<PAGE>   1

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 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, 1998

               [ ]    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:
                                   333-62797

                               BIRCH TELECOM, INC.
             (Exact name of Registrant as specified in its charter)

                   Delaware                            43-1766929
         (State or other jurisdiction               (I.R.S. Employer
       of incorporation or organization)          Identification No.)

             2020 Baltimore Avenue                       64108
             Kansas City, Missouri                     (Zip Code)
   (Address of principal executive offices)

              Registrant's telephone number, including area code:
                                 (816) 300-3000
                                 --------------

           Securities registered pursuant to Section 12(b) of the Act:
                            14% Senior Notes due 2008
                                (Title of Class)

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

         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
                                              ---     ---

         Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K 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 or any
amendment to this Form 10-K. [ ]



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                                     PART I

THIS FORM 10-K CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS
AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM
THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN
FACTORS, INCLUDING THOSE SET FORTH UNDER THE CAPTION "BUSINESS--RISK FACTORS"
AND ELSEWHERE IN THIS FORM 10-K. UNLESS THE CONTEXT SUGGESTS OTHERWISE,
REFERENCES IN THIS FORM 10-K TO THE "COMPANY" OR "BIRCH" MEAN BIRCH TELECOM,
INC. AND ITS WHOLLY OWNED SUBSIDIARIES.

ITEM 1.  BUSINESS

GENERAL

         Birch is a competitive local exchange carrier (CLEC) serving small to
mid-sized businesses and, to a lesser extent, residential customers, in selected
markets in Missouri, Kansas, and Texas. The Company provides its customers with
integrated telecommunications services, including local and long distance
service, customer premises equipment (CPE), and Internet services, such as
access, web hosting, web site design and Intranet development. Birch provides
telecommunications services to its customers through a combination of owned and
leased network facilities and resold services. For the year ended December 31,
1998, the Company's total revenue was $26.1 million.

         Birch provides local, long distance, and CPE services in Missouri and
Kansas, principally in territories served by Southwestern Bell Telephone Company
(SWBT), including Kansas City, St. Louis and St. Joseph, Missouri and Wichita,
Topeka, Manhattan, Lawrence, Emporia, Salina and Dodge City, Kansas. In 1999,
the Company began providing local services in selected Texas markets. The
Company also provides Internet services in selected markets in Kansas and
Missouri. Birch currently operates a long distance circuit switch in Wichita,
Kansas and a local/long distance circuit switch in Kansas City, Missouri. The
Company expects to deploy additional local/long distance circuit switches in St.
Louis, Missouri and Wichita, Kansas, in the second quarter of 1999.
Additionally, in 1999, the Company expects to deploy asynchronous transfer mode
(ATM) packet switches in various markets in which it offers telecommunications
services.

         Birch was incorporated under the laws of Delaware in December 1996. The
Company's principal executive offices are located at 2020 Baltimore Avenue,
Kansas City, Missouri 64108 and its telephone number is (816) 300-3000.

RECENT TRANSACTIONS

         In February 1998, Birch merged with Valu-Line Companies, Inc.
(Valu-Line) in a transaction valued at $19.5 million, consisting of $4.75
million in cash, 2,968,750 shares of Series A Preferred Stock of the Company
having an aggregate liquidation preference of $4.75 million, and 6,593,750
shares of Series C Preferred Stock having an aggregate liquidation preference of
$10.0 million. Valu-Line, founded in 1982, has been primarily providing switched
long distance services, CPE sales and services and, since March 1997, local
service in selected smaller markets throughout the state of Kansas.

         On March 13, 1998, Birch completed a private placement of 6,264,063
shares of its Series B Preferred Stock having an aggregate liquidation
preference of $9.5 million and $3.5 million in aggregate principal amount of
convertible notes, raising aggregate net proceeds of approximately $12.4 million
which were used to pay the cash portion of the consideration for the Valu-Line
merger, to repay certain debt and for general corporate purposes. In June 1998,
the convertible notes were converted into 2,307,965 shares of Series B Preferred
Stock of the Company.

         In May 1998, Birch acquired Dunn & Associates, Inc., d/b/a Boulevard
Phone Company (Boulevard), a shared tenant service provider in the Kansas City
metropolitan area, for $300,000 in cash.


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         In May 1998, Birch acquired Telesource Communications, Inc.
(Telesource), a CPE provider in the Kansas City metropolitan area, for $325,000
in cash. In connection with the Telesource acquisition, the Company assumed
$290,000 of Telesource's debt which has since been repaid.

         During June 1998, the Company completed a $115 million private offering
of 14% Senior Notes (the Senior Notes) due June 2008 and 115,000 warrants to
purchase 1,409,734 shares of Common Stock of the Company. The warrants are
exercisable at $0.01 per share and expire June 2008. The Company received net
proceeds from the Senior Notes of $110.2 million and concurrently purchased
pledged securities of $44.2 million. The pledged securities are restricted for
interest payments on the Senior Notes and, together with the interest accruing
thereon, will be used to satisfy such interest payments through June 2001. The
Senior Notes were subsequently exchanged for substantially identical 14% notes
due June 2008 that had been registered under the Securities Act of 1933 in an
exchange offer that expired in March 1999.

         In September 1998, the Company purchased certain assets and liabilities
of TFSnet, Inc. (TFSnet), an Internet service provider in the Kansas City
metropolitan area, for $2.65 million.

         In February 1999, Birch acquired American Local Telecommunications,
L.L.C. (ALT), a local service provider in the Dallas metropolitan area for
$700,000 in cash and stock.

         In March 1999, Birch acquired Capital Communications Corporation
(Capital), a CPE provider in the St. Louis metropolitan area for $3.0 million in
cash and additional cash compensation from conversion of Capital's customer base
to Birch's local service.

TELECOMMUNICATIONS SERVICES

         Birch's telecommunication services are designed to appeal to small and
mid-sized businesses that not only rely on their telecommunications networks,
but who also value integrated telecommunications services packages from a single
provider.

     Local and Long Distance

         Birch provides local and long distance services to its customers in its
markets. Local service is currently provided through resale of SWBT services,
through a platform of SWBT's unbundled network elements and through Birch's
switch and SWBT's unbundled local loops. Birch's services feature simple
long-distance pricing structures and discounted local service packages (compared
to SWBT). Birch's services are billed on a single invoice and customer inquiries
are directed to a single customer service number. Long distance calling services
include outbound, toll free (800/888), and calling card. Customers may subscribe
to long distance services provided by other interexchange carriers (IXCs) upon
request.

     Customer Premises Equipment

         Birch sells and services CPE, including key systems, PBXs, and
voice-mail systems, and provides inside-wire services for commercial accounts,
including wiring for data networking. Birch is an authorized equipment
distributor for Northern Telecom, Inc. (NORTEL), Toshiba America Information
Systems, Inc. and NEC America Inc. As a result of Birch's acquisition of
Capital, it now also is an authorized equipment distributor for Executone
Information Systems, Inc. and Tadiran Electronic Industries, Inc. in the St.
Louis metropolitan area.

     Internet Services

         Birch provides Internet services, including both dial-up and dedicated
Internet access services, web hosting, web-site design and Intranet development
services. Birch targets customers that use the Internet as their primary
wide-area data network, and therefore Birch expects their Internet requirements
to grow both in terms of access capacity requirements and in the sophistication
of required services.



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         In addition to these telecommunication services, in certain geographic
areas, Birch provides a combination of equipment, local, long distance and
Internet services to multiple tenants of office buildings and complexes in the
greater Kansas City metropolitan area. Customers pay a monthly fee based solely
on the number of telephone stations they require, the amount of long distance
traffic they generate, and the Internet services for which they subscribe.

SALES AND MARKETING

     Sales

         As of December 31, 1998, Birch had a direct sales force of 55
representatives operating from nine offices throughout Missouri and Kansas. Of
these representatives, 10 were primarily selling CPE and the remaining 45 were
selling Birch's local and long-distance services. These sales representatives
are supported by sales managers.

         Birch focuses on converting customers in its targeted small to mid-size
business segment, seeking to establish a solid, long-term relationship with its
customers. The Company has developed a commission structure that enables it to
attract experienced, productive sales people. The Company's commission structure
incorporates both a revenue and a local-line quota, and is based on productivity
parameters. Birch's sales managers are experienced in disciplined,
activity-based sales management.

         Birch does not actively market to residential customers, but has found
that its other sales and promotional efforts attract residential customers, many
of whom are owners or employees of businesses using Birch's telecommunication
services.

     Advertising and Promotion

         Birch conducts an extensive marketing campaign in its local markets,
making use of advertising and public relations to position itself in the small
to mid-size business segment and contrasting its service attributes with that of
SWBT. This marketing campaign includes sponsorship of major local events,
affiliations with local organizations, and direct mailings. While the Company
does not actively market to residential customers, management believes that its
willingness to serve these customers -- unlike many other CLECs -- creates a
greater interest in Birch's development among the news media and general public.
In the past, Birch market launches have been accompanied by extensive local
media coverage.

         In keeping with Birch's philosophy of being accessible to its
customers, Birch establishes local sales and customer service offices in many of
the cities and towns in its markets. Birch is the only provider of local
telephone service that maintains an office in many of these cities and towns.
Birch's offices are open to walk-in traffic and often are located in
high-profile areas.

     Pricing

         Birch does not intend to position itself as the cheapest provider of
services, especially with respect to its long-distance services. Birch targets
customers who value the convenience of its service offerings and personalized
customer service. Customers who have the highest price sensitivity are likely to
move frequently among providers, driving up churn rates.
Birch has historically experienced a low churn rate.

NETWORK FACILITIES

     Ownership of Strategic Facilities

         Birch currently operates a long distance circuit switch in Wichita,
Kansas and a local/long distance circuit switch in Kansas City, Missouri. The
Company expects to deploy additional circuit switches in St. Louis, Missouri and
Wichita, Kansas in the second quarter 1999. Birch's local circuit switches are
manufactured by Lucent Technologies, Inc. (Lucent) and are the Series
5ESS(R)-2000 digital models. Birch has a five-year purchase agreement with
Lucent that allows it to purchase switching equipment at a discount from
published list prices and that contains no minimum purchase requirements.



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         In markets where Birch operates a circuit switch, the Company is also
collocating its electronic equipment at SWBT's main central office. This allows
Birch to connect to transmission lines leased by Birch from SWBT (unbundled
loops). Collocation and use of SWBT unbundled loops allows Birch to avoid the
extensive capital costs of complete network construction and enables it to build
its market share without undertaking a lengthy construction program.

         At the customer's premise, Birch connects unbundled loops directly to
customer-owned equipment. Birch also deploys electronic equipment (intelligent
channel banks or access servers) that concentrate traffic and enable Birch to
obtain higher capacity from the transmission line of the incumbent local
exchange carrier (ILEC).

         In addition to its circuit switches, Birch is deploying ATM packet
switches in 1999. These packet switches will make use of the same type of
monitoring, environmental control and power infrastructure that supports its
circuit switches. Initially, the Company will use these packet switches to
transmit data over its leased transmission lines, but also plans to also use
these packet switches to transmit voice traffic.

     Leasing of Transmission Facilities

         Birch leases transmission facilities connecting Birch's switches with
its collocated equipment in SWBT's main central offices and unbundled loops
primarily from SWBT. Birch believes that by leasing these local transmission
facilities, rather than building them, it is able to access local transmission
facilities at a competitive price. Given the existing capacity of local
networks, the Company does not anticipate having to build local transmission
facilities in the future. Similarly, Birch believes that the existing capacity
of long-distance networks renders direct ownership of long distance transmission
facilities unnecessary.

         Leasing rather than building transmission lines supports Birch's
strategy of rapid local market development insofar as the Company's sales
activity is not constrained by network construction. Moreover, Birch's services
can generally be made available throughout a metropolitan area utilizing leased
transmission facilities rather than at a limited number of locations to which a
provider has built transmission facilities.

OPERATIONS

     Emporia Service Center

         Central to Birch's ability to offer excellent service and support its
growth is its service center in Emporia, Kansas. This service center processes
orders, interfaces with SWBT's operational support systems, provides customer
service, trouble resolution, billing and collection for the Company's customers.
The Emporia service center provides rapid, human assistance, rather than the
automated, cumbersome customer interface currently used by many
telecommunications providers.

     Field Technical Operations

         Birch's field technicians service its owned facilities and
customer-owned facilities. These technicians install, repair and maintain
digital switches, transmission equipment, PBXs, key systems, data equipment and
inside wiring, including wiring for data networking. Field technicians are often
the most respected source of telecommunications advice for small and mid-sized
business customers. Birch believes that having a skilled, in-demand group of
technicians supports Birch's CPE customer base and strengthens customer loyalty.

INFORMATION SYSTEMS

         Birch's proprietary information systems provide integrated customer
service, ordering, provisioning, trouble tracking and billing. The Company
intends to upgrade its existing systems to add capabilities providing for
multi-state management of its local networks, automating the provisioning
process and improving Birch's billing capabilities. These upgrades are being
accomplished through the licensing of industry-leading operations support and
billing systems. Birch personnel are responsible for integrating these modules
with each other and with the Company's existing systems, and for ongoing
management of the systems. The Company also maintains an



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electronic data interface with SWBT and intends to continuously improve this
interface in order to achieve even more efficient provisioning intervals and
customer service response.

REGULATION

     Overview

         Telecommunications services provided by Birch are subject to regulation
by federal, state and local government agencies. At the federal level, the
Federal Communications Commission (FCC) has jurisdiction over interstate and
international services. Interstate services are communications that originate in
one state and terminate in another. Intrastate services are communications that
originate and terminate in a single state. State regulatory commissions (State
Commissions) exercise jurisdiction over intrastate services. Additionally,
municipalities and other local government agencies may regulate limited aspects
of Birch's business, such as use of government-owned rights-of-way, and may
require permits such as zoning approvals and building permits.

     In recent years, the regulation of the telecommunications industry has been
in a state of flux as the United States Congress and various state legislatures
have passed laws seeking to foster greater competition in telecommunications
markets. The FCC and State Commissions have adopted many new rules to implement
this legislation and encourage competition. These changes are incomplete. The
following summary of regulatory developments and legislation does not purport to
describe all present and proposed federal, state and local regulations and
legislation affecting the telecommunications industry. Certain of these and
other existing federal and state regulations are currently the subject of
judicial proceedings, legislative hearings and administrative proposals which
could change, in varying degrees, the manner in which this industry operates.
Neither the outcome of these proceedings, nor their impact upon the
telecommunications industry or Birch can be predicted at this time.

     Removal of Entry Barriers

         Federal law prohibits state and local governments from enforcing any
law, rule or legal requirement that prohibits or has the effect of prohibiting
any entity from providing interstate or intrastate telecommunications services.
This should enable Birch to provide a full range of local telecommunications
services in any state. This also reduces the barriers to entry by other
potential competitors and therefore increases the level of competition Birch
will likely face in all its markets.

     Interconnection with ILEC Facilities

         A CLEC cannot compete effectively with an ILEC in switched local
telephone services unless it is able to connect its facilities with the ILEC and
obtain access to certain essential services and resources under reasonable
rates, terms and conditions. The Telecommunications Act of 1996 (the
Telecommunications Act) imposes a number of access and interconnection
requirements on all local exchange carriers (LECs), including CLECs, with
additional requirements imposed on ILECs. These requirements will provide access
to certain networks under reasonable rates, terms and conditions. Specifically,
all LECs, including the Company, must provide the following:

         -        Telephone Number Portability. Telephone number portability
                  enables a customer to keep the same telephone number when the
                  customer switches LECs.

         -        Dialing Parity. All LECs must provide dialing parity, which
                  means that a customer calling to or from a competing LEC
                  network cannot be required to dial more digits than would be
                  required for a comparable call originating and terminating on
                  the other LEC's network.

         -        Reciprocal Compensation. The duty to provide reciprocal
                  compensation means that a carrier must terminate calls that
                  originate on another carrier's network in exchange for
                  compensation.

         -        Resale. LECs generally may not prohibit or place unreasonable
                  restrictions on the resale of their services by other
                  carriers.

         -        Access to Rights-of-Way. All LECs must provide access to their
                  poles, ducts, conduits and rights-of-way to competing carriers
                  on a reasonable, nondiscriminatory basis.



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         In addition, ILECs must offer local exchange services to resellers at a
wholesale rate that is less than the retail rate charged to end users. State
commissions are charged with determining the size of this discount. ILECs also
must offer access to various unbundled elements of their networks. This
requirement allows new entrants to purchase elements of an ILEC's network, at
cost-based rates, that may be necessary to provide service to a new entrant's
customers. While ILECs are generally required to offer to CLECs interconnection,
including reciprocal compensation for mutual termination of traffic, unbundled
network elements and services that can be resold by CLECs, ILEC-CLEC
interconnection agreements may have short terms, requiring the CLEC to
renegotiate the agreements. ILECs may not provide timely provisioning or
adequate service quality, thereby impairing a CLEC's reputation with customers
who can easily switch back to the ILEC. In addition, the prices set in the
agreements or through State Commissions arbitration proceedings may be subject
to changes mandated by State Commissions as they develop permanent rules
governing interconnection.

         The FCC is charged with establishing national guidelines to implement
certain portions of the Telecommunications Act. The FCC issued its
Interconnection Order on August 8, 1996. In July of 1997, however, the United
States Court of Appeals for the Eighth Circuit issued a decision vacating the
FCC's pricing rules, as well as certain other portions of the FCC's
interconnection rules, on the grounds that the FCC had improperly intruded into
matters reserved for state jurisdiction. On January 25, 1999, the Supreme Court
largely reversed the Eighth Circuit's order, holding that the FCC has general
jurisdiction to implement the local competition provisions of the
Telecommunications Act. The Supreme Court stated that the FCC has authority to
set pricing guidelines for unbundled network elements, to prevent ILECs from
separating existing combinations of network elements, and to establish "pick and
choose" rules regarding interconnection agreements (which would permit a carrier
seeking interconnection to "pick and choose" among the terms of various other
interconnection agreements between the ILECs and other CLECs). This action
reestablishes the validity of many of the FCC rules vacated by the Eighth
Circuit. Although the Supreme Court affirmed the FCC's authority to develop
pricing guidelines, the Supreme Court did not evaluate the specific pricing
methodology adopted by the FCC and has remanded the case to the Eighth Circuit
for further consideration. In addition, the Supreme Court concluded that it was
proper for the FCC to conclude that unbundled network elements could include not
only physical facilities such as transmission lines, but also services such as
directory assistance, operator services, and vertical switching functions such
as caller ID, call waiting, and call forwarding. However, it also vacated the
FCC's rule that identifies the unbundled network elements that ILECs must
provide to CLECs because the FCC had failed to consider which of those unbundled
network elements were "necessary" for the CLEC or would "impair" the ability of
the CLEC to provide the services it seeks to offer. The FCC is expected to
reconsider the statutory criteria for requiring ILECs to make those network
elements available to CLECs during 1999. Thus, while the Supreme Court resolved
many issues, including the FCC's jurisdictional authority, other issues remain
subject to further consideration by the courts and the FCC, and the Company
cannot predict the ultimate disposition of those matters. The possible impact of
this decision, including the portion dealing with unbundled network elements, on
existing interconnection agreements between ILECs and CLECs or on agreements
that may be negotiated in the future, cannot be determined at this time.

         In June 1997, SWBT notified Birch and other CLECs in SWBT's service
territory that it would not pay or collect reciprocal compensation under
interconnection agreements for traffic terminated at an Internet service
provider (ISP). On December 31, 1997, Birch filed a petition with the Missouri
Public Service Commission to arbitrate the terms of an interconnection agreement
between Birch and SWBT. In its pleading, Birch claimed, among other things, that
ISP traffic is local in nature, and that the rate of reciprocal compensation
payments for traffic to an ISP should be the same as the rate for other local
calls. On April 23, 1998, the Missouri Public Service Commission ordered the
parties, pending final resolution of these issues by the FCC, to compensate each
other for ISP traffic at the same rate as is applicable to other local calls. On
February 25, 1999, the FCC (1) adopted an order concluding that dial-up traffic
to ISPs is jurisdictionally mixed and appears to be primarily interstate in
nature, but that parties are bound by existing interconnection agreements, as
interpreted by State Commissions, and thus are subject to reciprocal
compensation obligations to the extent provided by such agreements or as
determined by State Commissions, and (2) issued a notice or proposed rulemaking
to determine the appropriate compensation arrangements in the future for this
type of traffic. If a decision adverse to Birch is issued on any appeal or
review of the order of the Missouri Public Service Commission, or a future rule
of the FCC eliminates or changes the compensation for ISP traffic, then the
ability of Birch to serve existing and future ISP customers profitably would be
limited, which could have a material adverse effect on Birch's business,
operating results and financial condition.



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     Birch Interconnection Agreements

         Birch has entered into interconnection agreements with SWBT covering
Missouri, Kansas and Texas, each of which provides (1) the right to purchase
SWBT's local telecommunications services at state-specific wholesale discount
percentages (19.2% in Missouri, 21.6% in Kansas, and 21.6% in Texas, in
general), and (2) comprehensive terms covering collocation, interconnection,
exchange of traffic between the Birch and SWBT networks, access to rights of
way, number portability, and Birch's purchase of unbundled network elements from
SWBT for transmission facilities to Birch's customers. On March 16, 1999, SWBT
provided notice to Birch of its intention to terminate the Missouri and Texas
interconnection agreements at the expiration of their terms (May 21, 1999 and
January 22, 2000, respectively), and to negotiate the terms and conditions of
successor interconnection agreements. Notwithstanding the notice of termination,
each of the Missouri and Texas interconnection agreements provides that they
will remain in effect until a replacement agreement has been negotiated by the
parties, arbitrated (if necessary to resolve any disputed issues), and approved
by the Missouri Public Service Commission or Texas Public Utilities Commission
respectively.

     SWBT Entry into Long-Distance Service

         Birch's principal competitor in each of its markets is SWBT. Section
271 of the Telecommunications Act establishes procedures under which a Bell
Operating Company (BOC), like SWBT, can provide services originating from (and
in certain cases, terminating in) its telephone exchange service area
("in-region" interLATA service). SWBT is currently permitted to provide
interLATA services to customers outside of its telephone exchange service areas
("out-of-region" interLATA service), and other "incidental" interLATA service.
Before SWBT can provide non-incidental in-region interLATA service, it must
offer interconnection on terms approved by the State Commission and receive
approval from the FCC, with input from the U.S. Department of Justice and State
Commissions. The interconnection offered by SWBT must comply with a "competitive
checklist" that incorporates the interconnection requirements discussed above,
as well as other requirements. SWBT sought authority pursuant to Section 271 to
enter the in-region interLATA market in Oklahoma, and this application was
denied by the FCC on June 26, 1997. SWBT has filed notices with the Missouri
Public Service Commission, Kansas Corporation Commission and Texas Public
Utilities Commission of its intention to file Section 271 applications with the
FCC in the future, but has no other Section 271 applications pending before the
FCC at this time. The Texas Public Utilities Commission and Kansas Corporation
Commission concluded that SWBT had not yet met the requirements of the
competitive checklist in their respective states. The Missouri Public Service
Commission held hearings on SWBT's Section 271 filing in March 1999 and is
expected to conclude in the near future whether it believes SWBT has met the
requirements of the competition checklist in Missouri.

         After receiving approval from the FCC as described above, SWBT will be
able to provide in-region interLATA services, which will enable it to provide
customers with a full range of local and long distance telecommunications
services. The provision of interLATA services by SWBT is expected to reduce the
market share of the major IXCs, which may be significant customers of Birch's
services. Consequently, the entry of the BOCs into the long distance market may
have adverse consequences on the ability of CLECs both to generate access
revenue from the IXCs and to compete in offering a package of local and long
distance services. No BOC has yet won FCC approval to enter the interLATA
market, but industry analysts believe approval for the first such entry could
occur as early as the fourth quarter of 1998.

     Relaxation of Regulation

         A long-term goal of the Telecommunications Act is to increase
competition for telecommunications services, thereby reducing the need for
regulation of these services. To this end, the Telecommunications Act requires
the FCC to streamline its regulation of ILECs and permits the FCC to forbear
from regulating particular classes of telecommunications services or providers.
Because Birch is considered a non-dominant carrier and, therefore, is not
heavily regulated by the FCC, the potential for regulatory forbearance likely
will be more beneficial to the ILECs than Birch in the long run.



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<PAGE>   9

     Federal Regulation Generally

         Comprehensive amendments to the Communications Act were made by the
Telecommunications Act, which was signed into law on February 8, 1996. The
Telecommunications Act changed regulation at both the federal and state levels
that affect virtually every segment of the telecommunications industry. The
stated purpose of the Telecommunications Act is to promote competition in all
areas of telecommunications. Through a series of proceedings, the FCC has
established different levels of regulation for "dominant carriers" and
"non-dominant carriers." Only ILECs are classified as dominant; all other
providers of domestic interstate services are classified as non-dominant
carriers. As a non-dominant carrier, Birch is subject to relatively limited
regulation by the FCC. Birch may offer domestic interstate service without prior
FCC approval. Birch must offer interstate services at just and reasonable rates
in a manner that is not unreasonably discriminatory.

         The FCC has adopted rules requiring ILECs to provide "collocation" to
CLECs for the purpose of interconnecting their competing networks. Under the
rules adopted by the FCC, ILECs are required to provide either physical
collocation or virtual collocation at their switching offices.

         As discussed earlier, all LECs, including CLECs, must make their
services available for resale by other carriers, provide nondiscriminatory
access to rights-of-way, offer reciprocal compensation for termination of
traffic and provide dialing parity and telephone number portability. ILECs must
offer "equal access" to competing IXCs, making it easier for new IXCs to attract
customers. The Telecommunications Act requires all telecommunications carriers
to contribute to the universal service mechanism established by the FCC and to
ensure that their services are accessible to and usable by persons with
disabilities. Moreover, the FCC is currently engaged in a number of rulemakings
in which it is considering regulatory implications of various aspects of local
exchange competition. Any or all of these proceedings may negatively affect
CLECs, including Birch.

         The FCC could grant ILECs substantial pricing flexibility with regard
to interstate access services. The May 21, 1997 order reforming the FCC's price
cap formula affords LECs greater flexibility in establishing rates and provides
additional incentives to foster efficiency. To the extent these regulatory
initiatives enable or require ILECs to offer selectively reduced rates for
access services, the rates Birch may charge for access services will likely be
constrained by competitive pressures. Birch's rates also will likely be
constrained by the fact that competitors other than the ILECs are subject to the
same streamlined regulatory regime as Birch and can price their services to meet
competition.

         States who have ruled on the issue treat traffic to ISPs terminated in
the local exchange as local calls, for which end user customers normally pay
fixed monthly charges or low per minute rates up to a cap. ILECs contend that
traffic routed to ISPs is interstate in nature and the charge for such calls
should be charged at a different rate. As discussed above, on February 25, 1999,
the FCC concluded that parties are bound by existing interconnection agreements,
as interpreted by State Commissions, and thus are subject to reciprocal
compensation obligations to the extent provided by such agreements or as
determined by State Commissions, but issued a notice or proposed rulemaking to
determine the appropriate compensation arrangements in the future for this type
of traffic. Therefore, in the future CLECs might no longer receive the benefit
of substantial reciprocal compensation call-termination revenue for CLEC ISP
customers.

         Federal law also protects the privacy of certain information about
telecommunications customers that a carrier such as Birch acquires by virtue of
its provision of telecommunications services to such customers. Protected
information, known as Customer Proprietary Network Information (CPNI), includes
information related to the quantity, technological configuration, type,
destination and the amount of use of a telecommunications service. A carrier may
not use the CPNI acquired through one of its service offerings to market certain
other service offerings without the approval of the affected customers. These
restrictions may affect Birch's ability to market a variety of packaged services
to existing customers.

     State Regulation Generally

         Most State Commissions require companies that wish to provide
intrastate common carrier services to register or be certified to provide such
services. These certifications generally require a showing that the carrier has



                                      -9-
<PAGE>   10

adequate financial, managerial and technical resources to offer the proposed
services in a manner consistent with the public interest. States also impose a
variety of other requirements, including service quality, universal service and
other obligations on CLECs.

         Several states, including Missouri, Kansas and Texas, provide ILECs
with flexibility for their rates, special contracts (selective discounting) and
tariffs, particularly for services deemed subject to competition. This pricing
flexibility increases the ability of SWBT and other ILECs to compete with Birch
and constrains the rates Birch may charge for its services. In light of the
additional competition that is expected to result from the Telecommunications
Act, states may grant ILECs additional pricing flexibility. At the same time,
some ILECs may request increases in local exchange rates to offset revenue
losses due to competition.

         Birch is currently certified by the Missouri Public Service Commission,
the Kansas Corporation Commission, and the Texas Public Utilities Commission to
provide both local and long distance service in Missouri, Kansas and Texas.

     Local Regulation Generally

         If Birch desires to install its own transmission facilities, Birch may
be required, in certain cities, to obtain from municipal authorities zoning
variances, street opening and construction permits, permission to use rights-
of-way, and other approvals. Birch also may be required to obtain a franchise to
place facilities in public rights of way. In some areas, Birch may be required
to pay license or franchise fees for such approvals. There can be no assurances
that fees will remain at current levels, or that Birch's competitors will face
the same expenses, although the Telecommunications Act does require that any
such fees charged by municipalities be reasonable and non-discriminatory as
among telecommunications carriers.

COMPETITION

         The telecommunications industry is highly competitive. The Company
believes that the principal competitive factors affecting its business are
customer service, accurate billing, variety of services, and, to a lesser
extent, pricing levels and clear pricing policies. The ability of the Company to
compete effectively depends upon its continued ability to maintain high quality,
market-driven services at prices generally equal to or below those charged by
its competitors. To maintain its competitive posture, the Company believes that
it must be in a position to reduce its prices in order to meet reductions in
rates, if any, by others. Any such reductions could adversely affect the
Company. Many of the Company's current and potential competitors have financial,
personnel and other resources, including brand name recognition, substantially
greater than those of the Company, as well as other competitive advantages over
the Company.

     Incumbent Local Exchange Carriers

         In its existing markets, Birch competes principally with SWBT. As a
recent entrant in the telecommunications services industry, Birch has not
achieved and does not expect to achieve a significant market share for any of
its services in its larger markets. In particular, SWBT and other local
telephone companies have long-standing relationships with their customers, have
financial, technical and marketing resources substantially greater than those of
the Company, have the potential to subsidize competitive services with revenue
from a variety of businesses and currently benefit from certain existing
regulations that favor these ILECs over Birch in certain respects. While recent
regulatory initiatives, which allow CLECs such as the Company to interconnect
with ILEC facilities, provide increased business opportunities for Birch, such
interconnection opportunities have been (and likely will continue to be)
accompanied by increased pricing flexibility for and relaxation of regulatory
oversight of the ILECs. Future regulatory decisions could afford ILECs with
increased pricing flexibility or other regulatory relief and, such decisions
could also have a material adverse effect on the Company.

     CLECs/IXCs/Other Market Entrants

         The Company also faces, and expects to continue to face, competition
from other current and potential market entrants, including long distance
carriers competing with Birch's long distance services and seeking to enter,




                                      -10-
<PAGE>   11

reenter or expand entry into the local exchange market such as AT&T, MCI
WorldCom, GTE and Sprint. Competition also comes from other CLECs, resellers of
local exchange services, competitive access providers (CAPs), cable television
companies, electric utilities, microwave carriers, wireless telephone system
operators and private networks built by large end users. In addition, a
continuing trend toward consolidation and strategic alliances of
telecommunications companies, as well as the development of new technologies,
could give rise to significant new competitors to the Company, putting Birch at
a competitive disadvantage. The Telecommunications Act includes provisions which
impose certain regulatory requirements on all LECs, including the Company, while
granting the FCC expanded authority to reduce the level of regulation applicable
to any or all telecommunications carriers, including ILECs. The manner in which
these provisions of the Telecommunications Act are implemented and enforced
could have a material adverse effect on the Company's ability to compete
successfully against ILECs and other telecommunications service providers

         The changes in the Telecommunications Act radically altered the market
opportunity for traditional CAPs and CLECs. Due to the fact that most existing
CAP/CLECs initially entered the market providing dedicated access in the
pre-1996 era, these companies had to build a fiber infrastructure before
offering services. Since passage of the Telecommunications Act, many CAPs have
added switches to become CLECs to take advantage of the opening of the local
market. With the Telecommunications Act requiring unbundling of the LEC
networks, CAP/CLECs will now be able to more rapidly enter the market by
installing switches and leasing trunk and loop capacity until traffic volume
justifies building facilities. Newer CLECs, like the Company and some
competitors that Birch may encounter in some of its markets, will not have to
replicate existing facilities and can be more opportunistic in designing and
implementing networks.

         In addition to the CLECs, IXCs and other competitors listed above, the
Company may face competition from other market entrants such as electric
utilities, cable television companies and wireless companies. Electric utilities
have existing assets and low cost access to capital which could allow them to
enter a market rapidly and accelerate network development. Cable television
companies are also entering the telecommunications market. Some cable television
companies are upgrading their networks with fiber optics and installing
facilities to provide fully interactive transmission of broadband voice, video
and data communications. Some cable companies are attempting to offer Internet
access and local telephone service over hybrid fiber-coaxial cable systems.
Finally, wireless companies have announced intentions to develop wireless
technology to be deployed in the United States as a broadband substitute for
traditional wireline local telephones.

     Long Distance Services

         The long distance telecommunications industry has numerous entities
competing for the same customers and a high average churn rate, as customers
frequently change long distance providers in response to the offering of lower
rates or promotional incentives by competitors. Prices in the long distance
market have declined significantly in recent years and are expected to continue
to decline. Birch's primary competitors are the major IXCs and resellers of long
distance services. The Company believes that pricing levels are a principal
competitive factor in providing long distance service; however Birch seeks to
avoid direct price competition by packaging long distance service, local
service, CPE and Internet access service together with a simple pricing plan.

     CPE

         The Company competes with numerous equipment vendors and installers,
and telecommunications management companies with respect to CPE sales and
related services. Birch generally offers its products at prices consistent with
other providers and differentiates its service through its product packages.

     Data/Internet Services Providers

         The Internet services market is highly competitive, and the Company
expects that competition will continue to intensify. Internet service, both
Internet access and on-line content services, is provided by ISPs,
satellite-based companies, long-distance carriers and cable television
companies. Many of these companies provide businesses and individuals with
direct access to the Internet and a variety of supporting services. In addition,
many companies (such as America Online, Inc., MSN, Prodigy Services Company and
WebTV Networks) offer "online" services consisting



                                      -11-
<PAGE>   12

of access to closed, proprietary information networks with services similar to
those available on the Internet, in addition to direct access to the Internet.
Long distance companies, for example, are aggressively entering the Internet
access markets. Long distance carriers have substantial transmission
capabilities, traditionally carry data to large numbers of customers and have an
established billing system infrastructure that permits them to add new services.
Satellite companies are offering broadband access to the Internet from desktop
PCs and cable companies are starting to provide Internet services using cable
modems to customers in major markets. Many of these competitors have
substantially greater financial, technological, marketing, personnel and other
resources than those available to Birch.

EMPLOYEES

         At December 31, 1998, the Company employed approximately 345 persons.
Additionally, the Company utilizes temporary employees in some of its processes.
The Company is not party to any collective bargaining arrangements. The Company
believes that its relationship with its employees is satisfactory.

RISK FACTORS

         This 10-K includes "forward looking statements" within the meaning of 
Section 27A of the Securities Act and Section 21E of the Exchange Act. Although
Birch believes that its plans, intentions and expectations reflected in such
forward looking statements are reasonable, it can give no assurance that such
plans, intentions or expectations will be achieved. Important factors that could
cause actual results to differ materially from Birch's forward looking
statements are set forth below and elsewhere in this Form 10-K. All forward
looking statements attributable to Birch or persons acting on its behalf are
expressly qualified in their entirety by the cautionary statements set forth
below.

   Substantial Future Operating Losses; Negative Cash Flow From Operations

         The expansion of Birch's business and the deployment of its services
and systems will require significant capital expenditures, a substantial portion
of which will need to be incurred before the realization of significant revenue.
Birch expects to generate negative earnings before interest, income taxes,
depreciation and amortization (EBITDA) while it emphasizes deployment of its
switches and further development of its telecommunications services business and
until it establishes a sufficient revenue-generating customer base. There can be
no assurance that an adequate revenue base will be established. For the year
ended December 31, 1998, the Company had an operating loss of $10.9 million, net
loss of $16.2 million and EBITDA loss of $8.6 million. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations." Birch
expects to experience increasing operating losses and negative EBITDA as it
expands its operations. There can be no assurance that Birch will achieve or
sustain profitability or generate sufficient EBITDA to meet its working capital,
capital expenditures and debt service requirements, which could have a material
adverse effect on Birch's business, operating results and financial condition
and its ability to achieve sufficient cash flow to service the Notes. See 
"-- Substantial Leverage; Ability to Service Indebtedness;" "-- Need for 
Additional Financing" and "Management's Discussion and Analysis of Financial 
Condition and Results of Operations -- Liquidity and Capital Resources."

SUBSTANTIAL LEVERAGE; ABILITY TO SERVICE INDEBTEDNESS

         The Company is highly leveraged. At December 31, 1998 Birch had total
long term indebtedness of approximately $115.8 million (most of which consisted
of the Senior Notes) and total stockholders' deficit (excluding $14.1 million in
aggregate liquidation preference of Series B Preferred Stock) of approximately
$7.1 million. For the years ended December 31, 1997 and 1998, earnings were
insufficient to cover fixed charges by approximately $1.8 million and $16.2
million, respectively. The Company and its subsidiaries are permitted to incur
substantial additional indebtedness in the future.

         The ability of the Company to fund the capital expenditures and other
costs contemplated by its business plan and to make scheduled payments with
respect to the Senior Notes will depend upon, among other things, its ability to
seek and obtain additional financing within the next year, to implement its
business plan, to deploy its network and expand its operations, and to obtain
and retain a significant number of customers in its target markets,



                                      -12-
<PAGE>   13

and the future operating performance of Birch and its subsidiaries. Each of
these factors is, to a large extent, subject to economic, financial,
competitive, political, regulatory and other factors, many of which are beyond
Birch's control. Birch expects that it will generate operating losses for the
foreseeable future and that its business will not generate positive cash flow
for the foreseeable future. In addition, the Company will require significant
amounts of additional financing, which may not be available, before it will be
able to generate positive cash flow. No assurance can be given that Birch will
be successful in developing and maintaining a level of cash flow from operations
sufficient to permit it to pay the principal of, and interest and any other
payments, if any, on the Senior Notes. If Birch is unable to generate sufficient
cash flow from operations to service its indebtedness, including the Senior
Notes, it may have to modify its growth plans, limit its capital expenditures,
restructure or refinance its indebtedness, seek additional capital or liquidate
its assets. There can be no assurance (i) that any of these strategies could be
effected on satisfactory terms, if at all, in light of Birch's high leverage or
(ii) that any such strategy would yield sufficient proceeds to service the
Senior Notes. Any failure by Birch to satisfy its obligations with respect to
the Senior Notes at maturity or prior thereto would constitute a default under
the agreements governing the Senior Notes (Indenture) and could cause a default
under agreements governing other indebtedness of Birch. See "-- Limited History
of Operations as a Combined Organization," "-- Need for Additional Financing"
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."

         The degree to which Birch is leveraged could have important
consequences to holders of the Senior Notes, including (i) making it more
difficult for Birch to satisfy its obligations with respect to the Senior Notes;
(ii) increasing Birch's vulnerability to general adverse economic and industry
conditions; (iii) limiting Birch's ability to obtain additional financing to
fund its expected capital expenditures for the next two years, future working
capital (including anticipated future operating losses), or other general
corporate requirements; (iv) requiring the dedication of a substantial portion
of Birch's cash flow from operations (if any) to the payment of principal of,
and interest on, its indebtedness, thereby reducing the availability of such
cash flow to fund working capital, capital expenditures or other general
corporate purposes; (v) limiting Birch's flexibility in planning for, or
reacting to, changes in its business and the telecommunications industry; (vi)
limiting Birch's ability to expand into new markets; and (vii) placing Birch at
a competitive disadvantage relative to less leveraged competitors. In addition,
Birch's operating and financial flexibility will be limited by covenants
contained in agreements governing the indebtedness of Birch, including the
Indenture. Among other things, the covenants in the Indenture limit, and
covenants in agreements governing other indebtedness will likely limit, the
ability of Birch and its subsidiaries to incur additional indebtedness, issue
preferred stock, pay dividends or make distributions to its stockholders or to
make certain other restricted payments, create certain liens upon assets, apply
the proceeds from the disposition of certain assets or enter into certain
transactions with affiliates. There can be no assurance that such covenants will
not adversely affect Birch's ability to finance its future operations or capital
needs or to engage in other business activities which may be in the interests of
Birch.

         The Company currently anticipates that, in order to pay the principal
of the Senior Notes or to redeem or repurchase the Senior Notes upon a change of
control, Birch may be required to adopt one or more alternatives, such as
refinancing its indebtedness or selling its equity securities or the equity
securities or assets of its subsidiaries. There can be no assurance that any of
the foregoing actions could be effected on satisfactory terms, that any of the
foregoing actions would enable the Company to pay the principal amount of the
Senior Notes or that any of such actions would be permitted by the terms of the
Indenture or any of the debt instruments of Birch or Birch's subsidiaries then
in effect.

NEED FOR ADDITIONAL FINANCING

         Birch expects to make significant capital outlays for the foreseeable
future in order to continue the development activities called for in its current
business plan and thereafter and to fund expected operating losses. In order for
the Company to implement its current business plan and finance its projected
capital expenditures, Birch will be required to seek and obtain significant
amounts of additional financing (debt and/or equity) within the next year. The
Company's ongoing expansion into Texas is dependent upon raising substantial
additional financing in the near term. If Birch's plans or assumptions change,
if its assumptions prove to be inaccurate, or if it experiences unanticipated
costs or competitive pressures, Birch will be required to seek additional
capital sooner than currently anticipated, possibly within the next six months.
In particular, if Birch elects to pursue significant additional acquisition
opportunities or to deploy more switches than currently planned, its cash needs
may be increased



                                      -13-
<PAGE>   14

substantially. There can be no assurance that Birch's current projection of cash
flow (and losses) from operations (which will depend upon numerous future
factors and conditions, many of which are outside of Birch's control) will be
accurate. Because Birch's cost of developing new networks and services, funding
other strategic initiatives and operating its business will depend on a variety
of factors (including the number of subscribers and the service for which they
subscribe, the nature and penetration of services that may be offered by Birch,
regulatory changes, changes in technology and actions taken by competitors in
response to Birch's strategic initiatives), it is almost certain that actual
costs and revenue will vary from expected amounts, very likely to a material
degree, and such variations are likely to affect Birch's future capital
requirements. Birch intends to seek additional debt and/or equity financing
necessary to fund Birch's liquidity needs. There can be no assurance that Birch
will be able to raise additional capital on satisfactory terms or at all. If
Birch decides to raise additional funds through the incurrence of debt, its
interest obligations will increase and it may become subject to additional or
more restrictive financial covenants. For example, Birch's ability to access the
cash flow of its subsidiaries may be restricted by such future debt covenants.
If Birch decides to raise additional funds through the issuance of equity,
equity holders will be diluted. In the event that Birch is unable to obtain such
additional capital or to obtain it on acceptable terms or in sufficient amounts,
Birch will be required to delay the development of its network or take other
actions that could have a material adverse effect on Birch's business, operating
results and financial condition and its ability to achieve sufficient cash flow.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."

LIMITED HISTORY OF OPERATIONS AS A COMBINED ORGANIZATION

         Birch commenced operations on January 1, 1997 and merged with Valu-Line
in February 1998. Prior to the merger, Birch had been a development stage
company with no revenue. While Valu-Line has a 15-year operating history, it
only has been under the guidance of Birch management for about one year.
Additionally, in 1998, Birch acquired Boulevard, Telesource and TFSnet, and in
1999, Capital and ALT. Prospective investors, therefore, have limited financial
or operating information about Birch as a combined organization. Birch's
viability, profitability and growth depend upon its ability to successfully
integrate its acquired companies. The implementation of Birch's business plan
will be subject to numerous risks, many of which are outside of its control and
any of which could require substantial changes to proposed plans or otherwise
alter the time frames or budgets currently contemplated. Such risks include (i)
risks related to the integration of Birch's acquired companies into a cohesive
and efficient enterprise; (ii) the risks of unfavorable regulatory changes;
(iii) the need to obtain required governmental and local regulatory approvals;
(iv) the need to negotiate acceptable purchase, lease, joint venture and other
agreements, including interconnection agreements with SWBT, other ILECs and long
distance service providers; (v) identifying, financing and completing suitable
acquisitions; (vi) risks associated with developing its operational support and
back office systems; (vii) risks associated with entry into new markets; (viii)
risks associated with recruiting and training new employees; and (ix) risks
typically associated with any business venture, such as unanticipated cost
increases. There can be no assurance that the implementation of Birch's current
business plan will be successful, and the failure to integrate Birch's acquired
companies successfully would have a material adverse effect on Birch's business,
operating results and financial condition.

RISKS ASSOCIATED WITH ACQUISITIONS

         Birch's current business plan contemplates future acquisitions and may
result in acquisitions of companies that are larger than Birch. Future
acquisitions by Birch could result in the incurrence of debt or contingent
liabilities, which could have a material adverse effect on Birch's business,
financial condition and results of operations. Such transactions commonly
involve certain risks, including, among others: the difficulty of assimilating
the acquired operations and personnel; the potential disruption of Birch's
ongoing business and diversion of resources and management time; the possible
inability of management to maintain uniform standards, controls, procedures and
policies; the risks of entering markets in which Birch has little or no direct
prior experience; and the potential impairment of relationships with employees
or customers as a result of changes in management. There can be no assurance
that any future acquisition will be made, that Birch will be able to obtain
additional financing needed to finance such acquisitions and, if any
acquisitions are so made, that the acquired business will be successfully
integrated into Birch's operations or that the acquired business will perform as
expected. The failure to integrate any such future acquisition successfully
would have a material adverse effect on Birch's business, operating results and
financial condition and its ability to achieve sufficient cash flow.



                                      -14-
<PAGE>   15

BUSINESS EXPANSION RISKS; POSSIBLE INABILITY TO MANAGE GROWTH

         Birch's business strategy contemplates expanding its operations rapidly
into new markets. Birch's success will depend, among other things, upon Birch's
ability to secure significant amounts of additional financing, assess potential
markets, obtain required governmental authorizations and permits, provision new
customers, implement interconnection and collocation with ILEC facilities, lease
adequate trunking capacity from ILECs or other CLECs, purchase and install
switches in additional markets, implement efficient operations support systems
and other back office systems, and develop a sufficient customer base. The
successful implementation of Birch's business plan will result in rapid
expansion of its operations. Rapid expansion of Birch's operations may place a
significant strain on Birch's management, financial and other resources. See 
"-- Need for Additional Financing."

         The Company's ability to manage future growth, should it occur, will
depend upon its ability to develop efficient operations support systems and
other back office systems, monitor operations, control costs, maintain
regulatory compliance, maintain effective quality controls and significantly
expand Birch's internal management, technical, information and accounting
systems and to attract, assimilate, train and retain additional qualified
personnel, including sales, marketing and technical personnel. See 
"-- Dependence on New Employees." Failure of Birch to manage its future growth
effectively could adversely affect the expansion of Birch's customer base and
service offerings. There can be no assurance that the Company will successfully
implement and maintain such operational and financial systems or successfully
obtain, integrate and utilize the employees and management, operational and
financial resources necessary to manage a developing and expanding business in
an evolving, highly regulated and increasingly competitive industry. Any failure
to expand these areas and to implement and improve such systems, procedures and
controls in an efficient manner at a pace consistent with the growth of Birch's
business could have a material adverse effect on Birch's business, operating
results and financial condition and its ability to achieve sufficient cash flow.

         If Birch were unable to hire sufficient qualified personnel or develop,
acquire and integrate successfully its operational, customer service and other
information systems, customers could experience delays in connection of service
and/or lower levels of customer service. Failure by Birch to meet the demands of
customers and to manage the expansion of its business and operations could have
a material adverse effect on Birch's business, operating results and financial
condition and its ability to achieve sufficient cash flow.

REGULATION

         Birch is subject to, and benefits from, varying degrees of federal,
state, and local regulation of its business and the businesses of its
competitors. On the federal level, Birch is not currently subject to rate
regulation, nor is it currently required to obtain FCC authorization for the
installation, acquisition, or operation of its network facilities. Birch's
subsidiaries that provide intrastate services are generally subject to
certification and tariff-filing requirements by state regulators. In addition,
Birch must comply with various state and federal obligations, such as the duty
to contribute to universal service subsidies, the impact of which cannot yet be
fully assessed. Failure to comply with federal and state reporting and
regulatory requirements may result in fines or other penalties, including loss
of certification to provide services.

         The Telecommunications Act, state laws, the rules of the FCC and State
Commissions may provide ILECs with increased pricing flexibility for their
services and other regulatory relief, which could have a material adverse effect
on CLECs, including Birch. There can be no assurance that future regulatory
provisions will not be less favorable to CLECs and more favorable to their
competitors. If ILECs like SWBT are allowed by regulators to lower the rates for
their services, to engage in substantial volume and term discount pricing
practices for their customers, or to charge CLECs unreasonable fees for
interconnection to the ILECs' networks, Birch's business, operating results and
financial condition could be materially adversely affected. ILECs may also seek
to delay competitors through legal or regulatory challenges, or by recalcitrant
responses to requirements that they open their markets through interconnection
and unbundling of network elements. For example, SWBT has refused to pay
reciprocal compensation to Birch for calls to Internet Service Providers (ISPs).
See "Business -- Regulation -- Interconnection with ILEC Facilities." Increased
local exchange competition resulting from various legislative initiatives,
including the Telecommunications Act, may allow Bell Operating Companies (BOCs)
such as SWBT to provide long distance services under provisions of the
Telecommunications Act more quickly than had earlier been



                                      -15-
<PAGE>   16

anticipated. When SWBT is permitted to provide such services, it will be in a
position to offer integrated local and long distance service, subject to certain
regulatory constraints, and Birch will no longer enjoy the competitive advantage
of being one of the only companies in its markets to offer integrated local and
long distance service and billing. See "Business -- Regulation -- SWBT Entry
into Long-Distance Service."

         There are currently many regulatory actions under way and being
contemplated by federal and state authorities regarding interconnection pricing
and other issues that could result in significant changes to the business
conditions in the telecommunications industry. State Commissions determine the
size of the wholesale discount at which ILECs must offer local exchange services
to resellers. Prices set forth in interconnection agreements or through
proceedings before State Commissions may be subject to changes mandated by State
Commissions as they develop permanent rules governing interconnection. No
assurance can be given that changes in current or future regulations adopted by
the FCC or state regulators, or other legislative, administrative, or judicial
initiatives relating to the telecommunications industry, would not have a
material adverse effect on Birch's business, operating results and financial
condition. In particular, Birch's belief that the entire local exchange market
will open to CLEC competition depends upon continued favorable pro-competitive
regulatory changes, and the ability of Birch to compete in these new market
segments may be adversely affected by the greater pricing flexibility and other
regulatory relief granted to ILECs under the Telecommunications Act and under
changes in state regulatory policy. See "Business -- Regulation."

COMPETITION

         The telecommunications industry is highly competitive. Birch expects it
will face substantial and increasing competition from a variety of service
providers due to regulatory changes and a trend toward business combinations and
alliances in the market. Birch faces competition from integrated service
providers as well as entities that serve individual market segments targeted by
Birch. In each of the cities served by Birch's networks, the services offered by
Birch compete principally with the services offered by the ILEC serving that
area. ILECs, like SWBT, have established networks, long-standing relationships
with their customers, strong political and regulatory influence, the potential
to subsidize competitive services from monopoly service revenue, and the benefit
of state and federal regulations that, until recently, have favored ILECs. In
the local exchange market, the ILECs continue to hold near-monopoly positions.
Other ILECs are already offering in-region long distance services.

         Birch also expects to face competition from other current and potential
market entrants, including other CLECs, IXCs, cable television companies,
electric utilities, microwave carriers, wireless telephone system operators, and
private networks built by large end users. The Telecommunications Act
facilitates such entry by requiring ILECs to allow new entrants to acquire local
services at wholesale prices for resale and to purchase unbundled network
elements at cost-based prices. A continuing trend toward combinations and
strategic alliances in the telecommunications industry, including potential
consolidation among ILECs, or among CLECs in smaller markets, or transactions
between telephone companies and cable companies, or between IXCs and CLECs,
could give rise to significant new competitors. Many of Birch's current and
potential competitors have financial, personnel, and other resources, including
broad name recognition, substantially greater than those of Birch, as well as
other competitive advantages over Birch.

         The World Trade Organization (WTO) agreement on basic
telecommunications services could increase the level of competition faced by
Birch. Under this agreement, the United States and 68 other members of the WTO
committed themselves to opening their respective telecommunications markets,
including permitting foreign entry into basic telecommunications services
markets and adopting regulatory measures to protect competitors against
anticompetitive behavior by dominant telecommunications companies, effective in
some cases as early as January 1998. The FCC has introduced streamlined
processing of applications to facilitate entry into the U.S. market by entities
of WTO-member origin. There can be no assurance that the pro-competitive effects
of the WTO agreement will not have a material adverse effect on Birch's
business, operating results and financial condition and its ability to achieve
sufficient cash flow to service the Senior Notes.

         Birch currently purchases all of its resold local services from SWBT
and is therefore heavily dependent on the availability of the network of SWBT.
To the extent Birch interconnects with and uses the networks of other ILECs,
CLECs, and fiber optic transport providers to service its customers, Birch is
and will be dependent upon the



                                      -16-
<PAGE>   17

technology and capabilities of those carriers to meet certain telecommunications
needs of Birch's customers and to maintain its service standards. Birch must
interface with the ILEC's operations support systems in order to properly
provision new customers. There can be no assurance that Birch will be able to
obtain the interconnection it requires at rates and on terms and conditions that
permit Birch to offer switched services that are both competitive and
profitable. See "-- Reliance on Leased Transport Facilities and ILEC
Interconnection; Relationship with SWBT." In the event that Birch experiences
difficulties in obtaining high quality, reliable and reasonably priced services
from SWBT and other carriers, the attractiveness of Birch's services to its
customers would be significantly impaired.

         The long distance telecommunications market has numerous entities
competing for the same customers and a high average churn rate, as customers
frequently change long distance providers in response to the offering of lower
rates or promotional incentives. Prices in the long distance market have
declined significantly in recent years and are expected to continue to decline.
The Company will face competition from large carriers such as AT&T, MCI WorldCom
and Sprint. Other competitors are likely to include BOCs providing out-of-
region (and, with the removal of regulatory barriers, in-region) long distance
services, other ILECs, other CLECs, microwave and satellite carriers and private
networks owned by large end users. See "-- Regulation."

         The FCC may authorize a BOC to provide interLATA (Local Access and
Transport Area) services in a state when the BOC satisfies 14 specified
interconnection requirements and receives approval from the FCC. In evaluating a
BOC application for interLATA entry, the FCC must consult with the U.S.
Department of Justice and the state regulatory commission. If and when SWBT
obtains authority to provide interLATA services in a state, it will be able to
offer customers local and long distance telephone services. This will permit
SWBT to offer a full range of services to potential customers in that state and
thus eliminate an existing competitive advantage of Birch. Given the resources
and experience that SWBT currently possess in the local exchange market, the
ability to provide both local and long distance services could make SWBT a very
strong competitor. See "Business -- Regulation -- SWBT Entry into Long-Distance
Service."

         The Company competes with equipment vendors and installers, and
telecommunications management companies with respect to certain portions of its
business.

         The Internet services market is also highly competitive and the Company
expects that competition will continue to intensify. Birch's competitors in this
market will include other Internet service providers, other telecommunications
companies, on-line services providers and Internet software providers. Many of
these competitors have substantially greater financial, technological,
marketing, personnel and other resources than those available to Birch.

         The Company believes that the principal competitive factors affecting
its business operations are service quality, network reliability, reliable
customer service, accurate billing and variety of services, to a lesser extent,
pricing levels and clear pricing policies. The ability of Birch to compete
effectively will depend upon its ability to maintain high quality, market-driven
services at prices generally equal to or below those charged by its competitors.
To maintain its competitive posture, the Company believes that it must be in a
position to reduce its prices in order to meet reductions in rates, if any,
offered by others. Any such reductions could adversely affect Birch's business,
operating results and financial condition. See "Business -- Competition."

RELIANCE ON LEASED TRANSPORT FACILITIES AND ILEC INTERCONNECTION; RELATIONSHIP
WITH SWBT

         Because Birch has elected to lease transport capacity, it is dependent
upon the availability of fiber optic transmission facilities owned by ILECs (in
particular SWBT), CLECs and other fiber optic transport providers whose fiber
optic networks are being or will be leased by Birch. The risks inherent in this
approach include, but are not limited to, negotiating and renewing favorable
supply agreements, and the timeliness of the ILECs, CLECs or other fiber optic
transport providers in processing Birch's orders for customers who seek to
utilize Birch's service. Alternatively, if and when Birch seeks to install its
own fiber, Birch must obtain permits, access to rights-of-way, and permission to
utilize underground conduit and aerial pole space from entities such as ILECs
and other utilities, railroads, long distance companies, state highway
authorities, local governments and transit authorities, and may be required to
obtain franchises from municipal governments. There can be no assurance that
Birch will be able to obtain and maintain the franchises, permits and rights
needed to implement its network buildout on acceptable terms.



                                      -17-
<PAGE>   18

The failure to enter into and maintain any such required arrangements for a
particular network may affect Birch's ability to develop that network and may
have a material adverse effect on Birch's business, operating results and
financial condition and its ability to achieve sufficient cash flow.

         In addition to transport providers, the Company is reliant on executing
interconnection agreements with the ILECs, in particular SWBT, operating in its
target markets. Birch's interconnection agreements with SWBT in Missouri, Kansas
and Texas currently provide that Birch's connection and maintenance orders will
be executed at parity with SWBT's customers and that SWBT will provide adequate
trunking capacity to keep call blockage within industry standards. Accordingly,
Birch and its customers are currently dependent on SWBT and will in the future
be dependent on other ILECs to assure uninterrupted service. Blocked calls
result in customer dissatisfaction and risk the loss of business. ILEC-CLEC
interconnection agreements, such as the agreements between SWBT and certain
operating subsidiaries of Birch, typically may have short terms, requiring Birch
to renegotiate the agreements continually. ILECs may not provide timely
provisioning or adequate service quality, thereby impairing Birch's reputation
with customers who can easily switch back to the ILEC. In addition, the prices
set in the agreements may be subject to significant rate increases at the
discretion of the states. There can be no assurance that ILECs like SWBT will
comply with their network provisioning requirements, or that Birch will be able
to procure interconnections in other markets on terms comparable to the
interconnection agreements Birch currently has in place. In addition, there can
be no assurance that the rates charged to Birch under such interconnection
agreements will allow Birch to offer low enough usage rates to attract a
sufficient number of customers and to operate its business profitably. See
"Business -- Regulation -- Birch Interconnection Agreements."

         As described above, Birch is reliant on the continued cooperation of
and the continued lack of competition from SWBT. Any extended interruption in
SWBT's cooperation could disrupt Birch's operations and have a material adverse
effect on Birch's business, operating results and financial condition and its
ability to achieve sufficient cash flow. It is also possible that SWBT may
expand and refocus its product offerings and networks to compete directly with
Birch. Accordingly, there can be no assurance that SWBT will continue to lease
transport capacity to Birch or that SWBT will continue to renew the
interconnection agreements it has with Birch, which would have a material
adverse effect on Birch's business, financial condition and results of
operations.

RISKS RELATING TO LONG DISTANCE BUSINESS

         As part of its offering of a package of telecommunications services to
its customers, Birch offers long distance services to its customers. The long
distance business is extremely competitive and prices have declined
substantially in recent years and are expected to continue to decline. In
addition, the long distance industry has historically had a high average churn
rate, as customers frequently change long distance providers in response to the
offering of lower rates or promotional incentives by competitors. Birch will
initially rely on other carriers to provide transmission and termination
services for all of its long distance traffic. Birch will need resale agreements
with long distance carriers to provide it with transmission services. Such
agreements typically provide for the resale of long distance services on a
per-minute basis and may contain minimum volume commitments. Negotiation of
these agreements involves estimates of future supply and demand for transmission
capacity as well as estimates of the calling patterns and traffic levels of
Birch's future customers. In the event Birch fails to meet its minimum volume
commitments, it may be obligated to pay underutilization charges and in the
event it underestimates its need for transmission capacity, Birch may be
required to obtain capacity through more expensive means. The incurrence of any
underutilization charges, rate increases or termination charges could have a
material adverse effect on Birch's business, operating results and financial
condition and its ability to achieve sufficient cash flow.

DEPENDENCE ON BILLING, CUSTOMER SERVICE AND INFORMATION SYSTEMS

         Sophisticated back office information and processing systems are vital
to Birch's growth and its ability to monitor costs, bill customers, provision
customer orders, provide customer service and achieve operating efficiencies.
Birch's plans for the development and implementation of these operations support
systems rely, for the most part, on choosing products and services offered by
third party vendors and integrating such products and services in-house to
produce efficient operational solutions. There can be no assurance that these
systems will be successfully implemented on a timely basis or that they will
perform as expected. Failure of these vendors to deliver proposed products and
services in a timely and effective manner and at acceptable costs, failure by
Birch to



                                      -18-
<PAGE>   19

adequately identify all of its information and processing needs, failure of
Birch's related processing or information systems, failure by Birch to integrate
effectively such products or services, or the failure by Birch to upgrade
systems as necessary could have a material adverse effect on Birch. In addition,
Birch's right to use these systems is dependent upon license agreements with
third party vendors. Certain of such agreements may be cancelable by the vendor
and the cancellation or nonrenewal of these agreements may have an adverse
effect on Birch's business, operating results and financial condition and its
ability to achieve sufficient cash flow.

RISK OF NEW SERVICE ACCEPTANCE BY CUSTOMERS

         The success of Birch's service offerings will be dependent upon, among
other things, the willingness of customers to accept Birch as a new provider of
telecommunications services. There can be no assurance that Birch will be
successful in overcoming the resistance of customers or that customers will be
willing to contract for Birch's services. The lack of such acceptance could have
a material adverse effect on Birch's business, operating results and financial
condition and its ability to achieve sufficient cash flow.

RAPID TECHNOLOGICAL CHANGE

         The telecommunications industry is subject to rapid and significant
changes in technology. Birch will be subject to competitive threats from new
technology that becomes available before and after its networks are built. The
effect of technological changes on the businesses of Birch, however, cannot be
predicted. Birch believes its future success will depend, in part, on its
ability to anticipate and adapt to such changes and to offer, on a timely basis,
services that meet customer demands. Thus, there can be no assurance that
technological developments will not have a material adverse effect on Birch's
business, operating results and financial condition and its ability to achieve
sufficient cash flow.

RISK OF LOSS OR REDUCTION OF ACCESS CHARGE REVENUES

         A portion of Birch's revenue comes from access charges, which are paid
to Birch by long distance carriers for originating and terminating calls to
customers served by Birch. The amount of access charge revenue that Birch
receives is calculated based on guidelines set by federal and state regulatory
bodies, and such guidelines could change at any time. These circumstances could
have a material adverse effect on Birch's business, operating results and
financial condition and its ability to achieve sufficient cash flow. See
"Business -- Telecommunications Services" and "Business -- Regulation -- Federal
Regulation Generally."

DIFFICULTIES IN IMPLEMENTING ENHANCED SERVICE FEATURES

         Birch has begun, and plans to continue, to deploy switches in the
cities in which it will operate networks and plans initially to rely on ILEC or
CLEC facilities for certain aspects of interconnection. Subject to obtaining
interconnection with SWBT, Birch will be able to offer a variety of enhanced
service features (such as voicemail, call waiting, caller ID and call
forwarding). Although under the Telecommunications Act the ILECs will be
required to unbundle network elements and permit Birch to purchase only the
origination and termination services it needs, there can be no assurance that
such unbundling will be effected in a timely manner and result in prices
favorable to Birch. In addition, Birch's ability to implement successfully its
enhanced service features will require the negotiation of resale agreements with
ILECs and other CLECs and the negotiation of interconnection and collocation
agreements with ILECs, which can take considerable time, effort and expense and
are subject to federal, state and local regulation.

         Birch's enhanced service features may not be profitable due to, among
other factors, lack of customer demand, inability to secure access to ILEC
facilities on acceptable terms, and competition and pricing pressure from the
ILECs and other CLECs. There can be no assurance that Birch will be able to
successfully implement its switched and enhanced service features strategy.

CONTROL OF COMPANY BY CURRENT STOCKHOLDERS

         As of December 31, 1998, the executive officers and directors of the
Company beneficially owned 14,103,752 shares of Common Stock, representing
approximately 60.1% of the Common Stock on a fully-diluted



                                      -19-
<PAGE>   20

basis. The Company's executive officers and directors as a group will be able to
exercise significant influence over such matters as the election of the
directors of the Company and other fundamental corporate transactions such as
mergers, assets sales and the sale of the Company. In addition, the Purchasers
Rights Agreement (as defined) provides that each of the parties thereto will
vote in favor of the election of certain designees to the Company's Board of
Directors. See "Security Ownership of Certain Beneficial Owners and Management,"
"Certain Relationships and Related Party Transactions -- Purchasers Rights
Agreement".

         In addition, the Company may adopt certain procedural and other
requirements or amend its Certificate of Incorporation or By-Laws in a manner
that could have the effect of delaying, deterring or preventing a change in
control of the Company or make it more difficult for stockholders to effect
certain corporate actions, including the ability to replace incumbent directors
and to accomplish transactions opposed by the incumbent Board of Directors.

DIVIDEND POLICY

         The Company has no plans to pay cash dividends on its Common Stock in
the foreseeable future. The declaration and payment of any dividends in the
future will be determined by the Board of Directors, in its discretion, and will
depend on a number of factors, including the Company's earnings, capital
requirements and overall financial condition. In addition, the Company's ability
to declare and pay dividends will be substantially restricted under the terms of
the Indenture.

DEPENDENCE ON KEY PERSONNEL

         Birch's business is managed by a small number of key executive
officers, particularly David E. Scott, Birch's President and Chief Executive
Officer, Jeffrey D. Shackelford, Birch's Senior Vice President of Sales, Gary L.
Chesser, Birch's Senior Vice President of Engineering and Operations, David W.
Vranicar, Birch's Senior Vice President of Business Development, Bradley A.
Moline, Birch's Senior Vice President of Finance and Chief Financial Officer,
Donald H. Goldman, Birch's Senior Vice President of Internet Services, Gregory
C. Lawhon, Birch's Senior Vice President of Public Policy and General Counsel,
and Stephen L. Sauder, Vice President of Birch, the loss of any of whom could
have a material adverse effect on Birch's business, operating results and
financial condition. Birch believes that its future success will depend in large
part on its continued ability to attract and retain highly skilled and qualified
executive personnel. See "Part III, Item 10, Directors and Executive Officers of
the Registrant."

DEPENDENCE ON NEW EMPLOYEES

         Birch's future success will depend in large part on its ability to
obtain the services of motivated technical, information systems, marketing, and
sales personnel. Birch is particularly dependent on its ability to identify,
hire, train, retain, and manage highly skilled and experienced network engineers
to execute the installation, development, and operation of Birch's networks, as
well as sales and marketing personnel to create and expand Birch's customer
base. The pace of growth of the CLEC industry may make it difficult to recruit
qualified labor for key functions, particularly general managers, sales
representatives, sales management, public policy experts, technicians,
engineers, and operations management. Because many of Birch's markets are small,
finding the right employees who are willing to relocate may be more difficult.
There can be no assurance that Birch will be able to obtain or retain the
services of additional personnel necessary for Birch's growth.

RISK OF SYSTEM FAILURE

         Birch's operations are dependent upon its ability to protect its
network infrastructure against damage from fire, earthquakes, floods, power
loss, and similar events and to construct networks that are not vulnerable to
the effects of such events. The occurrence of a natural disaster or other
unanticipated problem at Birch's facilities or at the sites of its switches
could cause interruptions in the services provided by Birch. The failure of a
switch would result in interruption of service to the customers served by such
switch until necessary repairs were effected or replacement equipment were
installed. Additionally, failure of the other telecommunications providers to
provide the data communications capacity required by Birch as a result of
natural disaster, operational disruption or for any other reason could cause
interruptions in the services provided by Birch. Any damage or failure that
causes interruptions in Birch's operations could have a material adverse effect
on Birch's business, financial condition and results of operations.



                                      -20-
<PAGE>   21

YEAR 2000 ISSUE

         All companies that rely on computers face an issue as the year 2000
approaches. The "year 2000" problem is the result of the past practice in the
computer industry of computer programs using two digits rather than four to
define the applicable year. This practice will result in incorrect results when
computers perform arithmetic operations, comparisons or data field sorting
involving years later than 1999. Any of Birch's computer programs that have
date-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in a system failure or miscalculations
causing disruptions of operations, including, among other things, a temporary
inability to process transactions, send invoices, or engage in similar normal
business activities. Based on ongoing assessments, the Company has determined
that it will be required to modify or replace portions of its software so that
its computer systems will function properly with respect to dates in the year
2000 and thereafter. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."

         There can be no assurance until the year 2000 that Birch's systems will
be year 2000 compliant. In addition, Birch uses SWBT's facilities to service its
customers, and such facilities currently utilize numerous date-sensitive
computer applications. If SWBT's facilities are not year 2000 compliant, or if
the systems of other ILECs, long-distance carriers and others upon which Birch
relies are not year 2000 compliant, it would have a material adverse effect on
Birch's business, operating results and financial condition and its ability to
achieve sufficient cash flow.

















                                      -21-
<PAGE>   22



ITEM 2.  PROPERTIES

         At December 31, 1998, the Company owned or leased the following
facilities:

<TABLE>
<CAPTION>
                                                                  APPROXIMATE                         EXPIRATION
LOCATION                  FUNCTION                                SQUARE FEET       LEASE/OWN        DATE OF LEASE
--------                  --------                                -----------       ---------        -------------
<S>                       <C>                                     <C>               <C>             <C>
Kansas City, MO           Company Headquarters, Engineering          30,000            Lease         Month-to-Month
                          & Operations
Kansas City, MO           Future Company Headquarters,               47,000            Lease           March 2007
                          Engineering & Operations
Kansas City, MO           Sales Office                                3,000            Lease         Month-to-Month
Kansas City, MO           Switch Site                                 8,300            Lease           March 2003
Emporia, KS               Customer Care Center & Customer            58,500             Own               N/A
                          Premises Equipment
Emporia, KS               Advertising & Print Shop                    3,000            Lease         Month-to-Month
Sunset Hills (St.         Sales Office                                3,000            Lease           June 2002
Louis), MO
Maryland Heights (St.     Switch Site                                 5,100            Lease         November 2008
Louis), MO
Wichita, KS               Sales Office                                2,000            Lease            May 2001
Wichita, KS               Switch Site                                 6,300            Lease         September 2008
Wichita, KS               Switch Site                                 1,100            Lease          August 2000
St. Joseph, MO            Sales Office                                1,500            Lease         November 1999
Topeka, KS                Sales Office                                2,100            Lease           April 2003
Salina, KS                Sales Office & Customer Premises            5,000             Own               N/A
                          Equipment Warehouse
Manhattan, KS             Sales Office & Warehouse                    5,000            Lease         Month-to-Month
Dodge City, KS            Sales Office                                1,000            Lease         Month-to-Month
Tyler, TX                 Sales Office                                2,500            Lease          January 2002
Waco, TX                  Sales Office                                2,600            Lease         December 2001
Beaumont, TX              Sales Office                                3,300            Lease         December 2001
Longview, TX              Sales Office                                1,000            Lease         December 1999
Mission (Kansas City),    Internet Operations                         1,000            Lease         December 1999
KS
Overland Park (Kansas     Shared Tenant Services                      3,200            Lease         September 2001
City), KS
Lawrence, KS              Sales Office                                  775            Lease            May 1999
Irving, TX                Sales Office                                1,000            Lease         Month-to-Month
Leawood (Kansas City),    Customer Premises Equipment                 2,300            Lease         December 1999
KS
</TABLE>




                                      -22-
<PAGE>   23



ITEM 3.  LEGAL PROCEEDINGS

         Birch knows of no pending or threatened material litigation or
proceedings involving the Company.

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

         During the fourth quarter of 1998, the Company initiated the
solicitation of stockholder approval for a proposal to (i) increase the
authorized size of the Company's Board of Directors from five to seven, and (ii)
to increase the number of shares of the Company's common stock authorized for
issuance under the Company's 1998 Stock Option Plan to 6,195,845.























                                      -23-
<PAGE>   24




                                     PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

A)       MARKET INFORMATION

         There is no established public trading market for the Company's Common
         Stock

B)       HOLDERS

         As of March 29, 1999, there were 81 holders of record of the Company's
         Common Stock.

C)       DIVIDENDS

         The Company has not paid any cash dividends on its Common Stock since
its inception and does not intend to pay any dividends on its Common Stock in
the foreseeable future.

D)       RECENT SALES OF UNREGISTERED SECURITIES

         In February 1998, Birch merged with Valu-Line Companies, Inc.
(Valu-Line) in a transaction valued at $19.5 million, consisting of $4.75
million in cash, 2,968,750 shares of Series A Preferred Stock of the Company
having an aggregate liquidation preference of $4.75 million, and 6,593,750
shares of Series C Preferred Stock having an aggregate liquidation preference of
$10.0 million. Valu-Line, founded in 1982, has been primarily providing switched
long distance services, CPE sales and services and, since March 1997, local
service in selected smaller markets throughout the state of Kansas. The
securities in connection with the merger were issued pursuant to an exemption
from registration provided by Section 4(2) of the Securities Act of 1933.

         On March 13, 1998, Birch completed a private placement of 6,264,063
shares of its Series B Preferred Stock having an aggregate liquidation
preference of $9.5 million and $3.5 million in aggregate principal amount of
convertible notes, raising aggregate net proceeds of approximately $12.4 million
which were used to pay the cash portion of the consideration for the Valu-Line
merger, to repay certain debt and for general corporate purposes. In June 1998,
the convertible notes were converted into 2,307,965 shares of Series B Preferred
Stock of the Company. The securities in connection with this private placement
were issued pursuant to an exemption under Rule 506 promulgated under Section
4(2) of the Securities Act of 1933.

         During June 1998, the Company completed a $115 million private offering
of 14% Senior Notes (the Senior Notes) due June 2008 and 115,000 warrants to
purchase 1,409,734 shares of Common Stock of the Company. The warrants are
exercisable at $0.01 per share and expire June 2008. The Company received net
proceeds from the Senior Notes of $110.2 million and concurrently purchased
pledged securities of $44.2 million. The pledged securities are restricted for
interest payments on the Senior Notes and, together with the interest accruing
thereon, will be used to satisfy such interest payments through June 2001. The
Senior Notes were issued pursuant to Rull 144A promulgated under the Securities
Act of 1933. The Senior Notes were subsequently exchanged for substantially
identical 14% notes due June 2008 that had been registered under the Securities
Act of 1933 in an exchange offer that expired in March 1999.

         In February 1999, Birch acquired American Local Telecommunications,
L.L.C. (ALT), a local service provider in the Dallas metropolitan area for
$700,000 in cash and stock. The securities in connection with the merger were
issued pursuant to an exemption from registration provided by Section 4(2) of
the Securities Act of 1933.




                                      -24-
<PAGE>   25



ITEM 6.  SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

The following table sets forth selected consolidated financial data and should
be read in conjunction with and is qualified by reference to "Management's
Discussion and Analysis of Financial Condition and Results of Operations," the
Consolidated Financial Statements of the Company, the notes thereto and the
other financial data contained elsewhere in this Form 10-K.

<TABLE>
<CAPTION>
                                                                      YEAR ENDED DECEMBER 31,
                                            ---------------------------------------------------------------------------
                                                             THE PREDECESSOR(1)                       THE COMPANY
                                            -------------------------------------------------   -----------------------
                                               1994         1995         1996         1997         1997        1998
                                            ---------    ---------    ----------   ----------   ---------   -----------
                                                                      (DOLLARS IN THOUSANDS)
<S>                                         <C>          <C>          <C>          <C>          <C>         <C>
STATEMENT OF OPERATIONS DATA:
   Revenue................................  $  10,741    $  12,226    $   13,217   $   16,801   $       -   $    26,087
   Cost of services.......................      6,713        8,284         8,749       11,842           -        18,886
                                            ---------    ---------    ----------   ----------   ---------   -----------
   Gross margin...........................      4,028        3,942         4,468        4,959           -         7,201
   Selling, general and administrative....      3,022        3,520         3,561        4,067       1,776        15,769
   Depreciation and amortization..........        199          189           311          341          27         2,308
                                            ---------    ---------    ----------   ----------   ---------   -----------
   Income (loss) from operations..........        807          233           596          551      (1,083)      (10,876)
   Interest, net..........................         48           58           102           97         (14)       (5,332)
                                            ---------    ---------    ----------   ----------   ---------   -----------
   Income (loss) before income taxes......        759          175           494          454      (1,789)      (16,208)
   Provision for income taxes.............        319           81           205          186           -             -
                                            ---------    ---------    ----------   ----------   ---------   -----------
   Net income (loss)......................  $     440    $      94    $      289   $      268      (1,789)      (16,208)
                                            =========    =========    ==========   ==========
   Preferred stock dividends..............                                                              -         1,696
   Amortization of preferred stock
   issuance costs.........................                                                              -            29
                                                                                                ---------   -----------
   Loss applicable to common stock........                                                      $  (1,789)  $   (17,933)
                                                                                                =========   ===========

   Weighted average shares outstanding -
   basic and diluted......................                                                          1,235         3,809
                                                                                                =========   ===========

   Loss per common share - basic and
   diluted................................                                                      $   (1.45)    $   (4.71)
                                                                                                =========   ===========
</TABLE>



(1) The Predecessor company is Valu-Line which merged with Birch during February
    1998. Prior to February 1998, Birch had no revenues and was in the
    developmental stage.



                                      -25-
<PAGE>   26



<TABLE>
<CAPTION>
                                                                           DECEMBER 31,
                                            ---------------------------------------------------------------------------
                                                             THE PREDECESSOR                          THE COMPANY
                                            -------------------------------------------------   -----------------------
                                               1994         1995         1996         1997         1997        1998
                                            ---------    ---------    ----------   ----------   ----------  -----------
                                                                      (Dollars in thousands)
<S>                                         <C>          <C>          <C>          <C>          <C>         <C>
BALANCE SHEET DATA:
Cash and cash equivalents.................  $     333    $      96    $      158   $      258   $      210  $    39,745
Pledged securities........................          -            -             -            -            -       37,785
Property and equipment....................      2,063        2,265         2,721        2,964          128       26,900
Total assets..............................      3,748        3,971         3,868        4,802          534      134,149
Long-term debt and capital lease
obligations...............................      1,188        1,431           792          681            -      115,791
Redeemable preferred stock................          -            -             -            -            -       14,063
Total stockholders' equity (deficit)......      1,014        1,108         1,397        1,665           29       (7,099)

OTHER FINANCIAL DATA:
Cash flows from operating activities......  $     568    $    (267)   $      834   $      488   $   (1,464) $   (10,643)
Cash flows from investing activities......       (753)        (230)         (513)        (243)        (215)     (67,093)
Cash flows from financing activities......        395          259          (257)        (145)       1,889      117,271
EBITDA(1).................................      1,006          422           907          892       (1,776)      (8,568)
Capital expenditures......................        753          230           513          243          128      (21,550)
Ratio of earnings to fixed charges(2).....       14.1x         3.5x          5.2x         4.9x           -            -
Deficiency of earnings to fixed charges(2)          -            -             -            -        1,789       16,208

OPERATING DATA:
Access Lines .............................          -            -             -       14,700            -       39,323
Local Customers...........................          -            -             -        5,835            -       14,735
Average lines per business customer.......          -            -             -            *            -         4.73
Average lines per residential customer....          -            -             -            *            -         1.25
Employees at end of period................         51           58            61           84           14          345
</TABLE>

(1) "EBITDA" is defined as earnings before interest, taxes, depreciation and
    amortization. Although EBITDA is not a measure of performance calculated in
    accordance with generally accepted accounting principles (GAAP), Birch's
    management believes that EBITDA is accepted as a generally recognized
    measure of performance in the telecommunications industry. Birch's
    management has noted that EBITDA is generally recognized as a measure of
    comparison of different CLECs in the telecommunications industry and,
    therefore, the Company believes that such information is useful and relevant
    to investors. Nevertheless, this measure should not be considered in
    isolation or as a substitute for operating income (as determined in
    accordance with GAAP) as an indicator of Birch's operating performance, or
    to cash flows from operating activities (as determined in accordance with
    GAAP) as a measure of liquidity. In addition, it should be noted that
    companies calculate EBITDA differently and , therefore, EBITDA as presented
    for the Company may not be comparable to EBITDA reported by other companies.
    See the consolidated financial statements of Valu-Line and Birch and related
    notes thereto (collectively, the Consolidated Financial Statements) included
    elsewhere in this Form 10-K for a review of the cash used in and provided
    by operating and investing activities. Furthermore, there are legal and
    functional requirements that limit management's discretionary use of funds
    depicted by EBITDA. See "Risk Factors - Substantial Future Operating Losses;
    Negative Cash Flow from Operations" and "Rick Factors - Substantial
    Leverage; Ability to Service Indebtedness."

(2) For purposes of calculating the ratio of earnings to fixed charges, earnings
    are defined as loss before income taxes plus fixed charges. Fixed charges
    consist of interest expense and a reasonable approximation of the interest
    factor included in rental payments on operating leases. Earnings were
    insufficient to cover fixed charges for the years ended December 31, 1997
    and 1998.

(*) Information not available.



                                      -26-
<PAGE>   27

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

         The following discussion and analysis should be read in conjunction
with the consolidated financial statements, including the notes thereto,
appearing elsewhere in this Annual Report on Form 10-K. Except for the
historical information contained herein, the matters discussed in this Annual
Report contain forward-looking statements within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, that are based on management's beliefs and assumptions,
current expectations, estimates, and projections. Statements that are not
historical facts, including without limitation statements which are preceded by,
followed by or include the words "believes," "anticipates," "plans," "expects,"
"may," "should" or similar expressions are forward-looking statements. Many of
the factors that will determine the Company's future results are beyond the
ability of the Company to control or predict. These statements are subject to
risks and uncertainties and, therefore, actual results may differ materially.
The Company disclaims any obligation to update any forward-looking statements
whether as a result of new information, future events or otherwise.

         Important factors that may affect future results include, but are not
limited to: the impact of competitive products and pricing, product development,
changes in law and regulations, customer demand, litigation, availability of
future financing, uncertainty of market acceptance of new products, and other
risks detailed from time to time in the Company's SEC reports, copies of which
are available upon request from the Company's investor relations department.

OVERVIEW

         Birch was organized on December 23, 1996 to become a leading provider
of telecommunications services to small and mid-sized businesses in its target
markets. Since such date and prior to the Valu-Line acquisition, Birch was a
development stage company with no revenue and principal activities consisting of
procuring governmental authorizations, raising capital, hiring management and
other key personnel, designing and developing its telephone networks, acquiring
equipment and facilities, negotiating resale and interconnection agreements and
pursuing acquisition opportunities. Birch had no assets, liabilities or
financial activity prior to January 1, 1997.

         In February 1998, Birch merged with Valu-Line in a transaction valued
at $19.5 million, consisting of $4.75 million in cash, 2,968,750 shares of
Series A Preferred Stock having an aggregate liquidation preference of $4.75
million, and 6,593,750 shares of Series C Preferred Stock having an aggregate
liquidation preference of $10.0 million. Valu-Line, founded in 1982, has been
primarily providing switched long distance services, CPE sales and services and,
since March 1997, local service.

         On March 13, 1998, Birch completed a private placement of 6,264,063
shares of its Series B Preferred Stock having an aggregate liquidation
preference of $9.5 million and $3.5 million in aggregate principal amount of its
Convertible Notes, raising aggregate net proceeds of approximately $12.4 million
which were used to pay the cash portion of the consideration in the Valu-Line
merger, to repay certain debt and for general corporate purposes. The
Convertible Notes have been converted to 2,307,965 shares of Series B Preferred
Stock.

         In May 1998, Birch acquired Boulevard, a shared tenant service provider
in the Kansas City metropolitan area, for $300,000 in cash. In May 1998, Birch
acquired Telesource, a CPE provider in the Kansas City metropolitan area, for
$325,000 in cash. In connection with the Telesource acquisition, the Company
assumed $290,000 of Telesource's debt which has since been repaid.

         During June 1998, the Company completed a $115 million private offering
of 14% Senior Notes due June 2008 and 115,000 warrants to purchase 1,409,734
shares of common stock. Interest on the Senior Notes is payable semi-annually in
arrears on June 15 and December 15 of each year. Warrants are exercisable at
$0.01 per share and expire June 2008. The Company received net proceeds from the
Senior Notes of $110.2 million and concurrently purchased pledged securities of
$44.2 million. The pledged securities are restricted for interest payments on
the Senior Notes and, together with the interest accruing thereon, will be used
to satisfy such interest payments through June 2001. The Company classifies its
pledged securities, consisting of $37.8 million of U.S. Treasury securities at
December 31, 1998, as held to maturity recorded at amortized cost and maturing
between six and thirty months. A



                                      -27-
<PAGE>   28

portion of the proceeds of this offering, $337,000, was allocated to the
warrants, and the resulting debt discount is being amortized over the life of
the debt on the straight-line method, which does not differ materially from the
effective interest method. Unamortized discount was $319,000 at December 31,
1998. The amount allocated to the warrants represents the estimated fair value
of the warrants at the date of issuance. The Senior Notes rank pari pasu in
right of payment to all existing and future senior indebtedness of the Company
and rank senior in the right of payment to all existing and future subordinated
indebtedness of the Company.

         In September 1998, the Company purchased certain assets and liabilities
of TFSnet, an Internet service provider in the Kansas City metropolitan area,
for $2.65 million. The Valu-Line, Telesource, Boulevard, and TFSnet acquisitions
were recorded using the purchase method of accounting. Results from the acquired
companies are included in the financial statements from the date of the
respective acquisitions.


         In February 1999, Birch acquired ALT, a local service provider in the
Dallas metropolitan area for $700,000 in cash and stock. In March 1999, Birch
acquired Capital, a CPE provider in the St. Louis metropolitan area for $3.0
million in cash and additional cash compensation from conversion of Capital's
customer base to Birch's local service.

         Birch is focused on the development of its existing markets in Missouri
and Kansas and expansion into neighboring markets in SWBT's service area,
including Texas. In May 1998, Birch expanded its markets to include Kansas City,
St. Louis and St. Joseph, Missouri and Topeka and Wichita, Kansas. Birch
currently operates a long distance circuit switch in Wichita, Kansas, a
local/long distance circuit switch in Kansas City, Missouri, and is in the
process of deploying local/long distance switches in St. Louis, Missouri and
Wichita, Kansas. By operating its own switch in a particular market, Birch can
"unbundle" the services traditionally offered by the ILEC in that market and
retain a much higher percentage of the service charges paid by its customers.

     Revenue

         Birch generates most of its revenue from the sale of local and long
distance telephone service, CPE and Internet service to small to mid-sized
business customers. Birch offers local and long distance service packages in
certain markets in Missouri, Kansas and Texas. Revenue from local services
consists of charges for basic local service and custom calling features. Birch
offers local telephone service at a discount to the competing ILEC and offers
long distance service at a flat per minute rate for calls within the continental
United States. CPE and related services are offered at negotiated rates
generally consistent with other competitors. Birch also offers Internet access
in selected markets primarily at a flat monthly rates.

     Operating Expenses

         Birch's primary operating expenses consist of cost of services and
selling, general and administrative expenses.

         Cost of Services. Birch's cost of services include the cost of
purchasing the "bundle" of traditional ILEC services for resale to its local
service subscribers. Birch purchases local telephone service for its customers
on a "wholesale" basis pursuant to an interconnection agreement with the ILEC in
Birch's targeted markets. Once a Birch switch is operational in a market, Birch
can "unbundle" the local services offered by the ILEC in that market and retain
a much higher percentage of the service charges paid by its customers as most
charges relate only to leasing the transmission lines.

         Additionally, ILECs typically charge both a start-up fee as well as a
monthly recurring fee for use of their central offices for collocation of CLEC
transmission equipment. By physically collocating its transmission equipment in
or near existing ILEC switching offices, Birch has more direct control over its
ILEC links for both unbundled loops and trunking facilities. Birch also invests
in transmission and distribution electronics equipment associated with its
switches.



                                      -28-
<PAGE>   29

         The Company's primary long distance expenses are expenses associated
with the Company's leased long distance network. For calls terminating outside
of Birch's network, long distance carriers are used to provide services.

         Birch's primary expense associated with providing Internet access to
its customers is the cost of leasing transmission facilities. Birch's primary
expense associated with CPE is the cost of purchasing equipment from
manufacturers and labor for equipment installation.

         Selling, General and Administrative Expenses. Birch's selling, general
and administrative expenses include its selling and marketing costs and customer
service, billing, corporate administration, personnel and network maintenance
expense.

         Birch employs a direct sales force in each of its target markets. To
attract and retain a highly qualified sales force, Birch offers its sales
personnel a compensation package that emphasizes commissions. Birch expects to
incur significant selling and marketing costs as it expands its operations.

         Birch has implemented and continues to refine tailored systems for
operations support systems and other back office systems that provision and
track customer orders from point of sale to the installation and testing of
service. Along with the development costs of these systems, Birch also incurs
ongoing expenses for customer service and billing systems. As Birch's strategy
stresses the importance of personalized customer service, Birch expects that its
customer service department will become a larger part of Birch's ongoing
administrative expenses. Birch also expects billing costs to increase as its
number of customers and the call volume increases. Birch incurs other costs and
expenses, including the costs associated with the maintenance of its network,
administrative overhead, office leases and bad debt. Birch expects that these
costs will grow significantly as it expands its operations and that
administrative overhead will be a large portion of these expenses during the
expansion phase of Birch's business. However, Birch expects these expenses to
become smaller as a percentage of Birch's revenue as Birch builds its customer
base.

         The Company has experienced operating losses since its inception as a
result of efforts to build its customer base, develop and construct its network
infrastructure, build its internal staffing, develop its systems and expand to
new markets. The Company expects to continue to focus on increasing its customer
base and geographic coverage. Accordingly, the Company expects that its cost of
service, selling, general and administrative expenses, and capital expenditures
will continue to increase significantly, all of which may have a negative impact
on operating results. The projected increases in capital expenditures will
continue to generate negative cash flows from construction activities during the
next several years as the Company develops and constructs its switch network.
The Company may also be forced to change its pricing policies to respond to a
changing competitive environment, and there can be no assurance that the Company
will be able to maintain its operating margin. There can be no assurance that
growth in the Company's revenue or customer base will continue or that the
Company will be able to achieve or sustain profitability or positive cash flows.

         The Company has generated net operating losses since its inception and,
accordingly, has incurred no income tax expense. The Company has reduced the net
deferred tax assets generated by these losses by a valuation allowance which
offsets the net deferred tax asset due to the uncertainty of realizing the
benefit of the tax loss carryforwards. The Company will reduce the valuation
allowance when, based on the weight of available evidence, it is more likely
than not that some portion or all of the deferred tax assets will be realized.

RESULTS OF OPERATIONS

     Year Ended December 31, 1998 Compared to Year Ended December 31, 1997

         Revenue. Revenue was $26.1 million for the year ended December 31, 1998
compared to $-0- for the year ended December 31, 1997, principally as a result
of the Valu-Line, Boulevard, Telesource and TFSnet acquisitions and opening five
new markets in 1998. Revenue increases in excess of revenue gained from
acquisitions in 1998 were largely from new customer sales particularly focused
on local. For 1998, as a percentage of total revenue,



                                      -29-
<PAGE>   30

communications and other services were 81.4% (including revenue from Internet
access services, which was 2% of total revenue for such period) and CPE sales
were 18.6%.

         Cost of services. Cost of services was $18.9 million for 1998 compared
to $0 for 1997, principally as a result of the Valu-Line, Boulevard, Telesource
and TFSnet acquisitions and opening five new markets in 1998. Gross margin for
1998 was $7.2 million, or 27.6% of revenue.

         Selling, general and administrative expenses. Selling, general and
administrative expenses were $15.8 million for 1998 compared to $1.8 million for
1997. These expenses increased principally as a result of the Valu-Line,
Boulevard, Telesource and TFSnet acquisitions and opening five new markets in
1998. Additionally, the Company expanded its engineering and operations staff in
preparation for switch deployment. EBITDA was $(8.6) million for 1998 compared
to $(1.8) million for 1997.

         Depreciation and amortization. Depreciation and amortization was $2.3
million for 1998 compared to $27,000 for 1997, most of which was attributable to
the fixed and intangible assets acquired in the Valu-Line, Boulevard, Telesource
and TFSnet acquisitions.

         Interest. Interest expense was $8.2 million for 1998 primarily from the
senior note interest charges. Interest income was $2.9 million in 1998 compared
to $14,000 for 1997 primarily as a result of invested funds received from the
Senior Notes.

         Net loss. Net loss was $16.2 million for 1998 compared to $1.8 million
for 1997, as discussed above.

     VALU-LINE (PREDECESSOR COMPANY)

     Year Ended December 31, 1997 Compared to Year Ended December 31, 1996

         Revenue. Revenue increased 27.1% to $16.8 million for the year ended
December 31, 1997, from $13.2 million for the year ended December 31, 1996,
primarily as a result of entering the local service market in March 1997 and
long distance volumes increasing faster than the decline in long distance
pricing. As a percent of total revenue, communications and other services were
82%, or $13.8 million, and CPE sales were 18%, or $3.0 million for the year
ended December 31, 1997 compared to 80.9%, or $10.7 million, and 19.1%, or $2.5
million, for the year ended December 31, 1996.

         Cost of services. Cost of services increased 35.4% to $11.8 million for
the year ended December 31, 1997, from $8.7 million for the year ended December
31, 1996 primarily as a result of the increase in revenue. Gross margin
increased 11.0% to $5.0 million, or 29.5% of revenue, for the year ended
December 31, 1997 from $4.5 million, or 33.8% of revenue, for the year ended
December 31, 1996 primarily as a result of low margins on resold local service,
which was started in March 1997.

         Selling, general and administrative expenses. Selling, general and
administrative expenses increased 14.2% to $4.1 million for the year ended
December 31, 1997, from $3.6 million for the year ended December 31, 1996,
primarily as a result of sales commissions related to increased business volumes
and increased customer service expenditures associated with the commencement of
local service. EBITDA decreased 1.7% to $892,000 for the year ended December 31,
1997 from $907,000 for the year ended December 31, 1996 primarily as a result of
the start-up costs associated with offering local service.

         Depreciation and amortization. Depreciation and amortization increased
9.6% to $341,000 for the year ended December 31, 1997, compared to $311,000 for
the year ended December 31, 1996.

         Interest expense. Interest expense was $97,000 for the year ended
December 31, 1997 compared to $102,000 for the year ended December 31, 1996.

         Income taxes. Income taxes were 9.3% to $186,000 for the year ended
December 31, 1997, compared to $205,000 for the year ended December 31, 1996.



                                      -30-
<PAGE>   31

         Net income. Net income was $268,000 for the year ended December 31,
1997, compared to $289,000 for the year ended December 31, 1996, as discussed 
above.

LIQUIDITY AND CAPITAL RESOURCES

         The expansion of Birch's business will require significant capital to
fund capital expenditures, working capital needs, debt service and the cash flow
deficits generated by operating losses. Birch's principal capital expenditure
requirements include the purchase and installation of switches and transmission
equipment collocated in ILEC central offices and the further development of
operations support systems and other automated back office systems. Management
does not expect that the growth of Birch's long distance and CPE business will
require significant capital expenditures.

         To date, Birch has primarily funded its expenditures through the Senior
Notes, private sale of equity securities, and the convertible notes. During the
first quarter of 1997, the Company sold equity securities worth $1.8 million. In
February and March 1998, Birch raised approximately $12.4 million in a private
placement of its Series B Preferred Stock and Convertible Notes.
On June 18, 1998, the Company sold Senior Notes for net proceeds of $110.2
million.

         Birch expects to make significant capital outlays for the foreseeable
future in order to continue the development activities called for in its current
business plan and to fund expected operating losses. Birch currently estimates
that the cash required to fund capital expenditures for its expansion plans will
be approximately $35.0 million in 1999. In order for the Company to implement
its current business plan and finance its projected capital expenditures for
1999 and thereafter, Birch will be required to seek and obtain significant
amounts of additional financing (debt and/or equity) within the next year. The
Company's expansion into Texas is dependent upon raising substantial additional
financing in the near term. If Birch's plans or assumptions change, if its
assumptions prove to be inaccurate, or if it experiences unanticipated costs or
competitive pressures, Birch will be required to seek additional capital sooner
than currently anticipated, possibly within the next six months. In particular,
if Birch elects to pursue significant additional acquisition opportunities or to
deploy more switches than currently planned, its cash needs may be increased
substantially. There can be no assurance that Birch's current projection of cash
flow (and losses) from operations (which will depend upon numerous future
factors and conditions, many of which are outside of Birch's control) will be
accurate. Because Birch's cost of developing new networks and services, funding
other strategic initiatives and operating its business will depend on a variety
of factors (including, among other things, the number of subscribers and the
service for which they subscribe, the nature and penetration of services that
may be offered by Birch, regulatory changes, and actions taken by competitors in
response to Birch's strategic initiatives), it is almost certain that actual
costs and revenue will vary from expected amounts, very likely to a material
degree, and that such variations are likely to affect Birch's future capital
requirements. Current cash balances will not be sufficient to fund Birch's
current business plan beyond the next year. As a consequence, Birch intends to
seek additional debt and/or equity financing to fund Birch's liquidity. There
can be no assurance that Birch will be able to raise additional capital on
satisfactory terms or at all. In the event that Birch is unable to obtain such
additional capital or to obtain it on acceptable terms or in sufficient amounts,
Birch will be required to delay the development of its network or take other
actions that could have a material adverse effect on Birch's business, operating
results and financial condition and its ability to achieve sufficient cash flow
to service debt requirements.

         The ability of Birch to fund the capital expenditures and other costs
contemplated by its business plan and to make scheduled payments with respect to
the Senior Notes, will depend upon, among other things, its ability to seek and
obtain additional financing within the next year, to implement its business
plan, to deploy its network and expand its operations and to obtain and retain a
significant number of customers in its target markets, and the future operating
performance of Birch and its subsidiaries. Each of these factors is, to a large
extent, subject to economic, financial, competitive, political, regulatory and
other factors, many of which are beyond Birch's control. Birch expects that it
will generate operating losses for the foreseeable future and that its business
will not generate positive cash flow for the foreseeable future. In addition,
the Company will require significant amounts of additional financing, which may
not be available, before it will be able to generate positive cash flow. No
assurance can be given that Birch will be successful in developing and
maintaining a level of cash flow from operations sufficient to permit it to pay
the principal of, and interest and any other payments on, the Senior Notes. If
Birch is unable to generate sufficient cash flow from operations to service its
indebtedness, including the senior notes, it may have to



                                      -31-
<PAGE>   32

modify its growth plans, limit its capital expenditures, restructure or
refinance its indebtedness or seek additional capital or liquidate its assets.
There can be no assurance (i) that any of these strategies could be effected on
satisfactory terms, if at all, in light of Birch's high leverage or (ii) that
any such strategy would yield sufficient proceeds to service the Senior Notes.

YEAR 2000 ISSUE

         The year 2000 issue is the result of computer programs being written
using two digits rather than four to define the applicable year. Any of Birch's
computer programs that have date-sensitive software may recognize the date using
"00" as the year 1900 rather than the year 2000. The Company anticipates
spending $20 million on new systems from inception through the end of 1999 from
funds provided by the Senior Notes or from new sources of capital. Specific
expenditures for year 2000 costs are not being made related to the new systems.
The Company has completed its assessment on the consequences of the year 2000 on
information technology systems. As the Company has a relatively short history,
virtually all systems are newly created or are being created. During information
technology development, year 2000 issues have been consistently addressed. The
new information technology systems will, in certain cases, replace systems of
acquired companies in order to provide consistent and integrated systems. The
acquired companies' systems are not all year 2000 compliant, however, these
systems will be replaced by the third quarter of 1999. If all such systems are
not replaced and year 2000 issues occur, significant disruption to the Company's
operations could occur. The most significant system of the acquired companies
relates to the provisioning and billing of resale local and long distance
services which, if not replaced, could prevent the Company from billing or
provisioning service to existing and future customers. Installation of the
integrated billing and provisioning system is on schedule to date.

         Other non-information technology systems which may be affected by the
year 2000 issue include systems provided to the Company by third parties. The
most significant third party systems are those which operate SWBT's interfaces
and billing records, switching equipment and customer premises equipment. The
Company has been assured by significant third parties that year 2000 compliance
will be accomplished by the end of 1999. If such compliance is not achieved by
these third parties, it would have a material adverse effect on Birch's
business, operating results and financial condition and its ability to achieve
sufficient cash flow.

IMPACT OF INFLATION

         The Company does not believe that inflation has had a significant
impact on the Company's consolidated operations.

SEASONALITY

         The Company's business is not considered to be seasonal.

RECENTLY ISSUED ACCOUNTING STANDARDS

         The Company adopted Statement of Financial Accounting Standards (SFAS)
No. 130, "Reporting Comprehensive Income" during 1998. SFAS No. 130 establishes
standards for reporting and display of comprehensive income and its components
(revenues, expenses, gains, and losses) in a full set of general purpose
financial statements. SFAS No. 130 requires that an enterprise (a) classify
items of other comprehensive income by their nature in a financial statement and
(b) display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of a
statement of financial position. SFAS No. 130 had no material impact on the
Company's consolidated financial statements.

         The Company also adopted SFAS No. 131, "Disclosure About Segments of an
Enterprise and Related Information" in 1998. SFAS No. 131 established standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to shareholders. It also establishes standards for related
disclosure about products and services, geographic areas, and major customers.
The adoption of SFAS No. 131 required no additional disclosures in the Company's
consolidated financial statements.



                                      -32-
<PAGE>   33

         In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which supersedes SFAS No. 80, "Accounting
for Futures Contracts," SFAS No. 105, "Disclosure of Information About Financial
Instruments with Off-Balance-Sheet Risk and Financial Instruments with
Concentration of Credit Risk," and SFAS No. 119, "Disclosures about Derivative
Financial Instruments and Fair Value of Financial Instruments," and also amends
certain aspects of other SFAS's previously issued. SFAS No. 133 establishes
accounting and reporting standards for derivative instruments and hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the balance sheet and measure those instruments at fair
value. SFAS No. 133 is effective for the Company's consolidated financial
statements for the year ending December 31, 2000. The Company does not expect
the impact of SFAS No. 133 to be material in relation to its consolidated
financial statements.

ITEM 7A.          QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         The Company's exposure to market risk - through derivative financial
instruments and other financial instruments, such as investments in marketable
securities and long-term debt - is not material.

ITEM 8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         For information required by Item 8, refer to the "Consolidated
Financial Statements" section of the Financial Statements and Financial
Statement Schedules filed as part of this document.

ITEM 9.           CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                  AND FINANCIAL DISCLOSURE

         None















                                      -33-
<PAGE>   34



                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS, EXECUTIVE OFFICERS AND OTHER KEY EMPLOYEES

         The following table sets forth certain information concerning the
directors, executive officers and other key personnel of Birch, including their
ages as of December 31, 1998:

<TABLE>
<CAPTION>
NAME                                              AGE                             POSITION
----                                              ---                             --------
<S>                                               <C>   <C>
Henry H. Bradley............................      53    Chairman of the Board

David E. Scott..............................      39    President, Chief Executive Officer and Director

Gregory C. Lawhon...........................      39    Senior Vice President of Public Policy and General Counsel

Gary L. Chesser.............................      52    Senior Vice President of Engineering and Operations

David W. Vranicar...........................      40    Senior Vice President of Business Development

Bradley A. Moline...........................      31    Senior Vice President of Finance and Chief Financial Officer

Jeffrey D. Shackelford......................      38    Senior Vice President of Sales and Marketing

Donald H. Goldman...........................      39    Senior Vice President of Internet Services

Stephen L. Sauder...........................      52    Vice President and Director

Ian R. N. Bund..............................      55    Director

David W. Bergmann...........................      49    Director
</TABLE>

         Henry H. Bradley is Birch's Chairman of the Board of Directors (the
Board). Mr. Bradley also is the Chairman of the Board of News-Press & Gazette
Company (NPG), a co-founder of Birch. NPG is a family-owned company that owns
and operates a daily newspaper, cable television systems, network affiliate
broadcast television stations and FM and AM radio stations. Mr. Bradley has held
a number of other positions with NPG since joining NPG in 1971, including terms
as the Editor and Publisher of the St.
Joseph News-Press.

         David E. Scott, a co-founder and Director of Birch, is also its
President and Chief Executive Officer. Mr. Scott has 16 years of managerial
experience in the telecommunications industry. Prior to joining Birch, Mr. Scott
was President and General Manager of Kansas City FiberNet, a CLEC owned jointly
by the country's two largest cable operators, TCI and Time Warner. Prior to his
tenure at Kansas City FiberNet, Mr. Scott was Vice President of Strategic
Development for Sprint, responsible for developing investment plans in the
competitive local exchange, wireless (PCS) and international marketplaces. Mr.
Scott also served as Director of Strategic Planning for Sprint from 1988 to
1991. Mr. Scott also serves as a Director of DNS Publishing, an Internet
publishing company he co-founded with Donald H. Goldman. DNS Publishing produces
web sites that serve as on-line trade publications. Their first web site,
C-LECinfo (www.clec.com), serves the competitive local exchange carrier
industry.

         Gregory C. Lawhon joined Birch in January 1997 as its Senior Vice
President of Public Policy and General Counsel. Prior to joining Birch, Mr.
Lawhon practiced law for twelve years with the 90-lawyer Kansas City firm of
Spencer Fane Britt & Browne. A partner in the firm since 1990, he was head of
the firm's Communications and Media Group and a member of its Business Group.
Mr. Lawhon's areas of practice were mergers and acquisitions, with an emphasis
on communications industry acquisitions, cable television franchising, and
commercial and regulatory issues with respect to the telecommunications
industry.

         Gary L. Chesser joined Birch in March 1997 as its Senior Vice President
of Engineering and Operations. Prior to joining Birch, Mr. Chesser was Vice
President-Director of Engineering & Operations with Time Warner Connect, a
startup business unit offering local and long distance telephony, cable
television, and home security



                                      -34-
<PAGE>   35

services. Prior to joining Time Warner, Mr. Chesser was employed by US West
leading business process development and implementation for a startup data
communications business unit called !NTERPRISE. Prior to joining US West, Mr.
Chesser was employed by SWBT from 1965 to 1991 in a variety of engineering and
operations and managerial positions.

         David W. Vranicar joined Birch in March 1997 as its Senior Vice
President of Business Development. Prior to joining Birch, Mr. Vranicar was Vice
President, International Business Development, at Sprint. In that capacity, he
directed Sprint's pursuit of numerous international strategic partnering
opportunities, including ventures in China, Israel, Taiwan, Japan, Italy and
Spain. During his tenure at Sprint, which began in 1992, Mr. Vranicar played a
key role in many domestic business development activities, including a PCS joint
venture with TCI, Cox Cable Communications, Inc. and Comcast Corp.

         Bradley A. Moline joined Birch in July 1997 as its Senior Vice
President of Finance and Chief Financial Officer. From 1994 to 1997, Mr. Moline
was the Treasurer and Chief Financial Officer of Covenant Transport, Inc., a
transportation company in Chattanooga, Tennessee that became publicly traded
during his tenure. Prior to joining Covenant Transport, Mr. Moline worked for
Ernst & Young LLP in Kansas City, Missouri and Grant Thornton in Lincoln,
Nebraska, providing client services in the auditing and consulting areas.

         Jeffrey D. Shackelford, a co-founder of Birch, is Senior Vice President
of Sales and Marketing. Mr. Shackelford has 13 years of experience in the
telecommunications industry. Prior to joining Birch, Mr. Shackelford served as
Director of Sales and Marketing for Kansas City FiberNet. Prior to joining
Kansas City FiberNet, Mr. Shackelford was the Branch Manager for Sprint's
Commercial Sales office in Kansas City and was responsible for sales and service
of small to large business clients. During his tenure at Sprint, which began in
1988, Mr. Shackelford also developed the long distance industry's first PC-based
call management system, FONVIEW.

         Donald H. Goldman joined Birch in March 1998 as its Senior Vice
President of Internet Services. Mr. Goldman has over 13 years of managerial
experience in the telecommunications industry. Prior to joining Birch, Mr.
Goldman served as Vice President, Corporate Development at Sprint where he
developed the strategy and managed the acquisition of companies in the areas of
systems integration, Internet telephony, and wireless (PCS) services among
others. Mr. Goldman also serves as a Director of DNS Publishing, an Internet
publishing company he co-founded with David E. Scott.

         Stephen L. Sauder is a Vice President and Director of the Company. Mr.
Sauder was elected as a Director of Birch in February 1998, as the designee of
the holders of the Company's Series C Preferred Stock. Mr. Sauder was a
co-founder of Valu-Line in 1982, and served as President and Chief Executive
Officer of Valu-Line until February 1998, when Birch and Valu-Line were merged.

         Ian R. N. Bund was elected as a director of Birch in February 1998, as
the designee of White Pines Management L.L.C. (White Pines). Mr. Bund also has
been President of White Pines since 1996. From 1990 to 1996, Mr. Bund served as
president of White Pines Capital Corporation, a management company, and general
partner of its predecessor partnership. In addition, from 1993 to 1995, while
continuing to operate his management company, Mr. Bund served as Senior Vice
President -- Corporate Finance of First Michigan Corporation, a leading Michigan
investment banking and brokerage firm. Mr. Bund also currently serves on the
boards of directors of several private companies.

         David W. Bergmann was elected as a director of Birch in February 1998,
as the designee of Advantage Capital Missouri Partners I, L.P. (Advantage).
Since 1992, he has been involved in the analysis, negotiation of terms, and
structuring of various portfolio company investments at Advantage Capital
Partners, which he co-founded. Mr. Bergmann also serves on the boards of
directors of several private companies as well as one commercial bank. In
addition, he is the Chairman of the Board of Interface Security, L.L.C., an
electronic security firm. He also serves as a consultant to Barnes Associates,
an investment banking firm specializing in evaluations, mergers, acquisitions,
and financing in the electronic security and communications fields.



                                      -35-
<PAGE>   36

ITEM 11.          EXECUTIVE COMPENSATION

COMPENSATION OF DIRECTORS

         Directors do not receive compensation for their service as directors,
except that [NON-EMPLOYEE] directors are reimbursed for out-of-pocket expenses
incurred in connection with attendance at meetings of the Board and its
committees.

COMPENSATION OF EXECUTIVE OFFICERS

                             SUMMARY OF COMPENSATION

         The following table sets forth the cash and non-cash compensation paid
or incurred on behalf of Birch to its Chief Executive Officer and four other
executive officers (the Named Executive Officers) for the years ended December
31, 1998 and 1997:

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                                                         LONG-TERM COMPENSATION
                                                                                                 AWARDS
                                                                                         ----------------------
                                                   ANNUAL COMPENSATION                   SECURITIES UNDERLYING       ALL OTHER
NAME AND                                           -------------------  OTHER ANNUAL            OPTIONS            COMPENSATION
PRINCIPAL POSITION             YEAR      SALARY($)       BONUSES      COMPENSATION($)            (#)(A)               ($)(E)
--------------------------     ----     ----------     ----------     ---------------    -----------------------   ------------
<S>                            <C>      <C>            <C>            <C>                <C>                       <C>
David E. Scott.............    1998       175,000            --              --                  1,052,362             7,000
  President and Chief          1997       164,904            --              --                    --                   --
  Executive Officer(b)
Gregory C. Lawhon..........    1998       175,000            --              --                    328,863             5,386
  Senior Vice President of     1997       164,904            --              --                    --                   --
  Public Policy and
  General Counsel(b)
Gary L. Chesser............    1998       140,000         35,000             --                    301,458              --
  Senior Vice President of     1997       115,769         35,000             --                    --                   --
  Engineering and
  Operations(c)
David W. Vranicar..........    1998       150,000            --              --                    274,052             6,000
  Senior Vice President of     1997       118,269            --              --                    --                   --
  Business Development(c)
Stephen L. Sauder..........    1998       226,471            --              --                    --                   --
  Vice President(d)            1997       134,577            --           128,667                  --                   --
</TABLE>

--------------------------------------------
(a)  Includes options to purchase shares of the Company's Common Stock, which
     were issued pursuant to the 1998 Stock Option Plan. Prior to the private
     placement of the Company's Series B Preferred Stock, Birch was a party to
     various stock option agreements with employees of the Company, all of which
     were governed by the Company's 1997 Stock Option Plan. In connection with
     the private placement of Series B Preferred Stock, the 1997 Stock Option
     Plan was replaced with the 1998 Stock Option Plan, and all stock option
     agreements governed by the 1997 Stock Option Plan were terminated. Options
     issued to the members of management listed above pursuant to the 1998 Stock
     Option Plan are exercisable immediately on grant at an exercise price of
     $.001 per share, and vest over a four-year period, at a rate of 6.25% per
     quarter. The stock options have been adjusted to reflect the Stock Dividend
     on June 23, 1998. Holders of exercised options have voting power with
     respect to all shares of Common Stock underlying the options. Upon
     termination of employment with the Company, Birch has the right to purchase
     all options which have not vested as of that date, subject to certain
     exceptions.

(b)  Reflects compensation paid to Messrs. Scott and Lawhon commencing in
     January 1997.

(c)  Reflects compensation paid to Messrs. Chesser and Vranicar commencing in
     March 1997.

(d)  Mr. Sauder joined Birch after the Valu-Line acquisition and currently
     serves as Vice President of the Company. Compensation listed was paid by
     Valu-Line from January 1997 to February 1998.

(e)  Reflects matching contributions made by the Company under its 401(k) plan.


                                      -36-
<PAGE>   37




                                 OPTIONS GRANTS

         STOCK OPTION GRANTS AND EXERCISES

         The Company grants options to its executive officers under its 1998
Stock Option Plan (the Plan). As of March 29, 1999, options to purchase a total
of 5,352,934 shares were outstanding under the Plan and options to purchase
842,911 shares remained available for grant thereunder.

         The following table shows, for the fiscal year ended December 31, 1998,
certain information regarding options granted to, exercised by, and held at year
end by the Named Executive Officers:

<TABLE>
<CAPTION>
                                                                                                      POTENTIAL
                                                                                                  REALIZABLE VALUE
                                                     INDIVIDUAL GRANTS                               AT ASSUMED
                                --------------------------------------------------------------     ANNUAL RATES OF
                                  NUMBER OF          % OF TOTAL                                      STOCK PRICE
                                 SECURITIES           OPTIONS                                     APPRECIATION FOR
                                 UNDERLYING          GRANTED TO      EXERCISE OR                    OPTION TERM(C)
                                   OPTIONS          EMPLOYEES IN      BASE PRICE   EXPIRATION     -----------------
NAME                            GRANTED(#)(A)      FISCAL YEAR(B)       ($/SH)        DATE        5%($)      10%($)
----                            -------------      --------------    -----------   ----------     -----      ------
<S>                             <C>                <C>               <C>           <C>            <C>        <C>
David E. Scott ............        931,696             18.4%            .001        2/10/2008     555        1,407
                                   120,666              2.4%            .001        3/13/2008      72          182
Gregory C. Lawhon..........        291,155              5.7%            .001        2/10/2008     174          440
                                    37,708              0.7%            .001        3/13/2008      22           57
Gary L. Chesser............        266,893              5.3%            .001        2/10/2008     159          403
                                    34,565              0.7%            .001        3/13/2008      21           52
David W. Vranicar..........        242,628              4.8%            .001        2/10/2008     145          367
                                    31,424              0.6%            .001        3/13/2008      19           47
Stephen L. Sauder..........             --             --                 --               --      --           --
</TABLE>

---------------------
(a)  Includes options to purchase shares of Common Stock, which were issued
     pursuant to the 1998 Stock Option Plan. Prior to the private placement of
     Series B Preferred Stock, Birch was a party to various stock option
     agreements with employees of the Company, all of which were governed by the
     Company's 1997 Stock Option Plan. In connection with this private placement
     of Series B Preferred Stock, the 1997 Stock Option Plan was replaced with
     the 1998 Stock Option Plan, and all stock option agreements governed by the
     1997 Stock Option Plan were terminated. Options issued pursuant to the 1998
     Stock Option Plan are exercisable immediately on grant at an exercise price
     of $.001 per share, and vest over a four-year period, at a rate of 6.25%
     per quarter. The stock options have been adjusted to reflect the Stock
     Dividend on June 23, 1998. Holders of exercised options have voting power
     with respect to all shares of Common Stock underlying the options. Upon
     termination of employment with the Company, Birch has the right to purchase
     all options which have not vested as of that date, subject to certain
     exceptions.

(b)  Based on an aggregate of options to purchase 5,352,934 shares of Birch's
     Common Stock granted to employees of Birch in fiscal 1998, including the
     Named Executive Officers.

(c)  The potential realizable value assumes a per-share market price at the time
     of the grant to be approximately $.001 with an assumed rate of appreciation
     of 5% and 10%, respectively, compounded annually for 10 years.




                                      -37-
<PAGE>   38


 AGGREGATED OPTIONS EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION 
VALUES(A)

<TABLE>
<CAPTION>
                                                                         NUMBER OF SECURITIES         VALUE OF
                                                                              UNDERLYING             UNEXERCISED
                                                                              UNEXERCISED           IN-THE-MONEY
                                           SHARES                             OPTIONS(#)             OPTIONS($)
                                         ACQUIRED ON          VALUE         EXERCISABLE(E)         EXERCISABLE(E)
NAME                                   EXERCISE(#)(B)      REALIZED($)    UNEXERCISABLE(U)(C)    UNEXERCISABLE(U)(C)
----                                   --------------      ----------    --------------------    -------------------
<S>                                    <C>                 <C>           <C>                     <C>
David E. Scott..................          197,318               --                 -- (E)              -- (E)
                                                                              855,044 (U)              -- (U)
Gregory C. Lawhon...............           61,662               --                 -- (E)              -- (E)
                                                                              267,201 (U)              -- (U)
Gary L. Chesser.................           56,523               --                 -- (E)              -- (E)
                                                                              244,935 (U)              -- (U)
David W. Vranicar...............           51,385               --                 -- (E)              -- (E)
                                                                              222,667 (U)              -- (U)
Stephen L. Sauder...............               --               --                 -- (E)              -- (E)
                                                                                   -- (U)              -- (U)
</TABLE>

-----------------------------------
(a)  The options/SARs shown reflect options granted as of December 31, 1998.

(b)   For purposes of this table alone, "exercise" means an employee's
      acquisition of shares of Common Stock which have already vested,
      "exercisable" means options to purchase shares of Common Stock which are
      subject to exercise and "unexercisable" means all other options to
      purchase shares of Common Stock

(c)  Includes options to purchase shares of Common Stock, which were issued
     pursuant to the 1998 Stock Option Plan. Prior to the private placement of
     Series B Preferred Stock, Birch was a party to various stock option
     agreements with employees of the Company, all of which were governed by the
     Company's 1997 Stock Option Plan. In connection with this private placement
     of Series B Preferred Stock, the 1997 Stock Option Plan was replaced with
     the 1998 Stock Option Plan, and all stock option agreements governed by the
     1997 Stock Option Plan were terminated. Options issued pursuant to the 1998
     Stock Option Plan are exercisable immediately on grant at an exercise price
     of $.001 per share, and vest over a four-year period, at a rate of 6.25%
     per quarter. The stock options have been adjusted to reflect the Stock
     Dividend on June 23, 1998. Holders of exercised options have voting power
     with respect to all shares of Common Stock underlying the options. Upon
     termination of employment with the Company, Birch has the right to purchase
     all options which have not vested as of that date, subject to certain
     exceptions.

EMPLOYMENT AGREEMENTS

     David E. Scott. Mr. Scott is party to an employment agreement with Birch
dated as of February 10, 1998. Under his employment agreement, Mr. Scott
receives a base salary of $175,000 per annum. Mr. Scott is also eligible for a
bonus based on achievement of performance criteria established by the Board. Mr.
Scott's employment agreement is for an initial three-year term, and
automatically renews for additional one-year terms unless either Mr. Scott or
Birch provides written notice to each other at least 90 days prior to such
renewal. Mr. Scott's employment agreement provides that upon termination of
employment by Birch, other than for cause, disability or death, Birch shall pay
Mr. Scott's salary for the remainder, if any, of the calendar month in which
such termination is effective and for 24 consecutive calendar months thereafter.
The agreement also provides for noncompetition, nonsolicitation and
nondisclosure covenants.

     Gregory C. Lawhon. Mr. Lawhon is party to an employment agreement with
Birch dated as of February 10, 1998. Under his employment agreement, Mr. Lawhon
receives a base salary of $175,000 per annum. Mr. Lawhon is also eligible for a
bonus based on achievement of performance criteria established by the Board. Mr.
Lawhon's employment agreement is for an initial one-year term, and automatically
renews for additional one-year terms unless either Mr. Lawhon or Birch provides
written notice to each other at least 90 days prior to such renewal. Mr.
Lawhon's employment agreement provides that upon termination of employment by
Birch, other than for cause, disability or death, Birch shall pay Mr. Lawhon's
salary for the remainder, if any, of the calendar month in which



                                      -38-
<PAGE>   39

such termination is effective and for 12 consecutive calendar months thereafter.
The agreement also provides for noncompetition, nonsolicitation and
nondisclosure covenants.

     Gary L. Chesser. Mr. Chesser is party to an employment agreement with Birch
dated as of February 10, 1998. Under his employment agreement, Mr. Chesser
receives a base salary of $150,000 per annum. Mr. Chesser is also eligible for a
bonus based on achievement of performance criteria established by the Board. Mr.
Chesser's employment agreement is for an initial one-year term, and
automatically renews for additional one-year terms unless either Mr. Chesser or
Birch provides written notice to each other at least 90 days prior to such
renewal. Mr. Chesser's employment agreement provides that upon termination of
employment by Birch, other than for cause, disability or death, Birch shall pay
Mr. Chesser's salary for the remainder, if any, of the calendar month in which
such termination is effective and for 12 consecutive calendar months thereafter.
The agreement also provides for noncompetition, nonsolicitation and
nondisclosure covenants.

     David W. Vranicar. Mr. Vranicar is party to an employment agreement with
Birch dated as of February 10, 1998. Under his employment agreement, Mr.
Vranicar receives a base salary of $150,000 per annum. Mr. Vranicar is also
eligible for a bonus based on achievement of performance criteria established by
the Board. Mr. Vranicar's employment agreement is for an initial one-year term,
and automatically renews for additional one-year terms unless either Mr.
Vranicar or Birch provides written notice to each other at least 90 days prior
to such renewal. Mr. Vranicar's employment agreement provides that upon
termination of employment by Birch, other than for cause, disability or death,
Birch shall pay Mr. Vranicar's salary for the remainder, if any, of the calendar
month in which such termination is effective and for 12 consecutive calendar
months thereafter. The agreement also provides for noncompetition,
nonsolicitation and nondisclosure covenants.

     Stephen L. Sauder. Mr. Sauder is party to an employment agreement with
Birch dated as of February 10, 1998. Under his employment agreement, Mr. Sauder
receives a base salary of $213,000 per annum. Mr. Sauder is also eligible for a
bonus based on achievement of performance criteria established by the Board. Mr.
Sauder's employment agreement is for an initial one-year term, and automatically
renews for additional one-year terms unless either Mr. Sauder or Birch provides
written notice to each other at least 90 days prior to such renewal. Mr.
Sauder's employment agreement provides that upon termination of employment by
Birch, other than for cause, disability or death, Birch shall pay Mr. Sauder's
salary for the remainder, if any, of the calendar month in which such
termination is effective and for 12 consecutive calendar months thereafter. The
agreement also provides for noncompetition, nonsolicitation and nondisclosure
covenants.











                                      -39-
<PAGE>   40


COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

     The Compensation Committee of the Board of Directors consists of Ian R. N.
Bund, Henry H. Bradley and David E. Scott.

Report of the Compensation Committee of the Board of Directors

       REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS ON
                             EXECUTIVE COMPENSATION


         COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION

         The following is a report of the Compensation Committee of the Board
(the "Committee") describing the compensation policies applicable to the
Company's executive officers (including the Named Executive Officers) during the
fiscal year ended December 31, 1998.

         GENERAL POLICIES

         The Committee is responsible for assisting the Company's Chief
Executive Officer (the "CEO") in devising the general compensation policies and
compensation plans of the Company, as well as the specific compensation levels
for individual executive officers. The Committee also administers the Company's
stock option, employee stock purchase and 401(k) plans and determines the terms
and conditions of grants thereunder. The Committee consists of two non-employee
Board members and the CEO. The CEO does not participate in Committee
deliberations or decisions involving his own compensation.

         The Company's compensation policies are designed to link the executive
officers' compensation to the annual and long-term performance of the Company,
to provide compensation that is competitive with that of executives in the
industry, to reward performance and teamwork, and to attract and retain superior
talent. The compensation mix reflects a balance of annual cash payments,
consisting of annual base salary payments and incentive bonus payments, and
long-term stock-based incentives in the form of stock options. The emphasis in
incentive compensation is placed on strategic, stock-based options that align
the financial interests of the Company's employees with those of its
stockholders.

         BASE SALARIES

         The salary component of executive compensation is based on the
executive's level of responsibility for meeting Company objectives and
performance. Base salaries for executives are reviewed and adjusted at least
annually based on information regarding competitive salaries, the results of
industry compensation surveys, individual experience and performance.

         CASH BONUSES

         The Company's incentive program for executive officers provides direct
financial incentives in the form of cash bonuses based on previous year
performance.

         STOCK OPTIONS

         The Company's 1998 Stock Option Plan provides for the issuance of stock
options to officers and employees of the Company to purchase shares of the
Company's common stock at an exercise price equal to the fair market value of
such stock on the date of grant. The Company's stock options typically vest over
a 48-month period.

         The Company's compensation policies recognize the importance of stock
ownership by senior executives, and stock options are an integral part of each
executive's compensation. The Committee believes that the



                                      -40-
<PAGE>   41

opportunity for stock appreciation through stock options that vest over time
promotes the relationship between long-term interests of executive officers and
stockholders. The size of specific grants takes into account the executive
officer's salary and the number of options previously granted to the officer, as
well as his or her contributions to the Company's success.

         COMPENSATION OF THE CHIEF EXECUTIVE OFFICER

         David E. Scott has served as President and CEO since the Company's
inception. In February 1998 he entered into an employment agreement with the
Company, the terms of which are described in more detail in "Employment
Agreements."

         During fiscal 1998, Mr. Scott received a base salary of $175,000 and
options to purchase an aggregate of 1,052,362 shares of the Company's common
stock. In reviewing the compensation paid to Mr. Scott for fiscal 1998, the
Committee applied the factors discussed above in this Report under the headings
"Base Salaries," "Cash Bonuses," and "Stock Options." In addition, the Committee
considered a number of other factors, including competitive market compensation
packages, Mr. Scott's past performance at the Company and the responsibilities
he was undertaking in assuming the position of CEO. Based on its internal review
and informal information reviewed by the Committee, the Committee believes that
the base salary level for the CEO is commensurate with salaries paid to chief
executive officers of comparable companies engaged in similar industries.

         Overall, the Committee believes that Mr. Scott is being appropriately
compensated in a manner that is consistent with the long-term interests of
stockholders.

         The members of the Committee submit the foregoing report.

                         COMPENSATION COMMITTEE:

                            Henry H. Bradley
                            Ian R. N. Bund
                            David E. Scott

ITEM 12.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         Birch's outstanding capital stock as of December 31, 1998 consisted of
5,000,296 shares of Common Stock, 8,572,039 shares of Series B Preferred Stock
and 8,492,749 shares of Series C Preferred Stock.

         The following table sets forth certain information regarding the
beneficial ownership of the capital stock of Birch by: (i) each of the directors
and the Named Executive Officers of Birch; (ii) all directors and Named
Executive Officers as a group and (iii) each owner of more than 5% of the equity
securities of Birch (5% Owners). Unless otherwise noted, the address for each
director and Named Executive Officer of Birch is c/o Birch Telecom, Inc., 2020
Baltimore Avenue, Kansas City, Missouri 64108.

<TABLE>
<CAPTION>
                                                                                                            PERCENTAGE
                                                                                                              OF TOTAL
                                            NUMBER OF SHARES                        PERCENTAGE OF           VOTING POWER
                                            BENEFICIALLY OWNED                       CLASS OWNED                 OF
  NAME AND ADDRESS OF              -------------------------------------    ------------------------------  FULLY DILUTED
   BENEFICIAL OWNER(A)             COMMON(B)     SERIES B      SERIES C     COMMON(B) SERIES B    SERIES C   COMMON STOCK
-----------------------------      ---------    ----------    ----------    --------- --------    --------  --------------
<S>                                <C>          <C>           <C>           <C>       <C>         <C>       <C>
DIRECTORS AND EXECUTIVE
  OFFICERS:
Henry H. Bradley(c) ..........            --     1,978,128     1,582,500         --%    23.1%       18.6%        15.2%
David E. Scott ...............     1,190,768            --       189,900       18.6       --         2.2          5.9
Gregory C. Lawhon ............       380,137        49,453            --        5.9        *           --         1.8
Gary L. Chesser ..............       348,459        32,969            --        5.4        *           --         1.6
David W. Vranicar ............       316,780        36,266            --        4.9        *           --         1.5
Bradley A. Moline(d) .........       297,932        70,625            --        4.6        *           --         1.6
Jeffrey D. Shackelford .......       794,160            --       126,600       12.4       --          1.5         3.9
Stephen L. Sauder(e) .........            --        85,719     6,311,797         --      1.0         74.3        27.3
Donald H. Goldman ............       263,750            --            --        4.1       --           --         1.1
Ian R. Bund(f) ...............            --        47,808            --         --        *           --           *
David W. Bergmann(g) .........            --            --            --         --       --           --          --
All directors and
  executive officers as
  a group (11 persons) .......     3,591,987     2,300,968     8,210,797       56.0     26.8         96.7        60.1
5% OWNERS:
News-Press & Gazette
  Company(h) .................            --     1,648,438     1,582,500         --     19.2         18.6        13.8
Advantage Capital
  Missouri Partners I,
  L.P.(g)(i) .................            --     1,318,750            --         --     15.4           --         5.6
Pacific Capital, L.P.(f)(j) ..            --     1,219,925            --         --     14.2           --         5.2
</TABLE>


                                      -41-
<PAGE>   42

--------------------------------------------
 *       Less than one percent
(a)   Beneficial ownership is determined in accordance with the Commission's
      rules and includes voting and investment power with respect to the shares.
(b)   Includes options to purchase shares of the Common Stock, which were issued
      pursuant to the 1998 Stock Option Plan. Certain options are exercisable
      immediately on grant at an exercise price of $.001 per share, and vest
      over a four-year period, at a rate of 6.25% per quarter. Holders of
      exercised options have voting power with respect to all shares of Common
      Stock underlying the options. Upon termination of employment with the
      Company, Birch has the right to purchase all options which have not vested
      as of that date, subject to certain exceptions.
(c)   Includes 1,648,438 shares of Series B Preferred Stock and 1,582,500 shares
      of Series C Preferred Stock held by NPG. Mr. Bradley and his brother hold
      voting power of NPG. Also includes 329,687 shares of Series B Preferred
      Stock held by various trusts and relatives of the Bradley family.
(d)   Includes 5,275 shares of Series B Preferred Stock held by Mr. Moline's
      father.
(e)   Includes 65,937 shares of Series B Preferred Stock held by Mr. Sauder's
      father.
(f)   Mr. Bund is the president of White Pines Management which provides
      management of White Pines L.P. I and the Pacific Capital, L.P. investment
      funds. Mr. Bund serves on the Board of Birch.
(g)   Mr. Bergmann is a general partner of Advantage Capital Missouri Partners
      I, L.P. and serves on the Board of Birch.
(h)   The principal business address of NPG is 825 Edmond Street, St. Joseph, MO
      64501.
(i)   The principal business address of Advantage is 7733 Forsyth Boulevard,
      Suite 1850, St. Louis, MO 63105.
(j)   The principal business address of Pacific Capital, L.P. is 2401 Plymouth
      Road, Suite B, Ann Arbor, MI 48105.

ITEM 13.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

PURCHASE OF SERIES A PREFERRED STOCK BY STEPHEN L. SAUDER

         In connection with the merger of Birch and Valu-Line, the Company paid
to Stephen L. Sauder, the principal stockholder of Valu-Line, 2,968,750 shares
of its Series A Preferred Stock, 5,982,746 shares of its Series C Preferred
Stock and $4,750500,000 in cash. During the year ended December 31, 1998, the
Company paid dividends of $168,000 to Mr. Sauder, the holder of all of the
Company's Series A Preferred Stock. Pursuant to the Purchasers Rights Agreement
dated February 10, 1998 (the Purchasers Rights Agreement), Mr. Sauder was
elected as a Director of the Company. In June 1998, Birch repurchased all of the
outstanding shares of Birch's Series A Preferred Stock held by Mr. Sauder.

SERIES B PREFERRED STOCK OFFERING

         On March 13, 1998, Birch completed a private placement of 6,264,074
shares of its Series B Preferred Stock (the Series B Preferred Stock Offering)
having an aggregate liquidation preference of $9.5 million and $3.5 million in
aggregate principal amount of its Convertible Notes which on June 18, 1998 were
converted to 2,307,965 shares of Series B Preferred Stock, raising aggregate net
proceeds of approximately $12.4 million. The transaction was consummated
pursuant to the Purchasers Rights Agreement and the Securities Purchase
Agreement, agreements



                                      -42-
<PAGE>   43

which designate certain rights and obligations of the Series B Preferred Stock.
See "-- Purchasers Rights Agreement" and "-- Securities Purchase Agreement."
Pursuant to the Securities Purchase Agreement, NPG, a stockholder which owns in
excess of 5% of the Company's voting securities, purchased $2,500,000 of Series
B Preferred Stock, and certain parties affiliated with NPG, including Henry H.
Bradley, Chairman of the Board of the Company, purchased $500,000 of Series B
Preferred Stock. In addition, pursuant to the Securities Purchase Agreement,
Bradley A. Moline and Gregory C. Lawhon, executive officers of Birch, purchased
$105,000 and $75,000 of Series B Preferred Stock, respectively. In connection
with this Series B Preferred Stock Offering, NPG surrendered 1,500,000 shares of
Common Stock and 1,500,000 warrants exercisable into shares of Common Stock in
exchange for 1,582,500 shares of Series C Preferred Stock; David E. Scott,
Birch's President, Chief Executive Officer and Director, surrendered 180,000
shares of Common Stock and 180,000 warrants exercisable into shares of Common
Stock in exchange for 189,900 shares of Series C Preferred Stock; and Jeffrey D.
Shackleford, Birch's Senior Vice President of Sales and Marketing, surrendered
120,000 shares of Common Stock and 120,000 warrants exercisable into shares of
Common Stock in exchange for 126,600 shares of Series C Preferred Stock. The
Company then cancelled the exchanged shares and warrants exercisable into shares
of common stock.

         In connection with this Series B Preferred Stock transaction, Gregory
C. Lawhon, Birch's Senior Vice President of Public Policy and General Counsel,
purchased 49,453 shares, Gary L. Chesser, Birch's Senior Vice President of
Engineering and Operations, purchased 32,969 shares, David W. Vranicar, Senior
Vice President of Business Development, purchased 36,266 shares and Bradley A.
Moline, Birch's Senior Vice President of Finance and Chief Financial Officer,
purchased 70,625 shares.

PURCHASERS RIGHTS AGREEMENT

         Current stockholders of Birch are parties to the Purchasers Rights
Agreement, pursuant to which they agreed to vote their respective shares in such
a manner as to elect certain persons to serve as Directors. The holders of
Series B Preferred Stock have agreed to vote their shares to elect one designee
of NPG; one designee of Advantage and one designee of White Pines. In addition,
the holders of Series C Preferred Stock agreed to vote their shares to elect
Stephen L. Sauder, and the holders of Common Stock agreed to vote their shares
for the election of David E. Scott. As a result, so long as the Purchasers
Rights Agreement is in effect, these investors will effectively control the
election of the Company's Board of Directors.

     Registration Rights

         The parties to the Purchasers Rights Agreement, subject to certain
conditions, have certain registration rights with respect to shares of Common
Stock, including shares of Common Stock issuable upon conversion or redemption
of shares of Series B Preferred Stock or upon conversion of shares of Series C
Preferred Stock. Such purchasers may, subject to certain conditions, require
Birch to register their shares of Common Stock pursuant to the Securities Act in
connection with an underwritten public offering of the Common Stock to the
general public. Each purchaser of stock pursuant to the Purchasers Rights
Agreement is subject to lock-up restrictions in the event of a public offering
of Birch's securities.

     Restrictions on Transfer

         Birch's outstanding Common Stock (including shares issued pursuant to
Options), Series B Preferred Stock and Series C Preferred Stock are subject to
certain restrictions on transfer. Holders of Common Stock, Series B Preferred
Stock and Series C Preferred Stock that are parties to the Purchasers Rights
Agreement, subject to certain exceptions, may not transfer their shares without
first giving Birch the opportunity to purchase such shares (a Right of First
Refusal). In addition, holders of Common Stock and Series C Preferred Stock that
are parties to the Purchasers Rights Agreement, subject to certain exceptions,
may not transfer their shares without first giving the holders of Series B
Preferred Stock the opportunity to participate in such transfer (a Co-Sale
Right). Holders of Common Stock, Series B Preferred Stock and Series C Preferred
Stock that are parties to the Purchasers Rights Agreement are required to sell
their shares in the event of an agreement by 66-2/3% of the outstanding shares
of Common Stock (assuming conversion or exercise of all convertible securities,
options or warrants) to sell or transfer their shares, or to sell all or
substantially all of the assets of Birch to a third party.



                                      -43-
<PAGE>   44

     Pre-Emptive Rights

         Holders of Birch's Series B Preferred Stock and Series C Preferred
Stock have the right to purchase a pro rata portion of any Common Stock or
Preferred Stock that Birch proposes to sell and issue, subject to certain
exceptions.

     Size of the Board of Directors

         The Purchasers Rights Agreement provides that so long as 10% or more of
the outstanding shares of Series B Preferred Stock are held by the parties to
the Purchasers Rights Agreement, the approval by the vote or written consent of
the holders of at least a majority of the then-outstanding shares of Series B
Preferred Stock shall be necessary to change the size of the Board of Directors.

SECURITIES PURCHASE AGREEMENT

         In connection with the Series B Preferred Stock Offering, the current
stockholders entered into the Securities Purchase Agreement. Pursuant to this
agreement, Birch sold shares of its Common Stock to certain of its employees
pursuant to the Stock Purchase Plan and sold shares of its Series B Preferred
Stock and Convertible Notes to certain investors. In addition, pursuant to the
Securities Purchase Agreement, Birch implemented a plan of recapitalization
whereby it exchanged all shares of its Common Stock and warrants for shares of
its Common Stock issued and outstanding prior to the Securities Purchase
Agreement for shares of its Series C Preferred Stock. Birch then cancelled the
exchanged shares of common stock and warrants exercisable into shares of common
stock.

SALES OF COMMON STOCK TO EXECUTIVE OFFICERS OF THE COMPANY

         In connection with the Series B Preferred Stock Offering, 474,750
shares of the Company's Common Stock were sold to certain employees of the
Company for an aggregate purchase price of $450.00. The shares were sold
pursuant to the Company's Stock Purchase Plan. In connection with this
transaction, David E. Scott, Birch's President, Chief Executive Officer and
Director, purchased 138,405 shares of Common Stock, Jeffrey D. Shackelford,
Birch's Senior Vice President of Sales and Marketing, purchased 92,587 shares of
Common Stock, Gregory C. Lawhon, Birch's Senior Vice President of Public Policy
and General Counsel, purchased 51,273 shares of Common Stock, Gary L. Chesser,
Birch's Senior Vice President of Engineering and Operations, purchased 47,000
shares of Common Stock, David W. Vranicar, Senior Vice President of Business
Development, purchased 42,728 shares of Common Stock and Bradley A. Moline,
Birch's Senior Vice President of Finance and Chief Financial Officer, purchased
34,182 shares of Common Stock.

NPG LOAN

         On December 16, 1997, the Company borrowed $250,000 from NPG in order
to satisfy its working capital needs. NPG is a stockholder which owns in excess
of 5% of the Company's voting securities. The loan was repaid with the proceeds
of the Company's private placement of its Series B Preferred Stock and
Convertible Notes.

VALU-LINE LOANS

         As of December 31, 1997, Valu-Line, which merged into Birch on February
10, 1998, had notes payable of $111,870 from Stephen L. Sauder. Mr. Sauder was
the President and principal stockholder of Valu-Line at the time the loan was
made and is currently a Vice President and a Director of the Company. In
addition, as of December 31, 1997, Valu-Line had notes payable of $105,457 from
Mr. Sauder's father. The loans were due on demand. As of December 31, 1998, the
amounts outstanding under these loans were fully repaid.

DEALINGS WITH VALU-BROADCASTING, INC.

         In 1996, 1997, and 1998, Valu-Line provided services principally
related to rent and operating costs to Valu-Broadcasting, Inc., an affiliate of
Valu-Line and owned by a Birch stockholder at the time of the transactions, in
the amounts of $74,000, $81,000 and $30,000 respectively. Valu-Line also
received services principally related to advertising from Valu-Broadcasting,
Inc. in the amounts of $31,000, $41,000 and $40,000 in 1996, 1997 and
1998,respectively.




                                      -44-
<PAGE>   45


                                     PART IV

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

(a)      Documents filed as part of this report

         (1)      Financial Statements

                  See "Item 8. Financial Statements and Supplementary Data" for
                  Financial Statements included with this Annual Report on Form
                  10-K.

         (2)      Financial Statement Schedules

         All schedules have been omitted because they are not required, not
applicable, or the information is otherwise set forth in the financial
statements or notes thereto.

         (3)      Exhibits

                  (a)  Exhibits

<TABLE>
<CAPTION>
   EXHIBIT
     NO.                                  DESCRIPTION OF EXHIBIT
   -------                                -----------------------
   <S>          <C>
     2.1        Agreement and Plan of Merger among Birch Telecom, Inc.,
                Valu-Line Companies, Inc., Stephen L. Sauder, Paula K. Sauder,
                Richard L. Tidwell, Sarah J. Tidwell, Stormy Supiran and Carla
                S. Supiran. (incorporated by reference to Exhibit 2.1 to Birch
                Telecom, Inc.'s Registration Statement on Form S-4, as amended
                (SEC File No. 333-62797), originally filed September 3, 1998
                (the "Form S-4")).
     3.1        Amended and Restated Certificate of Incorporation of Birch
                Telecom, Inc. (incorporated by reference to Exhibit 3.1 to the
                Form S-4).
    #3.2        Certificate of Amendment of Amended and Restated Certificate of
                Incorporation.
     3.3        Restated Bylaws of Birch Telecom, Inc. (incorporated by
                reference to Exhibit 3.2 to the Form S-4).
     4.1        Indenture, dated as of June 23, 1998, between Birch Telecom,
                Inc. and Norwest Bank Minnesota, National Association, as
                trustee, relating to $115,000,000 aggregate principal amount of
                14% Senior Notes due 2008 (incorporated by reference to Exhibit
                4.1 to the Form S-4).
     4.2        Specimen Certificate of 14% Senior Notes due 2008 (the "Exchange
                Notes") (included in Exhibit 4.1, which is incorporated by
                reference to Exhibit 4.1 to the Form S-4).
     4.4        Collateral Pledge and Security Agreement, dated as of June 23,
                1998 from Birch Telecom, Inc., Pledgor, to Norwest Bank
                Minnesota, National Association, Trustee (incorporated by
                reference to Exhibit 4.5 to the Form S-4).
     10.1       Birch Telecom, Inc. Securities Purchase Agreement (incorporated
                by reference to Exhibit 10.1 to the Form S-4).
     10.2       Birch Telecom, Inc. Purchasers Rights Agreement (incorporated by
                reference to Exhibit 10.2 to the Form S-4).
     10.3       Employment Agreement dated as of February 10, 1998 between Birch
                Telecom, Inc. and David E. Scott (incorporated by reference to
                Exhibit 10.3 to the Form S-4).
</TABLE>


                                      -45-
<PAGE>   46

<TABLE>
     <S>        <C>
     10.4       Employment Agreement dated as of February 10, 1998 between Birch
                Telecom, Inc. and Gregory C. Lawhon (incorporated by reference
                to Exhibit 10.4 to the Form S-4).
     10.5       Employment Agreement dated as of February 10, 1998 between Birch
                Telecom, Inc. and Gary L. Chesser (incorporated by reference to
                Exhibit 10.5 to the Form S-4).
     10.6       Employment Agreement dated as of February 10, 1998 between Birch
                Telecom, Inc. and David W. Vranicar (incorporated by reference
                to Exhibit 10.6 to the Form S-4).
     10.7       Employment Agreement dated as of February 10, 1998 between Birch
                Telecom, Inc. and Stephen L. Sauder (incorporated by reference
                to Exhibit 10.7 to the Form S-4).
     10.8       General Agreement between Birch Telecom, Inc. and Lucent
                Technologies Inc. (incorporated by reference to Exhibit 10.12 to
                the Form S-4).
     10.9       Interconnection Agreement under Sections 251 and 252 of the
                Telecommunications Act of 1996 by and between Southwestern Bell
                Telephone Company and Birch Telecom of Missouri, Inc. (the
                "Missouri Interconnection Agreement") (incorporated by reference
                to Exhibit 10.13 to the Form S-4).
    *10.10      Amendment No. 1 dated May 27, 1998 to Missouri Interconnection
                Agreement.
    +10.11      Software License Agreement between Birch Telecom, Inc. and
                Saville Systems Inc. (incorporated by reference to Exhibit 10.14
                to the Form S-4).
    *10.12      Interconnection Agreement under Sections 251 and 252 of the
                Telecommunications Act of 1996 by and between Southwestern Bell
                Telephone Company and Birch Telecom of Kansas, Inc.
    *10.13      Interconnection Agreement under Sections 251 and 252 of the
                Telecommunications Act of 1996 by and between Southwestern Bell
                Telephone Company and Birch Telecom of Texas Ltd., LLP.
    #10.14      1998 Stock Option Plan
    #10.15      Form of Incentive Stock Option Agreement under 1998 Stock
                Option Plan
    #10.16      Form of Nonstatutory Stock Option Agreement under 1998 Stock
                Option Plan
    #10.17      Lease Agreement between Francor, L.L.C. and Birch Telecom, Inc.
                dated July 20, 1998
     12.1       Statement of Computation of Ratio of Earnings to Fixed Charges
                (incorporated by reference to Exhibit 12.1 to the Form S-4).
     21.1       Subsidiaries of Birch Telecom, Inc. (incorporated by reference
                to Exhibit 21.1 to the Form S-4).
     24.1       Power of Attorney (included on the signature page to this Form
                10-K).
     27.1       Financial Data Schedule
</TABLE>

*  Filed herewith.
+ Portions of this exhibit have been omitted pursuant to a request for
confidential treatment. Such portions have been filed separately with the
Commission.
# To be filed by amendment

 (B)     REPORTS ON FORM 8-K

         No report on Form 8-K was filed during the fourth quarter of fiscal
         1998.









                                      -46-
<PAGE>   47


SIGNATURES

         PURSUANT TO THE REQUIREMENTS OF THE SECTION 13 OR 15(D) OF THE
SECURITIES AND EXCHANGE ACT OF 1934, AS AMENDED, THE REGISTRANT HAS DULY CAUSED
THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY
AUTHORIZED, IN THE CITY OF KANSAS CITY, STATE OF MISSOURI, ON MARCH 31, 1999.

                                            BIRCH TELECOM, INC.


                                By:             /s/ David E. Scott
                                    -------------------------------------------
                                                   David E. Scott
                                        President and Chief Executive Officer


                                POWER OF ATTORNEY

         KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints David E. Scott and Bradley A. Moline, and
each of them, his attorneys-in-fact and agents, with full power of substitution
and resubstitution, for him and in his name, place, and stead, in any and all
capacities, to sign any and all amendments to this Report on Form 10-K, and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission granting unto such
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
connection therewith, as fully to all intents and purposes as he might or could
do in person, hereby ratifying and confirming that all such attorneys-in-fact
and agents, or any of them or their or his substitute or substituted, may
lawfully do or cause to be done by virtue hereof.


         PURSUANT TO THE REQUIREMENTS OF THE SECURITIES AND EXCHANGE ACT OF
1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE CAPACITIES AND
AS OF THE DATES INDICATED.

<TABLE>
<CAPTION>
               SIGNATURE                                        TITLE                               DATE
               ---------                                        -----                               ----
<S>                                           <C>                                             <C>
           /s/ DAVID E. SCOTT                 President and Chief Executive Officer           March 31, 1999
----------------------------------------      (Principal Executive Officer)
             DAVID E. SCOTT

          /s/ BRADLEY A. MOLINE               Chief Financial Officer (Principal              March 31, 1999
----------------------------------------      Financial and Accounting Officer)
           BRADLEY A. MOLINE

         /s/ HENRY H. BRADLEY                 Director                                        March 31, 1999
----------------------------------------
            HENRY H. BRADLEY

         /s/ STEPHEN L. SAUDER                Director                                        March 31, 1999
----------------------------------------
           STEPHEN L. SAUDER
                                              Director                                        March __, 1999
----------------------------------------
             IAN R. N. BUND
                                              Director                                        March 31, 1999
         /s/ DAVID W. BERGMANN
----------------------------------------
           DAVID W. BERGMANN
</TABLE>







                                      -47-
<PAGE>   48



                          INDEX TO FINANCIAL STATEMENTS



<TABLE>
<S>                                                                                                    <C>
BIRCH TELECOM, INC.
Report of Independent Auditors.....................................................................    F-2
Consolidated Balance Sheets as of December 31, 1997 and 1998.......................................    F-3
Consolidated Statements of Operations for the years ended December 31, 1997 and 1998...............    F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 1997
  and 1998.........................................................................................    F-5
Consolidated Statements of Cash Flows for the years ended December 31, 1997 and 1998...............    F-6
Notes to Consolidated Financial Statements.........................................................    F-7

VALU-LINE COMPANIES, INC.  
Report of Independent Auditors.....................................................................    F-16
Consolidated Balance Sheets as of December 31, 1997................................................    F-17
Consolidated Statements of Income and Retained Earnings for the years ended December 31, 
  1996 and 1997....................................................................................    F-18
Consolidated Statements of Cash Flows for the years ended December 31, 1996 and 1997...............    F-19
Notes to Consolidated Financial Statements.........................................................    F-20

</TABLE>


<PAGE>   49


                         REPORT OF INDEPENDENT AUDITORS

THE BOARD OF DIRECTORS AND STOCKHOLDERS
BIRCH TELECOM, INC.

         We have audited the accompanying consolidated balance sheets of Birch
Telecom, Inc. (the Company) as of December 31, 1997 and 1998, and the related
consolidated statements of operations, stockholders' equity (deficit), and cash
flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

         We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

         In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Birch
Telecom, Inc. at December 31, 1997 and 1998, and the consolidated results of its
operations and its cash flows for the years then ended, in conformity with
generally accepted accounting principles.

                                                               Ernst & Young LLP
Kansas City, Missouri
February 19, 1999








                                      F-2

<PAGE>   50


                               BIRCH TELECOM, INC.
                           CONSOLIDATED BALANCE SHEETS
                           DECEMBER 31, 1997 AND 1998
                        (In thousands except share data)


<TABLE>
<CAPTION>
                                                                                 1997           1998
                                                                                -------      ---------
<S>                                                                             <C>          <C>
ASSETS
Current assets:
   Cash and cash equivalents ..............................................     $   210      $  39,745
   Pledged securities .....................................................          --         15,888
   Accounts receivable, net ...............................................          --          4,039
   Inventory ..............................................................          --            916
   Prepaid expenses and other .............................................           7            526
                                                                                -------      ---------
Total current assets ......................................................         217         61,114
Property and equipment, net ...............................................         101         26,153
Pledged securities - noncurrent ...........................................          --         21,897
Goodwill, net .............................................................          --         16,863
Other intangibles, net ....................................................          --          7,689
Other assets ..............................................................         216            433
                                                                                -------      ---------
Total assets ..............................................................     $   534      $ 134,149
                                                                                =======      =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Current maturities of long-term debt and capital lease obligations .....     $    --      $     335
   Notes payable to related parties .......................................         250             --
   Accounts payable .......................................................         255          8,503
   Accrued expenses .......................................................          --          2,556
                                                                                -------      ---------
Total current liabilities .................................................         505         11,394
14% Senior Notes ..........................................................          --        114,681
Capital lease obligations, net of current maturities ......................          --            778
Other long-term debt, net of current maturities ...........................          --            332

Preferred stock, $.001 par value; 25,000,000 shares authorized:
   Series B Redeemable Preferred Stock, 8,572,039 shares issued and
     outstanding (stated at redemption and aggregate liquidation value) ...          --         14,063
Stockholders' equity:
   Series C Preferred Stock, 8,492,749 shares issued and outstanding ......          --              8
   Common stock, $.01 par value, 20,000,000 shares authorized,
     1,800,000 shares issued and outstanding at December 31, 1997 .........          18             --
   Common stock, $.001 par value, 27,000,000 shares authorized,
     5,000,296 shares issued and outstanding at December 31, 1998 .........          --              5
   Warrants ...............................................................          18            337
   Additional paid-in capital .............................................       1,782         12,273
   Accumulated deficit ....................................................      (1,789)       (19,722)
                                                                                -------      ---------
Total stockholders' equity (deficit) ......................................          29         (7,099)
                                                                                -------      ---------
Total liabilities and stockholders' equity (deficit) ......................     $   534      $ 134,149
                                                                                =======      =========
</TABLE>

See accompanying notes.

                                      F-3

<PAGE>   51


                               BIRCH TELECOM, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                     YEARS ENDED DECEMBER 31, 1997 AND 1998
                        (In thousands except share data)

<TABLE>
<CAPTION>
                                                               1997          1998
                                                             -------      --------
<S>                                                          <C>          <C>
Revenue:
  Communications services, net .........................     $    --      $ 21,783
  Equipment sales, net .................................          --         4,304
                                                             -------      --------
Total revenue ..........................................          --        26,087
Cost of services:
  Cost of communications services ......................          --        16,339
  Cost of equipment sales ..............................          --         2,547
                                                             -------      --------
Total cost of services .................................          --        18,886
                                                             -------      --------
Gross margin ...........................................          --         7,201
Selling, general and administrative expense ............       1,776        15,769
Depreciation and amortization expense ..................          27         2,308
                                                             -------      --------
Loss from operations ...................................      (1,803)      (10,876)
Interest expense .......................................          --        (8,254)
Interest income ........................................          14         2,922
                                                             -------      --------
Net loss ...............................................      (1,789)      (16,208)
Preferred stock dividends ..............................          --        (1,696)
Amortization of preferred stock issuance costs .........          --           (29)
                                                             -------      --------
Loss applicable to common stock ........................     $(1,789)     $(17,933)
                                                             =======      ========
Loss per common share-- basic and diluted ..............     $ (1.45)     $  (4.71)
                                                             =======      ========
Weighted average number of common shares outstanding ...       1,235         3,809
</TABLE>

See accompanying notes.

                                      F-4

<PAGE>   52


                               BIRCH TELECOM, INC.
            CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                     YEARS ENDED DECEMBER 31, 1997 AND 1998
                                 (In thousands)

<TABLE>
<CAPTION>
                                    SERIES A PREFERRED STOCK   SERIES C PREFERRED STOCK           COMMON STOCK
                                    ------------------------   ------------------------    -----------------------
                                       NUMBER                   NUMBER OF                  NUMBER OF
                                     OF SHARES    $.001 PAR      SHARES      $.001 PAR      SHARES        $.01 PAR
                                     ---------    ---------      ------      ---------      ------        --------
<S>                                 <C>           <C>          <C>           <C>          <C>             <C>
Balance at December 23,
   1996 (date of
   inception) and
   December 31, 1996 .......             --       $   --             --      $   -             --          $ --
Issuance of common
   stock and warrants ......             --           --             --          -          1,800            18
Net loss ...................             --           --             --          -             --            --
Balance at December 31,
   1997 ....................             --           --             --          -          1,800            18
Recapitalization ...........             --           --          1,800          2         (1,800)          (18)
Issuance of common
   stock ...................             --           --             --          -             --            --
Merger with Valu-
   Line ....................          2,969            3          6,250          6             --            --
Issuance of Warrants in
   connection with 14%
   Senior Notes ............             --           --             --          -             --            --
Redemption of
   Series A Preferred
   Stock ...................         (2,969)          (3)            --          -             --            --
Stock dividend .............             --           --            443          -             --            --
Option exercise ............             --           --             --          -             --            --
Early exercised options
   terminated ..............             --           --             --          -             --            --
Restatement of Series B
   Preferred Stock
   dividends ...............             --           --             --          -             --            --
Amortization of
   Preferred Stock
   issuance costs ..........             --           --             --          -             --            --
Series A Preferred
   Stock dividends .........             --           --             --          -             --            --
Series B Preferred
   Stock dividends .........             --           --             --          -             --            --
Net loss ...................             --           --             --          -             --            --
Balance at December 31,
   1998 ....................             --       $   --          8,493      $   8             --          $ --

<CAPTION>
                                                              COMMON STOCK
                                                   -------------------------------
                                                   NUMBER OF                               ADDITIONAL      ACCUMULATED
                                   WARRANTS         SHARES    $.001 PAR   WARRANTS      PAID-IN CAPITAL      DEFICIT         TOTAL
                                   --------         ------    ---------   --------      ---------------      -------         -----

<C>                               <C>              <C>        <C>         <C>           <C>                <C>             <C>
Balance at December 23,
   1996 (date of
   inception) and
   December 31, 1996 .......         $ --             --          $-         $ --         $     --          $     --       $     --
Issuance of common
   stock and warrants ......           18             --           -           --            1,782                --          1,818
Net loss ...................           --             --           -           --               --            (1,789)        (1,789)
Balance at December 31,
   1997 ....................           18             --           -           --            1,782            (1,789)            29
Recapitalization ...........          (18)            --           -           --               34                --             --
Issuance of common
   stock ...................           --            450           -           --               --                --             --
Merger with Valu-
   Line ....................           --             --           -           --           14,741                --         14,750
Issuance of Warrants in
   connection with 14%
   Senior Notes ............           --             --           -          337               --                --            337
Redemption of
   Series A Preferred
   Stock ...................           --             --           -           --           (4,747)               --         (4,750)
Stock dividend .............           --            262           1           --               (1)               --             --
Option exercise ............           --          4,305           4           --               --                --              4
Early exercised options
   terminated ..............           --            (17)          -           --               --                --             --
Restatement of Series B
   Preferred Stock
   dividends ...............           --             --           -           --               64                --            464
Amortization of
   Preferred Stock
   issuance costs ..........           --             --           -           --               --               (29)           (29)
Series A Preferred
   Stock dividends .........           --             --           -           --               --              (168)          (168)
Series B Preferred
   Stock dividends .........           --             --           -           --               --            (1,528)        (1,528)
Net loss ...................           --             --           -           --               --           (16,208)       (16,208)
Balance at December 31,
   1998 ....................         $ --          5,000          $5         $337         $ 12,273        $  (19,722)      $ (7,099)
</TABLE>

See accompanying notes



                                      F-5

<PAGE>   53


                               BIRCH TELECOM, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                     YEARS ENDED DECEMBER 31, 1997 AND 1998
                                 (In thousands)

<TABLE>
<CAPTION>
                                                                                    1997        1998
                                                                                  ---------   ---------
      OPERATING ACTIVITIES
      <S>                                                                         <C>         <C>
      Net loss..................................................................  $  (1,789)  $ (16,208)
      Adjustments to reconcile net loss to net cash from operating activities:
        Depreciation............................................................         27         720
        Amortization............................................................         --       1,588
        Provision for losses on accounts receivable.............................         --         140
        Other ..................................................................         50          16
        Changes in operating assets and liabilities, net of effects of
        acquisitions:
           Accounts receivable..................................................         --      (1,905)
           Inventory............................................................         --        (300)
           Prepaid expenses.....................................................         (7)       (370)
           Other assets.........................................................         --        (198)
           Accounts payable.....................................................        255       3,888
           Accrued expenses.....................................................         --       1,986
                                                                                  ---------   ---------
      Net cash from operating activities........................................     (1,464)    (10,643)
      INVESTING ACTIVITIES
      Purchase of property and equipment........................................       (128)    (21,550)
      Costs of interconnection agreements.......................................        (87)         --
      Business acquisitions, net of cash acquired...............................         --      (7,757)
      Amortization of discount on pledged securities............................         --      (1,231)
      Maturity of pledged securities............................................         --       7,692
      Purchase of pledged securities............................................         --     (44,247)
                                                                                  ---------   ---------
      Net cash from investing activities........................................       (215)    (67,093)
      FINANCING ACTIVITIES
      Proceeds from issuance of common stock and warrants.......................      1,768         342
      Proceeds from issuance of preferred stock.................................         --       9,500
      Deferred financing costs..................................................       (129)     (4,922)
      Payment of Series A Preferred Stock dividends.............................         --        (168)
      Proceeds from convertible notes...........................................         --       3,500
      Proceeds from 14% Senior Notes...........................................          --     114,663
      Redemption of Series A Preferred Stock...................................          --      (4,750)
      Repayment of capital lease obligations....................................         --        (172)
      Proceeds from long-term debt..............................................         --         123
      Repayment of long-term debt...............................................         --        (321)
      Borrowing (repayment) of notes payable to stockholder.....................        250        (524)
                                                                                  ---------   ---------
      Net cash from financing activities........................................      1,889     117,271
                                                                                  ---------   ---------
      NET INCREASE IN CASH AND CASH EQUIVALENTS.................................        210      39,535
      CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR............................         --         210
                                                                                  ---------   ---------
      CASH AND CASH EQUIVALENTS AT END OF YEAR..................................  $     210   $  39,745
                                                                                  =========   =========
      Supplementary schedule of non-cash investing and financing activities:
         Amounts recorded in connection with acquisitions:
           Fair value of net assets acquired, net of cash acquired..............  $      --   $   5,735
           Fair value of intangible assets.....................................          --      20,839
           Assumption of long-term debt and capital lease obligations...........         --      (3,999)
           Issuance of Series A Preferred Stock.................................         --     (10,000)
           Issuance of Series C Preferred Stock.................................         --      (4,750)
        Common stock issued in exchange for other assets........................         50          --
        Property and equipment acquired through capital lease...................         --         728
        Property and equipment additions included in accounts payable...........         --       2,157
      Supplemental disclosure of cash flow information:
        Cash payment for interest, net of interest capitalized of $436 in 1998..         --       7,725
</TABLE>

See accompanying notes.


                                      F-6
<PAGE>   54



                               BIRCH TELECOM, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.   THE COMPANY

         Birch Telecom, Inc. was incorporated December 23, 1996, as a Delaware
corporation for the purpose of providing local, long distance, Internet access,
and other communications services to business and residential customers
initially in Kansas and Missouri. The consolidated financial statements of Birch
Telecom, Inc. include the accounts of Birch Telecom, Inc. and the accounts of
its subsidiaries, all of which are wholly owned (collectively, the Company). The
Company's business is highly competitive and is subject to various federal,
state and local regulations.

         The Company was in the development stage for the period from December
23, 1996 (date of inception) to February 10, 1998. Accordingly, the Company had
no operating revenue and incurred operating losses and operating cash flow
deficits during that period.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Cash and Cash Equivalents

         For purposes of reporting cash flows, the Company includes as cash and
cash equivalents highly liquid investments with original maturities of three
months or less.

     Revenue Recognition

         Revenue for communications services are recognized when customers use
the associated services. Equipment revenue is recognized when systems or
services are substantially complete. Revenue on billings to customers in advance
of providing services is deferred and recognized when earned.

     Cost of Services

         Cost of services includes local and long-distance services purchased
from Southwestern Bell Telephone, interexchange carriers and certain providers
of fiber optic telephone networks. Cost of services also includes costs
associated with the sale and installation of telephone systems.

     Inventory

         Inventory is carried at the lower of average cost or market determined
on a first-in, first-out basis and consists primarily of parts and equipment
used in the maintenance and installation of telephone systems.

     Advertising Costs

         Advertising costs are expensed as incurred and totaled $895,000 for the
year ended December 31, 1998.

     Property and Equipment

         Property and equipment is stated at cost and depreciated using the
straight-line method over the following estimated useful lives of the assets:

<TABLE>
<CAPTION>
                                                                          Years
                                                                        --------
           <S>                                                          <C>
           Communications network.....................................    3-10
           Buildings, furniture, fixtures and equipment...............    3-40
</TABLE>





                                      F-7
<PAGE>   55




     Goodwill

         Goodwill represents the excess of the purchase price paid over the fair
value of the net assets acquired in the Company's acquisitions. Goodwill is
being amortized over 25 years using the straight-line method and is periodically
reviewed for impairment based upon an assessment of future operations to ensure
that it is appropriately valued. Accumulated amortization on goodwill totaled
$599,000 at December 31, 1998.

     Other Intangibles

         Other intangibles consist primarily of customer lists and noncompete
agreements related to the Company's acquisitions and deferred financing costs.
Customer lists and noncompete agreements are amortized over periods ranging from
1 to 5 years using the straight-line method. The deferred financing costs are
amortized over 5 to 10 years, the term of the associated financing, using the
straight-line method. Accumulated amortization on other intangibles totaled
$1,050,000 at December 31, 1998.

     Income Taxes

         The Company recognizes deferred tax assets and liabilities for the
expected future tax consequences of events that have been included in the
financial statements or tax returns. Under this method, deferred tax assets and
liabilities are determined based on the differences between the financial
statement and tax bases of assets and liabilities using enacted tax rates in
effect for the year in which the differences are expected to reverse. Net
deferred tax assets are reduced by a valuation allowance when appropriate (see
Note 11). Deferred tax assets and liabilities are adjusted for the effects of
changes in tax laws and rates on the date of enactment.

     Stock Options

         The Company has adopted the disclosure provisions of Statement of
Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation, which establishes a fair value based method for the financial
reporting of its stock-based employee compensation plans. However, as allowed by
SFAS No. 123, the Company has elected to continue to measure compensation using
the intrinsic value based method as prescribed by Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees. Under this method,
compensation is measured as the difference between the market value of the stock
on the grant date, less the amount required to be paid for the stock. The
difference, if any, is charged to expense over the vesting period of the
options. The estimated market value used for the stock options granted was
determined on a periodic basis by the Company's Board of Directors.

     Fair Values of Financial Instruments

         The carrying amount of cash and cash equivalents approximates fair
value due to the short maturity of the instruments. The fair value of the
Company's pledged securities was $38 million at December 31, 1998. The fair
value of the Company's senior notes is estimated to be $106 million at December
31, 1998 based on the quoted market rates for the debt. The fair value of other
long-term debt approximates the recorded value.

     Use of Estimates in Financial Statements

         The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.

     Loss Per Share

         The net loss per share amount reflected on the consolidated statement
of operations is based on the weighted-average number of common shares
outstanding. Stock options and convertible preferred stock are anti-



                                       F-8
<PAGE>   56

dilutive, and therefore excluded from the computation of earnings per share. In
the future, these stock equivalents may become dilutive.

     Reclassifications

         Certain items in the 1997 consolidated financial statements have been
reclassified to be consistent with the classification in the 1998 consolidated
financial statements.

3.   ACQUISITIONS

         In February 1998, Birch merged with Valu-Line in a transaction valued
at $19.5 million, consisting of $4.75 million in cash, 2,968,750 shares of
Series A Preferred Stock having an aggregate liquidation preference of $4.75
million and 6,250,000 shares of Series C Preferred Stock having an aggregate
liquidation preference of $10.0 million. Since 1982, Valu-Line has been
primarily providing switched long distance services, customer premises equipment
(CPE) sales and services and, since March 1997, local service. In connection
with the merger, intangible assets were recorded related to customer lists and
goodwill totaling $2,000,000 and $15,541,878, respectively.

         In May 1998, Birch acquired Boulevard Phone Company, a shared tenant
service provider in the Kansas City metropolitan area, for $300,000 in cash.
Goodwill totaling $274,000 was recorded related to the acquisition.

         In May 1998, Birch acquired Telesource Communications, Inc.
(Telesource), a CPE provider in the Kansas City metropolitan area, for $325,000
in cash. In connection with the Telesource acquisition, the Company assumed
$290,000 of Telesource's liabilities. Goodwill and customer lists associated
with the acquisition were recorded totaling $325,000 and $328,000, respectively.

         In September 1998, Birch acquired TFSnet, Inc., an Internet service
provider based in the Kansas City metropolitan area, for $2.65 million in cash.
Goodwill and customer lists associated with the acquisition were recorded
totaling $1.1 million and $1.2 million, respectively.

         All acquisitions were recorded using the purchase method of accounting.
Results from the acquired companies are included in the consolidated financial
statements from the date of the respective acquisitions.

         The following is unaudited pro forma information reflecting the affect
of the acquisitions on the Company's results as though they had been completed
effective January 1, 1997 and 1998 (in thousands except per share amounts):

<TABLE>
<CAPTION>
                                                               December 31,
                                                           1997            1998
                                                      --------------- ----------------
         <S>                                          <C>             <C>
         Revenue.................................     $     18,847    $     29,193
         Net loss................................           19,325          28,921
         Loss per common share...................            15.65            8.05
</TABLE>


4.   ACCOUNTS RECEIVABLE

         The composition of accounts receivable, net is as follows (in
thousands):

<TABLE>
<CAPTION>
                                                               December 31,
                                                           1997            1998
                                                      --------------- ----------------
         <S>                                          <C>             <C>
         Billed..................................     $      --       $      3,144
         Unbilled................................            --              1,129
                                                             --              4,273
                                                      ---------       ------------
         Less allowance for doubtful accounts....            --                234
                                                      ---------       ------------
                                                      $      --       $      4,039
                                                      =========       ============
</TABLE>



                                      F-9


<PAGE>   57

5.   PROPERTY AND EQUIPMENT

         The following is a summary of the Company's property and equipment as
of December 31, 1997 and 1998 (in thousands):

<TABLE>
<CAPTION>
                                                                       1997      1998
                                                                      ------   --------
           <S>                                                        <C>      <C>
           Communications network................................     $ --     $  5,966
           Buildings, furniture, fixtures and equipment..........       128       6,529
           Construction in progress..............................       --       14,405
                                                                      -----    --------
                                                                        128      26,900
           Less accumulated depreciation and amortization........        27         747
                                                                      -----    --------
           Property and equipment, net...........................     $ 101    $ 26,153
                                                                      =====    ========
</TABLE>

6.   PLEDGED SECURITIES, WARRANTS, AND DEBT

         During June 1998, the Company completed a $115 million private offering
of 14% Senior Notes (the Senior Notes) due June 2008 and 115,000 warrants to
purchase 1,409,734 shares of common stock. Interest on the Senior Notes is
payable semi-annually in arrears on June 15 and December 15 of each year.
Warrants are exercisable at $0.01 per share and expire June 2008. The Company
received net proceeds from the Senior Notes of $110.2 million and concurrently
purchased pledged securities of $44.2 million. The pledged securities are
restricted for interest payments on the Senior Notes and, together with the
interest accruing thereon, will be used to satisfy such interest payments
through June 2001. The Company classifies its pledged securities, consisting of
$37.8 million of U.S. Treasury securities at December 31, 1998, as held to
maturity recorded at amortized cost and maturing between six and thirty months.
A portion of the proceeds of this offering, $337,000, was allocated to the
warrants, and the resulting debt discount is being amortized over the life of
the debt on the straight-line method, which does not differ materially from the
effective interest method. Unamortized discount was $319,000 at December 31,
1998. The amount allocated to the warrants represents the estimated fair value
of the warrants at the date of issuance. The Senior Notes rank pari pasu in
right of payment to all existing and future senior indebtedness of the Company
and rank senior in the right of payment to all existing and future subordinated
indebtedness of the Company.

         The Company filed a registration statement with the Securities and
Exchange Commission (SEC) for the registration of $115 million aggregate
principal amount of 14% Senior Notes due December 2008 (the Exchange Notes) to
be offered in exchange for the Senior Notes (the Exchange Offer). The
registration statement was declared effective by the SEC in February 1999, and
the Exchange Offer was commenced at that time. The Exchange Offer will expire in
March 1999, at which time all of the Senior Notes will be exchanged for the
Exchange Notes. The form and terms of the Exchange Notes are identical in all
material respects to the form and terms of the Senior Notes except the Exchange
Notes will have been registered under the Securities Act and holders of the
Exchange Notes will not be entitled to certain rights under a registration
agreement relating to the Senior Notes.

         The indenture related to the Senior Notes contains certain covenants
which, among other things, restrict the ability of the Company to incur
additional indebtedness, pay dividends or make distributions of the Company's or
its subsidiaries' stock, enter into sale and leaseback transactions, create
liens, enter into transactions with affiliates or related persons, consolidate,
merge or sell all of its assets. The Company was in compliance with these
covenants at December 31, 1998.


                                      F-10
<PAGE>   58


         The Company's debt consisted of the following at December 31, 1997 and
1998 (in thousands):

<TABLE>
<CAPTION>
                                                                                           December 31,
                                                                                        1997            1998
                                                                                     ---------       -----------
        <S>                                                                          <C>             <C>
        14 % Senior Notes......................................................      $      --       $    114,681
                                                                                     =========       ============

        Other long-term debt, interest accruing between 8.9% and 9.8%, maturing
        through 2013, secured by buildings.....................................             --                345

        Less current maturities................................................             --                 13
                                                                                     ---------       ------------
                                                                                     $      --       $        332
                                                                                     =========       ============
</TABLE>

         Assets securing the other long-term debt total $814,000, net of
accumulated depreciation of $19,000.

         Principal payments required on the outstanding debt during each of the
next five years are as follows (in thousands):

<TABLE>
        <S>                                                       <C>
        1999..............................................        $    13
        2000..............................................             14
        2001..............................................             16
        2002..............................................             17
        2003..............................................             19
</TABLE>


7.   CAPITAL LEASE OBLIGATIONS

         The Company leases telecommunications equipment and computer equipment
under capital leases with imputed interest between 8.0% and 10.2%. Assets under
capital lease total $1,459,000, net of accumulated amortization of $210,000 at
December 31, 1998. The future minimum lease payments under the capital leases
and the present value of the net minimum lease payments as of December 31, 1998
are as follows (in thousands):

<TABLE>
        <S>                                                       <C>
        1999..............................................        $   447
        2000..............................................            447
        2001..............................................            257
        2002..............................................             58
        2003..............................................             58
                                                                  =======
        Total minimum lease payments......................          1,267
        Less amount representing interest.................            167
                                                                  -------
        Present value of net minimum lease payments.......          1,100
        Less current maturities...........................            322
                                                                  -------
                                                                  $   778
                                                                  =======
</TABLE>


Amortization expense for assets under capital lease was $157,000 for the year
ended December 31, 1998.

8.   CAPITAL STRUCTURE

         During 1997, 1,750,000 shares of common stock and 1,800,000 warrants
were sold to management and equity investors for $1.00 and $0.01 per share,
respectively. The warrants entitled the holders to purchase an additional 1.8
million shares in the aggregate of common stock at $1.00 per share. In addition
to cash investments, members of management contributed the business plan to the
Company in exchange for 50,000 shares of common stock valued at $1.00 per share.
During 1998, all common stock was exchanged for Series C Preferred Stock and the
warrants were surrendered.



                                      F-11
<PAGE>   59


         First Quarter 1998 Recapitalization

         During February and March 1998, the Company issued $9.5 million of
Series B Preferred Stock, issued $3.5 million of Convertible Notes, converted
common stock to Series C Preferred Stock, canceled the 1997 Stock Option Plan,
and created the 1998 Stock Option Plan in transactions related to new investors.

         The Series B Preferred Stock and Convertible Notes generated net
proceeds of $12.4 million. In June 1998, the Convertible Notes were converted
into Series B Preferred Stock. The Series B Preferred Stock accrues cumulative
compounding dividends at 15% per annum and is mandatorily redeemable in equal
annual installments in 2003, 2004 and 2005 provided, however, that so long as
any of the Company's Senior Notes due 2008 are outstanding, none of the Series B
Preferred Stock may be redeemed until the earlier of June 15, 2008 or the 91st
day after redemption in full of the Senior Notes. During the year ended December
31, 1998 cumulative dividends on the Series B Preferred Stock totaled 1,063,000.
The Series B Preferred Stock is convertible into 8,572,039 (after considering
stock dividend described below) shares of common stock at the option of the
holders. The shares have liquidation preference over the Series C Preferred
Stock and common stock at the greater of (1) par value plus accrued but unpaid
dividends or (2) par value plus the fair market value of common stock into which
the shares could be converted. Each share can be converted into a share of
common stock at the option of the holder.

         In February 1998, the old common stockholders exchanged all of the
previously issued and outstanding $1.00 par value common stock for an equal
number of shares of Series C Preferred Stock and relinquished all rights to the
warrants previously held. The Series C Preferred Stock outstanding after the
conversion and merger transactions total 8,492,750 shares (after considering
stock dividend described below). All shares were issued at $1.52 per share and
have a $0.001 par value. The convertible, voting shares have a 10%
non-cumulative dividend. The shares have liquidation preference over the common
stock at the greater of (1) par value plus accrued but unpaid dividends or (2)
par value plus the fair market value of common stock into which the shares could
be converted. Each share can be converted into a share of common stock at the
option of the holder. Voting rights are exercised together with Series B and
Series C Preferred Stocks but not common stock. The Series C Preferred Stock is
subordinate to the Series B Preferred Stock.

         The 1997 Stock Option Plan was canceled and vested options were
forfeited and the 1998 Stock Option Plan was created (See Note 12). Certain
employees were allowed to purchase 474,750 (after considering stock dividend
described below) shares of new common stock at par value ($0.001 per share) in
exchange for the forfeiture of the vested options.

         The new common stock has voting rights equal to the Series B and C
Preferred Stock. Common stock dividends, if any, will be declared at the
discretion of the board of directors.

        The Series A Preferred Stock issued in connection with the Valu-Line
Merger (See Note 3) was fully redeemed in June 1998. Dividends paid totaled
$168,000 in 1998.

     Stock Dividend

         On June 23, 1998, the Company paid a dividend in kind, in the amount of
0.055 shares per share, to the holders of the Company's Series B Preferred
Stock, Series C Preferred Stock, and common stock as of June 15, 1998.

9.   RELATED-PARTY TRANSACTIONS

         During December 1997, the Company borrowed $250,000 from the Company's
principal stockholder under a note payable. The note payable was fully repaid in
February 1998.

         The Company acquired notes payable to Valu-Line shareholders totaling
$274,000 in the Valu-Line merger. These notes were fully repaid during 1998.

         During 1998, a broadcasting company owned by one of the Birch's
shareholders rented office space from Birch for $30,000. Birch purchased
advertising from the broadcasting company totaling $40,000 in 1998.


                                      F-12
<PAGE>   60

10.  COMMITMENTS AND CONTINGENCIES

         Future minimum rental commitments at December 31, 1998 for all
noncancelable operating leases, consisting mainly of leases for office space and
equipment, are as follows (in thousands):

<TABLE>
         <S>                                                       <C>
         1999................................................      $ 1,180
         2000................................................        1,050
         2001................................................        1,060
         2002................................................          945
         2003................................................          836
         Thereafter..........................................        2,891
                                                                   -------
         Total...............................................      $ 7,962
                                                                   =======
</TABLE>

         Total rent expense for the years ended December 31, 1997 and 1998 was
$81,000 and $485,000, respectively.


         In February 1998, the Company entered into a five-year general
agreement with Lucent Technologies, Inc. (Lucent) establishing terms and
conditions for the purchase of Lucent products, services and licensed materials.
This agreement includes a five-year exclusivity commitment for the purchase of
products and services related to new switches. The agreement contains no minimum
purchase requirements.

11.  INCOME TAXES

         Net deferred taxes consist of the following as of December 31, 1997 and
1998 (in thousands):

<TABLE>
<CAPTION>
                                                                            1997       1998
                                                                           -----     -------
         <S>                                                               <C>       <C>
         Deferred tax assets:
           Net operating loss carryforwards...........................     $  --     $ 5,528
           Accruals and reserves not currently deductible.............        --          91
           Other......................................................       681         668
                                                                           -----     -------
                                                                             681       6,287
           Valuation allowance........................................      (681)     (5,799)
                                                                           -----     -------
                                                                              --         488
                                                                           -----     -------
         Deferred tax liabilities:
           Property and equipment.....................................        --         488
                                                                           -----     -------
                                                                           $  --     $    --
                                                                           =====     =======
</TABLE>

         In the years ended December 31, 1997 and 1998, the net income tax
benefits of approximately $681,000 and $6.0 million, respectively, have been
offset by increases in the valuation allowance. At December 31, 1998, the
Company had operating loss carryforwards for federal income tax purposes of
approximately $13.8 million, expiring in 2013.


        The primary difference that caused the effective tax rate to vary from
the statutory federal income tax rate of 35% was the valuation allowance.


                                      F-13
<PAGE>   61


12.  STOCK OPTION PLAN

         At December 31, 1997, the Company had granted options to purchase
common stock under the 1997 Stock Option Plan. The options granted had a term of
10 years and vested over a four-year period. This plan was terminated and
superseded in 1998 by the 1998 Stock Option Plan. No options were or ever will
be exercised and no shares were or will ever be issued under the terminated and
superseded 1997 Stock Option Plan.

         Stock option activity under the 1997 Stock Option Plan was as follows:

<TABLE>
<CAPTION>
                                                                                         Weighted-Average
                                                                                             Per Share
                                                                                             Exercise
                                                                               Shares          Price
                                                                              ---------  ----------------

           <S>                                                               <C>         <C>
           Granted....................................................        2,783,000     $   1.00
           Exercised..................................................               --           --
           Forfeited..................................................               --           --
                                                                             ----------     --------
           Outstanding at December 31, 1997...........................        2,783,000         1.00
           Terminated.................................................       (2,783,000)       (1.00)
                                                                             ----------     --------
           Outstanding at December 31, 1998...........................               --     $     --
                                                                             ========== 
</TABLE>

         Stock option activity under the 1998 Stock Option Plan was as follows:

<TABLE>
<CAPTION>
                                                                                           Weighted-Average
                                                                                               Per Share
                                                                                               Exercise
                                                                                Shares          Price
                                                                             -----------   ----------------
           <S>                                                               <C>           <C>
           Granted....................................................        5,065,984         $  0.26
           Exercised..................................................        4,542,139            0.01
           Forfeited..................................................           44,918            1.55
                                                                              ---------         -------
           Outstanding at December 31, 1998...........................          478,927         $  2.48
                                                                              ========= 
           Exercisable at December 31, 1998...........................               --
                                                                              =========
</TABLE>

         The 1998 Stock Option Plan authorized the grant of options for up to
6,195,844 shares of the Company's common stock. The options have a term of 10
years and vest over a four-year period. All options exercised during 1998 were
for options granted with an early exercise provision. The shares from exercised
options continue to be subject to the four-year vesting period.


         Options granted in 1998 had exercise prices approximating the market
value. Exercise prices for options outstanding at December 31, 1998 ranged from
$0.001 to $2.50. The weighted average remaining contractual life of those
options is 3.1 years. At December 31, 1998, the Company has reserved 1,129,860
shares of common stock for issuance under the 1998 Stock Option Plan.

         The Company estimated the fair value of each option grant using the
minimum value method permitted by SFAS No. 123 for entities not publicly traded.
The Company utilized the following assumptions in the calculation: risk-free
interest rate of 5.25%, expected life of four years and no dividends being paid
over the life of the options. Had compensation cost for the stock based
compensation plan been determined as prescribed by SFAS No. 123, the net loss
and loss per common share would have been as follows for the years ended
December 31, 1997 and 1998 (in thousands except per share data):

<TABLE>
<CAPTION>
                                                                                1997              1998
                                                                           ---------------- -----------------
      <S>                                                                  <C>              <C>
      Net loss-- as reported...........................................    $     (1,789)    $    (16,208)
      Net loss-- pro forma.............................................          (1,921)         (16,212)
      Loss per share-- Basic and Diluted-- Pro Forma...................           (1.56)           (4.26)
</TABLE>



                                      F-14

<PAGE>   62


13.  EMPLOYEE BENEFIT PLAN

     The Company sponsors a 401(k) profit-sharing plan covering substantially
all employees under which employees can contribute up to 15% of their annual
salary subject to annual maximum limitations. Employees can participate after
meeting the plan's eligibility requirements. The Company may also make
discretionary contributions. Company contributions to the plan were $148,000 for
the year ended December 31, 1998.

14.  EMPLOYMENT AGREEMENTS

         The Company has entered into employment agreements with certain
executive employees, which provide for payments to be made in connection with
certain termination of employment or change of control. The benefits include
cash compensation, immediate vesting of outstanding stock options and coverage
under the Company's group health plan.

15.  SIGNIFICANT SUPPLIERS

         The Company purchased telephone services from Southwestern Bell
Telephone amounting to 29% of revenue in the year ended December 31, 1998. The
Company purchased switches and other network equipment and software from Lucent
Technologies amounting to $7.5 million in the year ended December 31, 1998.

16.  SUBSEQUENT EVENTS

         In February 1998, the Company acquired American Local
Telecommunications (ALT), a competitive local exchange carrier based in the
Dallas, Texas metropolitan area. The acquisition, which was recorded as a
purchase, included substantially all assets of ALT. The total purchase price was
approximately $700,000.

         In February 1998, the Company signed a letter of intent to acquire the
stock of Capital Communications Corporation, a telecommunications equipment
provider based in the St. Louis, Missouri metropolitan area. The purchase price
is anticipated to be $3.0 million, plus the potential for additional
consideration based on lines converted to the Company's service from Capital
Communications Corporation's existing customer base.

17.  QUARTERLY DATA -- UNAUDITEd

         The following table includes summarized quarterly financial data for
the years ended December 31, (in thousands):

<TABLE>
<CAPTION>
                                                           Quarters
                                  -----------------------------------------------------------
                                      First         Second          Third         Fourth
                                  -------------- -------------- -------------- --------------
<S>                               <C>            <C>            <C>            <C>
1998:
Revenue                           $       3,705  $       6,060  $       7,478  $       8,844
Gross margin                              1,063          1,628          2,305          2,205
Operating loss                             (567)        (1,486)        (2,996)        (5,827)
Net loss                                   (623)        (1,766)        (5,468)        (8,351)
Loss per  common share                    (0.79)         (0.55)         (1.19)         (1.76)

1997:
Revenue                           $          --  $          --  $          --  $          --
Gross margin                                 --             --             --             --
Operating loss                             (111)          (573)          (549)          (570)
Net loss                                   (112)          (570)          (543)          (564)
Loss per common share                     (0.22)         (0.52)         (0.35)         (0.31)
</TABLE>


                                      F-15


<PAGE>   63

                         REPORT OF INDEPENDENT AUDITORS

                             THE BOARD OF DIRECTORS
                            VALU-LINE COMPANIES, INC.

         We have audited the accompanying consolidated balance sheet of the
Valu-Line Companies, Inc. (the Company) as of December 31, 1997, and the related
consolidated statements of income and retained earnings, and cash flows for two
years in the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

         We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

         In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Valu-Line Companies, Inc. at December 31, 1997 and the consolidated results of
its operations and its cash flows for each of the two years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.


Ernst & Young LLP


Kansas City, Missouri
May 15, 1998






                                      F-16
<PAGE>   64




                            VALU-LINE COMPANIES, INC.
                           CONSOLIDATED BALANCE SHEETS
                                December 31, 1997
                                 (In thousands)

<TABLE>
<S>                                                                     <C> 
    ASSETS
    Current assets:
      Cash and cash equivalents...............................        $  258
      Accounts receivable, net of allowance of $80 and $70,
      respectively............................................         1,790
      Other receivables -- related parties....................            97
      Inventories.............................................           530
      Prepaid expenses........................................            37
      Income taxes receivable.................................            30
      Other assets............................................            60
      Deferred income taxes...................................            71
                                                                      ------
    Total current assets......................................         2,873
    Property and equipment, net...............................         1,612
    Other assets..............................................           317
                                                                      ------
    Total assets..............................................        $4,802
                                                                      ======

    LIABILITIES AND STOCKHOLDERS' EQUITY 

    Current liabilities:
      Current maturities of long-term debt and capital lease          $  110
         obligation...........................................
      Notes payable -- related parties........................           240
      Accounts payable........................................         1,262
      Accrued expenses........................................           225
      Customer deposits.......................................            39
      Accrued salaries and commissions........................           266
      Deferred revenue........................................           287
      Income taxes payable....................................            --
                                                                      ------
    Total current liabilities.................................         2,429
    Long-term debt, net of current maturities.................           345
    Capital lease obligation, net of current maturities.......           336
    Deferred income taxes.....................................            27
    STOCKHOLDERS' EQUITY
    Common stock, no par value, 100,000 shares authorized;
      10,360 issued and outstanding                                      181
    Retained earnings                                                  1,484
                                                                      ------
    Total stockholders' equity                                         1,665
                                                                      ------
    Total liabilities and stockholders' equity                        $4,802
                                                                      ======
</TABLE>


See accompanying notes.





                                      F-17
<PAGE>   65




                            VALU-LINE COMPANIES, INC.
             CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS

<TABLE>
<CAPTION>
                                                                       DECEMBER 31,
                                                            ---------------------------------
                                                                  1996              1997
                                                            ---------------   ---------------
                                                             (IN THOUSANDS EXCEPT SHARES AND
                                                                     PER SHARE DATA)
<S>                                                         <C>               <C>            
Revenue:
   Communications services, net...........................  $        10,686   $        13,785
   Equipment sales, net...................................            2,531             3,016
                                                            ---------------   ---------------
Total revenue.............................................           13,217            16,801
Cost of services:
   Cost of communications services........................            7,308             9,859
   Cost of equipment sales................................            1,441             1,983
                                                            ---------------   ---------------
Total cost of services....................................            8,749            11,842
                                                            ---------------   ---------------
Gross margin..............................................            4,468             4,959
Selling, general and administrative.......................            3,561             4,067
Depreciation and amortization.............................              311               341
                                                            ---------------   ---------------
Income from operations....................................              596               551
Interest expense..........................................              102                97
                                                            ---------------   ---------------
Income before income taxes................................              494               454
Income tax expense........................................              205               186
                                                            ---------------   ---------------
Net income................................................              289               268
Retained earnings, beginning of year......................              927             1,216
                                                            ---------------   ---------------
Retained earnings, end of year............................  $         1,216   $         1,484
                                                            ===============   ===============
Earnings per share -- basic and diluted...................  $         27.90   $         25.87
                                                            ===============   ===============
Common shares outstanding -- basic and diluted............           10,360            10,360
                                                            ===============   ===============
</TABLE>


See accompanying notes.



                                      F-18
<PAGE>   66




                            VALU-LINE COMPANIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                   DECEMBER 31,
                                                                             ------------------------
                                                                                1996         1997
                                                                             -----------  -----------
                                                                                  (In thousands)
<S>                                                                          <C>          <C>        
OPERATING ACTIVITIES
Net income...............................................................    $       289  $       268
Adjustments to reconcile net income to net cash from operating activities:
   Depreciation and amortization.........................................            311          341
   Deferred income taxes.................................................              7          (14)
   Income tax expense....................................................             43           73
   Changes in operating assets and liabilities:
     Accounts receivable.................................................            185         (660)
     Other receivables -- related parties................................            (18)         (52)
     Inventory...........................................................           (122)         (94)
     Income taxes receivable/payable.....................................            290          (56)
     Accounts payable....................................................           (303)         520
     Accrued expenses and other current liabilities......................            188          304
     Other...............................................................            (36)        (142)
                                                                             -----------  -----------
Net cash from operating activities.......................................            834          488

INVESTING ACTIVITIES
Purchase of property and equipment.......................................           (513)        (243)
                                                                             -----------  -----------
Net cash from investing activities.......................................           (513)        (243)

FINANCING ACTIVITIES
Proceeds from issuance of long-term debt.................................             92           --
Proceeds from issuance of note payable...................................             --           --
Proceeds from issuance of notes payable -- related parties...............             33           --
Payment of notes payable.................................................           (300)         (11)
Payment of notes payable -- related parties..............................             --          (44)
Payment of long-term debt................................................             --           --
Payment of capital lease obligation......................................            (82)         (90)
                                                                             -----------  -----------
Net cash from financing activities.......................................           (257)        (145)
                                                                             -----------  -----------
Net increase (decrease) in cash and cash equivalents.....................             64          100
Cash and cash equivalents, beginning of year.............................             94          158
                                                                             -----------  -----------
Cash and cash equivalents, end of year...................................    $       158  $       258
                                                                             ===========  ===========

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Equipment financed under capital lease...................................    $        --  $        --
                                                                             ===========  ===========
</TABLE>


See accompanying notes.



                                      F-19
<PAGE>   67




                            VALU-LINE COMPANIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                     YEARS ENDED DECEMBER 31, 1997 AND 1996

1.   THE COMPANY

         These consolidated financial statements include the accounts of
Valu-Line Companies, Inc., a Kansas Corporation, and its wholly-owned
subsidiaries (collectively, the "Company"), Valu-Line of Kansas, Inc. and IS
Advertising. The Company was acquired by Birch Telecom, Inc. in February 1998
(see Note 11). The accounts of Valu Broadcasting, Inc. and Steve Sauder Real
Estate, respectively, a wholly-owned subsidiary of and a division of Valu-Line
Companies, Inc., both of which were spun off in December 1997, have been
excluded for all periods from these consolidated financial statements in order
to reflect financial position and operating results on a basis consistent with
the businesses acquired by Birch Telecom, Inc. All intercompany balances and
transactions have been eliminated in consolidation.

         The Company provides local, long distance, Internet, customer premises
equipment and other communications services to business and residential
customers in the state of Kansas.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Cash and Cash Equivalents

         For purposes of reporting cash flows, the Company includes as cash and
cash equivalents, cash and marketable securities with original maturities of
three months or less.

     Revenue Recognition

         Revenue from communications services is recognized when the services
are provided. Revenue on billings to customers in advance of providing services
is deferred and recognized when earned.

     Concentration of Credit Risk

         The Company is exposed to concentrations of credit risk principally
from customer accounts receivable. At December 31, 1997, the Company's customers
are located in the state of Kansas. The Company performs ongoing credit
evaluations of its customers as a means to reduce credit risk.

     Fair Values of Financial Instruments

         As of December 31, 1997, the fair values of the Company's financial
instruments, including cash equivalents and notes payable -- related parties,
approximate their carrying value.

     Inventories

         Inventories, which consist of customer premises communications
equipment held for sale and supplies, are valued at lower of average cost or
market.

     Property and Equipment

         Property and equipment, including assets held under capital leases, are
stated at cost and are depreciated using the straight-line method over the
estimated useful lives of the related assets or lease term.





                                      F-20
<PAGE>   68

     Use of Estimates in Financial Statements

         The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.

3.   PROPERTY AND EQUIPMENT

         The components of property and equipment at December 31, 1997 are as
follows:

<TABLE>
<CAPTION>
                                                            ESTIMATED
                                                           USEFUL LIVES         1997
                                                           ------------         ----
                                                                  (In thousands)
<S>                                                         <C>                 <C>   
         Telecommunications and other equipment.......      5 years             $1,103
         Office equipment, furniture and other........      3 - 7 years          1,178
         Buildings and improvements...................      40 years               683
                                                                                ------
                                                                                 2,964
         Accumulated depreciation and amortization....                          (1,352)
                                                                                ------
                                                                                $1,612
                                                                                ======
</TABLE>


         Telecommunication equipment under capital lease was $607,000 at
December 31, 1997. Accumulated amortization totaled $194,000 as of December 31,
1997. Amortization of assets under capital lease is included in depreciation and
amortization expense. Interest expense associated with the obligations under
these leases amounted to $47,000 in 1997.

4.   CAPITAL LEASE OBLIGATION

         The Company leases telecommunications equipment under a capital lease.
The future minimum lease payments under the capitalized lease and the present
value of the net minimum lease payments as of December 31, 1997 are as follows
(in thousands):

<TABLE>
<S>               <C>                                                             <C> 
                  1998.........................................................   $137
                  1999.........................................................    137
                  2000.........................................................    137
                  2001.........................................................     57
                  2002.........................................................     57
                  2003.........................................................     57
                                                                                  ----
                  Total minimum lease payments.................................    582
                  Less amount representing interest............................   (147)
                                                                                  ----
                  Present value of net minimum lease payments with interest        435
                    at 10.0%...................................................
                  Less current maturities......................................    (99)
                                                                                  ----
                                                                                  $336
                                                                                  ====
</TABLE>

5.   LONG TERM DEBT AND NOTES PAYABLE

         The Company entered into a note payable with a financial institution in
the amount of $300,000 in 1992 to finance the remodeling of a building. The note
is payable in monthly installments through 2007. Interest is payable at prime
plus 1 1/2% (10.0% at December 31, 1997). The note is secured by the building
and the deposit accounts of the Company with the financial institution. The
outstanding principal balance on the note was $262,000 at December 31, 1997.

         In 1996, the Company issued a note payable of $100,000 to finance the
purchase of an office building. The note is payable in monthly installments
through 2011. Interest is payable at a variable rate (8.90% at December, 31,






                                      F-21
<PAGE>   69

1997). The note is secured by the building. The outstanding principal balance on
the note was $94,000 at December 31, 1997.

         Maturities on the aforementioned notes payable are as follows (in
thousands):

<TABLE>
<S>               <C>                                                   <C>
                  1998...............................................  $ 11
                  1999...............................................    13
                  2000...............................................    14
                  2001...............................................    15
                  2002...............................................    17
                  Thereafter.........................................   286
                                                                       ----
                  Total..............................................  $356
                                                                       ====
</TABLE>

         The Company also has notes payable to officers of the Company and
members of their families. The notes are unsecured and payable on demand.
Interest is payable at the treasury rate (5.85% at December 31, 1997). The
outstanding principal balance on these notes was $240,000 at December 31, 1997.
Principal and interest payments were $43,000 and $128,000 for 1996 and 1997,
respectively.

         Total interest paid for the years 1996 and 1997 was $102,000 and
$97,000, respectively.

6.   EMPLOYEE BENEFIT PLAN

         The Company sponsors a 401(k) profit-sharing plan covering
substantially all employees under which employees can contribute up to 15% of
their annual salary subject to annual Internal Revenue Code maximum limitations.
Employees can participate after meeting the plan's eligibility requirements. The
Company may make a discretionary contribution. Company contributions to the plan
were $72,000 and $81,000 for 1996 and 1997, respectively.

7.   INCOME TAXES

         The income tax expense (benefit) consisted of the following:

<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                           ----------- ----
                                                           1996        1997
                                                           ----        ----
                                                          (In thousands)
<S>                                                        <C>         <C> 
                  Current:
                    Federal...........................     $174        $175
                    State.............................       24          25
                                                           ----        ----
                  Total Current.......................      198         200
                  Deferred:
                    Federal...........................        6         (12)
                    State.............................        1          (2)
                                                           ----        ----
                  Total deferred......................        7         (14)
                                                           ----        ----
                  Income tax expense..................     $205        $186
                                                           ====        ====
</TABLE>






                                      F-22
<PAGE>   70

         The differences between the amount computed by applying the statutory
federal income tax rate to income before income taxes and the provision for
income taxes are as follows:

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                             ----------------
                                                             1996        1997
                                                             ----        ----
                                                            (In thousands)
<S>                                                          <C>         <C> 
                  Tax computed at statutory rate..........   $173        $159
                  State taxes, net of federal effect......     24          22
                  Other, net..............................      8           5
                                                             ----        ----
                  Income tax expense......................   $205        $186
                                                             ====        ====
</TABLE>

         Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for federal and state income tax
purposes. Significant components of the Company's deferred tax assets and
liabilities at December 31, 1997 are as follows (in thousands):

<TABLE>
<S>                                                                    <C>
                  Deferred tax assets (current):
                    Accrued liabilities..............................  $32
                    Allowance for doubtful accounts..................   28
                    Inventory capitalization.........................   11
                                                                       ---
                                                                        71
                  Deferred tax liability (noncurrent):...............
                    Depreciation.....................................   27
                                                                       ---
                  Net deferred tax assets............................  $44
                                                                       ===
</TABLE>

         Net cash paid (refunded) for income taxes for the years ended December
31, 1996 and 1997 was $(48,000) and $225,000, respectively.

8.   ADDITIONAL FINANCIAL INFORMATION

     Related Parties

         In 1996 and 1997 Valu-Line provided services principally related to
rent and operating costs to Valu-Broadcasting, Inc., an affiliate of Valu-Line
at the time of the transactions, in the amounts of $74,000 and $81,000
respectively. Valu-Line also received services principally related to
advertising from Valu-Broadcasting, Inc. in the amounts of $31,000 and $41,000
in 1996 and 1997, respectively. In February 1998, Valu-Line merged with and into
the Company pursuant to the Merger.

     Major Supplier Information

         Cost of communications services provided by Southwestern Bell
approximated 39% and 40% of the total cost of communication services for the
years ended December 31, 1996 and 1997, respectively. Equipment purchases from
Toshiba approximated 76% and 59% of cost of equipment sales for the years ended
December 31, 1996 and 1997, respectively.

9.   COMMITMENTS AND CONTINGENCIES

         Minimum rental commitments at year-end 1997 for all noncancelable
operating leases, consisting mainly of leases for office space and vehicles, are
as follows (in thousands):

<TABLE>
<S>                                                                      <C>
                  1998...............................................    $30
                  1999...............................................     19
                  2000...............................................      9
                                                                         ---
                  Thereafter.........................................    $58
                                                                         ===
</TABLE>

         Total rent expense for the years ended 1996 and 1997 was $48,000 and
$56,000, respectively.





                                      F-23
<PAGE>   71

10.  SUBSEQUENT EVENT

         In February 1998, the Company was acquired by Birch Telecom, Inc. for
$19,500,000. Shareholders of the Company received $4,750,000 of cash and
$14,750,000 of preferred stock in Birch Telecom, Inc.

11.  YEAR 2000 COMPLIANCE -- UNAUDITED

         Year 2000 issues arise from computer programs written using two digits
rather than four to define the applicable year. Any of the Company's computer
programs that have time-sensitive software may recognize a date using 00 as the
year 1900 rather than the year 2000. This could result in a system failure or
miscalculation causing disruptions of operations, including, among other things,
a temporary inability to process transactions, send invoices or engage in
similar normal business activities.

         Based on ongoing assessments, the Company determined that it will be
required to modify or replace portions of its software so that its computer
systems will function properly with respect to dates in the year 2000 and
thereafter. The Company presently believes that with modifications to existing
software and conversions to new software, the year 2000 issue will not pose
significant operational problems for its computer systems. The Company estimates
it will incur minimal expenses to modify and convert its systems and anticipates
completing the year 2000 project by the year ending December 31, 1998.

         While the Company believes that its systems will be year 2000
compliant, there can be no assurance until the year 2000 occurs that all systems
will function adequately. In addition, the Company interconnects and uses
various local exchange companies' facilities to service its customers, and such
facilities currently utilize numerous, date-sensitive computer applications. If
these facilities are not year 2000 compliant, or if the systems of other local
exchange companies, long-distance carriers and others upon which the Company
relies are not year 2000 compliant, it could have a material effect on the
Company's business, operating results and financial condition.




                                      F-24