<PAGE>

                                 UNITED STATES

                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C.  20549
                                _______________

                                   FORM 10-K

(Mark One)

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

                  For the fiscal year ended December 31, 2000

                                      OR

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

            For the transition period from            to

                       Commission File Number: 333-59393

                          Rhythms NetConnections Inc.
            (Exact name of registrant as specified in its charter)

            Delaware                                     33-0747515
(State or other jurisdiction of            (I.R.S.  Employer Identification No.)
 incorporation or organization)

      9100 East Mineral Circle                             80112
            Englewood, CO                                (Zip Code)
(Address of principal executive offices)

      Registrant's telephone number, including area code: (303) 410-2000

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

                                                      Name of exchange
     Title of each class                             On which registered
     -------------------                             -------------------
            None.                                            None.

          Securities registered pursuant to section 12(g) of the Act:
                    Common Stock, par value $.001 per share
                               (Title of Class)

Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period as the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.  Yes [X]  No [_]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form-10K or any
amendment to this Form 10-K.  [X]

The aggregate market value of voting common equity held by non-affiliates of the
Registrant was approximately $115,395,998.  This calculation is based upon the
close price of such common equity on February 2, 2001 of $1.94 and the number of
shares held by non-affiliates, which was 59,482,473 shares on December 31, 2000.
As of December 31, 2000, the number of outstanding shares of the Registrant's
(1) $.001 par value Common Stock (Common Stock) was 79,739,764; (2) $.001 par
value 8 1/4% Series E Convertible Preferred Stock due 2015 was 250,000; (3)
Series 1 Junior Participating Preferred Stock was 0; and (4) $.001 par value 6
3/4% Series F Cumulative Convertible Preferred Stock was 3,000,000.
<PAGE>

               CAUTIONARY NOTE ABOUT FORWARD-LOOKING STATEMENTS

All statements contained herein that are not statements of historical fact
constitute "Forward-Looking Statements" within the meaning of Section 27A of the
Securities Act of 1933, as amended (Securities Act), and Section 21E of the
Securities Exchange Act of 1934, as amended (Exchange Act).  Such forward-
looking statements involve known and unknown risks, uncertainties and other
factors that could cause our actual results to differ materially from historical
results or from any future results expressed or implied by such forward-looking
statements.  Readers are urged to consider statements that include the terms
"believe," "belief," "expects," "plans," "anticipates," "intends" or the like to
be uncertain and forward-looking.  Forward-looking statements also include
projections of financial performance, statements regarding management's plans
and objectives and statements concerning any assumptions relating to the
foregoing.  For a discussion of developments since December 31, 2000, see
"Developments Since December 31, 2000" below.

The fiscal years ended December 31, 1997, 1998, 1999 and 2000, and the fiscal
year ending December 31, 2001, are referred to herein as "1997," "1998," "1999,"
"2000" and "2001," respectively.


                                    PART 1

Item 1 - Business

Formed in February 1997, Rhythms NetConnections Inc. (the Company) is a leading
provider of broadband local access communication services.  Our services include
a range of high-speed, "always on" connections that offer our customers both
cost and performance advantages when accessing the Internet or private networks.
We use multiple digital subscriber line (DSL) technologies to provide data
transfer rates ranging from 128 kbps to 8.0 Mbps delivering data to the end user
and from 128 kbps to 1.5 Mbps receiving data from the end user.

Our customers include large enterprises, telecommunication carriers and their
Internet service provider (ISP) affiliates and other ISPs.  Enterprise customers
typically purchase our services indirectly from our telecommunications carriers
or directly from us to provide employees, branch offices and other affiliates
with high-speed remote access to the enterprise's local and wide area networks
(LAN or WAN).  Telecommunications carriers and their ISP affiliates typically
purchase our services for resale to business and consumer customers.  ISPs
typically purchase our services to provide high-speed Internet access to their
business and consumer end users.

As of December 31, 2000, we offered our services in 60 markets in the United
States (U.S.) representing 97 of the largest metropolitan statistical areas
(MSAs).  We believe we have one of the nation's largest DSL networks with
approximately 1,850 built or operational central offices (COs).

In January 2001, we announced that, although we intended to maintain a physical
presence in all 60 markets and 1,850 COs, we planned to focus on, and provide
services in, only our top 40 markets, representing approximately 1,400 COs. We
continue to review the number of markets we are in, the number of COs we
operate, the size of our work force and our other selling, general and
administrative (SG&A) costs with a view to conserving cash and enhancing our
ability to achieve future profitability.

As of December 31, 2000, we had approximately 67,000 DSL lines in service.

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Over the past two years, we expanded our services internationally into Canada
and formed a joint venture in Japan.

Market Opportunity

Demand for broadband local access communication services is growing

Demand for broadband local access communication services is growing at a rapid
rate.  The number of residential and business DSL subscribers has grown from
nearly 500,000 in 1999 to 2.4 million in 2000, and the Yankee Group believes DSL
subscribers will grow to in excess of 15 million by 2005.  According to
Dataquest, DSL subscribers are expected to surpass cable subscribers in 2005.

DSL is a cost-effective technology for broadband local access communication
services

We believe that many of the traditional network alternatives for broadband local
access communication services are inadequate and/or more costly compared to DSL.
Only a fraction of buildings in the U.S. are currently connected to high-speed
fiber networks -- typically large buildings in metropolitan areas or clusters of
buildings in regional campus parks.  Consequently, a significant number of
connections to the Internet or private networks are through slow, dial-up modems
connected to the traditional, circuit-switched public telephone system.

DSL technology significantly increases the data, voice and video-carrying
capacity of standard copper telephone lines.  Our peak data transfer rates range
as high as 140 times the speed of the fastest dial-up modem and more than 60
times the speed of integrated services digital network (ISDN) lines.

DSL services are generally favorably priced relative to other available
alternatives.  Traditional T1 frame relay and private line services are
typically more costly than DSL service, as are heavily-used ISDN services that
are priced based on usage.  Consumer class DSL services are generally priced
competitively with cable modem services.

Business Strategy

Maintain and build our relationships with leading customers to grow our
subscriber base

We offer our services to large enterprises, telecommunications carriers and
their ISP affiliates and other ISPs.  We believe these indirect distribution
channels are more cost effective because we can leverage our resellers' existing
customer base and brand names, thereby reducing our selling and marketing costs,
and avoiding customer service and support costs associated with serving end
users directly.  This distribution strategy enables us to focus on our core
broadband access offerings.

Our business is generally not seasonal in nature.  Our customer base is not
concentrated in any particular industry and except for Cisco Systems, Inc.
(Cisco) and Telocity, Inc. (Telocity), no customer accounted for more than 10%
of net revenue in any of the last three years.  Cisco accounted for 33% and 21%
of total net revenue in 1999 and 2000, respectively, and Telocity accounted for
16% of total net revenue in 2000.

Cisco

In 1998, we entered into an enterprise services solution agreement with Cisco,
in which Cisco engaged us to manage and upgrade its remote access program. We
are currently renegotiating our agreement with Cisco.  We anticipate the new
contract will have a one year term.

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Telocity

In 2000, we entered into an agreement with Telocity, in which Telocity agreed to
purchase our Consumer Links services for use and/or resale in select markets
nationwide.  We are currently renegotiating our agreement with Telocity.  We
anticipate the new contract will have a one year term.

Offer an attractive value compared to alternative local access communication
services providers

We offer multiple local access speed options.  For end users that subscribe at
the 8.0 Mbps rate, our network provides speeds greater than 140 times the speed
of the fastest dial-up modem, more than 60 times the speed of ISDN lines at
monthly rates similar to or lower than those for heavily-used ISDN lines, and
more than five times the speed of T1 private lines and frame relay circuits at a
lower price.  Because we use dedicated connections from each end user to the
network of our customer, end users can receive dependable data transfer rates
and reduce the risk of unauthorized access.  Unlike dial-up modems and ISDN
lines, the DSL solution is "always on," and provides 24-hour continuous
connection.

In addition to a broad range of economical broadband local access services, we
provide a national offering with dense CO coverage in each of the markets we
serve.  In January 2001, we announced that, although we intended to maintain a
physical presence in all 60 markets and 1,850 COs, we planned to focus on, and
provide services in, only our top 40 markets, representing approximately 1,400
COs.  We continue to review the number of markets we serve and the number of COs
we operate.

In addition, we believe we are unique in that we offer service to business end
users up to 50,000 feet from the CO.

We also offer a broad range of end user functionality.  We support multiple,
bridged and routed user endpoint devices to address less complex consumer needs
as well as more complex business requirements.  In addition, we offer both self-
installation (when we provision our services using line sharing) and our
standard on-site installation.  For our business end users, we offer business
class service level agreements, including such service parameters as service up
time, throughput and average time to repair.  See Network Architecture below.

We also electronically bond with our customers; provide 24 hour support, 365
days a year; and offer multiple local access connectivity options, including
Internet protocol (IP) with our Complete Links service See Products and Services
below.

Expand the number of network services we offer

Our network has been designed to be upgradeable to support additional network
services.  Additional network services currently offered include Virtual Reach,
IP Path and Frame Relay over DSL (see Service Offerings below).  We are also
currently in trial with a voice over IP service offering.

Reduce costs to conserve cash and enhance our ability to achieve future
profitability

We continue to reduce our costs by focusing on our top markets, improving
operational productivity, using line sharing to provision our services in the
consumer market and reducing certain SG&A costs.

Line sharing allows us to use an existing copper telephone line rather than
installing a new copper telephone line.  Line sharing significantly improves the
economics of the consumer market due to lower one-time customer acquisition
costs by eliminating the need for a truck roll, shortening the provisioning
interval, increasing our provisioning capacity, and decreasing the one-time
copper telephone line charge from the

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incumbent local exchange carrier (ILEC). In addition, line sharing reduces the
monthly recurring copper telephone line charge from the ILEC as compared to the
monthly recurring charge for a new copper telephone line.

In January 2001, we announced our intention to focus on, and provide services
in, only our top 40 markets.  We continue to review the number of markets we are
in and the number of COs we operate.  By focusing on our top markets, we believe
we will be able to reduce the service and support costs associated with smaller
markets and at the same time decrease the time required to achieve future
profitability in our larger markets.

We continue to improve our ability to provision and scale our business through
process engineering and ongoing system upgrades.  In addition, we implemented a
work force reduction in January 2001, and developed plans to reduce our facility
costs, professional service fees and customer marketing development funds.  We
continue to review the size of our work force and our other SG&A costs with a
view to conserving cash and enhancing our ability to achieve future
profitability. See Employees below.

Service Offerings

Local connection services

Our local connection services connect individual users or multiple users on a
LAN through our metropolitan network to our national network, the Internet or a
telecommunications carrier's network using DSL technology over traditional
copper telephone lines.  The speed and effectiveness of the local DSL connection
will vary based on a number of factors, including the distance of the end user
from the CO and the condition of the copper telephone line that connects the end
user to the CO.

DSL Technologies

Our primary DSL technologies include:

Rate adaptive DSL (RADSL)

RADSL technology allows each end user or LAN to utilize the full digital
capability of the underlying copper telephone line.  Speeds reach up to 8.0 Mbps
downstream and up to 1.1 Mbps upstream if the end user or LAN is within 7,800
feet from the CO.  Our RADSL connection competes favorably on a price and
performance basis relative to traditional, fractional T1 and frame relay
services.  Our RADSL service also provides the highest speed of any of our DSL
services for bandwidth intensive applications and is necessary to support line
sharing.

Symmetrical DSL (SDSL)

Our SDSL technology allows each end user or LAN to achieve up to 1.5 Mbps speeds
both downstream and upstream.  Depending on the quality of the copper telephone
line, 1.5 Mbps can typically be achieved if the end user or LAN is within 8,000
feet from the CO.

Integrated digital subscriber line (IDSL)

IDSL technology allows us to reach end users or LANs within 50,000 feet from the
CO.  Our IDSL service operates at up to 144 kbps in each direction.  We also
offer IDSL to end users that have telephone lines that do not consist of
continuous copper, such as digital-loop-carrier lines that are partially copper
and partially fiber.

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Products and Services

Our broadband solutions offer our customers a choice between a Layer 2 network,
which enables a customer to manage and maintain the network, and a Layer 3
network where we manage and maintain the network for the customer.

Select Links, a Layer 2, high-speed DSL access solution provides a selection of
routed DSL customer equipment that is installed at the customer's premise,
enabling DSL access speeds from 128 kbps to 8.0 Mbps.

Consumer Links, a basic and affordable DSL access solution, is provided over a
Layer 2 network.  Consumer Links provides high-speed DSL access to residential
customers via line sharing.

Complete Links, a Layer 3 access solution, offers a fully managed IP over DSL
service available in symmetric (up to 1.5 Mbps) and asymmetric (up to 8.0 Mbps)
access speeds.  Complete Links is a high-speed access solution for small and
medium-sized businesses and corporate teleworkers for connectivity to the
Internet, corporate databases and remote offices.

IP Path, an extension of the Complete Links product, offers a bundled IP over
DSL, high-speed local and long distance solution.

Virtual Reach, an optional feature we offer with many of our products, enables a
customer to establish a virtual presence in a remote market by transporting DSL
traffic from remote metropolitan areas back to its physical point of presence
over our WAN.

Strategic Partnership

WorldCom, Inc. (WorldCom)

In March 1999, we entered into a strategic partnership with WorldCom.  We have
been designated WorldCom's first choice in its alternative carrier access
provisioning system for DSL services in areas where we deploy our network for
all new DSL services, except for services to certain subsidiaries and in
locations where WorldCom deploys its own DSL equipment.  We have designated
WorldCom as our preferred provider of network services, including metropolitan
area network (MAN) services and long-haul backbone services.

International

In the future, we may elect to replicate our business model in select
international markets.

In January 2000, we formed a Canadian corporate joint venture, Rhythms Canada
Inc. (Rhythms Canada) with Axxent Corp., a wholly-owned subsidiary of Axxent
Inc. (formerly known as OCI Communications Inc.) (Axxent). Upon formation of
Rhythms Canada, we received 100,000 shares of Class A voting stock (representing
50% of the total outstanding common shares of Rhythms Canada). In December,
2000, we funded a $2.5 million capital call and received an additional 588,235
shares of Class A voting stock. In addition, we purchased 763,680 shares of
Class B non-voting stock of Axxent for $5.3 million.

In June 2000, we formed a Japanese joint venture, Garnet Connections Planning,
Inc. (Garnet Connections), with Mitsui & Co. Ltd. and certain other partners to
explore the development of DSL based services in Japan.  We own 3,400 shares of
common stock of Garnet Connections (representing 34.3% of the total outstanding
shares of Garnet Connections), for which we paid $1.6 million

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Network Architecture

Our network is an overlay network.  We place our network electronics on an
existing physical network that we lease from existing transport services
providers, local access telephone lines from ILECs, metropolitan fiber from
ILECs or competitive local exchange carriers (CLECs), and long distance backbone
fiber from long distance interexchange carriers (IXCs).  The primary components
of our network are our connection points, local transport, high-speed MAN, metro
service centers (MSCs), backbone, customer endpoint devices and our network
operations center (NOC).

Connection points

Through our interconnection agreements with the ILECs, we secure collocation
space in COs serving the area where we intend to offer our services.  In each of
these connection points, we connect our end user's DSL endpoint-equipped copper
telephone line to our DSL multiplexing equipment (DSLAMs).

Local transport

Our local transport connects customer endpoint devices to our network using a
DSL-capable copper telephone line leased by us from the ILEC under terms
specified in our interconnection agreements and/or the terms and conditions set
by the state public utility commissions.

High-speed MAN

In each of our targeted metropolitan area markets, we operate a private MAN.
The network consists of high-speed asynchronous transfer mode (ATM)
communications circuits that we lease from CLECs or ILECs to connect our
connection points to the MSC.

MSCs

The MSC is a physical point of presence within a metropolitan area where local
access traffic is aggregated from the connection points over our high-speed MAN.
Although we generally have one MSC in each of our targeted metropolitan areas,
in larger metropolitan areas, we may have two.  The MSC houses our ATM switches
and IP routers.  We design our MSCs for high availability including battery
backup power, redundant equipment and active network monitoring.

Backbone

Our backbone interconnects our MSCs so that communications traffic can be
transported among different metropolitan areas using either the ATM or IP
protocol.  We currently buy ATM and frame relay backbone from a number of long
distance carriers.

Customer endpoint devices

Depending on the needs of our customers, we will either include the end-user
endpoint device (the DSL modem or router) as part of our complete service
offering, or require the customer or end user to buy the DSL endpoint device.

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NOC

Our network is managed from the NOC located in Denver, Colorado.  From this
center, we provide network monitoring and management 24 hours a day, 365 days a
year.  From the NOC, we monitor the entire network including each MSC and each
connection point.

Interconnection Agreements with ILECs

Interconnection agreements with ILECs are critical to our business.  These
agreements cover a number of aspects of our relationships with ILECs, including:

     .  the prices we pay to lease and the access we have to the ILECs' copper
        telephone lines;
     .  the removal by the ILECs of equipment or electronics from lines to
        enable these lines to transmit DSL signals;
     .  the price and terms for collocation of our equipment in the ILECs' COs;
     .  the price we pay and the access we have to the ILECs' transport
        facilities; our ability to access conduits and other rights-of-way the
        ILECs use to construct their own network facilities;
     .  the operational support systems and interfaces we use to place orders
        and report and monitor the ILECs' responses to our requests;
     .  the dispute resolution process we use with the ILECs to resolve
        disagreements on the terms of the interconnection agreements; and
     .  the term of the interconnection agreements, their transferability to
        successors, their liability limits and other general aspects of our
        relationship with the ILECs.

We have signed interconnection agreements with SBC Communications Inc., Verizon
Communications Inc. (Verizon), BellSouth Corp. (BellSouth), Qwest Communications
International Inc. (Qwest) and Cincinnati Bell Inc.  We are currently
renegotiating our agreements with Verizon and BellSouth.  Our interconnection
agreements have a maximum term of three years, requiring us to renegotiate the
existing terms in the future.

Regulatory Climate

A significant portion of the services we offer, particularly through our wholly-
owned subsidiaries, Rhythms Links Inc. (Links) and Rhythms Links Inc. Virginia
(Links VA), may be subject to regulation at the federal, state and local levels.

1996 Telecommunications Act

The 1996 Telecommunications Act (1996 Act) allows CLECs, such as us, to leverage
portions of the existing ILEC infrastructure, as opposed to building all
portions of a competing infrastructure at significant cost.  The 1996 Act in
some sections is self-executing.  However, the Federal Communications Commission
(FCC) and the state public utilities commissions (PUCs) issue regulations that
identify specific requirements upon which our competitors and we rely in
implementing the changes it prescribes.  From time to time Congress considers
legislation that could change the terms and conditions of the 1996 Act, and the
FCC's rules, that are favorable to us.  The outcome of these various, ongoing,
legislative activities and rulemaking proceedings, including reconsideration
proceedings, or judicial appeals of such proceedings could materially affect our
business and financial prospects.

The 1996 Act was designed to create an incentive for ILECs that were formerly
part of the Bell system to cooperate with the CLECs.  An ILEC cannot provide
long distance service until regulators determine that

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the ILEC has met a "checklist" showing that it is meeting the 1996 Act's
requirements in opening its network and markets to competition. The 1996 Act
requires traditional telephone companies, among other things, to:

     .    allow CLECs to lease copper telephone lines on a line-by-line basis;
     .    provide CO space for the CLECs' DSL and other equipment used to
          connect to the leased copper telephone lines;
     .    lease access on their CO fiber backbone to link the CLECs' equipment;
          and
     .    allow CLECs to use their operational support systems to place orders
          and access their databases.

The FCC, in interpreting the 1996 Act, has emphasized the need for competition-
driven innovation in the deployment of advanced telecommunications services,
such as DSL services.

Line sharing

The FCC mandated "line sharing" in a November 1999 decision that became
effective in June 2000.  Line sharing, where available, will allow us to provide
our RADSL service on the same copper telephone lines as the ILEC uses to provide
its voice service.  In January 2001, the FCC clarified its mandate, permitting
CLECs to provide line sharing over fiber facilities and allowing CLECs also to
line share with voice competitors.  Some details of implementation of this
mandate may be reconsidered by the FCC and both the original line sharing
decision and the clarification are currently on judicial appeal before the D.C.
Circuit.  The decisions of the D.C. Circuit or of the U.S. Supreme Court on
these issues could materially adversely affect our business and financial
prospects.

State regulation

Some of our services, particularly those of Links and Links VA, may be
classified as intrastate services subject to state regulation.  All of the
states where we operate, or will operate, require some degree of state
regulatory commission approval to provide certain intrastate services.  In most
states, intrastate tariffs are also required for various intrastate services,
although we are not typically subject to price or rate of return regulation for
tariffed intrastate services.  Actions by state PUCs could cause us to incur
substantial legal and administrative expenses.

Under the 1996 Act, states have undertaken or completed regulatory proceedings
to determine the pricing of unbundled network elements and services, and the
results of these proceedings will determine the price we pay for, and whether it
is economically attractive for us to use, these elements and services.

We are subject to requirements in some states to obtain prior approval for, or
notify the state commission of, any transfers of control, sales of assets,
corporate reorganizations, issuances of stock or debt instruments and related
transactions.  Although we believe such authorizations could be obtained, there
can be no assurance that the state commissions would grant us authority to
complete any transactions.

Competition

Competition for broadband access services is intense.  We face competition from
many competitors with significantly greater financial resources, well-
established brand names and large, existing installed customer bases.  Moreover,
we expect the level of competition to increase in the future.  We expect
significant competition from:

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ILECs.  All of the ILECs in our target markets offer DSL services.  As a result,
the ILECs represent our strongest competition in all of our markets, and we
expect this competition to intensify.  The ILECs have well-established brand
names and reputations, possess significant capital and own the COs and copper
telephone lines.  Importantly, they are offering both digital data services and
their existing voice services over a single line to achieve a lower cost per
line per month than we can. In addition, some ILECs are modifying their networks
by deploying fiber further into neighborhoods and placing DSL electronics in
these neighborhoods.  Unless we can achieve equivalent access to these locations
and these services, the ILECs will have a significant advantage to providing DSL
under the new architecture.

Traditional and Newer IXCs.  Many of the leading traditional and newer IXCs are
rapidly expanding their networks to include high-speed, local access services,
and/or acquiring other companies with high-speed, local access capabilities,
including cable modem.  They also have interconnection agreements with the ILECs
and may have secured collocation spaces from which they may have begun to offer
competitive DSL services.  When combined with their extensive existing MANs and
WANs, and full range of Internet and private networking services, they are able
to provide their customers with a complete broadband communications offer
capable of voice, data and video solutions.  Because these competitors have
significantly greater financial resources, enjoy strong brand recognition and
have large, existing business and consumer franchises, they represent
significant competition.

Cable Modem Service Providers.  Cable modem service providers and their cable
partners are offering high-speed Internet access over hybrid fiber coaxial cable
networks to consumers and, increasingly, businesses.  These networks provide
Internet access services similar to our services, and in some cases at higher
speeds.  In certain cases cable modem services are priced lower than our
services partly because operators share the bandwidth available on their cable
networks among multiple end users.

ISPs.  ISPs provide Internet access to residential and business customers.
These companies provide such Internet access, on a dial-up basis, over the
ILECs' circuit-switched networks at ISDN speeds (either 64 kbps or 128 kbps) or
below.  Many ISPs also offer DSL-based access using their own DSL services, or
DSL services offered by the ILECs or other DSL-based CLECs.  Because certain
large, national ISPs have made investments in our competitors and entered into
joint marketing arrangements nationwide, it is difficult for us to recruit these
ISPs as customers, and as a result, they represent important competitors.

Online Service Providers.  Online service providers include companies that
provide, over the Internet and/or over proprietary networks, content and
applications ranging from news and sports to consumer video conferencing.  These
services are designed for broad consumer access over telecommunications-based
transmission media, which enable the provision of digital services to the
significant number of consumers who have personal computers with modems.  Many
of these online service providers have developed their own access networks for
modem connections.  If these online service providers were to extend their
access networks to include DSL or other high-speed service technologies, they
would become competitors of ours.

CLECs.  Certain national CLECs offer DSL-based broadband access services using a
business strategy similar to ours.  In addition, regional CLECs offer DSL-based
access services that compete with the services we offer.

Wireless and Satellite Data Service Providers.  Wireless and satellite data
service providers are developing wireless and satellite-based Internet and
private network connectivity.

Strategic Investments in 2000

During 2000, we, directly or indirectly, through one or more of our wholly-owned
subsidiaries, made the following strategic investments:

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       .  In April 2000, we purchased 473,335 shares of Series B Preferred Stock
          of @Home Networks Solutions, Inc. (Solutions), an affiliate of
          Excite@Home (@Home), for $14,999,986. In addition, we entered into a
          multiyear strategic relationship with @Home.

       .  In September 2000, we received 3% of the common stock of FireTap
          Communications Incorporated (FireTap), an affiliate of Homestore.com,
          in exchange for certain services and other non-cash consideration.

       .  In December 2000, we purchased 2,659,575 shares of Series C
          Convertible Participating Preferred Stock of Winfire, Inc. (a/k/a
          Steel Enterprise Holdings, Inc.) (Winfire) for $5.0 million. In
          addition, we entered into a strategic relationship with Winfire.

       .  In December 2000, we purchased 1,000,000 shares of Series D Preferred
          Stock of MegaPath Networks Incorporated (MegaPath) for $2.5 million.

See also International above for a discussion of our strategic investments in
our two international joint ventures, Garnet Connections and Rhythms Canada.

Many of the companies that we have invested in, entered into strategic
partnerships or joint ventures with are young, emerging companies that are not
fully funded and have ongoing funding obligations of their own that may affect
the value of our investment in them, the services they provide as required by
the strategic agreement and their ongoing viability as operating entities.

See Developments Since December 31, 2000 below for a discussion of the current
status of these strategic investments.

Employees

As of December 31, 2000, we had approximately 2,000 employees.  As a result of
our decision to focus on our top 40 markets and due to productivity improvements
in our business, in January 2001, we announced plans to reduce our work force by
450 employees.  We continue to review the size of our work force in light of our
evolving business plan.  We believe that our future success will depend in part
on our continued ability to attract, hire and retain qualified personnel.
Competition for such personnel is intense, and we may be unable to identify,
attract and retain such personnel in the future.  None of our employees are
represented by a labor union or are the subject of a collective bargaining
agreement.  We have never experienced a work stoppage and believe that our
employee relations are good.

Developments Since December 31, 2000

First quarter 2001 restructuring charge

In January 2001, as a result of our intention to focus on, and provide serves
in, only our top 40 markets and in connection with our plans to reduce our work
force by 450 employees, we announced our intent to take a one-time, 2001 first
quarter restructuring charge between $15 million and $17 million.

Strategic alternatives

In March 2001, our board of directors (Board) engaged Lazard Freres & Co. LLC,
an investment banking firm, to provide financial advice and to assist us in
evaluating strategic alternatives and other possible financial transactions,
including, but not limited to, a sale of our Company, a strategic transaction,
joint venture or partnership with a financial, strategic or industry partner or
other similar transaction, a debt and/or equity financing or restructuring, a
public or private sale of debt or equity securities or assets and/or an
acquisition, merger, consolidation, reorganization, recapitalization or other
business

                                       10
<PAGE>

combination. In conjunction with our strategic alternative initiatives, we are
continuing to review the number of markets we are in, the number of COs we
operate, the size of our work force and our other SG&A costs with a view to
conserving cash and enhancing our ability to achieve future profitability. While
we will consider all commercially reasonable strategic alternatives, there can
be no assurance that a transaction will be consummated on terms acceptable to
our Board, or at all.

Delisting of our Common Stock from the Nasdaq National Market

The Nasdaq Stock Market, Inc. (Nasdaq) has informed us of its intention to send
us a formal notice regarding Nasdaq's intention to delist our Common Stock from
the Nasdaq National Market (National Market) because of our failure to satisfy
(1) the $4.0 million net tangible asset continued listing requirement applicable
to a National Market issuer with a per share stock price of at least $1.00 or
(2) the $5.00 minimum per share stock price alternative continued listing
requirement for a National Market issuer who failed to satisfy the net tangible
assets continued listing requirement.  We have not yet received a formal
delisting notice from Nasdaq.  We have not decided yet whether we would appeal
such proposed delisting to the Nasdaq Listing Qualifications Hearing Board.  If
we appeal, there is no assurance that we will prevail in our appeal.  If we
decide not to pursue our appeal or if the Nasdaq Listing Qualifications Hearing
Board denies our appeal, we would seek to have our Common Stock listed on the
Nasdaq Small Cap Market.  Because our Common Stock continues to trade below
$1.00 per share, there is no assurance that Nasdaq would permit us to list our
Common Stock on the Small Cap Market.  If we were unsuccessful in moving our
Common Stock to the Small Cap Market, we would intend to then move to the Nasdaq
Over-The-Counter Bulletin Board.

Strategic Investments

Winfire.     In March 2001, we entered into an Assignment of DSL Lines and
Mutual Release with Steel Enterprise Holdings, Inc. (f/k/a Winfire) (SEH).
Pursuant to that agreement and in exchange for a mutual release by both parties
of any claims either may have against the other: (a) SEH agreed to assign to us
all of its rights to the line-shared DSL circuits installed by us or ordered
from us and not yet installed; and (b) we agreed to convert approximately $1.0
million of accounts receivable that SEH owed to us as of February 28, 2001 and
approximately $2.9 million in funds we prepaid to Winfire for marketing and
development into 2,034,878 additional shares of Series C Preferred Stock of SEH.
SEH is attempting to restructure its balance sheet.  If it is unable to do so,
it has advised us that it may consider filing for protection under the federal
bankruptcy laws.

Solutions.   Due to a change in Solutions' business strategy, as announced in
January 2001 by its parent corporation, @Home, in March 2001, Mr. Chandler and
Mr. Braukman resigned as directors of Solutions and requested, on our behalf,
that Solutions redeem our shares of Solutions Series B Preferred Stock for their
liquidation value. The Solutions board of directors is currently soliciting the
consents of the other Solutions stockholders for such redemption.

Firetap.   Firetap is in the process of recapitalizing its equity structure.
Accordingly, it has asked all of its common stockholders to consent to the
conversion of their common stock into various classes of preferred stock.  We
are reviewing the recapitalization documents.

Rhythms Canada.   In March 2001, we funded an additional $2.7 million capital
call and received 635,323 additional shares of Class A voting stock of Rhythms
Canada.

Garnet Connections.   The managers of Garnet Connections are expected to make a
decision on whether to roll out DSL services in Japan on a commercial basis in
April or May 2001.

                                       11
<PAGE>

Risk Factors  (See also Interconnection Agreements with ILECs, Regulatory
Climate and Competition above).


We have incurred substantial operating losses and our auditors have issued a
"going concern" audit opinion.

Our consolidated financial statements as of December 31, 2000 have been prepared
on the assumption that we will continue as a going concern.  Our independent
accountants have issued a report dated February 22, 2001 stating that our
recurring losses and accumulated deficits, among other things, raise substantial
doubt about our ability to continue as a going concern.

Our success will depend on the development of this new and rapidly evolving
market and our ability to compete effectively in this market.  To address these
risks, we must, among other things:

     .  raise additional capital;
     .  attract and retain customers;
     .  rapidly scale our operations and the systems that support those
        operations;
     .  effectively respond to competitive developments;
     .  comply with governmental regulatory requirements; and
     .  continue to attract, retain and motivate qualified personnel.

We may not be successful in addressing these and other risks, and our failure to
address these risks would materially and adversely affect our Business.

The market in which we operate is highly competitive, and we may not be able to
compete effectively, especially against established industry competitors with
significantly greater financial resources

We will face competition from many competitors with significantly greater
financial resources, well-established brand names and large, existing installed
customer bases.  We expect the level of competition to intensify in the future.
See Competition above.  It is possible that present or future competitors may
reduce prices for competitive services, perhaps significantly.

We believe that we compare unfavorably with many of our competitors with regard
to, among other things, brand recognition, existing relationships with end
users, available pricing discounts, CO access, capital availability and
exclusive contracts.  We may not be able to compete effectively in our target
markets.  The ILECs are larger, better capitalized, have stronger brand
recognition, offer a wider range of products and services, own the copper lines
and have many more existing relationships with potential end users than we do.
Our failure to compete effectively would have a material and adverse effect on
our Business.

                                       12
<PAGE>

We cannot predict our future success because our business model is unproven

We formed our Company in February 1997 and have a short operating history.  We
entered into our first ILEC interconnection agreement in July 1997 and began to
offer commercial services in our first market in April 1998.  We believe that
the combination of our unproven business model and the highly competitive and
fast changing market in which we compete makes it impossible to predict the
extent to which our services will achieve market acceptance and our overall
success.  To be successful, we must develop and market network services that are
widely accepted at profitable prices.  To date we have not achieved, and  we may
never be able to achieve, significant market acceptance, favorable operating
results or profitability or generate sufficient cash flow to repay our debt.  In
addition, certain of our ISP customers have unproven business models and their
inability to succeed may negatively impact our results.  In the past 12 months,
several of our ISP customers significantly reduced operations, in some cases
ceased operations and in other cases, filed for protection under the federal
bankruptcy law.   Any continued or ongoing failure for any reason of large
customers to roll out our services or failure to validate our business model
would materially and adversely affect our Business.

Our network services may not achieve significant market acceptance because our
prices are often higher than those charged for competing services

Our prices are in some cases higher than those that our competitors charge for
some of their services.  Prices for digital communication services have fallen
historically, and we expect prices in the industry, and for the services we
offer now and plan to offer in the future, to continue to fall.  We may be
required to reduce prices periodically to respond to competition and to generate
increased sales volume.  Our prices may not permit our network services to gain
a desirable level of commercial acceptance, and we may be unable to sustain any
current or future pricing levels.  Furthermore, we expect that the mix of
services our customers purchase will change from time to time and that a mix
more heavily weighted toward lower priced services will reduce the average
revenue we receive per customer.  Due to these factors, we cannot accurately
forecast our revenues or the rate at which we will add new customers.

We need significant additional funds, which we may not be able to obtain

The operations of our business will require significant additional capital. We
intend to seek substantial additional financing in the future to fund the growth
of our operations. We believe that our current capital resources will be
sufficient to fund our aggregate capital expenditures and working capital
requirements, including operating losses, into January of 2002. Our actual
funding requirements may differ materially if our assumptions underlying this
estimate turn out to be incorrect.

We may be unable to obtain future debt or equity financing on acceptable terms,
or at all. Recently, the financial markets have experienced extreme price
fluctuations. The ongoing market downturn and continuing general market
uncertainty, as well as the recent decline in the DSL industry, are adversely
affecting our ability to secure additional financing. The indentures that govern
our 1998 senior discount notes, the 1999 senior notes and the 2000 senior notes
(our Indentures) restrict our ability to obtain additional debt financing. Any
future borrowing instruments, such as credit facilities and lease agreements,
are likely to contain similar or more restrictive covenants and could require us
to pledge assets as security for the borrowings. If we are unable to obtain
additional capital (or vendor financing) or are required to obtain it on terms
less satisfactory than what we desire, we will need to further limit our network
services or take other actions that could adversely affect our Business. If we
are unable to generate sufficient cash flow or obtain funds necessary to meet
required payments of our debt, then we will be in default on our debt

                                       13
<PAGE>

instruments. To date, our cash flow from operations has been insufficient to
cover our expenses and capital needs.

The securities markets are currently not available to us. We need to raise
additional financing. We may be required to restructure our balance sheet. It is
unlikely that we could obtain additional financing without effecting such
restructuring. There is no assurance that we would be able to successfully
restructure our balance sheet on terms acceptable to us, or at all. If we are
unable to restructure our balance sheet and obtain additional financing, we
likely will be unable to fund our operating requirements and meet our debt and
Preferred Stock obligations as they come due. The current general economic
downturn is adversely affecting our industry and customers below.

We may need to reduce our debt and Preferred Stock to manageable levels to
obtain additional financing in the future

We are highly leveraged and need to obtain additional debt and/or equity
financing in the future. As of December 31, 2000, we had approximately $832.3
million of long-term debt and approximately $451.3 million of mandatorily
redeemable Preferred Stock. We likely will not generate sufficient revenue to
fund our operations or to repay our debt. Our substantial leverage poses the
risks that:

     .    we may be unable to pay dividends on our Preferred Stock or to repay
          our debt;
     .    we may be unable to obtain additional debt or equity funding; and
     .    we must dedicate a substantial portion of our cash flow from
          operations to service our debt and Preferred Stock.

As a result of the economic downturn,  and in the face of increasing competitive
pressures, we may be unable to respond effectively to changing business and
economic conditions.

For example, our Indentures prohibit or limit our ability to make dividend
payments, incur additional debt, make certain investments in other businesses
and engage in certain business activities.  These restrictions may materially
and adversely affect our ability to finance future operations or capital needs
or conduct additional business activities.  Any future debt or preferred stock
that we may incur or issue will likely impose additional restrictions on us. If
we fail to comply with any existing or future restrictions, we could default
under the terms of our Indentures and be unable to meet our debt obligations. If
we default, the holders of the applicable debt could demand that we repay the
debt, including interest, immediately. In January 2001, one of our leasing
companies, GATX Capital Corporation (GATX), notified us that an event of default
had occurred under our lease program due to our failure to meet the operating
cash flow covenant. We may be unable to make the required payments or raise
sufficient funds from alternative sources to make the payments. Even if
additional financing is available in the event that we default, it may not be on
acceptable terms. We may need to restructure our existing debt and Preferred
Stock to manageable levels to obtain additional financing in the future.

We expect our losses to continue

We have incurred losses and experienced negative operating cash flow for each
month since our formation.  As of December 31, 2000, we had an accumulated
deficit of approximately $825.8 million.  We will continue to incur significant
expenditures and operating expenses in an effort to expand our subscriber base.
We expect to have annual interest and amortization expense relating to our
Indentures of approximately $83.4 million in 2001, $83.4 million in 2002 and
$103.0 million in 2003.  In addition, we may incur more debt in the future.
Dividends of approximately $126.0 million will accrue on the Series E Preferred
Stock through February 2005.  No cash dividends are payable on the Series E
Preferred Stock until 2005, and at our option such dividends may continue to
accrue as liquidation preference.  Dividends on the 6 3/4% Series

                                       14
<PAGE>

F Preferred Stock are cumulative from the date of issuance in an annual amount
of approximately $20.3 million. As permitted by the terms of the Series F
Preferred Stock, we stopped making cash dividend payments on our Series F
Preferred Stock as of December 3, 2000, and are currently accruing those
dividend obligations. As a result of these factors, we expect to incur
substantial operating and net losses and negative operating cash flow for the
foreseeable future. We will need to obtain additional financing to pay our
expenses and to make payments on our debt. We cannot provide any assurance
about whether or when we will have sufficient cash flows to satisfy our funding
requirements or pay our debt service and Preferred Stock obligations.

The current general economic downturn is adversely affecting our industry and
customers.

In the last 12 months, the U.S. economy has suffered a sharp decline.  The
telecommunications industry has been particularly hard hit by this downturn.
We, like many telecommunications companies, have seen our stock price fall
dramatically, and our ability to raise additional funding in the public and
private markets has been severely limited.  Many of our customers have reduced
their expenditures for telecommunications services, including our services, and
in some cases delayed (or announced they are considering delaying) decisions to
roll out our services or decisions to make initial evaluations of our services.
Some of our customers, which are startup or emerging businesses themselves, have
experienced a sharp decline in their businesses.  Some have gone out of business
or filed for protection under the federal bankruptcy laws, calling into question
the likelihood of collection of the full amounts they owe us and the continued
viability of the customer lines they have installed with us.  Other national DSL
providers have also experienced significant financial difficulties.  One has
filed for bankruptcy and the bankruptcy court has approved the sale of
substantially all of its assets to AT&T Corp. or one of its subsidiaries.  These
developments with respect to our competitors have adversely affected us and the
entire DSL industry.  A continuation of this economic downturn, and the results
thereof, could have a material and adverse effect on our Business.

Our operating results in one or more future periods are likely to fluctuate
significantly and may fail to meet or exceed the expectations of securities
analysts or investors

Our annual and quarterly operating results are likely to fluctuate significantly
in the future due to numerous factors, many of which are outside of our control.
These factors include:

     .  the rate of customer acquisition and turnover;
     .  the success of our relationships with our customers;
     .  the prices our customers are willing to pay which may decline due to
        competitive factors;
     .  introduction of new services or technologies by our competitors;
     .  our ability to effectively develop and market additional network
        services;
     .  our ability to scale our business to meet the demands of our customers;
     .  our ability to control our corporate overhead while rapidly growing our
        business;
     .  the amount and timing of expenditures to augment our services and
        infrastructure;
     .  regulatory developments, including interpretations of the 1996 Act;
     .  the success of our strategic investments/alliances;
     .  the condition of the telecommunication and network service industries;
     .  general economic conditions;
     .  the fact that several of our customers are young, emerging companies
        that are not fully funded and have ongoing funding obligations of their
        own that may affect the amount of services they purchase from us, the
        timing of their payments to us and their ongoing viability as operating
        entities;
     .  the ability of our equipment and service suppliers to meet our needs;
        and
     .  technical difficulties of network downtime.

                                       15
<PAGE>

Because of these factors, our operating results in one or more future periods
could fail to meet or exceed the expectations of securities analysts or
investors.  In that event, the trading price of our Common Stock would likely
decline.

Because our market is new and evolving, we cannot predict its future growth or
ultimate size, and we may be unable to compete effectively

The market for broadband local access DSL communication services using copper
telephone lines is in the early stages of development.  Since this market is new
and evolving and because our current and future competitors are likely to offer
or introduce competing services, we cannot accurately predict the rate at which
this market will grow, if at all, or whether new or increased competition will
result in market saturation.  If the markets for our services fail to develop,
grow more slowly than anticipated or become saturated with competitors, these
events could materially and adversely affect our business, operating results and
financial condition (collectively, our Business).

We depend on third parties for the marketing and sales of our services

We rely significantly on indirect sales channels for the marketing and sales of
our services.  We will seek to continue to establish and maintain relationships
with numerous telecommunications carriers and ISPs to gain access to end users.
Our agreements to date with these customers are non-exclusive, generally short
term and can be cancelled by the customer without significant financial
consequence.  We cannot control how these customers perform and cannot be
certain that their performance will be satisfactory to us or the end user.
Several of these customers are young, emerging companies that are not fully
funded and have ongoing funding obligations of their own that may affect the
amount of services they purchase from us, the timing of their payments to us,
their ability to pay us for services rendered and their own ongoing viability as
operating entities.  Many of these companies have similar arrangements with our
competitors and may also compete directly with us.  If the number of customers
we obtain through indirect sales channels is significantly lower than our
forecast for any reason, or if these customers are unsuccessful in competing in
their own intensely competitive markets, these events would have a material and
adverse effect on our Business.

We depend on third parties for equipment, installation and provision of field
service

We purchase our equipment from many vendors and outsource the majority of our
network field service and non-line-shared installations to third parties.  Our
reliance on third party vendors involves a number of risks, including the
absence of guaranteed capacity and reduced control over delivery schedules,
quality assurance, production yields and costs, and, in the case of certain
vendors, reduced availability of vendor financing.  If any of our suppliers
reduces or interrupts its supply, or if any significant installer or field
service provider interrupts its service to us, this reduction or interruption
could disrupt our Business.

We may be unable to effectively expand our network services and provide high
performance to a substantial number of end users

Due to the limited deployment of our network services, we cannot guarantee that
our network will be able to connect and manage a substantial number of end users
at high transmission speeds.  We may be unable to scale our network to service a
substantial number of end users while achieving high performance.  Further, our
network may be unable to achieve and maintain competitive digital transmission
speeds.  While digital transmission speeds of 8.0 Mbps are possible on certain
portions of the network, that speed is not available over a majority of our
network.  Actual transmission speeds on our network will depend on a variety of
factors and many of these factors are beyond our control, including the type of
DSL technology deployed, the distance an end user is located from a CO, the
quality of the copper telephone lines, the presence of interfering transmissions
on nearby telephone lines and other factors.  As a result, we may not be able to
achieve and maintain digital transmission speeds that are attractive in the
market.

We depend on ILECs for collocation and transmission facilities

We must use copper telephone lines controlled by the ILECs to provide DSL
connections to customers.  We also depend on the ILECs for collocation and for a
substantial portion of the transmission facilities we use to connect our
equipment in ILEC COs to our MSCs.  In addition, we depend on the ILECs to test
and maintain the quality of the copper telephone lines that we use.  In many
cases, we may be unable to obtain access to collocation space or transmission
facilities from the ILECs, or to gain access at acceptable rates,

                                       16
<PAGE>

terms and conditions, including timeliness. We have experienced, and expect to
experience in the future, delays between our request for and the actual
provision of the collocation space and copper telephone lines. An inability to
obtain or maintain adequate and timely access to collocation space or
transmission facilities on acceptable terms and conditions from the ILECs could
have a material adverse effect on our Business.

Because we compete with ILECs in our markets, they may be reluctant to cooperate
with us.  If this occurs, we may not have alternate means of connecting our DSL
equipment with the copper telephone lines or connecting our equipment in COs to
MSCs.  Delays in obtaining copper telephone lines could result in delays in, and
increased expenses associated with the delivery of our services, which in turn
could have a material adverse effect on our Business.

We are unable to control the terms and conditions under which we gain access to
ILEC collocation and transmission facilities

We cannot control the terms under which we collocate our equipment, connect to
copper telephone lines or gain the use of an ILECs' transmission facilities.
State tariffs, state PUCs, the FCC and interconnection agreements with the ILECs
determine the price, terms and conditions under which collocation space is made
available, and they make these administrative determinations in ongoing
hearings.  Interconnection agreements and state PUCs, as well as the FCC also
determine the terms and conditions of access to copper telephone lines and other
components of an ILEC's network. See Interconnection Agreements with ILECs
above.

We may be unable to extend our existing interconnection agreements or negotiate
or enter into new interconnection agreements on acceptable terms or at all.  In
addition, we cannot be sure that the ILECs will abide by their obligations under
those agreements.  Delays in renewing interconnection agreements could adversely
affect service in certain markets.  In addition, disputes may arise between us
and the ILECs with respect to interconnection agreements, and we may be unable
to resolve disputes in our favor.  If we are unable to renew interconnection
agreements or unable to do so on favorable terms, this inability or delay could
adversely affect our Business.

The FCC and state regulatory commissions establish the rates for DSL-capable
copper telephone lines as well as other rates, terms and conditions of our
dealings with the ILECs in ongoing public hearings.  Participation in these
hearings will involve significant management time and expense.  The ILECs may
from time to time propose new rates, and the outcomes of hearings and rulings
could have a material and adverse effect on our Business.

We depend on third parties for fiber optic transport facilities

We depend on the availability of fiber optic transmission facilities from third
parties to connect our equipment within and between metropolitan areas.  These
third party fiber optic carriers include long distance carriers, ILECs and other
CLECs.  Many of these entities are, or may become, our competitors.  This
approach includes a number of risks.  For instance, we may be unable to
negotiate and renew favorable supply agreements.  Further, we depend on the
timeliness of these companies to process our orders for customers who seek to
use our services.  We have in the past experienced supply problems with certain
of our fiber optic suppliers, and they may not be able to meet our needs on a
timely basis in the future.  Moreover, the fiber optic transport providers whose
networks we lease may be unable to obtain or maintain permits and rights-of-way
necessary to develop and operate existing and future networks.

                                       17
<PAGE>

A system failure or breach of network security could cause delays or
interruptions of service to our customers

Our operations depend on our ability to avoid damages from fires, earthquakes,
floods, power losses, excessive sustained or peak user demand,
telecommunications failures, network software flaws, transmission cable cuts and
similar events.  A natural disaster or other unanticipated problem at our owned
or leased facilities could interrupt our services.  Additionally, if an ILEC,
CLEC or other service provider fails to provide the communications capacity we
require, as a result of a natural disaster, operational disruption or any other
reason, then this failure could interrupt our services.

Despite the implementation of security measures, our network may be vulnerable
to unauthorized access, computer viruses and other disruptive problems.
Corporate networks and ISPs have in the past experienced, and may in the future
experience, interruptions in service as a result of accidental or intentional
actions of Internet users, current and former employees and others.
Unauthorized access could also potentially jeopardize the security of
confidential information stored in the computer systems of our customers, which
might cause us to be liable to our customers, and also might deter potential
customers.  Eliminating computer viruses and alleviating other security problems
may require interruptions, delays or cessation of service to our customers and
our customers' end users.

Our services are subject to government regulation, and changes in current or
future laws or regulations could restrict the way we operate our Business

A significant portion of the services that we offer through our subsidiaries may
be subject to regulation at the federal, state and local levels.  Future federal
or state regulations and legislation may be less favorable to us than current
regulation and legislation and therefore have an adverse impact on our Business.
In addition, we may expend significant financial and managerial resources to
participate in rule-setting or legislative proceedings at either the federal or
state level, without achieving a favorable result.  In particular, we believe
that ILECs have and will continue to work aggressively to modify or restrict
the operation of many provisions of the 1996 Act. We expect ILECs will pursue
litigation in courts, institute administrative proceedings with the FCC and
other regulatory agencies and lobby the U.S. Congress, all in an effort to
affect laws and regulations in a manner favorable to the ILECs and against the
interest of CLECs, such as us. If the ILECs succeed in any of their efforts, if
these laws and regulations change or if the administrative implementation of
laws develops in an adverse manner, these events could have a material and
adverse effect on our Business.

Any failure to manage growth could adversely affect us

We have rapidly and significantly expanded our operations.  We anticipate
further development of our operations and the systems supporting those
operations in an effort to achieve business objectives.  If our marketing
strategy is successful, we may experience difficulties responding to customer
demand for services and technical support in a timely manner and in accordance
with their expectations.  As a result, rapid growth of our business would make
it difficult to implement successfully our strategy to provide superior customer
service.  To manage any growth of our operations, we must:

     .  improve existing and implement new operational, financial and management
        information controls, operational support systems, reporting systems and
        procedures;
     .  improve existing and implement new customer relations, billings and
        collections practices, procedures and systems;
     .  expand and upgrade our core technologies; and

                                       18
<PAGE>

     .  effectively manage multiple relationships with our customers, suppliers
        and other third parties.

We may not be able to install operational support systems or management
information and control systems in an efficient and timely manner, and our
current or planned personnel, systems, procedures and controls may not be
adequate to support our future operations.  Failure to manage our future growth
effectively could adversely affect the expansion of our customer base and
service offerings.  Any failure to successfully address these issues could
materially and adversely affect our Business.

Our need for additional funding may restrict our future growth..  For example,
while in January 2001, we announced that, although we intended to maintain a
physical presence in 60 markets, we planned to focus on, and provide services
in, only our top 40 markets, and we continue to review the number of markets we
are in, the number of COs we operate, the size of our work force and our other
SG&A costs with a view to conserving cash and enhancing our ability to achieve
future profitability.

The telecommunications industry is undergoing rapid technological change, and
new technologies may be superior to the technology we use

The telecommunications industry is subject to rapid and significant
technological changes, such as continuing developments in DSL technology and
alternative technologies for providing high-speed data communications.  We
cannot predict the effect of technological changes on our business.  We will
rely in part on third parties, including certain of our competitors and
potential competitors, for the development of and access to communications and
networking technology.  New products and technologies that develop in our market
may be superior to and/or render obsolete the products and technologies that we
currently use.  Our future success will depend, in part, on our ability to
anticipate and adapt to technological changes and evolving industry standards.
We may be unable to obtain access to new technology on acceptable terms or at
all, and we may be unable to adapt to new technologies and offer services in a
competitive manner.  Our joint development projects and our strategic
arrangements may not produce useful technologies or services for us.  Further,
new technologies and products may not be compatible with our technologies and
business plan.  In addition, many of the products and technologies that we
intend to use in our network services are relatively new and unproven and may be
unreliable.  See also Competition: ILECs above

Our success depends on our retention of certain key personnel and on the
performance of those personnel

Our success depends on the performance of our officers and key employees.
Members of our senior management team have worked together for only a short
period of time.  We do not have "key person" life insurance policies on any of
our employees nor do we have employment agreements for fixed terms with any of
our employees.  Any of our employees, including any member of our senior
management team, may terminate his or her employment with us at any time.  Our
future success also depends on our continuing ability to identify, hire, train
and retain highly qualified technical, sales, marketing and customer service
personnel.  Moreover, the industry in which we compete has a high level of
employee mobility and aggressive recruiting of skilled personnel.  We may be
unable to continue to employ our key personnel or to attract and retain
qualified personnel in the future.  We have entered into retention arrangements
with most, but not all, of our senior managers and other key personnel.  There
can be no assurance that these programs will be successful in retaining such
senior managers and/or key employees.

Uncertain federal and state tax and other surcharges on our services may
increase our payment obligations

Telecommunications providers pay a variety of surcharges and fees on their gross
revenues from interstate and intrastate services.  The division of our services
between interstate and intrastate services is a matter of interpretation, and in
the future the FCC or relevant state commission authorities may contest this
division.

                                       19
<PAGE>

A change in the characterization of the jurisdiction of our services could cause
our payment obligations to increase. In addition, pursuant to periodic revisions
by state and federal regulators of the applicable surcharges, we may be subject
to increases in the surcharges and fees currently paid.

Our intellectual property protection may be inadequate to protect our
proprietary rights, and we may be subject to infringement claims

We rely on a combination of licenses, confidentiality agreements and other
contracts to establish and protect our technology and other intellectual
property rights.  We have applied for trademarks and service marks on certain
terms and symbols that we believe are important for our business.  We currently
have no patents or patent applications pending.  The steps we have taken may be
inadequate to protect our technology or other intellectual property.  Moreover,
our competitors may independently develop technologies that are substantially
equivalent or superior to ours.  Third parties may assert infringement claims
against us and, in the event of an unfavorable ruling on any claim, we may be
unable to obtain a license or similar agreement to use technology we rely upon
to conduct our business.  We also rely on unpatented trade secrets and know-how
to maintain our competitive position, which we seek to protect, in part, by
confidentiality agreements with employees, consultants and others.  However,
these agreements may be breached or terminated, and we may not have adequate
remedies for any breach.  In addition, our competitors may otherwise learn or
discover our trade secrets.  Our management personnel were previously employees
of other telecommunications companies.  In many cases, these individuals are
conducting activities for us in areas similar to those in which they were
involved prior to joining us.  As a result, our employees or we could be subject
to allegations of violation of trade secrets and other similar claims.


We may be delisted from the Nasdaq National Market

Nasdaq has notified us that we are not in compliance with the continued listing
requirements pursuant to the Nasdaq Market Place Rules, and that it intends to
send us a formal notice informing of its intent to delist our Common Stock from
the Nasdaq National Market.  We have yet received this formal notice and have
yet to determine how we will respond to such notice.

If our Common Stock is delisted, it will be more difficult to buy or sell our
Common Stock or to obtain timely and accurate quotations to buy or sell our
Common Stock.  In addition, the delisting could result in a decline in the
trading market for our Common Stock that could depress our stock price.

We expect our stock price to be volatile

The trading price of our Common Stock has been and is likely to continue to be
highly volatile.  Our stock price could fluctuate widely in response to many
factors, including the following:

     .  our historical and anticipated quarterly and annual operating results;
     .  announcements of new products or services by us or our competitors or
        new competing technologies;
     .  the addition or loss of business or service provider customers;
     .  variations between our actual results and analyst and investor
        expectations;
     .  investor perceptions of the DSL industry, us and comparable public
        companies;
     .  conditions or trends in the telecommunications industry, including
        regulatory developments;
     .  announcements by us of significant acquisitions, strategic partnerships,
        joint ventures or capital commitments;

                                       20
<PAGE>

     .  additions or departures of key personnel;
     .  future equity or debt offerings or our announcements of such offerings;
     .  the financial failures or downturns of certain of our customers;
     .  our ability to raise additional capital and restructure our debt and
        Preferred Stock on a timely basis; and
     .  general market and economic conditions.

In addition, in recent years and, in particular, during the past 12 months, the
stock market in general, and the Nasdaq National Market and the market for
Internet and technology companies in particular, have experienced extreme price
and volume fluctuations.  These fluctuations have often been unrelated or
disproportionate to the operating performance of these companies.  These market
and industry factors may materially and adversely affect our stock price,
regardless of our operating performance.

Director and Officer insurance (D&O Insurance) renewal

Our Director and Officer Insurance expires on April 7, 2001.  We are currently
in renewal discussions with our D&O Insurance providers.  While we believe that
we will be able to obtain a renewal of our D&O Insurance, there can be no
assurance that we will be able to do so on terms acceptable to our Board, or at
all.  If we are unable to obtain D&O Insurance at a level acceptable to our
Board, there is a risk that one or more of our officers or directors may resign.

Qwest Communications Corporation "take-or-pay" contract

We are currently in negotiations with Qwest Communications Corporation ("Qwest")
regarding their obligation to make certain payments to us under our agreement
with Qwest. If the negotiations prove unsuccessful, we may incur litigation and
other expenses in pursuing present and future payments from Qwest.

Anti-takeover provisions could negatively impact our stockholders

Our Board has adopted a stockholder rights plan.  Our stockholder rights plan
would cause substantial dilution to any person or group that attempts to acquire
us on terms not approved in advance by our Board.  In addition, some of the
provisions that may be included in our certificate of incorporation and bylaws
may discourage, delay or prevent a merger or acquisition at a premium price.
These provisions include:

     .  authorizing the issuance of "blank check" preferred stock;
     .  providing for a classified Board with staggered, three-year terms;
     .  eliminating the ability of stockholders to call a special meeting of
        stockholders;
     .  limiting the removal of directors by the stockholders to removal for
        cause; and
     .  requiring a super-majority stockholder vote to effect certain
        amendments.

In addition, certain provisions of the Delaware General Corporation Law and our
stockholder rights plan may deter someone from acquiring or merging with us,
including a transaction that results in stockholders receiving a premium over
the market price for the shares of Common Stock held by them.  Section 203 of
the Delaware General Corporation Law also imposes certain restrictions on
mergers and other business combinations between any holder and us of more than
15% and less than 85% of our Common Stock.

Our Indentures require us to offer to repurchase all of the notes listed
thereunder for 101% of their principal amount or accreted value, as the case may
be, plus any accrued interest and liquidated damages, within 30 days after a
change of control.  We might not have sufficient funds available at the time of
any change of

                                       21
<PAGE>

control to make any required payment, as well as any payment that may be
required pursuant to any other outstanding indebtedness at the time, including
our indebtedness to equipment financing lenders, or outstanding Preferred Stock.
These covenants may also deter third parties from entering into a change of
control transaction with us.

Sales of substantial amounts of Common Stock in the public market or the
appearance that a large number of shares are available for sale could adversely
affect the market price for the Common Stock.  In addition to the adverse effect
a price decline could have on holders of Common Stock, that decline would likely
impede our ability to raise capital through the issuance of additional shares of
Common Stock or other equity securities.

If forecasted sales for services sold directly to our business customers for a
particular period are not realized in that period due to the lengthy sales cycle
of our services, our operating results will be harmed

The sales cycle of our network services can be very lengthy, particularly for
large businesses.  Our sales cycle for large businesses typically lasts at least
six months.  During this lengthy sales cycle, we will incur significant expenses
in advance of the receipt of revenues.  If sales that we forecast for a
particular period do not occur because of our lengthy sales cycle, this event
could materially and adversely affect our business, prospects, operating results
and financial condition.

Consolidation within the telecommunications industry could reduce our market
share and harm our financial performance

Consolidation of some of the major telecommunication service providers and
strategic alliances among other service providers have occurred since the
passage of the 1996 Act.  Further consolidations and alliances among our
competitors and/or our customers could lead to fewer large volume sales, reduced
operating margins, increased "one stop shopping" among consumers, loss of market
share, increased competition and increased difficulties penetrating new markets.

Our international alliances and investments expose us to international and
market risks

Our current investments in Japan and Canada (and any other future international
investments) could expose us to risks inherent in international operations, such
as:

     .  general economic, social and political conditions;
     .  ownership of a non-controlling, minority position in a foreign entity;
     .  reliance on the management and business acumen of our foreign partners;
     .  difficulties in obtaining foreign licenses or interconnection agreements
        on acceptable terms or at all; and
     .  change in U.S.  laws that could affect our foreign investments.

Both of these companies are young, emerging companies that are not fully funded
and have ongoing funding obligations of their own that may affect the value of
our investment in them, the services they provide as required by their business
plans and agreements with us and their ongoing viability as operating entities.

Risks associated with investments in certain strategic relationships

During 2000, we invested in, and entered into certain strategic relationships
with several new start-up companies.  For more information, please see Part I,
Item 1 - International and 2000 Strategic

                                       22
<PAGE>

Investments and Developments Since December 31, 2001 above. Many of the
companies we have invested in, or entered into strategic partnerships with, are
young, emerging companies that are not fully funded and have ongoing funding
obligations of their own that may affect the value of our investments in them,
the services they provide as required by the strategic agreements and their
ongoing viability as operating entities.

Our domestic alliances and strategic investments with U.S. partners expose us to
minority investor risks, such as:

     .  ownership of a non-controlling, minority position in a domestic entity;
     .  reliance on the management and business acumen of other partners, who,
        individually or in the aggregate, may control the operations of the
        entity;
     .  reliance on the financial strength of our partners and the investment
        entity; and
     .  the ability of such entities to successfully implement, carry out,
        finance and execute their own business plans.

Item 2 -- Properties

Our headquarters are located in facilities consisting of approximately 153,000
square feet in Englewood, Colorado, which we occupy under a lease that expires
in September 2008.  This lease may be extended.  We also lease space for network
equipment installations and business offices in a number of other locations. In
April 2000, we acquired land adjacent to our corporate headquarters with the
intent of consolidating various Denver-based operations currently being leased
into this facility.   We began construction mid-year and through December 31,
2000, had incurred $3.2 million of costs for the land and facility construction.
We believe the new facility will cost approximately $18.0 million and have
87,000 square feet.  It is our intent to sell and then lease-back this facility,
but there can be no assurance we will be successful in this effort.

Item 3 -- Legal Proceedings

Lafleur Litigation - On February 18, 1999, we filed a complaint for declaratory
relief in San Diego County Superior Court, North County against Thomas R.
Lafleur, seeking a determination as to the ownership of 438,115 shares of our
stock option shares previously granted to him.  The trial in this matter began
on May 5, 2000.  On June 2, 2000, the court entered a Stipulated Statement of
Decision holding that Thomas R. Lafleur became fully vested in ownership of the
438,115 shares of Common Stock in question on June 5, 1998.  On June 3, 2000, we
entered into an Agreement of Settlement and Compromise, pursuant to which the
Lafleurs agreed to release and dismiss, with prejudice, all of their claims
against us and we agreed to deliver 438,115 shares of treasury stock and to make
a cash payment of $8.8 million to the Lafleurs.  In addition, we incurred legal
fees relating to this litigation totaling $3.1 million. We have filed claims
with our insurance carriers seeking reimbursement for litigation and legal fees
relating to this case.  As of December 31, 2000, we had received $15.0 million,
subject to a reservation of right by the insurers.  Furthermore, on November 14,
2000, Reliance Insurance Company (Reliance) filed a legal action in the Superior
Court of California, County of San Diego seeking declaratory relief and
restitution for the $5.0 million of insurance payments made by Reliance in
connection with the Lafleur litigation.  On January 5, 2001, Rhythms filed a
general denial of the Reliance claims and a cross complaint against Reliance,
Agricultural Excess and Surplus Insurance Company (AESIC), and Executive Risk
Specialty Insurance Company (Executive Risk) for declaratory relief.  We intend
to vigorously defend our claim to reimbursement of the settlement and defense
costs associated with the Lafleur litigation.

                                       23
<PAGE>

i2 Litigation - i2 Technologies, Inc. (i2) filed an action in the U.S.  District
Court in the Northern District of Texas on January 7, 2000, challenging our use
of the name "Rhythms" on various grounds and alleging that our use of that name
infringes certain trademarks owned by i2 Technologies.  We denied that it
infringes any legitimate trademark rights of i2 Technologies, in part on the
grounds that we have priority in the Rhythms name with respect to the goods and
services provided by us and that our use of those marks is not likely to cause
confusion among the consumers of our services, and the services provided by i2
Technologies, respectively.  On February 12, 2001, Rhythms and i2 agreed to
dismiss their claims with prejudice, except for Rhythm's claim for cancellation
of certain i2 marks, which claim was dismissed without prejudice.

Guild Litigation - Guild Colorado, LLC (Guild) filed an action in the Texas
State Court for Dallas County alleging that we breached a construction contract.
We intend to vigorously defend these claims and file counterclaims as
appropriate.

Lacy Litigation - On January 22, 2001, John Lacy, a former Rhythms' employee,
filed an action in the U.S.  District Court for the District of Colorado
alleging breach of contract and demanding relief in the amount of $1.3 million.
We intend to vigorously defend against this claim.

In addition, we are subject to state commission, FCC and court decisions as they
relate to the interpretation and implementation of the 1996 Act, the
interpretation of CLEC interconnection agreements in general and our
interconnection agreements in particular.  In some cases, we may be deemed to be
bound by the results of ongoing proceedings of these bodies.  We therefore may
participate in proceedings before these regulatory agencies or judicial bodies
that affect, and allow us to advance, our business plans.

Item 4 - Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the quarter ended
December 31, 2000.


                                    PART II

Item 5 - Market for Registrant's Common Equity and Related Stockholder Matters

Nasdaq National Market Trading price of our Common Stock

Our Common Stock currently is traded on the Nasdaq National Market under the
symbol "RTHM."   See Part I, Item 1 - Developments Since December 31, 2000 above
for information concerning the notice we received from Nasdaq informing us that
we no longer satisfy all of the requirements for continued listing of our Common
Stock on the Nasdaq National Market and the steps we are taking in response to
that notice.

As of March 1, 2001, there were approximately 301 shareholders of record of our
Common Stock.  Our Common Stock began trading on the Nasdaq National Market on
April 7, 1999, the date of our initial public offering (IPO).  Prior to April 7,
1999, there was no public market for our Common Stock.  The following table sets
forth, for the period indicated, the high and low closing daily bid prices for
our Common Stock as quoted by the Nasdaq National Market.

                                                                  High     Low
Fourth Quarter 2000                                              $ 6.44   $ 0.69
Third Quarter 2000                                               $17.38   $ 6.50
Second Quarter 2000                                              $33.00   $12.44
First Quarter 2000                                               $48.88   $26.69

                                       24
<PAGE>

Fourth Quarter 1999                                              $45.50   $26.69
Third Quarter 1999                                               $68.94   $30.00
Second Quarter 1999 (from April 1, 1999, through June 30, 1999)  $93.13   $45.25

Dividend policy

We have not paid dividends on our Common Stock and currently intend to continue
this policy to retain earnings for use in our business.  In addition, the terms
of our Indentures contain restrictions on our ability to pay dividends or other
distributions.

Sales of unregistered/registered securities

Since our incorporation in February 1997, we have issued and sold unregistered
securities as follows (adjusted for subsequent stock splits):

(1) An aggregate of 2,161,764 shares of Common Stock was issued in private
placements in February through June 1997 to Enterprise Partners in connection
with our initial funding.  The consideration received for such shares was $901.

(2) An aggregate of (a) 12,280,000 shares of Series A Preferred Stock (which
were converted into 29,472,000 shares of Common Stock) was issued in a private
placement in July 1997 and (b) 210,000 shares of Series A Preferred Stock (which
were converted into 504,000 shares of Common Stock) was issued in a private
placement upon the closing of the IPO to Brentwood Venture Capital, Enterprise
Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and certain other
purchasers pursuant to a Series A Preferred Stock Purchase Agreement.  The
consideration received for such shares was approximately $12.5 million.

(3) An aggregate of 365,094 shares of Series A Preferred Stock (which were
converted into 876,226 shares of Common Stock) was issued in a private placement
in February 1998 to Catherine Hapka in connection with the Series A Preferred
Stock Purchase Agreement, the Subsequent Closing Purchase Agreement and an
employment agreement between us and Ms. Hapka.  The consideration received for
such shares was $292,075.

(4) An aggregate of 4,044,943 shares of Series B Preferred Stock (which were
converted into 9,707,863 shares of Common Stock) was issued in a private
placement in March 1998 to Brentwood Venture Capital, Enterprise Partners,
Kleiner Perkins Caufield & Byers, the Sprout Group and Enron Communications
Group, Inc.  The consideration received for such shares was approximately $18
million.

(5) In May 1998, we issued 290,000 units consisting of 13 1/2% senior discount
notes due 2008 and warrants to purchase an aggregate of 4,732,800 shares of
Common Stock with exercise prices of $0.004 per share to Merrill Lynch & Co. and
Donaldson, Lufkin & Jenrette Securities Corporation, as initial purchasers, for
resale to qualified institutional buyers.  Merrill Lynch & Co. and Donaldson,
Lufkin & Jenrette Securities Corporation received commissions of approximately
$5.3 million for acting as initial purchasers in connection with this
transaction.  Effective November 20, 1998, we completed an exchange offer of the
13 1/2% senior discount notes that allowed for registration of such notes under
the Securities Act.  Of the original issue notes, $289.0 million were tendered
for exchange.  The registered notes have substantially the same terms and
conditions as the unregistered notes, except that the registered notes are not
subject to the restrictions on resale or transfer that applied to the
unregistered notes.

                                       25
<PAGE>

(6) In May 1998, we issued to Sun Financial Group, Inc., now GATX, a warrant to
purchase 574,380 shares of Common Stock with an exercise price of $1.85 per
share in connection with an equipment lease financing.

(7) In March 1999, we issued to WorldCom Venures (f/k/a MCI WorldCom Venture
Fund, Inc.) and to Microsoft Corporation 3,731,410 and 3,731,409 shares of
Series C Preferred Stock, respectively, and issued to each of them a warrant to
purchase 720,000 shares of Common Stock with an exercise price of $6.70 per
share for an aggregate purchase price of $60.0 million.

(8) In April 1999, we issued to Qwest 932,836 shares and 441,176 shares of
Series C and Series D Preferred Stock, respectively, and warrants to purchase
180,000 shares of Common Stock with an exercise price of $6.70 per share for an
aggregate purchase price of $15.0 million.

(9) Effective April 12, 1999, we completed an IPO of our Common Stock.  A total
of 10,781,250 shares of Common Stock were issued at $21.00 per share for
aggregate proceeds of approximately $210.1 million after payment of underwriting
fees and related issue costs.  Upon completion of the offering, all classes of
outstanding Preferred Stock automatically converted to Common Stock, resulting
in an additional 51,076,051 shares of Common Stock being issued, leaving no
shares of Preferred Stock issued and outstanding at that time.

(10) In April 1999, we issued $325.0 million aggregate principal amount of 12
3/4% senior notes due 2009 for net proceeds of approximately $314.5 million,
before $113.2 million that was escrowed to pay the first six scheduled interest
payments.  The notes are redeemable at our option, in whole or in part, at any
time after April 15, 2004, at predetermined redemption prices, together with any
accrued and unpaid interest through the date of redemption.  Upon a change of
control, each holder of the senior notes may require us to purchase the notes at
101% of the principal amount thereof, plus any accrued and unpaid interest to
the date of purchase.  The 1999 senior notes contain restrictive covenants,
including limitations on future indebtedness, restricted payments, transactions
with affiliates, liens, sale of stock of subsidiaries, entering new lines of
business, dividends, mergers and transfer of assets.  Effective September 17,
1999, we completed an exchange offer of the 12 3/4% senior notes that allowed
for registration of such notes under the Securities Act.  Of the original issue
notes, $325.0 million were tendered for exchange.  The registered notes have
substantially the same terms and conditions as the unregistered notes, except
that the registered notes are not subject to the restrictions on resale or
transfer that applied to the unregistered notes.

(11) Effective August 17, 1999, we completed a secondary public offering of our
Common Stock in a transaction that allowed certain holders of warrants issued in
connection with the 13 1/2% senior discount notes to exercise those warrants and
sell the resulting Common Stock at $29.00 per share.  In connection with the
secondary offering, the underwriters of the offering were allowed to purchase
594,279 shares of Common Stock from us for $29.00 per share.  The sale of these
shares was completed on September 14, 1999, for aggregate proceeds of $16.4
million, net of underwriting discount.

(12) In February 2000, we issued $300.0 million aggregate principal amount of
14% senior notes due 2010 for net proceeds of approximately $291.3 million.  The
notes are redeemable at our option, in whole or in part, at any time after
February 15, 2005, at predetermined redemption prices, together with any accrued
and unpaid interest through the date of redemption.  Upon a change of control,
each holder of the senior notes may require us to purchase the notes at 101% of
the principal amount thereof, plus any accrued and unpaid interest to the date
of purchase.  The 2000 senior notes contain restrictive covenants, including
limitations on future indebtedness, restricted payments, transactions with
affiliates, liens, sale of stock of subsidiaries, entering new lines of
business, dividends, mergers and transfer of assets. Effective May 23, 2000, we
completed an exchange offer of the 14% senior notes that allowed for
registration of

                                       26
<PAGE>

such notes under the Securities Act. Of the original issue notes, $300.0 million
were tendered for exchange. The registered notes have substantially the same
terms and conditions as the unregistered notes, except that the registered notes
are not subject to the restrictions on resale or transfer that applied to the
unregistered notes.

(13) In February and March 2000, we issued 3,000,000 shares of 6 3/4% Series F
Cumulative Convertible Preferred Stock in a private placement.  Net proceeds
were approximately $291.0 million.  Each share of Series F Preferred Stock is
convertible into 2.35 shares of Common Stock at any time at a conversion price
of $42.56 per share, subject to adjustment.  Holders of Series F Preferred Stock
are entitled to dividends on a cumulative basis at an annual rate of 6 3/4%,
payable quarterly in cash.  The Preferred Stock is redeemable at our option, in
whole or in part, at any time after March 6, 2003, at predetermined redemption
prices, together with any accrued and unpaid dividends through the date of
redemption.  Upon a change of control, each holder of the preferred shares may
require us to purchase any or all of the shares at 100% of the liquidation
preference, plus any accrued and unpaid dividends to the date of purchase.  The
Series F Preferred Stock is subject to mandatory redemption on March 3, 2012.
On August 25, 2000, we filed a Form S-3 (Registration Statement No.  333-38334)
registering the 3,000,000 shares of the Series F Cumulative Convertible
Preferred Stock, and the underlying Common Stock issuable upon conversion of the
Series F Cumulative Convertible Preferred Stock.

(14) In March 2000, we sold $250.0 million of 8 1/4% Series E Convertible
Preferred Stock to Hicks, Muse, Tate & Furst Incorporated (HMTF) for net
proceeds of approximately $235.7 million.  Each share of Series E Preferred
Stock is convertible into shares of Common Stock at any time at a conversion
price of $37.50 per share, subject to adjustment.  In addition, we issued HMTF
warrants to purchase 1,875,000 shares of Common Stock at an exercise price of
$45.00 per share, exercisable for three years from the date of issuance;
1,875,000 shares of Common Stock at an exercise price of $50.00 per share,
exercisable for five years from the date of issuance; and 1,875,000 shares of
Common Stock at an exercise price of $55.00 per share, exercisable for seven
years from the date of issuance.

(15) From December 31, 1997, through December 31, 2000, we granted stock options
to purchase an aggregate of 19,831,585 shares of Common Stock to employees and
consultants with aggregate exercise prices ranging from $.21 to $56.94 per share
pursuant to our stock option plan.  As of December 31, 2000, 8,938,019 shares of
Common Stock have been issued upon exercise of options.  We filed a Form S-8, as
amended (Registration Statement 333-72995), registering the issuance of shares
of Common Stock under our stock option plans.

(16) From December 31, 1997, through December 31, 2000, we granted stock awards
in an aggregate of 3,172,245 shares of Common Stock to employees and consultants
at no cost per share pursuant to our stock award plan.  As of December 31, 2000,
677,527 shares of Common Stock have been issued under the stock award plan.  We
filed a Form S-8, as amended (Registration Statement 333-72995), registering the
issuance of shares of Common Stock under our stock option plans, and filed two
Form S-8s (Registration Statements 333-38986 and 333-41874) registering
3,000,000 shares of Common Stock for issuance under our 2000 Stock Award Plan.

No underwriters were used in connection with these sales and issuances except
for the issuance of the senior discount notes and related warrants in (5) above;
issuances of Common Stock in our public and secondary offerings in (9) and (11)
above, issuance of senior notes in (10) and (12) above and issuances of
Preferred Stock in (13) above.  The sales and issuances of these securities,
except for those in (5), (9), (10), (11), (12) and (13) above, were exempt from
registration under the Securities Act pursuant to Rule 701 promulgated
thereunder on the basis that these securities were offered and sold either
pursuant to a written compensatory benefit plan or pursuant to written contracts
relating to consideration, as provided by Rule 701, or pursuant to Section 4(2)
thereof on the basis that the transactions did not involve a public

                                       27
<PAGE>

offering. The sales and issuance in (5), (12), (13) and (14) above were exempt
from registration under the Securities Act pursuant to Section 4(2) and, in
connection with the resale by the initial purchasers of the securities described
above, Rule 144A thereunder.

Use of Proceeds

We continue to use the remaining net proceeds from our IPO and other securities
offerings as follows:

     .  to fund the expenditures incurred in the continuing deployment of
        network services in our existing markets;
     .  for expenses associated with the continued development of our sales and
        marketing activities;
     .  to fund the addition of subscribers or end users;
     .  to fund operating losses;
     .  to pay interest on our debt obligations; and
     .  for general corporate purposes.

We have also invested them in short-term, investment grade securities to the
extent permitted by the covenants in our Indentures and the applicable debt and
statistical asset tests imposed by the Investment Company Act of 1940.

                                       28
<PAGE>

The actual amounts we spend have varied and will vary significantly depending
upon a number of factors, including future revenue growth, if any, capital
expenditures, the amount of cash generated by our operations and other factors,
many of which are beyond our control.  Additionally, we may modify the number,
selection and timing of our entry and/or expansion with respect to any or all of
our targeted markets.  Accordingly, our management has and will retain broad
discretion in the expenditure of available funds.

                                       29
<PAGE>

Item 6 - Selected Financial Data

  The following table sets forth the Selected Consolidated Financial Data for
the Company.  Such data should be read in conjunction with the Company's
Consolidated Financial Statements and the notes thereto incorporated into this
report in Item 8 and Management's Discussion and Analysis of Financial Condition
and Results of Operations.

<TABLE>
<CAPTION>
(In thousands, except per share amounts)
-------------------------------------------------------------------------------------------------------------------
                                                              Period From
                                                           February 27, 1997,
                                                              (Inception)                     Year Ended
                                                                Through                      December 31,
                                                              December 31,    ----------------------------------------
                                                                 1997             1998          1999           2000
----------------------------------------------------------------------------------------------------------------------
<S>                                                        <C>                <C>            <C>            <C>
Statement of Operations:
Revenue                                                    $         -        $     528      $  11,089      $   46,138
Operating expenses:
    Network and service costs                                        -            4,695         68,161         210,274
    Selling, marketing, general and administrative                 2,534         23,153        114,689         279,978
    Depreciation and amortization                                      1          1,081         12,639          49,968
    Amortization of deferred business acquisition costs              -              -            4,765          10,280
----------------------------------------------------------------------------------------------------------------------
      Total operating expenses                                     2,535         28,929        200,254         550,500
----------------------------------------------------------------------------------------------------------------------
Loss from operations                                              (2,535)       (28,401)      (189,165)       (504,362)
Interest and other income (expense)                                  113         (7,933)       (29,715)        (63,802)
----------------------------------------------------------------------------------------------------------------------
Net loss                                                   $      (2,422)     $ (36,334)     $(218,880)     $ (568,164)
======================================================================================================================
Net loss available to common shareholders                  $      (2,422)     $ (36,334)     $(218,880)     $ (606,917)
======================================================================================================================
Net loss per share (basic and diluted)                     $       (1.12)     $  (12.18)     $   (4.15)     $    (7.99)
======================================================================================================================

Balance Sheet:
Cash, cash equivalents, and short-term investments         $      10,166      $ 136,812      $ 340,255      $  504,494
Restricted cash                                            $         -        $     -        $  96,233      $   64,403
Total assets                                               $      12,241      $ 171,726      $ 685,424      $1,056,261
Total debt                                                 $         568      $ 158,270      $ 506,140      $  832,278
Mandatorily redeemable common stock warrants               $         -        $   6,567      $      42      $       42
Mandatorily redeemable preferred stock                     $         -        $     -        $     -        $  449,782
Total stockholders' equity (deficit)                       $      10,346      $  (6,747)     $ 116,287      $ (366,003)

Other Financial Data:
EBITDA  (1)                                                $      (2,342)     $ (26,562)     $(167,870)     $ (432,471)
Adjusted EBITDA  (2)                                       $      (2,342)     $ (24,970)     $(146,250)     $ (368,579)
Net cash used for operating activities                     $      (1,560)     $ (19,024)     $(153,774)     $ (453,519)
Net cash used for investing activities                     $      (1,345)     $(139,032)     $(471,401)     $ (396,659)
Net cash provided by financing activities                  $      13,071      $ 169,205      $ 652,107      $ (813,375)
</TABLE>

(1)  EBITDA consists of the net loss excluding net interest, depreciation and
     amortization of capital assets, deferred business acquisition costs,
     deferred compensation expense, litigation settlement and equity losses of
     affiliates. EBITDA is presented to enhance an understanding of our
     operating results and is not intended to represent cash flow or results of
     operations in accordance with generally accepted accounting principles for
     the period indicated and may be calculated differently than EBITDA for
     other companies.

(2)  Adjusted EBITDA reflects EBITDA excluding total operating lease expenses to
     GATX and Cisco Systems Capital Corporation (Cisco). No amounts were
     incurred to GATX and Cisco for operating leases in 1997. Total operating
     expenses for the year ended December 31, 1998, include $1.6 million of
     operating lease

                                       30
<PAGE>

     expense to GATX. Total operating expenses for the years ended December 31,
     1999, and December 31, 2000, include $21.6 million and $63.9 million of
     operating lease expense to GATX and Cisco.


Item 7 - Management's Discussion and Analysis of Financial Condition and Results
of Operation

Overview

We are a leading service provider of broadband local access communication
services to businesses and consumers.  As of December 31, 2000, we offered our
services in 60 markets in the U.S. representing 97 of the MSAs.  We have
approximately 1,850 built or operational COs.  In January 2001, we announced
that, although we intended to maintain a physical presence in all 60 markets and
1,850 COs, we planned to focus on, and provide services in, only our top 40
markets, representing approximately 1,400 COs.  We continue to review the number
of markets we are in, the number of COs we operate, the size of our work force
and our other SG&A costs with a view to conserving cash and enhancing our
ability to achieve future profitability.

As of December 31, 2000, we had approximately 67,000 DSL lines in service.

Since our inception in February 1997, our primary activities have consisted of:

     .  obtaining required governmental authorizations;
     .  negotiating and executing interconnection agreements with ILECs;
     .  identifying collocation space and locations for our connection points,
        Metro Service Centers and business offices;
     .  acquiring and deploying equipment and facilities;
     .  raising capital;
     .  hiring management and other personnel;
     .  entering into strategic alliances, joint ventures and similar projects
        with industry partners;
     .  adding end user subscribers to our network;
     .  conducting various marketing and sales activities;
     .  creating and expanding relationships with new and existing customers;
     .  implementing process improvement and quality programs; and
     .  developing and integrating our operations support system and other back
        office systems.

During 1999, we continued the development of our business operations as follows:

     .  entered 28 new markets for a total of 38 markets at December 31, 1999;
     .  added 1,025 COs for a total of 1,225 COs at December 31, 1999;
     .  added 12,000 DSL lines for a total of 12,500 DSL lines at December 31,
        1999; and
     .  increased headcount by 1,090 employees for a total of approximately
        1,250 employees at December 31, 1999.

During 2000, we continued the development of our business plan as follows:

     .  entered 22 new markets for a total of 60 markets at December 31, 2000;
     .  added 625 COs for a total of 1,850 COs at December 31, 2000;
     .  added 54,500 DSL lines for a total of 67,000 DSL lines at December 31,
        2000; and

                                       31
<PAGE>

     .  increased headcount by approximately 750 employees for a total of
        approximately, 2000 employees at December 31, 2000.

See Part I, Item 1  - Developments Since December 31, 2000 for a discussion of
developments during the first quarter of 2001.

We have incurred operating losses, net losses and negative operating cash flow
for each month since our formation.  As of December 31, 1999 and 2000, we had
accumulated deficits of $257.6 million and $825.8 million, respectively.  Such
losses are expected to continue for at least the next several years.

Results of Operations

2000 Compared to 1999

Revenue

We recorded $46.1 million in revenue in 2000 compared to $11.1 million in
revenue in 1999. Revenue consisted of net monthly recurring service fees of
$39.8 million in 2000 compared to $7.5 million in 1999.  Nonrecurring net
installation revenue totaled $6.3 million compared to $3.6 million in 1999.  The
significant increase in revenue in 2000 compared to 1999 is a result of
increased subscriber growth and network deployment in 60 markets compared to 38
markets one year ago.

Effective January 1, 2000, we adopted the Securities and Exchange Commission
(SEC) Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements" (SAB 101).  SAB 101 sets forth certain SEC views on how revenue
should be recognized and whether revenues can be split among associated elements
of a contract.  Based on our review of SAB 101, we determined that certain
revenues associated with installation and equipment sales should be deferred and
recognized over the expected customer life.  Costs associated with these
revenues up to the amount of deferred revenues are also deferred and amortized
over the expected customer life.  Costs in excess of revenues have also been
deferred and are being amortized over the contractual life.  The impact of the
adoption of SAB 101 had no impact on the net loss in 2000.  Net revenue deferred
at December 31, 2000, was $12.4 million.

Network and Service Costs

Network and service costs in 2000 were $210.3 million compared to $68.2 million
in 1999.  The increase in network and service costs is attributable to the
expansion of our network and continued growth in our subscriber base.

Selling, Marketing, General and Administrative

Selling, marketing, general and administrative expenses in 2000 were $280.0
million compared to $114.7 million in 1999.  This increase reflected continued
growth in staffing levels, sales and marketing efforts, and legal expenses
associated with the development and launch of new markets, service delivery and
customer service efforts.  Selling, marketing, general and administrative
expenses included deferred compensation expense of $11.7 million in 2000
compared to $3.7 million in 1999.  This increase reflects the granting of stock
awards and stock options to employees and officers with prices below the per
share fair market values of our Common Stock on the grant dates.  The deferred
compensation is amortized over the vesting period of such grants, typically four
years.

                                       32
<PAGE>

Depreciation and Amortization

Depreciation and amortization in 2000 was $50.0 million compared to $12.6
million in 1999.  This increase reflects the build out of our system
infrastructure, as well as rapid expansion of our network into 60 markets in the
U.S. at December 31, 2000, a 58% increase compared to the 38 markets at December
31, 1999.

During the first and second quarters of 1999, we entered into strategic
arrangements with Microsoft Corporation (Microsoft) and Qwest.   In addition to
their investments in the Company totaling $45.0 million, the strategic
arrangements provide for certain other business relationships.  Combined, these
business relationships were valued at $23.2 million and have been capitalized as
deferred assets, which are being amortized over three- and five-year periods.
In 2000, $10.3 million in amortization for deferred business acquisition costs
was recorded compared to $4.8 million in 1999.  Included in the 2000 amount is
$4.0 million resulting from our determination that the remaining capitalized
costs associated with our relationship with Microsoft were impaired.

Net Interest Income and Expense

Interest income in 2000 was $51.3 million compared to $22.7 million in 1999.
The increase is primarily attributable to an increase in invested cash balances.
As of December 31, 2000, unrestricted cash and investments totaled $504.5
million compared to $340.3 million at December 31, 1999.  The increase in
invested cash balances during 2000 resulted from a variety of financing
activities, including:

     .  issuing $300 million of 14% Senior Notes in February 2000 for net cash
        proceeds of $291.3 million;
     .  issuing $250 million of Series E Preferred Stock and warrants in the
        first quarter of 2000 for net cash proceeds totaling $235.7 million; and
     .  issuing $300 million of 6 3/4% Series F Cumulative Convertible Preferred
        Stock in February and March 2000 for net cash proceeds of $291.0
        million.

Interest expense and amortized debt discount and issue costs increased to $105.2
million in 2000 compared to $52.5 million in 1999.  This increase primarily
resulted from the Senior Notes issued in February 2000.

Litigation Settlement

See Part I, Item 3 - Legal Proceedings above for background information
concerning the Lafleur litigation and the terms of the settlement thereof which
occurred in the first quarter of 2000.

Equity in Losses of Affiliate

Equity in losses of affiliates are $2.4 million in 2000 compared to $0 for 1999.
This amount represents the equity losses we are recording for our strategic
investments made during 2000.

Income Taxes

We generated net operating loss carryforwards of  approximately $21.2 million,
$186.9 million and $501.3 million in 1998, 1999 and 2000, respectively, which
are available to offset future taxable income through 2020 for federal tax
purposes.  We expect significant consolidated losses for the foreseeable future
that will generate additional net operating loss carryforwards. However, our
ability to use net operating losses may be subject to annual limitations. In
addition, income taxes may be payable during this time due to operating income
in certain tax jurisdictions. In the future, if we achieve operating profits and
the net operating losses have been exhausted or have expired, we may incur
significant tax expense. Any tax benefit has been offset by a full valuation
allowance because we do not currently believe it is more likely than not that
these benefits will be realized.

                                       33
<PAGE>

1999 Compared to 1998

Revenue

We recorded $11.1 million in revenue in 1999 compared to $0.5 million in revenue
in 1998. Revenue consisted of net monthly recurring service fees of $7.5 million
in 1999 compared to $0.3 million in 1998.  Nonrecurring net installation revenue
totaled $3.5 million for 1999 compared to $0.2 million in 1998.  We recorded
late fees of $0.1 million in 1999 compared to none in 1998. The substantial
increase in revenue in 1999 is a result of our increased sales and marketing
efforts and continued network deployment.  Each new market we entered provided
us with an additional revenue opportunity, but also higher costs until we have
an established customer base in the market.

Network and Service Costs

Our network and service costs for 1999 were $68.2 million compared to $4.7
million in 1998. Network and service costs in 1999 increased as a result of our
continued network deployment.

Selling, Marketing, General and Administrative

Our selling, marketing, general and administrative expenses were $114.7 million
in 1999 compared to $23.2 million in 1998. This increase reflected our continued
growth in staffing levels, sales and marketing efforts, and legal expenses
associated with the development and launch of new markets. Deferred compensation
expense increased to $3.7 million in 1999 as compared to $0.7 million in 1998
and reflected the granting of stock options to our employees and officers with
per share exercise prices below the per share fair values of our Common Stock at
the dates of grant.  The deferred compensation is amortized over the vesting
period of the applicable options, typically four years.

Depreciation and Amortization

Depreciation and amortization in 1999 was $12.6 million compared to $1.1 million
recorded in 1998.  This increase reflected the rapid expansion of our network,
as discussed above, and included amortization of collocation fees and
depreciation on operating equipment as we began service in each new location.

During the first and second quarters of 1999, we entered into strategic
arrangements with Microsoft and Qwest. In addition to their investments in us
totaling $45.0 million, the strategic arrangements provided for certain other
business relationships. Combined, these business relationships were valued at
$23.2 million, and we have capitalized these costs as deferred assets. These
assets are amortized over three- and five-year periods. Accordingly, during 1999
we recorded $4.8 million in amortization for deferred business acquisition costs
that have no corresponding amortization in 1998.

Net Interest Income and Expense

During 1999, we recorded interest income of $22.7 million compared to $5.8
million in 1998. The increase between years resulted primarily from a
substantial increase in invested cash balances. As of December 31, 1999, we had
unrestricted cash and investments totaling $340.3 million compared to
unrestricted cash and investments of $136.8 million at December 31, 1998. The
increase during 1999 resulted from a variety of financing activities, including:

     .  issuing Series C and Series D Preferred Stock and warrants for cash
        proceeds totaling $75.0 million in March and April 1999 (all of which
        converted into Common Stock in the IPO);
     .  issuing Common Stock upon our IPO in April 1999 for net cash proceeds of
        $210.1 million;

                                       34
<PAGE>

     .  issuing 12 3/4% senior debt in April 1999 for net cash proceeds of
        $314.5 million;
     .  executing additional equipment lease lines of $100.0 million; and
     .  issuing Common Stock in our secondary public offering in September 1999
        for net cash proceeds of $16.4 million.

Interest expense and amortized debt discount and issue costs increased
significantly to $52.5 million in 1999 as compared to $13.8 million in 1998.
This increase primarily resulted from the senior notes we issued in April 1999.

Income Taxes

We generated net operating loss carryforwards of $21.2 million and $186.9
million in  1998 and 1999, respectively.  We expect significant consolidated
losses for the foreseeable future that will generate additional net operating
loss carryforwards. However, our ability to use net operating losses may be
subject to annual limitations. In addition, income taxes may be payable during
this time due to operating income in certain tax jurisdictions. In the future,
if we achieve operating profits and the net operating losses have been exhausted
or have expired, we may incur significant tax expense  Any tax benefit has been
offset by a full valuation allowance because we currently believe it is unlikely
that these benefits will be realized.

Liquidity and Capital Resources

During 2000, we obtained additional financing for our operations and network
primarily through:

     .  issuing $300 million of 14% Senior Notes in February 2000 for net cash
        proceeds of $291.3 million;
     .  issuing $250 million of Series E Preferred Stock and warrants in the
        first quarter of 2000 for net cash proceeds totaling $235.7 million;
     .  issuing $300 million of 6 3/4% Series F Cumulative Convertible Preferred
        Stock in February and March 2000 for net cash proceeds of $291.0
        million; and
     .  obtaining equipment vendor financing lease lines of $125.0 million.

Refer to Note 4 and Note 6 of the accompanying consolidated financial statements
for terms and descriptions of these transactions.

In 2000, net cash used in operating activities was $453.5 million compared to
$153.8 million in 1999. This cash was used for a variety of operating purposes,
including salaries, consulting and legal expenses, network operations and
overhead expenses. The increase in the use of cash in 2000 compared to 1999 is
primarily attributable to the expansion of the scope or our operations. Net cash
used for investing activities in 2000 was $396.7 million compared to $471.4
million in 1999. This cash was used primarily for purchases of short-term
investments and equipment and payments of collocation fees. Net cash provided by
financing activities in 2000 was $813.4 million compared to $652.1 million in
1999 and resulted primarily from the issuance of Preferred Stock, Common Stock
and senior debt.

In 1999, net cash used in our operating activities was $153.8 million. This cash
was used for a variety of operating purposes, including salaries, consulting and
legal expenses, network operations and overhead expenses. Our net cash used for
investing activities in 1999 was $471.4 million and was used primarily for
purchases of short-term investments and equipment and payments of collocation
fees. Net cash provided by financing activities in 1999 was $652.1 million and
primarily came from the issuance of Common Stock and Senior Notes.

                                       35
<PAGE>

In 1998, net cash used in our operating activities was $19.0 million.  This cash
was used for a variety of operating purposes, including salaries, consulting and
legal expenses, network operations and overhead expenses.  Our net cash used for
investing activities in 1998 was $139.0 million and was used primarily for
purchases of short-term investments and equipment and payments of collocation
fees.  Net cash provided by financing activities in 1998 was $169.2 million and
primarily came from the issuance of the senior discount notes and from the
issuance of Preferred Stock.

The development and expansion of our business require substantial capital
expenditures.  During 2000, these capital expenditures primarily included
network build costs such as the procurement, design and construction of
connection points and one or two MSCs in each market, as well as other costs
that support the network design and development. Capital expenditures, including
payments for collocation fees, were $202.4 million in 2000. We expect our
capital expenditures to be lower in future periods, since our initial network
build out is substantially complete.  We anticipate, our capital expenditures in
2001 will be approximately $75 million.

In January 2001, we announced that although we intended to maintain a physical
presence in all 60 markets and approximately 1,850 COs, we planned to focus on,
and provide services in, our top 40 markets representing approximately 1,400
COs.  This will enable us to conserve cash and enhance our ability to achieve
future profitability.

We have substantial indebtedness and debt service obligations. At December 31,
2000, total indebtedness was $832.3 million, cash and investments totaled $568.9
million ($64.4 million of which is restricted in accordance with the terms of
the Company's 1999 Senior Notes) and the accumulated deficit was $825.8 million.
In addition, the Company has operating lease payments of approximately $221.9
million due over the next three years. In January 2001, one of our leasing
companies, GATX, notified us that an event of default had occurred under their
lease program because of our failure to meet the operating cash flow covenant.

The indentures for our 1998 senior discount notes and the 1999 and 2000 senior
notes contain covenants that limit our ability to:

     .  pay dividends on, redeem or repurchase our capital stock;
     .  incur additional debt;
     .  make investments;
     .  consolidate, merge or transfer all or substantially all of our assets;
        and
     .  make dividend or other payments to us by our restricted subsidiaries.

We are not generating sufficient revenue to fund our operations or to repay debt
and Preferred Stock obligations. Our substantial leverage poses the risks that:

     .  we may be unable to obtain additional debt or equity funding;
     .  we may be unable to pay dividends on our Preferred Stock or to repay our
        debt; and
     .  we must dedicate a substantial portion of our cash flow from operations
        to service our debt and Preferred Stock.


                                       36
<PAGE>

As a result of the economic downturn, we may be unable to withstand competitive
pressures and we may be unable to respond to changing business and economic
conditions.

Subsequent to December 31, 2000:

     . In January 2001, as a result of our intention to focus on, and provide
       services in, only our top 40 markets and in connection with our plans to
       reduce our workforce by 450 employees, we announced our intent to take a
       one-time, 2001 first quarter restructuring charge between $15 and $17
       million.

     . In February 2001, our Compensation Committee approved a key management
       retention plan whereby certain key managers received cash and stock
       bonuses for remaining with us for specified periods of time.

     . In March 2001, our Board engaged Lazard Freres & Co. LLC, an investment
       banking firm, to provide financial advice and to assist us in evaluating
       strategic alternatives and other possible financial transactions,
       including, but not limited to, a sale of our Company, a strategic
       transaction, joint venture or partnership with a financial, strategic or
       industry partner or other similar transaction, a debt and/or equity
       financing or restructuring, a public or private sale of debt or equity
       securities or assets, and/or acquisition, merger, consolidation,
       reorganization, recapitalization or other business combination. In
       conjunction with our strategic alternative initiatives, we are continuing
       to review the number of markets we are in, the number of COs we operate,
       the size of our workforce and our other SG&A costs with a view to
       conserving cash and enhancing our ability to achieve future
       profitability. While we will consider all commercially reasonable
       strategic alternatives, there can be no assurance that a transaction will
       be consummated on terms acceptable to our Board, or at all.

     . In March 2001, we entered into an Assignment of DSL Lines and Mutual
       Release with SEH. Pursuant to that agreement and in exchange for a mutual
       release by both parties of any claims either may have against the other:
       (a) SEH agreed to assign to us all of its rights to the line share DSL
       circuits installed by us or ordered from us and not yet installed; and
       (b) we agreed to convert approximately $1.0 million of accounts
       receivable that SEH owed to us as of February 28, 2001, and approximately
       $2.9 million in funds we prepaid to Winfire for marketing and
       development into 2,034,878 additional shares of Series C Preferred Stock
       of SEH.

We believe that our cash and investment balances as of December 31, 2000, and
anticipated future revenue generated from operations and lease financing
proceeds should be sufficient to fund our operating losses, capital
expenditures, lease payments and interest payments into January 2002.
Significant operating losses are expected to continue, which will require
additional financing.

Item 7A - Quantitative and Qualitative Disclosures About Market Risk

We maintain an investment portfolio of cash and cash equivalents, short-term
investments, accounts receivable and investments in privately held companies.
We have no investments in any publicly traded securities of other companies,
except for Axxent, which is listed on the Toronto Stock Exchange and is recorded
at fair market value.  The carrying amounts for all of these investments, other
than investments in privately held companies, approximate fair value because of
the immediate or short-term maturity of these financial instruments.  The
carrying amounts reported for long-term debt, other than our Indenture debt,
approximate fair value based upon management's best estimates of what interest
rates would be available for the same or similar instruments.  Our Indenture
debt is publicly traded.  The combined quoted fair market

                                       37
<PAGE>

value and the combined carrying amount of our Indenture debt at December 31,
2000, was $197.5 million and $832.2 million, respectively. Certain of our
investments in privately held companies are classified as available-for-sale
securities and are carried at fair value, with the net unrealized gains or
losses, net of taxes, reported as a separate component of stockholders' equity.
Many of the privately held companies that we have invested in can still be
considered in the start-up or development stages. These investments are
inherently risky as the market for the technologies or products they have under
development are typically in the early stages and may never materialize. We
could lose our entire initial investment in these companies.

Financial instruments, which potentially subject us to concentration of credit
risk, consist primarily of cash equivalents and short term investments.  We have
invested our cash in excess of operation needs in money market funds,
certificates of deposit with high quality financial institutions, obligations of
the U.S.  government and its agencies and commercial paper rated A-1, P-1 to
minimize credit risk as well as interest rate risk.  Because of the extremely
short-term nature of our investment portfolio, we believe that increases or
decreases in interest rates should not have a material adverse impact on the
fair value of our investment portfolio.  We do not currently hedge interest rate
exposures.

Item 8 - Financial Statements and Supplementary Data

The financial statements required pursuant to this item are included in Item 14
of this Form 10-K and are presented beginning on page F-1.

Item 9 - Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures

None.

                                   PART III

Item 10 - Directors and Executive Officers of the Registrant

Members of our Board of Directors

Directors

Susan Mayer, 51, has been one of our directors since March 1999.  Ms. Mayer is
the president of WorldCom Ventures (f/k/a MCI WorldCom Venture Fund) and a
senior vice president and treasurer of WorldCom (f/k/a MCI WorldCom Inc.).
Previously, she was senior vice president of MCI Communications Corporation from
1993 to 1998.  From 1996 to 1997, Ms. Mayer was also president and chief
operating officer of Sky MCI.  Ms. Mayer is a director of LCC International,
Inc. and several other privately held companies.  Ms. Mayer's term as a director
ends upon our 2001 Annual Meeting of Stockholders (2001 Annual Meeting).

William R. Stensrud, 50, has been a director since our inception in February
1997 and also served as our president and chief executive officer from February
1997 to June 1997.  Mr. Stensrud has been a general partner at the venture
capital investment firm of Enterprise Partners since January 1997.  From June
1996 through December 1996, Mr. Stensrud served as president of Paradyne
Corporation.  Previously, from February 1992 to March 1996, Mr. Stensrud served
as president and chief executive officer of Primary Access Corporation.  Mr.
Stensrud is a director of Juniper Networks, Inc., Paradyne Networks, Inc.
(Paradyne), a DSL equipment manufacturer and supplier to us, Packateer, Inc.,and
several privately held companies.  Mr. Stensrud was elected a director as the
nominee of Enterprise Partners, under the terms of a voting agreement.  Mr.
Stensrud's term as a director ends upon our 2001 Annual Meeting.

                                       38
<PAGE>

Catherine M. Hapka, 46, has been our chief executive officer  and a director
since June 1997.  In addition, she was elected chairman of the Board in June
1999.  Prior to joining us, Ms. Hapka served as president of NETS, Inc., an
electronic commerce software company, from March 1997 to May 1997.  NETS, Inc.
filed a bankruptcy petition in May 1997.  Prior to joining NETS, Inc., Ms. Hapka
served as executive vice president, Markets, for US WEST Communications, Inc.
from January 1995 to October 1996.  In this capacity, Ms. Hapka led business and
consumer telecommunications units responsible for the voice, data, wireless,
video and long distance businesses.  Ms. Hapka is a director of Avici Systems,
Inc., FireTap and a privately held company.  We are a stockholder of FireTap.
Ms. Hapka is also a director of our following wholly-owned subsidiaries: Links,
Links VA, Rhythms NetConnections Europe B.V.  (Rhythms Europe) and Rhythms
Deutschland GmbH (Rhythms Deutschland).  In addition, Ms. Hapka also serves as
the chief executive officer of Links and Links VA.  Ms. Hapka's term as a
director ends upon our 2002 Annual Meeting of Stockholders (2002 Annual
Meeting).

Kevin R. Compton, 41, has been a director since July 1997.  Since 1990, Mr.
Compton served as a general partner of Kleiner Perkins Caufield & Byers, a
venture capital investment firm.  Mr. Compton is a director of Citrix Systems,
Inc., 360networks inc., VeriSign, Inc. and Corsair Communications, Inc., and is
also a director of several privately held companies.  Mr. Compton was elected a
director as the nominee of Kleiner Perkins Caufield & Byers under the terms of a
voting agreement.  Mr. Compton's term as a director ends upon our 2002 Annual
Meeting.

Keith B. Geeslin, 47, has served as a director since July 1997. Mr. Geeslin has
been employed by the Sprout Group, a venture capital investment firm, since
1984. Since April 2000, Mr. Geeslin has served as the managing general partner
of The Sprout Group. Mr. Geeslin is a director of GlobeSpan Corporation,
Innoveda, Inc. and Paradyne and is also a director of several privately held
companies.  Mr. Geeslin was elected a director as the nominee of the Sprout
Group, under the terms of a voting agreement.  Mr. Geeslin's term as a director
ends upon our 2003 Annual Meeting of Stockholders.

Michael J. Levitt, 42, is a partner of HMTF.  Mr. Levitt is involved in
originating, structuring and monitoring HMTF's investments and in building
relationships with investment banks and commercial banking firms worldwide.  Mr.
Levitt serves as a director of AMFM Corp., AMFMi Corp., Awards.com, El Sitio,
Inc., G.H.  Mumm/Perrier Jouet & Cie., Globix Corporation, i.Party Corp., and
Ibero American Media Partners, L.P.  Mr. Levitt was elected a director as the
nominee of HMTF and its affiliates, the holders of the Series E stock.  Pursuant
to the terms of the Series E Preferred Stock Purchase Agreement, HMTF and its
affiliates have the right to appoint one representative to the Board provided
that they continue to hold 40% of the Series E stock or the underlying Common
Stock or any combination thereof.

John Walecka and Edward J. Zander both resigned their positions on the Board in
February 2001.

Director compensation

Directors do not receive compensation for services provided as a director or for
participation on any committee of our Board.  All directors are reimbursed for
their out-of-pocket expenses in serving on our Board or any of the Board's
committees.

Executive Officers

Catherine M.  Hapka.  Ms. Hapka's biography is included in Part III, Item 10 -
Directors and Executive Officers of the Registrant - Members of Our Board of
Directors above.

Steve Stringer, 46, has been our president and chief operating officer since May
1999. Prior to joining us, Mr. Stringer served in various positions at GE
Capital from 1991 to May 1999, most recently as global

                                       39
<PAGE>

chief operating officer of GE Capital IT Solutions. At GE Capital, Mr. Stringer
also held the position of president and chief executive officer of the United
States Division, president of the Midwest and Atlantic regions and chief
executive officer of GE Capital's Federal System group. Mr. Stringer is (1) the
president and chief operating officer for Links and Links VA, (2) the president
and chief executive officer for RCanada, Inc. (RCanada), RATHM, Inc. (RATHM),
RGarnet, Inc. (RGarnet), RHOMS, Inc. (RHOMS), RMegaPath, Inc. (RMegaPath),
RAxxent, Inc. (RAxxent) and Rhythms Winfire, Inc. (Rhythms Winfire), all of
which are wholly owned subsidiaries of the Company and (3) on the advisory board
of Paradyne.

John (Jay) W. Braukman, 47, has been our Executive vice president and chief
financial officer since March 2000.  Prior to joining us, Mr. Braukman served in
various positions at GE for nearly 25 years.  Mr. Braukman's career with GE
spanned nine different business divisions including GE Motors, Transportation &
Power Systems along with GE Capital.  Most recently, Mr. Braukman was senior
vice president of Global Finance and chief financial officer at GE Capital IT
Solutions.  Mr. Braukman is both a director and the CFO for RCanada, RATHM,
RGarnet, RHOMS, RMegaPath, RAxxent and Rhythms Winfire and was a director of
Solutions from April 2000 through March 2001.

Scott C. Chandler, 39, has served as our senior vice president, global business
development, since March 2000.  Prior to that, Mr. Chandler served as our chief
financial officer starting in March 1998.  From August 1996 to April 1998, Mr.
Chandler served as president and chief executive officer of C-COR.net, a
manufacturer of broadband telecommunications equipment.  From June 1990 to
August 1996, Mr. Chandler served in various positions at U S WEST and its
subsidiaries, most recently as vice president and general manager of U S WEST
Cable and Multimedia from September 1995 to August 1996.  Mr. Chandler is a
director for Rhythms Europe, Rhythms Deutschland, Rhythms Canada and Garnet
Connections and was a director of Solutions from April 2000 through March 2001.

Rand A. Kennedy, 43, has served as our senior vice president , Networks, since
January 2000. Prior to that, Mr. Kennedy served as our vice president,
Engineering, starting in August 1997. Mr. Kennedy oversees the design,
engineering, construction and management of our networks nationwide, as well as
driving the design, implementation and management of the NOC in Denver,
Colorado. Mr. Kennedy was previously principal network architect for CompuServe
Incorporated. From 1995 to 1996, he directed the engineering of CompuServe's
global 500+ Points of Presence network. While at CompuServe, Mr. Kennedy was
awarded a U.S. patent for communications technology involving financial card
authorization. Mr. Kennedy has more than 17 years of experience designing and
implementing next-generation network architectures for CompuServe, including
frame relay, ATM and IP.


Section 16(b) Beneficial Ownership Reporting Compliance

The members of our Board, our executive officers and persons who hold more than
10% of our outstanding Common Stock are subject to the reporting requirements of
Section 16(a) of the Securities Exchange Act, which require them to file reports
with respect to their ownership of the Common Stock and their transactions in
such Common Stock.  Based upon (i) the copies of Section 16(a) reports that we
received from such persons for transactions in the Common Stock during 2000 and
their Common Stock holdings, and (ii) the written representations received from
one or more of such persons that no annual Form 5 reports were required to be
filed by them for 2000, we believe that all reporting requirements under Section
16(a) for such fiscal year were met in a timely manner by our directors,
executive officers and greater than 10% beneficial owners except as follows: (A)
Mr. Braukman did not timely report a transaction occurring in (i) the month of
April 2000, which he reported in his May 2000 Form 4 filing and (ii) the months
of October 2000 and November 2000, which he reported in his March 2001 Form 4
filing; (B) Mr. Stringer did not timely report a transaction occurring in the
month of February 1999, which reported in his March 2001

                                       40
<PAGE>

Form 4 filing; and (C) Mr. Walecka did not timely file a Form 4 for transactions
occurring in the month of July 2000, which he reported in his September 2000
Form 4 filing.

Item 11 - Executive Compensation

                 EXECUTIVE COMPENSATION AND OTHER INFORMATION

Summary of Cash and Certain Other Compensation

The following table provides certain summary information concerning the
compensation earned by our (1) chief executive officer, (2) each of our four
other most highly compensated executive officers and (3) two additional
individuals no longer employed by us, but who would have qualified as one of our
four most highly compensated executive officers, whose salary and bonus for 2000
exceeded $100,000, for services rendered in all capacities to us and our
subsidiaries for 2000, 1999 and 1998.  The listed individuals shall be
hereinafter referred to as the "Named Executive Officers."

                                       41
<PAGE>

                           Summary Compensation Table

<TABLE>
<CAPTION>
                                       Annual Compensation                   Long-Term Compensation
                                --------------------------------    --------------------------------------
                                                                              Awards               Payouts
                                                                    --------------------------     -------
                                                                    Restricted      Securities
Name and                                             Other annual      Stock        Underlying      LTIP      All Other
principal                       Salary     Bonus     Compensation      Awards      Options/SARs    Payouts   Compensation
position                Year     ($)        ($)           ($)           ($)             (#)          ($)          ($)
--------------------------------------------------------------------------------------------------------------------------
<S>                     <C>     <C>       <C>        <C>            <C>            <C>             <C>       <C>
Catherine Hapka         2000    364,903   276,838          -             -               -            -         170,000(1)
  Chairman and          1999    350,000   178,838          -             -            240,000(2)      -            -
  CEO                   1998    339,583   134,584          -             -               -            -            -

Steve Stringer          2000    309,606   187,923          -          327,000(3)      950,000(4)      -         130,000(1)
  President and         1999    157,690   150,000          -             -            720,252(4)      -          65,654(5)
  COO                   1998          -         -          -             -               -            -            -

Jay Braukman(6)         2000    206,252   126,250          -        2,542,500(3)      550,000(4)      -         141,749(7)
  EVP and CFO           1999          -         -          -             -               -            -            -
                        1998          -         -          -             -               -            -            -

Scott Chandler          2000    183,654    76,909          -          393,750(3)         -            -          65,250(1)
  SVP, Global           1999    180,962    44,509          -             -             96,000(2)      -          55,299(5)
  Business              1998    129,577    28,746          -             -            384,000(2)      -            -
  Development

Rand Kennedy            2000    193,447    65,265          -          393,750(3)      100,000(4)      -          81,563(1)
  SVP, Networks         1999    138,240    28,710          -             -             48,000(4)      -          19,828(5)
                        1998    132,000    11,000          -             -             24,000(2)      -

Michael Lanier(8)       2000    232,184    94,433          -          600,000(3)         -            -         317,500(9)
                        1999    186,538    49,433          -             -            300,000(4)      -          50,000(10)
                        1998          -         -          -             -               -            -            -

Richard Johnston(11)    2000    260,894   185,000          -          905,625(3)         -            -            -
                        1999    106,635    31,250          -             -            250,000(4)      -            -
                        1998          -         -          -             -               -            -            -
</TABLE>

(1)  Represents a retention bonus received.
(2)  Represents the number of shares of Common Stock issued upon the exercise of
     options.
(3)  Represents the dollar value of an award of shares of Common Stock.
(4)  Represents the number of shares of Common Stock that may be issued upon the
     exercise of options.
(5)  Represents actual costs related to relocation expenses and/or temporary
     living expenses.
(6)  Mr. Braukman has been employed since March 2000, and the amount listed sets
     forth his compensation since such date.
(7)  Represents a retention bonus of $99,688 and a reimbursement for relocation
     expenses of $42,061.
(8)  Mr. Lanier was employed as our CIO from April 1999 to November 2000, and
     the amounts listed set forth his compensation during such time.
(9)  Represents a severance payment.
(10) Represents a signing bonus.
(11) Mr. Johnston was employed by us from July 1999 through November 2000, most
     recently serving as our chief sales officer.  The amounts listed set forth
     his compensation during such time.

                                       42
<PAGE>

Stock Options and Stock Appreciation Rights

          The following table contains information concerning the stock options
granted to the Named Executive Officers during 2000.  All of the grants are
governed by the terms and conditions of our 1999 Stock Incentive Plan.  No stock
appreciation rights (SARs) were granted to the Named Executive Officers during
2000.

                           Options/SAR Grants in 2000

<TABLE>
<CAPTION>
                                                                                                  Potential Realizable
                                                  Individual Grants                                 Value at Assumed
                            -----------------------------------------------------------          Annual Rates of Stock
                             Number of       % of Total                                             Appreciation for
                            Securities        Options         Exercise                               Option Term(1)
                            Underlying       Granted to      Price Per                      ------------------------------
                              Options        Employees         Share        Expiration           5%               10%
       Name                 Granted (#)       in 2000        ($/Sh)(2)        Date(3)           ($)               ($)
--------------------------------------------------------------------------------------------------------------------------
<S>                         <C>              <C>             <C>           <C>              <C>              <C>
Catherine Hapka                 -                 -               -            -                 -                 -
 Chairman and
 CEO

Steve Stringer              150,000(4)           2.9%           21.94       5/4/10(4)          11,992(4)         30,390(4)
 President and COO           75,000(5)           1.5%           21.94       5/4/10(5)             n/a(5)            n/a(5)
                             25,000(6)           0.5%           21.94       5/4/10(6)         344,949(6)        874,168(6)
                            250,000              4.8%            1.09      11/30/10(7)        171,374           434,295
                            450,000              8.7%            1.09      11/30/10(8)        308,473           781,731

Jay Braukman                250,000              4.8%           31.52        4/2/10(9)      4,955,690        12,558,691
 EVP and CFO                 50,000              1.0%           20.00        4/2/10(10)       628,895         1,593,742
                            250,000              4.8%            1.09      11/30/10(7)        171,374           434,295

Scott Chandler                 -                  -               -             -                -                 -
 SVP, Global
 Business
 Development

Rand Kennedy                100,000              .02%           12.25        8/6/10(11)       770,396         1,952,335
 SVP, Networks

Michael Lanier                 -                  -               -             -                -                 -

Richard Johnston               -                  -               -             -                -                 -
</TABLE>

                                       43
<PAGE>

(1)  There can be no assurance provided to any executive officer or other holder
     of our securities that the actual stock price appreciation over the 10 year
     option term will be at the assumed 5% and 10% levels or at any other
     defined level.  Unless the market price of the Common Stock appreciates
     over the option term, no value will be realized from those option grants
     which were made to the Named Executive Officers with an exercise price
     equal to the fair market value of the option shares on the grant date.

(2)  The exercise price may be paid in cash or in shares of our Common Stock
     valued at fair market value on the exercise date. Alternatively, the option
     may be exercised through a cashless exercise procedure pursuant to which
     the optionee provides irrevocable instructions to a brokerage firm to sell
     the purchased shares and to remit to us, out of the sale proceeds, an
     amount equal to the exercise price plus all applicable withholding taxes.
     The Compensation Committee of our Board (Compensation Committee) may also
     assist an optionee in the exercise of an option by (i) authorizing a loan
     from us in a principal amount not to exceed the aggregate exercise price
     plus any tax liability incurred in connection with the exercise or (ii)
     permitting the optionee to pay the option price in installments over a
     period of years upon terms established by the Compensation Committee.

(3)  All the options, unless otherwise indicated, will become exercisable on an
     accelerated basis upon a liquidation or dissolution of the Company or a
     merger or consolidation in which there is a change in ownership of
     securities possessing more than 50% of the total combined voting power of
     our outstanding securities, unless the option is assumed by the surviving
     entity.  In addition, the Compensation Committee may accelerate the vesting
     of the option in the event (i) there is a change in the composition of the
     Board over a period of two years or less such that those individuals
     serving as Board members at the beginning of the period cease to represent
     a majority of the Board or (ii) change of ownership of securities
     possessing more than 50% of the total combined voting power of our
     outstanding securities pursuant to a hostile tender offer.

(4)  The option become exercisable quarterly in accordance with achievement of
     certain designated performance targets, starting with the target ended
     March 31, 2000.  Mr. Stringer only vested in 17,494 option shares.  The
     remaining 132,506 option shares were forfeited on December 31, 2000.

(5)  The option became exercisable at the end of 2000 in accordance with
     achievement of certain designated performance targets.  Mr. Stringer did
     not vest in any of these option shares.  All 75,000 option shares were
     forfeited on December 31, 2000.

(6)  The option became exercisable at the end of 2000 in accordance with
     achievement of certain designated performance targets.  Mr. Stringer vested
     in all 25,000 option shares.

(7)  The option will become exercisable in 12.5% equal installments on each of
     the following dates March 1, 2001, June 1, 2001, September 1, 2001,
     December 1, 2001, March 1, 2002, June 1, 2002, September 1, 2002, and
     December 1, 2002.

(8)  The option will become exercisable in 12.5% equal installments on each of
     the following dates:  April 1, 2001; July 1, 2001; October 1, 2001; January
     1, 2002; April 1, 2002; July 1, 2002; October 1, 2002 and January 1, 2003.

(9)  The option will become exercisable in 25% of the shares upon Mr. Braukman's
     completion of one year of service measured from the grant date and will
     become exercisable for the balance of the shares in 36 successive equal
     monthly installments upon completion of each additional month of service
     thereafter.

(10) The option became exercisable in 24 equal monthly installments starting on
     April 30, 2000.

(11) The option will become exercisable in 25% of the shares on August 8, 2001,
     and will become exercisable for the balance of the shares in 36 successive
     equal monthly installments upon completion of each additional month of
     service thereafter.

                                       44
<PAGE>

Aggregated Option\SAR Exercises and 2000 Year-End Values

The following table provides information, with respect to the Named Executive
Officers, concerning the exercise of options during 2000 and unexercised options
held by them at of the end of 2000.  None of the Named Executive Officers
exercised any SARs during 2000, and no SARs were held by the Named Executive
Officers at the end of 2000.

         Aggregated Options Exercised in 2000 and 2000 Year-End Values

<TABLE>
<CAPTION>
                                                            Number of Unexercised         Value of Unexercised in-the-Money
                                                        Options/SARs at 2000 Year-End       Options/SARs at 2000 Year-End
                             Shares        Value                     (#)                               ($)(2)
                          Acquired on     Realized      -----------------------------     ---------------------------------
         Name             Exercise (#)     ($)(1)       Exercisable     Unexercisable     Exercisable         Unexercisable
---------------------------------------------------------------------------------------------------------------------------
<S>                       <C>             <C>           <C>             <C>               <C>                 <C>
Catherine M.  Hapka             -             -              -                 -               -                     -

Steve Stringer                  -             -           328,117          1,134,629           -                  763,243

Jay Braukman                    -             -            18,747            531,253           -                  272,500

Scott C.  Chandler              -             -              -                 -               -                     -

Rand Kennedy                    -             -            23,000            125,000           -                     -

Michael Lanier                  -             -              -                 -               -                     -

Richard Johnston                -             -              -                 -               -                     -
</TABLE>

     (1)  Based upon the market price of the purchased shares on the exercise
          date less the option exercise price paid for those shares.

     (2)  Based upon the market price of $1.125 per share, determined on the
          basis of the closing selling price per share of Common Stock on the
          Nasdaq National Market on the last trading day of the 2000 year, less
          the option exercise price payable per share.


              EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT AND
                         CHANGE OF CONTROL ARRANGEMENTS

None of our executives are employed for a specified term, and each executive's
employment with us is subject to termination at any time by either party for any
reason, with or without cause.

Ms. Hapka

In 2000, the Compensation Committee increased Ms. Hapka's base salary to
$400,000 per year and her target bonus to 70% of her base salary.  In October
2000, the Compensation Committee adopted a compensation, retention and incentive
program (the 2000 Retention Program).  Under the 2000 Retention Program, Ms.
Hapka is entitled to (a) a retention bonus equal to her 2000 base salary plus
her 2000 bonus payment, 25% of which was paid to her in November 2000 and the
remainder of which is payable to her on May 1, 2001(Ms. Hapka's Retention
Bonus).  Ms. Hapka is entitled to receive her 2000 Retention Bonus only if she
is employed with us on the applicable payment dates.

                                       45
<PAGE>

Ms. Hapka's employment offer letter, dated June 10, 1997, provides that in the
event her employment is terminated involuntarily and without cause, Ms. Hapka
will be entitled to receive a lump sum payment in an amount equal to her then
current annual salary.

Mr. Stringer

In 2000, the Compensation Committee increased Mr. Stringer's base salary to
$325,000 per year, effective July 1, 2000.  His target bonus remained at 60% of
his base salary.  Under the 2000 Retention Program, Mr. Stringer (a) is entitled
to a retention bonus equal to his 2000 base salary plus his 2000 bonus, 25% of
which was paid to him in November 2000 and the remainder of which is payable to
him in May 2001 (Stringer's 2000 Retention Bonus), (b) is entitled to a bonus
equal to his 2000 base salary plus his 2000 bonus payable upon a change of
control, (c) was granted options to purchase a total of 700,000 shares of Common
Stock at an exercise price of $1.09 under the 1999 Stock Incentive Plan and (d)
was granted 300,000 shares of Common Stock at no cost under the 2000 Stock Award
Plan.

In February 2001, the Compensation Committee (a) increased Mr. Stringer's base
salary to $400,000, (b) granted Mr. Stringer a guaranteed bonus for both 2001
and 2002 of 60% of his then current base salary and (c) granted Mr. Stringer a
$2 million, retention bonus (grossed up for taxes), $500,000 of which was paid
to him in February 2001, another $750,000 of which is payable to him on January
2, 2002 and the final $750,000 of which is payable to him on January 2, 2003
(Mr. Stringer's 2001 Retention Bonus).

Mr. Stringer is entitled to receive his 2000 and 2001 Retention Bonuses only if
he is employed with us on the applicable payment dates or if his employment is
terminated prior to such dates by us, other than for cause.

Mr. Stringer's employment offer letter, dated April 17, 1999, provides that in
the event his employment is terminated without cause, he will be eligible to
receive monthly payments at his then applicable monthly base salary for a period
of 12 months from the date of termination of his employment.

Mr. Braukman

Mr. Braukman's employment offer letter, dated February 28, 2000, provided for an
initial base salary of $275,000 per year, payable in accordance with our regular
pay period practices.  It also provided for a guaranteed bonus for a one year
period following his hire date of $150,000, payable in quarterly installments.
In future years, Mr. Braukman's bonus was to be determined under the senior
management bonus plan, as approved by the Board.  In connection with his
employment, Mr. Braukman was (a) granted options to purchase 250,000 shares of
Common Stock at an exercise price equal to the Common Stock's fair market value
on the date of grant under the 1999 Stock Incentive Plan and (b) granted an
option outside the 1999 Stock Incentive Plan to purchase 50,000 shares of Common
Stock at an exercise price of $20 per share, which are subject to a vesting
schedule that accelerates upon a corporate transaction or change of control (as
those terms are defined in the 1999 Stock Incentive Plan).  In addition, Mr.
Braukman's employment offer letter provides (a) that we will secure for his
benefit a term life insurance policy with a $1 million face value and (b) that
in the event his employment is terminated without cause, he will be eligible to
receive monthly payments at his then applicable monthly base for a period of 12
months from the date of termination of his employment.

Under the 2000 Retention Program, Mr. Braukman (a) is entitled to a retention
bonus equal to his 2000 base salary plus his 2000 bonus payments, 25% of which
was payable to him in November 2000 and the remainder of which is payable to him
in May 2001 (Mr. Braukman's 2000 Retention Bonus), (b) is entitled to a bonus
equal to his 2000 base salary plus his 2000 bonus payments payable upon a change
of control, (c) was granted options to purchase 250,000 shares of Common Stock
at an exercise price of $1.09 under the

                                       46
<PAGE>

1999 Stock Incentive Plan and (d) was granted 170,000 shares of Common Stock at
no cost under the 2000 Stock Award Plan.

In February 2001, the Compensation Committee (a) increased Mr. Braukman's base
salary to $300,000, (b) granted Mr. Braukman a guaranteed bonus for 2001 equal
to 60% of his base salary and (c) granted Mr. Braukman a $1 million retention
bonus (grossed up for taxes), $250,000 of which was paid to him in February
2001, another $375,000 of which is payable to him on January 2, 2002 and the
final $375,000 of which is payable to him on January 2, 2003 (Mr. Braukman's
2001 Retention Bonus).  Mr. Braukman is entitled to receive his 2000 and 2001
Retention Bonuses only if he is  employed with us on the applicable payment
dates or if his employment is terminated prior to such dates by us, other than
for cause.

Mr. Chandler

In 2000, the Compensation Committee increased Mr. Chandler's base salary to
$275,000 per year, effective December 1, 2000.  His target bonus increased to
45% of his base salary.  Under the 2000 Retention Program, Mr. Chandler is
entitled to (a) a retention bonus equal to his 2000 base salary plus his 2000
bonus, 25% of which was paid to him in November 2000 and the remainder of which
is payable to him in May 2001.

Mr. Kennedy

In connection with his employment, Mr. Kennedy entered into an agreement not to
compete with the Company for 2 years following his termination of employment
with us.  However, if Mr. Kennedy is terminated without cause, the covenant not
to compete is reduced from 2 years to 1 year.

In 2000, the Compensation Committee increased Mr. Kennedy's base salary to
$225,000 per year, effective August 1, 2000.  His target bonus increased to 45%
of his base salary.  Under the 2000 Retention Program, Mr. Kennedy is entitled a
retention bonus equal to (a) his 2000 base salary plus his 2000 bonus, 25% of
which was paid to him in November 2000 and the remainder of which is payable to
him in May 2001 and (b) 100,000 shares of Common Stock at no cost under the 2000
Stock Award Plan, 25% of which vested in November 2000 and the remainder of
which vests in May 2001 (Mr. Kennedy's 2000 Retention Bonus).  In addition, Mr.
Kennedy is entitled to a bonus equal to his 2000 base salary plus his 2000 bonus
payments upon change of control, as defined in the 1999 stock option plan, 25%
of which is payable upon the announcement of the change of control and the
remainder of which is payable upon the close of the change of control.

In February 2001, the Compensation Committee (a) increased Mr. Kennedy's base
salary to $300,000, (b) granted Mr. Kennedy a retention bonus equal to his 2001
base salary plus 2001 bonus (Mr. Kennedy's 2001 Retention Bonus), (c) granted
Mr. Kennedy another  bonus equal to his 2001 base salary plus 2001 bonus
payments payable upon a change of control, as defined in the 1999 stock option
plan, (d) granted Mr. Kennedy an option to purchase 400,000 shares of Common
Stock under the 1999 Stock Incentive Plan and (e) 500,000 performance shares,
with a value of no less than $2 per share and no more than $4 per share.  Mr.
Kennedy is entitled to receive his 2000 and 2001 Retention Bonuses only if he is
employed with us on the applicable payment date or if his employment is
terminated prior to such dates by us, other than for cause.  As of the date
hereof, Mr. Kennedy has not yet signed his 2001 retention agreement.

                                       47
<PAGE>

Mr. Lanier

In connection with the termination of Mr. Lanier's employment in November 2000,
the Company paid Mr. Lanier $317,500, plus other miscellaneous benefits.

          COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The Compensation Committee reviews and approves the compensation and benefits to
be provided to our executive officers and other key employees.  In addition, the
Compensation Committee administers the 1999 Stock Incentive Plan and 2000
Amended and Restated Stock Award Plan and all retention and incentive plans.
The Compensation Committee currently consists of Ms. Mayer and Messrs. Compton
and Levitt. Prior to September 2000, the Compensation Committee consisted of
Messrs. Stensrud, Walecka and Zander.  Mr. Stensrud was our President and Chief
Executive Officer from February 1997 through June 1997.  None of our executive
officers serves or served on the compensation committee of the board of
directors of another entity performing similar functions during 2000, and none
of our executive officers serves or served as a director of another entity one
of whose executive officers serves or served on the Compensation Committee or
the Board during 2000.

Board Compensation Committee Report on Executive Compensation

Notwithstanding anything to the contrary set forth in any of our previous
filings under the Securities Act or the Exchange Act that might incorporate
future filings, including this Form 10-K, in whole or in part, the report
presented shall not be incorporated by reference into any such filings.

         REPORT OF THE COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION

The Compensation Committee approves and oversees our compensation policies,
approves salaries and annual bonuses for executive management, including the
Named Executive Officers, and administers our 1999 Stock Incentive Plan and 2000
Stock Award Plan, predecessor option plans and the Employee Stock Purchase Plan.
In fulfilling its responsibilities, the Compensation Committee receives
significant input from the CEO, COO, CFO, other members of senior management and
other members of the Board.

1.  Compensation Policy

Our compensation policy for executive management is designed to recruit,
motivate and retain highly qualified individuals by (i) rewarding individual
achievements, (ii) enabling individuals to share in the risks and rewards of our
overall performance, (iii) paying compensation that is competitive with industry
compensation levels and (iv) offering retention incentives.  Our compensation
policy is based, in part, on certain recommendations made by an independent
compensation consultant previously retained by us.  The key components of our
current compensation policy, which is designed to balance short-term and long-
term considerations, are competitive salaries, annual cash performance bonuses
and long-term equity incentives. The Compensation Committee believes that the
base salaries paid to executive officers  in 2000 were commensurate with the
services they rendered they to us and generally in the range of base salaries
paid to similarly situated executives in the telecommunications industry.  The
2000 executive bonuses were based upon a percentage of each executive's base
salary, our achievement of certain corporate goals (which were the same for all
executive officers) and the achievement of certain personal goals (that were
specific to each executive).

                                       48
<PAGE>

2.  Compensation in 2000

Annual Salaries.  Ms. Hapka, the Chairman of the Board and CEO, has authority to
hire all members of executive management, subject to the Compensation
Committee's approval of the compensation to be paid to such executives.  She has
delegated to Mr. Stringer, the President and COO, authority to hire all members
of executive management who report to Mr. Stringer, also subject to Compensation
Committee approval.  Subject to the approval of the Compensation Committee, Ms.
Hapka and Mr. Stringer also determine the compensation payable to persons
offered executive level employment with us and annual salary increases for
members of executive management.  The Compensation Committee determines annual
adjustments to Ms. Hapka's salary and bonus compensation.  In determining and
approving the amount of annual salary and salary increases for executive
management, Ms. Hapka and the Compensation Committee consider factors such as
the executive's contribution to our overall operating effectiveness, strategic
success and profitability; the executive's role in developing and maintaining
key client relationships; the level of responsibility, scope and complexity of
such executive's position relative to other executive management; and the
executive's leadership, growth and management development over the past year.

Performance Bonuses.  Cash performance bonuses are determined and approved
annually by the Compensation Committee based on an objective evaluation of our
performance relative to predetermined corporate performance goals and specific
individual performance goals based upon factors over which each executive has
significant control.  Performance against corporate goals drove 20 percent of
each executive's award; performance against individual goals drove 80 percent.
Corporate goals in 2000 were the numbers of central offices built, the order
backlog, the number of installed customer lines, timely implementation of our
line sharing initiative and the margin by which average revenue per line
installed exceeded that of key competitors.  An objective evaluation of the
results was used to determine individual awards.  All executives participated in
the bonus plan on this basis, except for Messes.  Braukman and Shaneyfelt whose
bonuses were guaranteed in the first year of employment with us.  The
Compensation Committee is of the view that such a system aligned all employees
around common goals, promoted teamwork to meet corporate wide objectives, and
simultaneously provided rewards for individual initiative.

Long-Term Incentives.  Stock-based compensation is also an important element of
our compensation policy.  Stock options are offered to induce executive
management and all employees to accept employment with us.  The Compensation
Committee believes that stock options which vest over time and are subject to
forfeiture, align the interests of employees with the interests of our
stockholders.  The Compensation Committee also believes that substantial equity
ownership by individuals in leadership positions with us ensures that such
individuals will remain focused on building stockholder value.  Initial stock
option awards given at the time of employment are based on a series of
guidelines for each job, designed to provide a material incentive to each
executive over and above his/her salary and annual bonus.  Additional stock
option awards are recommended on an annual basis to adjust stock option award
levels.  All stock option grants are approved by the Compensation Committee
based on a resolution from the full Board delegating authority to the
Compensation Committee to do so.

Restricted Stock Awards.  The Board approved a restructured stock award program,
the 2000 Stock Award Program, in August, 2000.  The program made available
3,000,000 shares of Common Stock for award by the Compensation Committee to
employees.  Awards under the plan were made to retain key employees at all
levels.  The Compensation Committee considers these awards critical in employee
retention, given general financial and employment market conditions.

Key Management Retention Plan in 2000.  The Compensation Committee also approved
during 2000 a key management retention plan whereby key managers received cash
bonuses for remaining with us for

                                       49
<PAGE>

specified periods of time. The Compensation Committee believes the plan has been
key to retaining critical managers in the face of falling equity prices and
uncertainties facing the business.

Key Management Retention Plan in the First Quarter of 2001.  The Compensation
Committee also approved during the first quarter of 2001 a key management
retention plan whereby key managers received cash bonuses and stock options for
remaining with us for specified periods of time.  The Compensation Committee
believes the plan is key to retaining critical managers in the face of falling
equity prices and uncertainties facing the business.

Compensation of the CEO.  The compensation paid to Catherine Hapka is set
specifically by the Board, effective as of December 17, 2000.  Ms. Hapka is
entitled to receive an annual base salary of $400,000 and also is eligible to
receive an annual performance bonus of up to 70 percent of that figure, based on
the achievement by the Company of certain predetermined performance goals
established each year by the Compensation Committee.

Limitations on the Deductibility of Compensation.  Provisions of the Internal
Revenue Code of 1986, as amended (Code), disallow the deductibility of certain
compensation in excess of $1 million paid to a public company's chief executive
officer and certain other highly paid executive officers.  The deductibility
limitation does not apply to performance-based compensation, as defined in Code,
provided certain stockholder approval and other requirements are met.  The
Compensation Committee anticipates that our compensation policy for executive
officers will continue to consist primarily of performance-based compensation
and also will be designed to satisfy the requirements of Section 162(m).  Given
the level of Ms. Hapka's salary and bonus, the Compensation Committee
anticipates no issues in meeting the requirements for deductibility.

                                                   Submitted by the Compensation
                                                          Committee of the Board

                         Michael J. Levitt, Member of the Compensation Committee
                          Kevin R. Compton, Member of the Compensation Committee
                               Susan Mayer, Member of the Compensation Committee
                                                            Dated:March 30, 2001

                                       50
<PAGE>

                            STOCK PERFORMANCE GRAPH


The graph covers the period from April 7, 1999, the date of our IPO of shares of
Common Stock, to December 31, 2000.

Notwithstanding anything to the contrary set forth in any of our previous
filings made under the Securities Act or the Securities Exchange Act that might
incorporate future filings made by us under those statutes, neither the
preceding Stock Performance Graph nor the Compensation Committee Report is to be
incorporated by reference into any such prior filings, nor shall such graph or
report be incorporated by reference into any future filings made by us under
those statutes.


                       [PERFORMANCE GRAPH APPEARS HERE]

                                       51
<PAGE>

Item 12 - Security Ownership of Certain Beneficial Owners and Management

The following table sets forth certain information known to us with respect to
the beneficial ownership of our Common Stock as of December 31, 2000, by (i) all
persons who are beneficial owners of five percent (5%) or more of our Common
Stock, (ii) each director and nominee for director, (iii) the Named Executive
Officers (as defined below) and (iv) all current directors and executive
officers as a group.  Unless otherwise indicated, each of the stockholders has
sole voting and investment power with respect to the shares beneficially owned,
subject to community property laws, where applicable.

<TABLE>
<CAPTION>
                                                                                 Number of       Percentage
                                                                                   Shares       Beneficially
Title of                                                                        Beneficially      Owned (1)
 Class                          Beneficial Owner (1)                               Owned
--------------------------------------------------------------------------------------------------------------
<S>                                                                             <C>             <C>
Common
Stock      Five Percent Stockholders:

             KPCB Entities (2)                                                   6,208,988              7.8%
             Hicks, Muse, Tate & Furst Incorporated (3)                         12,734,722             13.8%
             WorldCom Ventures (4)                                               5,334,692              6.6%
             Microsoft Corporation (5)                                           5,197,691              6.5%
             Viking Global Performance, LLC (6)                                  5,292,333              6.6%

           Directors and Named Executive Officers:

             Catherine M.  Hapka (7)                                             2,704,905              3.4%
             Steve Stringer (8)                                                    434,439                *
             John W. Braukman (9)                                                  103,630                *
             Scott C. Chandler (10)                                                416,569                *
             Rand A. Kennedy (11)                                                  248,413                *
             Michael S. Lanier (12)                                                 11,318                *
             Richard Johnston (13)                                                  25,420                *
             Kevin R. Compton (14)                                                  83,845                *
             Keith B. Geeslin (15)                                               2,878,653              3.6%
             Susan Mayer (16)                                                            0                *
             William R. Stensrud (17)                                              266,364                *
             John L. Walecka (18)                                                2,651,774              3.3%
             Edward J. Zander (19)                                                       0                *
             Michael J. Levitt (20)                                                      0                *
             All current directors and executive officers as a group (15         9,825,330             12.3%
             persons)(21)
</TABLE>


(1) Represents beneficial ownership of less than one percent of the outstanding
    shares of Common Stock.  Except as indicated by footnote, we understand that
    the persons named in the table above have sole voting and investment power
    with respect to all shares shown as beneficially owned by them, subject to
    community property laws where applicable.

(2) Consists of 5,650,391 shares held by Kleiner Perkins Caufield & Byers VIII,
    L.P., 441,631 shares held by KPCB VIII Founders Fund, L.P.  and 116,966
    shares held by KPCB VIII Information Sciences Zaibatsu Fund II, L.P.
    (collectively, the KPCB Entities) The address for each of the KPCB Entities
    is 2750 Sand Hill Road, Menlo Park, California 94025.

                                       52
<PAGE>

(3)  Consists of 12,734,722 shares issuable upon conversion of the Series E
     Stock and exercise of warrants that are convertible and exercisable within
     60 days of December 31, 2000. HM4 Rhythms Qualified Fund, LLC owns 113,743
     shares of Series E Stock and 2,559,228 warrants; HM4 Rhythms Private Fund,
     LLC owns 806 shares of Series E Stock and 18,132 warrants; HM PG-IV
     Rhythms, LLC owns 6,056 shares of Series E Stock and 136,248 warrants;
     HM 4-SBS Rhythms Coinvestor, LLC owns 2,724 shares of Series E Stock and
     61,287 warrants; HM 4-EQ Rhythms Coinvestor, LLC owns 1,671 shares of
     Series E Stock and 37,605 warrants (collectively, the HMTF Entities). The
     address for each of the HMTF Entities is 200 Crescent Court, Suite 1600,
     Dallas, Texas 75201.

(4)  WorldCom Ventures is formerly known as MCI WorldCom Venture Fund. Includes
     856,996 shares issuable upon exercise of warrants exercisable within 60
     days of December 31, 2001. The address for WorldCom Ventures is c/o
     WorldCom, Inc., 1801 Pennsylvania Avenue, Washington, D.C. 20006.

(5)  Includes 720,000 shares issuable upon exercise of a warrant exercisable
     within 60 days of December 31, 2000. The address for Microsoft Corporation
     is One Microsoft Way, Redmond, Washington 98502.

(6)  Includes 3,015,833 shares held by Viking Global Equities LP and 2,318,859
     shares held by Viking Global Performance LLC (collectively, the Viking
     Global Entities). The address for the Viking Global Entities is 280 Park
     Avenue, 35th Floor, New York, New York 10017.

(7)  Includes shares held by Ms. Hapka's children, Christopher H. Safaya and
     Catherine A. Safaya, in the amount of 5,333 shares each. Also includes
     407,076 shares from option exercises subject to repurchase by us.

(8)  Includes 51,058 shares issuable upon exercise of an option within 60 days
     of December 31, 2000 and 75,000 stock award shares, which vested within 60
     days of December 31, 2000. Of the 75,000 stock award stock award shares, we
     retained 32,866 to pay Mr. Stringer's tax obligations.

(9)  Includes 35,416 shares issuable upon exercise of an option within 60 days
     of December 31, 2000 and 10,625 stock award shares, which vested within 60
     days of December 31, 2000. Of the 10,625 stock award shares, we retained
     8,240 to pay Mr. Braukman's tax obligations.

(10) Includes 158,000 shares from option exercise subject to repurchase by us.

(11) Includes 2,000 shares issuable upon exercise of an option within 60 days of
     December 31, 2000 and 38,382 shares from option exercise subject to
     repurchase by us.

(12) As of November 2000, Mr. Lanier's employment with us was terminated.

(13) As of November 2000, Mr. Johnston's employment with us was terminated.

(14) Excludes shares held by the KPCB Entities.  Mr. Compton, as a General
     Partner of KPCB, may be deemed to have voting and investment power over the
     shares held by the KPCB Entities.  Mr. Compton disclaims beneficial
     interest in such shares, except to the extent of his pecuniary interest
     therein.  Includes 45 shares which were mistakenly excluded in the Proxy
     Statement for the 1999 Annual Meeting.

(15) Includes 57,574 shares held by DLJ Capital Corporation, 287,866 shares held
     by DLJ First ESC L.L.C., 2,504,129 shares held by Sprout Capital VII, L.P.
     and 29,084 shares held by The Sprout CEO Fund, L.P. (collectively, the
     Sprout Entities). Mr. Geeslin, as a General Partner of The Sprout Group,
     may be deemed to have voting and investment power over the shares held by
     the Sprout Entities. Mr. Geeslin disclaims beneficial interest in such
     shares, except to the extent of his pecuniary interest therein.

(16) Excludes shares held by WorldCom Ventures . Ms. Mayer, as President of
     WorldCom Ventures, may be deemed to have voting and investment power over
     the shares held by such fund. Ms. Mayer disclaims beneficial interest of
     such shares, except to the extent of her pecuniary interest therein.

                                       53
<PAGE>

(17) Includes 200,015 shares held by Blue Goose, Ltd., of which the Stensrud
     Family Trust UTA 9-16-93 (the Stensrud Trust) is a General and Limited
     Partner, 46,299 shares held by the Stensrud Trust, 10,000 shares held by
     the Stensrud Charitable Remainder Trust and 50 shares held by his son, Ross
     Stensrud. Mr. Stensrud is a trustee and one of the beneficiaries of the
     Stensrud Trust. Mr. Stensrud disclaims beneficial ownership of these shares
     except to the extent of his pecuniary interest therein.

(18) Includes 103,652 shares held by Brentwood Affiliates Fund, L.P. and
     2,491,506 shares held by Brentwood Associates VII, L.P., of which Brentwood
     VII Ventures, L.P. is the general partner (collectively, the Brentwood
     Entities). Mr. Walecka, as a General Partner of Brentwood Venture Capital,
     may be deemed to have voting and investment power over the shares held by
     the Brentwood Entities. Mr. Walecka disclaims beneficial interest in such
     shares, except to the extent of his pecuniary interest therein. This
     includes 56,616 shares held in trust, of which Mr. Walecka is the trustee
     and beneficiary. Mr. Walecka disclaims beneficial ownership of these shares
     except to the extent of his pecuniary interest therein. Mr. Walecka
     resigned as one of our directors in February 2001.

(19) Mr. Zander resigned as one of our directors in February 2001.

(20) Mr. Levitt disclaims beneficial ownership of all shares held by the HMTF
     Entities.

(21) Includes 254,723 shares issuable upon exercise of options or warrants
     exercisable and stock award shares which will vest within 60 days of
     December 31, 2000 and 603,458 shares from options exercises subject to
     repurchase by us.  Excludes shares held by Brentwood Entities, the KPCB
     Entities, WorldCom Ventures, HMTF Entities, Microsoft Corporation and
     Viking Global Performance L.P.

                                       54
<PAGE>

Item 13 - Certain Relationships and Related Transactions

Mr. Stensrud, a member of the Board, served as our President and Chief Executive
Officer from February 1997 to June 1997.  Mr. Stensrud and Mr. Geeslin, also a
member of the Board, both serve as directors for Paradyne Corporation, one of
our vendors.  Mr. Stringer, our Chief Operating Officer, also serves on the
board of advisors for Paradyne.  Additionally, from June 1996 through December
1996, Mr. Stensrud served as President of Paradyne. John L. Walecka, a former
member of the Board, served until July 1999 as a director for Xylan Corporation,
an indirect vendor of ours. The total net purchases during 1998, 1999, and 2000
from Paradyne were approximately $13.0 million, $54.0 million, and $4.4 million,
respectively. In addition, during 2000, we acquired additional equipment from
this supplier of approximately $18.6 through vender financing. We do not
purchase any products directly from Xylan Corporation; rather, purchases of
Xylan Corporation products are sourced through Paradyne. The Registrant believes
that its transactions with Paradyne and Xylan Corporation were completed at
rates similar to those available from alternative vendors.

Ms. Mayer, a member of our Board, serves as President of WorldCom's investment
fund and a Senior Vice President of WorldCom.  In March 1999, we entered into a
strategic arrangement with WorldCom.  As part of this strategic arrangement,
WorldCom's investment fund invested $30.0 million in us.  In addition, WorldCom,
as part of the strategic relationship, agreed to designate us as the first
choice in its alternative access provisions system for DSL services in certain
circumstances. Under this arrangement, WorldCom is committed to sell at least
100,000 of our DSL lines over a period of five years, subject to penalties for
failure to reach target commitments. There was no revenue received from WorldCom
in 1998 and 1999 under this arrangement. In turn, we have designated WorldCom as
our preferred provider of network services. Total purchases from WorldCom during
1998, 1999, and 2000 were approximately $0.4 million, $12.8 million, and $46.3
million, respectively.

Mr. Levitt was elected to the Board of Directors by HMTF pursuant to the terms
of the Series E purchase agreement and serves at the discretion of HMTF. HMTF
has the right to appoint one representative to our Board provided that it
continues to hold 40% of the Series E Preferred Stock purchased by them or the
underlying common stock or any combination thereof.

Mr. Blumenfeld served as our Chief Legal Officer and General Counsel from August
1997 through March 2001.  He has been a partner in the Washington, D.C. law firm
of Blumenfeld & Cohen since 1984.  In connection with Mr. Blumenfeld's
employment with us, we issued to him options to purchase 438,115 shares of
Common Stock at an exercise price of $0.04 per share, which were exercised in
January 1998.  In addition, Mr. Blumenfeld and certain other partners of
Blumenfeld & Cohen purchased an aggregate of 140,000 shares of Series A
Preferred Stock at $1.00 per share, which converted into 336,000 shares of
Common Stock upon the closing of our IPO in April 1999.  For the years ended
December 31, 1999 and 2000, we incurred expenses for legal fees to Blumenfeld &
Cohen of approximately $2.4 million and $4.7 million, respectively.  Under the
terms of a written employment agreement with Mr. Blumenfeld, we agreed to employ
him as Chief Legal Officer and General Counsel at an annual salary of $110,000
for a minimum time commitment by Mr. Blumenfeld of 24 hours a week.  Under the
terms of such agreement, Blumenfeld & Cohen has agreed to charge us at a
discount from its regular rates for legal services, including Mr. Blumenfeld's
time in excess of his minimum time commitment.   In connection with the
termination of Mr. Blumenfeld's employment effective as of March 31, 2001, the
Company paid Mr. Blumenfeld $290,000, plus miscellaneous benefits.

In addition to the indemnification provisions contained in our Restated
Certificate of Incorporation and Bylaws, we have entered into separate
indemnification agreements with each of its directors and officers.  These
agreements require us to, among other things, indemnify such director or officer
against expenses (including attorneys' fees), judgments, fines and settlements
(collectively, Liabilities) paid by such individual in connection with any
action, suit or proceeding arising out of such individual's status or service as
one of our directors or officers (other than Liabilities arising from willful
misconduct or conduct that is knowingly fraudulent or deliberately dishonest)
and to advance expenses incurred by such individual in connection with any
proceeding against such individual with respect to which such individual may be
entitled to indemnification by us.

                                       55
<PAGE>

All future transactions between us and our officers, directors, principal
stockholders and affiliates will be approved by a majority of the independent
and disinterested members of the Board and will be on terms no less favorable to
us than could be obtained from unaffiliated third parties.

                                       56
<PAGE>

                                    PART IV

Item 14 - Exhibits, Financial Statement Schedules, Reports on Form 8-K

Financial Statements:

     .  Report of Independent Accountants
     .  Consolidated Balance Sheets as of December 31, 2000 and 1999
     .  Consolidated Statements of Operations and Comprehensive Income as of
        December 31, 2000, 1999 and 1998
     .  Consolidated Statements of Cash Flows as of December 31, 2000, 1999 and
        1998
     .  Consolidated Statements of Stockholders' Equity as of December 31, 2000,
        1999 and 1998

Financial Statement Schedules:

     .  Report of Independent Accountants on Financial Statement Schedule
        Schedule II - Valuation and Qualifying Accounts

     All other schedules have been omitted because the information is not
     required or is included in the consolidated financial statements.

Current Reports on Form 8-K:

No reports on Form 8-K were filed during the last quarter of 2000.

Exhibits:

Exhibit
No.         Description
--------------------------------------------------------------------------------

3.1(8)      Restated Certificate of Incorporation of Rhythms NetConnections Inc.
3.2(8)      Certificate of Amendment of Restated Certificate of Incorporation of
            the Registrant.
3.3(2)      Certificate of Designation of Series 1 Junior Participating
            Preferred Stock of Registrant.
3.4(2)      Restated Bylaws of the Registrant.
3.5(7)      Certificate of Designation of 6 3/4% Series F Convertible Preferred
            Stock of Registrant.
3.6(7)      Certificate of Designation of 8 1/4% Series E Convertible Preferred
            Stock of Registrant.
4.1(2)      Form of Certificate of common stock.
4.2(1)      Indenture, dated as of May 5, 1998, by and between the Registrant
            and State Street Bank and Trust Company of California, N.A., as
            trustee, including form of the Registrant's 13 1/2% Senior Discount
            Notes due 2008, Series A and form of Registrant's 13 1/2% Senior
            Discount Notes due 2008, Series B.
4.3(1)      Warrant Agreement, dated as of May 5, 1998, by and between the
            Registrant and State Street Bank and Trust Company of California,
            N.A.
4.4(1)      Warrant Registration Rights Agreement, dated as of May 5, 1998, by
            and among the Registrant and Merrill Lynch & Co., Merrill Lynch,
            Pierce, Fenner & Smith Incorporated, and Donaldson, Lufkin &
            Jenrette Securities Corporation.
4.5(2)      Warrant to Purchase Shares of Common Stock, dated May 19, 1998, by
            and between Registrant and Sun Financial Group, Inc.
4.6(2)      Common Stock Purchase Warrant, dated March 3, 1999, by and between
            the Registrant and MCI WorldCom Venture Fund, Inc.
4.7(2)      Common Stock Purchase Warrant, dated March 16, 1999, by and between
            the and Microsoft Corporation.
4.8(2)      Warrant to Purchase Shares of Common Stock, dated March 31, 1999, by
            and between and GATX Capital Corporation.

                                       57

<PAGE>

Exhibit
No.         Description
--------------------------------------------------------------------------------
4.9(2)      Warrant Purchase Agreement, dated as of April 6, 1999, by and
            between Registrant and MCI WorldCom Venture Fund, Inc.
4.10(2)     Common Stock Purchase Warrant, dated April 6, 1999, by and among the
            Registrant and MCI WorldCom Venture Fund, Inc.
4.11(2)     Common Stock Purchase Warrant, dated April 6, 1999, by and among the
            Registrant and U.S. Telesource, Inc.
4.12(2)     Common Stock Purchase Warrant, dated April 5, 1999, by and among the
            Registrant and Cisco Systems Capital Corporation.
4.13(2)     Rights Agreement, dated April 2, 1999, by and among Registrant and
            American Securities Transfer & Trust, Inc.
4.14(3)     Indenture, dated as of April 23, 1999, by and between the Registrant
            and State Street Bank and Trust Company of California, N.A., as
            trustee, Including form of the Registrant's 12 3/4% Senior Notes due
            2009, Series A and form of the Registrant's 12 3/4% Senior Notes due
            2009, Series B.
4.15(3)     Notes Registration Rights Agreement, dated as of April 23, 1999, by
            and among the Registrant and Merrill Lynch & Co., Merrill Lynch,
            Pierce Fenner & Smith Incorporated, Salomon Smith Barney Inc. and
            Chase Securities Inc.
4.16(3)     Pledge and Escrow Agreement, dated as of April 23, 1999, from the
            Registrant as Pledgor to State Street Bank and Trust Company of
            California, N.A., as trustee.
4.17(4)     Amendment No. 1 to Warrant Agreement, dated as of August, 1999
            between the Registrant and State Street Bank and Trust Company of
            California, N.A.
4.18(7)     Indenture, dated February 23, 2000, by and between the Registrant
            and State Street Bank and Trust Company of California, N.A., as
            trustee, including form of the Registrant's 14% Senior Notes due
            2010, Series A and form of the Registrant's 14% Senior Notes due
            2010, Series B.
4.19(7)     Notes Registration Statement, dated as of February 23, 2000, among
            the Registrant, Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner
            and Smith Incorporated, and Salomon Smith Barney Inc., Chase
            Securities Inc., and Credit Suisse First Boston.
4.20(7)     Registration Rights Agreement, dated March 3, 2000, by and among the
            Registrant and Merrill Lynch, Pierce, Fenner and Smith Incorporated
            and Salomon Smith Barney Inc.
4.21(7)     Registration Rights Agreement, dated March 16, 2000, by and among
            the Registrant and the entities listed on Schedule I thereto.
4.22(12)    Rhythms NetConnections Inc. 2000 Stock Award Plan and Form of Stock
            Award Agreement.
4.23(9)     Amended and Restated Rhythms NetConnections Inc. 2000 Stock Award
            Plan and Form of Stock Award Agreement.
9.1(1)      Voting Trust Agreement, dated as of May 5, 1998, by and among Sprout
            Capital VII, L.P., Donaldson Lufkin & Jenrette Securities
            Corporation, and First Union Trust Company, National Association, as
            trustee.
9.2(1)      Voting Trust Agreement, dated as of March 12, 1998, by and between
            Enron Communications Group, Inc. and the Registrant, as trustee.
10.1(1)     Series A Preferred Stock Purchase Agreement, dated July 3, 1997, by
            and among the Registrant and the Investors listed on Schedule A
            thereto.
10.2(1)     Subsequent Closing Purchase Agreement, dated December 23, 1997, by
            and among the Registrant and the Investors listed on Schedule A
            thereto.
10.3(1)     Series B Preferred Stock Purchase Agreement, dated March 12, 1998,
            by and among the Registrant and the Investors listed on Schedule A
            thereto.
10.4(2)     Enterprise Services Solution Agreement between Cisco Systems, Inc.
            and the Registrant, dated December 3, 1998
10.5(2)     Series C Preferred Stock Purchase Agreement, dated March 3, 1999, by
            and among the Registrant and MCI WorldCom Venture Fund, Inc.
10.6(2)     Amended and Restated Investors' Rights Agreement, dated March 3,
            1999, by and among the Registrant and the Investors listed on
            Schedule A thereto.
10.7(2)     Agreement, dated March 3, 1999, by and between the Registrant and
            MCI WorldCom, Inc.

                                       58
<PAGE>

Exhibit
No.         Description
--------------------------------------------------------------------------------
10.8(2)     Series C Preferred Stock and Warrant Purchase Agreement, dated March
            16, 1999, by and among the Registrant and Microsoft Corporation.
10.9(2)     Amended and Restated Investors' Rights Agreement, dated March 16,
            1999, by and among the Registrant and the Investors listed on
            Schedule A thereto.
10.10(2)    Distribution Agreement, dated March 16, 1999, by and among the
            Registrant and Microsoft Corporation.
10.11(1)    Master Lease Agreement No. 1642 and Addendum thereto, each dated
            November 19, 1997, and Second Addendum thereto, dated as of May 19,
            1998, between the Registrant and Sun Financial Group, Inc.
10.12(2)    Business Lease (Single Tenant) between the Registrant and BR
            Venture, LLC dated September 1998.
10.13(1)    Employment Agreement between the Registrant and Catherine M. Hapka,
            dated June 10, 1997.
10.14(1)    1997 Stock Option/Stock Issuance Plan.
10.15(2)    1999 Stock Incentive Plan.
10.16(2)    1999 Employee Stock Purchase Plan.
10.17(1)    Form of Indemnification Agreement between the Registrant and each of
            its directors.
10.18(1)    Form of Indemnification Agreement between the Registrant and each of
            its officers.
10.19(2)    QuickStart Loan and Security Agreement, dated October 29, 1997,
            between the Registrant and Silicon Valley Bank.
10.20(2)    Third Addendum, dated March 31, 1999, to Master Lease Agreement,
            dated November 19, 1997, by and among Company and GATX Capital
            Corporation
10.21(2)    Master Lease Agreement, dated March 31, 1999, by and among Company
            and GATX Capital Corporation.
10.22(2)    First Addendum, dated March 31, 1999, to Master Lease Agreement,
            dated March 31, 1999, by and among Company and GATX Capital
            Corporation.
10.23(2)    Amendment No. 1, dated April 6, 1999, to Framework Agreement, dated
            March 3, 1999, by and among the Registrant and MCI WorldCom, Inc.
10.24(2)    Series C Preferred Stock and Warrant Purchase Agreement, dated April
            6, 1999, by and among the Registrant and U.S Telesource, Inc.
10.25(2)    Series D Preferred Stock Purchase Agreement, dated April 6, 1999, by
            and among the Registrant and the Investors listed on Schedule A
            thereto.
10.26(2)    Amended and Restated Investors' Rights Agreement, dated April 6,
            1999, by and among the Registrant and the Investors listed on
            Schedule A thereto.
10.27(2)    Lease Agreement, dated April 5, 1999, by and among the Registrant
            and Cisco Systems Capital Corporation.
10.28(3)    Amendment No. 2, dated May 10, 1999, to Framework Agreement, dated
            March 3, 1999, by and among the Registrant and MCI WorldCom, Inc.
10.29(4)    Employment Agreement with Steve Stringer.
10.30(2)    Employment Agreement with Michael Lanier.
10.31(5)    Master Lease Agreement, dated July 30, 1999, by and between the
            Company and GATX Capital Corporation
10.32(6)    ACI Plus Service Agreement, dated April 6, 1999, by and between the
            Company and Qwest Communications Corporation.
10.33(7)    Joint Venture Agreement, dated January 1, 2000, by and between the
            Company, Rhythms Links, Inc. and Optel Communications Corporation.
10.34(7)    Preferred Stock and Warrant Purchase Agreement, dated February 6,
            2000 by and between the Registrant and the Purchasers listed on
            Schedule I thereto.
10.35(13)   Amendment to Rights Agreement, dated February 6, 2000, by and
            between Registrant and Computershare Trust Company, Inc.
10.36(7)    Purchase Agreement, dated February 16, 2000, by and between the
            Registrant and the Initial Purchasers listed on Schedule I thereto.

                                       59
<PAGE>

Exhibit
No.         Description
--------------------------------------------------------------------------------
10.37(7)    Purchase Agreement, dated February 28, 2000 by and between the
            Registrant and Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner &
            Smith Incorporated and Salomon Smith Barney Inc.
10.38(7)    Employment Agreement with David J.  Shimp.
10.39(7)    Employment Agreement with Scott C.  Chandler.
10.40(4)    Plus Service Agreement, dated April 6, 1999, by and between the
            Registrant and Qwest Communications Corporation.
10.41(8)    Sublease, dated January 1, 2000, by and between the Registrant and
            Cyprus Amax Minerals Company
10.42(11)   Purchase and Sale Agreement, dated April 6, 2000, by and between
            Rhythms NetConnections Inc. and MGA Development Associates, L.P.
10.43(11)   Special Warranty Deed, dated May 8, 2000, by and between Rhythms
            NetConnections Inc. and MGA Development Associates. L.P.
10.44(11)   Dividend Payment Agreement, dated June 2, 2000, by and between
            Rhythms NetConnections Inc. and American Securities Transfer &
            Trust, Inc.
10.45(14)   Series B Preferred Stock Purchase Agreement, dated July 12, 2000, by
            and between At Home Network Solutions, Inc., RATHM, Inc. and other
            Investors signatory hereto.
10.45(14)   Consent and Amendment, dated October 2, 2000, by and between the
            Registrant, Rhythms Links Inc., RAxxent, Inc., RCanada, Inc., Axxent
            Corp. and Rhythms Canada Inc.
10.46*      Restricted Stock Purchase Agreement, dated September 29, 2000,
            between the Registrant and FireTap Communications Incorporated
10.47*      Employment Offer letter with J. W. Braukman
10.48*      Assignment of DSL Lines and Mutual Release, dated March 16, 2001,
            between Registrant and Steel Enterprise Holdings, Inc.
10.49*      Stock Purchase Agreement, dated December 2000, between Registrant
            and MegaPath Networks Incorporated
12.1(13)    Computation of Ratio of Earning to Combined Fixed Changes and
            Preferred Dividends.
21.1 *      Subsidiaries of the Registrant.
23.1 *      Consent of PricewaterhouseCoopers LLP.
24.1(10)    Power of Attorney.
------------

*    Filed herewith.

(1)  Previously filed with the Commission as an exhibit to the registration
statement on Form S-4 (File No. 333-59393) and incorporated herein by reference.

(2)  Previously filed with the Commission as an exhibit to the registration
statement on Form S-1 (File No. 333-72409) and incorporated herein by reference.

(3)  Previously filed with the Commission as an exhibit to the registration
statement on Form S-4 (File No. 333-82637) and incorporated herein by reference.

(4)  Previously filed with the Commission as an exhibit to the registration
statement on Form S-1 (File No. 333-82867) and incorporated herein by reference.

(5)  Previously filed with the Commission as an exhibit to Form 10-Q filed
November 11, 1999 and incorporated herein by reference.

(6)  Previously filed with the Commission as an exhibit to Form 10-Q filed
August 11, 1999 and incorporated herein by reference.

(7)  Previously filed with the Commission as an exhibit to Form 10-K filed March
30, 2000 and incorporated herein by reference.

                                       60
<PAGE>

(8)  Previously filed with the Commission as an exhibit to the registration
statement on Form S-4 (File No. 333-37618) and incorporated herein by reference.

(9)  Previously filed with the Commission as an exhibit to the registration
statement on Form S-8 (File No. 333-41874) and incorporated herein by reference.

(10) Included in Part IV of this annual report on Form 10-K under the
caption "Signatures."

(11) Previously filed with the Commission as an exhibit to Form 10-Q filed
August 14, 2000 and incorporated herein by reference.

(12) Previously filed with the Commission as an exhibit to the registration
statement on Form S-8 (File No. 333-41874) and incorporated herein by reference.

(13) Previously filed with the Commission as an exhibit to the registration
statement on Form S-3 (File No. 333-38334) and incorporated herein by reference.

(14)  Previously filed with the Commission as an exhibit to Form 10-K file
November 11, 2000 and incorporated by reference.

                                       61
<PAGE>

                                  SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized.

                           RHYTHMS NETCONNECTIONS INC.

Dated: March 30, 2001      By:  /s/ J.  W. Braukman
                              --------------------------------------------------
                                    J. W. Braukman,
                                    Chief Financial Officer
                                    (Principal Financial and Accounting Officer)

Know all mean by these presents, that each person whose signature appears below
constitutes and appoints Catherine M. Hapka and J.W. Braukman, his or her
attorney-in-fact, with power of substitution in any and all capacities, to sign
any amendments to this Annual Report on Form 10-K, and to file the same with
exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and confirming all that the
attorney-in-fact or his substitute or substitutes may do or cause to be done by
virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.


Dated: March 30, 2001               By:  /s/ Catherine M. Hapka
                                       ----------------------------------
                                    Catherine M. Hapka
                                    Chairman and Chief Executive Officer

Dated: March 30, 2001               By:  /s/ Steve Stringer
                                       ----------------------------------
                                    Steve Stringer
                                    President and Chief Operating Officer

Dated: March 30, 2001               By:  /s/ J. W. Braukman
                                       ----------------------------------
                                    J. W. Braukman
                                    Chief Financial Officer

Dated: March 30, 2001               By:  /s/ Susan Mayer
                                       ----------------------------------
                                    Susan Mayer
                                    Director

Dated: March  30, 2001              By:  /s/ William R. Stensrud
                                       ----------------------------------
                                    William R. Stensrud
                                    Director

Dated: March 30, 2001               By:  /s/ Keith B. Geeslin
                                       ----------------------------------
                                    Keith B. Geeslin
                                    Director
<PAGE>

Dated: March 30, 2001               By:  /s/ Kevin R. Compton
                                       ----------------------------------
                                    Kevin R. Compton
                                    Director

Dated: March 30, 2001               By:  /s/ Michael J. Levitt
                                       ----------------------------------
                                    Michael J. Levitt
                                    Director
<PAGE>

                       Report of Independent Accountants

To the Board of Directors and Stockholders
  of Rhythms NetConnections Inc.

In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of comprehensive income (loss), of cash
flows, and of stockholders' equity (deficit) present fairly, in all material
respects, the financial position of Rhythms NetConnections Inc. and its
subsidiaries at December 31, 2000 and 1999, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2000 in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern.  As discussed in Note 1 to the
financial statements, the Company has suffered recurring losses from operations
and has a total stockholders' deficit.  In addition, one of the Company's
leasing companies has notified the Company that an event of default has occurred
for failure to maintain certain covenants.  These factors raise substantial
doubt about its ability to continue as a going concern.  Management's plans in
regard to these matters are also described in Note 1.  The financial statements
do not include any adjustments that might result from the outcome of this
uncertainty.



PricewaterhouseCoopers LLP
Denver, Colorado
February 22, 2001, except for Note 12,
as to which the date is March 29, 2001

                                      F-1
<PAGE>

                          RHYTHMS NETCONNECTIONS INC.
                          CONSOLIDATED BALANCE SHEETS
                     (In thousands, except share amounts)

<TABLE>
<CAPTION>
                                                                                            December 31,       December 31,
                                     ASSETS                                                     1999               2000
-------------------------------------------------------------------------------------------------------------------------
<S>                                                                                         <C>                <C>
Current assets:
Cash and cash equivalents                                                                   $   48,247            $ 11,444
Short-term investments                                                                         292,008             493,050
Restricted cash                                                                                 36,707              43,132
Accounts, loans, interest, and other receivables, net                                           10,844              36,371
Inventory                                                                                        4,071               7,911
Prepaid expenses and other current assets                                                        8,460              37,034
--------------------------------------------------------------------------------------------------------------------------
Total current assets                                                                           400,337             628,942
--------------------------------------------------------------------------------------------------------------------------
Furniture, fixtures and equipment, net                                                         124,831             256,837
Collocation fees, net                                                                           57,421              77,947
Restricted cash                                                                                 59,526              21,271
Deferred business acquisition costs, net of accumulated amortization of $4,765 and $10,280      18,425               8,145
Deferred debt issue costs, net of accumulated amortization of $924 and $1,434                   16,194              23,824
Other assets                                                                                     8,690              39,295
--------------------------------------------------------------------------------------------------------------------------

TOTAL ASSETS                                                                                 $ 685,424         $ 1,056,261
==========================================================================================================================


                      LIABILITIES AND STOCKHOLDERS' EQUITY
---------------------------------------------------------------------------------------------------------------------------
Current liabilities:
Current portion of long-term debt                                                            $     333         $       110
Accounts payable                                                                                22,408              38,296
Cash overdrafts                                                                                  8,487                   -
Interest payable                                                                                 8,787              24,537
Accrued expenses and other current liabilities                                                  23,163              69,517
--------------------------------------------------------------------------------------------------------------------------
Total current liabilities                                                                       63,178             132,460
--------------------------------------------------------------------------------------------------------------------------
Long-term debt                                                                                     111                   -
Senior notes payable                                                                           505,696             832,168
Other liabilities                                                                                  110               7,812
--------------------------------------------------------------------------------------------------------------------------
Total liabilities                                                                              569,095             972,440
--------------------------------------------------------------------------------------------------------------------------

Mandatorily redeemable common stock warrants                                                        42                  42
Mandatorily redeemable preferred stock                                                               -             449,782
--------------------------------------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' equity (deficit):
Common stock, $0.001 par value; 250,000,000 shares authorized;
      78,255,707 shares issued as of 1999 and 79,739,764 as of 2000                                 78                  80
Treasury stock, at cost; 988,894 shares as of 1999 and none as of 2000                            (469)                  -
Additional paid-in capital                                                                     373,604             424,330
Warrants                                                                                        10,397              58,506
Deferred compensation                                                                          (12,320)            (18,542)
Accumulated deficit                                                                           (257,636)           (825,800)
Accumulated comprehensive income                                                                 2,633              (4,577)
--------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity (deficit)                                                           116,287            (366,003)
--------------------------------------------------------------------------------------------------------------------------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)                                         $ 685,424         $ 1,056,261
==========================================================================================================================
</TABLE>

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

                                      F-2
<PAGE>

                          RHYTHMS NETCONNECTIONS INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
              (In thousands, except share and per share amounts)
<TABLE>
<CAPTION>
                                                                                           Year Ended
                                                                                          December 31,
                                                                     --------------------------------------------------
                                                                         1998                1999              2000
-----------------------------------------------------------------------------------------------------------------------
<S>                                                                  <C>                <C>                <C>
Revenue:
   Service and installation, net                                     $      528         $    11,089        $    46,138
-----------------------------------------------------------------------------------------------------------------------
Operating Expenses:
   Network and service costs                                              4,695              68,161            210,274
   Selling, marketing, general and administrative                        23,153             114,689            279,978
   Depreciation and amortization                                          1,081              12,639             49,968
   Amortization of deferred business acquisition costs                        -               4,765             10,280
-----------------------------------------------------------------------------------------------------------------------
       Total operating expenses                                          28,929             200,254            550,500
-----------------------------------------------------------------------------------------------------------------------

Loss from operations                                                    (28,401)           (189,165)          (504,362)
-----------------------------------------------------------------------------------------------------------------------

Other Income (Expense):
Interest income                                                           5,813              22,673             51,286
Interest expense (including amortized debt
   discount and issue costs)                                            (13,779)            (52,537)          (105,213)
 Litigation settlement                                                        -                   -             (7,588)
 Equity in losses of affiliates                                               -                   -             (2,432)
Other income                                                                 33                 149                145
-----------------------------------------------------------------------------------------------------------------------
       Total other income (expense)                                      (7,933)            (29,715)           (63,802)
-----------------------------------------------------------------------------------------------------------------------

=======================================================================================================================
Net Loss                                                             $  (36,334)        $  (218,880)       $  (568,164)
=======================================================================================================================

Preferred stock dividends and accretion                                       -                   -             38,753
=======================================================================================================================
Net Loss Available to Common Shareholders                            $  (36,334)        $  (218,880)       $  (606,917)
=======================================================================================================================

Net Loss Per Share:
   Basic                                                             $   (12.18)        $     (4.15)       $     (7.99)
=======================================================================================================================
   Diluted                                                           $   (12.18)        $     (4.15)       $     (7.99)
=======================================================================================================================

Shares Used in Computing Net Loss Per Share:
   Basic                                                              2,984,216          52,770,402         75,941,610
=======================================================================================================================
   Diluted                                                            2,984,216          52,770,402         75,941,610
=======================================================================================================================
</TABLE>

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

                                      F-3
<PAGE>

                          RHYTHMS NETCONNECTIONS INC.
            CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
                                (In thousands)

<TABLE>
<CAPTION>
                                                               Year Ended December 31,
                                                  -------------------------------------------------
                                                     1998               1999                2000
---------------------------------------------------------------------------------------------------
<S>                                               <C>               <C>                 <C>
Net Loss                                          $ (36,334)        $ (218,880)         $ (568,164)

Cumulative translation adjustment                         -                  -                 110

Loss on available-for-sale securities                     -              2,633              (7,320)
---------------------------------------------------------------------------------------------------

Total comprehensive loss                          $ (36,334)        $ (216,247)         $ (575,374)
---------------------------------------------------------------------------------------------------
</TABLE>

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

                                      F-4
<PAGE>

                          RHYTHMS NETCONNECTIONS INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (In thousands)

<TABLE>
<CAPTION>
                                                                                             Year Ended December 31,
------------------------------------------------------------------------------------------------------------------------------
                                                                                     1998             1999            2000
------------------------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>             <C>            <C>
Cash Flows from Operating Activities:
     Net loss                                                                     $  (36,334)     $ (218,880)    $   (568,164)
     Adjustments to reconcile net loss to net cash used for operating activities:
         Depreciation and amortization of furniture, fixtures, equipment, and
           collocation fees                                                              539          12,639           49,968
         Amortization of deferred business acquisition costs                               -           4,765           10,280
         Amortization of debt discount and deferred debt issue costs                  13,882          23,939           27,906
         Amortization of deferred compensation                                           725           3,742           11,696
         Equity in losses of affiliates                                                    -               -            2,432
         Bad debt expense                                                                 50             317            5,233
         Other                                                                           387            (142)              52
         Changes in assets and liabilities:
            Increase in accounts, loans, interest, and other receivables, net         (2,426)         (8,785)         (30,760)
            Increase in inventory                                                       (340)         (3,731)          (3,840)
            Increase in prepaid expenses and other current assets                       (135)         (8,230)         (28,574)
            Increase in other assets                                                    (318)           (382)         (15,297)
            Increase in accounts payable                                               2,287          11,807           15,888
            Increase in interest payable                                                  39           8,748           15,750
            Increase in accrued expenses and other current liabilities                 2,440          20,347           46,354
            Increase in other liabilities                                                180              72            7,557
------------------------------------------------------------------------------------------------------------------------------
                Net cash used for operating activities                               (19,024)       (153,774)        (453,519)
------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities:
     Purchases of short-term investments                                            (451,870)       (451,660)      (6,685,550)
     Maturities of short-term investments                                            336,373         275,149        6,484,508
     Purchases (maturities) of government securities as restricted cash, net               -         (96,233)          31,830
     Investment in common stock and preferred stock                                        -          (5,325)         (25,000)
     Purchases of furniture, fixtures, and equipment                                  (9,973)       (147,358)        (175,343)
     Payments of collocation fees                                                    (13,562)        (45,974)         (27,104)
------------------------------------------------------------------------------------------------------------------------------
                Net cash used for investing activities                              (139,032)       (471,401)        (396,659)
------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
     Proceeds from leasing company for equipment                                       6,606          23,755                -
     Proceeds from issuance of senior notes and warrants                             150,365         325,000          300,000
     Payments of debt issue costs                                                     (6,519)        (10,598)          (9,064)
     Proceeds from borrowings on long-term debt                                          432               -                -
     Repayments of long-term debt                                                       (195)           (361)            (334)
     Proceeds from issuance of common stock                                              242         248,748            4,847
     Proceeds from issuance of preferred stock and warrants, net                      18,292          75,000          526,655
     Payments of equity issue costs                                                        -         (17,473)               -
     Bank overdraft                                                                        -           8,487           (8,487)
     Purchase of treasury stock                                                          (18)           (451)            (242)
------------------------------------------------------------------------------------------------------------------------------
                Net cash provided by financing activities                            169,205         652,107          813,375
------------------------------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents                                             11,149          26,932          (36,803)
Cash and cash equivalents at beginning of period                                      10,166          21,315           48,247
------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period                                        $   21,315      $   48,247     $     11,444
------------------------------------------------------------------------------------------------------------------------------
Supplemental schedule of cash flow information:
     Cash paid for interest                                                       $       66      $   19,850     $     61,529
------------------------------------------------------------------------------------------------------------------------------
Supplemental schedule of non-cash investing and financing activities:
------------------------------------------------------------------------------------------------------------------------------
     Furniture, fixtures, and equipment purchases payable                         $    7,363      $      547     $      1,086
     Business acquisition costs from issuance of preferred stock and warrants     $        -      $   22,010     $          -
     Warrants issued to leasing companies                                         $        -      $    1,180     $          -
     Dividends paid with stock                                                    $        -      $        -     $     10,125
------------------------------------------------------------------------------------------------------------------------------
</TABLE>

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

                                      F-5
<PAGE>

                          RHYTHMS NETCONNECTIONS INC.
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                   (In thousands, except per share amounts)

<TABLE>
<CAPTION>
                                     Preferred           Common
                                       Stock             Stock          Treasury                                          Total
                                      $0.001            $0.001            Stock       Addit-                              Stock-
                                     par value         par value         at Cost      ional     Deferred       Accu-      holders'
                                -----------------  ----------------  --------------   Paid-In    Compen-      mulated      Equity
                                Shares     Amount  Shares    Amount  Shares  Amount   Capital    sation       Deficit     (Deficit)
-----------------------------------------------------------------------------------------------------------------------------------
<S>                             <C>        <C>     <C>       <C>     <C>     <C>      <C>       <C>           <C>         <C>
Balance at December 31, 1997    12,490,000     12  2,482,222      2       -       -    14,012     (1,258)      (2,422)      10,346

Issuance of Series A
  preferred stock for cash         365,094      1          -      -       -       -       291          -            -          292
Issuance of Series B
  preferred stock for cash       4,044,943      4          -      -       -       -    17,996          -            -       18,000
Issuance of common stock
  upon exercise of options               -      -  5,560,308      6       -       -       236          -            -          242
Purchase of treasury stock
  for cash                               -      -          -      - 438,115     (18)        -          -            -          (18)
Deferred compensation from
  grants of options to
  purchase common stock                  -      -          -      -       -       -     4,908     (4,908)           -            -
Amortization of deferred
  compensation                           -      -          -      -       -       -         -        725            -          725
Reversal of deferred
  compensation from
  cancellatioin of grants
  to purchase common stock               -      -          -      -       -       -      (231)       231            -            -
Net loss                                 -      -          -      -       -       -         -          -      (36,334)     (36,334)
Balance at December 31, 1998    16,900,037 $   17  8,042,530 $    8 438,115  $  (18)  $37,212   $ (5,210)    $(38,756)    $ (6,747)
-----------------------------------------------------------------------------------------------------------------------------------
</TABLE>

                                      F-6
<PAGE>

<TABLE>
<CAPTION>


                                           Preferred Stock         Common Stock       Treasury Stock
                                          $0.001 par value      $0.001 par value          at Cost      Additional
                                          -----------------    -----------------    ----------------    Paid-In
                                          Shares     Amount    Shares     Amount    Shares    Amount    Capital    Warrants
---------------------------------------------------------------------------------------------------------------------------
<S>                                      <C>         <C>      <C>         <C>      <C>       <C>      <C>        <C>
Balance at December 31, 1998             16,900,037  $    17   8,042,530  $    8   438,115   $  (18)  $  37,212  $      -
Issuance of common stock
 in initial public offering                       -       -   10,781,250      11         -       -      226,395         -
Issuance of common stock upon
 exercise of options for cash                     -       -    2,711,247       3         -       -        3,333         -
Issuance of common stock in
 secondary offering                               -       -      594,279       -         -       -       17,233         -
Issuance of common stock upon
 cashless exercise of warrants                    -       -    4,954,085       5         -       -        6,520         -
Issuance of Series C preferred
 stock and warrants for cash              8,395,655       8            -       -         -       -       60,368     7,124
Issuance of Series D preferred
 stock and warrants for cash                441,176       -            -       -         -       -        6,317     1,183
Business relationship value
 arising from issuance of
  Series C and D preferred stock                  -       -            -       -         -       -       21,100         -
Costs arising from issuances of
 Series C and D preferred stock                   -       -            -       -         -       -         (245)        -
Conversion of preferred stock to
 common upon initial
  public offering                       (25,736,868)    (25)  51,076,051      51         -       -          (26)        -
Costs arising from
 public offerings                                 -       -            -       -         -       -      (17,224)        -
Purchase of treasury stock
 for cash                                         -       -            -       -   550,779    (451)           -         -
Issuance of warrants to
 leasing companies                                -       -            -       -         -       -            -     1,180
Issuance of warrants to business
 partner                                          -       -            -       -         -       -            -       910
Stock issuance under employee
 stock purchase plan                              -       -       96,265       -         -       -        1,769         -
Deferred compensation from grants
 of options to purchase
  common stock                                    -       -            -       -         -       -       11,428         -
Amortization of deferred compensation             -       -            -       -         -       -            -         -
Reversal of deferred compensation
 from cancellation of grants to
  purchase common stock                           -       -            -       -         -       -         (576)        -
Net loss                                          -       -            -       -         -       -            -         -
Unrealized gain on available-
 for-sale securities                              -       -            -       -         -       -            -         -
-------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1999                      -     $ -   78,255,707     $78   988,894   $(469)    $373,604  $ 10,397


<CAPTION>
                                                                                   Accumulated
                                                                                     Other            Total
                                                    Deferred     Accumulated      Comprehensive    Stockholders'
                                                  Compensation    Deficit            Income      Equity (Deficit)
                                                  ---------------------------------------------------------------
<S>                                               <C>            <C>              <C>            <C>
Balance at December 31, 1998                      $  (5,210)     $  (38,756)      $      -         $  (6,747)
Issuance of common stock
 in initial public offering                              -                -              -           226,406
Issuance of common stock upon
 exercise of options for cash                            -                -              -             3,336
Issuance of common stock in
 secondary offering                                      -                -              -            17,233
Issuance of common stock upon
 cashless exercise of warrants                           -                -              -             6,525
Issuance of Series C preferred
 stock and warrants for cash                             -                -              -            67,500
Issuance of Series D preferred
 stock and warrants for cash                             -                -              -             7,500
Business relationship value
 arising from issuance of
  Series C and D preferred stock                         -                -              -            21,100
Costs arising from issuances of
 Series C and D preferred stock                          -                -              -              (245)
Conversion of preferred stock to
 common upon initial
  public offering                                        -                -              -                 -
Costs arising from
 public offerings                                        -                -              -           (17,224)
Purchase of treasury stock
 for cash                                                -                -              -              (451)
Issuance of warrants to
 leasing companies                                       -                -              -             1,180
Issuance of warrants to business
 partner                                                 -                -              -               910
Stock issuance under employee
 stock purchase plan                                     -                -              -             1,769
Deferred compensation from grants
 of options to purchase
  common stock                                     (11,428)               -              -                -
Amortization of deferred compensation                3,742                -              -            3,742
Reversal of deferred compensation
 from cancellation of grants to
  purchase common stock                                576                -              -                -
Net loss                                                 -         (218,880)             -         (218,880)
Unrealized gain on available-
 for-sale securities                                     -                -          2,633            2,633
-----------------------------------------------------------------------------------------------------------
Balance at December 31, 1999                      $(12,320)       $(257,636)       $ 2,633        $ 116,287
-----------------------------------------------------------------------------------------------------------
</TABLE>

                                      F-7
<PAGE>
                          RHYTHMS NETCONNECTIONS INC.
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                     (in thousands, except share amounts)
<TABLE>
<CAPTION>
                                    Common Stock
                                      $0.001        Treasury Stock                          Def-                          Total
                                     par value          at Cost      Additional            erred     Accumu-  Compre-  Stockholders'
                                  --------------------------------    Paid-In              Compen-    lated   hensive     Equity
                                  Shares    Amount  Shares  Amount    Capital    Warrants  sation    Deficit   Income   (Deficit)
--------------------------------------------------------------------------------------------------------------------------------
<S>                               <C>        <C>    <C>      <C>     <C>        <C>      <C>       <C>        <C>      <C>
Balance at December 31, 1999      78,255,707 $ 78   988,894  $(469)  $ 373,604  $ 10,397 $(12,320) $(257,636) $ 2,633  $ 116,287

Issuance of common stock
     upon exercise of
     options for cash                346,006    -         -      -       1,258         -        -          -        -      1,258
Issuance of treasury stock
     upon settlement
     of litigation                         -    -  (438,115)    18          71         -        -          -        -         89
Issuance of Series E
     preferred stock warrants
     for cash, net                         -    -         -      -           -    48,109        -          -        -     48,109
Beneficial conversion feature
     of Series E preferred
     stock                                 -    -         -      -      57,410         -        -          -        -     57,410
Purchase of treasury stock
     for cash                              -    -   358,959   (242)          -         -        -          -        -       (242)
Issuance of treasury stock
     upon cashless exercise
     of warrants                           -    -     9,041   (197)          -         -        -          -        -       (197)
Accrued Series E and F
     preferred stock dividends             -    -         -      -     (34,500)        -        -          -        -    (34,500)
Accretion of Series E and F
     preferred stock                       -    -         -      -      (4,253)        -        -          -        -     (4,253)
Stock issuance under employee
     stock purchase plan             282,916    -  (282,919)   434       3,155         -        -          -        -      3,589
Deferred compensation from
     grants of common stock                -    -  (635,860)   456      23,017         -  (23,473)         -        -          -
Amortization of deferred
     compensation                          -    -         -      -           -         -   11,696          -        -     11,696
Reversal of deferred
     compensation from
     cancellation of grants
     to purchase common stock              -    -         -      -      (5,555)        -    5,555          -        -          -
Series F preferred stock
     dividend paid                   855,135    2         -      -      10,123         -        -          -        -     10,125
Net loss                                   -    -         -      -    (568,164)        - (568,164)
Cumulative translation adjustment          -    -         -      -           -         -        -          -      110        110
Unrealized loss on available-
     for-sale securities                   -    -         -      -           -         -        -          -   (7,320)    (7,320)
--------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2000      79,739,764 $ 80         -  $   -   $ 424,330   $58,506 $(18,542) $(825,800) $(4,577) $(366,003)
--------------------------------------------------------------------------------------------------------------------------------


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



                                      F-8
<PAGE>

RHYTHMS NETCONNECTIONS INC.
Notes to Consolidated Financial Statements


1.  THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Operations

Rhythms NetConnections Inc. (the Company), a Delaware corporation, was formed in
February 1997. The Company is in the business of providing broadband local
access communication services to large enterprises, telecommunications carriers
and their Internet service provider (ISP) affiliates and other ISPs. The
Company's services include a range of high-speed, "always on" connections that
offer its customers both cost and performance advantages when accessing the
Internet or private networks. The Company uses multiple digital subscriber line
(DSL) technologies to provide data transfer rates ranging from 128 kbps to 8.0
Mbps delivering data to the end user and from 128 kbps to 1.5 Mbps receiving
data from the end user. The Company began offering commercial services in the
U.S. in April 1998.

The Company has had losses since inception of approximately $825.8 million, had
negative cash flows from operations of $453.5 million in 2000, and has a net
stockholders' deficit of $367.5 million at December 31, 2000.  While the Company
estimates that  it has sufficient cash to fund its operations into January 2002,
the Company continues to use significant amounts of its available cash balances
to fund its operating needs and capital expenditures.  Also, in January 2001,
one of the Company's leasing companies, GATX Capital Corporation, notified the
Company that an Event of Default had occurred for failure to maintain certain
operating cash flow covenants (see Note 11).  These factors raise substantial
doubt about the Company's ability to continue as a going concern.  These
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.

In March 2001, the Company's Board of Directors (Board) engaged Lazard Freres &
Co. LLC, an investment banking firm to provide financial advice and assist the
Company in evaluating strategic alternatives and other possible financial
transactions, including, but not limited to, a sale of the Company, a strategic
transaction, joint venture or partnership with a financial, strategic or
industry partner or other similar transaction,  a debt and/or equity financing
or restructuring, a public or private sale of debt or equity securities or
assets, and/or acquisition, merger, consolidation, reorganization,
recapitalization or other business combination.  While the Company will consider
all commercially reasonable alternatives, there can be no assurance that a
transaction will be consummated on terms acceptable to the Board, or at all.

The Company's ultimate success depends upon, among other factors, raising
substantial additional financing; attracting and retaining customers; rapidly
scaling operations and the systems that support those operations; effectively
responding to competitive developments; complying with governmental regulatory
requirements; and continuing to attract, retain and motivate qualified
personnel.  There can be no assurance that the Company will be successful in
addressing these matters and failure to do so could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition. The Company's significant operating losses are expected to continue,
which will require additional financing.

Principles of Consolidation and Basis of Presentation

The consolidated financial statements include the accounts of the Company and
its majority-owned subsidiaries. The equity method of accounting is used for
companies and other investments in which the Company has significant influence.
Generally this represents ownership of at least 20% and not more than 50% (see
Note 7). All significant intercompany transactions have been eliminated in
consolidation.

                                      F-9
<PAGE>

Use of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting periods. Actual results
could differ from those estimates and assumptions.

Revenue Recognition

Revenue consists of recurring fees for monthly DSL service and customer network
connectivity, and nonrecurring fees, which can include certain fees such as
service activation, equipment and installation.  Customer contracts are
renewable and range from one to three years in duration with payments due on a
monthly basis.  Monthly recurring service revenue is recorded in the month the
services are rendered.  Effective January 1, 2000, the Company adopted
Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 101,
"Revenue Recognition in Financial Statements" (SAB 101).  SAB 101 sets forth
certain SEC views on how revenue should be recognized and whether revenues can
be split among associated elements of a contract.  Based on the Company's review
of SAB 101, it determined that certain revenues associated with installation and
equipment sales should be deferred and recognized over the expected customer
life.  Costs associated with these revenues up to the amount of deferred
revenues are deferred and amortized over the expected customer life.  Costs in
excess of revenues are deferred and are being amortized over the contractual
life.  The adoption of SAB 101 had no impact on the Company's net loss or
earnings per share in 2000. Revenue deferred at December 31, 2000 was $12.4
million.  If SAB 101 had been adopted January 1, 1998, proforma revenue and
network service costs would have been $74,000 and $4.2 million, respectively, in
1998 and $8.1 million and $65.1 million, respectively, in 1999.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand, money market funds, certificates
of deposit, obligations of the U.S. government and its agencies and commercial
paper with a maturity of three months or less at the time of purchase.  Included
in accounts payable are outstanding checks in excess of cash balances of $8.5
million at December 31, 1999 and none at December 31, 2000.

Short-Term Investments

Short-term investments consist of obligations of the U.S. government and its
agencies and commercial paper that have a maturity between 91 days and one year
from the date of purchase. Management determines the appropriate classification
of marketable debt and equity securities at the time of purchase.

Restricted Cash

Restricted cash is made up of a portfolio of U.S. government securities
purchased to secure payment of the first six scheduled interest payments, of
which three payments remain, on the 1999 senior notes.

Fair Value of Financial Instruments

The carrying amounts reported in the balance sheets for cash and cash
equivalents, short-term investments, accounts receivable, and accounts payable
approximate fair value because of the immediate or short-term maturity of these
financial instruments.  The carrying amounts reported for long-term debt other
than the 12 3/4% senior notes, 13 1/2% senior discount notes, and 14% senior
notes, approximate fair value based upon management's best estimates of what
interest rates would be available for the same or similar instruments.  The
senior notes are publicly traded securities.  The combined quoted fair market
value and the combined carrying

                                      F-10
<PAGE>

amount of the senior notes at December 31, 1999 are $471.9 million and $505.7
million, respectively, and $194.2 million and $832.2 million, respectively, at
December 31, 2000.

Inventory

Inventory consists of communications equipment that will be installed at
customer locations. Inventory is accounted for using the first-in, first-out
method at the lower of cost or market.

Furniture, Fixtures, and Equipment

Furniture, fixtures, and equipment consists of purchased equipment, furniture,
internal use software, and leasehold improvements. Furniture, fixtures, and
equipment is recorded at cost. Depreciation is computed using the straight-line
method over the estimated useful lives of the assets, generally three to seven
years or the lease term, if shorter. When items are retired, sold or otherwise
disposed of, the cost and related accumulated depreciation are removed from the
accounts, and gains and losses resulting from such transactions are reflected in
operations.  Depreciation expense for the years ended December 31, 1998, 1999,
and 2000 was $454, $10,285, and $43,391, respectively.

Collocation Fees

Collocation fees represent nonrecurring fees paid to secure central office space
for location of certain Company equipment. The fees are amortized over their
estimated useful lives of ten years.  Amortization expense for the years ended
December 31, 1998, 1999, and 2000 was $85, $2,354, and $6,577, respectively.

Impairment of Long-Lived Assets

The Company investigates potential impairments of its long-lived assets
periodically in accordance with the provision of Statement of Financial
Accounting Standards (SFAS) No. 121, Accounting for the impairment of long-lived
assets and for long-lived assets to be disposed of.  An impairment review is
performed when events or changes in circumstances indicate that the carrying
value may not be recoverable.  Factors the Company considers important which
could trigger an impairment review include, but are not limited to, significant
underperformance relative to historical or projected future operating results,
significant changes in the manner of use of the acquired assets in the strategy
for the Company's overall business, significant negative industry or economic
trends, a significant decline in the Company's stock price for a sustained
period, and the Company's market capitalization relative to net book value.
When the Company determines that the carrying value of long-lived assets may not
be recoverable based upon the existence of one or more of the above indicators
of impairment, the Company evaluates the projected undiscounted cash flows
related to the asset.  If these cash flows are less than the carrying value of
the asset, the Company measures the impairment using discounted cash flows or
other methods of determining fair value.

Concentrations of Credit Risk

Financial instruments, which potentially subject the Company to concentrations
of credit risk, consist primarily of cash equivalents and short-term
investments. Cash in excess of operating requirements is invested in money
market funds, certificates of deposit with high quality financial institutions,
obligations of the U.S. government and its agencies, and commercial paper rated
A-1, P-1 to minimize risk.

At December 31, 1999 and 2000, accounts receivable balances from two significant
customers were 33.2% and 28.0%, respectively, of the total net accounts
receivable balance and 40.8% and 37.5%, respectively, of revenues.  A portion of
the Company's revenue is derived from companies with unproven business models.
Ongoing credit evaluations of customers' financial conditions are performed and,
generally, no collateral is required.  The Company maintains an allowance for
potential credit losses. At December 31, 1999 and 2000, the allowance for
doubtful accounts was $0.4 million and $5.6 million, respectively.  The
Company's customer base is widespread geographically.

                                      F-11
<PAGE>

Advertising Costs

Advertising costs are expensed as incurred.  Approximately $0.7 million, $6.9
million, and $16.3 million of advertising costs were incurred in 1998, 1999, and
2000, respectively.

Income Taxes

The Company provides for income taxes utilizing the liability method. Under the
liability method, current income tax expense or benefit represents income taxes
expected to be payable or refundable for the current period. Deferred income tax
assets and liabilities are established for both the impact of differences
between the financial reporting bases and tax bases of assets and liabilities
and for the expected future tax benefit to be derived from tax credits and tax
loss carryforwards. Deferred income tax expense or benefit represents the change
during the reporting period in the net deferred income tax assets and
liabilities. Deferred tax assets are reduced by a valuation allowance when, in
the opinion of management, it is more likely than not that some portion or all
of the deferred tax assets will not be realized.

Net Loss Per Share

Basic earnings per share (EPS) is calculated by dividing the income or loss
available to common stockholders by the weighted average number of common shares
outstanding for the period without consideration for common stock equivalents.
Diluted EPS is computed by dividing the income or loss available to common
stockholders by the weighted average number of common shares and common stock
equivalents outstanding for the period. Shares subject to repurchase by the
Company are considered common stock equivalents for purposes of this
calculation. Shares issuable upon conversion of preferred stock, upon the
exercise of outstanding stock options and warrants and shares issued subject to
repurchase by the Company totaling 52,958,513, 6,897,060, and 36,628,231,
respectively, for the years ended December 31, 1998, 1999, and 2000, have been
excluded from the computation since their effect would be antidilutive.

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) of  $2.6 million and ($4.6)
million at December 31, 1999 and December 31, 2000, respectively, is primarily
attributable to the unrealized gain (loss) on the Axxent, Inc. common stock
which is held as an available-for-sale security that is carried at fair value.
No gains or losses have been realized on this investment.

Assets and liabilities denominated in foreign functional currencies are
translated at the exchange rate as of the balance sheet date.  Translation
adjustments are recorded as a separate component of shareholders' equity.
Revenues, costs and expenses denominated in foreign functional currencies are
translated at the weighted-average exchange rate for the period.  The cumulative
translation adjustment at December 31, 2000 was $110,000 compared to none
recorded at December 31, 1999.

Stock Options, Stock Awards and Stock Purchase Warrants

The Company uses the intrinsic value method of accounting for all employee stock
option, stock award and stock purchase warrant arrangements.  Compensation cost
is recognized for all stock options, stock awards and stock purchase warrants
granted to employees when the exercise price is less than the market price of
the underlying common stock on the date of grant.  Statement of Financial
Accounting Standards No. 123 (SFAS No. 123), "Accounting for Stock-Based
Compensation" requires pro forma disclosures regarding earnings (loss) as if
compensation cost for stock options and stock purchase warrants had been
determined in accordance with the fair value based method prescribed in SFAS No.
123.  Estimates of the fair market value are made for each stock option and
stock purchase warrant at the date of grant by the use of the Black-Scholes
option pricing model.

                                      F-12
<PAGE>

New Accounting Pronouncements

In June 1998, the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging
Activities".  SFAS No. 133, as amended by SFAS Nos. 137 and 138, is effective
for fiscal years beginning January 1, 2001.  SFAS No. 133 requires that all
derivative instruments be recorded on the balance sheet at fair value.  Changes
in the fair value of derivatives are recorded each period in current earnings or
other comprehensive income, depending on whether a derivative is designated as
part of a hedge transaction, the type of hedge, and the extent of hedge
ineffectiveness.  The adoption will not have a material impact on the Company's
financial position or results of operations.

Reclassifications

Certain balances in the 1998 and 1999 financial statements have been
reclassified to conform to the 2000 presentation.  The reclassifications had no
effect on financial condition, results of operations or cash flows.


2.  SHORT-TERM INVESTMENTS

The Company's marketable debt securities are classified as held-to-maturity and
carried at amortized cost, which approximates fair value, therefore there were
no significant unrealized gains or losses.  Short-term investments consist of
the following:

================================================================================
                                                               December 31,
                                                       -------------------------
(In thousands)                                            1999            2000
--------------------------------------------------------------------------------

Commercial paper                                       $  75,902       $ 470,322
U.S. government securities                               216,106          22,728
--------------------------------------------------------------------------------
                                                       $ 292,008       $ 493,050
--------------------------------------------------------------------------------

                                      F-13
<PAGE>

3.  COMPOSITION OF CERTAIN BALANCE SHEET COMPONENTS
<TABLE>
<CAPTION>
=========================================================================================
                                                                        December 31,
                                                                -------------------------
(In thousands)                                                     1999            2000
-----------------------------------------------------------------------------------------
<S>                                                             <C>             <C>
Accounts, loans, interest and other receivables, net:
   Trade, net of allowance for doubtful accounts of
      $367 in 1999 and $5,600 in 2000, respectively             $   4,016       $  23,358
   Interest                                                         5,011           6,105
   Other receivables from third parties                             1,701           6,351
   Employee expense advances and loans                                116             557
-----------------------------------------------------------------------------------------
                                                                $  10,844       $  36,371
=========================================================================================

Furniture, fixtures and equipment, net:
   Operating equipment                                          $  86,814       $ 147,774
   Office furniture                                                14,773           9,639
   Leasehold improvements                                           2,995           5,540
   Computer software                                                7,993          34,409
   Computer equipment                                              17,239          33,117
   Land and buildings                                                   -           5,431
   Lab equipment                                                      605             658
   Accumulated depreciation                                       (10,631)        (53,968)
-----------------------------------------------------------------------------------------
                                                                $ 124,831       $ 256,837
=========================================================================================

Collocation fees, net:
   Collocation fees                                                49,316          86,964
   Accumulated amortization                                        (2,439)         (9,017)
-----------------------------------------------------------------------------------------
                                                                 $ 57,421        $ 77,947
=========================================================================================

Accrued expenses and other current liabilities:
   Accrued payroll                                                $ 8,851        $ 13,773
   Carrier services and other operating costs                       8,492          50,436
   Other                                                            5,820           5,308
-----------------------------------------------------------------------------------------
                                                                 $ 23,163        $ 69,517
=========================================================================================
</TABLE>

4.  DEBT

Outstanding debt consists of the following:
<TABLE>
<CAPTION>
=======================================================================================================
                                                                                     December 31,
                                                                              -------------------------
(In thousands)                                                                  1999            2000
-------------------------------------------------------------------------------------------------------
<S>                                                                           <C>             <C>
Note payable to bank; due in monthly installments of $28;
   interest at prime plus 0.25% (8.0% and 8.75%, respectively);
   collateralized by certain assets; matures April 2001                       $     444       $     110
13 1/2% senior discount notes; due May 2008; net of unamortized
   discount of $109,304 in 1999 and $82,832 in 2000; unsecured                  180,696         207,168  (a)
12 3/4% senior notes; due April 2009; unsecured                                 325,000         325,000  (b)
14% senior notes; due February 2010; unsecured                                        -         300,000  (c)
-------------------------------------------------------------------------------------------------------
Total debt                                                                      506,140         832,278
Less current portion                                                               (333)           (110)
-------------------------------------------------------------------------------------------------------
                                                                              $ 505,807       $ 832,168
-------------------------------------------------------------------------------------------------------
</TABLE>

                                      F-14
<PAGE>

(a) The sale of the 1998 senior discount notes included warrants to purchase
4,732,800 shares of common stock at an exercise price of $0.004 per share.  The
notes were issued at a discount, and cash proceeds from the issuance of the
notes and warrants were $150.4 million. The value ascribed to the warrants of
$6.6 million resulted in additional debt discount. The debt issue costs are
being amortized to interest expense using the effective interest method over the
period that the notes are outstanding. The notes will accrete in value through
May 15, 2003, at a rate of 13 1/2% per annum, compounded semi-annually; no cash
interest will be payable prior to that date. Upon a change in control or upon
certain asset sales, the Company must offer to repurchase all or a portion of
the outstanding notes. In addition, the Company has the option to repurchase the
notes upon payment of a premium of accreted value at that point in time. The
notes contain restrictive covenants including limitations on future
indebtedness, restricted payments, transactions with affiliates, liens, sale of
stock of subsidiaries, dividends, mergers and transfers of assets.

Effective November 20, 1998, the Company completed an exchange offer of the 13
1/2% senior discount notes that allowed for registration of such notes under the
Securities Act of 1933, as amended.  Of the original issue notes, $289.0 million
were tendered for exchange. The registered notes have substantially the same
terms and conditions as the unregistered notes, except that the registered notes
are not subject to the restrictions on resale or transfer that applied to the
unregistered notes.

(b) Net cash proceeds from the issuance of the 1999 senior notes were
approximately $314.5 million of which approximately $113.2 million was used to
purchase a portfolio of U.S. government securities to secure payment of the
first six scheduled interest payments on the 1999 senior notes.  These senior
notes are unsecured obligations of the Company and mature on April 15, 2009.
The notes are redeemable at the Company's option, in whole or in part, at any
time after April 15, 2004, at predetermined redemption prices, together with any
accrued and unpaid interest through the date of redemption.  Upon a change of
control, each holder of the senior notes may require the Company to purchase the
notes at 101% of the principal amount thereof, plus any accrued and unpaid
interest to the date of purchase.  The 1999 senior notes contain restrictive
covenants, including limitations on future indebtedness, restricted payments,
transactions with affiliates, liens, sale of stock of subsidiaries, entering new
lines of business, dividends, mergers and transfers of assets.

Effective September 17, 1999, the Company completed an exchange offer of the 12
3/4% senior notes that allowed for registration of such notes under the
Securities Act of 1933, as amended.  The original issue notes of $325.0 million
were tendered for exchange. The registered notes have substantially the same
terms and conditions as the unregistered notes, except that the registered notes
are not subject to the restrictions on resale or transfer that applied to the
unregistered notes.

(c) Net cash proceeds from the issuance of the 2000 senior notes were
approximately $291.3 million. These senior notes are unsecured obligations of
the Company and mature on February 15, 2010.  The notes are redeemable at the
Company's option, in whole or in part, at any time after February 15, 2005, at
predetermined redemption prices, together with any accrued and unpaid interest
through the date of redemption.  Upon a change of control, each holder of the
senior notes may require the Company to purchase the notes at 101% of the
principal amount thereof, plus any accrued and unpaid interest to the date of
purchase.  The 2000 senior notes contain restrictive covenants, including
limitations on future indebtedness, restricted payments, transactions with
affiliates, liens, sale of stock of subsidiaries, entering new lines of
business, dividends, mergers and transfers of assets.

Effective May 23, 2000, the Company completed an exchange offer of the 14%
senior notes that allowed for registration of such notes under the Securities
Act.  Of the original issue notes, $300.0 million were tendered for exchange.

Future maturities of outstanding debt are $0.1 million in 2001, none in 2002,
none in 2003, none in 2004, none in 2005, none in 2006 and $915.0 million
thereafter.

                                      F-15
<PAGE>

5.  STOCKHOLDERS' EQUITY

The Company was initially capitalized in February 1997 with common stock.

On July 3, 1997, the Company issued 12,280,000 shares of its Series A Preferred
Stock to new and existing investors for an aggregate purchase price of $12.3
million, which converted into 29,472,000 shares of Common Stock upon the closing
of the initial public offering (IPO) of the Company's Common Stock as discussed
below.  In addition, 210,000 shares of Series A Preferred Stock were sold to
certain investors for an aggregate purchase price of $0.2 million, which
converted into 504,000 shares of Common Stock upon the closing of the IPO of the
Company's Common Stock as discussed below.  The Company also issued 365,094
shares of Series A Preferred Stock at a purchase price of $0.80 per share which
converted into 876,226 shares of Common Stock upon the closing of the IPO of the
Company's Common Stock in April 1999 as discussed below.

On March 12, 1998, the Company issued 4,044,943 shares of its Series B Preferred
Stock to new and existing investors at a price of $4.45 per share.  The Company
received proceeds totaling $18.0 million, which converted into 9,707,863 shares
of Common Stock upon the closing of the IPO of the Company's Common Stock in
April 1999 as discussed below.

In March 1999, the Company issued 3,731,410 shares of Series C Preferred Stock
to WorldCom Ventures' (f/k/a MCI WorldCom Ventures Fund, Inc.) (WorldCom
Ventures) for an aggregate purchase price of $30.0 million, which converted into
4,477,692 shares of Common Stock upon the closing of the IPO of the Company's
Common Stock in April 1999 as discussed below.  The terms of the transaction
also provided for the Company and WorldCom, Inc. (f/k/a MCI WorldCom, Inc.)
(WorldCom) to enter into various business relationships, including WorldCom's
commitment to sell 100,000 of the Company's DSL lines over a period of five
years, subject to penalties for failure to reach target commitments.  This
transaction included certain warrants as discussed in Note 8.

In March 1999, the Company issued 3,731,409 shares of Series C Preferred Stock
to Microsoft for an aggregate purchase price of $30.0 million, which converted
into 4,477,691 shares of Common Stock upon the closing of the IPO of the
Company's Common Stock in April 1999 as discussed below. The terms of the
transaction also provided for the Company and Microsoft to enter into various
business relationships.  In connection with these business relationships, the
Company capitalized $10.0 million in business acquisition costs that was being
amortized to operating expense over a three-year period.  This transaction
included certain warrants as discussed in Note 8.  At December 31, 2000, the
Company determined that this asset was impaired and expensed the remaining
capitalized costs of $4.0 million.

In April 1999, the Company issued 932,836 shares of Series C Preferred Stock to
Qwest, which converted into 1,119,403 shares of Common Stock upon the closing of
the IPO of the Company's Common Stock in April 1999, as discussed below.  Also
included was 441,176 shares of Series D Preferred Stock, that converted into
441,176 shares of Common Stock upon the closing of the IPO of the Company's
Common Stock.  The aggregate purchase price for these transactions was $15.0
million.  In accordance with provisions of the agreement underlying this
investment, the Company and Qwest have entered into certain business
relationships.  In connection with these business relationships, the Company
capitalized $11.1 million in business acquisition costs that is being amortized
to operating expense over a five-year period.  This transaction included certain
warrants as discussed in Note 8.

Effective April 12, 1999, the Company completed an IPO of its Common Stock.  A
total of 10,781,250 Common Shares were issued at $21.00 per share; net proceeds
to the Company were approximately $210.1 million after payment of underwriting
fees and related issue costs.  Upon completion of the offering, all classes of
Preferred Stock automatically converted to Common Stock, resulting in an
additional 51,076,051 shares of Common Stock being issued leaving no shares of
Preferred Stock issued and outstanding.

                                      F-16
<PAGE>

Effective August 17, 1999, the Company completed a secondary public offering of
its Common Stock in a transaction that allowed  holders of warrants issued in
connection with the 13 1/2% senior discount notes to exercise those warrants and
sell the resulting Common Stock at $29.00 per share. A total of 3,961,862 shares
were issued in the transaction; the company received no proceeds from the sale
of these shares.  In connection with the secondary offering, the underwriters of
the offering were allowed to purchase 594,279 shares of Common Stock from the
Company for $29.00 per share.  The sale of these shares was completed on
September 14, 1999, and the Company received proceeds of $16.4 million, net of
underwriting discount.

Effective November 4, 1998, the Company completed a two-for-one split of its
Common Stock.  Effective March 19, 1999, the Company completed a six-for-five
split of its Common Stock. The accompanying consolidated financial statements
have been restated for all periods presented to reflect the stock splits.

6.  MANDATORILY REDEEMABLE PREFERRED STOCK

In March 2000, the Company sold $250.0 million of 8 1/4% Series E Convertible
Preferred Stock (Series E Preferred Stock) to Hicks, Muse, Tate & Furst
Incorporated (HMTF).  The Company received approximately $236.3 million of net
proceeds from the sale.  Each share of Series E Preferred Stock is convertible
into shares of Common Stock at any time at a conversion price of $37.50 per
share, subject to adjustment.  In addition, the Company issued HMTF warrants to
purchase (a) 1,875,000 shares of Common Stock at an exercise price of $45.00 per
share, exercisable for three years; (b) 1,875,000 shares of Common Stock at an
exercise price of $50.00 per share, exercisable for five years; and (c)
1,875,000 shares of Common Stock at an exercise price of $55.00 per share,
exercisable for seven years.  Since the effective conversion price of the Series
E Preferred Stock was below the fair market value of the Common Stock at the
issuance date, the Company has recognized a beneficial conversion feature of
$57.4 million.  This amount has been recorded as an increase in additional paid
in capital and a reduction of mandatorily redeemable preferred stock.

Holders of Series E Preferred Stock are entitled to vote on all matters upon
which the holders of Common Stock  are entitled to vote.  In addition, holders
of Series E Preferred Stock affiliated with HMTF have the right to appoint one
representative to the Company's Board of Directors so long as they continue to
hold 40% of the Series E Preferred Stock originally purchased by them or the
underlying Common Stock into which such shares of Series E Preferred Stock are
convertible, or any combination of the two.  In March 2000, HMTF appointed
Michael J. Levitt, a partner of HMTF, to the Company's Board of Directors.

Upon a change of control of the Company, each holder of Series E Preferred Stock
may require the Company to purchase any or all of its shares of Series E
Preferred Stock at 101% of the liquidation preference, plus any accrued and
unpaid dividends to the date of purchase and the special dividend amount, if
any, as defined in the Series E Preferred Stock certificate of designation.  The
Series E Preferred Stock is subject to mandatory redemption on or after March
31, 2015.

In February and March 2000, the Company issued 3,000,000 shares of 6 3/4% Series
F Cumulative Convertible Preferred Stock (Series F Preferred Stock) to qualified
investors in a private placement.  The Company received approximately $291.0
million of net proceeds from the sale.  Each share of Series F Preferred Stock
is convertible into 2.35 shares of Common Stock at any time at a conversion
price of $42.56 per share, subject to adjustment.  Holders of Series F Preferred
Stock are entitled to dividends on a cumulative basis at an annual rate of 6
3/4%, payable quarterly in cash. The Company has the right to defer payment of
these dividends.  During 2000, the Company paid dividends totaling $10.1 million
and elected to defer dividends in the amount of $5.1 million.  The Series F
Preferred Stock is redeemable at the Company's option, in whole or in part, at
any time after March 6, 2003, at predetermined redemption prices, together with
any accrued and unpaid dividends through the date of redemption.  Upon a change
of control of the Company, each holder of Series F Preferred Stock may require
the Company to purchase any or all of its shares of Series F Preferred Stock
at 100% of the liquidation preference, plus any accrued and unpaid dividends to
the date of purchase.  The Series F Preferred Stock is subject to mandatory
redemption on March 3, 2012.  The holders of the Series F Preferred Stock have
limited voting rights.

                                      F-17
<PAGE>

7.  INVESTMENTS

On October 29, 1999, the Company completed a strategic investment in Axxent
Communications Inc. (Axxent), a provider of telecommunications services in
Canada.  In exchange for a $5.3 million cash investment, the Company received
warrants convertible into 763,680 shares of Class B non-voting stock in Axxent.
These warrants were converted in December 1999.  As part of this investment, the
Company received various rights, including the ability to appoint a
representative to Axxent's Board of Directors. This investment is classified as
an available-for-sale security and is carried at fair value, with the unrealized
gains and losses, net of tax, reported as a separate component of stockholders'
equity. At December 31, 2000, the investment balance was $0.6 million.

In January 2000, the Company formed a Canadian corporate joint venture, known as
Rhythms Canada, Inc. (Rhythms Canada) with Axxent Corp., a wholly-owned
subsidiary of Axxent, to offer DSL-based services in select Canadian markets.
The Company and Axxent Corp. each received 100,000 shares of Class A voting
stock of Rhythms Canada.  Axxent Corp. also purchased 10,000,000 shares of
Series A preferred stock with a  redemption amount of U.S. $1.00 per share for
$10.0 million.  The Series A preferred stock has no voting or conversion rights,
but will earn dividends at a rate of six percent per annum payable only upon
redemption. To the extent the joint venture is unable to receive sufficient
financing through third parties, the Company and Axxent shall have the option to
provide additional capital contributions through installments.  In December
2000, the Company and Axxent Corp. each made additional capital contributions of
$2.5 million (see Note 12).  At December 31, 2000, the investment balance in the
joint venture was $1.2 million.  Accounting for the joint venture is on the
equity method.

In April 2000, the Company entered into a multiyear strategic relationship with
Excite@Home (@Home).  @Home is a leading broadband provider.   On July 12, 2000,
the Company, through its wholly-owned subsidiary, RATHM, Inc., purchased 473,335
shares of Series B Preferred Stock of @Home Solutions (Solutions), an affiliate
of @Home, for $14,999,986.  The Series B Preferred Stock is convertible into
shares of common stock  of Solutions at a conversion price of $10.56 per share,
subject to standard protective conversion price adjustments.  In addition, the
Company is entitled to earn warrants to purchase up to 5,250,000 shares of
Solutions' common stock, over the next four years, based upon the number of
customers subscribing to Solutions' DSL at a price of $5.01 per share for the
first 3,000,000 warrant shares and $6.44 per share for the last 2,250,000
warrant shares (see Note 12). At December 31, 2000, the investment balance was
$14.4 million.  Accounting for this investment is on the equity method.

On June 28, 2000, the Company, through its wholly-owned subsidiary, RGarnet,
Inc. ("RGarnet"), formed a Japanese joint venture, Garnet Connections Planning
Inc. ("Garnet Connections"), with Mitsui & Co. Ltd. and certain other Japanese
partners to explore the deployment of DSL based services in Japan.  RGarnet owns
3,400 shares of common stock of Garnet Connections (representing 34.34% of the
total outstanding shares of Garnet Connections), for which it paid $1.6 million.
Accounting for the joint venture is on the equity method.  At December 31, 2000,
the investment balance was $1.5 million.

In September 2000, the Company entered into a strategic relationship with
FireTap, Inc. (FireTap), an affiliate of Homestore.com.  FireTap intends to
offer DSL, internet service provider (ISP) and other telecom services through
alliances with persons in the real estate industry and key technology providers.
As part of this transaction, the Company, through its wholly-owned subsidiary,
RHOMS, Inc., acquired three percent of the shares of FireTap's common stock (on
a fully-diluted basis) in exchange for certain past services and other non-cash
consideration.  The Company also received the right to acquire up to an
additional two percent of the shares of FireTap's common stock (on a fully-
diluted basis) in exchange for certain future services and other non-cash
consideration, including Catherine Hapka's (the Company's Chairman and CEO)
services as a director.  In addition, over the next six months, the Company has
the right to earn up to an additional 0.1% of the shares of FireTap's common
stock (on a fully-diluted basis) for every $1.0 million of investment accepted
by FireTap from an investor that the Company identifies, refers to or otherwise
introduces to FireTap (see Note 12).  At December 31, 2000, there was no
investment balance in FireTap.

                                      F-18
<PAGE>

In October 2000, the Company, through its wholly-owned subsidiary, Rhythms
Winfire, Inc. (f/k/a RWinfire, Inc.), purchased 2,659,575 shares of Series C
Convertible Participating Preferred Stock of Winfire, Inc. (Winfire) (a/k/a
Steel Enterprise Holdings, Inc.) for $5.0 million. Each share of Series C
Convertible Participating Preferred Stock is convertible into four shares of
Series A Common Stock of Winfire, subject to standard protective conversion
price adjustments. In addition, the Company entered into a one year strategic
relationship whereby, (a) the Company is Winfire's preferred data local exchange
carrier (DLEC) supplier of line shared DSL circuits and (b) Winfire agreed to
provide the Company with 30,000 line sharing circuit orders. (see Note 12). At
December 31, 2000, the investment balance was $4.7 million. Accounting for this
investment is on the equity method.

In December 2000, the Company, through its wholly-owned subsidiary, RMegaPath,
Inc., purchased 1,000,000 shares of Series D Preferred Stock of MegaPath
Networks Incorporated (MegaPath) for $2.5 million.  The Series D Preferred Stock
is convertible into shares of common stock of MegaPath at a conversion price of
$2.50 per share, subject to standard protective conversion price adjustments.
At December 31, 2000, the investment balance was $2.4 million.  Accounting for
this investment is on the equity method.

8.   STOCK OPTIONS, STOCK AWARDS AND WARRANTS

The Company has established the 1999 Stock Incentive Plan (the 1999 Plan) as the
successor equity incentive program to the 1997 Option/Stock Issuance Plan (the
1997 Plan). The 1999 Plan provides for the grant of options to employees,
directors and outside consultants for purchase of up to an aggregate of
17,173,530 shares of common stock.  All outstanding options under the 1997 Plan
were incorporated into the 1999 Plan, and no further options grants may be made
under the 1997 Plan. Options granted under the 1997 Plan are immediately
exercisable and expire within ten years after the date of grant. Shares acquired
upon exercise are subject to repurchase by the Company ratably over a four-year
period from the date of grant, at the option of the Company and at the exercise
price. Options granted under the 1999 Plan are exercisable ratably over a four-
year period from date of grant and expire within ten years of the date of the
grant. The 1999 Plan provides for both incentive option and non-statutory option
grants and for accelerated vesting in the event of a 50% or more change in
control of the Company.

The Plan activity is as follows:

<TABLE>
<CAPTION>
===============================================================================================
                                                                   Weighted        Weighted
                                                  Number of         Average         Average
                                                   Shares         Fair Value     Exercise Price
-----------------------------------------------------------------------------------------------
<S>                                             <C>             <C>             <C>
   Outstanding at December 31, 1997               5,481,256                         $      0.04

Granted, below market                             3,364,680         $   2.62        $      0.84
Exercised                                        (5,560,308)                               0.04
Canceled                                           (136,348)                               0.22
-----------------------------------------------------------------------------------------------
   Outstanding at December 31, 1998               3,149,280                         $      0.89

Granted, at market                                6,160,030         $  13.21        $     31.58
Granted, below market                             2,081,298             7.44               6.36
Exercised                                        (2,711,247)                               1.23
Canceled                                           (962,100)                              13.65
-----------------------------------------------------------------------------------------------
   Outstanding at December 31, 1999               7,717,261                         $     25.12

Granted, at market                                8,175,577         $  10.89        $     16.60
Granted, below market                                50,000            24.81              20.00
Exercised                                          (346,006)                               3.29
Canceled                                         (4,406,962)                              31.07
-----------------------------------------------------------------------------------------------
   Outstanding at December 31, 2000              11,189,870                         $     19.80
-----------------------------------------------------------------------------------------------
</TABLE>

                                      F-19
<PAGE>

The following summarizes the outstanding and exercisable options under the 1999
Plan at December 31, 2000:

<TABLE>
<CAPTION>
        =============================================================================================
                                          Options Outstanding                 Options Exercisable
                               -----------------------------------------   --------------------------
                                               Weighted       Weighted                       Weighted
                                               Average        Average                        Average
             Exercise             Shares      Remaining       Exercise        Shares         Exercise
              Price            Outstanding      Life           Price        Exercisable        Price
        ---------------------------------------------------------------------------------------------
        <S>                    <C>            <C>            <C>           <C>             <C>
        $0.21 to $0.25              88,490    7.51 years         $0.22           88,490         $0.22
        $1.09 to $1.88           1,226,810    9.70 years         $1.18          950,000         $1.09
        $2.50 to $8.63           1,892,194    9.14 years         $4.95                -             -
        $12.00 to $16.00         2,701,224    9.09 years        $14.23                -             -
        $18.00 to $29.19         2,117,415    9.14 years        $24.25                -             -
        $31.52 to $56.94         3,163,737    8.85 years        $38.19                -             -
        ---------------------------------------------------------------------------------------------
</TABLE>

In May 2000, the Company adopted its 2000 Stock Award Plan (the 2000 Plan), a
new incentive compensation program, providing for the direct award to employees,
at no cost, of up to 1,200,000 shares of Common Stock.  In July 2000, the
Company amended and restated the 2000 Stock Award Plan (the Amended Plan) to
increase (a) the maximum number of shares of Common Stock available for grant
under the Amended Plan by 1,800,000 shares, from 1,200,000 shares to 3,000,000
shares, and (b) increase the maximum number of stock award shares that may be
granted to any employee in any calendar year under the Amended Plan by 270,000
shares, from 30,000 shares to 300,000 shares.  On June 27, 2000, the Company
granted 417,850 shares of Common Stock under the 2000 Plan.  In July 2000, these
grants were cancelled and replaced by awards under the Amended Plan with
substantially the same terms.  The new grants vest in two tranches, with 50% at
various times beginning in November 2000 continuing through May 2001.  The
remaining 50% vest ratably over the subsequent four quarters.  As of December
31, 2000, the Company has awarded 3,172,245 shares under the 2000 Plan to more
than 700 employees.

The 2000 Stock Award Plan activity is as follows:

                                                                    Weighted
                                                   Number of         Average
                                                     Shares        Fair Value
        ---------------------------------------------------------------------
        Outstanding at December 31, 1999                   -       $        -
        Granted                                    3,172,245       $     7.13
        Vested                                      (677,527)      $     8.37
        Canceled                                    (366,892)      $     9.63
        ---------------------------------------------------------------------
        Outstanding at December 31, 2000           2,127,826       $     6.31
        ---------------------------------------------------------------------

During 1998, 1999, and 2000, options and awards were granted to employees at
less than fair value on the date of grant, resulting in $4.9 million, $11.4
million, and $23.5 million, respectively, of deferred compensation recorded as a
reduction of stockholders' equity. These amounts are being amortized as a charge
to selling, marketing, general and administrative expense over the vesting
periods of the applicable options and awards; such amortization totaled $0.7
million, $3.7 million and $11.7 million for the periods ended December 31, 1998,
1999, 2000, respectively.

Had compensation expense for the Company's option grants been determined based
on the fair value method of accounting for stock-based compensation, the
Company's net loss and net loss per share, basic and diluted, for the periods
ended December 31, 1998, 1999, and 2000 would have been increased by $60,000,
$10.8 million, and $12.5 million, and $0.02, $0.20, and $0.17, per share,
respectively. For purposes of determining this

                                      F-20
<PAGE>

compensation expense, the fair value of each option grant is estimated on the
grant date using the Black-Scholes option pricing model with the following
weighted average assumptions used for grants during the periods ended December
31, 1998, 1999, and 2000, respectively: no dividend yield; risk-free interest
rates of 4.9%, 5.5%, and 6.2%, respectively; expected volatility of nil for pre-
IPO grants; and 105% for post-IPO grants and expected term of four years for
common options.

The following summarizes the issued, outstanding, and exercised warrants at
December 31, 2000:

<TABLE>
<CAPTION>
======================================================================================================================
                                                   Number of
                                                   Original     Number of    Number of
                                                   Warrants     Warrants      Warrants    Exercise Price    Expiration
                                                    Issued      Exercised   Outstanding      Per Share         Date
----------------------------------------------------------------------------------------------------------------------
<S>                                                <C>          <C>         <C>           <C>               <C>
Warrants issued with 13 1/2% senior
   discount notes                                   4,732,800    4,701,973        30,827  $        0.004     May 2008
Warrants issued with Series C Preferred Stock       1,440,000            -     1,440,000            6.70    March 2004
Warrants issued with Series C Preferred Stock         136,996                    136,996           21.00    April 2004
Warrants issued with Series D Preferred Stock         180,000            -       180,000            6.70    April 2004
May 1998 warrants issued with lease agreement         574,380      337,707       236,673            1.85    March 2009
March 1999 warrants issued with lease agreement        45,498            -        45,498           10.55    March 2009
April 1999 warrants issued with lease agreement        75,000            -        75,000           10.55    April 2002
July 1999 warrants issued with lease agreement         10,000            -        10,000           50.00     July 2004
Warrants issued with Series E Preferred Stock       1,875,000            -                         45.00    March 2003
Warrants issued with Series E Preferred Stock       1,875,000            -                         50.00    March 2005
Warrants issued with Series E Preferred Stock       1,875,000            -                         55.00    March 2007
----------------------------------------------------------------------------------------------------------------------
</TABLE>


In August 1999, after a "net exercise" of the warrants associated with the 13
1/2% senior discount notes, 3,961,862 of these shares were sold and an
additional 740,111 shares were sold by the selling stockholders in November
1999. The Company received no proceeds from these sales.  The remaining warrants
have an expiration date of May 15, 2008. The warrants may be required to be
repurchased by the Company for cash upon the occurrence of a repurchase event,
such as a consolidation, merger, or sale of assets to another entity, as defined
in the provisions of the Warrant Agreement, at a price to be determined by an
independent financial expert selected by the Company. In the event a repurchase
event occurs, the difference between the repurchase price and the carrying value
of the warrants would be charged to equity.

During May 1998, the Company entered into a 36-month lease line that provides
for $24.5 million in equipment on an operating lease basis. In connection with
this lease agreement, the Company issued 574,380 warrants to purchase common
stock at a price of $1.85 per share, exercisable immediately. In March 1999, the
Company entered into additional 36-month lease lines for an aggregate of up to
$24.0 million in lease financing. In connection with these March 1999 lease
lines, the Company issued warrants to purchase an aggregate of 45,498 shares of
common stock at a price of $10.55 per share.  These warrants are immediately
exercisable. In April 1999, the Company entered into an agreement for up to
$20.0 million in equipment lease financing and issued a warrant to purchase up
to 75,000 shares of common stock at an exercise price per share of $10.55.  This
warrant is immediately exercisable.  In July 1999, the Company entered into an
additional 36-month lease line for an aggregate of up to $26.0 million in lease
financing to be used for equipment.  In connection with this July 1999 lease,
the Company issued a warrant to purchase 10,000 shares of common stock at a
price of $50.00 per share.  This warrant is immediately exercisable.

9.  INCOME TAXES

As of December 31, 1999 and December 31, 2000, the Company had net operating
loss carryforwards of approximately $210.2 million and $711.5 million,
respectively, which are available to offset future taxable income through 2020
for federal tax. A portion of these loss carryforwards will be subject to the
limitations of Internal Revenue Code Section 382 relating to changes in
ownership of the Company.  The deferred tax asset arising from the loss
carryforwards has been fully offset by a valuation allowance since the
utilization is

                                      F-21
<PAGE>

uncertain. The valuation allowance increased by approximately $13.9 million,
$84.0 million, and $212.7 million, during 1998, 1999, and 2000, respectively,
primarily as a result of the losses in each of these periods.

Components of deferred income taxes are as follows:

        =======================================================================
        (In thousands)                                    1999          2000
        -----------------------------------------------------------------------
        Deferred tax assets:
           Net operating loss carryforwards             $ 85,028      $ 277,494
           Original issue discount and other              13,885         34,129
        -----------------------------------------------------------------------
        Gross deferred tax asset                          98,913        311,623
        Valuation allowance                              (98,913)      (311,623)
        -----------------------------------------------------------------------
        Net deferred income taxes                       $    -        $     -
        -----------------------------------------------------------------------

The provision for (benefit from) income taxes reconciles to the statutory
federal tax rate as follows:

==============================================================================
                                                 1998        1999        2000
------------------------------------------------------------------------------
Statutory federal tax rate                      (34.0%)     (35.0%)     (35.0%)
State income tax, net of federal benefit         (5.4%)      (5.3%)      (3.9%)
Other (including non-deductible items)            0.9%        1.7%        1.0%
Deferred tax asset valuation allowance           38.5%       38.6%       37.9%
------------------------------------------------------------------------------
                                                   - %         - %         - %
------------------------------------------------------------------------------

10.  RELATED PARTY TRANSACTIONS

The Company's former in-house legal counsel is also a partner in a law firm used
externally by the Company. During 1998, 1999, and 2000, the Company incurred
legal fees and expenses of approximately $1.3 million, $2.4 million, and $4.7
million, respectively, to the external firm in addition to the salary paid to
the in-house counsel.  At December 31, 2000, the Company had a balance payable
of approximately $0.2 million to this entity.   In connection with the
termination of Mr. Blumenfeld's employment effective as of March 31, 2001, the
Company paid Mr. Blumenfeld $290,000, plus miscellaneous benefits.

Two members of the Company's Board of Directors serve as directors to Paradyne
Networks, Inc. a supplier of equipment to the Company. The total net purchases
during 1998, 1999, and 2000 from the equipment supplier were approximately $13.0
million, $54.0 million, and $4.4 million, respectively.  In addition, during
2000, the Company acquired additional equipment from this supplier of
approximately $18.6 million through vendor lease financing.  At December 31,
2000, the Company had a balance payable of approximately $4.8 million to this
entity.

One member of the Company's Board of Directors serves as President of WorldCom
Venture and a Senior Vice President of WorldCom. Total purchases from WorldCom
during 1998, 1999 and 2000 were approximately $0.4 million, $12.8 million, and
$46.3 million, respectively. In March 1999, the Company entered into a strategic
arrangement with WorldCom.  There was no revenue received from WorldCom in 1998
and 1999 under this arrangement.  The Company received $1.3 million in revenue
during 2000 under this arrangement.


11.  COMMITMENTS AND CONTINGENCIES

The Company leases office space and certain office equipment, telecommunications
equipment, network equipment and furniture under non-cancelable operating lease
agreements. The leases range in term from 24 months to 60 months and, in certain
instances, provide for options to extend.  Rent expense under the operating

                                      F-22
<PAGE>

leases for 1998, 1999, and 2000 totaled $2.0 million, $21.0 million, and $66.4
million, respectively. Future minimum rental payments under the leases are $98.1
million in 2001, $81.5 million in 2002, $42.3 million in 2003, $4.0 million in
2004, $2.9 million in 2005, and $7.6 million thereafter.

On January 31, 2001, GATX  notified the Company that an Event of Default had
occurred and is continuing for failure to satisfy the operating cash flow
covenants for the periods ending September 30, 2000 and December 31, 2000.  GATX
has reserved its rights related to a variety of remedies, including but not
limited to, equipment repossession and/or declaration of all sums immediately
due and payable.  The Company is in discussions with GATX about waiving or
curing such default.  Total remaining lease payments due under the GATX lease
were approximately $94.0 million at December 31, 2000.

Lafleur Litigation - On February 18, 1999, the Company filed a complaint for
declaratory relief in San Diego County Superior Court, North County against
Thomas R. Lafleur, seeking a determination as to the ownership of 438,115 shares
of the Company's stock option shares previously granted to him.  The trial in
this matter began on May 5, 2000.  On June 2, 2000, the court entered a
Stipulated Statement of Decision holding that Thomas R. Lafleur became fully
vested in ownership of the 438,115 shares of Common Stock in question on June 5,
1998.  On June 3, 2000, the Company entered into an Agreement of Settlement and
Compromise, pursuant to which the Lafleurs agreed to release and dismiss, with
prejudice, all of their claims against the Company and the Company agreed to
deliver 438,115 shares of treasury stock and to make a cash payment of $8.8
million to the Lafleurs.  In addition, the Company incurred legal fees relating
to this litigation totaling $3.1 million. The Company filed claims with its
insurance carriers seeking reimbursement for litigation and legal fees relating
to this case.  As of December 31, 2000, the Company had received $15.0 million,
subject to a reservation of right by the insurors. Furthermore, on November 14,
2000, Reliance Insurance Company (Reliance) filed a legal action in the Superior
Court of California, County of San Diego seeking declaratory relief and
restitution for the $5.0 million of insurance payments made by Reliance in
connection with the Lafleur litigation.  On January 5, 2001, the Company filed a
general denial of the Reliance claims and a cross complaint against Reliance,
Agricultural Excess and Surplus Insurance Company (AESIC), and Executive Risk
Specialty Insurance Company (Executive Risk) for declaratory relief.  The
Company intends to vigorously defend its claim to reimbursement of the
settlement and defense costs associated with the Lafleur litigation.

i2 Technologies, Inc., filed an action in the U.S. District Court in the
Northern District of Texas on January 7, 2000, challenging the Company's use of
the name "Rhythms" on various grounds and alleging that the Company' use of that
name infringes certain trademarks owned by i2 Technologies. The Company denied
that it infringed any legitimate trademark rights of i2 Technologies, in part on
the grounds that the Company has priority in the Rhythms name with respect to
the goods and services provided by it and that the Company's use of those marks
is not likely to cause confusion among the consumers of the Company's services,
and the services provided by i2 Technologies, respectively. On February 12, 2001
the Company and i2 agreed to dismiss their claims with prejudice, except for the
Company's claim for cancellation of certain i2 marks, which claim was dismissed
without prejudice.

Guild Litigation - On December 11, 2000, Guild Colorado, LLC filed an action in
the Texas State Court for Dallas County alleging that the Company breached a
construction contract.  The Company intends to vigorously defend these claims
and file counterclaims as appropriate.

Lacey Litigation - On January 22, 2001, John Lacy, a former Rhythms employee,
filed an action in the U.S. District Court for the District of Colorado alleging
breach of contract and demanding relief in the amount of $1.3 million.  The
Company intends to vigorously defend against this claim.

The Company does not believe the ultimate outcome of any of these legal cases
will have a material impact on the Company's financial position, results of
operations or cash flows.

                                     F-23
<PAGE>

In addition, the Company is subject to state commission, FCC and court decisions
as they relate to the interpretation and implementation of the 1996 Act, the
interpretation of CLEC interconnection agreements in general and its
interconnection agreements in particular.  In some cases, the Company may be
deemed to be bound by the results of ongoing proceedings of these bodies. The
Company therefore may participate in proceedings before these regulatory
agencies or judicial bodies that affect, and allow it to advance, its business
plans.


12.  SUBSEQUENT EVENTS

First quarter 2001 restructuring charge

In January 2001, as a result of its intention to focus on, and provide services
in, only its top 40 markets and in connection with its plans to reduce its
workforce by 450 employees, the Company announced its intent to take a one time,
2001 first quarter restructuring charge.

2001 Retention Program

In February 2001, the Company's Compensation Committee approved a key management
retention plan whereby key managers received cash and stock bonuses for
remaining with the Company for specified periods of time.

Winfire Agreement

In March 2001, the Company entered into an Assignment of DSL Lines and Mutual
Release with Steel Enterprise Holding, Inc. (f/k/a Winfire, Inc.) (SEH).
Pursuant to that agreement and in exchange for a mutual release by both parties
of any claims either may have against the other: (a) SEH agreed to assign to the
Company  all of its rights to the line shared DSL circuits installed by the
Company or ordered from the Company and not yet installed; and (b) the Company
agreed to convert approximately $1.0 million of accounts receivable that SEH
owed it as of February 28, 2001, and approximately $2.9 million in funds the
Company prepaid to SEH for marketing and development into 2,034,878 additional
shares of Series C Preferred Stock of SEH.  SEH is attempting to restructure its
balance sheet.  If it is unable to do so, it has advised the Company that it may
consider filing for protection under the federal bankruptcy laws.

Solutions

In March 2001, the Company's representatives resigned as directors of Solutions
and requested, on the Company's behalf, that Solutions redeem its shares of
Solutions Series B Preferred Stock for their liquidation value.  The Solutions
board of directors is currently soliciting the consents of the other Solutions
stockholders for such redemption.

Rhythms Canada.

In March 2001, the Company made an additional $2.7 million capital-call
contribution to Rhythms Canada and received 635,323 additional shares of Class A
voting stock of Rhythms Canada.


13.  QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

The following table sets forth certain unaudited consolidated statements of
income data for each of the Company's last eight quarters. This data has been
derived from unaudited consolidated financial statements that have been prepared
on the same basis as the annual audited consolidated financial statements,
except as discussed below, and, in the opinion of the Company, include all
adjustments (consisting only of normal recurring adjustments) necessary for a
fair presentation of such information. These unaudited quarterly results should
be read in conjunction with the

                                     F-24

<PAGE>

consolidated financial statements and notes. The consolidated results of
operations for any quarter are not necessarily indicative of the results for any
future period.

<TABLE>
<CAPTION>
                                                                                     Quarter Ended
-------------------------------------------------------------------------------------------------------------------------
(In thousands, except per share data)                           March 31         June 30       Sept. 30         Dec. 31
-------------------------------------------------------------------------------------------------------------------------
<S>                                                            <C>             <C>            <C>             <C>
1999:
Revenue                                                        $      660      $    1,641     $    3,317      $    5,471

Total costs and expenses                                       $   20,716      $   37,370     $   55,980      $   86,188

Loss from operations                                           $  (20,056)     $  (35,729)    $  (52,663)     $  (80,717)
Net loss                                                       $  (23,899)     $  (42,857)    $  (61,778)     $  (90,346)
-------------------------------------------------------------------------------------------------------------------------
Net loss per share (basic and diluted)                         $    (5.38)     $    (0.68)    $    (0.89)     $    (1.23)
-------------------------------------------------------------------------------------------------------------------------

2000:
Revenue, before impact of SAB 101 (a)                          $    8,137      $   12,172     $   17,199      $        -

Revenue, as restated for impact of SAB 101 (a)                 $    6,251      $    9,073     $   13,568      $   17,246

Total costs and expenses, before impact of SAB 101 (a)         $  112,314      $  132,805     $  150,573      $        -

Total costs and expenses, as restated for
    impact of SAB 101 (a)                                      $  110,428      $  129,706     $  146,942      $  163,424

Loss from operations                                           $ (104,177)     $ (120,633)    $ (133,374)     $ (146,178)

Net loss                                                       $ (118,031)     $ (139,657)    $ (147,619)     $ (162,857)

Preferred stock dividends and accretion (b)                    $    2,609      $   11,675     $   11,609      $   12,860

Loss available to common shareholders                          $ (120,640)     $ (151,332)    $ (159,228)     $ (136,964)
-------------------------------------------------------------------------------------------------------------------------

Net loss per share (basic and diluted)                         $    (1.63)     $    (2.00)    $    (2.07)     $    (2.25)
-------------------------------------------------------------------------------------------------------------------------
</TABLE>

(a)  As discussed in Note 1, the Company was required to adopt SAB 101 effective
     January 1, 2000. The first three quarters of 2000 have been restated to
     reflect the adoption of SAB 101.

(b)  At the November 2000 Emerging Issues Task Force meeting, the SEC indicated
     that registrants who had not applied the "accounting conversion price"
     method for accounting for beneficial conversion features in past filings
     for convertible securities issued after May 21, 1999, would be required to
     adopt this method via a cumulative catch-up adjustment in the fourth
     quarter of 2000.  The Company had one security that met this criteria, the
     Series E Preferred Stock.  Accordingly, the Company has adopted this method
     in the fourth quarter of 2000.  Under the "accounting conversion price
     method", the Company is required to use the accounting value assigned to
     the Series E Preferred Stock to determine an accounting conversion price.
     This price is then compared to the actual conversion price to determine if
     there is a beneficial conversion feature.  Using this method, the Company
     determined that there was a beneficial conversion feature associated with
     the Series E Preferred Stock which was assigned a value of $57.4 million.
     The Company has recorded this amount as a component of stockholders' equity
     and reduced the value of the Series E Preferred Stock accordingly.  The
     additional reduction in the value of the Series E Preferred Stock is being
     accreted similar to a dividend on preferred stock over the mandatory
     redemption period of the Series E Preferred Stock.  The cumulative catch-up
     impact of the adoption on the fourth quarter net loss available to common
     shareholders and net loss per share was $1.2 million and $.02 per share,
     respectively.

                                      F-25
<PAGE>

                       Report of Independent Accountants
                        on Financial Statement Schedule

To the Board of Directors of
Rhythms NetConnections Inc.

     Our audits of the consolidated financial statements referred to in our
report dated February 22,2001, except for Note 12, as to which the date is March
29, 2001, included in this Annual Report on Form 10-K also included an audit of
the financial statement schedule listed in the index in Item 14 of this Form 10-
K.  In our opinion, this financial statement schedule presents fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements.


PricewaterhouseCoopers LLP


Denver, Colorado
February 22, 2001

                                      F-26
<PAGE>

                       Valuation and Qualifying Accounts
                                (in thousands)
<TABLE>
<CAPTION>

-------------------------------------------------------------------------------------------------------------------------------
                                                   Balance at      Charged to Costs           Deductions/        Balance at End
                                                   Beginning         and Expense              Write-offs            of Period
                                                   of Period
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                <C>             <C>                      <C>                  <C>
Allowance for uncollectible trade receivables:
     Year ended December 31, 1997                  $        -      $              -         $          -         $           -
     Year ended December 31, 1998                  $        -      $             50         $          -         $          50
     Year ended December 31, 1999                  $       50      $            325         $         (8)        $         367
     Year ended December 31, 2000                  $      367      $          7,709         $     (2,476)        $       5,600
-------------------------------------------------------------------------------------------------------------------------------
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------------
                                                   Balance at      Charged to Costs           Deductions/        Balance at End
                                                   Beginning         and Expense              Write-offs            of Period
                                                   of Period
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                <C>             <C>                      <C>                  <C>
Valuation allowance for deferred tax assets:
     Year ended December 31, 1997                  $       -       $           (997)        $          -         $        (997)
     Year ended December 31, 1998                  $    (997)      $        (13,905)        $          -         $     (14,902)
     Year ended December 31, 1999                  $ (14,902)      $        (84,011)        $          -         $     (98,913)
     Year ended December 31, 2000                  $ (98,913)      $       (212,710)        $          -         $    (311,623)
-------------------------------------------------------------------------------------------------------------------------------
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------------
                                                   Balance at      Charged to Costs           Deductions/        Balance at End
                                                   Beginning         and Expense              Write-offs            of Period
                                                   of Period
-------------------------------------------------------------------------------------------------------------------------------
<S>                                                <C>             <C>                      <C>                  <C>
Valuation of Inventory:
     Year ended December 31, 1997                  $       -       $              -         $          -         $           -
     Year ended December 31, 1998                  $       -       $              -         $          -         $           -
     Year ended December 31, 1999                  $       -       $              -         $          -         $           -
     Year ended December 31, 2000                  $ 689,305       $     (1,675,000)        $          -         $    (985,695)
---------------------------------------------------------------------------------------------------------------------------------
</TABLE>

                                     F-27