** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549-0001**

 

----

 

**FORM 10-Q**

 

**(MARK ONE)**

 
| **ý**                                        | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15**(d)**OF**                                      |
|---------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|
| ** **                                        | ** ** | **THE SECURITIES EXCHANGE ACT OF 1934**                                                         |
|                                              |       |                                                                                            |   |   |   |   |
| **For the quarterly period ended  June 30, 2005** |
|                                              |       |                                                                                            |   |   |   |   |
| **OR**                                            |
|                                              |       |                                                                                            |   |   |   |   |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15**(d)**OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                              |       |                                                                                            |   |   |   |   |

**Commission File Number 000-50706**

 

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**ESCHELON TELECOM, INC.**

**(Exactname of registrant as specified in its charter)**

** **

| **Delaware**                             | **41-1843131**       |
|------------------------------------------|----------------------|
| (State or other jurisdiction of          | (I.R.S.  Employer    |
| incorporation or organization)           | Identification  No.) |
|                                     |                 |
| **730 Second Avenue**                    |                 |
| **Minneapolis, MN**                      | **55402**            |
| (Address of principal executive offices) | (Zip  Code)          |

 

Registrant’stelephone number, including area code: **(612) 376-4400**

 

----

 

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

 

Indicate by check mark whether the registrant is anaccelerated filer as defined in Rule 12b-2 of the Exchange Act.  Yes o     No ý

 

As of August 9, 2005, thenumber of outstanding shares of the Registrant’s Common Stock, par value $.01per share, was 14,653,709 shares.

** **

 

----

** **

**ESCHELONTELECOM, INC.**

**INDEX TOFORM 10-Q**

 

 
| **PART I.  FINANCIAL INFORMATION** |   |
|-----------------------------------------|--------|
| ** **                              |   |
| Item 1.                                 |   | Financial  Statements: | 3 |
|                                    |   |   |   |
|                                    |   | Consolidated  Balance Sheets — December 31, 2004 and June 30, 2005 (Unaudited) | 3 |
|                                    |   |   |   |
|                                    |   | Unaudited Consolidated  Statements of Operations — Three months and six months ended June 30, 2004  and 2005 | 4 |
|                                    |   |   |   |
|                                    |   | Unaudited Consolidated  Statements of Cash Flows — Six months ended June 30, 2004 and 2005 | 5 |
|                                    |   |   |   |
|                                    |   | Notes to  Consolidated Financial Statements | 6 |
|                                    |   |   |   |
| Item 2.                                 |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 19 |
|                                    |   |   |   |
| Item 3.                                 |   | Quantitative  and Qualitative Disclosures About Market Risk | 27 |
|                                    |   |   |   |
| Item 4.                                 |   | Controls and  Procedures | 27 |
|                                    |   |   |   |
| **PART II.  OTHER INFORMATION**    |   |
|                                    |   |   |   |
| Item 1.                                 |   | Legal Proceedings | 28 |
|                                    |   |   |   |
| Item 2.                                 |   | Unregistered  Sales of Equity Securities and Use of Proceeds | 28 |
|                                    |   |   |   |
| Item 3.                                 |   | Defaults Upon  Senior Securities | 28 |
|                                    |   |   |   |
| Item 4.                                 |   | Submission of  Matters to a Vote of Security Holders | 28 |
|                                    |   |   |   |
| Item 5.                                 |   | Other Information | 28 |
|                                    |   |   |   |
| Item 6.                                 |   | Exhibits | 29 |
|                                    |   |   |   |
| Signature                               | 30     |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

## **Item1.  Financial Statements**

 

**EschelonTelecom, Inc.**

**Consolidated Balance Sheets**

**(InThousands, Except Share and Per Share Amounts)**

 
| ** **                                                                                                                                                                                            | ** ** | **December  31,** | ** ** | **June 30,**    | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2004**          | ** ** | **2005**        | ** ** |
|                                                                                                                                                                                                  |       |              |       | **(Unaudited)** |       |
| **Assets**                                                                                                                                                                                            |       |              |       |            |       |
| Current  assets:                                                                                                                                                                                      |       |              |       |            |       |
| Cash and cash equivalents                                                                                                                                                                             |       | $                 | 26,435     |            | $          | 9,379 |   |
| Restricted cash                                                                                                                                                                                       |       | 722               |       | 875             |       |
| Available-for-sale securities                                                                                                                                                                         |       | 6,194             |       | 11,772          |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Accounts receivable, net of allowance for doubtful accounts of $817  and $826, respectively                                                                                                           |       | 18,941            |       | 21,103          |       |
| Other receivables                                                                                                                                                                                     |       | 2,976             |       | 3,032           |       |
| Inventories                                                                                                                                                                                           |       | 2,873             |       | 2,993           |       |
| Prepaid expenses                                                                                                                                                                                      |       | 2,410             |       | 1,831           |       |
| Discontinued assets held for sale                                                                                                                                                                     |       | —            |       | 822             |       |
| Total current assets                                                                                                                                                                                  |       | 60,551            |       | 51,807          |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Property and equipment,  net                                                                                                                                                                          |       | 102,849           |       | 103,667         |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Other assets                                                                                                                                                                                          |       | 1,985             |       | 1,888           |       |
| Goodwill                                                                                                                                                                                              |       | 38,776            |       | 38,776          |       |
| Intangible assets, net                                                                                                                                                                                |       | 32,958            |       | 33,235          |       |
| Total assets                                                                                                                                                                                          |       | $                 | 237,119    |            | $          | 229,373 |   |
|                                                                                                                                                                                                  |       |              |       |            |       |
| **Liabilities and stockholders’  deficit**                                                                                                                                                       |       |              |       |            |       |
| Current liabilities:                                                                                                                                                                                  |       |              |       |            |       |
| Accounts payable                                                                                                                                                                                      |       | $                 | 8,375      |            | $          | 6,999 |   |
| Accrued telecommunication costs                                                                                                                                                                       |       | 7,616             |       | 8,027           |       |
| Accrued office rent                                                                                                                                                                                   |       | 2,336             |       | 2,295           |       |
| Accrued interest expense                                                                                                                                                                              |       | 4,070             |       | 4,070           |       |
| Accrued expenses                                                                                                                                                                                      |       | 5,998             |       | 5,160           |       |
| Deferred revenue                                                                                                                                                                                      |       | 7,300             |       | 7,673           |       |
| Accrued compensation expenses                                                                                                                                                                         |       | 3,588             |       | 4,818           |       |
| Capital lease obligation, current maturities                                                                                                                                                          |       | 1,629             |       | 1,117           |       |
| Discontinued liabilities held for sale                                                                                                                                                                |       | —            |       | 1,416           |       |
| Total current liabilities                                                                                                                                                                             |       | 40,912            |       | 41,575          |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Long-term liabilities:                                                                                                                                                                                |       |              |       |            |       |
| Commitments and contingencies (see Note 3)                                                                                                                                                            |       |              |       |            |       |
| Other long-term liabilities                                                                                                                                                                           |       | 630               |       | 824             |       |
| Capital lease obligation, less current maturities                                                                                                                                                     |       | 2,824             |       | 4,781           |       |
| Notes payable                                                                                                                                                                                         |       | 137,778           |       | 139,697         |       |
| Total liabilities                                                                                                                                                                                     |       | 182,144           |       | 186,877         |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Series A convertible preferred stock, $0.01 par  value per share;100,000,000 shares authorized; issued and outstanding shares  — 77,526,136 at December 31, 2004 and June 30, 2005               |       | 48,155            |       | 49,717          |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Series B convertible preferred stock, $0.01 par value per share; 25,000,000  shares authorized; issued and outstanding shares — 20,000,000 at December 31,  2004 and 20,205,736 at June 30, 2005 |       | 15,000            |       | 15,759          |       |
|                                                                                                                                                                                                  |       |              |       |            |       |
| Stockholders’ deficit:                                                                                                                                                                           |       |              |       |            |       |
| Common stock, $0.01 par value per share; 200,000,000 shares authorized;  issued and outstanding shares — 351,134 shares at December 31, 2004; and  416,974 at June 30, 2005            |       | 4                 |       | 4               |       |
| Additional paid-in capital                                                                                                                                                                            |       | 115,876           |       | 115,781         |       |
| Accumulated other comprehensive income                                                                                                                                                                |       | 30                |       | 90              |       |
| Accumulated deficit                                                                                                                                                                                   |       | (124,056          | )          | (137,467        | )          |
| Deferred compensation                                                                                                                                                                                 |       | (34               | )          | (1,388          | )          |
| Total stockholders’  deficit                                                                                                                                                                     |       | (8,180            | )          | (22,980         | )          |
| Total liabilities and  stockholders’ deficit                                                                                                                                                     |       | $                 | 237,119    |            | $          | 229,373 |   |
|                                                                                                                                                                                                       |            |                   |            |                 |            |  |  |  |

* *

*See accompanying notes.*

 

3

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**EschelonTelecom, Inc.**

**Unaudited Consolidated Statements of Operations**

**(InThousands, Except Share and Per Share Amounts)**

 
| ** **                                           | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                           | ** ** | **2004**               | ** ** | **2005**             | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenue:                                             |       |                   |       |                 |       |   |   |   |   |
| Network services                                     |       | $                      | 32,745     |                 | $          | 50,095 |   | $ | 64,857 |   | $ | 98,763 |   |
| Business telephone systems                           |       | 6,406                  |       | 6,826                |       | 12,490 |   | 12,691 |   |
| Total revenue                                        |       | 39,151                 |       | 56,921               |       | 77,347 |   | 111,454 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Cost of revenue:                                     |       |                   |       |                 |       |   |   |   |   |
| Network services                                     |       | 11,592                 |       | 24,901               |       | 23,357 |   | 44,902 |   |
| Business telephone systems                           |       | 3,818                  |       | 4,191                |       | 7,480 |   | 7,821 |   |
| Total cost of revenue                                |       | 15,410                 |       | 29,092               |       | 30,837 |   | 52,723 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Gross profit:                                        |       |                   |       |                 |       |   |   |   |   |
| Network services                                     |       | 21,153                 |       | 25,194               |       | 41,500 |   | 53,861 |   |
| Business telephone systems                           |       | 2,588                  |       | 2,635                |       | 5,010 |   | 4,870 |   |
| Total gross profit                                   |       | 23,741                 |       | 27,829               |       | 46,510 |   | 58,731 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                  |       |                   |       |                 |       |   |   |   |   |
| Sales, general and administrative                    |       | 17,084                 |       | 23,080               |       | 33,526 |   | 45,445 |   |
| Depreciation and amortization                        |       | 7,277                  |       | 8,707                |       | 15,212 |   | 17,281 |   |
| Operating loss                                       |       | (620                   | )          | (3,958               | )          | (2,228 | ) | (3,995 | ) |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Other income (expense):                              |       |                   |       |                 |       |   |   |   |   |
| Interest income                                      |       | 26                     |       | 102                  |       | 38 |   | 233 |   |
| Interest expense                                     |       | (2,760                 | )          | (4,952               | )          | (5,074 | ) | (9,814 | ) |
| Gain on debt restructuring                           |       | —                 |       | —               |       | 18,195 |   | — |   |
| Other income (expense)                               |       | (23                    | )          | 54                   |       | (24 | ) | 54 |   |
| Income (loss) before taxes                           |       | (3,377                 | )          | (8,754               | )          | 10,907 |   | (13,522 | ) |
| Income taxes                                         |       | —                 |       | —               |       | — |   | — |   |
| Net income (loss) before  discontinued operation     |       | (3,377                 | )          | (8,754               | )          | 10,907 |   | (13,522 | ) |
| Income from discontinued  operation                  |       | —                 |       | 111                  |       | - |   | 111 |   |
| Net income (loss)                                    |       | (3,377                 | )          | (8,643               | )          | 10,907 |   | (13,411 | ) |
| Less preferred stock  dividends                      |       | (854                   | )          | (1,088               | )          | (1,708 | ) | (2,167 | ) |
| Net income (loss)  applicable to common stockholders |       | $                      | (4,231     | )                    | $          | (9,731 | ) | $ | 9,199 |   | $ | (15,578 | ) |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Net income (loss) per  share:                        |       |                   |       |                 |       |   |   |   |   |
| Basic                                                |       | $                      | (14.74     | )                    | $          | (26.32 | ) | $ | 33.15 |   | $ | (42.26 | ) |
| Diluted                                              |       | $                      | (14.74     | )                    | $          | (26.32 | ) | $ | 2.12 |   | $ | (42.26 | ) |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Weighted average number of  shares outstanding:      |       |                   |       |                 |       |   |   |   |   |
| Basic                                                |       | 287,094                |       | 369,743              |       | 277,488 |   | 368,631 |   |
| Diluted                                              |       | 287,094                |       | 369,743              |       | 8,006,120 |   | 368,631 |   |

* *

*See accompanying notes*

** **

4

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**EschelonTelecom, Inc.**

**Unaudited Consolidated Statements of Cash Flows**

**(InThousands)**

 

 
| ** **                                                                                | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                | ** ** | **June 30,**         | ** ** |
| ** **                                                                                | ** ** | **2004**             | ** ** | **2005** | ** ** |
| **Operating activities**                                                                  |       |                 |       |   |   |
| Net income (loss)                                                                         |       | $                    | 10,907     |   | $ | (13,411 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                 |       |   |   |
| Depreciation and amortization expense                                                     |       | 15,212               |       | 17,281 |   |
| Other non-cash items                                                                      |       | 1,409                |       | 3,406 |   |
| Gain on extinguishment of debt                                                            |       | (18,195              | )          | — |   |
| Changes in operating assets and liabilities:                                              |       |                 |       |   |   |
| Restricted cash                                                                           |       | —               |       | (153 | ) |
| Accounts receivable                                                                       |       | 987                  |       | (2,457 | ) |
| Inventories                                                                               |       | 28                   |       | (120 | ) |
| Other current assets and deposits                                                         |       | (1,312               | )          | 520 |   |
| Discontinued assets held for sale, net of liabilities                                     |       | —               |       | 810 |   |
| Accounts payable and accrued expenses                                                     |       | 4,519                |       | (1,838 | ) |
| Deferred revenue                                                                          |       | 720                  |       | 373 |   |
| Accrued compensation expense                                                              |       | (862                 | )          | 1,230 |   |
| Net cash provided by  operating activities                                                |       | 13,413               |       | 5,641 |   |
|                                                                                      |       |                 |       |   |   |
| **Investing activities**                                                                  |       |                 |       |   |   |
| Purchase of net assets  held for sale                                                     |       | —               |       | (216 | ) |
| Purchases of  available-for-sale securities                                               |       | —               |       | (18,637 | ) |
| Proceeds from sale of  available-for-sale securities                                      |       | —               |       | 13,218 |   |
| Purchases of property and  equipment                                                      |       | (6,981               | )          | (9,253 | ) |
| Cash paid for customer  installation costs                                                |       | (5,494               | )          | (6,640 | ) |
| Proceeds from sales of  assets                                                            |       | 2                    |       | 6 |   |
| Net cash used in investing  activities                                                    |       | (12,473              | )          | (21,522 | ) |
|                                                                                      |       |                 |       |   |   |
| **Financing activities**                                                                  |       |                 |       |   |   |
| Proceeds from issuance of  notes payable                                                  |       | 84,813               |       | — |   |
| Payments made on bank debt  and capital lease obligations                                 |       | (66,299              | )          | (1,028 | ) |
| Proceeds from issuance of  stock                                                          |       | 3                    |       | 200 |   |
| Increase in debt issuance  costs                                                          |       | (4,220               | )          | (347 | ) |
| Net cash provided by (used  in) financing activities                                      |       | 14,297               |       | (1,175 | ) |
|                                                                                      |       |                 |       |   |   |
| Net increase (decrease) in  cash and cash equivalents                                     |       | 15,237               |       | (17,056 | ) |
| Cash and cash equivalents  at beginning of period                                         |       | 8,606                |       | 26,435 |   |
| Cash and cash equivalents  at end of period                                               |       | $                    | 23,843     |   | $ | 9,379 |   |
| ** **                                                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
| **Supplemental cash flow  information**                                                   |       |                 |       |   |   |
| Cash paid for interest                                                                    |       | $                    | 4,167      |   | $ | 7,323 |   |
|                                                                                      |       |                 |       |   |   |
| **Supplemental noncash activities**                                                       |       |                 |       |   |   |
| Equipment purchases under  capital leases                                                 |       | $                    | 1,354      |   | $ | 2,473 |   |
| Value of common stock issued to management and  certain members of board of directors     |       | $                    | 14         |   | $ | 24 |   |

* *

*See accompanying notes.*

 

5

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**EschelonTelecom, Inc.**

**Notes to Consolidated Financial Statements**

**(InThousands, Except Share and Per Share Amounts)**

**(Unaudited)**

 

**1.)****         ****Summaryof Significant Accounting Policies**

 

**Basis of Presentation**

 

The accompanying unaudited consolidatedfinancial statements of Eschelon Telecom, Inc. and its subsidiaries (the “Company”)have been prepared in accordance with accounting principles generally acceptedin the United States of America for interim financial information and theinstructions to Form 10-Q and Article 10 of Regulation S-X promulgated by theUnited States Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of theinformation and notes required by accounting principles generally accepted inthe United States of America for complete financial statements.  In the opinion of management, all adjustments(consisting of normal and recurring adjustments and accruals) considerednecessary for a fair presentation for the periods indicated have beenincluded.  Operating results for thethree and six month periods ended June 30, 2005 are not necessarily indicativeof the results that may be expected for the year ending December 31, 2005.  The consolidated balance sheet at December31, 2004 has been derived from the audited consolidated financial statements atthat date but does not include all of the information and footnotes required bygenerally accepted accounting principles for complete financialstatements.  These financial statements shouldbe read in conjunction with the Company’s audited financial statements andrelated notes thereto for the year ended December 31, 2004 included in theEschelon Telecom, Inc. Form 10-K filed with the Securities and ExchangeCommission on March 31, 2005.

 

## **Available-for-Sale Securities**

 

Short-term investments are comprised ofmunicipal and United States government debt securities with maturities of morethan three months but less than one year. In accordance with SFAS No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*, and based on the Company’sintentions regarding these instruments, all investments in debt securities areclassified as available-for-sale and accounted for at fair value.  Fair value is determined by quoted marketprices, with unrealized gains and losses reported as a separate component ofstockholders’ deficit.  The Company usesthe specific identification of securities sold method to recognize realizedgains and losses in earnings.

 

The cost basis, fair value and grossunrealized gains of the investment securities available-for-sale as of June 30,2005 and December 31, 2004, are as follows:

 
| ** **                                             | ** ** | ** **     | ** ** | ** **     | ** ** | **Gross**      | ** ** | **Gross**      | ** ** |
|--------------------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                             | ** ** | ** **     | ** ** | ** **     | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** |
| ** **                                             | ** ** | ** **     | ** ** | ** **     | ** ** | **Holding**    | ** ** | **Holding**    | ** ** |
| ** **                                             | ** ** | **Cost Basis** | ** ** | **Fair Value** | ** ** | **Gains**      | ** ** | **(Losses)**   | ** ** |
| Available-for-sale  securities as of June 30, 2005     |       | $              | 11,682     |           | $          | 11,772         |       | $              | 104        |   | $ | (14 | ) |
|                                                   |       |           |       |           |       |           |       |           |       |
| Available-for-sale  securities as of December 31, 2004 |       | $              | 6,164      |           | $          | 6,194          |       | $              | 30         |   | $ | — |   |

 

Debt securities as of June 30, 2005 havematurities of six months or less.

 

## **Property and Equipment**

 

Property and equipment, including leaseholdimprovements, are stated at cost.  Allinternal costs directly related to the construction of the switches andoperating and support systems, including compensation of certain employees, arecapitalized.  Depreciation is providedusing the straight-line method over the estimated useful lives of theassets.  Leasehold improvements areamortized over the shorter of the related lease term or the estimated usefullife of the asset.

 

6

----

 

Property and equipment consist of thefollowing:

 
| ** **                                 | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                 | ** ** | **2004**         | ** ** | **2005**     | ** ** |
| Vehicles                                   |       | $                | 590        |         | $          | 1,074 |   |
| Office furniture and  equipment            |       | 16,746           |       | 18,010       |       |
| Computer equipment and  software           |       | 34,534           |       | 38,016       |       |
| Leasehold improvements                     |       | 19,504           |       | 19,801       |       |
| Switching and data  equipment and software |       | 99,736           |       | 105,825      |       |
|                                       |       | 171,110          |       | 182,726      |       |
| Less accumulated  depreciation             |       | (68,261          | )          | (79,059      | )          |
|                                       |       | $                | 102,849    |         | $          | 103,667 |   |

 

## **Goodwill and Other Intangible Assets**

 

Goodwill represents the excess of cost overthe fair value of net assets acquired.

 

Intangibles consist of customer installationcosts, debt issuance costs and non-compete agreements.  The customer installation costs are beingamortized over a period of 48 months, which approximates the average life of acustomer contract.  Debt issuance costsare being amortized over the term of the respective debt obligation.  Non-compete agreement costs represent costsassociated with various agreements the Company has entered into with existingmanagement of the companies it has acquired and a settlement agreement with aformer employee of the Company.  Thesecosts are being amortized over the terms of the agreements.

 

Intangible assets consist of the following:

 
| ** **                     | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|--------------------------------|------------|------------------|------------|--------------|------------|
| ** **                     | ** ** | **2004**         | ** ** | **2005**     | ** ** |
| Customer installation  costs   |       | $                | 64,087     |         | $          | 70,717 |   |
| Debt issuance costs            |       | 8,368            |       | 8,715        |       |
| Non-compete agreements         |       | 15               |       | 315          |       |
|                           |       | 72,470           |       | 79,747       |       |
| Less accumulated  amortization |       | (39,512          | )          | (46,512      | )          |
|                           |       | $                | 32,958     |         | $          | 33,235 |   |

 

## **Stock-Based Compensation**

 

The Company accounts for its stock-basedemployee compensation under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees,*and related interpretations.  Under APB No. 25, when the exercise price ofstock options equals the market price of the underlying stock on the date ofgrant, no compensation expense is recognized in the consolidated statement ofoperations.

 

In preparation for the Company’s initialpublic offering of its common stock (see Note 8), the Company’s board ofdirectors assessed its prior contemporaneous determinations of fair value forstock option and stock grants made since May 2004 and made adjustments to theseprior determinations of fair value.  As aresult of these retrospective adjustments to fair value, the Company recognizedcompensation expense associated with such stock option and stock grants of $636in the three months ended June 30, 2005. The Company will record a total of $1,367 of additional compensationexpense through July 2009, at which point all such stock options are fullyvested.

 

The following table illustrates the effect onnet income (loss) per share if the company had applied the fair valuerecognition provision of Statement of Financial Accounting Standards (SFAS) No.123, *Accounting for Stock-Based Compensation,*tostock-based employee compensation:

 

7

----

 
| ** **                                                                                                        | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                        | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                                                                                        | ** ** | **2004**               | ** ** | **2005**             | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income (loss) applicable to commonstockholders, as reported                                                   |       | $                      | (4,231     | )                    | $          | (9,731 | ) | $ | 9,199 |   | $ | (15,578 | ) |
| Add: Stock-based employee compensation expense included in reported  net income (loss)                            |       | —                 |       | 636                  |       | 20 |   | 648 |   |
| Deduct: Total stock-based employee compensation expense determined  under fair value-based methods for all awards |       | (16                    | )          | (272                 | )          | (48 | ) | (289 | ) |
| Pro forma net income (loss) applicable to common stockholders                                                     |       | $                      | (4,247     | )                    | $          | (9,367 | ) | $ | 9,171 |   | $ | (15,219 | ) |
|                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Net income (loss) per share:                                                                                      |       |                   |       |                 |       |   |   |   |   |
| Basic — as reported                                                                                          |       | $                      | (14.74     | )                    | $          | (26.32 | ) | $ | 33.15 |   | $ | (42.26 | ) |
| Basic — pro forma                                                                                            |       | $                      | (14.79     | )                    | $          | (25.33 | ) | $ | 33.05 |   | $ | (41.28 | ) |
|                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Diluted — as reported                                                                                        |       | $                      | (14.74     | )                    | $          | (26.32 | ) | $ | 2.12 |   | $ | (42.26 | ) |
| Diluted — pro forma                                                                                          |       | $                      | (14.79     | )                    | $          | (25.33 | ) | $ | 2.12 |   | $ | (41.28 | ) |

 

Pro forma information regarding net income(loss) and net income (loss) per share is required by SFAS No. 123, and hasbeen determined as if the Company had accounted for its employee stock optionsunder the fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant usingthe Black-Scholes option pricing model with the following assumptions for thethree and six-month periods ended June 30, 2004 and 2005:

 
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                       | ** ** | **2004**                        | ** ** | **2005**                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Expected dividend yield          |       | —                          |       | —                        |       | — |   | — |   |
| Expected stock price  volatility |       | 25                              | %          | 25                            | %          | 25 | % | 25 | % |
| Risk-free interest rate          |       | 3.88                            | %          | 3.83-4.24                     | %          | 3.25-3.88 | % | 3.71-4.24 | % |
| Expected life of options         |       | 5  years                        |       | 5  years                      |       | 5  years |   | 5  years |   |

 

The Black-Scholes option valuation model wasdeveloped for use in estimating the fair value of traded options which have novesting restrictions and are fully transferable.  In addition, option valuation models requirethe input of highly subjective assumptions. Because the Company’s employee stock options have characteristicssignificantly different from those of traded options and because changes in thesubjective input assumptions can materially affect the fair value estimate, inmanagement’s opinion, the existing models do not necessarily provide a reliablesingle measure of the fair value of its employee stock options.

 

## **Net Income (Loss) Per Share**

 

Basic earnings per share is computed based onthe weighted average number of common shares outstanding.  Diluted earnings per share is computed basedon the weighted average number of common shares outstanding adjusted by thenumber of additional shares that would have been outstanding had thepotentially dilutive common shares been issued. Potentially dilutive shares of common stock include stock options,unvested restricted stock grants, Series A Convertible Preferred Stock andSeries B Convertible Preferred Stock. During periods in which a net loss is incurred, diluted earnings pershare amounts are the same as basic per share amounts because the effect of alloptions, unvested restricted stock grants, Series A Convertible Preferred Stockand Series B Convertible Preferred Stock is anti-dilutive.

 

The following table presents a reconciliationof the numerators and denominators of basic and diluted earnings per commonshare:

 

8

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| ** **                                         | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                         | ** ** | **2004**               | ** ** | **2005**             | ** ** | **2004** | ** ** | **2005** | ** ** |
| Numerator:                                         | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) applicable to common             |       |                   |       |                 |       |   |   |   |   |
| stockholders, as reported                          |       | $                      | (4,231     | )                    | $          | (9,731 | ) | $ | 9,199 |   | $ | (15,578 | ) |
| Add: Cumulative preferred stock dividends          |       | —                 |       | —               |       | 7,835 |   | — |   |
| Deduct: Unrecognized deferred compensation expense |       | —                 |       | —               |       | (34 | ) | — |   |
| Numerator for diluted earnings per share           |       | $                      | (4,231     | )                    | $          | (9,731 | ) | $ | 17,000 |   | $ | (15,578 | ) |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Denominator:                                       |       |                   |       |                 |       |   |   |   |   |
| Weighted average common shares outstanding         |       | 287,094                |       | 369,743              |       | 277,488 |   | 368,631 |   |
| Effect of dilutive securities:                     |       |                   |       |                 |       |   |   |   |   |
| Restricted stock grants                            |       | —                 |       | —               |       | 31,501 |   | — |   |
| Employee stock options                             |       | —                 |       | —               |       | 336,282 |   | — |   |
| Series A convertible preferred stock               |       | —                 |       | —               |       | 7,360,849 |   | — |   |
| Denominator for diluted earnings per share         |       | 287,094                |       | 369,743              |       | 8,006,120 |   | 368,631 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Net income (loss) per  share:                      |       |                   |       |                 |       |   |   |   |   |
| Basic — as reported                           |       | $                      | (14.74     | )                    | $          | (26.32 | ) | $ | 33.15 |   | $ | (42.26 | ) |
| Diluted — as reported                         |       | $                      | (14.74     | )                    | $          | (26.32 | ) | $ | 2.12 |   | $ | (42.26 | ) |
|                                                    |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

## **New Accounting Pronouncements**

 

In December 2004,as amended on April 14, 2005, the Financial Accounting Standards Boardissued SFAS No. 123R, *Share-Based Payment:an amendment of FASB Statement No. 123 and FASB Statement No. 95*,which requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values. Prior to SFAS No. 123R, only certain pro forma disclosures offair value were required. SFAS 123R must be adopted no later than thebeginning of the first fiscal year beginning after June 15, 2005. We willadopt SFAS 123R on January 1, 2006.

 

SFAS 123R permits companies to adopt oneof two methods: (1) A “modified prospective” method in which compensationcost is recognized beginning with the effective date (a) based on therequirements of SFAS 123R for all share-based payments granted afterthe effective date and (b) based on the requirements of SFAS 123 forall awards granted to employees prior to the effective date of SFAS 123Rthat remain unvested on the effective date or (2) A “modifiedretrospective” method that includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under FAS 123 for purposes of proforma disclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. We are currently in the process ofevaluating the two option valuation methods and the potential impact on ourfinancial statements.

 

In December 2004, the FASB issued SFASNo. 153, *Exchanges of Nonmonetary Assets*.SFAS No. 153 addresses the measurement of exchange of nonmonetary assets.SFAS 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets in paragraph 21(b) ofAPB Opinion No. 29, *Accounting for NonmonetaryTransactions*, and replaces it with an exception for exchanges thatdo not have commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange. SFAS No. 153is effective for nonmonetary asset exchanges occurring in fiscal periodsbeginning after June 15, 2005. We are evaluating the potential impact ofour adoption of SFAS No. 153 on our consolidated financial statements.

 

**2.)****         ****Acquisitions**

 

*Advanced TelCom, Inc.*

 

On December 31, 2004, the Company acquired all of theoutstanding common stock of Advanced TelCom, Inc. (“ATI”) for $45,495, net ofcash acquired.  The results of ATI havebeen included in the consolidated financial statements since that date.  As a result of the acquisition, the Companystrengthened its presence in six markets, entered into six adjacent markets,entered one new market and created significant opportunities for cost savingsand increased profitability.

 

9

----

 

The Company allocated the purchase price on apreliminary basis using the information then available.  The allocation of the purchase price will befinalized in 2005.  Upon completion ofthe final purchase price allocation, an additional portion of the excesspurchase price may be allocated to certain intangibles that are separable fromgoodwill.  The Company accrued $2,531 inacquisition related expenses, which include severance benefits, relocationcosts and contract termination fees.  AtJune 30, 2005 the balance in the acquisition reserve was as follows:

 
| Balance at December 31, 2004 |   | $    | 2,531 |   |
|------------------------------|--------|------|-------|--------|
| Payments                     |   | (460 | )     |
| Balance at June 30, 2005     |   | $    | 2,071 |   |

 

The following unaudited pro forma financialinformation was prepared in accordance with SFAS No. 141, *BusinessCombinations*, and assumes the acquisition had occurred at thebeginning of the periods presented.  Theunaudited pro forma information is provided for informational purposesonly.  These pro forma results are basedupon the respective historical financial statements of the respectivecompanies, and do not incorporate, nor do they assume, any benefits from costsavings or synergies of operations of the combined company.  The pro forma results of operations do notnecessarily reflect the results that would have occurred had the acquisitionoccurred at the beginning of the periods presented or the results which mayoccur in the future.

 

The pro forma combinedresults of continuing operations for the three and six months ended June 30,2004 are as follows:

 
| ** **                           | ** ** | **Three months ended  June 30, 2004** | ** ** | **Six months ended  June 30, 2004** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| Revenue                              |       | $                                     | 53,729     |                                | $          | 107,305 |   |
| Net income                           |       | (1,841                                | )          | 16,097                              |       |
| Net income per share —  basic   |       | (6.41                                 | )          | 58.01                               |       |
| Net income per share —  diluted |       | (6.41                                 | )          | 2.77                                |       |
|                                      |            |                                       |            |                                     |            |  |  |

 

#### *GeneralElectric Business Productivity Solutions*

 

On October 13, 2004 the Company entered intoan agreement with General Electric Capital Corporation to purchasesubstantially all of the assets of General Electric Business Productivity Solutions(GEBPS) for $100.   The transactionclosed on March 31, 2005 and is being accounted for as a discontinuedoperation. GEBPS constitutes a group of assets that can be clearlydistinguished operationally and for financial reporting purposes from the restof the Company.  Management hasdetermined that the group of assets does not fit the Company’s future businessmodel and is committed to sell the net assets. The Company believes that the assets will be sold within the next twelvemonths.  At March 31, 2005 the Companydetermined that the plan of sale criteria in SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, had been metand classified the assets and liabilities accordingly on the balance sheet.

 

**3.)****         ****Commitmentsand Contingencies**

 

On June21, 2005, we settled the lawsuit brought against the Company by GlobalCrossing.  The parties agreed to releaseeach other from all claims related to the dispute and to amend their agreement.  The settlement agreement provides for the Companyto pay Global Crossing $5,000 and Global Crossing to credit the Company’sfuture bills for approximately $564 over the following six months.

 

Underthe terms of the Global Crossing settlement, the Carrier Services Agreementbetween the parties, which had provided that Global Crossing was the Company’sexclusive provider of voice and data services, subject to certain exceptions,and that the Company had a purchase commitment of $100,000 was amended toshorten the term of the agreement to July 1, 2006, to eliminate theexclusivity, purchase commitment and shortfall provisions and to provide thatGlobal Crossing will be the Company’s preferred provider for Internet transitand long haul data private line needs.

 

10

----

 

**4.)****         ****BenefitContribution Plan**

 

The Company has a definedcontribution salary deferral plan covering substantially all employees underSection 401(k) of the Internal Revenue Code. The Company contributes an amount equal to 45 cents for each dollarcontributed by each employee up to a maximum of 6% of each employee’scompensation.  The Company recognizedexpense for contributions to the plan for the three months ended June 30, 2004and 2005 of $190 and $242, respectively, and for the six months ended June 30,2004 and 2005 of $376 and $469, respectively.

 

**5.)****         ****CapitalStock**

 

**Preferred Stock**

 

Under the terms of theSeries A Convertible Preferred Stock and Series B Convertible Preferred Stock(collectively, Preferred Stock), the holders are entitled to receive, when andif declared by the Board of Directors, cumulative dividends on each share ofPreferred Stock at the rate of 8% per year which shall accrue daily and, to theextent not paid, shall accumulate quarterly in arrears.  At December 31, 2004 and June 30, 2005,dividends in arrears are $8,777 and $10,944, respectively.

 

## **Stock Options**

 

In November 2002, the Board of Directorsapproved the Eschelon Telecom, Inc. Stock Option Plan of 2002 (the 2002Plan).  A total of 1,632,414 shares ofthe Company’s common stock have been reserved for issuance under the 2002Plan.  At June 30, 2005, the Company had987,057 options outstanding and 192,255 shares of restricted common stockissued to certain directors and members of management under the 2002 Plan.

 

## **Restricted Common Stock**

 

In February 2003, the Company granted 183,399shares of restricted common stock to certain directors and members ofmanagement.  The fair value per share ofthis restricted stock was $0.68.  TheCompany records compensation expense as the restrictions are removed from thestock and recognizes compensation expense over the vesting period.  In February 2004, 29,958 shares vestedresulting in compensation expense of $20. In February 2005, 17,941 shares vested resulting in compensation expenseof $12.  In March 2005, the Companygranted 8,856 shares of restricted common stock to a member of the board ofdirectors.  The fair value per share ofthis restricted stock was $2.71.  TheCompany recorded related compensation expense of $24.

 

**6.)****         ****CondensedConsolidating Financial Information**

 

TheCompany’s 8 3/8% senior second secured notes due 2010 issued by EschelonOperating Company are fully and unconditionally guaranteed jointly andseverally by the Company and all existing subsidiaries and the indenturegoverning the notes requires that any future subsidiaries that are organized inthe United States must also guarantee the notes on the same basis.

 

Thefollowing tables present condensed consolidating balance sheets at December 31,2004 and June 30, 2005 and condensed consolidating statements of operations forthe three and six-month periods ended June 30, 2004 and 2005.

 

11

----

 

**UnauditedCondensed Consolidating Balance Sheets**

**As ofDecember 31, 2004**

**(InThousands)**

 
| ** **                                                 | ** ** | ** **        | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**      | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 |       |              |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 |       |              |       |          |       |             |       |             |       |             |       |
| Current assets:                                            |       |              |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                 | 26,332     |          | $          | —           |       | $                | 103        |             | $          | — |   | $ | 26,435 |   |
| Restricted cash                                            |       | 722               |       | —        |       | —           |       | —           |       | 722              |       |
| Available-for-sale securities                              |       | 6,194             |       | —        |       | —           |       | —           |       | 6,194            |       |
| Accounts receivable                                        |       | —            |       | —        |       | 18,941           |       | —           |       | 18,941           |       |
| Other receivables                                          |       | —            |       | —        |       | 2,976            |       | —           |       | 2,976            |       |
| Inventories                                                |       | —            |       | —        |       | 2,873            |       | —           |       | 2,873            |       |
| Prepaid expenses                                           |       | 1,227             |       | —        |       | 1,183            |       | —           |       | 2,410            |       |
| Total current assets                                       |       | 34,475            |       | —        |       | 26,076           |       | —           |       | 60,551           |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Property and equipment,  net                               |       | 82,550            |       | —        |       | 20,299           |       | —           |       | 102,849          |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Investment in affiliates                                   |       | 58,998            |       | —        |       | —           |       | (58,998          | )          | —           |       |
| Other assets                                               |       | 1,042             |       | —        |       | 943              |       | —           |       | 1,985            |       |
| Goodwill                                                   |       | —            |       | —        |       | 38,776           |       | —           |       | 38,776           |       |
| Intangible assets, net                                     |       | 20,438            |       | —        |       | 12,520           |       | —           |       | 32,958           |       |
| Total assets                                               |       | $                 | 197,503    |          | $          | —           |       | $                | 98,614     |             | $          | (58,998 | ) | $ | 237,119 |   |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| **Liabilities and stockholders’  equity (deficit)**   |       |              |       |          |       |             |       |             |       |             |       |
| Current liabilities:                                       |       |              |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                 | 4,314      |          | $          | —           |       | $                | 4,061      |             | $          | — |   | $ | 8,375 |   |
| Accrued telecommunication costs                            |       | —            |       | —        |       | 7,616            |       | —           |       | 7,616            |       |
| Accrued office rent                                        |       | 1,722             |       | —        |       | 614              |       | —           |       | 2,336            |       |
| Accrued interest expense                                   |       | —            |       | 4,069         |       | 1                |       | —           |       | 4,070            |       |
| Other accrued expenses                                     |       | 489               |       | —        |       | 5,509            |       | —           |       | 5,998            |       |
| Deferred revenue                                           |       | —            |       | —        |       | 7,300            |       | —           |       | 7,300            |       |
| Accrued compensation expenses                              |       | 2,172             |       | —        |       | 1,416            |       | —           |       | 3,588            |       |
| Capital lease obligation, current maturities               |       | 1,526             |       | —        |       | 103              |       | —           |       | 1,629            |       |
| Total current liabilities                                  |       | 10,223            |       | 4,069         |       | 26,620           |       | —           |       | 40,912           |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Long-term liabilities:                                     |       |              |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 76                |       | —        |       | 554              |       | —           |       | 630              |       |
| Capital lease obligation, less current maturities          |       | 2,607             |       | —        |       | 217              |       | —           |       | 2,824            |       |
| Notes payable                                              |       | —            |       | 137,778       |       | —           |       | —           |       | 137,778          |       |
| Due to (from) affiliates                                   |       | 235,611           |       | (182,260      | )          | (53,351          | )          | —           |       | —           |       |
| Total liabilities                                          |       | 248,517           |       | (40,413       | )          | (25,960          | )          | —           |       | 182,144          |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Convertible preferred  stock                               |       | 63,155            |       | —        |       | —           |       | —           |       | 63,155           |       |
| Stockholders’ equity  (deficit)                       |       | (114,169          | )          | 40,413        |       | 124,574          |       | (58,998          | )          | (8,180           | )          |
| Total liabilities and  stockholders’ equity (deficit) |       | $                 | 197,503    |          | $          | —           |       | $                | 98,614     |             | $          | (58,998 | ) | $ | 237,119 |   |
|                                                            |            |                   |            |               |            |                  |            |                  |            |                  |            |  |  |  |  |  |  |  |  |

 

12

----

 

**UnauditedCondensed Consolidating Balance Sheets**

**As ofJune 30, 2005**

**(InThousands)**

 
| ** **                                                 | ** ** | ** **        | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**      | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 |       |              |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 |       |              |       |          |       |             |       |             |       |             |       |
| Current assets:                                            |       |              |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                 | 7,091      |          | $          | —           |       | $                | 2,288      |             | $          | — |   | $ | 9,379 |   |
| Restricted cash                                            |       | 875               |       | —        |       | —           |       | —           |       | 875              |       |
| Available-for-sale securities                              |       | 11,772            |       | —        |       | —           |       | —           |       | 11,772           |       |
| Accounts receivable                                        |       | —            |       | —        |       | 21,103           |       | —           |       | 21,103           |       |
| Other receivables                                          |       | —            |       | —        |       | 3,032            |       | —           |       | 3,032            |       |
| Inventories                                                |       | —            |       | —        |       | 2,993            |       | —           |       | 2,993            |       |
| Prepaid expenses                                           |       | 997               |       | —        |       | 834              |       | —           |       | 1,831            |       |
| Discontinued assets held for sale                          |       | —            |       | —        |       | 822              |       | —           |       | 822              |       |
| Total current assets                                       |       | 20,735            |       | —        |       | 31,072           |       | —           |       | 51,807           |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Property and equipment,  net                               |       | 82,934            |       | —        |       | 20,733           |       | —           |       | 103,667          |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Investment in affiliates                                   |       | 58,998            |       | —        |       | —           |       | (58,998          | )          | —           |       |
| Other assets                                               |       | 939               |       | —        |       | 949              |       | —           |       | 1,888            |       |
| Goodwill                                                   |       | —            |       | —        |       | 38,776           |       | —           |       | 38,776           |       |
| Intangible assets, net                                     |       | 21,180            |       | —        |       | 12,055           |       | —           |       | 33,235           |       |
| Total assets                                               |       | $                 | 184,786    |          | $          | —           |       | $                | 103,585    |             | $          | (58,998 | ) | $ | 229,373 |   |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| **Liabilities and stockholders’  equity (deficit)**   |       |              |       |          |       |             |       |             |       |             |       |
| Current liabilities:                                       |       |              |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                 | 3,142      |          | $          | —           |       | $                | 3,857      |             | $          | — |   | $ | 6,999 |   |
| Accrued telecommunication costs                            |       | —            |       | —        |       | 8,027            |       | —           |       | 8,027            |       |
| Accrued office rent                                        |       | 1,604             |       | —        |       | 691              |       | —           |       | 2,295            |       |
| Accrued interest expense                                   |       | —            |       | 4,069         |       | 1                |       | —           |       | 4,070            |       |
| Other accrued expenses                                     |       | 1,695             |       | —        |       | 3,465            |       | —           |       | 5,160            |       |
| Deferred revenue                                           |       | —            |       | —        |       | 7,673            |       | —           |       | 7,673            |       |
| Accrued compensation expenses                              |       | 3,109             |       | —        |       | 1,709            |       | —           |       | 4,818            |       |
| Capital lease obligation, current maturities               |       | 1,010             |       | —        |       | 107              |       | —           |       | 1,117            |       |
| Discontinued liabilities held for sale                     |       | —            |       | —        |       | 1,416            |       | —           |       | 1,416            |       |
| Total current liabilities                                  |       | 10,560            |       | 4,069         |       | 26,946           |       | —           |       | 41,575           |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Long-term liabilities:                                     |       |              |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 817               |       | —        |       | 7                |       | —           |       | 824              |       |
| Capital lease obligation, less current maturities          |       | 4,618             |       | —        |       | 163              |       | —           |       | 4,781            |       |
| Notes payable                                              |       | —            |       | 139,697       |       | —           |       | —           |       | 139,697          |       |
| Due to (from) affiliates                                   |       | 251,303           |       | (175,350      | )          | (75,953          | )          | —           |       | —           |       |
| Total liabilities                                          |       | 267,298           |       | (31,584       | )          | (48,837          | )          | —           |       | 186,877          |       |
|                                                       |       |              |       |          |       |             |       |             |       |             |       |
| Convertible preferred  stock                               |       | 65,476            |       | —        |       | —           |       | —           |       | 65,476           |       |
| Stockholders’ equity  (deficit)                       |       | (147,988          | )          | 31,584        |       | 152,422          |       | (58,998          | )          | (22,980          | )          |
| Total liabilities and  stockholders’ equity (deficit) |       | $                 | 184,786    |          | $          | —           |       | $                | 103,585    |             | $          | (58,998 | ) | $ | 229,373 |   |
|                                                            |            |                   |            |               |            |                  |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |

 

13

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**UnauditedCondensed Consolidating Statement of Operations**

**For theThree Months Ended June 30, 2004**

**(InThousands)**

 
| ** **                         | ** ** | ** **        | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------|------------|-------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                         | ** ** | **Eschelon**      | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                         | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                               |       |              |       |          |       |             |       |             |       |
| Revenue:                           |       |              |       |          |       |             |       |             |       |
| Network services                   |       | $                 | —     |          | $          | —           |       | $                | 32,745     |   | $ | 32,745 |   |
| Business telephone systems         |       | —            |       | —        |       | 6,406            |       | 6,406            |       |
|                               |       | —            |       | —        |       | 39,151           |       | 39,151           |       |
|                               |       |              |       |          |       |             |       |             |       |
| Cost of revenue:                   |       |              |       |          |       |             |       |             |       |
| Network services                   |       | —            |       | —        |       | 11,592           |       | 11,592           |       |
| Business telephone systems         |       | —            |       | —        |       | 3,818            |       | 3,818            |       |
|                               |       | —            |       | —        |       | 15,410           |       | 15,410           |       |
|                               |       |              |       |          |       |             |       |             |       |
| Gross profit:                      |       |              |       |          |       |             |       |             |       |
| Network services                   |       | —            |       | —        |       | 21,153           |       | 21,153           |       |
| Business telephone systems         |       | —            |       | —        |       | 2,588            |       | 2,588            |       |
|                               |       | —            |       | —        |       | 23,741           |       | 23,741           |       |
| Operating expenses:                |       |              |       |          |       |             |       |             |       |
| Sales, general and administrative  |       | 8,986             |       | —        |       | 8,098            |       | 17,084           |       |
| Depreciation and amortization      |       | 4,668             |       | —        |       | 2,609            |       | 7,277            |       |
| Total operating expenses           |       | 13,654            |       | —        |       | 10,707           |       | 24,361           |       |
|                               |       |              |       |          |       |             |       |             |       |
| Operating income (loss)            |       | (13,654           | )          | —        |       | 13,034           |       | (620             | )          |
| Other income (expense)             |       | (207              | )          | (2,544        | )          | (6               | )          | (2,757           | )          |
| Income (loss) before  income taxes |       | (13,861           | )          | (2,544        | )          | 13,028           |       | (3,377           | )          |
| Income taxes                       |       | —            |       | —        |       | —           |       | —           |       |
| Net income (loss)                  |       | $                 | (13,861    | )             | $          | (2,544           | )          | $                | 13,028     |   | $ | (3,377 | ) |

 

14

----

 

**UnauditedCondensed Consolidating Statement of Operations**

**For theThree Months Ended June 30, 2005**

**(InThousands)**

 
| ** **                                       | ** ** | ** **        | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|-------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Eschelon**      | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                       | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                             |       |              |       |          |       |             |       |             |       |
| Revenue:                                         |       |              |       |          |       |             |       |             |       |
| Network services                                 |       | $                 | —     |          | $          | —           |       | $                | 50,095     |   | $ | 50,095 |   |
| Business telephone systems                       |       | —            |       | —        |       | 6,826            |       | 6,826            |       |
|                                             |       | —            |       | —        |       | 56,921           |       | 56,921           |       |
|                                             |       |              |       |          |       |             |       |             |       |
| Cost of revenue:                                 |       |              |       |          |       |             |       |             |       |
| Network services                                 |       | —            |       | —        |       | 24,901           |       | 24,901           |       |
| Business telephone systems                       |       | —            |       | —        |       | 4,191            |       | 4,191            |       |
|                                             |       | —            |       | —        |       | 29,092           |       | 29,092           |       |
|                                             |       |              |       |          |       |             |       |             |       |
| Gross profit:                                    |       |              |       |          |       |             |       |             |       |
| Network services                                 |       | —            |       | —        |       | 25,194           |       | 25,194           |       |
| Business telephone systems                       |       | —            |       | —        |       | 2,635            |       | 2,635            |       |
|                                             |       | —            |       | —        |       | 27,829           |       | 27,829           |       |
| Operating expenses:                              |       |              |       |          |       |             |       |             |       |
| Sales, general and administrative                |       | 10,652            |       | —        |       | 12,428           |       | 23,080           |       |
| Depreciation and amortization                    |       | 5,416             |       | —        |       | 3,291            |       | 8,707            |       |
| Total operating expenses                         |       | 16,068            |       | —        |       | 15,719           |       | 31,787           |       |
|                                             |       |              |       |          |       |             |       |             |       |
| Operating income (loss)                          |       | (16,068           | )          | —        |       | 12,110           |       | (3,958           | )          |
| Other income (expense)                           |       | (381              | )          | (4,434        | )          | 19               |       | (4,796           | )          |
| Income (loss) before  income taxes               |       | (16,449           | )          | (4,434        | )          | 12,129           |       | (8,754           | )          |
| Income taxes                                     |       | —            |       | —        |       | —           |       | —           |       |
| Net income (loss) before  discontinued operation |       | (16,449           | )          | (4,434        | )          | 12,129           |       | (8,754           | )          |
| Income from discontinued  operation, net of tax  |       | —            |       | —        |       | 111              |       | 111              |       |
| Net income (loss)                                |       | $                 | (16,449    | )             | $          | (4,434           | )          | $                | 12,240     |   | $ | (8,643 | ) |

 

15

----

 

**UnauditedCondensed Consolidating Statement of Operations**

**For theSix Months Ended June 30, 2004**

**(InThousands)**

 
| ** **                         | ** ** | ** **        | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------|------------|-------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                         | ** ** | **Eschelon**      | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                         | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                               |       |              |       |          |       |             |       |             |       |
| Revenue:                           |       |              |       |          |       |             |       |             |       |
| Network services                   |       | $                 | —     |          | $          | —           |       | $                | 64,857     |   | $ | 64,857 |   |
| Business telephone systems         |       | —            |       | —        |       | 12,490           |       | 12,490           |       |
|                               |       | —            |       | —        |       | 77,347           |       | 77,347           |       |
|                               |       |              |       |          |       |             |       |             |       |
| Cost of revenue:                   |       |              |       |          |       |             |       |             |       |
| Network services                   |       | —            |       | —        |       | 23,357           |       | 23,357           |       |
| Business telephone systems         |       | —            |       | —        |       | 7,480            |       | 7,480            |       |
|                               |       | —            |       | —        |       | 30,837           |       | 30,837           |       |
|                               |       |              |       |          |       |             |       |             |       |
| Gross profit:                      |       |              |       |          |       |             |       |             |       |
| Network services                   |       | —            |       | —        |       | 41,500           |       | 41,500           |       |
| Business telephone systems         |       | —            |       | —        |       | 5,010            |       | 5,010            |       |
|                               |       | —            |       | —        |       | 46,510           |       | 46,510           |       |
| Operating expenses:                |       |              |       |          |       |             |       |             |       |
| Sales, general and administrative  |       | 18,054            |       | —        |       | 15,472           |       | 33,526           |       |
| Depreciation and amortization      |       | 9,971             |       | —        |       | 5,241            |       | 15,212           |       |
| Total operating expenses           |       | 28,025            |       | —        |       | 20,713           |       | 48,738           |       |
|                               |       |              |       |          |       |             |       |             |       |
| Operating income (loss)            |       | (28,025           | )          | —        |       | 25,797           |       | (2,228           | )          |
| Other income (expense)             |       | (429              | )          | 13,577        |       | (13              | )          | 13,135           |       |
| Income (loss) before  income taxes |       | (28,454           | )          | 13,577        |       | 25,784           |       | 10,907           |       |
| Income taxes                       |       | —            |       | —        |       | —           |       | —           |       |
| Net income (loss)                  |       | $                 | (28,454    | )             | $          | 13,577           |       | $                | 25,784     |   | $ | 10,907 |   |

 

16

----

 

**UnauditedCondensed Consolidating Statement of Operations**

**For theSix Months Ended June 30, 2005**

**(InThousands)**

 
| ** **                                       | ** ** | ** **        | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|-------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Eschelon**      | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                       | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                             |       |              |       |          |       |             |       |             |       |
| Revenue:                                         |       |              |       |          |       |             |       |             |       |
| Network services                                 |       | $                 | —     |          | $          | —           |       | $                | 98,763     |   | $ | 98,763 |   |
| Business telephone systems                       |       | —            |       | —        |       | 12,691           |       | 12,691           |       |
|                                             |       | —            |       | —        |       | 111,454          |       | 111,454          |       |
|                                             |       |              |       |          |       |             |       |             |       |
| Cost of revenue:                                 |       |              |       |          |       |             |       |             |       |
| Network services                                 |       | —            |       | —        |       | 44,902           |       | 44,902           |       |
| Business telephone systems                       |       | —            |       | —        |       | 7,821            |       | 7,821            |       |
|                                             |       | —            |       | —        |       | 52,723           |       | 52,723           |       |
|                                             |       |              |       |          |       |             |       |             |       |
| Gross profit:                                    |       |              |       |          |       |             |       |             |       |
| Network services                                 |       | —            |       | —        |       | 53,861           |       | 53,861           |       |
| Business telephone systems                       |       | —            |       | —        |       | 4,870            |       | 4,870            |       |
|                                             |       | —            |       | —        |       | 58,731           |       | 58,731           |       |
| Operating expenses:                              |       |              |       |          |       |             |       |             |       |
| Sales, general and administrative                |       | 21,125            |       | —        |       | 24,320           |       | 45,445           |       |
| Depreciation and amortization                    |       | 10,688            |       | —        |       | 6,593            |       | 17,281           |       |
| Total operating expenses                         |       | 31,813            |       | —        |       | 30,913           |       | 62,726           |       |
|                                             |       |              |       |          |       |             |       |             |       |
| Operating income (loss)                          |       | (31,813           | )          | —        |       | 27,818           |       | (3,995           | )          |
| Other income (expense)                           |       | (727              | )          | (8,829        | )          | 29               |       | (9,527           | )          |
| Income (loss) before  income taxes               |       | (32,540           | )          | (8,829        | )          | 27,847           |       | (13,522          | )          |
| Income taxes                                     |       | —            |       | —        |       | —           |       | —           |       |
| Net income (loss) before  discontinued operation |       | (32,540           | )          | (8,829        | )          | 27,847           |       | (13,522          | )          |
| Income from discontinued  operation, net of tax  |       | —            |       | —        |       | 111              |       | 111              |       |
| Net income (loss)                                |       | $                 | (32,540    | )             | $          | (8,829           | )          | $                | 27,958     |   | $ | (13,411 | ) |

 

17

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**7.)****         ****ReverseStock Split**

 

TheCompany completed a 0.0738-for-one reverse stock split affecting all outstandingshares of common stock on August 2, 2005. All share and per share data have been adjusted to reflect the stocksplit.

 

**8.)****         ****SubsequentEvents**

 

OnAugust 9, 2005, an initial public offering of 5,357,143 of the Company’s commonstock at $14.00 per share was consummated. Net proceeds from the offering, after deducting estimated underwritingdiscounts and commissions, are $69,750. Proceeds will be used to redeem approximately $50,630 accreted value($57,750 principal amount) of our 8 3/8% senior second secured notes due March15, 2010 and to pay a $6,076 million premium due on redemption for these notesassuming that the redemption will occur on September 15, 2005; approximately$10,860 will be used for general corporate purposes, including the expansion ofour colocation network; and approximately $2,184 will be used for the paymentof fees and expenses associated with the offering.

 

Asa result of the offering, all of the convertible preferred stock outstandingand accumulated dividends automatically converted to common stock.

 

On August 9, 2005 the Company entered into anagreement with Manhattan Telecommunications Corporation to sell BusinessProductivity Solutions, Inc. (BPS).  BPSis a wholly-owned subsidiary of Eschelon Operating Company and is beingaccounted for as a discontinued operation held for sale.  The transaction is anticipated to close bythe end of 2005 pending regulatory approvals.

 

Also on August 9, 2005, the Company enteredinto a Management Services Agreement (MSA) with Manhattan TelecommunicationsCorporation.  The MSA will come intoeffect after the Federal Communications Commission approves the transfer andwill enable Manhattan Telecommunications Corporation to operate certainbusiness functions for BPS until all state regulatory approvals are received.

 

18

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

## **Forward-Looking and Cautionary Statements**

 

We make “forward-looking statements”throughout this document.  Whenever youread a statement that is not solely a statement of historical fact (such aswhen we state that we “may,” “will” or “plan to” perform in a certain manner orthat we “intend,” “believe,” “expect,” “anticipate,” “estimate” or “project”that an event will occur, or the negative thereof, and other similarstatements), you should understand that our expectations may not be correct,although we believe that they are reasonable. You should also understand that our plans may change.  We do not guarantee that the transactions andevents described in this document will happen as described or that any trendsnoted in this document will continue.

 

Forward-looking statements, such as thoseregarding management’s present plans or expectations for new product offerings,capital expenditures, cost-saving strategies and growth are not guarantees offuture performance.  They involve risksand uncertainties relative to return expectations and related allocation ofresources, and changing economic or competitive conditions, as well as thenegotiation of agreements with third parties and other factors discussedherein, which could cause actual results to differ from present plans orexpectations, and such differences could be material.  Similarly, forward-looking statements regardingmanagement’s present expectations for operating results and cash flow involverisks and uncertainties relative to these and other factors, such as theability to increase revenues and/or to achieve cost reductions and otherfactors discussed herein, which also would cause actual results to differ frompresent plans.  Such differences could bematerial.  All forward-looking statementsattributable to us or by any persons acting on our behalf are expresslyqualified in their entirety by these cautionary statements.

 

As such, actual results or circumstances mayvary materially from such forward-looking statements or expectations.  Readers are also cautioned not to place unduereliance on these forward-looking statements which speak only as of the datethese statements were made.  Except asrequired by law, we do not have any obligation to update these forward-lookingstatements, even if our situation changes in the future.

 

## **Company Overview**

 

We are a leading facilities-based provider ofvoice and data services and business telephone systems in 19 markets in thewestern United States.  As afacilities-based competitive communications services provider, we provideservices to our customers primarily through our own network of ownedtelecommunications switches and related equipment and primarily leasedtelecommunications lines, or transport. We target the small and medium-sized business segment and currentlyserve over 50,000 customers, primarily within the local service territory ofQwest.  We believe that we are either thefirst or second largest competitive communications services provider targetingthe small and medium-sized business segment, with an estimated range of 6% to15% of the market share in each of our markets, based on internally derivedmarket share data as of April 28, 2005.

 

Early in ourdevelopment, we expanded into new markets generally through acquisitions ofcompanies that we augmented with our network services capabilities. We werefounded in 1996 and shortly thereafter we merged with Cady Communications, abusiness telephone systems company based in Minnesota, and began offering localand long distance voice services. In 1997 and 1998, we acquired threeadditional business telephone systems companies and launched voice services infive additional markets, including Denver, Phoenix, Portland, Salt Lake Cityand Seattle. In December 1999, we activated our first switch. InJanuary 2000, we acquired an Internet service provider and began providingadvanced data services. In March 2000 we began providing voice and dataservices over our network, which began our transition to a facilities-basedcompetitive communications services provider. In January 2001, we acquireda business telephone systems company in Salt Lake City. On December 31,2004, we consummated our eighth acquisition, Advanced TelCom, Inc. (ATI),whereby we enhanced our presence in Washington, Oregon and Nevada and enteredCalifornia.

 

Wemeasure our operational performance using a variety of indicators includingrevenue growth, the percentage of our revenue that comes from customers that weserve on-switch, gross margin percentage, operating expenses as a percentage ofrevenue and access line churn rates. We monitor key operating and customerservice metrics to improve customer service, maintain the quality of our networkand reduce costs.

 

19

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ATI generated approximately$59.3 million of revenue in 2004. Through this acquisition, westrengthened our presence in six of the markets we already served, entered intosix adjacent markets, entered into one new market and created significantopportunities for cost savings and increased profitability. By combining ourbusinesses, we have been able to achieve a size and scale that we believe willprovide us with a competitive advantage in our markets and significantopportunities for cost savings and improved cash flow. We are in the process ofintegrating ATI’s operational, financial and support systems with ours. Weexpect that ATI will be substantially integrated by the end of 2005.

 

The telecommunications industry is highlycompetitive.  We believe we competeprincipally by offering superior customer service, accurate billing, a broadset of services and systems and competitive pricing.  We compete with the Regional Bell OperatingCompanies (RBOCs), other competitive communications services providers, andlong distance and data service providers. While wireless providers are competing with us, we do not believe theyare a competitive threat in the market nor are they likely to be in the nearfuture, because of the different service standards that business customersrequire.

 

**Key Components of Results of Operations**

 

***Revenue.***  Network services revenue consists primarilyof local dial tone, switched access lines, long distance, access charges anddata service. Revenue from local telephone service consists of charges forbasic local service, including dedicated T1 access, and custom-callingfeatures such as call waiting and call forwarding. Revenue from long distanceservice consists of per-minute-of-use charges for a full range of traditionalswitched and dedicated long distance, toll-free calling, international, callingcard and operator services. Carrier access revenue consists primarily of usagecharges that we bill long distance carriers to originate and terminate calls toand from our customers. In addition, in some of our markets we currently chargeother local exchange carriers usage charges to originate and terminate localcalls to and from certain customers (otherwise known as reciprocalcompensation).  Revenue from dataservices consists primarily of monthly usage fees for dedicated Internet accessservices. We typically commit our customers to contracts ranging from one tothree years and provide discounts for longer terms. Network services comprised88.6% of our revenue for the six months ended June 30, 2005 revenue andrepresents a predominantly recurring revenue stream.

 

Monthly recurring network services revenue is recognizedin the month the services are used. In the case of local service revenue,monthly recurring local services charges are billed in advance but accrued forand recognized on a prorated basis based on length of service in any givenmonth. Non-recurring revenues from network services are recognized over the averagelife of the customers. Long distance and access charges are billed in arrearsbut accrued based on monthly average usage. We have not historically receivedany revenues from reciprocal compensation due to our bill-and-keep arrangementwith Qwest. Under a bill-and-keep arrangement with another carrier, we have areciprocal agreement whereby we do not pay the other carrier to complete ourcustomers’ local calls to their customers and vice versa.  While we currently bill approximately $0.3million in annual revenue from reciprocal compensation from Qwest and SBCCommunications Inc. related to ATI customers, we are evaluating whether to seeka bill-and-keep arrangement with Qwest and /or SBC. We do not have anywholesale revenue other than access revenue and this reciprocal compensation.

 

Business telephone systems revenue consists of revenuefrom the sale of telephone equipment and the servicing of telephone equipmentsystems. Telephone equipment revenue is recognized upon delivery, completion ofthe installation and acceptance by the customer. Business telephone systemsrevenue is recognized upon completion of service or, in the case of maintenanceagreements, is spread equally over the life of the maintenance contract, whichtypically ranges from one to two years.

 

***Cost of Revenue.***  Our network services cost ofrevenue consists primarily of the cost of operating and maintaining our networkfacilities. The network components for our facilities-based businessinclude the cost of

 

•                  leasing local loops and digital T1 lines that connectour customers to our network;

 

•                  leasing high capacity digital lines that connect ourswitching equipment to our colocations;

 

•                  leasing high capacity digital lines that interconnectour network with the RBOCs;

 

•                  leasing space in the RBOC central offices forcolocating our equipment;

 

20

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•                  signaling system network connectivity;

 

•                  leasing our ATM long-haul Internet backbone network;and

 

•                  Internet transit and peering, which is the cost ofdelivering Internet traffic from our customers to the public Internet.

 

The costs to lease local loops, digital T1 lines and highcapacity digital interoffice facilities from the RBOCs vary by carrier and bystate and are regulated under federal and state laws. In virtually all areas,we lease local loops, T1 lines and interoffice transport facilities from theRBOCs. We lease interoffice transport facilities from carriers other than theRBOCs where possible in order to lower costs and improve network redundancy;however, in most cases, the RBOCs are our only source for local loops and T1lines.  Prior to January 2005, wepurchased, on a wholesale or negotiated basis, unbundled network elementsplatform, or UNE-P, and customized network element packages, or UNE-E, fromQwest.  We entered into a three-yearagreement in January 2005 with Qwest for the provision of their PlatformPlus, or  QPP, product which replaced UNE-Pand UNE-E.  The UNE-P and UNE-Eagreements were terminated with the adoption of the QPP agreement, and allUNE-E and UNE-P lines were moved to QPP on January 1, 2005.

 

Our network services cost of revenue also includes thefees we pay for long distance, data and other services. We have entered intolong-term wholesale purchasing agreements for these services. Some of theseagreements, including our agreement with MCI, also contain significanttermination penalties and/or minimum usage volume commitments. In the event wefail to meet these minimum volume commitments, we may be obligated to payunderutilization charges. We do not anticipate having to pay anyunderutilization charges in the foreseeable future.

 

We carefully review all of our vendor invoices andfrequently dispute inaccurate or inappropriate charges. In cases where we disputecertain changes, we frequently pay only undisputed amounts on vendor invoicesin order to pay proper amounts owed. Our single largest vendor is Qwest, towhich we paid $24.3 million for the six months ended June 30, 2005. We usesignificant estimates to determine the level of success in dispute resolutionand consider past historical experience, basis of dispute, financial status andcurrent relationship with vendors and aging of prior disputes in quantifyingour estimates.

We account for all of our network depreciation indepreciation and amortization expense and do not have any depreciation expensein cost of revenue.

Our most significant business telephone systems costs ofrevenue are the equipment purchased from manufacturers and labor for serviceand equipment installation. To take advantage of volume purchase discounts, wepurchase equipment primarily from three manufacturers pursuant to masterpurchase agreements we have with these manufacturers. For all businesstelephone systems installations, our policy is to require a 30% deposit beforeordering the equipment so our risk of excess inventory or inventoryobsolescence is low. Business telephone systems cost of revenue also includessalaries and benefits of field technicians as well as vehicle and incidentalexpenses associated with equipment installation, maintenance and serviceprovisioning.

***Sales, General andAdministrative.***  Sales, general and administrative expensesare comprised primarily of salaries and benefits, bonuses, commissions,occupancy costs, sales and marketing expenses, bad debt, billing andprofessional services.

Determining our allowance for doubtful accountsreceivable requires significant estimates. We consider two primary factors indetermining the proper level of the allowance, including historical collectionsexperience and the aging of the accounts receivable portfolio. We perform arigorous credit review process on each new customer that involves reviewing thecustomer’s current service provider bill and payment history, matchingcustomers with the National Telecommunications Data Exchange database fordelinquent customers and, in some cases, requesting credit reviews through Dunand Bradstreet. For the six months ended June 30, 2004 and 2005, our bad debtexpense as a percentage of revenue was 0.6% and 0.3%, respectively.

***Depreciation and Amortization.***  Our depreciation andamortization expense currently includes depreciation for network related voiceand data equipment, back office systems, furniture, fixtures, leasehold improvements,office equipment and computers. All internal costs directly related to theexpansion of our network and operating and support systems, including salariesof certain employees, are capitalized and depreciated over the lives of theswitches or systems, as the case may be. Capitalized customer installationcosts are amortized over the approximate average life of a customer, which iscurrently 48 months. Detailed annual time studies are used to determinelabor capitalization. These time studies are based on employee time sheets forthose engaged in capitalizable activities.

 

21

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## **Comparison of Financial Results**

 

                **Overview of Results**

 

                Selectedconsolidated financial and operating data for the three and six-month periodsended June 30, 2004 and 2005 is as follows (dollars in thousands, except perunit amounts):

 
| ** **                                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                         | ** ** | **2004**                        | ** ** | **2005**                      | ** ** | **% Change** | ** ** | **2004** | ** ** | **2005** | ** ** | **% Change** | ** ** |
| ** **                                         |       | **(unaudited)**                 | ** ** | **(unaudited)**               | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | **(unaudited)** |   |   |   |
| Total revenue                                      |       | $                               | 39,151     |                          | $          | 56,921 |   | 45.4 | % | $ | 77,347 |   | $ | 111,454 |   | 44.1 | % |
| Total gross margin (%)                             |       | 60.6                            | %          | 48.9                          | %          | (19.4 | )% | 60.1 | % | 52.7 | % | (12.4 | )% |
| Capital expenditures                               |       | $                               | 6,789      |                          | $          | 9,468 |   | 39.5 | % | $ | 13,829 |   | $ | 18,366 |   | 32.8 | % |
|                                               |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Voice lines in service                             |       | 162,622                         |       | 262,815                       |       | 61.6 | % | 162,622 |   | 262,815 |   | 61.6 | % |
| Data lines in service                              |       | 63,327                          |       | 134,821                       |       | 112.9 | % | 63,327 |   | 134,821 |   | 112.9 | % |
| Total lines in service                             |       | 225,949                         |       | 397,636                       |       | 76.0 | % | 225,949 |   | 397,636 |   | 76.0 | % |
| Percent of lines on switch                         |       | 77.4                            | %          | 84.0                          | %          | 8.6 | % | 77.4 | % | 84.0 | % | 8.6 | % |
| Lines sold                                         |       | 22,773                          |       | 26,780                        |       | 17.6 | % | 42,236 |   | 53,275 |   | 26.1 | % |
| Average monthly access  line churn                 |       | 1.52                            | %          | 1.38                          | %          | (9.5 | )% | 1.53 | % | 1.45 | % | (5.8 | )% |
| Average monthly network  services revenue per line |       | $                               | 49.06      |                          | $          | 42.48 |   | (13.4 | )% | $ | 49.73 |   | $ | 42.39 |   | (14.8 | )% |
|                                               |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Total employees                                    |       | 931                             |       | 1,134                         |       | 21.9 | % | 931 |   | 1,134 |   | 21.9 | % |
| Quota-carrying network  service salespeople        |       | 160                             |       | 208                           |       | 30.0 | % | 160 |   | 208 |   | 30.0 | % |

 

**Three Months Ended June 30, 2005 Compared to ThreeMonths Ended June 30, 2004**

 

                ***Revenue.***  Revenue for the three months ended June 30,2004 and 2005 is as follows:

 

| ** **                 | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):     |       |            |       |            |       |         |       |
| Voice and data services    |       | $               | 24.1       |            | $          | 38.0         |       | 58.2 | % |
| Long distance              |       | 5.4             |       | 8.7             |       | 61.7         | %          |
| Access                     |       | 3.3             |       | 3.4             |       | 1.3          | %          |
| Total network services     |       | 32.8            |       | 50.1            |       | 53.0         | %          |
| Business telephone systems |       | 6.4             |       | 6.8             |       | 6.6          | %          |
| Total revenue              |       | $               | 39.2       |            | $          | 56.9         |       | 45.4 | % |

 

                Networkservices revenue was $50.1 million for the three months ended June 30, 2005, anincrease of 53.0% from $32.8 million in the same period of 2004.  The increase in revenue was primarily due tothe inclusion of ATI, which was acquired on December 31, 2004.  Over the past 12 months the number of voicelines in service increased by 61.6% to 262,815 at June 30, 2005 and the numberof data lines in service increased by 112.9% to 134,821 at June 30, 2005.  The growth in access lines was partiallyoffset by declines in pre-subscribed interexchange carrier charge (PICC)revenue, access revenue per minute of use and a decline in data revenue perline.  The decline in PICC revenue wasdue to our now resolved dispute with Global Crossing.  As a result of that dispute, we elected notto record PICC revenue beginning in November 2004.  The PICC revenue impact was approximately$0.8 million for the three months ended June 30, 2005 as compared to the threemonths ended June 30, 2004.  Accessrevenue per minute of use declined as a result of the scheduled FCC reductionof interstate rate levels in June 2004. Data revenue per line declined due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets.  Weexpect all of the above trends in line growth, PICC revenue, access rates anddata revenue per line to continue for the foreseeable future.  As we continue 

 

22

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to grow, our size and average monthly accessline churn will begin to limit our access line growth rate on both an absoluteand a percentage basis unless we increase our sales force and extend ournetwork footprint.

 

                Businesstelephone systems (BTS) revenue was $6.8 million for the three months endedJune 30, 2005, an increase of 6.6% from $6.4 million in the same period of2004.  The increase in revenue wasprimarily due to an increase in revenue from new systems.  We cannot predict future trends in capitalspending by small and medium-sized business customers which drives our BTSrevenue.

 

                ***Cost of Revenue.***  Cost of revenue for the three months endedJune 30, 2004 and 2005 is as follows:

 
| ** **                      | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|---------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                      | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in  millions): |       |            |       |            |       |         |       |
| Network services                |       | $               | 11.6       |            | $          | 24.9         |       | 114.8 | % |
| Business telephone systems      |       | 3.8             |       | 4.2             |       | 9.8          | %          |
| Total cost of revenue           |       | $               | 15.4       |            | $          | 29.1         |       | 88.8 | % |

 

                Networkservices cost of revenue was $24.9 million for the three months ended June 30,2005, an increase of 114.8% from $11.6 million in the same period of 2004.  The increase was primarily due to theinclusion of ATI and recording approximately $4.7 million in costs related tothe settlement with Global Crossing in June 2005.  As a percentage of related revenue, networkservices cost of revenue for the three months ended June 30, 2005 increased to49.7% from 35.4% for the same period of 2004.

 

                BTScost of revenue was $4.2 million for the three months ended June 30, 2005, anincrease of 9.8% from $3.8 million in the same period of 2004.  Both materials cost and labor cost increaseddue in part to higher new systems sales in the three months ended June 30, 2005from the same period of 2004.  As apercentage of related revenue, BTS cost of revenue for the three months endedJune 30, 2005 increased to 61.4% from 59.6% for the same period of 2004.  We do not expect future improvements in BTScost of revenue as a percentage of related revenue unless we are able tosignificantly increase BTS revenue and therefore achieve greater volumediscounts or economies of scale in our workforce.

 

                ***Gross Profit.***  Gross profit for the three months ended June30, 2004 and 2005 is as follows:

 

| ** **                   | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                   | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in  millions): |       |            |       |            |       |         |       |
| Network services             |       | $               | 21.2       |            | $          | 25.2         |       | 19.1 | % |
| Business telephone systems   |       | 2.6             |       | 2.6             |       | 1.8          | %          |
| Total gross profit           |       | $               | 23.8       |            | $          | 27.8         |       | 17.2 | % |

 

                Theincrease in gross profit for the three months ended June 30, 2005, from thesame period of 2004, is primarily due to the inclusion of ATI which was offsetby approximately $4.7 million in costs related to the settlement with GlobalCrossing in June 2005.

 

                ***Sales, General and Administrative Expense.***  Sales, general and administrative expenseswere $23.1 million for the three months ended June 30, 2005, an increase of35.1% from $17.1 million in the same period of 2004.  This increase was primarily due to theinclusion of sales, general and administrative expenses of ATI.  As a percentage of revenue, sales, generaland administrative expenses for the three months ended June 30, 2005 declinedto 40.5% from 43.6% in the same period of 2004 due to the improved efficiencyof our existing operations resulting from our fixed cost structure supporting ahigher level of revenue.  We expect thistrend to continue as we add more access lines with only modest increases in ouremployee base.

 

                ***Depreciation and Amortization.***  Depreciation and amortization expense was$8.7 million for the three months ended June 30, 2005, an increase of 19.6%from $7.3 million in the same period of 2004. This increase was primarily due to the inclusion of ATI.  As a percentage of revenue, depreciation and 

 

23

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amortization decreased to 15.3% for the threemonths ended June 30, 2005 from 18.6% for the same period of 2004.

 

                ***Interest.***  Interest expense was $5.0 million for thethree months ended June 30, 2005, an increase of 79.4% from $2.8 million in thesame period of 2004.  This increase wasprimarily due to interest expense on our 8 3/8% senior second secured notes due2010 issued in March and November of 2004.

 

                ***Net Income (Loss).***  Net loss for the three months ended June 30,2005 was $8.6 million compared to a net loss of $3.4 million in the same periodof 2004.  This increase in net loss isprimarily due to recording approximately $4.7 million in costs related to thesettlement with Global Crossing in June 2005 and higher interest expense as aresult of having a higher average outstanding debt balance for the three monthsended June 30, 2005 compared to the three months ended June 30, 2004.

 

**Six Months Ended June 30, 2005 versusSix Months Ended June 30, 2004**

 

                ***Revenue.***  Revenue for the six months ended June 30,2004 and 2005 is as follows:

 
| ** **                 | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):     |       |            |       |            |       |         |       |
| Voice and data services    |       | $               | 47.6       |            | $          | 75.2         |       | 57.8 | % |
| Long distance              |       | 10.7            |       | 17.1            |       | 62.2         | %          |
| Access                     |       | 6.6             |       | 6.4             |       | (3.7         | )%         |
| Total network services     |       | 64.9            |       | 98.7            |       | 52.3         | %          |
| Business telephone systems |       | 12.5            |       | 12.7            |       | 1.6          | %          |
| Total revenue              |       | $               | 77.4       |            | $          | 111.4        |       | 44.1 | % |

 

                Networkservices revenue was $98.7 million for the six months ended June 30, 2005, anincrease of 52.3% from $64.9 million in the same period of 2004.  The increase in revenue was primarily due tothe inclusion of ATI, which was acquired on December 31, 2004.  Over the past 12 months the number of voicelines in service increased by 61.6% to 262,815 at June 30, 2005 and the numberof data lines in service increased by 112.9% to 134,821 at June 30, 2005.  The growth in access lines was partiallyoffset by declines in pre-subscribed interexchange carrier charge (PICC)revenue, access revenue per minute of use and a decline in data revenue perline.  The decline in PICC revenue wasdue to our now resolved dispute with Global Crossing.  As a result of that dispute, we elected notto record PICC revenue beginning in November 2004.  The PICC revenue impact was approximately$1.6 million for the six months ended June 30, 2005 as compared to the sixmonths ended June 30, 2004.  Accessrevenue per minute of use declined as a result of the scheduled FCC reductionof interstate rate levels in June 2004. Data revenue per line declined due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets.  Weexpect all of the above trends in line growth, PICC revenue, access rates anddata revenue per line to continue for the foreseeable future.  As we continue to grow, our size and averagemonthly access line churn will begin to limit our access line growth rate onboth an absolute and a percentage basis unless we increase our sales force andextend our network footprint.

 

                BTSrevenue was $12.7 million for the six months ended June 30, 2005, an increaseof 1.6% from $12.5 million in the same period of 2004.  We cannot predict future trends in capitalspending by small and medium-sized business customers.

 

24

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                ***Cost of Revenue.***  Cost of revenue for the six months ended June30, 2004 and 2005 is as follows:

 
| ** **                      | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|---------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                      | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in  millions): |       |            |       |            |       |         |       |
| Network services                |       | $               | 23.3       |            | $          | 44.9         |       | 92.2 | % |
| Business telephone systems      |       | 7.5             |       | 7.8             |       | 4.6          | %          |
| Total cost of revenue           |       | $               | 30.8       |            | $          | 52.7         |       | 71.0 | % |

 

                Networkservices cost of revenue was $44.9 million for the six months ended June 30,2005, an increase of 92.2% from $23.3 million in the same period of 2004.  The increase was primarily due to theinclusion of ATI and recording approximately $4.7 million in costs related tothe settlement with Global Crossing in June 2005.  As a percentage of related revenue, networkservices cost of revenue for the six months ended June 30, 2005 was 45.5% comparedto 36.0% for the same period of 2004.

 

                BTScost of revenue was $7.8 million for the six months ended June 30, 2005, anincrease of 4.6% from $7.5 million in the same period of 2004.  As a percentage of related revenue, BTS costof revenue for the six months ended June 30, 2005 increased to 61.6% from 59.9%for the same period of 2004.  We do notexpect future improvements in BTS cost of revenue as a percentage of relatedrevenue unless we are able to significantly increase BTS revenue and thereforeachieve greater volume discounts or economies of scale in our workforce.

 

                ***Gross Profit.***  Gross profit for the six months ended June30, 2004 and 2005 is as follows:

 
| ** **                   | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                   | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in  millions): |       |            |       |            |       |         |       |
| Network services             |       | $               | 41.5       |            | $          | 53.8         |       | 29.8 | % |
| Business telephone systems   |       | 5.0             |       | 4.9             |       | (2.8         | )%         |
| Total gross profit           |       | $               | 46.5       |            | $          | 58.7         |       | 26.3 | % |

 

                Theincrease in gross profit for the six months ended June 30, 2005, from the sameperiod of 2004, is primarily due to the inclusion of ATI which was offset byapproximately $4.7 million in costs related to the settlement with GlobalCrossing in June 2005.

 

                ***Sales, General and AdministrativeExpense.***  Sales, generaland administrative expenses were $45.4 million for the six months ended June30, 2005, an increase of 35.6% from $33.5 million in the same period of2004.  This increase was primarily due tothe inclusion of sales, general and administrative expenses of ATI.  As a percentage of revenue, sales, generaland administrative expenses for the six months ended June 30, 2005 declined to40.8% from 43.3% in the same period of 2004 due to the improved efficiency ofour existing operations resulting from our fixed cost structure supporting ahigher level of revenue.  We expect thistrend to continue as we add more access lines with only modest increase in ouremployee base.

 

                ***Depreciation and Amortization.***  Depreciation and amortization expense was$17.3 million for the six months ended June 30, 2005, an increase of 13.6% from$15.2 million in the same period of 2004. This increase was primarily due to the inclusion of ATI.  As a percentage of revenue, depreciation andamortization decreased to 15.5% for the six months ended June 30, 2005 from19.7% for the same period of 2004.

 

                ***Interest.***  Interest expense was $9.8 million for the sixmonths ended June 30, 2005, an increase of 93.4% from $5.1 million in the sameperiod of 2004.  This increase wasprimarily due to interest expense on our 8 3/8% senior second secured notes due2010 issued in March and November of 2004.

 

                ***Net Income (Loss).***  Net loss for the six months ended June 30,2005 was $13.4 million compared to net income of $10.9 million in the sameperiod of 2004.  Net income for the sixmonths ended June 30, 2004 included a gain on extinguishment of debt of $18.2million.  The gain on the extinguishmentof debt was the result of paying off our bank facility.  In June 2002, we restructured our bankfacility and because 

 

25

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the future cash flows could not be calculatedwith certainty, the gain was deferred. As a result of the repayment, the excess carrying value of $20.9 millionand debt issuance costs of $2.7 million resulted in the $18.2 million gain onextinguishment of debt.  Net income alsodecreased due to recording approximately $4.7 million in costs related to thesettlement with Global Crossing in June 2005 and higher interest expense as aresult of having a higher average outstanding debt balance for the six monthsended June 30, 2005 compared to the six months ended June 30, 2004.

 

## **Liquidity and Capital Resources**

 

**                *Principal Sources and Uses of Liquidity.* **Ourprincipal sources of liquidity are cash from operations and our cash and cashequivalents and available-for-sale securities. Our principal liquidityrequirements consist of debt service, capital expenditures and working capital.

 

                ***Cash Flows Provided by Operating Activities. ***Cash provided by operatingactivities was $5.6 million for the six months ended June 30, 2005 compared tocash provided by operating activities of $13.4 million for the same period of2004.  The decrease in cash provided byoperating activities was primarily due to the semi-annual interest payment inMarch 2005 on our senior second secured notes and due to the increase in costof revenue related to the settlement with Global Crossing in June 2005.

 

                ***Cash Flows Used in Investing Activities.***  Cash used in investing activities was $21.5million for the six months ended June 30, 2005 compared to $12.5 million forthe same period of 2004.  The cash usedin investing activities was for the maintenance and expansion of our networkand back office systems and for the investmentin available-for-sale securities with maturity dates of six months or less.

 

                ***Cash Flows Provided by (Used in) FinancingActivities.***  Cash used infinancing activities was $1.2 million for the six months ended June 30,2005.  The cash used in financingactivities was primarily for payments on capital lease obligation and for debtissuance costs.  For the six months endedJune 30, 2004, net cash provided by financing activities was $14.3million.  The net proceeds from theissuance of the senior second secured notes in March 2004 generatedapproximately $13.2 million, which is net of a $1.6 million prepayment penalty.  We also used cash for payments on capitallease obligations.

 

                On August 9, 2005, an initial public offeringof 5,357,143 of the Company’s common stock at $14.00 per share wasconsummated.  The company estimates thatnet proceeds from the offering, after deducting estimated underwritingdiscounts and commissions, will be approximately $69.8 million.  Proceeds will be used to redeem approximately$50.6 million accreted value ($57.8 million principal amount) of our 8 3/8%senior second secured notes due March 15, 2010 and to pay a $6.1 millionpremium due on redemption for these notes assuming that the redemption willoccur on September 15, 2005; approximately $10.9 million will be used forgeneral corporate purposes, including the expansion of our colocation network;and approximately $2.2 million will be used for the payment of fees andexpenses associated with the offering.

 

                ***Capital Requirements.***  For the six months ended June 30, 2005, wespent $18.4 million on capital expenditures. We expect to spend approximately $44.5 million on capital expendituresin 2005, approximately $4.5 million of which will be to integrate ATI into ouroperations.

 

Basedon our current level of operations and anticipated growth, we believe that ourexisting cash, cash equivalents and short-term investments will be sufficientto fund our operations and we do not currently anticipate the need to raiseadditional financing to fund capital expenditures or operations for at leastthe next 12 months.

 

26

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# ** **

# **Item3.  Quantitative and QualitativeDisclosures About Market Risk**

 

We are not exposed to market risks fromchanges in foreign currency exchange rates or commodity prices.  We do not hold any derivative financialinstruments nor do we hold any securities for trading or speculative purposes.

 

We are exposed to changes in interest rateson our investments in cash equivalents and short-term investments.  All of our investments have maturities of sixmonths or less which reduces our exposure to long-term interest ratechanges.  Interest income for the threeand six-month periods ended June 30, 2005 was $0.1 million and $0.2 million,respectively, therefore not exposing us to any meaningful interest income riskhad rates dropped.  We had $139.7 millionin senior second secured notes outstanding as of June 30, 2005.  These notes are at a fixed interest rate andare therefore not exposed to any interest rate risk.

 

# **Item 4: Controls and Procedures**

 

*Evaluation of disclosure controlsand procedures.*  Ourmanagement, under the direction and with the participation of Richard A. Smith,our President and Chief Executive Officer, and Geoffrey M. Boyd, our ChiefFinancial Officer, performed an evaluation of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15 under theSecurities Exchange Act of 1934).  Basedon that evaluation, Messers. Smith and Boyd concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures areeffective.

 

*Changes in internal controls overfinancial reporting.*  During thequarter ended June 30, 2005, there have been no changes in our internalcontrols over financial reporting that materially affected, or are reasonablylikely to materially affect, our reported financial results.

# ** **

# ** **

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# **PART II. OTHER INFORMATION**

 

# **Item 1.  LegalProceedings**

 

On June21, 2005, we settled the lawsuit brought against the Company by GlobalCrossing.  The parties agreed to releaseeach other from all claims related to the dispute and to amend theiragreement.  The settlement agreementprovides for the Company to pay Global Crossing $5.0 million and GlobalCrossing to credit the Company’s future bills for approximately $0.6 millionover the following six months.

 

Under the terms of theGlobal Crossing settlement, the Carrier Services Agreement between the parties,which had provided that Global Crossing was our exclusive provider of voice anddata services, subject to certain exceptions, and that we had a purchasecommitment of $100.0 million was amended to shorten the term of the agreementto July 1, 2006, to eliminate the exclusivity, purchase commitment andshortfall provisions and to provide that Global Crossing will be our preferredprovider for Internet transit and long haul data private line needs.

 

We settled an agediscrimination suit brought against us by a former employee for $80 thousand inexchange for a release of the individual’s claims against us.

 

In July 2005, theinvestigation in Arizona relating to our alleged failure to submitinterconnection agreements was settled, and the similar investigation inColorado against us was dropped.  Also inJuly 2005, the Minnesota Department of Commerce’s  complaint regarding our pricing of accessservices was settled.

 

We are party from timeto time to other ordinary course disputes that we do not believe to bematerial.

 

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

 

On April 1, 2005, we issued to nineaccredited investors 205,736 shares of series B convertible preferred stock,resulting in proceeds of $154,302. These securities were issued in relianceupon the exemption provided for in Rule 506 of the Securities Act relating tosales to accredited investors.

 

We relied upon Rule 701 promulgated under theSecurities Act to issue the following securities:

 

On April 1, 2005, we issued to 355participants under the Eschelon Telecom, Inc. Stock Option Plan of 2002 optionsto purchase an aggregate of 73,682 shares of common stock, at an exercise priceof $2.71 per share. These options generally vest 20% upon the initial grant and20% per year over four years from the date of grant.

 

On April 29, 2005, we issued to 15participants under the Eschelon Telecom, Inc. Stock Option Plan of 2002 optionsto purchase an aggregate of 221,426 shares of common stock, at an exerciseprice of $6.77 per share.  These optionsgenerally vest 33 1/3% upon the initial grant and 33 1/3% per year over twoyears from the date of grant.

 

On May 19, 2005, we issued to 236participants under the Eschelon Telecom, Inc. Stock Option Plan of 2002 optionsto purchase an aggregate of 11,053 shares of common stock, at an exercise priceof $6.77 per share.  These options generallyvest 20% upon the initial grant and 20% per year over four years from the dateof grant.

 

# **Item 3. Defaults Upon Senior Securities**

 

None.

 

# **Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

No matters were submitted to a vote of thesecurity holders during the quarter ended June 30, 2005.

 

# **Item 5.  OtherInformation**

 

None.

# ** **

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# ** **

# **Item 6.  Exhibits**

 
| **Exhibit**

**Number** | ** ** | **Description**                                                                                      | ** ** |
|-------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| 31.1                    |       | Certification by Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |       |
|                    |       |                                                                                                 |       |
| 31.2                    |       | Certification by Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |       |
|                    |       |                                                                                                 |       |
| 32.1                    |       | Certification by Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |       |
|                    |       |                                                                                                 |       |
| 32.2                    |       | Certification by Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |       |

 

29

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## **SIGNATURE**

 

                Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                  |   |                                                                                              |
|-----------------------|--------|---------------------------------------------------------------------------------------------------|
|                  |   | Eschelon Telecom, Inc.                                                                            |
|                  |   |                                                                                              |
| Date: August 15, 2005 | By:    | /S/ Geoffrey M. Boyd                                                                              |
|                  |   |                                                                                              |
|                  | Name:  | Geoffrey M. Boyd                                                                                  |
|                  | Title: | Chief Financial Officer  (Principal Financial and Accounting Officer and Duly Authorized Officer) |

 

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