027
                  
                  
                  $
                  36,103
  F -
23
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Level 3
assets consist of auction rate securities whose underlying assets are
state-issued student and educational loans that are substantially backed by the
federal government and the ARS Rights. While we continue to earn and accrue
interest on our auction rate securities at contractual rates, these investments
are not currently trading and therefore do not currently have a readily
determinable market value. Accordingly, the estimated fair value of auction rate
securities no longer approximates par value. Given that observable auction rate
securities market information was not available to determine the fair value of
our auction rate securities, we estimated the fair value of the auction rate
securities based on a wide array of market evidence related to each security’s
collateral, ratings and insurance to assess default risk, credit spread risk and
downgrade risk that we believe market participants would use in pricing the
securities in a current transaction. These assumptions could change
significantly over time based on market conditions. We then used a
trinomial discount model where the future cash flows of the auction rate
securities were priced by summing the present value of the future principal and
forecasted interest payments. We also considered probabilities of default,
auction failure, a successful auction at par value or repurchase at par value
and recovery rates in default for each of the securities. We then discounted the
weighted average cash flow for each period back to present value at the
determined discount rate for each auction rate security.
  Similar
to the auction rate securities, observable market information was not available
to determine the fair value of the ARS Rights. We estimated the fair value of
the ARS Rights based on a valuation approach commonly used for forward contracts
in which one party agrees to sell a financial instrument (generating cash flows)
to another party at a particular time for a predetermined price. In this
approach we subtracted the present value of all expected future cash flows from
the current fair value of the security, and calculated the resulting value as a
future value at an interest rate reflective of counterparty risk.
  The
following table provides a summary of changes in fair value of our Level 3
financial assets as of December 31, 2008 (in thousands):
 Auction
                                Rate
                                Securities
                              
                              
                              ARS
                                RightsBalance,
      December 31, 2007
                              
                              $
                              7,150
                              
                              
                              $
                              —Net
      realized loss included in earnings
                              
                              
                              (772
                              )
                              
                              
                              —Issuance
      of ARS Rights
                              
                              
                              —
                              
                              
                              
                              649Balance,
      December 31, 2008
                              
                              $
                              6,378
                              
                              
                              $
                              649
 
 7.
              PROPERTY
      AND EQUIPMENT
  Property
and equipment consists of the following (in thousands):
 December
      31,2008
                  
                  
                  2007Network
      equipment
                  
                  $
                  96,958
                  
                  
                  $
                  86,496Network
      equipment under capital lease
                  
                  
                  1,596
                  
                  
                  
                  1,596Furniture,
      equipment and software
                  
                  
                  33,853
                  
                  
                  
                  31,726Leasehold
      improvements
                  
                  
                  147,835
                  
                  
                  
                  111,216Buildings
      under capital lease
                  
                  
                  3,003
                  
                  
                  
                  —Property
      and equipment, gross
                  
                  
                  283,245
                  
                  
                  
                  231,034Less:
      Accumulated depreciation and amortization ($1,721 and $1,596 related to
      capital leases at December 31, 2008 and 2007,
respectively)
                  
                  
                  (185,895
                  )
                  
                  
                  (165,543
                  )$
                  97,350
                  
                  
                  $
                  65,491
  During
2008, we retired $2.0 million of assets with accumulated depreciation of $1.9
million. During 2007, we retired $2.7 million of fully depreciated assets. We
capitalized $0.3 million of interest during the year ended December 31, 2008.
For the years ended December 31, 2007 and 2006, we capitalized less than $0.1
million each year.
  F -
24
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  Depreciation
and amortization of property and equipment associated with direct costs of
network, sales and services and other depreciation expense is summarized as
follows (in thousands):
 Year
      ended December 31,2008
                                                
                                                
                                                2007
                                                
                                                
                                                2006Direct
      costs of network, sales and services
                                                
                                                $
                                                20,650
                                                
                                                
                                                $
                                                18,313
                                                
                                                
                                                $
                                                13,250Other
      depreciation and amortization
                                                
                                                
                                                3,215
                                                
                                                
                                                
                                                3,929
                                                
                                                
                                                
                                                2,606Subtotal
                                                
                                                
                                                23,865
                                                
                                                
                                                
                                                22,242
                                                
                                                
                                                
                                                15,856Amortization
      of acquired technologies(1)
                                                
                                                
                                                6,649
                                                
                                                
                                                
                                                4,165
                                                
                                                
                                                
                                                516Total
      depreciation and amortization
                                                
                                                $
                                                30,514
                                                
                                                
                                                $
                                                26,407
                                                
                                                
                                                $
                                                16,372
  (1) Amortization of acquired technologies for 2008 included an impairment
charge of $1,850 for developed advertising technology. See note 8 for further
details.
 
 8.
              GOODWILL
      AND OTHER INTANGIBLE ASSETS
  Goodwill
  Goodwill
represents the premium paid over the fair value of the net tangible and
intangible assets we have acquired in business combinations. We
recorded $154.7 million of goodwill in connection with the acquisition of
VitalStream in February 2007 described in note 3 and we recorded $36.3
million of goodwill from acquisitions in previous years. All of the VitalStream
goodwill has been allocated to the CDN services segment and all remaining
goodwill from previous acquisitions is included in our IP services segment. A
total of $17.1 million of goodwill is deductible for tax purposes.
  We test
goodwill for impairment at least annually. We perform our annual goodwill
impairment test as of August 1 of each calendar year, following our annual
strategic planning cycle. Our assessment of goodwill for impairment
includes comparing the fair value to the net book value of our reporting
units. We estimate fair value using a combination of discounted cash flow
models and market approaches. If the fair value of a reporting unit exceeds
its net book value, goodwill is not impaired and no further testing is
necessary. If the net book value of a reporting unit exceeds its fair
value, we perform a second test to measure the amount of impairment loss, if
any. To measure the amount of any impairment loss, we determine the implied
fair value of goodwill in the same manner as if the affected reporting unit were
being acquired in a business combination. Specifically, we allocate the fair
value of the affected reporting unit to all of the assets and liabilities of
that unit, including any unrecognized intangible assets, in a hypothetical
calculation that would yield the implied fair value of goodwill. If the implied
fair value of goodwill is less than the goodwill recorded on our balance sheet,
we record an impairment charge for the difference.
  As a
result of our August 1, 2008 assessment, we recorded a
$99.7 million goodwill impairment charge to adjust goodwill in our CDN
services segment to an implied fair value of $54.7 million. We present
the goodwill impairment charge separately in the accompanying statement of
operations for the year ended December 31, 2008. The goodwill impairment is
primarily due to declines in our CDN services revenues and operating results as
compared to our projections and unfavorable changes in market factors used to
estimate fair values. The declines in CDN services revenues and operating
results compared to projections are attributable to integration and reliability
issues in the acquired network and have now been resolved, a strategic shift to
larger, higher credit quality customers and more recently, a highly-competitive
market environment for CDN services that is driving lower pricing. Changes
in market factors include lower market multiples across the CDN services
industry from when we completed the acquisition of VitalStream and our own
now-lower market capitalization. The culmination of these factors leading
to our impairment of goodwill did not occur until the three months ended
September 30, 2008. The impairment charge does not have any impact on
our current cash balance or result in violation of any covenants of our debt
instruments.
  F -
25
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  The
changes in the carrying amount of goodwill for the years ended December 31, 2008
and 2007 are as follows (in thousands):
 DataIP
                  
                  
                  Center
                  
                  
                  CDNServices
                  
                  
                  Services
                  
                  
                  Services
                  
                  
                  TotalBalance,
      January 1, 2007
                  
                  $
                  36,314
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  36,314Goodwill
      acquired
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  154,653
                  
                  
                  
                  154,653Adjustments
      to pre-acquisition assets and liabilities
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  133
                  
                  
                  
                  133Utilization
      of a portion of net operating losses
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (423
                  )
                  
                  
                  (423
                  )Balance,
      December 31, 2007
                  
                  
                  36,314
                  
                  
                  
                  —
                  
                  
                  
                  154,363
                  
                  
                  
                  190,677Balance,
      January 1, 2008
                  
                  
                  36,314
                  
                  
                  
                  —
                  
                  
                  
                  154,363
                  
                  
                  
                  190,677Impairment
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  (99,700
                  )
                  
                  
                  (99,700
                  )Balance,
      December 31, 2008
                  
                  $
                  36,314
                  
                  
                  $
                  —
                  
                  
                  $
                  54,663
                  
                  
                  $
                  90,977
  The
assumptions, inputs and judgments used in performing the valuation analysis are
inherently subjective and reflect estimates based on known facts and
circumstances at the time the valuation is performed. These estimates and
assumptions primarily include, but are not limited to, the discount rate,
terminal growth rate, earnings before interest, taxes, depreciation and
amortization, or EBITDA, and capital expenditures forecasts. The use of
different assumptions, inputs and judgments, or changes in circumstances, could
materially affect the results of the valuation. Due to the inherent
uncertainty involved in making these estimates, actual results could differ from
our estimates and could result in an additional non-cash impairment charge in
the future. The following is a description of the valuation methodologies
we used to derive the fair value the CDN services segment:
 ●
              Income Approach: To
      determine fair value, we discounted the expected cash flows of the CDN
      services reporting unit. We calculated expected cash flows using a
      compounded annual revenue growth rate of approximately 20%, forecasting
      existing cost structures and considering capital reinvestment
      requirements. We used a discount rate of 20%, representing the
      estimated weighted average cost of capital, which reflects the overall
      level of inherent risk involved in our CDN services operations and the
      rate of return an outside investor would expect to earn. To estimate cash
      flows beyond the final year of our model, we used a terminal value and
      incorporated the present value of the resulting terminal value into our
      estimate of fair value.●
              Market-Based Approach:
      To corroborate the results of the income approach described above, we
      estimated the fair value of our CDN services reporting unit using several
      market-based approaches, including the enterprise value that we derive
      based on our stock price. We also used the guideline company method, which
      focuses on comparing our risk profile and growth prospects, to select
      reasonably similar/guideline publicly traded companies. Using the
      guideline company method, we selected revenue and EBITDA multiples below
      the median for our comparable
companies.
  We used
similar valuation methodologies to derive the fair values of our two IP services
reporting units: services and products. Our data center services operating
segment does not include any goodwill, but was valued using an income approach
as part of our determination of enterprise value. We will continue to perform
our annual impairment testing as of August 1 each year absent any impairment
indicators that may cause more frequent analysis. We assessed the likelihood of
triggering events and concluded that no such triggering events have
occurred that would cause us to re-assess goodwill for impairment subsequent to
August 1, 2008.
  The
impairment also caused us to reverse a deferred tax liability and create an
income tax benefit of $0.6 million associated with the CDN services
goodwill.
  Other
Intangible Assets
  In
conjunction with our review of our long-term financial outlook, we also
performed an analysis of the potential impairment and re-assessed the remaining
asset lives of other identifiable intangible assets acquired in the VitalStream
acquisition. The analysis and re-assessment of other identifiable
intangible assets recorded in the VitalStream acquisition resulted
in:
 ●
                an
      impairment charge of $1.9 million in developed advertising technology due
      to a strategic change in market focus,●
                an
      impairment charge of $0.8 million in trade names as a result of
      discontinuing use of the VitalStream trade name,
  and
  F -
26
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  ●
                      a
      change in our estimates that resulted in an acceleration of amortization
      expense of our customer relationships intangible asset over a shorter
      estimated useful life (four remaining years instead of an original
      estimated nine years) due to customer churn resulting in higher than
      expected attrition as of the acquisition
date.
 The impairment
charge of $1.9 million for developed advertising technology is included in the
caption “Direct costs of amortization of acquired technologies” in the
accompanying consolidated statements of operations. The impairment charge of
$0.8 million for the trade name is included in the caption “Restructuring and
other impairments” in the accompanying consolidated statements of
operations. The impairment charge for trade name is presented in the
accompanying statement of operations net of a non-cash increase of approximately
$1.0 million to our restructuring liability, as discussed in note 9. None
of the impairment charges have any impact on our current cash balance
or result in violation of any covenants of our debt instruments. The
change in accounting estimate for our customer relationship intangible asset
resulted in an increase to our net loss of $0.4 million, or less than $0.01 per
basic and diluted share for the year ended December 31, 2008.
  The
components of our amortizing intangible assets are as follows (in
thousands):
 December
      31, 2008
                                        
                                        December
      31, 2007Gross
                                        
                                        
                                        
                                        GrossCarrying
                                        
                                        Accumulated
                                        
                                        Carrying
                                        
                                        AccumulatedAmount
                                        
                                        Amortization
                                        
                                        Amount
                                        
                                        AmortizationTechnology
      based
                                        
                                        $
                                        40,061
                                        
                                        $
                                        (13,317
                                        )
                                        $
                                        41,911
                                        
                                        $
                                        (8,518
                                        )Contract
      based
                                        
                                        
                                        24,232
                                        
                                        
                                        (17,034
                                        )
                                        
                                        25,018
                                        
                                        
                                        (15,403
                                        )$
                                        64,293
                                        
                                        $
                                        (30,351
                                        )
                                        $
                                        66,929
                                        
                                        $
                                        (23,921
                                        )
  Amortization
expense for identifiable intangible assets during 2008, 2007 and 2006 was $6.4
million, $5.3 million and $0.5 million, respectively. This amortization expense
does not include impairment charges of $2.7 million in 2008. As of December 31,
2008, estimated amortization expense for the next five years is as follows (in
thousands):
 2009
                        
                        $
                        6,6962010
                        
                        
                        6,5092011
                        
                        
                        6,1812012
                        
                        
                        5,3562013
                        
                        
                        4,246Thereafter
                        
                        
                        4,954$
                        33,942
 
 9.
              RESTRUCTURING
      AND OTHER IMPAIRMENTS
  In
conjunction with the preparation of our financial statements as of and for the
year ended December 31, 2008 and in light of the recent and significant
deterioration in the real estate market, we completed an analysis of our
remaining accrued restructuring liability for leased facilities. After reviewing
the analysis, and specifically the underlying assumptions related to anticipated
sublease recoveries, we concluded that certain of the facilities remaining in
the restructuring accrual were taking longer than expected to sublease or were
otherwise not generating the expected levels of sublease income. The analyses
were based on discounted cash flows using the same credit-adjusted risk-free
rate that we used to measure the initial restructuring liability for leases that
were part of the 2007 restructuring plan and undiscounted cash flows for leases
that were part of the 2001 restructuring plan. The cumulative effect of these
changes was $1.1 million which we recorded as additional restructuring expense
and an increase to the liability. We also recorded a non-cash benefit of $0.1
million in the three months ended September 30, 2008 to reduce our restructuring
liability for employee separations. This non-cash adjustment removes the
liability for employee separations since we have paid all amounts.
  During
the year ended December, 31, 2007, we incurred a restructuring and impairment
charge of $10.3 million. The charge was the result of a review of our business,
particularly in light of our VitalStream acquisition and our plan to finalize
the overall integration and implementation of the acquisition. The charge to
expense included $7.8 million for leased facilities, representing both the costs
less anticipated sublease recoveries that will continue to be incurred without
economic benefit to us and costs to terminate leases before the end of their
term. The charge also included severance payments of $1.1 million for the
termination of certain employees and $1.4 million for impairment of assets.
After considering the adjustments for anticipated changes in sublease income
described above, we estimated net related expenditures for the 2007
restructuring plan to be $12.2 million, of which we paid $4.2 million through
December 31, 2008, and the balance continuing through December 2016, the last
date of the longest lease term. We expect to pay these expenditures from
operating cash flows. The $1.4 million impairment charge consisted of $1.3
million for restructured leases and less than $0.1 million for other assets. We
estimated cost savings from the restructuring to be approximately $0.8 million
per year through 2016, primarily for rent.
  F -
27
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  In 2001,
we implemented significant restructuring plans that resulted in substantial
charges for real estate and network infrastructure obligations, personnel and
other charges. Additional related charges have subsequently been incurred as we
continued to evaluate our restructuring reserve.
  All of
these adjustments to the restructuring liability are reported in “Restructuring
and other impairments” in the accompanying consolidated statement of operations.
The following table displays the activity and balances for the restructuring and
asset impairment activity for the years ended December 31, 2008 and 2007 (in
thousands):
 December
      31,
                
                
                Restructuring
                
                
                
                
                
                
                
                
                
                
                
                December
      31,
                
                
                
                
                
                
                
                
                December
      31,2006
                
                
                and
                
                
                
                
                
                Non-Cash
                
                
                Non-Cash
                
                
                2007
                
                
                
                
                
                Non-Cash
                
                
                2008Restructuring
                
                
                Impairment
                
                
                Cash
                
                
                Write-
                
                
                Plan
                
                
                Restructuring
                
                
                Cash
                
                
                Plan
                
                
                RestructuringLiability
                
                
                Charges
                
                
                Payments
                
                
                Downs
                
                
                Adjustments
                
                
                Liability
                
                
                Payments
                
                
                Adjustments
                
                
                LiabilityActivity
      for 2007 restructuring charge:Real
      estate obligations
                
                $
                —
                
                
                $
                7,755
                
                
                $
                (2,248
                )
                
                $
                —
                
                
                $
                805
                
                
                $
                6,312
                
                
                $
                (1,120
                )
                
                $
                1,084
                
                
                $
                6.276Employee
      separations
                
                
                —
                
                
                
                1,140
                
                
                
                (615
                )
                
                
                —
                
                
                
                (119
                )
                
                
                406
                
                
                
                (260
                )
                
                
                (146
                )
                
                
                —Total
      restructuring costs
                
                
                —
                
                
                
                8,895
                
                
                
                (2,863
                )
                
                
                —
                
                
                
                686
                
                
                
                6,718
                
                
                
                (1,380
                )
                
                
                938
                
                
                
                6,276Activity
      for 2007 impairment charge:Leasehold
      improvements
                
                
                —
                
                
                
                897
                
                
                
                —
                
                
                
                (897
                )
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Other
                
                
                —
                
                
                
                471
                
                
                
                —
                
                
                
                (471
                )
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Total
      asset impairments
                
                
                —
                
                
                
                1,368
                
                
                
                —
                
                
                
                (1,368
                )
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Activity
      for 2001 restructuring charge:Real
      estate obligations
                
                
                4,784
                
                
                
                —
                
                
                
                (1,199
                )
                
                
                —
                
                
                
                (211
                )
                
                
                3,374
                
                
                
                (647
                )
                
                
                19
                
                
                
                2,746Total
                
                $
                4,784
                
                
                $
                10,263
                
                
                $
                (4,062
                )
                
                $
                (1,368
                )
                
                $
                475
                
                
                $
                10,092
                
                
                $
                (2,027
                )
                
                $
                957
                
                
                $
                9,022
  The
impairment charges referenced in the table above were primarily associated with
our data center segment.
  We also
recorded a $1.1 million impairment during year ended December 31, 2007 for the
sales order-through-billing system. This impairment charge was not related to
any specific segment.
  In 2006,
we recorded a nominal charge for changes in estimated expenses related to real
estate obligations. Also, during the year ended December 31, 2006, we recognized
an impairment charge of $0.3 million as a result of the implementation of a new
financial system which began in 2004.
 10.
              ACCRUED
      LIABILITIES
  Accrued
liabilities consist of the following (in thousands):
 December
      31,2008
                          
                          2007Compensation
      and benefits payable
                          
                          $
                          2,918
                          
                          $
                          5,390Telecommunications,
      sales, use and other taxes
                          
                          
                          1,902
                          
                          
                          2,317Other
                          
                          
                          3,936
                          
                          
                          2,452$
                          8,756
                          
                          $
                          10,159
 
 11.
              REVOLVING
      CREDIT FACILITY AND NOTE PAYABLE
  On
September 14, 2007, we entered into a $35.0 million credit agreement with Bank
of America, N.A., as the administrative agent, and other lenders who may become
a party to the credit agreement from time-to-time, or the Credit
Agreement. Four of our subsidiaries, VitalStream Holdings, Inc.,
VitalStream, Inc., PlayStream, Inc., and VitalStream Advertising Services, Inc.,
were guarantors of the Credit Agreement.
  The
Credit Agreement replaced our prior credit agreement between us and Silicon
Valley Bank that was last amended on December 27, 2006. We paid off and
terminated this prior credit facility concurrently with the execution of the
Credit Agreement.
  F -
28
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  The
Credit Agreement originally provided for a four-year Revolving Credit Facility
in the aggregate amount of up to $5.0 million, which included a $5.0 million
sub-limit for letters of credit. With the prior approval of the
administrative agent, we had the option to increase the total commitments by up
to $15.0 million for a total commitment under the Revolving Credit Facility of
$20.0 million. The Revolving Credit Facility was available to finance
working capital, capital expenditures and other general corporate purposes. As
of December 31, 2007, we had a total of $8.0 million of letters of credit issued
(including $3.9 million which are secured by the Revolving Credit Facility and
the balance secured by restricted cash) and $1.1 million in borrowing capacity
on the Revolving Credit Facility. We had no amounts outstanding on the Revolving
Credit Facility as of December 31, 2007.
  The
Credit Agreement also originally provided for a term loan, in the amount of
$30.0 million, or the Term Loan. We borrowed $20.0 million concurrently
with the closing and used a portion of the proceeds from the Term Loan to pay
off the prior credit agreement. The Term Loan had $10.0 million in
borrowing capacity as of December 31, 2007.
  The
interest rate on the Revolving Credit Facility and Term Loan was a tiered
LIBOR-based rate that depended on our 12-month trailing EBITDA. As of December
31, 2007, the interest rate was 7.075%.
  The net
proceeds received from the Term Loan were reduced by $0.3 million for fees paid
to Bank of America and its agents. We treated these fees as a debt discount
and recorded less than $0.1 million of related amortization during the year
ended December 31, 2007. As of December 31, 2007, the balance on the Term Loan,
net of the discount, was $19.8 million. We incurred other costs of less than
$0.1 million in connection with entering into the Credit Agreement, which we
recorded as debt issue costs.
  As a
result of the transactions discussed above, we recorded a loss on extinguishment
of prior debt of less than $0.1 million during the year ended December 31, 2007.
The loss on extinguishment of debt is included in the caption “Interest expense”
within the Non-operating (income) expense section of the accompanying
consolidated statements of operations.
  Also
during the year ended December 31, 2007, we paid off the term loans and line of
credit issued pursuant to the loan and security agreement assumed in the
VitalStream acquisition, as discussed in note 3.
  We
subsequently amended the Credit Agreement on May 14, 2008 and September 30,
2008, or the Amendment (the Credit Agreement along with the Amendment are
referred to as the Amended Credit Agreement). The Amendment modified the
original Credit Amendment as follows:
 ●
              converted
      the Term Loan balance of $20.0 million as of September 30, 2008 into a
      loan under the Revolving Credit Facility under the Credit
      Agreement;●
              terminated
      the Term Loan under the Credit Agreement;●
              increased
      the total Revolving Credit Commitment (as defined in the Amended Credit
      Agreement) from $5.0 million to $35.0 million;●
              increased
      the Letter of Credit Sublimit (as defined in the Amended Credit Agreement)
      from $5.0 million to $7.0 million;●
              provided
      us and Bank of America with an option to enter into a lease financing
      agreement not to exceed $10.0 million; and●
              modified
      certain covenants and definitions.
  Because
the Amendment caused the Revolving Credit Facility to have substantially
different terms than the Term Loan, it is considered an extinguishment of debt.
We recorded a loss on extinguishment of debt in the amount of $0.2 million
during the year ended December 31, 2008. The loss on extinguishment of debt
is included in the caption “Interest expense” within the non-operating (income)
expense section of the accompanying consolidated statements of operations. We
also incurred other costs of less than $0.1 million in connection with the
Amendment, which we recorded as debt issue costs and will amortize over the
remaining term of the Amended Credit Agreement.
  The
interest rate on the Revolving Credit Facility as of December 31, 2008 was 3.0%
and is based on Bank of America’s prime rate less a 0.25% margin. The principal
amount of $20.0 million is due September 14, 2011. As of December 31, 2008, we
had a total of $4.2 million of letters of credit issued and $10.8 million in
borrowing capacity on the Revolving Credit Facility.
  The
Amended Credit Agreement includes customary representations, warranties,
negative and affirmative covenants (including certain financial covenants
relating to a net funded debt to EBITDA ratio, a debt service coverage ratio and
a minimum liquidity requirement, as well as a prohibition against paying
dividends, limitations on unfunded capital expenditures of $55.0 million for
2008 and $25.0 million or an amount to be mutually agreed upon for 2009 through
2011), customary events of default and certain default provisions that could
result in acceleration of the Credit Agreement.
  Our
obligations under the Amended Credit Agreement are pledged, pursuant to a pledge
and security agreement and an intellectual property security agreement, by
substantially all of our assets including the capital stock of our domestic
subsidiaries and 65% of the capital stock of our foreign
subsidiaries.
  F -
29
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  The fair
value of our debt approximates the carrying value due to the nature of our
credit facility.
 12.
              CAPITAL
      LEASES
  We record
capital lease obligations and the leased property and equipment at the time of
acquisition at the lesser of the present value of future lease payments based
upon the terms of the related lease agreement or the fair value of the assets
held under capital leases. As of December 31, 2008, our capital leases have
expiration dates ranging from May 2009 to April 2023.
  Historically
our capital leases relate to equipment; however, in May 2008 we entered into a
capital lease agreement for one of our data center locations which expires in
April 2023.
  Future
minimum capital lease payments together with the present value of the minimum
lease payments as of December 31, 2008, are as follows (in
thousands):
 2009
                      
                      $
                      8222010
                      
                      
                      5642011
                      
                      
                      5662012
                      
                      
                      5692013
                      
                      
                      581Thereafter
                      
                      
                      6,339Remaining
      capital lease payments
                      
                      
                      9,441Less:
      amounts representing imputed interest
                      
                      
                      (5,923
                      )Present
      value of minimum lease payments
                      
                      
                      3,518Less:
      current portion
                      
                      
                      (274
                      )$
                      3,244
 
 13.
              INCOME
      TAXES
  The
current and deferred income tax provision (benefit) for the years ended
December 31, 2008, 2007 and 2006 was as follows (in
thousands):
 Year Ended December 31,2008
                                                              
                                                              2007
                                                              
                                                              2006Current:Federal
                                                              
                                                              $
                                                              254
                                                              
                                                              $
                                                              15
                                                              
                                                              $
                                                              145State
                                                              
                                                              
                                                              181
                                                              
                                                              
                                                              —
                                                              
                                                              
                                                              —Foreign
      (including change in unrecognized tax benefits)
                                                              
                                                              
                                                              (668
                                                              )
                                                              
                                                              921
                                                              
                                                              
                                                              —Total
      current provision
                                                              
                                                              
                                                              (233
                                                              )
                                                              
                                                              936
                                                              
                                                              
                                                              145Deferred:Federal
                                                              
                                                              
                                                              (398
                                                              )
                                                              
                                                              356
                                                              
                                                              
                                                              —State
                                                              
                                                              
                                                              (16
                                                              )
                                                              
                                                              42
                                                              
                                                              
                                                              —Foreign
                                                              
                                                              
                                                              821
                                                              
                                                              
                                                              (4,414
                                                              )
                                                              
                                                              —Total
      deferred benefit
                                                              
                                                              
                                                              407
                                                              
                                                              
                                                              (4,016
                                                              )
                                                              
                                                              —Net
      income tax provision (benefit)
                                                              
                                                              $
                                                              174
                                                              
                                                              $
                                                              (3,080
                                                              )
                                                              $
                                                              145
  We
account for income taxes under the liability method. We determine deferred tax
assets and liabilities based on differences between financial reporting and tax
bases of assets and liabilities, and we measure such assets using the enacted
tax rates and laws that will be in effect when we expect the differences to
reverse. We provide a valuation allowance to reduce our deferred tax assets to
their estimated realizable value.
  F -
30
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  A
reconciliation of the effect of applying the federal statutory rate and the
effective income tax rate on our income tax provision (benefit) is as
follows:
 Year
      Ending December 31,2008
                      
                      2007
                      
                      2006Federal
      income tax (benefit) expense at statutory rates
                      
                      
                      (34
                      )%
                      
                      (34
                      )%
                      
                      34
                      %Goodwill
      impairment
                      
                      
                      29
                      
                      
                      —
                      
                      
                      —Foreign
      and state income tax (benefit) expense
                      
                      
                      —
                      
                      
                      (4
                      )
                      
                      4Stock-based
      compensation expense
                      
                      
                      1
                      
                      
                      6
                      
                      
                      8Tax
      reserves
                      
                      
                      —
                      
                      
                      11
                      
                      
                      —Other
                      
                      
                      —
                      
                      
                      —
                      
                      
                      1Change
      in valuation allowance
                      
                      
                      4
                      
                      
                      (14
                      )
                      
                      (43
                      )Effective
      tax rate
                      
                      
                      —
                      %
                      
                      (35
                      )%
                      
                      4
                      %
  Temporary
differences between the financial statement carrying amounts and tax bases of
assets and liabilities that give rise to significant portions of deferred taxes
relate to the following (in thousands):
 December
      31,2008
                      
                      
                      2007Current
      deferred income tax assets:Provision
      for doubtful accounts
                      
                      $
                      1,378
                      
                      
                      $
                      593Accrued
      compensation
                      
                      
                      205
                      
                      
                      
                      233Other
      accrued expenses
                      
                      
                      213
                      
                      
                      
                      196Deferred
      revenue
                      
                      
                      1,298
                      
                      
                      
                      1,648Restructuring
      costs
                      
                      
                      973
                      
                      
                      
                      910Foreign
      net operating loss carryforwards – current portion
                      
                      
                      —
                      
                      
                      
                      479Other
                      
                      
                      63
                      
                      
                      
                      77Current
      deferred income tax assets
                      
                      
                      4,130
                      
                      
                      
                      4,136Less:
      valuation allowance
                      
                      
                      (4,129
                      )
                      
                      
                      (3,625
                      )1
                      
                      
                      
                      511Non-current
      deferred income tax assets:Property
      and equipment
                      
                      
                      23,719
                      
                      
                      
                      21,488Goodwill
                      
                      
                      3,897
                      
                      
                      
                      —Intangible
      assets
                      
                      
                      2,574
                      
                      
                      
                      —Deferred
      revenue, less current portion
                      
                      
                      767
                      
                      
                      
                      717Restructuring
      costs, less current portion
                      
                      
                      2,455
                      
                      
                      
                      2,925Deferred
      rent
                      
                      
                      5,689
                      
                      
                      
                      4,184Stock
      compensation
                      
                      
                      3,378
                      
                      
                      
                      2,620U.
      S. net operating loss carryforwards
                      
                      
                      71,616
                      
                      
                      
                      81,766Foreign
      net operating loss carryforwards, less current portion
                      
                      
                      5,481
                      
                      
                      
                      13,717Capital
      loss carryforwards
                      
                      
                      2,271
                      
                      
                      
                      2,271Tax
      credit carryforwards
                      
                      
                      690
                      
                      
                      
                      180Other
                      
                      
                      539
                      
                      
                      
                      502Non-current
      deferred income tax assets
                      
                      
                      123,076
                      
                      
                      
                      130,370Less:
      valuation allowance
                      
                      
                      (120,626
                      )
                      
                      
                      (124,936
                      )2,450
                      
                      
                      
                      5,434Non-current
      deferred income tax liabilities:Purchased
      intangibles
                      
                      
                      —
                      
                      
                      
                      (1,531
                      )FIN
      48 liability related to net operating loss carryforwards
                      
                      
                      —
                      
                      
                      
                      (921
                      )Goodwill
                      
                      
                      —
                      
                      
                      
                      (398
                      )Non-current
      deferred income tax assets (liabilities), net
                      
                      
                      2,450
                      
                      
                      
                      2,584Net
      deferred tax assets
                      
                      $
                      2,451
                      
                      
                      $
                      3,095
  Based
upon a study conducted in 2008, we reduced our net operating loss carryforwards
due to limitations under Section 382 of the Internal Revenue Code with regard to
an ownership change in 2001.  As of December 31, 2008, we had U.S. net
operating loss carryforwards for federal tax purposes of approximately $188.5
million that will expire through 2026.All periods presented have been
revised to reflect these limitations. Of the total U.S. net operating loss
carryforwards, $16.8 million of net operating losses related to the deduction of
stock compensation that will be tax-effected and the benefit credited to
additional paid in capital when realized. In addition, we have alternative
minimum tax and state tax credit carryforwards of approximately $0.7 million,
which have an indefinite carryforward period, and foreign net operating loss
carryforwards of approximately $18.4 million that will begin to expire in
2009.
  F -
31
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
  We
determined that through December 31, 2008, no further ownership shifts have
occurred since 2001. Therefore, no additional material limitations exist on the
U.S. net operating losses related to Section 382 of the Internal Revenue Code as
of December 31, 2008. However, if we experience subsequent changes in stock
ownership as defined by Section 382 of the Internal Revenue Code, we may have
additional limitations on the future utilization of our U.S. net operating
losses.
  We
periodically evaluate the recoverability of the deferred tax assets and the
appropriateness of the valuation allowance. For U.S. tax purposes, we
established a valuation allowance of approximately $121.4 million against the
U.S. deferred tax assets that we do not believe are more likely than not to be
realized. We will continue to assess the requirement for a valuation
allowance on a quarterly basis and, at such time when we determine that it is
more likely than not that the deferred tax assets will be realized, we will
reduce the valuation allowance accordingly.
  Based on
analysis of our projected future U.S. pre-tax income, we may have sufficient
positive evidence within the next 12 months to release the valuation allowance
currently recorded against our U.S. deferred tax assets. Currently,
while we cannot guarantee that our expectations of future positive income
will occur, we may recognize an income tax benefit derived from total U.S.
deferred tax assets upon the release of the valuation allowance. This potential
release of the valuation allowance could be affected by an ownership change as
defined by Section 382 of the Internal Revenue Code which might limit the future
use of our U.S. net operating loss carryovers and thus reduce the potential
benefit of such losses in the future to offset taxable income and reduce cash
outflows for income taxes.
  During
the fourth quarter of 2007, we concluded that it was more likely than not that
we will realize our U.K. deferred tax assets in future years. The U.K.
deferred tax assets primarily consist of net operating loss carryforwards. The
total deferred tax asset was $11.6 million as of December 31, 2007. We
released $4.4 million of the valuation allowance associated with U.K. deferred
tax assets, which resulted in the recognition of a $4.4 million tax
benefit. The tax benefit was offset by a liability for uncertain tax
positions of $0.9 million, for a net recognized tax benefit of $3.5
million.
  Changes
in our deferred tax asset valuation allowance are summarized as follows (in
thousands):
 Year Ended December 31,2008
                                                                                  
                                                                                  2007
                                                                                  
                                                                                  2006Balance,
      January 1,
                                                                                  
                                                                                  $
                                                                                  128,561
                                                                                  
                                                                                  $
                                                                                  117,747
                                                                                  
                                                                                  $
                                                                                  130,316Decrease
      (increase) in deferred tax assets
                                                                                  
                                                                                  
                                                                                  (3,806
                                                                                  )
                                                                                  
                                                                                  15,228
                                                                                  
                                                                                  
                                                                                  (12,569
                                                                                  )Recognition
      of deferred tax assets
                                                                                  
                                                                                  
                                                                                  —
                                                                                  
                                                                                  
                                                                                  (4,414
                                                                                  )
                                                                                  
                                                                                  —Balance, December
      31,
                                                                                  
                                                                                  $
                                                                                  124,775
                                                                                  
                                                                                  $
                                                                                  128,561
                                                                                  
                                                                                  $
                                                                                  117,747
 The
impairment of goodwill and other intangible assets in the third quarter of 2008
had a material effect on the income tax provision. While a component of the CDN
services goodwill is deductible for tax purposes, the majority of the goodwill
had no basis for tax purposes. Accordingly, when the “non tax basis” goodwill of
$90.0 million was impaired for financial reporting purposes, it resulted in a
$30.5 million permanent difference that impacted our effective income tax rate.
The portion of goodwill where there was corresponding tax basis at the time of
the acquisition only impacted our effective income tax rate to the extent that
the tax amortization reduced the tax basis of the goodwill below the
corresponding book basis while we have a valuation allowance. In past years,
this resulted in a permanent difference of an aggregate $0.4 million relating to
the tax amortization difference. With the additional impairment of the “tax
basis” goodwill in 2008, we recorded a tax benefit for the reversal of the
previous income tax expense recognized related to the tax amortization of the
CDN services goodwill.
  We intend
to reinvest future earnings indefinitely within each country; however, it is not
practicable to determine the amount of the unrecognized deferred income tax
liability related to future foreign earnings. Accordingly, we have not recorded
deferred taxes for the difference between our financial and tax basis
investment in foreign entities.
  Effective
January 1, 2007, we adopted the provisions of FASB Interpretation No. 48,
Accounting for Uncertainty in
Income Taxes,or FIN 48. FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in our financial statements in accordance
with SFAS No. 109. FIN 48 requires us to determine whether it is
more likely than not that a tax position will be sustained upon examination
based upon the technical merits of the position. If the more-likely-than-not
threshold is met, we must measure the tax position to determine the amount to
recognize in the financial statements.
  F -
32
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




Upon the
adoption of FIN 48 on January 1, 2007, we recognized no increase in our
liability for unrecognized tax benefits. A reconciliation of the beginning and
ending amount of unrecognized tax benefits for the years ending December 31,
2008 and 2007 is as follows (in thousands):


Year
      Ending December 31,2008
                                
                                
                                2007Unrecognized
      tax benefits balance at January 1,
                                
                                $
                                921
                                
                                
                                $
                                —Additions
      for tax positions of prior years
                                
                                
                                —
                                
                                
                                
                                —Reductions
      for tax positions of prior years settlements
                                
                                
                                —
                                
                                
                                
                                —Additions
      for tax positions of current year
                                
                                
                                —
                                
                                
                                
                                921Foreign
      exchange (loss)
                                
                                
                                (253
                                )
                                
                                
                                —Lapse
      of statute of limitations
                                
                                
                                (668
                                )
                                
                                
                                —Unrecognized
      tax benefits balance at December 31,
                                
                                $
                                —
                                
                                
                                $
                                921




The
changes in the FIN 48 liability had no impact on our effective income tax rate
in the respective periods of change due to the offsetting changes in our U.K.
deferred tax asset.




We
classify interest and penalties arising from the underpayment of income taxes in
the accompanying consolidated statement of operations as a component of general
and administrative expenses. As of December 31, 2008 and 2007, we had no accrued
interest or penalties related to uncertain tax positions. Our federal income tax
returns remain open to examination for the tax years 2005 through 2007, however,
tax authorities have the right to adjust the net operating loss carryovers for
years prior to 2005. Returns filed in other jurisdictions are subject to
examination for years prior to 2005.


14.
              EMPLOYEE
      RETIREMENT PLAN




We
sponsor a defined contribution retirement savings plan that qualifies under
Section 401(k) of the Internal Revenue Code. Plan participants may elect to have
a portion of their pre-tax compensation contributed to the plan, subject to
certain guidelines issued by the Internal Revenue Service. Employer
contributions are discretionary and were $0.9 million, $0.8 million and $0.7
million for the years ended December 31, 2008, 2007 and 2006,
respectively.


15.
              COMMITMENTS,
      CONTINGENCIES, CONCENTRATIONS OF RISK AND LITIGATION, INCLUDING SUBSEQUENT
      EVENT




Operating
Leases




We, as a
lessee, have entered into leasing arrangements relating to office and service
point rental space and office equipment that are classified as operating leases.
Initial lease terms range from two to 20 years and contain various periods of
free rent and any renewal options. However, we record rent expense on a
straight-line basis over the initial lease term and any renewal periods that are
reasonably assured. Certain leases require that we maintain letters of credit or
restricted cash balances to ensure payment. Future minimum lease payments
on non-cancelable operating leases are as follows at December 31, 2008 (in
thousands):


2009
                    
                    $
                    24,8082010
                    
                    
                    25,7892011
                    
                    
                    26,1092012
                    
                    
                    26,8752013
                    
                    
                    24,846Thereafter
                    
                    
                    86,882$
                    215,309




Rent
expense was $21.5 million, $15.1 million and $18.8 million for the years ended
December 31, 2008, 2007 and 2006, respectively. Sublease income, recorded as a
reduction of rent expense, was $0.3 million, $0.5 million and $0.6 million
during the years ended December 31, 2008, 2007 and 2006,
respectively.





F -
33
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)





Service
Commitments




We have
entered into service commitment contracts with Internet network service
providers to provide interconnection services and data center providers to
provide data center services for our customers. Future minimum payments under
these service commitments having terms in excess of one year are as follows at
December 31, 2008 (in thousands):


2009
                  
                  $
                  7,1632010
                  
                  
                  4,9412011
                  
                  
                  1,278$
                  13,382




Subsequent
Event




On
January 29, 2009, we announced the resignation of James P. DeBlasio from
his positions as President and Chief Executive Officer effective as of March 16,
2009, or the Separation Date. Mr. DeBlasio also has resigned as our
director effective March 15, 2009. Pursuant to the terms of a separation
agreement, Mr. DeBlasio will receive (1) a cash payment of $0.9 million, (2)
full vesting of all equity awards previously granted to him as of the Separation
Date and (3) if he so elects, continued health, dental and vision insurance
coverage under our group health plan for 18 months from the Separation Date at
no cost to him. Mr. DeBlasio has 12 months following the Separation Date in
which to exercise any stock options held by him that were vested as of the
Separation Date. We will record the associated severance and stock-based
compensation expense in general and administrative costs during the three months
ended March 31, 2009. Also on January 29, 2009, we announced the
appointment of J. Eric Cooney as our President and Chief Executive Officer and
director, effective March 16, 2009.




Vendor
Disputes




In
delivering our services, we rely on a number of Internet network,
telecommunication and other vendors. We work directly with these vendors to
provision services such as establishing, modifying or discontinuing services for
our customers. Because of the volume of activity, billing disputes inevitably
arise. These disputes typically stem from disagreements concerning the starting
and ending dates of service, quoted rates, usage and various other factors. We
research disputed costs, both in the vendors’ favor and our favor, and discuss
our analysis with vendors on an ongoing basis until ultimately resolved. We
record the cost and a liability based on our estimate of the most likely outcome
of the dispute. We periodically review these estimates and modify the estimates
in light of new information or developments, if any. Because estimates regarding
disputed costs include assessments of uncertain outcomes, such estimates are
inherently vulnerable to changes due to unforeseen circumstances that could
materially and adversely affect our results of operations and cash
flows.




Concentrations
of Risk




We
participate in an industry that is characterized by relatively high
volatility and strong competition for market share. We and others in the
industry encounter aggressive pricing practices, evolving customer demands and
continual technological developments. Our operating results could be negatively
affected should we not be able to adequately address pricing strategies,
customers’ demands and technological advancements.




We depend
on other companies to supply various key elements of our infrastructure
including the network access local loops between our network access points and
our Internet network service providers and the local loops between our network
access points and our customers’ networks. In addition, the routers and switches
used in our network infrastructure are currently supplied by a limited number of
vendors. Furthermore, we do not carry significant supply inventories of the
products and equipment that we purchase and use, and we have no guaranteed
supply arrangements with our vendors. A loss of a significant vendor could delay
build-out of our infrastructure and increase our costs. If our limited source of
suppliers fails to provide products or services that comply with evolving
Internet standards or that interoperate with other products or services we use
in our network infrastructure, we may be unable to meet all or a portion of our
customer service commitments, which could adversely affect our business, results
of operations and financial condition.




Litigation




On
November 12, 2008, a putative securities fraud class action lawsuit was filed
against us and our Chief Executive Officer, James P. DeBlasio, in the United
States District Court for the Northern District of Georgia, captioned Catherine Anastasio and Stephen
Anastasio v. Internap Network Services Corp. and James P. DeBlasio, Civil
Action No. 1:08-CV-3462-JOF. The complaint alleges that we and the individual
defendant violated Section 10(b) of the Securities Exchange Act of 1934, or the
Exchange Act and that the individual defendant also violated Section 20(a) of
the Exchange Act as a “control person” of Internap. Plaintiffs purport to bring
these claims on behalf of a class of our investors who purchased our stock
between March 28, 2007 and March 18, 2008.





F -
34
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)





Plaintiffs
allege generally that, during the putative class period, we made misleading
statements and omitted material information regarding (1) integration of
VitalStream, (2) customer issues and related credits due to services outages,
and (3) our previously reported 2007 revenue that we subsequently reduced in
2008 as announced on March 18, 2008. Plaintiffs assert that we and the
individual defendant made these misstatements and omissions in order to keep our
stock price high. Plaintiffs seek unspecified damages and other
relief.




While we
intend to vigorously contest this lawsuit, we cannot determine the final
resolution of this lawsuit or when it might be resolved. In addition to the
expenses incurred in defending this litigation and any damages that may be
awarded in the event of an adverse ruling, our management’s efforts and
attention may be diverted from the ordinary business operations to address these
claims. Regardless of the outcome, this litigation may have a material adverse
impact on our results because of defense costs, including costs related to our
indemnification obligations, diversion of resources and other
factors.




We are subject
to other legal proceedings, claims and litigation arising in the ordinary course
of business. Although the outcome of these matters is currently not
determinable, we do not expect that the ultimate costs to resolve these matters
will have a material adverse effect on our financial condition, results of
operations or cash flows.


16.
            PREFERRED
      STOCK AND STOCKHOLDERS’ EQUITY




Preferred
Stock




Effective
July 11, 2006, we implemented a one-for-10 reverse stock split for our common
stock. At the time, the authorized number of shares of preferred stock was not
accordingly reduced and remained at 200 million shares. We intended the reverse
stock split to reduce the authorized number of shares of preferred
stock. Accordingly, effective June 19, 2008, we reduced the number of
authorized shares of preferred stock from 200 million shares to 20 million
shares. Of the resulting 20 million authorized shares of preferred stock,
19.5 million shares are blank check preferred stock, the terms and conditions of
which our board of directors may designate. Our board of directors
previously designated the remaining 0.5 million shares of preferred stock as
series B preferred stock pursuant to a certificate of designation of rights,
preferences and privileges on April 11, 2007. We have no shares of preferred
stock outstanding.




Rights
Agreement




On March
15, 2007, our board of directors declared a dividend of one preferred share
purchase right, or a Right, for each outstanding share of our common stock, par
value $0.001 per share. The dividend was payable on March 23, 2007 to the
stockholders of record on that date. Each Right entitles the registered holder
to purchase from us 1/1000 of a share of our Series B Preferred Stock, par
value $0.001 per share, or the Preferred Shares, at a price of $100.00 per
1/1000 of a Preferred Share, subject to adjustment. Our Certificate of
Designation of Rights, Preferences and Privileges of Series B Preferred Stock
designates 0.5 million shares of Series B Preferred Stock. The description and
terms of the Rights are set forth in a Rights Agreement between us and American
Stock Transfer & Trust Company, as Rights Agent, dated April 11,
2007.




Common
Stock




On
September 18, 2006, our common stock began trading on the NASDAQ Global Market,
under the symbol “INAP.” We voluntarily delisted our common stock from the
American Stock Exchange, or AMEX, effective September 17, 2006.




On July
10, 2006, we implemented a one-for-10 reverse stock split of our common stock.
Stockholders approved the stock split on June 21, 2006. Our common stock began
trading on a split-adjusted basis on July 11, 2006. All share and per share
information herein (including shares outstanding, earnings per share and warrant
and stock option exercise prices) have been retroactively restated for
all periods presented to reflect the reverse stock split.




Treasury
Stock




During
2006 and 2008, we acquired shares of treasury stock as payment of taxes on
stock-based compensation from employees. These shares will be subsequently
reissued as part of our stock-based compensation plans.




Warrants
to Purchase Common Stock




On
October 20, 2003, we issued warrants to purchase less than 0.1 million shares of
common stock at an exercise price of $9.50 in connection with a private
placement of our common stock. These warrants expired on August 22,
2008.





F -
35
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)





17.
            STOCK-BASED
      COMPENSATION PLANS




We
measure stock-based compensation cost at the grant date based on the calculated
fair value of the award. We recognize the expense over the employees’ requisite
service period, generally the vesting period of the award. For
performance-based awards, we periodically assess whether the performance
conditions are probable of being met and record compensation expense based on
this assessment of probability. We estimate the fair value of stock options at
the grant date using the Black-Scholes option pricing model with weighted
average assumptions for the activity under our stock plans. Option pricing model
input assumptions such as expected term, expected volatility and risk-free
interest rate, impact the fair value estimate. Further, the forfeiture rate
impacts the amount of aggregate compensation. These assumptions are subjective
and generally require significant analysis and judgment to develop. When we
elect to pay certain bonuses in shares of stock, the total amount to be paid is
determined similarly to cash bonuses and the number of shares to be granted is
determined based on the fair value of our stock at the date of
grant.




Stock-Based
Compensation Expense




The
following table summarizes the amount of stock-based compensation expense, net
of estimated forfeitures in accordance with SFAS No. 123R, included in the
accompanying consolidated statements of operations for the years ended December
31, 2008, 2007 and 2006 (in thousands):




Year
      ended December 31,2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006Direct
      costs of customer support
                                    
                                    $
                                    1,369
                                    
                                    
                                    $
                                    1,892
                                    
                                    
                                    $
                                    1,102Product
      development
                                    
                                    
                                    688
                                    
                                    
                                    
                                    856
                                    
                                    
                                    
                                    628Sales
      and marketing
                                    
                                    
                                    1,782
                                    
                                    
                                    
                                    2,135
                                    
                                    
                                    
                                    2,145General
      and administrative
                                    
                                    
                                    3,660
                                    
                                    
                                    
                                    3,798
                                    
                                    
                                    
                                    2,067Total
      stock-based compensation expense included in net income
                                    
                                    $
                                    7,499
                                    
                                    
                                    $
                                    8,681
                                    
                                    
                                    $
                                    5,942




We have
not recognized any tax benefits associated with stock-based compensation due to
our tax net operating losses. We capitalized less than $0.1 million of
stock-based compensation during each of the years ended December 31, 2008, 2007
and 2006.




We
estimated the fair values of stock options at the date of grant using a
Black-Scholes option pricing model. The significant weighted average assumptions
used for estimating the fair value of the activity under our stock option plans
for the years ended December 31, 2008, 2007 and 2006, were expected terms of
4.0, 6.2 and 5.7, respectively; historical volatilities of 72%, 114% and 123%
respectively; risk free interest rates of 2.61%, 4.44% and 4.63%, respectively
and no dividend yield. The weighted average estimated fair value per share of
our employee stock options at grant date was $3.79, $13.71 and $7.75 for the
years ended December 31, 2008, 2007 and 2006, respectively. The expected
term represents the weighted average period of time that granted options are
expected to be outstanding, giving consideration to the vesting schedules and
our historical exercise patterns. Because our options are not publicly traded,
assumed volatility is based on the historical volatility of our stock. The
risk-free interest rate is based on the U.S. Treasury yield curve in effect at
the time of grant for periods corresponding to the expected term of the options.
We have also used historical data to estimate option exercises, employee
termination and forfeiture rates.




In June
2006, our stockholders approved the repricing of certain outstanding options
under our existing equity incentive plans. Options with an exercise price per
share greater than or equal to $13.00 were eligible for the repricing. We
implemented the repricing through an exchange program under which eligible
participants were offered the opportunity to exchange their eligible options for
new options to purchase shares. Each new option had substantially the same terms
and conditions as the eligible options cancelled except as follows:


●
              The
      exercise price per share of each replacement option granted in the
      exchange offer was $14.46, the average of the closing prices of the common
      stock as reported by the American Stock Exchange and the NASDAQ Global
      Market, as applicable, for the 15 consecutive trading days ending
      immediately prior to the grant date of the replacement
      options;●
              For
      all eligible options with an exercise price per share greater than or
      equal to $20.00, the exchange ratio was one-for-two;
and●
              Each
      new option has a 10-year term and a three-year vesting period, vesting in
      equal monthly installments over three years, so long as the grantee
      continues to be a full-time
employee.





F -
36
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




A total
of 50 employees eligible to participate in the exchange offer tendered, and
we accepted for cancellation, eligible options to purchase an aggregate of
344,987 shares of common stock, representing 49.4% of the total shares of common
stock underlying options eligible for exchange in the exchange offer. We issued
replacement options to purchase an aggregate of 179,043 shares of common stock
in exchange for the cancellation of the tendered eligible options. We will
recognize $0.1 million of incremental compensation cost over the three-year
vesting period as a result of the option exchange. The incremental expense was
measured as the excess of the fair value of the repriced options over the fair
value of the original options immediately before the terms of the original
options were modified. The measurement was based on the share price and other
pertinent factors at the date of modification.




Stock
Compensation and Option Plans




On June
23, 2005, we adopted the Internap Network Services Corporation 2005 Incentive
Stock Plan, or the 2005 Plan, which we amended and restated on March 15, 2006.
Under the 2005 Plan, we may issue stock options, stock appreciation rights,
stock grants and stock unit grants to eligible employees and directors. The 2005
Plan is administered by the compensation committee of our board of directors. On
October 1, 2008, we filed a registration statement on Form S-8 to register 4.0
million additional shares of our common stock for issuance under the 2005 Plan.
We have reserved a total of 10.8 million shares of stock for issuance under the
2005 Plan, comprised of 6.0 million shares designated in the 2005 Plan plus 1.0
million shares that remain available for issuance of options and awards and 3.8
million shares of unexercised options under certain pre-existing plans. We will
not make any future grants under the specified preexisting plans, but each of
the specified pre-existing plans were made a part of the 2005 Plan so that the
shares available for issuance under the 2005 Plan may be issued in connection
with grants made under those plans. As of December 31, 2008, 2.6 million options
were outstanding, 0.8 million shares of non-vested restricted stock awards were
outstanding and 6.6 million shares of stock were available for issuance
under the 2005 Plan.




Under the
2005 Plan, we may not grant in any calendar year an option to any employee or
director to purchase more than 1.4 million shares of stock or a stock
appreciation right based on the appreciation with respect to more than 1.4
million shares of stock. Similarly, we may not make in any calendar year a stock
grant or stock unit grant to any employee or director where the fair market
value of the stock subject to such grant on the grant date exceeds $3.0
million. Furthermore, we may not issue more than 0.7 million non-forfeitable
shares of stock pursuant to stock grants.




As a
result of the acquisition of VitalStream as discussed in note 3, we assumed the
VitalStream Stock Option/Stock Issuance Plan, or the VitalStream Plan, and all
of the corresponding options to purchase stock. Under the terms of the merger
agreement, each VitalStream stock option that was outstanding and unexercised
was converted into an option to purchase Internap common stock and we assumed
that stock option in accordance with the terms of the applicable VitalStream
stock option plan and terms of the stock option agreement. Based on
VitalStream’s stock options outstanding at February 20, 2007, we converted
options to purchase approximately 3.0 million shares of VitalStream common stock
into options to purchase approximately 1.5 million shares of our common stock.
We determined the fair value of the outstanding options using a Black-Scholes
valuation model with the following assumptions: volatility of 48.8% to 120.1%;
risk-free interest rates ranging from 4.7% to 5.1%; remaining expected lives
ranging from 0.18 to 6.25 years; and dividend yield of zero.




The
VitalStream Plan provided for the granting of incentive stock options,
non-statutory stock options or shares of common stock directly to certain key
employees, members of the board of directors, consultants and independent
contractors according to the terms of the plan. There were 5.4 million
VitalStream shares, or 2.8 million Internap shares on a post-converted basis,
reserved for issuance under the plan and 0.5 million VitalStream shares, or 0.3
million Internap shares on a post-converted basis, available for grant.
Generally, the assumed options had exercise prices equal to the stock price on
the date of grant and had contractual terms of five years. Vesting schedules
ranged from quarterly periods over one year to four years with 1/4 th vesting
after one year and 1/16 th vesting
each quarter thereafter.




In July
1999, we adopted the 1999 Non-Employee Directors’ Stock Option Plan, or the
Director Plan. The Director Plan provides for the grant of non-qualified stock
options to non-employee directors. A total of 0.4 million shares of our common
stock have been reserved for issuance under the Director Plan. Under the
Director Plan, non-employee directors receive fully-vested and exercisable
initial option for 8,000 shares of our common stock on the date such person is
first elected or appointed as a non-employee director. The Director Plan
provides that on the day after each of our annual stockholder meetings, each
non-employee director receives a fully vested and exercisable option for 5,000
shares, provided such person has been a non-employee director for at least the
prior six months. The options have an exercise price equal to 100% of the fair
market value of our common stock on the grant date and are fully vested and
exercisable as of the grant date. Each director also receives an annual grant of
2,500 restricted stock awards, which vest ratably over three years, subject to
the terms of the 2005 Plan, under which these restricted stock awards are
granted. In addition, new non-employee directors receive a grant of 12,500
restricted stock awards, which vest ratably over three years, subject to the
terms of the 2005 Plan and the stock grant agreement under which the restricted
stock awards are granted. As of December 31, 2008, 0.2 million options were
outstanding and 0.2 million shares were available for grant pursuant to the
Director Plan.





F -
37
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




The
option price for each share of stock subject to an option generally may not be
less than the fair market value of a share of stock on the grant date. Stock
options generally have a maximum term of 10 years from the grant date. Incentive
stock options, or ISOs, may be granted only to eligible employees and if granted
to a 10% stockholder, the terms of the grant will be more restrictive than for
other eligible employees. Terms for stock appreciation rights are similar to
those of options. Upon exercise of a stock appreciation right, the compensation
committee of our board of directors determines the form of payment as cash,
shares of stock issued under the 2005 Plan based on the fair market value of a
share of stock on the date of exercise or a combination of cash and
shares.




Options
and stock appreciation rights become exercisable in whole or in part from
time-to-time as determined at the grant date by our board of directors or the
compensation committee of our board of directors, as applicable. Stock options
generally vest 25% after one year and monthly or quarterly over the following
three years, except for non-employee directors who usually receive immediately
exercisable options. Conditions, if any, under which stock will be issued under
stock grants or cash will be paid under stock unit grants and the conditions
under which the interest in any stock that has been issued will become
non-forfeitable are determined at the grant date by the compensation committee.
If the only condition to the forfeiture of a stock grant or stock unit grant is
the completion of a period of service, the minimum period of service will
generally be three years from the grant date. We have reserved common stock
under each of the stock compensation plans to satisfy option exercises with
newly issued stock. However, we may also use treasury stock to satisfy
option exercises




On March
20, 2008, we granted 0.2 million shares of restricted common stock with
performance-based vesting. The awards will vest in increments of one-third
beginning on the first anniversary of the grant date if we achieve revenue and
adjusted earnings levels established by our board of directors. ”Adjusted
earnings” is defined in the 2005 Plan. We will either meet or not meet both
goals in a given year. With respect to all shares of performance-based
restricted stock that do not vest during any of the three years, 50% of such
shares will vest on the fourth anniversary of the date of grant. For the
performance-based restricted stock awards, we recognize compensation expense
based on our assessment of the probability that the performance conditions will
be achieved. We must use our judgment to make the probability assessment and, as
of December 31, 2008, we believed the performance conditions would not be
met.




Option
activity for the year ended December 31, 2008 under all of our stock option
plans is as follows (shares in thousands):


Shares
                                
                                
                                Weighted
                                  Average
                                  Exercise
      PriceBalance,
      January 1, 2008
                                
                                
                                3,173
                                
                                
                                $
                                13.29Granted
                                
                                
                                660
                                
                                
                                
                                6.90Exercised
                                
                                
                                (78
                                )
                                
                                
                                4.08Forfeitures
      and post-vesting cancellations
                                
                                
                                (974
                                )
                                
                                
                                13.62Balance,
      December 31, 2008
                                
                                
                                2,781
                                
                                
                                $
                                11.91Exercisable,
      December 31, 2008
                                
                                
                                1,738
                                
                                
                                $
                                13.37




Fully
vested and exercisable stock options and stock options expected to vest as of
December 31, 2008 are further summarized as follows (shares in
thousands):


Fully
                                Vested
      and
                                Exercisable
                              
                              
                              Expected
                                to
      VestTotal
      shares
                              
                              
                              1,738
                              
                              
                              
                              2,616Weighted-average
      exercise price
                              
                              $
                              13.37
                              
                              
                              $
                              12.07Aggregate
      intrinsic value
                              
                              $
                              2,925
                              
                              
                              $
                              2,925Weighted-average
      remaining contractual term, in years
                              
                              
                              5.8
                              
                              
                              
                              6.6




The total
intrinsic value of options exercised was $0.2 million, $11.8 million and $2.6
million for the years ended December 31, 2008, 2007 and 2006, respectively. None
of our stock options or the underlying shares is subject to any right to
repurchase by us.





F -
38
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




Restricted
stock activity for the year ended December 31, 2008 is as follows (shares in
thousands):


Shares
                    
                    
                    Weighted-Average
                      Grant
      Date Fair
                      ValueNon-vested
      balance, January 1, 2008
                    
                    
                    679
                    
                    
                    $
                    13.19Granted
                    
                    
                    724
                    
                    
                    
                    4.07Vested
                    
                    
                    (256
                    )
                    
                    
                    10.84Forfeited
                    
                    
                    (302
                    )
                    
                    
                    9.22Non-vested
      balance, December 31, 2008
                    
                    
                    845
                    
                    
                    $
                    7.76




The total
fair value of restricted stock awards vested during the years ended December 31,
2008, 2007 and 2006 was $1.1 million, $2.3 million and $2.1 million,
respectively. The cumulative effect of the change in the forfeiture rate for
non-vested restricted stock upon our adoption of SFAS No. 123R on January 1,
2006 was immaterial and recorded as part of operating expense. The total
intrinsic value at December 31, 2008 of all non-vested restricted stock awards
was $2.1 million.




Total
unrecognized compensation costs related to non-vested stock-based compensation
as of December 31, 2008 is summarized as follows (dollars in
thousands):


December
      31, 2008Stock
                  Options
                
                Restricted
                  Stock
                
                TotalUnrecognized
      compensation
                
                $
                8,367
                
                $
                8,253
                
                $
                16,620Weighted-average
      remaining recognition period (in years)
                
                
                2.5
                
                
                2.6
                
                
                2.6




Employee
Stock Purchase Plan




Effective
June 15, 2004, we adopted the 2004 Internap Network Services Corporation
Employee Stock Purchase Plan, or the Purchase Plan. The purpose of the Purchase
Plan is to encourage ownership of our common stock by each of our eligible
employees by permitting eligible employees to purchase our common stock at a
discount. Eligible employees may elect to participate in the Purchase Plan for
two consecutive calendar quarters, referred to as a “purchase period,” during a
designated period immediately preceding the purchase period. Purchase periods
have been established as the six-month periods ending June 30 and December 31 of
each year. A participation election is in effect until it is amended or revoked
by the participating employee, which may be done at any time on or before the
last day of the purchase period.




Initially,
the price for shares of common stock purchased under the Purchase Plan was the
lesser of 85% of the closing sale price per share of common stock on the first
day of the purchase period or 85% of such closing price on the last day of the
purchase period. The Purchase Plan was intended to be a non-compensatory plan
for both tax and financial reporting purposes. However, upon our adoption of
SFAS No. 123R in the first quarter of 2006, we recognized compensation expense
of $0.1 million during the year ended December 31, 2006, representing the
estimated fair value of the benefit to participants as of the beginning of the
purchase period. In January 2006, we amended the Purchase Plan to change the
purchase price from 85% to 95% of the closing sale price per share of common
stock on the last day of the purchase period and to eliminate the alternative to
use the first day of the offering period as a basis for determining the purchase
price. This amendment restored the plan to being non-compensatory for financial
reporting purposes and was effective for the purchase period July 1 through
December 31, 2006. As such, we did not recognize additional compensation expense
for the Purchase Plan after June 30, 2006. We granted less than 0.1 million
shares under the Purchase Plan during each of the years ended December 31, 2008
and 2007, and we granted approximately 0.1 million shares under the Purchase
Plan during the year ended December 31, 2006. Cash received from participation
in the Purchase Plan was $0.2 million for each of the years ended December 31,
2008 and 2007 and $0.5 million for the year ended December 31, 2006. At December
31, 2008, 0.2 million shares were reserved for future issuance under the
Purchase Plan.




At
December 31, 2008, we had reserved 9.8 million total shares for future awards
under all plans. Cash received from all stock-based compensation arrangements
was $0.5 million, $8.6 million and $3.0 million for the years ended December 31,
2008, 2007 and 2006, respectively.


18.
            RELATED
      PARTY TRANSACTIONS




As
discussed in note 5, we had an investment in Aventail, who was also a customer
for data center and connectivity services. We invoiced Aventail $0.2 million
during 2007 and $0.3 million during 2006. As of December 31, 2007, our
outstanding receivable balance with Aventail was less than $0.1 million. We
incurred a charge during the period ended June 30, 2007, totaling $1.2 million,
representing the write-off of the remaining carrying value of our investment in
series D preferred stock of Aventail.





F -
39
 INTERNAP
NETWORK SERVICES CORPORATION AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)




One of
our former executive officers had a material equity ownership interest in and is
a member of the board of directors of a customer of ours, Surfline/Wavetrak,
Inc., or Surfline. We invoiced Surfline $0.2 million and $0.1 million during
2008 and 2007, respectively, of which less than $0.1 million was
outstanding as of both December 31, 2008 and 2007. Surfline was not a customer
prior to 2007. This executive officer resigned from the Company in June
2008.


19.
              UNAUDITED
      QUARTERLY RESULTS




The
following table sets forth selected unaudited quarterly data for the years ended
December 31, 2008 and 2007. The quarterly operating results below are not
necessarily indicative of those in future periods (in thousands, except for
share data).


Quarter
      Ended2008
                    
                    March
      31
                    
                    
                    June
      30
                    
                    
                    September
      30
                    
                    
                    December
      31Revenues
                    
                    $
                    62,053
                    
                    
                    $
                    62,325
                    
                    
                    $
                    65,399
                    
                    
                    $
                    64,212Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization
                    
                    
                    31,363
                    
                    
                    
                    33,484
                    
                    
                    
                    35,404
                    
                    
                    
                    35,626Direct
      costs of amortization of acquired technologies
                    
                    
                    1,229
                    
                    
                    
                    1,229
                    
                    
                    
                    3,049
                    
                    
                    
                    1,142Direct
      costs of customer support
                    
                    
                    4,365
                    
                    
                    
                    4,203
                    
                    
                    
                    3,950
                    
                    
                    
                    3,699Impairments
      and restructuring
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    100,415
                    
                    
                    
                    1,026Net
      income (loss)
                    
                    
                    739
                    
                    
                    
                    (3,237
                    )
                    
                    
                    (101,405
                    )
                    
                    
                    (910
                    )Basic
      net income (loss) per share
                    
                    
                    0.02
                    
                    
                    
                    (0.07
                    )
                    
                    
                    (2.06
                    )
                    
                    
                    (0.02
                    )Diluted
      net income (loss) per share
                    
                    
                    0.01
                    
                    
                    
                    (0.07
                    )
                    
                    
                    (2.06
                    )
                    
                    
                    (0.02
                    )







Quarter
      Ended2007
                    
                    March
      31
                    
                    
                    June
      30
                    
                    
                    September
      30
                    
                    
                    December
      31Revenues
                    
                    $
                    53,534
                    
                    
                    $
                    58,494
                    
                    
                    $
                    60,426
                    
                    
                    $
                    61,636Direct
      costs of network, sales and services, exclusive of depreciation and
      amortization
                    
                    
                    28,
      629
                    
                    
                    
                    29,617
                    
                    
                    
                    29,272
                    
                    
                    
                    30,876Direct
      costs of amortization of acquired technologies
                    
                    
                    654
                    
                    
                    
                    1,054
                    
                    
                    
                    1,228
                    
                    
                    
                    1,229Direct
      costs of customer support
                    
                    
                    3,388
                    
                    
                    
                    4,330
                    
                    
                    
                    4,495
                    
                    
                    
                    4,334Impairments
      and restructuring
                    
                    
                    11,349
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Acquired
      in-process research and development
                    
                    
                    450
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Write-off
      of investment
                    
                    
                    —
                    
                    
                    
                    1,178
                    
                    
                    
                    —
                    
                    
                    
                    —Net
      (loss) income
                    
                    
                    (10,695
                    )
                    
                    
                    (1,683
                    )
                    
                    
                    1,383
                    
                    
                    
                    5,440Basic
      and diluted net (loss) income per share
                    
                    
                    (0.26
                    )
                    
                    
                    (0.03
                    )
                    
                    
                    0.03
                    
                    
                    
                    0.11





F -
40




INTERNAP
NETWORK SERVICES CORPORATION


FINANCIAL
STATEMENT SCHEDULE




VALUATION
AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS)


Balance
      at
                        Beginning
                        of
      Fiscal
                        Period
                      
                      Charges
      to
                        Costs
      and
                        Expense
                      
                      Charges
      to
                        Other
                        Accounts
                      
                      Deductions
                      
                      Balance
      at
                        End
      of
                        Fiscal
                        PeriodYear
      ended December 31, 2006:Allowance
      for doubtful accounts
                      
                      $
                      963
                      
                      $
                      548
                      
                      $
                      —
                      
                      $
                      (1,130
                      )(1)
                      $
                      381Year
      ended December 31, 2007:Allowance
      for doubtful accounts
                      
                      
                      381
                      
                      
                      2,261
                      
                      
                      928
                      (2)
                      
                      (1,219
                      )(1)
                      
                      2,351Year
      ended December 31, 2008:Allowance
      for doubtful accounts
                      
                      
                      2,351
                      
                      
                      5,322
                      
                      
                      —
                      
                      
                      (4,896
                      )(1)
                      
                      2,777







__________________(1)
                Deductions
      in the allowance for doubtful accounts represent write-offs of
      uncollectible accounts net of recoveries.(2)
                Purchase
      price adjustment associated with our acquisition of VitalStream Holdings,
      Inc.






S -
1